Comparability Adjustments in Transfer Pricing

January 11, 2024

Someone wonders, when performing a Transfer Pricing study, how these transactions would have been agreed upon with an independent third party. Therefore, the comparison of the transactions agreed upon between related parties with similar transactions agreed upon with or between independent parties is the analysis leading to the final result of the study, thus calling comparables to the latter transactions.

Paragraph 3.24 of the OECD guidelines states that “a comparable unrelated transaction is given between two independent parties, which is comparable to the related party transaction under analysis. This may be either a comparable transaction between a party of the related party transaction and an independent party (‘internal comparable’) or between two independent enterprises, neither of which is a party of the related party transaction (‘external comparable’).”

The selection of appropriate Transfer Pricing comparables is a crucial process that directly affects the result of the analysis, as well as the tax integrity and risk management of an enterprise. Therefore, selecting comparables must consider the functional similarity, industry, size and volume of transactions, geographic location, market conditions, other key criteria established by the OECD, and the regulations of each country, depending on the type of transaction to be analyzed to guarantee a fair and equitable valuation of the transactions under analysis, avoiding possible manipulation of profits and ensuring regulatory compliance, thus reducing potential disagreements with the tax authorities. This will provide a solid defense before a tax audit through the necessary documentation supporting the results.

Generally, these standards state that a transaction or enterprise is comparable with the tested party when there are no differences between them that significantly affect the price or amount of the consideration among related parties. Conversely, differences in the comparables may arise due to several reasons, such as geographic differences, size of the enterprise, market characteristics, and economic and legal conditions. Thus, due to these discrepancies, reasonable comparability adjustments must be applied to ensure accuracy and reliability, both in the general application of the Arm’s Length Principle and each specific method.

Likewise, these adjustments should be only applied when expected to improve the reliability of the results because, although differences between related party transactions and those of comparable third parties are unavoidable, the comparison may be valid if an unadjusted difference does not affect the reliability of the results; otherwise, the need to make numerous significant adjustments in key factors may indicate that the transactions carried out by independent third parties are not sufficiently comparable. Thus, the OECD points out that certain comparability adjustments, such as those related to differences in the level of working capital, should not be considered routine or indisputable; others, such as those related to country risk, are considered more subjective and, therefore, subject to additional testing and reliability requirements. Therefore, despite comparability adjustments are important, these cannot be overdone and should only be made when it is anticipated that they will improve comparability.

Examples of comparability adjustments include those for accounting consistency to eliminate differences caused by the diversity of accounting criteria between related and Arm’s Length transactions, segmentation of financial data to eliminate non-comparable transactions, and adjustments made for differences in capital, functions, assets, and risks.

Therefore, one of the Transfer Pricing challenges is the identification and the proper selection of comparables. Conversely, comparability adjustments and transparency of public data have been playing a key role in this selection process. In addition, disclosure of relevant information on the Transfer Pricing policies and methods employed also enables tax authorities to assess the appropriateness of prices and address potential discrepancies. Although significant progress has been accomplished, challenges remain in the complete elimination of differences in comparables. The diversity of tax and economic environments presents obstacles, and the adaptability of regulations to changing market dynamics remains an ongoing challenge.

In conclusion, the selection of proper comparables and the appropriate comparability adjustment are essential to maintain tax integrity, comply with the Transfer Pricing regulations, prevent tax controversies, or have all the documentation supporting the analysis performed before an eventual audit process.