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Presented By:Prof A Venter CA(SA)
Transfer Pricing Year Course
Lecture 13Comparability Analysis III
Adjustments
Does the difference have a material impact on the profit of loss?
Can the difference be quantified accurately to increase reliability?
Comparability AdjustmentsBASIC QUESTIONS
Adjustments based on:Commercial practicesEconomic PrinciplesStatistical Analysis
Comparability Adjustments
Comparability AdjustmentsAdjustment based on Commercial Practices
A: Clothing
Co
B: Buying Agent
B: compensated on a commission basis (standard industry
practice)5% plus 1% for every additional
services:product testing, vendor
qualification, freight consolidation (max 8%)
Comparability AdjustmentsAdjustment based on Commercial Practices
A: Clothing
Co
B: Buying Agent
B: NO VALUE ADDED SERVICES
5%
A: Clothing
Co
C: Controlled Buying Agent
C: 5% plus 1% for testing and 1% for
vendor qualification: 7%
Adjust B’s rate with 2%
Comparability AdjustmentsAdjustment based on Economic PrinciplesProfits Methods: controlled distributor lower
Inventory/Sales ratio than controlled ABest PLI: operating profit/salesAccount for differences in Inventory/Sales
ratio’s effect on PLI:Imputing interest to A for higher level of
inventory in excess of inventory carried by comparable
Basic Economic Principle: return on capital employed (including investment in inventory)
Circumstances the same as uncontrolled sales,
exceptDifferently configured
than radios in uncontrolled sales
Comparability AdjustmentsAdjustment based on Statistical Analysis
Need to know the estimated effect of the difference in configuration on the price
Determine what the price to uncontrolled buyer would have been if the radios had that specific configuration
Regression Analysis: formal statistical methodology frequently utilised in empirical economic analysis
B: Controlle
d
Sells radios in uncontrolled sales: 10
different featuresPrice depends on the features of the radio
A: Radio Manufacturer
Comparability AdjustmentsTYPES OF DIFFERENCES
Comparability factors: functions, risk, economic conditions, features of the product/services, contractual terms
Adjustment relevant to TP methodCUP: similarity of productRPM:
Inventory levelsTurnover ratesCost structuresBusiness experienceManagement efficiency
Comparability AdjustmentsTYPES OF DIFFERENCES
Cost Plus: Complexity of manufacturing and assemblyCost structuresBusiness experienceManagement efficiency
Profit Methods:Resources employedCost structuresBusiness experienceManagement eficiencyLevels of APLevels of AR
Comparability AdjustmentsTRANSACTION BASED METHODS
Compare price or gross marginNeed for adjustments:
Transaction based: higher level of comparability needed
Questions: How similar does it have to be? If not sufficiently similar, can adjustment for observed
difference be made? How is the adjustment made How much confidence can be placed in the
assumption that adjustments are accurate?
Comparability AdjustmentsTRANSACTION BASED METHODS
If a material difference is identified:Question: do you make the adjustment or use a more
forgiving method? General: more accurate method used –
expectation of higher sensitivity to comparability differences
There are often note enough information available to compare each comparability factor (almost always use imperfect info) – keep in mind when making decision on adjusting or using another method
Comparability AdjustmentsTRANSACTION BASED METHODS
Product Specific Factors
A: US distributor of washing machines
B: Related foreign
manufacturerHigh end models
HE label
Method: RPM(product nor similar enough to use CUP)
C: US Unrelated
manufacturerLow end modelsLE label
OTHER ISSUES….
Comparability AdjustmentsTRANSACTION BASED METHODS
Product Specific Factors: BUNDLING
Products are offered for sale with other products or services, to enhance competitiveness
Buyer may not want additional products or services, but buy package since the main product is sough after
Common techniques: support services, warranties, quality assurance
Must recognize the value of the additional products/services
Comparability AdjustmentsTRANSACTION BASED METHODS
Product Specific Factors (Bundling)
A: US distributor of washing machines
B: Related foreign
manufacturerHigh end models
HE label
C: US Unrelated
manufacturerLow end modelsLE label
Approach: - Use LE as benchmark for main product, find additional benchmarks for services - Warranty liability risk: justifies a higher return - Alternatively: base value of warranty on costs to perform service
Include warranty and service plan
Standard warranty provided by unrelated,
manufacturer
More complex if Intangibles are
involved….
