INTM467150 - Establishing the arm's length price: gathering your own evidence - Searching for comparables: range of results

Calculating an arm’s length price is not an exact science in the same way that pricing between independents is rarely predicated on exact science. While it is possible on occasion to fix an exact price, in the vast majority of cases any transfer pricing model will produce a range of possible results. You must use all available evidence to conclude what the arm’s length price would have been. Most cases will involve comparing either the gross margins, or more likely, the net margins of a number of comparable companies. If the results of the tested party fall within an acceptable range of arm’s length prices, then no adjustment should be made. If the results of the tested party fall outside an acceptable range you need to agree what adjustments should be made to replace the transfer price with the arm’s length price.

Read this page in conjunction with INTM463070.

Key issues to consider when faced with a wide range of arm’s length results

Generally there are two key issues to consider when looking at a range of results:

• How that range has been calculated (transfer pricing reports invariably use an interquartile range).
• Where in the range the arm’s length price should fall?

Often transfer pricing reports will contain a lot of comparable companies, and the range of comparable results can be quite large. You should always consider all of the facts and circumstances to make an informed judgement on where in a range a tested party would be at arm’s length.

One of the most important tasks in putting forward your calculations and transfer pricing model is being able to demonstrate that the range of results should be as narrow as possible to reflect the fact that functionally similar companies which are accurately comparable are likely to have similar results.

A possible outcome would be along the lines of the illustration below. In this case the Officer has demonstrated that the range of arm’s length prices is between 5% and 8%, rather than 2% and 8%. He has also put forward a case for setting the transfer price at the upper end of the revised range.

Range put forward by taxpayer
				Arm’s length range
0%											10%
	Operating profit rate set at this price
Range put forward by HMRC
						Arm’s length
							range
					5%				8%
0%											10%
	Operating profit rate set at this price

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How many comparable companies should there be?

There is no set number of comparables that is necessary. The number will depend on the particular facts of the case you are enquiring into. You should not include comparable companies just to increase the size of your model. From the outset your task is to look for accurate comparables and to construct a model based on those companies.

OECD Transfer Pricing Guidelines say nothing about producing a set of comparables that will be statistically valid. The Guidelines are concerned with establishing that the companies chosen are truly comparable. It does not matter if you can only find one company that is carrying on virtually the same activities as your company, dealing in the same type of products, in similar quantities, to the same type of market. There are no minimum figures. A range of results from two good comparables is much better than a range encompassing two good and twelve mediocre comparables.

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The use of an interquartile range

A transfer pricing report will invariably produce a number of comparable companies. The results are often summarised as an interquartile range. An interquartile range discards the results of the bottom quarter and top quarter of the results. The median is the mid-point of the interquartile range. The median will generally produce a different result to the average of the range being considered.

Consider the following examples:

Example 1

In this study there are eight comparable companies and the results have been listed in ascending order. The top two and bottom two results are discarded to give the interquartile range, which shows operating profit rates from 3.3% to 6.3%. The mid-point, or median of the interquartile range is 4.8%. The average for the whole range is 4.8%, whereas the average for the interquartile range is 5.0%.

Example 2

In this study there are ten comparable companies and again the results have been listed in ascending order. The top quarter and bottom quarter results need to be discounted to get the interquartile range. However with ten results, you cannot discard whole numbers of results at the bottom and top of the range. Instead the bottom of the interquartile range is the average of company 2 and 3 results and the top of the interquartile range is the average of company 8 and 9’s results. The mid-point or median of the interquartile range is 4.7%. The average of both the whole range and the interquartile range is 4.9%.

That is how an interquartile range is calculated. The question is, should you accept the use of an interquartile range? In a case where all the comparables being used are more or less equally valid, and there is no reason why your company is any better performance wise than those comparables companies, then there is probably nothing wrong with using the interquartile range.

There is nothing in either TIOPA10/Part 4 or the OECD Transfer Pricing Guidelines that say you must use an interquartile range, although paragraph 3.57 of the 2010 OECD Transfer Pricing Guidelines states that the use of an interquartile range may enhance the reliability of a range in which non-quantifiable comparability defects remain as a result of the limitations in available information on the comparables used. A potential problem with using the interquartile range is the discarding of more accurate comparables which fall within the full range but outside of the inter-quartile range. It is therefore important to carry out as robust a comparability analysis as is reasonably possible in arriving at the arm’s length range from which the inter-quartile range is derived.

If you are satisfied that the comparables are all highly reliable, then there is no need to restrict yourself to using an interquartile range. The task is to find the accurate comparables.

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Factors to take into account when trying to narrow the range

To narrow the range of results you have to consider the comparable companies put forward very carefully. This involves looking at the available information about the comparable companies, in particular what they say about themselves on their own web-sites. Think about the following points

• Should any of the companies obviously be excluded? Are there any companies which should be included? This will involve you carrying out your own search of commercial databases. Companies do get missed out.
• Is there a subset of comparables within the larger range? For example, consider a company carrying out contract R & D in the field of computer software. You may find that the transfer pricing report contains 16 comparable companies carrying out contract R & D in the computer field (ranging from hardware, operating systems, communications, switching and software), but that there are 3 companies involved in just software R & D. Why not use just those 3 companies as a starting point? These companies should in theory be more comparable to the tested party.

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Deciding where, within a range of results, the transfer price should be set

The OECD Transfer Pricing Guidelines say that if the results of the tested party fall within the arm’s length range of results (or the inter-quartile range where this is used to enhance the reliability), then no adjustment should be made. If they fall outside that range then you need to view where in the range the transfer price should be set.

The reliability of the comparability analysis should be taken into account in deciding where, in a range, the transfer price should be set. If all points in the range are considered highly reliable, it could be argued that any point in the range satisfies the arm’s length principle. However, if unidentifiable or unquantifiable comparability defects remain (for example, due to limitations in information available on the comparable transactions) the use of measures of central tendency such as the median, mean or weighted average etc may be useful in deciding where to set the transfer price. In all cases, selecting the appropriate measure of central tendency maximises the likelihood that the adjusted price falls within the true arm’s length range. You should always look at a tested party in the round and exercise judgement and common sense to decide what its results would be if it were independent. It might be that a well-run company, efficient and competitive, would profit more that one where the opposite was true. On other occasions, these factors might not materially affect profit in a commercial world. A company which is inefficient might still have a product that is profitable.

If a company pays for expert services (either performing them directly or buying them in from a third party or an affiliate) an independent company would expect a return on top of any expense. If you conclude that this applies in a particular enquiry, then this would allow a judgement to be made about whether the company would have shown more or less profit than a comparable independent.