The Importance of Segmenting Financial Information on Related Party Transactions in the Transfer Pricing Framework

December 12, 2023

Transfer Pricing methodologies require companies to file certain types of information regarding their related company transactions and/or information from their financial statements. This information will vary depending on the nature of each transaction and the management that each company has and shares with its related parties. The Transactional Net Margin is the methodology that, in certain cases, allows the support of the Arm’s Length Principle of a transaction to be indirect, providing consolidated information of the global results of the company, called global information, and not specific information of the transaction and the costs and expenses incurred to carry out such commercial transaction, also known as segmented information. Conversely, as discussed here, companies should strive to provide segmented information, both due to the recommendations of the OECD guidelines and the regulations of several tax administrations, which emphasize filing this level of detailed information.

According to Chapter II of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, “traditional transaction-based methods are considered to be the most direct means of determining whether the terms of the business or financial relations of associated enterprises are at Arm’s Length Principle.” The traditional methods are the Comparable Uncontrolled Price method, the Resale Price method, and the Cost-Plus method. As suggested by the OECD, these methods are based on the analysis of the direct information of the transaction, and aside from the direct pricing information requirement of the CUP, the other two methods require companies to file segmented financial information, transaction revenues, and associated costs to analyze the gross margins obtained in related-party transactions.

Similarly, regarding the Transactional Net Margin method, one of the results-based methods, the OECD guidelines state that “to determine or test the taxpayer’s net profit from a related party transaction (or from transactions to be added, according to paragraphs 3.9 to 3.12), a certain degree of segmentation of its financial data must be available. Therefore, it would be inappropriate to apply the Transactional Net Margin method at the whole company level if this carries out different related party transactions that cannot be compared on an aggregated basis with those of an independent company.” This citation emphasizes the use of segmented information, given that the alternative, a global information analysis, would require ruling out that the company has more than one activity related to the transaction and other exhaustive comparability analyses.

Finally, regarding the Peruvian case, Article 113 of Chapter XIX, Income Tax Law Regulation on the Transactional Net Margin method: “Income and expenses not related to the transaction, that significantly affect comparability, should not be considered. Otherwise, if it is not possible to demonstrate this, the financial data should be segmented, and the method should not be applied to the whole company if it carries out different related party transactions that cannot be compared on a combined basis with those of an independent company”. These paragraphs somewhat reflect the OECD’s proposal to mainly use segmented information, highlighting that the information cannot be gathered to proceed to a global analysis.

After examining the OECD guidance and regulations on the use of segmental information, it is necessary to explain why companies might have difficulties filing this type of information, strive to gather this type of information, and file it.

The segmented information that companies must file before tax administrations is not often available, similar to companies having to support the margins earned by their related companies for rendering services to them. In these cases, the information on the associated costs belongs to the related companies and not to the company supporting its Transfer Pricing report. Therefore, the related company may not be willing to share this information or may not have readily available and accessible information to share. Another difficulty in accessing segmented information arises when a service lasts for several periods, similar to construction and mining projects and others in which, due to the nature of the transactions, the margin of the service will be available at the end of the project. In these cases and for some periods, it will be difficult to support with segmented data on income and costs that the project has margins consistent with the market. Companies may also have difficulties in allocating expenses due to the complexity of some services and the lack of the necessary methodologies, mainly because operating expenses are not usually associated with each specific operation but with certain cost centers, requiring further analysis to obtain the details of the expenses related to each particular transaction. In addition to the complexity of obtaining segmented information, there are costs associated with obtaining it that companies may not be willing to assume.

On the other hand, despite the difficulties that companies may have in obtaining segmented information, they must strive to do so due to the possibility that tax administrations reject the filing of the global information of the business or the lack of reality of the price of related-party transactions in the global information, in some cases. An example of the latter arises when a company does not have segmented information regarding its income transactions for a service to a related party, in which it could have obtained a positive margin according to the market, filing the global information with negative results. The negative results allow the tax authority to infer a relationship between this and the related party transactions, given the lack of sufficient support, the authority could even propose an adjustment to the company’s transactions, thus modifying the taxable base. An additional reason to prepare segmented information is the increase by the administrations of the supporting requirements of the related party transactions. These requirements sometimes have a legal nature, as in the case of paragraph i) of Article 32°A of the Income Tax Law, which links the deduction of the cost and expense of these transactions to the support of the services and the demonstration of the margins applied to prove the services are of high or low added value.

According to the aforementioned, companies must gather segmented information regarding their related party transactions through the gradual adoption of certain policies at the group level, allowing the gathering of this type of information. The benefit of gathering this information will be the reduction of possible Transfer Pricing tax contingencies.