TRANSFER PRICING CASE STUDIES

WORKSHOP

SAN JOSE

31 MARCH - 4 APRIL 2014

3-c. Comparability

1

OECD freely authorises the use of this material for non-commercial purposes. All requests for commercial uses of this material or for translation rights should be submitted to rights@oecd.org.The opinions expressed and arguments employed herein are those of the author and do not necessarily reflect the official views of the OECD or of the governments of its member countries.

1995 TP Guidelines 2010 Version

Chapter I: The arm’s length principle and comparability

Chapter I: The arm’s length principle and the fundamentals of comparability

Chapter II: Traditional transaction methods

Chapter II: Transfer pricing methods:

-Part I: Selection of the method

- Part II: Traditional transaction methods

- Part III: Transactional profit methods

Chapter III: Other methods: transactional profit methods

Chapter III: Comparability analysis

2

Reorganization of Chapters I-III:

¶¶ 3.2-3.3 • Most reliable comparables in the

circumstances of the case, keeping in mind the limitations in availability of information and that searches for comparables data can be burdensome

• No requirement for an exhaustive search of all possible sources of comparables/ all methods

3

The notion of “reliable comparables”

Comparability Analysis

1. Characteristics of property or service

2. Functional analysis

3. Contractual terms

4. Economic circumstances

5. Business strategies

4

• The 5 Comparability Factors(para. 1.38 – 1.63 OECD Guidelines)

Note: For any substantial differences between the compared transactions or enterprises appropriate comparability adjustments need to be made!

¶¶1.33; 3.27-3.38• Comparable:

– Between one party to the controlled transaction and a non-associated party (“internal comparable”)

– Between two independent enterprises, neither of which is a party to the controlled transaction (“external comparable”).

5

Internal and external comparables

¶¶1.33; 3.24-3.54• A « comparable » is:

– An uncontrolled transaction (not between associated enterprises);

– None of the differences could materially affect the conditions (price or margin), or

– Reasonably accurate adjustments (“comparability adjustments”) can be made to eliminate the effects of such differences

6

Internal and external comparables

¶¶1.33; 3.27-3.28• Internal comparables can:

– Be easier to find and more reliable; – Be more complete and less costly to

document• This is not always the case there is

no hierarchy between internal and external comparables

• But where internal comparables are reasonably reliable no need to make a database search

7

Internal and external comparables

8

Internal Comparables

A. China(related distributor)

A. China(related distributor)

Controlled Transaction

Potential Internal Comparable

A. Japan(Manufacturer

)

A. Japan(Manufacturer

)

A. Japan(Manufacturer

)

A. Japan(Manufacturer

)

Example 1: Contract manufacturing case study

• For the purposes of evaluating transactions (sales or services) with related parties, a potential internal comparable would exist if the taxpayer (tested party) sells the same of similar products or provides the same or similar services under comparable conditions to unrelated (independent) parties.

ControlledTransaction

UncontrolledUncontrolledTransactionTransaction

(arm’s length price)(arm’s length price)

XYZ India(IndependentDistributor)

XYZ India(IndependentDistributor)

Internal Comparables

Evaluation of potential internal comparables

Controlled transaction

(A. Japan to A. China)

Uncontrolled transaction

(A. Japan to XYZ India)

Adjust ?

+ or -

1 Revenue ($) 70 million 30 million

2 Sales Volume (# units) 100 million 36 million

3 Product Quality / Specification A. standard Customized for XYZ

4 Terms of Sale Ex-Factory CIF

5 Terms of Payment Net 30 days Net 120 days

6 Sales Costs

Significant marketing

expenditure by A. China

Limited expenditure by XYZ India

7 Brands Own brand Private Label

8 Market Asia EMEA9

Segmented Financials

ItemsOverall

BusinessRelated Party

Business/SalesThird Party

Business/Sales

Net Sales 144,044 100,000 44,044 Cost of Goods Sold (128,368) (92,000) (36,368)Gross Profit 15,676 8,000 7,676 Sales, General & Administrative Expenses

(7,273) (3,000) (4,273)

Operating Income 8,403 5,000 3,403 Total Cost (135,641) (95,000) (40,641)

Gross Profit Margin 10.88% 8.00% 17.43%Return on Sales 5.83% 5.00% 7.73%Operating Income/Total Cost

6.20% 5.26% 8.37%10

US$ ’000 Overall Financials

Internal ComparablesExample 2: Distribution Company A.

