Presented By: Prof A Venter CA(SA). Does the difference have a material impact on the profit of...

Presented By:Prof A Venter CA(SA)

Transfer Pricing Year Course

Lecture 13Comparability Analysis III

Adjustments

Does the difference have a material impact on the profit of loss?

Can the difference be quantified accurately to increase reliability?

Comparability AdjustmentsBASIC QUESTIONS

Adjustments based on:Commercial practicesEconomic PrinciplesStatistical Analysis

Comparability Adjustments

Comparability AdjustmentsAdjustment based on Commercial Practices

A: Clothing

Co

B: Buying Agent

B: compensated on a commission basis (standard industry

practice)5% plus 1% for every additional

services:product testing, vendor

qualification, freight consolidation (max 8%)

Comparability AdjustmentsAdjustment based on Commercial Practices

A: Clothing

Co

B: Buying Agent

B: NO VALUE ADDED SERVICES

5%

A: Clothing

Co

C: Controlled Buying Agent

C: 5% plus 1% for testing and 1% for

vendor qualification: 7%

Adjust B’s rate with 2%

Comparability AdjustmentsAdjustment based on Economic PrinciplesProfits Methods: controlled distributor lower

Inventory/Sales ratio than controlled ABest PLI: operating profit/salesAccount for differences in Inventory/Sales

ratio’s effect on PLI:Imputing interest to A for higher level of

inventory in excess of inventory carried by comparable

Basic Economic Principle: return on capital employed (including investment in inventory)

Circumstances the same as uncontrolled sales,

exceptDifferently configured

than radios in uncontrolled sales

Comparability AdjustmentsAdjustment based on Statistical Analysis

Need to know the estimated effect of the difference in configuration on the price

Determine what the price to uncontrolled buyer would have been if the radios had that specific configuration

Regression Analysis: formal statistical methodology frequently utilised in empirical economic analysis

B: Controlle

d

Sells radios in uncontrolled sales: 10

different featuresPrice depends on the features of the radio

A: Radio Manufacturer

Comparability AdjustmentsTYPES OF DIFFERENCES

Comparability factors: functions, risk, economic conditions, features of the product/services, contractual terms

Adjustment relevant to TP methodCUP: similarity of productRPM:

Inventory levelsTurnover ratesCost structuresBusiness experienceManagement efficiency

Comparability AdjustmentsTYPES OF DIFFERENCES

Cost Plus: Complexity of manufacturing and assemblyCost structuresBusiness experienceManagement efficiency

Profit Methods:Resources employedCost structuresBusiness experienceManagement eficiencyLevels of APLevels of AR

Comparability AdjustmentsTRANSACTION BASED METHODS

Compare price or gross marginNeed for adjustments:

Transaction based: higher level of comparability needed

Questions: How similar does it have to be? If not sufficiently similar, can adjustment for observed

difference be made? How is the adjustment made How much confidence can be placed in the

assumption that adjustments are accurate?


If a material difference is identified:Question: do you make the adjustment or use a more

forgiving method? General: more accurate method used –

expectation of higher sensitivity to comparability differences

There are often note enough information available to compare each comparability factor (almost always use imperfect info) – keep in mind when making decision on adjusting or using another method


Product Specific Factors

A: US distributor of washing machines

B: Related foreign

manufacturerHigh end models

HE label

Method: RPM(product nor similar enough to use CUP)

C: US Unrelated

manufacturerLow end modelsLE label

OTHER ISSUES….


Product Specific Factors: BUNDLING

Products are offered for sale with other products or services, to enhance competitiveness

Buyer may not want additional products or services, but buy package since the main product is sough after

Common techniques: support services, warranties, quality assurance

Must recognize the value of the additional products/services


Product Specific Factors (Bundling)

A: US distributor of washing machines

B: Related foreign

manufacturerHigh end models

HE label

C: US Unrelated

manufacturerLow end modelsLE label

Approach: - Use LE as benchmark for main product, find additional benchmarks for services - Warranty liability risk: justifies a higher return - Alternatively: base value of warranty on costs to perform service

Include warranty and service plan

Standard warranty provided by unrelated,

manufacturer

More complex if Intangibles are

involved….


