Transfer Pricing: 9 Step Approach to Comparability Analysis

The purpose of #transferpricing, from a tax perspective, is to compute the arm’s length price of transactions carried out between associated enterprises or related parties. This computation is based on identifying comparable transactions. The process of comparing controlled transactions with comparable uncontrolled transactions is known as a "comparability analysis" and is at the heart of the application of the Arm’s Length Principle.

#OECD has recommended 9 step approach to have robust comparability analysis. This process is considered an accepted good practice but it is not a compulsory one, and any other search process leading to the identification of reliable comparables may be acceptable as reliability of the outcome is more important than process (i.e. going through the process does not provide any guarantee that the outcome will be arm’s length, and not going through the process does not imply that the outcome will not be arm’s length).

The OECD has recommended a 9-step approach to ensure a robust comparability analysis. While this process is considered a good practice, it is not mandatory. Any search process that leads to identifying reliable comparables may be acceptable, as the reliability of the outcome is more important than the specific process followed.

Step 1: Determination of years to be covered

Step 2: Broad-based analysis of the taxpayer’s circumstances: This step involves examining industry, competition, economic, and regulatory factors that affect the taxpayer’s environment in general, without focusing on specific controlled transactions. This steps helps to understand the conditions of both controlled and comparable uncontrolled transactions, particularly from an economic perspective.

Step 3: Review of the controlled transaction and choice of tested party: This step involves understanding the controlled transaction under review to identify key factors that influence the choice of the tested party, the most appropriate transfer pricing method, the financial indicator to be tested, and significant comparability factors.

Step 4: Review of existing internal comparables: Internal comparable refers to a comparable uncontrolled transaction between a taxpayer or any other group entity and independent enterprise. Generally, internal comparables are considered better over external comparables because of more direct and closer relationship to the controlled transaction.

Step 5: External comparable and source of information: Wherein internal comparable doesn’t exists or to strengthen the analysis, identifying external comparables becomes important. There are various sources that can be used to identify external comparables. ?Generally, commercial databases are used for this purpose. Whichever database the taxpayer chooses to select comparables from, adequate documentation should be maintained to demonstrate the results of the comparability analysis.

Step 6: Selection of the most appropriate transfer pricing method and, depending on the method, determination of the relevant financial indicator (e.g. determination of the relevant net profit indicator in case of a transactional net margin method).

Step 7: Identification of potential comparables: Key characteristics that an uncontrolled transaction must meet to be considered comparable are identified. These are based on factors such as the characteristics of the transaction, functions performed, assets used, risks assumed, contractual terms, economic conditions, and business strategies.

Step 8: Determination of and making comparability adjustments: To be comparable means that none of the differences (if any) between the situations being compared could materially affect the condition being examined in the methodology or that reasonably accurate adjustments can be made to eliminate the effect of any such differences. Comparability adjustments should be considered if (and only if) they are expected to increase the reliability of the results.

Step 9: Interpretation and use of data collected, determination of the arm’s length remuneration.

In practice, the application of above process depends on the specific facts of the case and successful implementation relies on the experience and expertise of the transfer pricing consultant.

CA Gaurav Garg SGPM & Associates JGarg Economic Advisors Pvt. Ltd.