Comparability AdjustmentsTRANSACTION BASED METHODS
Product Specific Factors : VOLUME DISCOUNTS
Reflect efficiencies realized by producers in selling large volumes – the cost saving is shares through volume discounts
Mainly the result of the allocation of fixed costsNB question: WOULD UNRELATED PARTIES
OFFER THE VOLUME DISCOUNT? (not always shared)
May use estimations: possible cost saving for a third party by extrapolation
Be careful: cost saving that give rise to discount may diminish at very large volumes
Comparability AdjustmentsTRANSACTION BASED METHODS
Product Specific Factors : PREPARATION
Packaging: distributors may purchase in bulk and package in-house to save the weight of transport costs
Price: recover packaging/finishing product for sale
Adjustments for packaging: RPM: value the product packaging function plus a GP mark-up (third party would require a profit on packaging services
Cost and mark-up on service (packaging)
Comparability AdjustmentsTRANSACTION BASED METHODS
Contractual Terms
Rights, privileges, and restrictions on entitiesOr allocation of transaction costsAdjustment: reallocation of costs to be similar
to what uncontrolled terms would beAllocation of risks: very difficult to estimateNB: delivery terms, payment terms,
exclusivity
Comparability AdjustmentsTRANSACTION BASED METHODS
Contractual Terms: DELIVERY
Differences in delivery may impact transportation, insurance, handling
Adjustment: measurement of delivery termsExample: Convert a FOB destination price to a
FOB origin priceFOB: US and other countries differing
interpretationsFOB: when risks and rewards of ownerships are
transferred from buyer to seller; AND who are responsible for what transport from that point onwards
Comparability AdjustmentsTRANSACTION BASED METHODS
Contractual Terms: Payment Terms
Time allowed for payment (can be that interest is charged beyond that pint in time or not)
Standard Industry PracticesAny delay in payment: as a finance cost and
credit risk for the seller – prompt payment discounts as incentives to be earlier
Adjustment: days difference x interest rateAlternative: adjustment of AR and AP (profit
methods)
Comparability AdjustmentsTRANSACTION BASED METHODS
Contractual Terms: Exclusive Condition
Common: Exclusive selling rights related to a geographical area; and exclusive licensing
Buyer would generally be willing to pay a higher price for exclusive selling rights or licensing
Comparability AdjustmentsTRANSACTION BASED METHODS
Market Factors: Market Level
Most challenging part of Comparability Adjustments
Base adjustment on economic principles or guidance by the law
Different levels in supply chainEach level adds value and increase the priceNot the same for all industries, products or
geographical locationsExample…
Comparability AdjustmentsTRANSACTION BASED METHODSMarket Factors: Level of Market
A: Distribution Company
B: Toy company selling o US
market
Adjustment: - Comparison: compare to same level in market - Each level increase the price to compensate for additional input by level owner
Operate manufacturing
facilities in China
Sell to retailers or smaller regional
wholesaler
Comparability AdjustmentsTRANSACTION BASED METHODS
Market Factors: Geographic Location
Foreign Exchange differencesProfit margin differences: different level of
competition or local business risk – lead to higher/lower profit
Shipping costs, government restrictions, border taxes, different supply and demand levels
Only transportation and transactions costs: quantify and adjust
Where the difference is due to supply and demand: more complex: look at income levels, preferences, levels of competition
Comparability AdjustmentsPROFITS METHODS
Background
Value of Inventory/Sales ratioAR/Sales rationAP/Sales ratioDifference: balance sheet difference between
tested party and comparable interpreted in reference to business “function” to which they correspond
Example: Seller: credit extension function is recorded under AR on balance sheet
Each function is valued based on rate of return on balance sheet amount associated with function
Comparability AdjustmentsPROFITS METHODS
Background
Value: market interest rate (standard practice amoung analysts)
Assume everything else remain the same, and that the profit can be altered directly by the implied valuations\
Adjustment become less precise as magnitude and number of adjustments increase
NB: understand the facts and underlying pattern
Comparability AdjustmentsPROFITS METHODS
BackgroundFactors to consider:
Comparability adjustment vs. selection criteria (goal is the fewest adjustments: rather better selection than more adjustments
Comparability Adjustments and PLI selection: use PLI denominator for adjustment
Functional vs. Efficiency Adjustments: Comparability adjustments reflect balance sheet or cost ratios,
interpreted as measures of the intensity of the functions performed
High level of AR: high intensity of credit extension Note: higher level of assets: not always due to higher intensity of
function – often a symptom of business problems (unplanned or unwanted levels of debtors or inventory not sold (slow-moving)
True higher intensity of function justifies return on investment
Comparability AdjustmentsPROFITS METHODS
Inventory, AR and AP adjustmentsTNMM: frequently working capital adjustment
when tested party is a distributor or another type of seller
Two basic functions of a distributor is extension of credit and carrying inventory
“Intensity” of these functions: measured by assets/sales
Higher ratio = higher “intensity”Credit adjustments: credit extended (AR) and
credit received (AP)
Comparability AdjustmentsPROFITS METHODS
Inventory, AR and AP adjustmentsMechanics:
Step 1: difference in ratio (between tested party and comparable) (ratio: balance sheet item/ denominator (PLI) normally sales, but can be operating expenses)
Step 2: Value: difference x interest rateStep 3: Value x net sales (comparable) to adjust
AFS figuresStep 4: PLI recomputed
Comparability AdjustmentsPROFITS METHODS
Inventory
FORMULA
( (AINV/S)C – (AINV/S) TP ) x i x SC
• AINV = Average Inventories
• S = Net Sales• i = Interest Rate• C= items from
Comparable• TP= items from Tested
Party
Interpretation: - Positive value: value of additional inventory carrying function by comparable related t tested party - Negative value: Comparable did not perform this function/ less intense
Comparability AdjustmentsPROFITS METHODS
Accounts Receivable
FORMULA
( (AAR/S)C – (AAR/S) TP ) x i/(1+i) x SC
• AAR = Average AR• S = Net Sales• i = Interest Rate
(diminished interest factor used in formula)
• C= items from Comparable
• TP= items from Tested Party
Interpretation: - Positive value: value of additional credit extension function by comparable related t tested party (decrease comparable’s net sales to compare)
Comparability AdjustmentsPROFITS METHODS
Accounts Receivable
FORMULA
( (AAP/S)C – (AAP/S) TP ) x i/(1+i) x SC
• AAP = Average AP• S = Net Sales• i = Interest Rate
(diminished interest factor used in formula)
• C= items from Comparable
• TP= items from Tested Party
Interpretation: - Positive value: if the comparable did not perform this function, it could have accepted a lower price for its goods
Purpose: elimination of comparability differences
Example: similar transactions, but one bears a currency risk: make adjustments to eliminate the risk (add back the portion off the purchase price attributable to the bearing of the risk)
Differences usually due to: accounting inconsistencies, and differences in capital, assets, risk and functions.
