What are the Five Comparability Factors for Transfer Pricing?
Comparability analysis is the foundation of transfer pricing. The arm’s length principle is founded on the comparability between a transaction controlled by two entities belonging to the same multinational group and a transaction between independent parties. The application of the arm’s length standard relies upon determining the conditions that independent parties would have agreed to in comparable (similar) transactions in comparable (similar) circumstances.
Before making comparisons with uncontrolled transactions, businesses need to identify the economically relevant characteristics of the commercial or financial relations as expressed in the controlled transaction. The economically relevant characteristics or comparability factors that need to be identified in the commercial or financial relations between the associated enterprises to accurately delineate (outline/define) the actual transaction can be broadly classified into five categories/. Here are the five comparability factors for the arm’s length principle:
The contractual terms of the transaction
A transaction is the result or expression of commercial or financial relations between the parties. A transaction is typically formalized by associated persons through written contractual agreements. Such written agreements provide a starting point delineating (outlining) the transaction between the parties and how the responsibilities, risks, and anticipated outcomes arising from their interaction were intended to be divided at the time of entering into the contract. The terms of a transaction may also be found in communications between the parties other than a written contract.
Functional analysis is vital for delineating the controlled transaction and determining comparability between controlled and uncontrolled transactions or entities. It seeks to identify the economically significant activities and responsibilities undertaken, assets used or contributed, and risks assumed by the parties to the transactions. The functional analysis focuses on what the parties actually do and the capabilities they provide. Such activities and capabilities will include decision-making, including decisions about business strategy and risks.
Characteristics of property or services
The differences in the specific characteristics of property or services may account for differences in their value in the open market. Comparing these features can be relevant for delineating (outlining) the transaction and in determining the comparability of controlled and uncontrolled transactions. The characteristics that are relevant in this regard include the following:
- For tangible property: Physical features of the property, quality and reliability, and the availability and volume of supply
- For services: Nature and extent of services
- For intangibles: Form of the transaction (e.g. licensing or sale), the type of property (e.g. patent, trademark, or know-how), the duration and degree of protection, and the anticipated benefits from the use of the property
Arm’s length prices may differ across different economic circumstances. For comparability, it is vital that the independent and associated enterprises operate do not have differences that have a material effect on the price or that appropriate adjustments can be made. As a first step, MNEs need to identify the relevant market or markets taking account of available substitute goods or services. Economic circumstances that may be relevant to determining market comparability include the following:
- Geographic location
- Size of the markets
- The extent of competition in the markets and the relative competitive positions of the buyers and sellers
- Availability (risk thereof) of substitute goods and services
- Levels of supply and demand in the market as a whole and in particular regions, if relevant; Consumer purchasing power
- Nature and extent of government regulation of the market
- Costs of production, including the costs of land, labour, and capital
- Transport costs
- Level of the market (e.g. retail or wholesale)
- Date and time of transactions
Business strategies would take into account many aspects of an enterprise, such as innovation and new product development, degree of diversification, risk aversion, assessment of political changes, the input of existing and planned labour laws, duration of arrangements, and other factors bearing upon the daily conduct of business.
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