Comparability Analysis in Transfer Pricing

1. COMPARABILITY ANALYSIS
(CA) IN TRANSFER PRICING
Aboyeji Oyekanmi M.
(ACA, Adv.Dip.TP)

2. Outline
• Overview
• Types of Comparables
• Comparability factors
• Typical Process of Comparability Analysis
• Review of Controlled Transaction
• Types of Comparability Adjustment
• Choice of tested party
• Arm’s Length Range

3. Overview
• Comparability analysis is the heart of Transfer Pricing
• Coined from the word “Compare”
• Involves the examination or comparison of
Conditions (attributes) between two (more) terms /
Transactions.
• Comparison of the conditions in a controlled
transactions with conditions in the transactions
between Independent entities
• Ensuring that no material difference exist.
• Where differences exist, they must be reasonably
adjusted for to eliminate the differences.
• The more the adjustments, the less reliable a
comparable is.

4. Overview
• CA requires an understanding of the economically relevant
characteristics of the entities involved.
• The higher the degree of Comparability, the more the
reliability of the comparables selected
• Remember, rational business decisions considers options
realistically available at the time of the decision; this is also
relevant in Comparability analysis and adjustment
• Selection of a Comparable Entity (with comparable
transaction) is just a step in comparability analysis
• CA requires (1) Examination of the factors affecting the
Taxpayer’s Controlled Transaction, and (2) Examination of the
factors affecting the Uncontrolled Transaction

5. Types of Comparable
Internal Comparable
• This is transaction between one party to the controlled transaction
and a non associated party
• Internal comparable can be easily found and are more reliable,
complete and less costly to document.
• There is really no hierarchy between internal and external
comparable but where internal comparable are reasonably reliable,
there is no need to obtain an external comparable.
HoldCo.
SubCo. 3rd Party

6. Types of Comparable
External Comparable
Transactions between two (2) independent
enterprises neither of which is a party to the
controlled transaction
HoldCo.
Independent
Party
SubCo.
Independent
Party
Sold Raw Material X @ N100
Controlled Tranx.
Sold Raw Material X @ N90
External Comparable

7. External Comparable – Sources of
Information
Databases
• They are developed commercially from publicly available
accounts information
• They can be electronically filtered to search for functionally
comparable companies.
• Widely used by advisors and Tax Authorities
• They provide “whole of company” data rather than
transactional data
• Usable data tends to be limited to companies whose whole
function is comparable to the tested function
• Financial ratios can also be easily extracted.
• Examples include Bureau Van Dijk TP Catalyst, Bureau Van
Dijk TP Orbis, Mergent, Royalty Stat, One Source and so on.

8. External Comparable – Sources of
Information
Absence of Reliable Data
What is the reason:
i. Lack of publicly disclosed information in the country
ii. Small market –lack of independent enterprises
iii. Uniqueness of taxpayer’s transactions
• In i & ii, data from other countries or industries might be
used, subject to reasonable comparability being achieved
(comparability adjustments).
• In iii, lacking evidence of what independent parties have
actually done, hypothesize whether the conditions of the
transactions would have been agreed between independent
parties.

9. Types of Comparable
Secret Comparable
• These are comparables which are not available in the public
domain but available only to either of the Taxpayer or the Tax
Authority.
• Both the tax authority and the taxpayer can not arrive at
these set of comparables if they embark on an independent
comparable search.
• For Instance, tax administrations may have information
available to them from examinations of other taxpayers or
from other sources of information(TPPD) that might not be
disclosed to the taxpayer. It would be unfair to apply TP
method on the basis of such data unless the tax
administration would be able within the limits of its domestic
confidentiality requirements disclose such data to the
taxpayer so that there would be an opportunity for the
taxpayer to defend its own position.
• The use of secret comparable is seriously discourage

10. Factors affecting Comparability
• Characteristics of Property or Services
• Functional Analysis
• Contractual Terms
• Economic Circumstances
• Business Strategies

11. Characteristics of Property or Services
• Focuses on product similarities, as this often influence the prices of such
products.
• Transfer of Tangible Property:
 The physical features of the property,
 Its quality and reliability,
 The availability and volume of supply
• Provision of services:
The nature and extent of the services
• Intangible Property:
The form of transaction (e.g. 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

12. Functional Analysis
• Focuses on functional similarities between the controlled and the uncontrolled
transaction. In terms of:
 Functions Performed (i.e. economically significant activities and responsibilities undertaken)
 Assets Employed
 Risk Assumed
• The higher the functions, the higher the risk is likely to be and the higher the
expected returns.
• Allocation of risk must be consistent with the economic substance of the
transaction.
• Assess the capability of the parties
• Understand the structure and organization of the group as it relates to the
taxpayer’s operation
• Determine the legal rights and obligations of the taxpayer in performing the
functions.