Internal ComparablesEvaluation of potential internal comparables

Related Party Business- Export -

3rd Party Business - Domestic Sales -

1 Product LCD LCD

2 Markets Asia India

3 Sales Revenue 100 million 44 million

4 Sales Volume (# units) 80 million 25 million

5 R&D Conducted by parent Local customization

6 Technology/Intangibles All provided by parent Limited local intangibles

7 Packaging/Labelling Provided by parent Local

8 Price Negotiation No Yes

9 Marketing No Yes

10 Sales & Distribution No Yes

11 Warehousing/Logistics Raw materials Raw materials/finished goods

12 After Sales Services No Yes

13 Royalties No Yes, 5% on 3rd party sales

14 Market Risk Minor Full

15 Inventory Risk Raw materials Raw materials/finished goods

16 Credit Risk Minor Full11

Conclusion?

12

External Comparables

• For the purposes of evaluating transactions (sales or services) with related parties, a potential external comparable would exist if (unrelated) third parties perform similar functions and sell the same or similar products or provide the same or similar services to unrelated parties under similar conditions.

• Problem: rarely do we find external “comparables” (except commodities, financial products)

External Comparables

13

• Search process for external comparables―Selection of Industry – Electronics Manufacturing

―Selection of Region

―Number of companies under the selected industry/region

―Number of controlled companies excluded, i.e., 50% or above owned by another company

―Number of companies excluded for insufficient data

―Number of companies excluded for sustained operating losses

―Number of companies excluded for incomparable functions, e.g., significant R&D, marketing, distribution, services, etc.

―Refined comparable set

―Should loss companies be removed?

¶ 3.4 1. Determination of years to be covered2. Broad-based analysis of the taxpayer’s circumstances3. Understanding the controlled transaction(s) under

examination, based in particular on a functional analysis, in order to choose the tested party (where needed), the most appropriate transfer pricing method to the circumstances of the case, the financial indicator that will be tested (in the case of a transactional profit method), and to identify the significant comparability factors that should be taken into account

4. Review of existing internal comparables, if any5. Determination of available sources of information on

external comparables where such external comparables are needed and the sources’ reliability 14

Typical 9- step process

¶ 3.4 6. Selection of the most appropriate transfer pricing

method and, depending on the method, determination of the relevant financial indicator (e.g. determination of the relevant net profit indicator in case of a transactional net margin method)

7. Identification of potential comparables: determining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable, based on the relevant factors identified in Step 3 and in accordance with the comparability factors

8. Determination of and making comparability adjustments where appropriate

9. Interpretation and use of data collected, determination of the arm’s length remuneration

15

Typical 9- step process

¶¶ 3.9-3.12 • Ideally, to arrive at the most precise approximation of

fair market value, the arm’s length principle should be applied on a transaction-by-transaction basis

• However, there are often situations where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis

• For instance, pricing a range of closely-linked products (e.g. in a product line)

• Portfolio approach business strategy consisting in bundling certain transactions for the purpose of determining or testing transfer price

• For instance: printers and cartridges, vending coffee machines and coffee capsules

16

Evaluation of a taxpayer’s separate and combined transactions

¶¶ 3.18-3.19

• The choice of the tested party should be consistent with the functional analysis of the transaction;

• The party to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, – It will most often be the one that has

the less complex functional analysis

17

Choice of the tested party

¶¶ 3.21-3.23 • One-sided methods (cost plus, resale

price or TNMM) require:– Qualitative information on the

comparability factors of both parties to the controlled transaction

– Financial information on the tested party (whether domestic or foreign)

• Two-sided methods (profit split method):– Financial information on all the parties to

the transactions

18

Information on the foreign associated enterprise

¶ 3.35• Non-domestic comparables should not

be automatically rejected ;• Examine whether non-domestic

comparables are reasonably reliable on a case-by-case basis: – Five comparability factors– Careful consideration of market

differences and accounting standards, and of whether reasonably reliable comparability adjustments can be made where needed

19

Foreign comparables

¶ 3.36

• It would be unfair to apply a transfer pricing method on the basis of such data unless the tax administration was able, within the limits of its domestic confidentiality requirements, to disclose such data to the taxpayer so that there would be an adequate opportunity for the taxpayer to defend its own position and to safeguard effective judicial control by the courts.

