Sebastien Gonnet, Vladimir Starkov and Madhura Maitra, NERA
Sebastien Gonnet and Vladimir Starkov are Vice Presidents; Madhura Maitra is a Consultant
One of the oft-encountered problems in the application of profit-based methods is the lack of reliable data for independent companies operating in the same country or economic region as that of the dependent tested party. This problem may manifest itself in some of the smaller developed countries, but is particularly acute in most of the emerging/developing economies.1
“The ability of tax administrations to compare relevant price information across jurisdictions is essential for the effective operation of transfer pricing rules, and a lack of data on comparable transactions is a significant issue for effective tax collection, particularly in developing countries. We ask the OECD to find ways to address the concerns expressed by developing countries on the quality and availability of the information on comparable transactions that is needed to administer transfer pricing effectively.”2
The lack of local comparables is often addressed by practitioners by using suitable comparables from other jurisdictions. Yet, when such comparables come from countries with significantly different economic conditions than the country of the tested party, some adjustments to account for these differences are called for. This series of two articles explores the options of improving comparability in cases where non-domestic comparables are used. The first article of the series presents theoretical approaches, while the second article (to be published later in 2013) will provide practical application and examples.
The rest of the article is organised as follows: section l provides an overview of existing guidelines and literature on adjustments for economic differences; section ll illustrates the need for economic circumstances adjustments and identifies those areas where differences in economic circumstances have a large impact on companies' profit patterns and can be reliably adjusted for. This section also provides descriptions of some of the applicable economic adjustments. The last section concludes.
A number of economic factors can contribute to differences in risk profile and cost structures, and, consequently, influence profit margins of companies. When considering companies operating in different locations, the following factors may influence the return that a company would expect to earn: degree of competition, political risk exposure, credit market conditions (in particular, the risk of default), access to borrowing, consumer purchasing power, regulatory differences, location specific costs of production, economic condition in the industry, level of inflation, exchange rate fluctuations, differences in payment terms, and other business and market-related risks. These differences in economic conditions, if material, are likely to affect the margins that companies earn in different geographies and hence affect the arm's length range computed, thus justifying the need for appropriate adjustments.
When selecting comparable companies, both the OECD and the UN Guidelines recognise five comparability factors, as follows:
• characteristics of the property or service transferred,
• functions performed by the parties taking into account assets employed and risks assumed, in short referred to as the “functional analysis”,
• contractual terms,
• economic circumstances, and
• business strategies pursued.
While putting considerable emphasis on comparability,3 the OECD and the UN Guidelines provide that domestic comparables are generally preferred but both seem to allow for the use of non-domestic comparables in the absence of local comparables.4 The OECD Transfer Pricing Guidelines point out that non-domestic comparables should not automatically be rejected merely because they are from another tax jurisdiction.5 The OECD Guidelines further recommend that when independent transactions are scarce in certain markets and industries a pragmatic approach needs to be developed on a case-by-case basis.
The UN Guidelines express a preference for uncontrolled comparables to be derived from the geographic market in which the controlled taxpayer operates since there may be significant differences in economic conditions between different markets.6 However, if information from the local market is not available, an uncontrolled comparable derived from a different geographical market may be considered if it can be determined that:
i. there are no material differences between the two markets that would affect the price or profit of the transaction or
ii. reasonably reliable adjustments can be made to account for such material differences between the two markets.
In transfer pricing practice, the use of non-domestic comparables is generally well accepted; for instance, pan-European samples have become a standard for most Multinational Enterprises (MNEs) to reduce compliance costs (and avoid the cost of searching for separate local comparables samples). While some tax authorities may insist on an exclusive use of domestic comparables, many do accept non-domestic comparables in certain circumstances. For example, Chinese tax authorities have been known to accept pan-Asian comparables samples in the absence of Chinese publicly listed comparables, preferring the pan-Asian sets of publicly listed companies to the sets of private Chinese comparables, whose financial data are viewed as not sufficiently reliable.
The underlying economic rationale for using regional comparables in the absence of suitable domestic comparables is that certain geographical regions, such as the European Union, have economic similarities. In the absence of suitable companies in closely comparable regions, one option is to carry out an expanded geographical search - the advantage being availability of a larger number of potentially comparable companies, but with the possible disadvantage of substantial inter-regional economic differences. These differences may affect the margins that companies earn in different geographies and hence reduce the reliability of the arm's length range computed.
The following section discusses various adjustments for economic circumstances that aim at improving the reliability of the results obtained from a non-domestic comparables' search. The analytical framework for these adjustments envisions reliably constructing an arm's length range for the tested party located in Country X based on evidence from comparables located in a different country (say, Country Y). This requires adjusting for the differences between the two countries that might affect the results so that the comparables from Country Y would reflect the outcome that would have been achieved had they been located in Country X. These adjustments require, in principle, an assessment of the market and competitive conditions in both countries and finally arriving at the conclusion that the inferences drawn from Country X can reasonably be applied to the comparables from Country Y.
