Transfer Pricing

This blog takes a brief look at the method of conducting a comparability analysis along with the challenges in the context of Indian Transfer Pricing regulations.

Meaning of Comparability Analysis
As per the Organisation for Economic Co-operation and Development (OECD), Comparability analysis involves identifying and comparing an uncontrolled transaction or company to the controlled transaction under review.
The primary objective of this analysis is to assess whether the conditions and economic circumstances surrounding the controlled transaction (transaction with related parties) align with those that would have existed between independent enterprises operating under comparable conditions. This analysis is essential to ensure that the terms of the transaction reflect an arm’s length standard, as would be expected in dealings between unrelated parties.

Need for Comparability Analysis
Comparability analysis is an important component of benchmarking, as it helps to set a base for selecting the most appropriate method of transfer pricing and determining the Arm’s Length Price (ALP) or Profit Level Indicator (PLI).
Further, it also involves thoroughly examining various factors, such as the Function performed, Assets employed and Risk Assumed (FAR Analysis) by the parties, that could influence a transaction’s pricing.

Steps in Conducting a Comparability Analysis
There are a total of 9 steps that are proposed by the OECD Guidelines to facilitate a comprehensive comparability analysis:

• Determination of years to be covered
  It refers to deciding the timeframe to be covered for the analysis, which typically ranges from three to five years.

• Broad-based analysis of the taxpayer’s circumstances
  This step includes analysing the industry, competition, economic trends and relevant regulations. The goal is not to focus on specific transactions between related parties, but rather to understand the broader conditions that affect the business. This step helps to understand the conditions of both controlled and comparable uncontrolled transactions, particularly from an economic perspective.

• Review of the controlled transaction and choice of the tested party
  The tested party is usually the participant in a transaction for which profitability can be ascertained most reliably and for which reliable data on comparables can be found. The tested party will also typically be the party with the least intangibles and lesser complex transactions.  

• Review of existing internal comparable
  This step usually involves examining the Function performed, assets employed and Risk assumed (FAR analysis) by each party involved in the controlled transactions.
  This examination helps to identify the influence on the price of the transaction, which can be controlled by the economically significant activities and responsibilities undertaken by the parties involved in the controlled transaction.

• External comparable and source of information
  It involves the 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
  The OECD TP Guidelines outline various transfer pricing method, which includes the Profit Split Method, Comparable Uncontrolled Price (CUP) method, Resale Price Method, Cost Plus Method and Transactional Net Margin Method (TNMM).
  Further, the selection of relevant financial indicators depends on the selection of the most appropriate method. (For example, determination of the relevant net profit indicator in case of a transactional net margin method or gross profit margin in case of the resale price method).

Identification of potential comparables:
It involves identifying potential companies or uncontrolled transactions that could serve as comparables. However, while identifying the comparables, one should make sure that this comparable is functionally similar and performs a similar function, employs similar assets and operates in a similar industry with similar risks as the tested party in the controlled transaction.

Determining Comparability and Making Adjustments:
Comparability means that any differences between the controlled and uncontrolled transactions do not materially affect the outcome or that accurate adjustments can be made to address those differences. Adjustments should only be made when they are expected to improve the reliability of the transfer pricing analysis. (Examples of adjustments can be capacity utilization adjustment, working capital adjustment and idle cost adjustment).

Determination of the Arm’s Length Range/Remuneration:
Once the selection of the most appropriate method of transfer pricing and application of it to the comparable selected is done, we have to determine the arm’s length range/remuneration. The range so determined represents the range of prices or profit levels that would be considered as arm’s length for the controlled transactions.