20

Secret comparables

¶¶ 1.37; 3.38-3.39

• Assess the relative importance of missing information before rejecting a potential “comparable”

• A pragmatic solution may need to be found on a case-by-case basis

21

Limitations in available comparables

¶¶ 3.47-3.54 + Annex• Not automatic: whether comparability

adjustments should be performed in a particular case is a matter of judgement that should be evaluated in light of the discussion of costs and compliance burden

• Comparability adjustments should be envisaged where (and only where) they can be expected to increase the reliability of the results

• Are the comparables data of sufficient quality to warrant comparability adjustments? Adjustments should not be made to create the wrong impression that the outcome is “scientific”

22

Comparability adjustments

¶¶ 3.47-3.54 + Annex• Too many adjustments or adjustments that greatly

affect the outcome may indicate that the third party transactions being adjusted is in fact not sufficiently comparable

• On the other hand, comparability adjustments do not need to be, and in fact should not be, performed to correct differences that have no material effect on the comparison

• Avoid automatic or « routine » adjustments• Comparability adjustments need to be documented

(reasons for adjustment/how?)• Example of a working capital adjustment provided in

Annex

23

Comparability adjustments

24

¶¶ 3.55-3.62• In some cases it will be possible to arrive at a single

figure (e.g. price or margin)• In most cases: arm’s length range where all figures

are relatively equally reliable• Where it is possible to determine that some

uncontrolled transactions have a lesser degree of comparability than others they should be eliminated.

• If comparability defects remain that cannot be identified and/or quantified, and are therefore not adjusted use of statistical tools that take account of central tendency might help to enhance the reliability of the analysis

25

Arm’s length range and statistical tools

¶¶ 3.55-3.62• If the relevant conditions of the controlled

transaction (e.g. price or margin) are within the arm’s length range no adjustment should be made

• If the relevant conditions of the controlled transaction (e.g. price or margin) fall outside the arm’s length range asserted by the tax administration the taxpayer should have the opportunity to present arguments that the conditions of the transaction satisfy the arm’s length principle, and that the arm’s length range includes their results.

26

Arm’s length range and statistical tools

Adjustment to a point in the range: ¶¶ 3.55-3.62• Point within the range that best reflects the facts

and circumstances of the particular controlled transaction

• Where the range comprises results of relatively equal and high reliability any point in the range satisfies the arm’s length principle.

• Where comparability defects remain use measures of central tendency (for instance the median, the mean or weighted averages, etc.) to minimise the risk of error due to unknown or unquantifiable remaining comparability defects.

27

Arm’s length range and statistical tools

¶¶ 3.63-3.66

• Not systematically rejected; no systematic interquartile range in the OECD TP Guidelines

• But are they truly comparable to the tested party? (risk profile in particular)

28

Loss-making comparables

¶¶ 1.70-1.72 and ¶ 3.64

• Associated enterprises, as independent ones, may be loss-making due for instance to start-up costs, unfavourable economic circumstances, commercial or industrial inefficiencies, etc.

29

Loss-making comparables

¶¶ 1.70-1.72 and ¶ 3.64

• However, an independent enterprise would not continue loss-making activities unless it has reasonable expectation of future profits.

Consistency with the functional and risk profile of the enterprise

30

Loss-making enterprises

¶¶ 1.70-1.72 and ¶ 3.64

• Furthermore, an independent enterprise would not remain loss-making indefinitely.

Where an associated enterprise remains loss-making over several years: is it providing a service to the group by maintaining a commercial presence?

31

Loss-Making Distributors

¶¶ 3.67-3.79

• Contemporaneous uncontrolled transactions are preferred (although availability of information may be limited in practice); otherwise, past information can be used as long as it is adjusted to account in case economic circumstances are significantly different

32

Timing issues

Questions and/or comments?