Benchmarking study or comparability analysis is the heart of the application of the arm’s length principle.
Application of the arm’s length principle is based on a comparison of the conditions in a controlled transaction with the conditions that would be applied between independent parties and undertaking a comparable transaction under comparable circumstances.
Benchmarking study or comparability analysis is the process of identification of an arm’s length ranges (market level) of prices/margin in order to compare the prices/margin in the controlled transaction with such range.
How to perform a Transfer Pricing benchmarking study
A comparison implies examining two terms:
- the controlled transaction under review;
- the uncontrolled transactions that are regarded as potentially comparable.
Below is a description of a typical process that can be followed when performing a comparability analysis (benchmarking study):
- Determination of years to be covered;
- Broad-based analysis of the taxpayer’s circumstances;
- Review the controlled transaction(s) under examination, in order to choose the tested party (where needed);
- Review of existing internal comparables, if any;
- Determination of available sources of information on external comparables where such external comparables are needed taking into account their relative reliability;
- Selection of the most appropriate transfer pricing method and, depending on the method, determination of the relevant financial indicator;
- Identification of potential comparables;
- Determination of and making comparability adjustments where appropriate;
- Interpretation and use of data collected, determination of the arm’s length remuneration.
In practice, this process is not a linear one. Steps 5 to 7 in particular might need to be carried out repeatedly until a satisfactory conclusion is reached, i.e. the most appropriate method is selected, especially because the examination of available sources of information may in some instances influence the selection of the transfer pricing method. For instance, in cases where it is not possible to find information on comparable transactions (step 7) and/or to make reasonably accurate adjustments (step 8), taxpayers might have to select another transfer pricing method and repeat the process starting from step 4.
Below you may find the description of the above-mentioned steps:
1. Determination of years to be covered
Usually the benchmarking study covers one year in which the controlled transaction was performed. There are cases when some business activity do not undergo significant changes, so the benchmarking study can be updated every 3-5 years. However, given the instability of the economy, it is recommended to update the benchmarks every year.
2. Broad-based analysis of the taxpayer’s circumstances
The “broad-based analysis” is an essential step in the comparability analysis. It can be defined as an analysis of the industry, competition, economic and regulatory factors and other elements that affect the taxpayer and its environment. This step helps understand the conditions in the controlled transaction as well as those in the uncontrolled transactions to be compared, in particular the economic circumstances of the transaction
3. Review of the controlled transaction under examination
The review of the controlled transaction (s) under examination aims at identifying the relevant factors that will influence the selection of the tested party (where needed), application of the most appropriate transfer pricing method, the financial indicator that will be tested, the selection of comparables and where relevant the determination of comparability adjustments.
Ideally, 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. Thus, sometimes transactions may be combined for the analysis purposes.
Choice of tested party
When applying a cost plus, resale price or transactional net margin method, it is necessary to choose the party to the transaction for which a financial indicator (mark-up on costs, gross margin, or net profit indicator) is tested.
The choice of the tested party should be consistent with the functional analysis of the transaction. As a general rule, the tested party is the one to which a transfer pricing method can be applied in the most reliable manner and for which the most reliable comparables can be found, i.e. it will most often be the one that has the less complex functional analysis – performs less functions, carries less risks, has less assets.
4. Review of existing internal comparables
A comparable uncontrolled transaction is a transaction between two independent parties that is comparable to the controlled transaction under examination. It can be either a comparable transaction between one party to the controlled transaction and an independent party (“internal comparable”) or between two independent enterprises, neither of which is a party to the controlled transaction (“external comparable”).
Internal comparables may have a more direct and closer relationship to the transaction under review than external comparables. The financial analysis may be easier and more reliable as it will presumably rely on identical accounting standards and practices for the internal comparable and for the controlled transaction. In addition, access to information on internal comparables may be both more complete and less costly.
It is useful to review all internal transactions with unrelated party and compare the circumstances of such transactions with the controlled transaction. If there are some differences it might be useful to make an adjustments in order to make them comparable.
5. Determination of available sources of information on external comparables
When reliable internal comparables exist, it is unnecessary to search for external ones.