It is important to recognise the fact that there is no universally accepted method for comparability adjustment when non-domestic comparables are being used7. Moreover, most statistical methods used to increase comparability will have their own limitations. Therefore, adjustment for geographic differences must be made carefully and only if reasonable and accurate adjustments can be made to increase the reliability of the results. There is a range of possible adjustments that can be undertaken to increase comparability between a foreign comparable and the tested party. The issue at stake when deciding on a comparability adjustment is not whether it is new or has been used before, but whether it reliably improves the comparability of the adjusted data. In the rest of this article we will discuss the following comparability adjustments:
• cost of capital adjustment
• working capital intensity adjustment
• other adjustments.
When suitable local third-party evidence is not available and non-domestic comparables are used, adjustments must be performed to appropriately account for differences in operating conditions between the tested party and the comparables. For example, ease of access to credit markets, interest rates, stock market volatility, market risk, level of inflation, tax rates etc. usually differ across countries and hence the cost of capital also varies across countries. In case there are significant difference in cost of capital, margins observed for the comparables in a non-domestic location will not appropriately reflect those that can be expected for the tested party. A country cost of capital adjustment is thus required to account for the fact that a comparable company is based in a different country than the tested party.8 To adjust for the difference in cost of capital, one needs to understand how such differences would impact the return that a rational investor would expect to earn if he/she were to invest in a particular location rather than another.
The definition of Return on Capital Employed (ROCE) is as follows:
In competitive markets, companies may generate returns that are either above or below their cost of capital, in the short-run. However, in the long-run equilibrium, excess profits will be reduced to zero due to competition and companies earning less than their cost of capital will be driven out of business. Hence, in the long-run companies must earn their cost of capital. Thus in the long run the following condition holds:
|ROCE =||WACC 9||(2)|
|Operating Profit =||WACC x Capital Employed||(3)|
Consequently, the cost of capital adjustment is the following:
|ΔOperatingProfit=||(WACCTestedParty-WACCComparable) x Capital Employed||(4)|
In general, the cost of capital varies not only across countries but also over time and the cost of capital adjustment captures both. The cost of capital adjustment also accounts for differences in capital structure between the tested party and the comparable companies. Moreover, the risk premium embedded in WACC typically encompasses the risks associated with a particular investment including political risk, credit risk, and other business and market specific risks. In fact, another way of understanding the cost of capital adjustment is to view it as a long-run no-arbitrage condition. The cost of capital adjustment operates on the presumption that the economic profit earned by companies is determined by their cost of capital on the ex antebasis, i.e., assuming no exogenous shocks to profitability take place.
It is important to note that the cost of capital adjustment can be used not only in conjunction with the balance-sheet-based PLIs10 such as Return on Capital Employed but also with the income-statement-based PLIs such as Return on Sales, Return on Total Costs, etc. The operating profit measure in every PLI has to be adjusted by the factor computed per formula (4) above.
As noted above, the basic underlying assumption for the cost of capital adjustment is that in the long-run routine returns earned by companies are expected to cover the cost of capital. Hence, if returns of comparables from a country with lower cost of capital, which implies a low risk economic environment, are adjusted to a country with higher cost of capital (usually, an emerging/developing economy), the adjusted profitability range will mechanically shift up. This result is consistent with basic finance theory of risk-return trade-off which implies that an investor investing in a riskier investment would ex ante expect a higher return. However, in higher-risk countries there is also a higher probability to both lose and gain more. Also, the actual returns observed in the short-run in such economies, depending on the economic conditions, can be higher or lower than the level implied by the cost of capital adjustment. Thus, one shortcoming of the cost of capital adjustment discussed above is that it does not take into account such volatility of market outcomes i.e. it does not widen the range of comparables' profitability observed in developed markets but only shifts it up.11
One can thus argue that a more appropriate adjustment technique should widen the range as well as move up the median when the target country has a higher level of risk than the country where the comparables are located. One example of such an adjustment can be found in the article by Stephen Curtis and Jean Francois Ruhashyankiko12which shows that under the assumption that comparables' returns are normally distributed, adjustments can be made to the standard deviation of the outcomes to widen the range of the comparables profitability results. Such an adjustment would complement the cost of capital adjustment discussed above and ensure that increased risk will be reflected in increased standard deviations and larger predicted inter-quartile ranges. However, the main drawback of this approach is that comparables' returns may not be normally distributed - this is most often the case when only a few comparables are used.
When non-domestic comparables are used, it is likely that the working capital intensity of the tested party located in emerging/developing economies will be significantly different from that of the comparables located elsewhere (e.g., in developed countries) due to differences in business environments. Such differences may include disparities in interest rates for the short term debt, differences in credit terms, and credit risks of typical business borrowers.
Thus, to improve comparability, it is important to adjust the working capital of the comparables and, if necessary, the tested party to the same terms (i.e., number of days outstanding for payables, receivables, and inventory) using interest rates that appropriately incorporate the above risks.
