Before conducting a benchmarking analysis using independent market entities (e.g. external comparables), it is advisable to first assess whether any of the parties to the related-party transaction engage in comparable transactions with independent third parties. Where the relevant comparability criteria are satisfied, such transactions may serve as internal comparables.
The choice between one approach and the other is not insignificant: the OECD Guidelines recognize that, in Transfer Pricing, a reliable internal comparable can offer significant advantages over an external search, although its use always depends on its actual degree of comparability.
Why an internal comparable tends to be more reliable?
A reliable internal comparable can offer a significant advantage because it involves one of the same parties to the related-party transaction. It also can support itself on accounting and operational information directly accessible to that party.
This can reduce certain comparability differences and facilitate the analysis. However, this does not mean that an internal comparable is automatically superior to an external one.
Factors such as the characteristics of the product or service, the functions performed, the assets used, the risks assumed, the contractual terms, the economic circumstances, and business strategies must also be reviewed.
The requirements that an internal comparable must meet to be valid
Not every transaction with a third party qualifies as a reliable internal comparable.
The arm’s-length transaction must be sufficiently comparable to the related-party transaction, taking into account, among other factors, the volume, payment terms, characteristics of the product or service, level in the distribution chain, and other economically relevant circumstances.
An occasional, low-volume sale to a third party, for example, is not necessarily comparable to a stable, high-volume business relationship with a related party, even if the product is identical.
If the identified differences have a material effect on the price or margin and cannot be corrected through reasonably precise adjustments, the internal comparable may no longer be reliable.
In which cases are external comparables unavoidable?
When there are no sufficiently reliable internal comparables, it may be necessary to use external comparables obtained from commercial databases or other sources of information.
In such cases, the analysis must identify companies or independent transactions that are sufficiently comparable to the transaction under review.
The use of external comparables typically requires a more extensive process of search, selection, and functional review, as well as comparability adjustments when there are material differences that can be reasonably corrected.
However, an external comparable should not automatically be considered inferior to an internal one. Depending on the circumstances, an external source may provide more reliable information than an internal transaction that exhibits significant differences.
The mistake of rejecting a good internal comparable in favor of a database
Relying directly on an external database without first evaluating the existence of internal comparables can lead to overlooking a potentially more direct and reliable source of information.
When a sufficiently reliable internal comparable exists, the OECD acknowledges that searching for external comparables may be unnecessary.
Therefore, the decision should not be based on an automatic preference for an internal or external source, but rather on a fundamental question: which alternative offers the highest degree of comparability and the most reliable information for analyzing the related-party transaction?
At TPC Group, we first evaluate the availability and quality of internal comparables before constructing an external benchmark, prioritizing the source of comparison that offers the highest degree of similarity and reliability for the transaction under analysis.