However, if it is necessary to search for external comparables, there are various sources of information that can be used.
A common source of information is commercial databases. They can be a practical and sometimes cost-effective way of identifying external comparables and may provide the most reliable source of information, depending on the facts and circumstances of the case.
All databases can be divided into 3 types depending on the searching information:
- comparable companies (for sales of goods and intra-group services transactions);
- interest rates (for financial transactions);
- remuneration rates (for intangible transactions).
Globally there are several benchmarking database providers for each type.
6. Selection of the most appropriate transfer pricing method and financial indicator
Based on the type of the controlled transaction, results of functional analysis and availability of information (internal, external comparables) the most appropriate transfer pricing method should be selected.
For some transfer pricing methods it is necessary to select relevant financial indicator.
7. Identification of potential comparables
For identification of the potentially comparable third party transactions the “deductive” approach is commonly used.
This approach starts with a wide set of companies that operate in the same sector of activity, perform similar broad functions and do not present economic characteristics that are obviously different. The list is then refined using selection criteria and publicly available information (e.g. from databases, Internet sites, information on known competitors of the taxpayer).
One advantage of the “deductive” approach is that it is reproducible and transparent. It is also easier to verify because the review concentrates on the process and on the relevance of the selection criteria retained.
The process followed to identify potential comparables is one of the most critical aspects of the comparability analysis and it should be transparent, systematic and verifiable. In particular, the choice of selection criteria has a significant influence on the outcome of the analysis and should reflect the most meaningful economic characteristics of the transactions compared. Complete elimination of subjective judgments from the selection of comparables would not be feasible, but much can be done to increase objectivity and ensure transparency in the application of subjective judgments. Ensuring transparency of the process may depend on the extent to which the criteria used to select potential comparables are able to be disclosed and the reasons for excluding some of the potential comparables are able to be explained. Increasing objectivity and ensuring transparency of the process may also depend on the extent to which the person reviewing the process (whether taxpayer or tax administration) has access to information regarding the process followed and to the same sources of data.
Based on the selected method and type of the controlled transactions there are different sources of information (databases) that could be used for selection of the comparable transactions.
However, all types of the controlled transactions may be covered by Transfer Pricing Benchmarking Database by Intra Pricing Solutions.
The Transfer Pricing Benchmarking Database consists of four search engines. Each of them can be utilised for a different set of results:
- Comparable Companies in Europe, Asia and North America: establish at arm’s-length remuneration using TNMM, Resale Minus and Cost Plus methods;
- Intermediary Financing Remuneration: establish at arm’s-length remuneration for companies involved in Intermediary Financing and Cash Pooling activities using CUP method;
- Interest Rate: establish at arm’s-length Interest Rate on Intercompany Loans using CUP method;
- Royalty: estimate the market rate for Licensing of Intellectual Property and Service Fees using CUP method.
8. Determination of and making comparability adjustments where appropriate
To be comparable means that none of the differences between the situations being compared could materially affect the condition being examined in the methodology or that reasonably accurate adjustments can be made to eliminate the effect of any such differences.
It is not appropriate to view some comparability adjustments as “routine”, and to view certain other adjustments as more subjective and therefore subject to additional requirements of proof and reliability. The only adjustments that should be made are those that are expected to improve comparability.
Ensuring the needed level of transparency of comparability adjustments may depend upon the availability of an explanation of any adjustments performed, the reasons for the adjustments being considered appropriate, how they were calculated, how they changed the results for each comparable and how the adjustment improves comparability.
9. Interpretation and use of data collected, determination of the arm’s length remuneration
Based on the comparable’s financials it is possible to identify the arm’s length remuneration.
If the relevant condition of the controlled transaction (e.g. price or margin) is within the arm’s length range, no adjustment should be made.
If the relevant condition of the controlled transaction (e.g. price or margin) falls 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 controlled transaction satisfy the arm’s length principle, and that the result falls within the arm’s length range. If the taxpayer is unable to establish this fact, the tax administration must determine the point within the arm’s length range to which it will adjust the condition of the controlled transaction.
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