A comparability analysis is an essential part of any transfer pricing analysis. Its purpose is to obtain an in-depth understanding of the significant characteristics of the controlled transaction and the roles of the respective parties involved which is needed in determining and substantiating the arm’s length remuneration of a controlled transaction.
Performing a comparability analysis consists of various steps and one of these steps (the OECD Transfer Pricing Guidelines provide 9 steps) is the benchmark study. As such, the benchmark study (i.e., the search for comparables) is only part of the comparability analysis and it should be neither confused with nor separated from the comparability analysis.
In this blog we will highlight 2 steps that we feel are very important and should not be forgotten as it will strengthen the substantiation of the arm’s length character of controlled transactions.
“Step 2: Broad-based analysis of the taxpayer’s circumstances”
An important step is a broad-based analysis of the taxpayer’s circumstances. 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, but not yet within the context of looking at the specific transactions in question. This step helps to obtain an in-depth understanding of the conditions in the taxpayer’s controlled transaction as well as those in the uncontrolled transactions to be compared, in particular the economic circumstances of the transaction.
The comparability analysis is more than just comparing a loan, royalty or service. Without taking all relevant circumstances of the taxpayer into account a comparability analysis is useless, as it is not clear what is to be comparable and what is not. For a good comparison of a loan transaction not only the amount is of importance but also the creditworthiness, region and industry of the taxpayer should be analyzed and be taken into account. In certain industries it might be more common to borrow relatively large amounts of money while in other industries debt is less common.
For a good comparison of manufacturing services at least the industry and volumes should be analyzed. In certain industries a manufacturer with a turnover of € 300,000 might for example not be comparable with a manufacturer with a turnover of € 10 million due to benefits of scale.
General market conditions might impact certain industries more than other industries. As such, the market conditions of the taxpayer should always be considered while performing a comparability analysis. Looking back at the COVID 19 pandemic, it had a major impact on the market (conditions) and subsequently the taxpayer’s profitability. When a benchmark study would be performed at this moment (i.e., in fiscal year 2023) the years to be covered would include the financial years 2021 and 2020. You should analyze and determine how to best take those specific years and its financial results into consideration when you start to prepare the strategy for your benchmark study, as the past years’ data might not ultimately provide a reliable range.
“Step 9: Interpretation and use of data collected, determination of the at arm’s length remuneration”
Once the comparability analysis is performed taking into account the guidance as provided by the OECD, there is one important step left: the interpretation of the data and the determination of the at arm’s length remuneration.
It is important to analyze the data of the potential comparables of the benchmark study and to determine the reliability of the data. Does the data itself make sense and are the comparables to be accepted sufficiently reliable or are there conflicting sources? If a potential comparable obtains a realistic margin on a multiple year analysis, but in the last year of the analysis it obtains an extreme high or negative margin, this could indicate that something exceptional has happened (one-off situation) which should make you think about whether the financial data for that specific year is sufficiently reliable and whether the company should be accepted as broadly comparable.
OECD state that an extreme result may be excluded on the basis that a previously overlooked significant comparability defect has been brought to light, not on the sole basis that the results arising from the proposed “comparable” merely appear to be very different from the results observed in other proposed “comparables”. Loss-making comparables that satisfy the comparability analysis should not be rejected on the sole basis that they suffer losses.
The outcome of the benchmark study is a set of broadly comparable (third-party) companies whose financial results are used to determine and substantiate the arm’s length character of a controlled transaction. Based on the comparability analysis performed (i.e., including a broad-based analysis of the taxpayer’s circumstances) a point within the range will be chosen that represents an arm’s length remuneration for the taxpayer’s controlled transaction.
Can I have an off-the-shelf benchmark study please?
Our answer is NO! So-called “off-the-shelf” benchmark studies are not based on a comparability analysis of the taxpayer. As such, it is likely to show results and comparables that do not match with the functionality & risk profile of the taxpayer.
As transfer pricing specialists we do not believe that benchmark studies can be based on a one-size-fits-all approach. A reliable benchmark study that takes into account the necessary aspects (as mentioned by the OECD) and is tailor made to the taxpayer, will minimize transfer pricing risks and mitigate the risks of discussions with tax authorities.
Which benchmark study’s range should you then use? Should this always be the interquartile range? The answer is to be found within the comparability analysis, as it might be very much defendable (based on the comparability between the taxpayer and the accepted companies) to use the full range (and for example choose a point below lower quartile). However, this under the assumption that the full range is based on reliable data and comparables.
Do you need help?
In case you are now doubting the quality and/or reliability of your benchmark study, you are in need of assistance with a comparability analysis, or you just want to know more about benchmark studies & comparability analyses, then please make an appointment for a free consultation or fill in our contact form. We are looking forward to meeting you.