Product Specific Factors : VOLUME DISCOUNTS

Reflect efficiencies realized by producers in selling large volumes – the cost saving is shares through volume discounts

Mainly the result of the allocation of fixed costsNB question: WOULD UNRELATED PARTIES

OFFER THE VOLUME DISCOUNT? (not always shared)

May use estimations: possible cost saving for a third party by extrapolation

Be careful: cost saving that give rise to discount may diminish at very large volumes


Product Specific Factors : PREPARATION

Packaging: distributors may purchase in bulk and package in-house to save the weight of transport costs

Price: recover packaging/finishing product for sale

Adjustments for packaging: RPM: value the product packaging function plus a GP mark-up (third party would require a profit on packaging services

Cost and mark-up on service (packaging)


Contractual Terms

Rights, privileges, and restrictions on entitiesOr allocation of transaction costsAdjustment: reallocation of costs to be similar

to what uncontrolled terms would beAllocation of risks: very difficult to estimateNB: delivery terms, payment terms,

exclusivity


Contractual Terms: DELIVERY

Differences in delivery may impact transportation, insurance, handling

Adjustment: measurement of delivery termsExample: Convert a FOB destination price to a

FOB origin priceFOB: US and other countries differing

interpretationsFOB: when risks and rewards of ownerships are

transferred from buyer to seller; AND who are responsible for what transport from that point onwards


Contractual Terms: Payment Terms

Time allowed for payment (can be that interest is charged beyond that pint in time or not)

Standard Industry PracticesAny delay in payment: as a finance cost and

credit risk for the seller – prompt payment discounts as incentives to be earlier

Adjustment: days difference x interest rateAlternative: adjustment of AR and AP (profit

methods)


Contractual Terms: Exclusive Condition

Common: Exclusive selling rights related to a geographical area; and exclusive licensing

Buyer would generally be willing to pay a higher price for exclusive selling rights or licensing


Market Factors: Market Level

Most challenging part of Comparability Adjustments

Base adjustment on economic principles or guidance by the law

Different levels in supply chainEach level adds value and increase the priceNot the same for all industries, products or

geographical locationsExample…

Comparability AdjustmentsTRANSACTION BASED METHODSMarket Factors: Level of Market

A: Distribution Company

B: Toy company selling o US

market

Adjustment: - Comparison: compare to same level in market - Each level increase the price to compensate for additional input by level owner

Operate manufacturing

facilities in China

Sell to retailers or smaller regional

wholesaler


Market Factors: Geographic Location

Foreign Exchange differencesProfit margin differences: different level of

competition or local business risk – lead to higher/lower profit

Shipping costs, government restrictions, border taxes, different supply and demand levels

Only transportation and transactions costs: quantify and adjust

Where the difference is due to supply and demand: more complex: look at income levels, preferences, levels of competition

Comparability AdjustmentsPROFITS METHODS

Background

Value of Inventory/Sales ratioAR/Sales rationAP/Sales ratioDifference: balance sheet difference between

tested party and comparable interpreted in reference to business “function” to which they correspond

Example: Seller: credit extension function is recorded under AR on balance sheet

Each function is valued based on rate of return on balance sheet amount associated with function


Background

Value: market interest rate (standard practice amoung analysts)

Assume everything else remain the same, and that the profit can be altered directly by the implied valuations\

Adjustment become less precise as magnitude and number of adjustments increase

NB: understand the facts and underlying pattern


BackgroundFactors to consider:

Comparability adjustment vs. selection criteria (goal is the fewest adjustments: rather better selection than more adjustments

Comparability Adjustments and PLI selection: use PLI denominator for adjustment

Functional vs. Efficiency Adjustments: Comparability adjustments reflect balance sheet or cost ratios,

interpreted as measures of the intensity of the functions performed

High level of AR: high intensity of credit extension Note: higher level of assets: not always due to higher intensity of

function – often a symptom of business problems (unplanned or unwanted levels of debtors or inventory not sold (slow-moving)

True higher intensity of function justifies return on investment


Inventory, AR and AP adjustmentsTNMM: frequently working capital adjustment

when tested party is a distributor or another type of seller

Two basic functions of a distributor is extension of credit and carrying inventory

“Intensity” of these functions: measured by assets/sales

Higher ratio = higher “intensity”Credit adjustments: credit extended (AR) and

credit received (AP)


Inventory, AR and AP adjustmentsMechanics:

Step 1: difference in ratio (between tested party and comparable) (ratio: balance sheet item/ denominator (PLI) normally sales, but can be operating expenses)

Step 2: Value: difference x interest rateStep 3: Value x net sales (comparable) to adjust

AFS figuresStep 4: PLI recomputed


Inventory

FORMULA

( (AINV/S)C – (AINV/S) TP ) x i x SC

• AINV = Average Inventories

• S = Net Sales• i = Interest Rate• C= items from

Comparable• TP= items from Tested

Party

Interpretation: - Positive value: value of additional inventory carrying function by comparable related t tested party - Negative value: Comparable did not perform this function/ less intense


