Economic analysis is one of the fundamental pillars of the transfer pricing regime, as it allows for the assessment of whether transactions between related parties are in line with the arm’s length principle. Its correct preparation is crucial both for regulatory compliance and for mitigating tax risks in the event of possible audits by tax authorities.
In a context of increasing international scrutiny, automatic exchange of information, and alignment with OECD standards, economic analysis takes on a central role in transfer pricing documentation, complementing and supporting functional and contractual analysis.
What is economic analysis in transfer pricing?
Economic analysis is a quantitative and comparative assessment that aims to determine whether the prices, margins, or financial results derived from a transaction between related companies are within a market range, taking as a reference comparable transactions carried out between independent parties under similar conditions.
In practical terms, this analysis allows us to answer the following key question: Is the remuneration assigned to each entity in the group consistent with the functions performed, the assets used, and the risks assumed?
Its development is required by most local legislation and by the OECD Transfer Pricing Guidelines, constituting an essential component of the Local File and, in certain cases, the Master File.
Relationship between functional analysis and economic analysis
Economic analysis cannot be conceived in isolation. Its starting point is functional analysis, which identifies and characterizes the functions, assets, and risks (FAR) of the entities involved in the transaction.
Once the functional characterization has been defined—for example, limited risk distributor, routine service provider, or full manufacturer—economic analysis is responsible for quantifying the expected remuneration for that entity, in accordance with what an independent third party would receive in comparable circumstances.
Consequently, any inconsistency between the functional analysis and the economic analysis may result in tax adjustments, challenges by the tax authority, and potential double taxation contingencies.
Key components of economic analysis
A technically robust economic analysis is usually structured in the following stages:
1. Delimitation of the transaction analyzed
This consists of precisely defining the intercompany transaction under analysis, considering its nature, contractual terms, economic context, and market conditions. This delimitation must be consistent with the economic reality of the transaction.
2. Selection of the transfer pricing method
In accordance with the OECD Guidelines, traditionally accepted methods should be evaluated, including:
- Comparable Uncontrolled Price (CUP) method
- Resale Price Method (RPM)
- Cost Plus method
- Transactional Net Margin Method (TNMM)
- Profit Split Method (PSM)
The choice of the most appropriate method depends on the degree of comparability, the availability of information, and the functional characterization of the parties involved.
3. Search and selection of comparables
This phase involves identifying comparable companies or transactions operating under similar conditions, using internationally recognized financial databases. The process includes quantitative and qualitative selection criteria, as well as comparability adjustments when necessary.
4. Determination of the financial indicator
Depending on the method selected, the most appropriate profitability indicator is defined, such as operating margin, mark-up on costs, gross margin, or return on assets, among others.
5. Construction of the arm’s length range
Based on the results obtained from the comparables, an interquartile range or statistical range is established that represents the expected market behavior. The position of the entity analyzed within that range allows us to conclude whether or not the transaction complies with the arm’s length principle.
Importance of economic analysis versus audits
Tax administrations have significantly increased their technical capacity to evaluate economic analyses, questioning aspects such as:
- Inappropriate selection of the method
- Unrepresentative comparables
- Lack of consistency with the functional analysis
- Use of unreliable financial information
- Absence of economic justification for recurring losses
A deficient economic analysis is often one of the main triggers for transfer pricing adjustments, which can lead to tax objections, fines, interest, and dispute resolution procedures.
On the contrary, a properly structured analysis not only serves a defensive function, but also allows for the optimization of the group’s transfer pricing policy, aligning profitability with the creation of economic value.
Economic analysis and transfer pricing documentation
Economic analysis is an integral part of local transfer pricing documentation and is one of the elements most frequently reviewed by tax authorities. Its consistency with accounting information, tax returns, and intercompany contracts is essential.
Furthermore, in a BEPS environment, this analysis must be consistent with the information reported globally, avoiding contradictions between jurisdictions that could lead to risks of correlative adjustments or double taxation.
Conclusion
Economic analysis in transfer pricing is much more than a numerical exercise. It is a complex technical assessment that requires a deep understanding of the business, the regulatory framework, and market conditions.
When done correctly, it demonstrates compliance with the arm’s length principle, reduces tax risks, and strengthens the taxpayer’s position in the face of audits and tax disputes. In this sense, having a solid and well-documented economic analysis is a strategic element for any business group with intercompany operations.
Do you need advice on transfer pricing?
Having the support of a company specializing in transfer pricing ensures that the economic analysis, documentation, and intercompany policy are aligned with the arm’s length principle and OECD standards. At TPC Group, we assist business groups in structuring, reviewing, and defending their transfer pricing, reducing tax risks and strengthening their position in the face of tax audits.
Source: OECD