Comparability in transfer pricing

A comparability analysis is an essential part of a transfer pricing analysis. In a transfer pricing analysis, a taxpayer seeks to determine for tax purposes the transfer pricing (i.e., price charged in the transactions between related parties) in accordance with the arm’s length principle based upon information reasonably available upon determination. In 1995, the Organization for Economic Cooperation and Development published the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘OECD Guidelines’). Transfer pricing regulations issued by different countries have been based mainly on the OECD Guidelines. Under the OECD Guidelines, the application of the arm’s length principle is generally based on a comparison of the conditions in a related-party transaction with the conditions in independent transactions (i.e., transactions between unrelated enterprises) [Paragraphs, 1.15 and 5.3]. Hence, the comparability analysis is an essential part of a transfer pricing analysis. 

 For the comparisons to be useful, the economically relevant characteristics of the situations being compared must be sufficiently comparable. To be comparable means that:

• none of the differences (if any) between the situations being compared could materially affect the condition being examined (i.e., the price or margin); or

• reasonably accurate adjustments can be made to eliminate the effect of any such differences (Ibid., Paragraph 1.15). 

To establish the degree of actual comparability, it is necessary to compare the attributes of the transactions or enterprises that may affect conditions in arm’s-length dealings. The OECD Guidelines provides five factors for determining comparability (Paragraph 1.17).  

The first factor is the characteristics of the property or services. Differences in the specific characteristics of property or services account for differences in their value in the open market. For example, a mobile phone with more features will command a higher selling price than a more basic phone. Hence, comparisons of the specific characteristics of the property or services may be useful in determining comparability. The OECD Guidelines provides the following considerations in doing comparability analysis:

• For transfers of tangible property: the physical features of the property, its quality and reliability, and the availability and volume of supply;

• For the sale of services: the nature and extent of the services; and

• For intangible property: the form of the transaction (e.g., whether licensing or sale), the type of property (e.g., patent, trademark, or know-how), the duration and degree of protection, and the anticipated benefits from the use of the property (Paragraph 1.19).

The second factor of comparability is the functional analysis. We compare the functions performed by the parties in the related-party transactions and independent transactions. For instance, we determine which party does the design, manufacturing, assembling, and the research and development. The comparison is based on a functional analysis, which seeks to identify and compare the economically significant activities and responsibilities undertaken by independent and related enterprises. The reason for this is that in independent transactions, compensation usually will reflect the functions that each enterprise performs, taking into account assets used and risks assumed. However, the functions that need to be compared should be those with economic significance in terms of their frequency, nature, and value to the parties to the transactions. It will also be relevant and useful to compare the assets employed (e.g., plant and equipment, use of intangibles) and the risks assumed (e.g., credit risk, foreign exchange risk) by the parties in the independent and related-party transactions. In the open market, the assumption of increased risk will also be compensated by an increase in the expected return (OECD Guidelines, Paragraphs 1.20 to 1.23.).

The third factor of comparability is the contractual terms of the transactions. In arm’s length dealings, the contractual terms of a transaction generally define how the responsibilities, risks and benefits are to be divided between the parties. The divergence of interests between the independent parties ensures that they will ordinarily seek to hold each other to the terms of the contract. The same divergence of interests may not exist in the case of related parties. It is, therefore, important to examine whether or not the conduct of the related parties conforms to the contractual terms or if their conduct indicates that the contractual terms have not been followed (Ibid., Paragraphs 1.28 to 1.29). 

The fourth factor will be the economic circumstances. The markets in which the independent and related parties operate should be comparable. Economic circumstances that may be relevant in determining market comparability include geographic location; size of the markets; extent of competition in the markets and relative competitive positions of the buyers and sellers; availability of substitute goods/services; and level of supply and demand (Ibid., Paragraph 1.30).

The fifth factor is business strategies. These business strategies take into account many aspects of an enterprise. These could also include market penetration schemes. A taxpayer seeking to penetrate a market or increase its market share might temporarily charge a price for its product that is lower than the price charged for otherwise comparable products in the same market. In the alternative, the taxpayer may temporarily incur higher costs. In either case, the taxpayer may likely achieve lower profit levels than other taxpayers operating in the same market (Ibid., Paragraph 1.32).

In practice, the search for comparables requires the transfer pricing analyst to use public databases that contain financial data and other information of companies. Examples of these databases are Osiris, OneSource, and LexisNexis. 

But before the analyst starts the comparable search, he should develop a search strategy that will achieve comparability. The search strategy should consider a number of criteria that a “comparable” should meet. The analyst will have to reject the companies that do not meet any one of the criteria. The criteria could include geographic scope, availability of financial data, screening for active companies, and independence requirements. On the matter of geographic scope, a question could be — should the analyst consider only companies originating from the country of the related party being tested? The answer may have to depend on the preference of the tax authority concerned. The screening for active companies aims to exclude non-operating companies. As for the requirement that the proposed “comparable” be independent, the OECD Guidelines do not provide for any guidance on this. The issue may have to be addressed eventually by the tax authority concerned. Of course, one criterion that should always be included in the search strategy is the similarity of the activities/functions of a comparable with those of the related party being tested. 

For the Philippines, in the absence of transfer pricing regulations, it is still unclear what search strategy or criteria will be acceptable to the Bureau of Internal Revenue (BIR). However, the BIR has already drafted the transfer pricing regulations. Transfer pricing practitioners may find themselves anticipating how the BIR handles this matter. 

Notwithstanding, transfer pricing analysts and taxpayers should bear in mind that transfer pricing is not an exact science. More often than not, it requires the exercise of judgment. Even the OECD Guidelines have recognized this (Paragraph 1.12).

(Maria Carmela M. Peralta is a Director for Tax and Corporate Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. Carmela is presently seconded to KPMG Singapore specializing in Transfer Pricing. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email [email protected] or [email protected]).