13. Transaction HoldCo. SubCo. 1 SubCo. 2
Functions Performed
Design X
Manufacturing, Assembling X
Research and Development X
Servicing, X
Purchasing X
Distribution X
Marketing and Advertising X
Transportation X X
Financing and Management X
Assets Employed
Property, Plant & Equipment X X
Intangible Property: Patents, Know-how X

14. Transaction HoldCo. SubCo. 1 SubCo. 2
Human Resources X X X
Intangible Property: Trademarks X X
Risks Assumed
Loss of PPE X X
R&D Risks X
Exchange Risks X
Interest Rate Risks X
Credit Risks X
Human Resource Risks X X X
• Functional analysis relies greatly on the level of information you
are able to obtained about the group as well as independent
parties

15. Contractual Terms
• When reviewing the Functional Analysis of a company, the
analysis of the Contractual Terms is very important.
• Under an arm’s Length Condition, it determines how
responsibilities, risks, and returns will be shared between
parties to a transaction
• Contract Agreements and correspondences between parties
are veritable tools for understanding the Contractual Terms in
a transaction.
• Conducts of the parties can also be useful in understanding
the terms.
• The economic principles that generally govern relationships
between independent enterprises are also useful.
• Substance Over form : Conduct of the parties must be
compared with the contractual terms. This will reveal whether
the terms have been followed or not.

16. Contractual Terms
• Information concerning the contractual terms of
potentially comparable uncontrolled transactions may
be either limited or unavailable, particularly where
external comparables provide the basis for the
analysis.
• The effect of deficiencies in information in establishing
comparability will differ depending on the type of
transaction being examined and the transfer pricing
method applied e.g. Licence Agreements can be
obtained from External Database in Cases of Use of
Intellectual Property where CUP method is used.

17. Economic circumstances
• Even when uncontrolled transactions shares economically
relevant characteristics (Comparability Factors) with the
controlled transaction, the Market where they operate goes a
long way in determining their extent of comparability.
• It is essential to identify the relevant market or markets taking
account of available substitute goods or services.
• Economic circumstances that may be relevant to determining
market comparability include :
 The geographic location;
 The size of the markets;
 The extent of competition in the markets and the relative
competitive positions of the buyers and sellers;

18. Economic circumstances
 The availability (risk thereof) of substitute goods and
services;
 The levels of supply and demand in the market as a whole
and in particular regions, if relevant
 Consumer purchasing power;
 The nature and extent of government regulation of the
market; costs of production, including the costs of land,
labour, and capital;
 Transport costs; the level of the market (e.g. Retail or
wholesale);
 The date and time of transactions; and so forth.
• Consequently, the extent to which these factors are in effect
reasonably homogeneous would affect the comparability.

19. Business Strategies
• Business decisions are made from array of realistically available
options depending on the strategic path of the entity.
• Strategies should be more of commercial decision rather than Tax
Decision
• Usually, Business strategies would take into account many
aspects of an enterprise, such as innovation and new product
development, degree of diversification, risk aversion,
assessment of political changes, input of existing and planned
labour laws, duration of arrangements, and other factors
bearing upon the daily conduct of business.
• The strategy employed by an entity influences the stage of the
market it operates at a particular point in time, its assets
requirement, IT Deployment and so on.
• A major consideration when reviewing the comparability of a
particular business strategy is:
1) The Timing of return. E.g. For how long will an entity continue to
report Losses as part of its business strategy?

20. Business Strategies
 For instance, Losses reported by a distributor can be as a result of
the pricing strategy employed by the entity. e.g. Penetration
Strategy. Inclusion or non-inclusion of warranty options can
influence whether higher or lower prices will be charged for
product sold. This does influence the comparability or otherwise of
margin reported by two entities.
2) Conduct of the Parties: Examine the conduct of the parties to
determine if it is consistent with the purported business strategy. For
example, if a manufacturer charges its associated distributor a
below-market price as part of a market penetration strategy, the cost
savings to the distributor may be reflected in the price charged to
the distributor's customers (General Market Impact) or in greater
market penetration expenses incurred by the distributor (i.e. Lower
Market Penetration Expense).
3) Cost of Strategy: Another factor to consider is whether the nature of
the relationship between the parties to the controlled transaction
would be consistent with the taxpayer bearing the costs of the
business strategy. No Independent distributor would want to bear
the cost of an unrelated entity’s market penetration strategy.

