The selection of comparables is one of the most critical elements in a transfer pricing study. A poorly executed comparability analysis can completely invalidate the application of a method, generate significant tax adjustments, and increase exposure to penalties from the tax authority. In practice, many of the adjustments in audits do not originate from the chosen methodology, but from recurring errors during the process of selecting comparable companies or transactions.
This article addresses the most frequent errors in the selection of comparables in transfer pricing, explains why they occur, and details how to mitigate them in accordance with OECD guidelines and international best practices.
What are comparables in transfer pricing?
In transfer pricing, comparables are independent companies or transactions that have a reasonable level of similarity to the transaction analyzed between related parties. Their function is to allow the determination of a market range that serves as a reference for assessing whether the agreed conditions comply with the arm’s length principle.
The correct selection of comparables requires analyzing, among other aspects:
- Functions performed
- Assets used
- Risks assumed
- Market characteristics
- Contractual conditions
This analysis, known as functional and comparability analysis, forms the technical basis of any transfer pricing study.
Common errors in the selection of comparables
1. Use of comparables without sufficient functional similarity
One of the most common errors in the selection of comparables is to rely exclusively on formal criteria, such as the economic activity code or the general description of the business, without performing a comprehensive functional analysis. While these classifications can serve as a starting point, they do not in themselves guarantee economic comparability.
Companies operating within the same sector may perform significantly different functions, assume dissimilar levels of risk, or use assets with varying degrees of sophistication. For example, a company that acts as a low-risk distributor cannot be adequately compared to another that assumes commercial, credit, and inventory risks, even if both belong to the same industry.
The OECD Guidelines emphasize that, before selecting comparables, an accurate delineation of the transaction must be made, identifying the underlying economic reality beyond the contractual form.
How to avoid it: The selection of comparables should be based primarily on functional analysis. It is essential to identify and document in detail the functions performed, the assets used, and the risks assumed by the analyzed party, and to compare them with those of potentially comparable companies. Industry classification should be considered only as a preliminary filter, not as a determining criterion.
2. Inclusion of companies with recurring losses without economic justification
Another common mistake is to include companies with recurring losses in the set of comparables without adequately analyzing the causes that generate them. The automatic inclusion of such companies can distort the market range and reduce the reliability of the analysis, especially when the analyzed party does not have sustained losses.
Losses may be due to extraordinary factors, operational inefficiencies, particular strategic decisions, or even exceptional situations that cannot be replicated under conditions of full competition. Without proper analysis, their inclusion can lead to incorrect conclusions regarding market value.
How to avoid it: Companies with losses should be evaluated on a case-by-case basis. It is only reasonable to include them when it is demonstrated that:
- The losses are structural to the market or sector in the period analyzed, or
- There are objective economic reasons that explain these losses and that also affect the analyzed party
In the absence of these conditions, it is advisable to exclude them from the comparability analysis.
3. Failure to cleanse and adjust financial information
The use of incomplete, inconsistent, or uncleansed financial information is another significant error in the selection of comparables. This occurs, for example, when the notes to the financial statements are not reviewed, adjustments for extraordinary income or expenses are omitted, or companies with atypical financial structures are included.
Such omissions can directly affect the margins used in the analysis and generate ranges that do not reflect comparable market conditions.
How to avoid it: It is essential to apply clear and consistent financial filters and to review in detail the information available for each comparable company. Where appropriate, comparability adjustments should be made to eliminate the effect of non-recurring items or extraordinary circumstances, ensuring that the data used represents transactions carried out under similar conditions.
4. Selection of comparables from non-comparable geographic markets
The selection of comparable companies located in geographic markets with very different levels of economic development, country risks, or regulatory environments can compromise the reliability of the analysis. Factors such as macroeconomic stability, labor costs, sector regulations, and access to financing directly influence companies’ financial results.
The indiscriminate use of foreign comparables, without adequate analysis of these variables, can generate ranges that do not adequately reflect the market conditions in which the analyzed party operates.
How to avoid it: Whenever possible, comparables from the same country or region should be prioritized. When there are not enough local companies and foreign comparables are used, it is essential to technically justify their selection, explaining why geographical differences do not significantly affect economic comparability.
5. Failure to periodically update the set of comparables
Reusing the same set of comparables for several fiscal years without verifying their validity is a common mistake. Changes in the business model, mergers, corporate restructuring, sectoral crises, or macroeconomic variations can render the originally selected sample obsolete.
Failure to update can lead to inconsistencies between the analysis and the economic reality of the period under review, increasing the risk of challenges from the tax authority.
How to avoid it: The set of comparables should be reviewed periodically and updated when there are relevant changes in economic conditions, available financial information, or the functional characteristics of the companies analyzed. This review should be properly documented as part of the transfer pricing study.
Importance of methodological consistency
The tax authority evaluates not only the results of the analysis, but also the consistency and reasonableness of the process followed. A well-documented comparable analysis, with clear and replicable criteria, significantly reduces the risk of tax adjustments.
In addition, a correct selection of comparables:
- Strengthens the technical defense in audits
- Improves the quality of the transfer pricing study
- Increases the tax predictability of the business group
Best practices for the correct selection of comparables
To mitigate risks, it is recommended to:
- Clearly document the search and exclusion criteria
- Technically support each filter applied
- Keep evidence of the information sources used
- Periodically review the sample of comparables
- Align the analysis with OECD guidelines and local regulations
Conclusion
The selection of comparables in transfer pricing is not a mechanical exercise, but a technical process that requires professional judgment, in-depth functional analysis, and regulatory knowledge. Errors at this stage can compromise the entire study and generate significant tax contingencies.
Implementing best practices and avoiding the most common mistakes strengthens the taxpayer’s position vis-à-vis the tax authority and ensures compliance with the arm’s length principle.
Do you need technical support in selecting comparables?
The correct selection of comparables is crucial to the soundness of a transfer pricing study and to an effective defense against a tax audit. At TPC Group, we have the technical expertise and methodologies aligned with OECD guidelines to develop consistent, properly documented comparability analyses adapted to local and international regulations. Our specialized team assists business groups in the preparation, review, and defense of their transfer pricing studies, reducing tax risks and strengthening their position with the tax authorities.
Source: OECD