The Problem With Price Comparison
10 September 2012
Posted by: Author: Karen Miller
The Problem With Price Comparison
Transfer pricing relies on the application of the arm’s length principle. In broad terms, this is applied by testing the pricing policy used for transactions between associated enterprises1 against the pricing policy between unrelated third parties.Where the taxpayer enters into substantively similar transactions between associated enterprises and unrelated entities, it can be possible to directly compare the prices applied(provided all the comparability criteria are met); however, this is very rare and the incidence of using this basis of comparability is low.
In the majority of cases taxpayer are left relying on the use of external databases such as Bureau van Dyk’s product, One Source.These are databases containing financial and non-financial data of companies which have a regulatory requirement to submit financial accounts.Once the financial accounts become public, the information can be sourced and collated onto the database.Coupled with this are broad company descriptions enabling comparative search criteria to be used in selecting the comparable companies to be used to support the pricing policy.
It is understandable why a comparison of the actual pricing policy is problematic.The OECD2 provides for the most appropriate method to be used to support a pricing policy. The methods endorsed are:
• Comparable uncontrolled price method (CUP)
• Resale price (margin) method (RPM)
• Cost plus method (CPM)
• Transactional net margin method (TNMM)
• Transactional profit split method (TPSM).
Of the above, only the CUP method seeks to compare the actual price charged.The remaining methods are generally outcome testing methods in that they seek to compare the profit achieved as a result of the policy.The two traditional transactional profit methods, being the CPM and the RPM, are often used to set prices in that they apply a profit mark up, or a profit discount to a cost base or price.The remaining two are pure profit methods, the TNMM being favoured the world over by revenue authorities as it has the most direct bearing on the tax take.
The problem is that all the above methods are transactional.That is they are applied to a specific transaction.The comparable data obtained from a database are entity outcome results.Therein lies the first challenge.Is it correct to compare the outcome of one single transaction in a business with the overall profit of a company? Perhaps there is argument that this can be done at a gross margin level where company data is segmented into business units, but even then there is some doubt? Certainly at the operating level this is problematic.
A company may have a number of profit drivers all impacting the mix and thus the overall profit.For instance, take the example of auto motives, one which revenue authorities around the world love to audit.Typically a motor manufacturer in a group in a certain jurisdiction will manufacture only one or two types of vehicles.The portfolio for the dealers is then complemented by fully imported units.Thus the profitability of the company is driven by a mix of manufactured products as well as imported products that are subsequently distributed.The revenue authority would look at this as two separate business lines and judge the profitability of each against independent companies operating firstly as manufacturers and secondly as distributors in the same industry.
An independent company, however, is not likely to operate in this way.It would not have to consider both sides of its business and vehicle mix as it is only concerned with one part of the business.To compare the net trading profit of the associated enterprise operating across both businesses with an independent company only operating in one business is likely to lead to absurd outcomes.
So how is this resolved? The OECD does accept the need for aggregation across business sectors were this can be commercially supported.But practically how is this achieved? Should the associated enterprise use a combination of distribution and manufacturing data? Does the OECD’s view on aggregation actually extend to the aggregation across functional activities?
The other key problem is that in comparing an associated enterprise’s outcome from a specific transaction with independent company data does not always account for variances in risk profiles.For instance, the associated enterprise may operate as a low-risk contract manufacturer for a group company.To compare this to a company which is truly independent could yield inappropriate results. Contract manufacturers do exist but rarely are they remunerated in the same way as an associated enterprise contract manufacturer.The independent will still seek to gain a return on its assets and costs and will be affected by market influences.A group contract manufacturer is often rewarded on a guaranteed basis which means it is completely sheltered from external influences.Thus the comparison is flawed.
There are a number of proposed adjustments which can be used to account for such variances in risk. Working capital adjustments are common.These seek to adjust for the cost of carrying inventory risk,debtor risk and creditor risk and require an adjustment to the comparable data set to match the working capital position of the taxpayer.This typically results in a reduced profit range in the comparables as a result of eliminating the impact of these risks.
Other adjustment mechanisms have been tabled,such as regression analysis to adjust an entity which bears risk to one which does not; and capital asset pricing adjustments to take into account the impact on profits of market variances between an entity directly affected by movements in the market, and one sheltered from the impact by means of the intra-group pricing policy.
All the above provide some improved level of comparability when using the results of an entity to test the outcome of a specific transaction undertaken between associated enterprises.The real issue for developing countries, such as those in Africa, seeking to implement comprehensive transfer pricing, is the lack of comparable financial information of companies within the region.The above adjustments make sense only when one is at least starting with comparable data from the same country or geographical region.In some areas we have seen the use of country risk adjustments to account for these market variances.This approach can work but as it relies on the CPI and bond yield rates for countries, it is not always applicable to all industries.It assumes a developing state across the board. Certainly some level of analysis is required when depending on comparable data from sources outside of the country in which the taxpayer is situated.
This suggests that using database sets to source comparables is only the very start of the analysis. Where no local comparables exist, it is necessary to take into account potential market differences.It would then be necessary to consider whether any further adjustments are required to account for risk variances.
1.OECD refers to associated enterprises for the purposes of Article 9. Domestic legislation may differ; for example, in South Africa transfer pricing applies to transactions between connected persons as defined.
2.OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations – 2010.
Source: By Karen Miller (TaxTALK)