Comparability Analysis

Comparable Period

Every taxpayer should strive to determine their transfer pricing for tax purposes in accordance with the arm’s length principle. This determination should be based on information that is reasonably available at the time. Therefore, the arm’s length price should be established by comparing the results of a controlled transaction with those of uncontrolled transactions that were conducted during the same year.

This requirement is based on the principle that compliance with the arm’s length principle must be maintained contemporaneously, on a year-by-year basis. A contemporaneous uncontrolled transaction serves as the most reliable comparison, as it takes place in an economic environment that is the same as or similar to that of the taxpayer’s controlled transaction.

Depending on the industry and circumstances, there may be situations where data from a specific financial year does not provide the most reliable comparison. For example, if a tested party’s accounting period ends on 31 March 2010 data from a company in the same industry with a financial year ending on 31 December 2009 would be considered a better comparable to another company with a financial year ending on 31 December 2010. This is because the economic environment for the company with a year ending on 31 December 2009 would be more relevant to that of the tested party.

Multiple Year Data

To gain a comprehensive understanding of the facts and circumstances related to a controlled transaction, it is beneficial to analyze data from both the years following the year under examination and previous years.

Examining data from previous years helps determine if a taxpayer’s reported loss on a transaction is part of a pattern of losses on similar transactions, a consequence of specific economic conditions in a prior year that led to increased costs in the subsequent year, or a reflection of the product being in the final stage of its life cycle.

Arm’s length range

An arm’s length range refers to a range of figures that are acceptable in establishing the arm’s length nature of a controlled transaction. The range is derived from applying the same transfer pricing method to multiple comparable data. It is important to note that transfer pricing is not an exact science, and using the most appropriate transfer pricing methodology may result in a range of results. Therefore, the facts and circumstances of a case play a crucial role in determining a range, or the point within a range, that represents the most reliable estimate of an arm’s length price or allocation.

The arm’s length range should only include comparable uncontrolled transactions that are highly reliable or have been adjusted to ensure a high level of reliability compared to the controlled transactions. If there is a significant deviation among points or between the data in the range (e.g. upper quartile and lower quartile), this may indicate that the comparable used are not reliable and that there are material differences in terms of functions, assets, and risks (FAR), which require comparability adjustments. In such cases, the reliability of the comparable data must be carefully assessed, and adjustments should be made to account for the material differences in the comparability analysis. The transfer pricing methodology should also be reviewed.

In situations where every effort has been made to exclude data with a lesser degree of comparability but some comparability defects still remain and cannot be adjusted, it may be appropriate to make transfer pricing adjustments to a value that best reflects the facts and circumstances of transactions between associated persons. This value can be derived by utilizing statistical tools based on the specific characteristics of the data set.

Separate and Combined transactions

To ensure the most accurate approximation of an arm’s length price or profit allocation, it is ideal to apply the arm’s length principle on a transaction-by-transaction basis. However, in certain cases, transfer pricing may need to be addressed at the level of a product line or business unit, rather than for each individual transaction.

When establishing transfer prices, taxpayers should set prices separately for each transaction they enter into with an associated person. However, if transactions are closely linked or continuous to the extent that they cannot be adequately evaluated separately, it may be appropriate to determine the transfer price based on bundled transactions. This is permissible if it can be demonstrated that it is common industry practice to set one price for a combination of transactions (such as goods and associated intangible property), or if it is not reasonable to expect reliable data to set prices for separate transactions. The lack of reliable data on comparable transactions may be due to complex dealings or relationships between the parties, thus allowing for an aggregate basis for the total amount.

It is generally acceptable to group intangibles associated with the provided product or service, if comparable independent transactions also involve these various transactions that cannot be separated and are bundled together with all associated costs included in the product’s price.

Other examples include:

Aggregation of transactions involving tangible and intangible products that are highly integrated

When a company licenses manufacturing know-how and supplies vital components that are highly integrated to an associated party, it may be more reasonable to assess the arm’s length price for these two activities as a single item rather than separately.

Aggregation of transactions where one product complements the other

Aggregation of transactions may also be appropriate in situations where a taxpayer is required to carry an unprofitable product or line of products that are auxiliary to the profitable items. This is especially true when there is sufficient profit available to provide an adequate return from the complete product range, considering the assets, functions, and risks of the enterprise. Common examples of bundled products falling under this category include printers with cartridges and razors with blades.