21. Business Strategies
4) Plausibility of Expectation: Whether there is a plausible
expectation that following the business strategy will
produce a return sufficient to justify its costs within a period
of time that would be acceptable in an arm's length
arrangement.
 Could the strategy in question plausibly be expected to
prove profitable within the foreseeable future (while
recognizing that the strategy might fail)?
 Would a party operating at arm's length have been
prepared to sacrifice profitability for a similar period under
such economic circumstances and competitive conditions.
 As part of the review of the strategy of an entity, you can
request for the expected Cash flow projection made as at
when the option (Strategic Path) was chosen. This will help
derive the level of return, the timing of return and so on.

22. Typical Process of CA
• Step 1: Determination of years to be covered.
• Step 2: Broad-based analysis of the taxpayer’s circumstances. The industry,
competition, economic and regulatory factors and other elements that affect the taxpayer and its
environment.
• Step 3: 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.
• Step 4: Review of existing internal comparables, if any.
• Step 5: Determination of available sources of information on external comparables
where such external comparables are needed taking into account their relative
reliability.

23. Typical Process of CA
• Step 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).
• Step 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
• Step 8: Determination of and making comparability adjustments
where appropriate.
• Step 9: Interpretation and use of data collected, determination of the
arm’s length remuneration.
**********There is no limit to step 5 to 7**********

24. Review of the controlled transaction
• Controlled Transactions must be reviewed on
Transaction by Transaction basis.
• However, Some transactions can be reviewed on
Combined Basis (Portfolio Approach) only:
 If they are closely linked or continuous that they
cannot be evaluated adequately on a separate basis.
E.g. As a result of strategy, some products may be
marketed by a taxpayer with a low profit or even at a
loss, because they create a demand for other products
and/or related services of the same taxpayer that are
then sold or provided with high profits. E.g. Sales of
Printers & Catridges.
• The Controlled Transaction must therefore be reviewed
given due consideration to the Comparability Factors.

25. Comparability Adjustment
Examples of comparability adjustments include
• Adjustments for accounting consistency designed to eliminate differences
that may arise from differing accounting practices between the controlled
and uncontrolled transactions;
• Segmentation of financial data to eliminate significant non-comparable
transactions;
• Adjustments for differences in capital, functions, assets, risks. E.g.
Working capital adjustment could be designed to reflect differing levels of
accounts receivable, accounts payable and inventory .
• The fact that such adjustments are found in practice does not mean that
they should be performed on a routine or mandatory basis. Rather, the
improvement to comparability should be shown when proposing these
types of adjustments (as for any type of adjustment).
• Further, a significantly different level of relative working capital between
the controlled and uncontrolled parties may result in further investigation
of the comparability characteristics of the potential comparable.

26. Comparability Adjustment
• Comparability adjustments should be
considered if (and only if) they are
expected to increase the reliability of the
results.
• The only adjustments that should be
made are those that are expected to
improve comparability.
• These must be properly documented

27. Choice of the tested party
• When applying a TP 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.
• 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.
• That is it will most often be the party that has the
less complex functional analysis.

28. Timing issues in comparability
• Timing of origin
 Contemporaneous uncontrolled transactions are expected to be the most
reliable information to use in a comparability analysis, because it reflects how
independent parties have behaved in an economic environment that is the
same as the economic environment of the taxpayer’s controlled transaction.
Availability of information on contemporaneous uncontrolled transactions
may however be limited in practice, depending on the timing of collection.
• Timing of collection
 Taxpayers establish transfer pricing documentation to demonstrate that they
have made reasonable efforts to comply with the arm’s length principle at the
time their intra-group transactions were undertaken, i.e. on an ex ante basis
(hereinafter “the arm’s length price-setting” approach), based on information
that was reasonably available to them at that point.
 Taxpayers might test the actual outcome of their controlled transactions to
demonstrate that the conditions of these transactions were consistent with
the arm’s length principle, i.e. on an ex post basis (hereinafter “the arm’s
length outcome-testing” approach).
 The issue of double taxation may arise where a controlled transaction takes
place between two associated enterprises where different approaches have
been applied and lead to different outcomes

29. Arm’s Length Range
• Using database for comparable search would result in
a list of several number of companies that provided
potential arms length comparable data based on the
Profit Level Indicator (PLI) Selected.
• if the relevant conditions of the controlled
transactions are within the arms length range, no
adjustment should be made.
• If the relevant conditions of the controlled transaction
fall outside the arms length range asserted by the tax
administration, the taxpayer should have the
opportunity to present arguments that the conditions
of the transaction satisfy ALP and that ALR includes
their results.

30. Arm’s Length Range
Adjustment to points within the range
• Adjustment is to a 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, then any point in the range
satisfies ALP
• Where comparability defects remain, use measures of
central tendency eg median, mean or weighted
averages to minimise risk of error due to unknown or
unquantifiable remaining comparability factors.

32. References
• OECD (2010), Transfer Pricing Guidelines
for Multinational Enterprises and Tax
Administrations