Accounts Receivable

FORMULA

( (AAR/S)C – (AAR/S) TP ) x i/(1+i) x SC

• AAR = Average AR• S = Net Sales• i = Interest Rate

(diminished interest factor used in formula)

• C= items from Comparable

• TP= items from Tested Party

Interpretation: - Positive value: value of additional credit extension function by comparable related t tested party (decrease comparable’s net sales to compare)


Accounts Receivable

FORMULA

( (AAP/S)C – (AAP/S) TP ) x i/(1+i) x SC

• AAP = Average AP• S = Net Sales• i = Interest Rate

(diminished interest factor used in formula)

• C= items from Comparable

• TP= items from Tested Party

Interpretation: - Positive value: if the comparable did not perform this function, it could have accepted a lower price for its goods

Purpose: elimination of comparability differences

Example: similar transactions, but one bears a currency risk: make adjustments to eliminate the risk (add back the portion off the purchase price attributable to the bearing of the risk)

Differences usually due to: accounting inconsistencies, and differences in capital, assets, risk and functions.

When? If it will increase the reliability of the result, with regards to materiality, quality of information and purpose of the adjustment.

OECD: Comparability Adjustments

http://www.corbisimages.com/stock-photo/rights-managed/42-18073315/businesswomen-trying-to-get-block-into-round-hole

Indian cases: several decisions on comparability adjustments: reliability and purpose

Working Capital Adjustment: fairly common in practice – does not mean that it should be a routine adjustments or is mandatory (especially in TNMM):Focuses on time value of money and rectifies the

time gap from investing to collecting cash.Profit level indicator chosen should be the base

(assets, turnover or costs)

OECD:Comparability Adjustments


Comparability AdjustmentsWorking Capital Adjustment

Working Capital Adjustment Y1 Y2 Y3

TestCo: (Receivables + Inventory-Payables)/Sales

25.6% 25.8% 24.1%

CompCo:(Receivables + Inventory-Payables)/Sales

19.9% 20.6% 28.7%

Difference (D) 5.7% 5.1% -4.7%

Interest rate (i) 4.8% 5.4% 5.0%

Adjustment (D*i) 0.27% 0.28% -0.23%

Comp Co EBIT/SALES (%) 1.32% 2.96% 2.59%

Working Capital AdjustedEBIT/Sales for Comp Co

1.59% 3.24% 2.35%


Comparability AdjustmentsForeign Exchange Adjustments

One Comparability Factor: FOREX RISK (fluctuations in rates of exchange

Questions: which taxpayer bears the particular risk?

Example: S (in UK) sells to P (US) and the invoice/contract price is USD, then S bears the FOREX risk.

Risk allocation will be respected if:S has adequate financial capacity to bear risk (incl

hedging of all or part of the risk)Conduct of S and P are consistent with terms of contract

(contract price not adjusted to reflect exchange movements)


Transactional Exchange RiskComparability Adjustments frequently made for

transactional FOREX risk (due to fluctuations on Forex movement)

More general type of risk:Example: S & P: long term depreciation of the

dollar against EURO. S’s profit margin will shrink because cost in USD value increases.

Alternatively: S & P use a TP method to maintain target profit level of S: P’s profit margin will be affected (especially if P cannot pass on higher costs to customers due o competition (us competitors may buy in USD))


Economic substanceEconomic substance must be considered in

deciding who actually bears the FOREX riskExample: contractual terms may include a

mechanism to effectively split the effect of the FOREX movement; or allocating risk to one party by tying it to contract price

Example….


Economic substance

Bears the FOREX risk

In year under review: USD depreciated against the EURO: negatively affecting USSUB’s GP

TEST TP: uncontrolled UD distributors: RPM (no currency risk since they purchase and sell in USD)

USSUB results: should be measure over multi-year period to determine if a sufficiently higher return is experienced in other years to set-off current losses

CAPM: estimate return

US SUB:Exclusiv

e distributor in US

Price expressed in EURO

FP: UKManufactures

macinery

Comparability AdjustmentsCase Law

Volkswagen Argentina case (Case 26,991-I, 12 July 2010)Extraordinary occurrences: comparability

Axalto Cards case: (ITA No 4015/Del/2007, 3 February 2010)Comparability: exclusive distribution rights can’t be

quantified; different risk profiles; storageIndian case: ITA 2000 (no internal CUP, use profit

split)Indian case: ITA 712 (net profit excluding

reimbursements)Indian case: ITA5224 (Internal comparable)

Presented By: Prof A Venter CA(SA). Does the difference have a material impact on the profit of...

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