Disaggregation of transactions where the nature of transactions is substantially different

Company M, located in Malaysia, was established to handle the distribution, sales, after-sales service, repair, and maintenance services of X group vehicles (trucks, buses, and coaches) imported from its parent company in Country X. Company M also serves as the regional hub for X in Southeast Asia, covering markets such as Singapore, Thailand, Vietnam, and Indonesia. Additionally, the regional office houses the regional training center, which trains mechanics, technicians, driver trainers, and managers from the Asia Pacific region to provide services to X’s group customers.

In this situation, the different activities should not be aggregated. Instead, Company M is required to prepare segmental accounts to evaluate the arm’s length nature of the controlled transactions on a transactional basis. The segmental accounts should be prepared for the following categories:

• Sales and distribution
• Repair and maintenance services
• Regional service

Re-Characterizations of Transaction

Examination of a controlled transaction should generally be based on the actual transaction carried out by the taxpayer, as long as it is consistent with the methods described in the Guidelines. However, when reviewing an agreement between associated persons, not only the terms of the agreement are considered, but also the actual conduct of the parties.

Therefore, the IRBM may disregard and re-characterize a controlled transaction under the following circumstances:

1. When the economic substance of a transaction differs from its form.
2. When the form and substance of a transaction are the same, but the arrangements made in relation to the transaction differ from those that would have been adopted by independent persons behaving in a commercially rational manner. This actual structure practically hinders the IRBM from determining an appropriate transfer price.

The need to re-characterize a transaction is based on the understanding that the nature of the transaction is derived from the relationship between the parties and is not determined by normal commercial conditions. The taxpayer may have structured the controlled transaction to avoid or minimize tax. This is supported by the fact that:

1. Associated persons have more freedom to enter into various contracts and agreements compared to independent persons, as the normal conflict of interest between independent parties is often absent.
2. Associated persons often enter into specific types of arrangements that are rarely encountered between independent persons.
3. Contracts under a controlled transaction can be easily altered, suspended, extended, or terminated according to the overall strategies of the multinational group, and such changes may even be made retroactively.

The above principle can be illustrated by the following examples taken from the OECD Guidelines:

Example 1:
If an investment in an associated enterprise takes the form of interest-bearing debt, it would not be expected to be structured the same way as if it were conducted at arm’s length, considering the economic circumstances of the borrowing company. In this case, it may be appropriate for a tax administration to characterize the investment according to its economic substance, treating the loan as a subscription of capital.

Example 2:
A sale under a long-term contract, with a lump sum payment, grants unlimited entitlement to intellectual property rights resulting from future research for the duration of the contract. While it may be recognized as a transfer of commercial property, it would still be appropriate for a tax administration to adjust the terms of that transfer in a manner that would reasonably be expected between independent persons. Therefore, in the case described above, it might be suitable for the tax administration to modify the conditions of the agreement in a commercially rational manner, considering it as an ongoing research agreement.

Transfer Pricing Adjustment

Where the DGIR determines that the price in a controlled transaction is not at arm’s length, they may make an adjustment to reflect the arm’s length price or interest rate for that transaction. This can be done by substituting or imputing the price or interest, as applicable. In such cases, the other party of the controlled transaction can also request a corresponding adjustment.

Adjustments will be made in the following situations:

1. When the consideration for the supply of property or services is less than what would have been received in an arm’s length arrangement.
2. When the consideration for the acquisition of property or services is more than what would have been agreed upon in an arm’s length arrangement.
3. When no consideration has been charged to the associated person for the supply of property or services.

Losses

Enterprises incur losses for various economic and business reasons, such as start-up losses, market penetration strategies, and research and development failures. However, an independent enterprise would not sustain continuous losses without taking appropriate measures to correct the situation within a reasonable time, as it would contradict the fundamental business objective of making profits. The fact that an associated enterprise consistently suffers losses may indicate that it is not being fairly compensated.

To determine the acceptability of the losses, it is important to ensure that the controlled transaction entered into is commercially realistic and economically viable. Taxpayers also need to establish that the losses are commercially motivated within the context of their characterization. In this regard, taxpayers are expected to maintain contemporaneous documentation that outlines the non-transfer pricing factors contributing to the losses.

A contract or toll manufacturer that only performs production as ordered by a related party, without undertaking functions such as operational strategy setting, product R&D, and sales, is expected to maintain a consistent level of profitability. If the manufacturer incurs losses, it must prove that these losses are not a result of its transactions with a related party.

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• Preparation of Transfer Pricing Documentation
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• Support companies in negotiating and securing Advanced Pricing Agreements with tax authorities.
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