When? If it will increase the reliability of the result, with regards to materiality, quality of information and purpose of the adjustment.
OECD: Comparability Adjustments
Indian cases: several decisions on comparability adjustments: reliability and purpose
Working Capital Adjustment: fairly common in practice – does not mean that it should be a routine adjustments or is mandatory (especially in TNMM):Focuses on time value of money and rectifies the
time gap from investing to collecting cash.Profit level indicator chosen should be the base
(assets, turnover or costs)
OECD:Comparability Adjustments
Comparability AdjustmentsWorking Capital Adjustment
Working Capital Adjustment Y1 Y2 Y3
TestCo: (Receivables + Inventory-Payables)/Sales
25.6% 25.8% 24.1%
CompCo:(Receivables + Inventory-Payables)/Sales
19.9% 20.6% 28.7%
Difference (D) 5.7% 5.1% -4.7%
Interest rate (i) 4.8% 5.4% 5.0%
Adjustment (D*i) 0.27% 0.28% -0.23%
Comp Co EBIT/SALES (%) 1.32% 2.96% 2.59%
Working Capital AdjustedEBIT/Sales for Comp Co
1.59% 3.24% 2.35%
Comparability AdjustmentsForeign Exchange Adjustments
One Comparability Factor: FOREX RISK (fluctuations in rates of exchange
Questions: which taxpayer bears the particular risk?
Example: S (in UK) sells to P (US) and the invoice/contract price is USD, then S bears the FOREX risk.
Risk allocation will be respected if:S has adequate financial capacity to bear risk (incl
hedging of all or part of the risk)Conduct of S and P are consistent with terms of contract
(contract price not adjusted to reflect exchange movements)
Comparability AdjustmentsForeign Exchange Adjustments
Transactional Exchange RiskComparability Adjustments frequently made for
transactional FOREX risk (due to fluctuations on Forex movement)
More general type of risk:Example: S & P: long term depreciation of the
dollar against EURO. S’s profit margin will shrink because cost in USD value increases.
Alternatively: S & P use a TP method to maintain target profit level of S: P’s profit margin will be affected (especially if P cannot pass on higher costs to customers due o competition (us competitors may buy in USD))
Comparability AdjustmentsForeign Exchange Adjustments
Economic substanceEconomic substance must be considered in
deciding who actually bears the FOREX riskExample: contractual terms may include a
mechanism to effectively split the effect of the FOREX movement; or allocating risk to one party by tying it to contract price
Example….
Comparability AdjustmentsForeign Exchange Adjustments
Economic substance
Bears the FOREX risk
In year under review: USD depreciated against the EURO: negatively affecting USSUB’s GP
TEST TP: uncontrolled UD distributors: RPM (no currency risk since they purchase and sell in USD)
USSUB results: should be measure over multi-year period to determine if a sufficiently higher return is experienced in other years to set-off current losses
CAPM: estimate return
US SUB:Exclusiv
e distributor in US
Price expressed in EURO
FP: UKManufactures
macinery
Comparability AdjustmentsCase Law
Volkswagen Argentina case (Case 26,991-I, 12 July 2010)Extraordinary occurrences: comparability
Axalto Cards case: (ITA No 4015/Del/2007, 3 February 2010)Comparability: exclusive distribution rights can’t be
quantified; different risk profiles; storageIndian case: ITA 2000 (no internal CUP, use profit
split)Indian case: ITA 712 (net profit excluding
reimbursements)Indian case: ITA5224 (Internal comparable)