When non-domestic comparables are being selected, a potentially wide range of other adjustments have to be evaluated to improve comparability with the domestic tested party. The potential comparability issues that need to be considered include location savings, effects of fluctuations in foreign exchange rates, differences in regulatory regimes, local economic conditions, and specifics of the local accounting practices. These types of adjustments must be applied on a case-by-case basis depending on the specific differences between the geography in which the tested party operates and where the comparables are located. Some of such adjustments are described below.13
Despite the ever-broadening adoption of uniform accounting standards such as IFRS by different countries, differences in accounting practices among countries still remain. Hence, it is important to investigate whether the differences in the accounting standards between the country where the tested party is located and the countries of the comparables will materially affect the reliability of the benchmarking analysis. Material differences in accounting standards and practices between the tested party and third-party comparables may lead to measurement errors, unless appropriate adjustments are made. In some cases, the differences in accounting standards, such as the lack of a clear distinction between direct costs and indirect costs, may justify the usage of net-margin-based method rather than a gross-margin-based method. However, even when using the net-margin-based method, such as TNMM,14 some accounting differences may still impact comparability, such as different depreciation periods or treatment of employee's stock options, which affect the operating profit. In some situations, it might be impossible to identify all the differences in accounting standards and accordingly adjust third-party accounts in foreign countries on the basis of publicly available information. This, clearly, is a weakness of the comparability analysis involving data from different countries.
The impact of the Great Recession of 2008, although significant, varied greatly across industries and countries. Thus, care must be exercised while considering such global economic impact, as the market behaviour in the country of the tested party and in the country of the potential comparable (if different from the tested party's) could be significantly different. For example during the meltdown of the global economy in 2008-2009, some of the banks and automobile companies reported substantial domestic losses, yet managed to earn profits in emerging/developing economies. The adjustment that accounts for differences in the magnitude of impact of an economic crisis on different economies could take a form of a regression analysis.15 The reliability of such an approach depends largely on the number of observations, and the quality of the underlying data.
This article provides guidance on how to carry out necessary adjustments when non-domestic comparables are used due to the lack of local comparables (or lack of reliable data for the local companies). The second article of the series (to be published later this year) will provide practical application and examples.
Sebastien Gonnet is a Vice President with NERA, working in both Paris and
Beijing. Vladimir Starkov is a Vice President and Madhura Maitra is a
Consultant, both based in NERA's Chicago office. They may be contacted at:
1 While we acknowledge that the existence and reliability of domestic comparables may vary from one country to the other, the article intends to be rather generic as opposed to focusing on a specific region or group of countries.
2 “G-8 Leaders Communiqué” by Lough Erne, White House Press Releases and Documents, June 2013.
3 Paragraph 1.36 of the OECD Guidelines and Paragraph 5.1.1. of the U.N. Transfer Pricing Guidelines.
4 UN.Transfer Pricing Guidelines, Paragraph 220.127.116.11.
5 OECD Transfer Pricing Guidelines, Paragraph 3.35.
6 UN Transfer Pricing Guidelines, Paragraph 18.104.22.168.4.
7 There is also no consensus among tax authorities in different countries about the reliability of different comparability adjustments. For example, according to the country-specific section of the U.N. Guidelines drafted by the Indian representatives (Chapter 10), the Indian revenue authorities are sceptical about using the Capital Asset Pricing Model (CAPM) for undertaking risk adjustments.
8 The article “Adjusting for Differences in Risk Levels Between Tested Parties and Comparable Firms”, by P. Urken, A. J. Barbera, and J. D. Cole (Transfer Pricing Report, May 2003) discusses how an adjustment in the cost of capital through stock's beta as captured in cost of equity can be used to adjust for risk between the tested party and the comparable companies. Another article “An Econometric Adjustment for Risk”, by S. L. Curtis, C. Marriott, and I. Nutsubidze (Transfer Pricing Report, May 2010) shows that the level of risk borne by the companies is a significant factor affecting their returns. Therefore, comparables should be selected based on the risk they bear vis-à-vis the tested party. The cost of capital adjustment proposed in our article accounts for inter-regional differences in cost of debt, risk free rate, equity risk premium, tax rate, and level of financial leverage and, potentially, may also account for differences in systematic risk between the tested party and the comparable companies if the comparables are publicly traded and the betas of their stocks are known.
9 WACC stands for “Weighted Average Cost of Capital”.
10 PLI stands for “Profit Level Indicator”.
11 In fact, the interquartile range after the cost of capital adjustment might decrease implying a lower associated risk - a counter-intuitive result.
12 “Risk-Adjustments to the Comparables Range”, S. L. Curtis and J. F. Ruhashyankiko, Transfer Pricing International Journal (August 2003).
13 A review of publications that discuss the adjustments for location savings is provided in “Location Specific Advantages - Principles”, S. Gonnet, P. Fris, T. Coriano, Transfer Pricing International Journal (June 2011). Examples of practical application of the location savings adjustments are provided in “Location Specific Advantages - Case Studies,” S. Gonnet, M. Ikeya, V. Starkov, Transfer Pricing International Journal (July 2011).
14 TNMM stands for “Transactional Net Margin Method”.
15 An example of such an analysis is given, for instance, in “Transfer Pricing in Troubled Times”, N. Mori, N. Mert-Beydilli, and G. Poole, Tax Management Transfer Pricing Report (May 2009).
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