## PART I: INTRODUCTION - ADDRESSING THE DIFFICULTIES IN PERFORMING COMPARABILITY

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### Scope and structure
- Establishes framework and roadmap for Parts II–IV and 20 Appendices (page references span "5" through "126").
- Major thematic coverage: issues in comparability analysis; approaches when comparables are absent; summary conclusions and calls to action.
- Practical tools signalled: case studies (Thermal Coal p.71; Construction p.75; Gold Production and Sales p.77), questionnaires (Appendix 1, p.83), business model characterisations (Appendix 2, p.90), commercial database listings (Appendix 3, p.91), formulas and worked examples (Appendices 9–11, pp.101–105), country risk adjustments and two‑step formulas (Appendices 13–14, pp.112–115).

### Major problems and analytical emphasis
- Core problem: scarcity and quality of comparables data in many jurisdictions increases uncertainty, compliance costs, and risks of misallocated tax revenue.
- Emphasis for practitioners/authorities:
  - Accurate delineation of transactions and identification of economically significant characteristics (Part II, section 2).
  - Data-centric comparability: use of commercial databases and tax-administration-held information (Part II, section 3; Appendices 3 and 12).
  - Adjustment mechanics: working capital adjustments, accounting differences, country risk (Part II, section 5; Appendices 9–11, 13–14).
  - Statistical and range-based inference: arm’s length ranges, interquartile range, build-up methods (Part II, section 6; Appendix 15).
  - Policy alternatives when comparables absent: safe harbours, prescriptive rules, transactional profit split, valuation techniques, APAs, anti-avoidance measures (Part III).

### Intended outcomes and call to action
- Encourage rigorous, data-driven comparability processes and clear transaction delineation.
- Provide practical methods to improve comparability and address lack of local comparables.
- Offer policy-level alternatives (safe harbours, prescriptive approaches).
- Summarise actionable conclusions and issue a "Call to action" (Part IV, section 3, page 67).

---

### Role and risk of transfer pricing & arm’s length principle
- Transfer price: price in a transaction between associated enterprises.
- Risks highlighted:
  - Non-arm’s length pricing can distort profit allocation and deny tax revenue.
  - Transfer pricing rules allow tax administrations to adjust taxable profits to arm’s length outcomes.
- Arm’s length principle aims to:
  - Provide parity of tax treatment between associated-enterprise transactions and independent-enterprise transactions.
  - Replicate market results using an international standard reflected in domestic rules and double tax treaties.

---

### H3: Accurate delineation of the controlled transaction — functional analysis and risks

### Process overview and priorities
- Accurate delineation follows background/context collection and drives:
  - Selection of the most appropriate transfer pricing method.
  - Parameters for the comparables search.
- Principle: substance over form — verify contractual terms against conduct; conduct prevails where conflict exists.

### Functional analysis — foundation of comparability
- Functional analysis identifies critical functions, key assets used, and economically significant risks assumed.
- Appendix 1: example functional analysis questionnaire; Appendix 2: characterisations by business model.
- Detailed risk analysis steps (OECD Guidelines para 1.60):
  1. Identify specific, economically significant risks.
  2. Determine contractual assumption of those risks.
  3. Gather evidence on conduct: which enterprise controls/mitigates risk and has financial capacity.
  4. (i) Check contractual consistency with conduct; (ii) determine control and financial capacity of risk assumer.
  5. If party assuming risk lacks control or capacity, reallocate risk to party that does and treat accordingly.

### Pricing implications and transaction disregarded
- Pricing must reflect financial consequences of risk assumption and reallocations.
- International standard permits, in specific circumstances, disregarding a transaction — adjust taxable profit to what it would have been absent the transaction or if structured commercially rationally.

### Illustrative numerical example (Box 2: Sugar Producer)
- Transfer price set by taxpayer: USD 0.08 per pound.
- Identified method: Comparable Uncontrolled Price (CUP) method where a market price for identical sugar exists; compare USD 0.08 per pound to market.

---

### H3: Selecting the most appropriate transfer pricing method (2.4)

### Five methods (OECD / UN)
- (a) Comparable Uncontrolled Price (CUP) Method
  - Preferred when internal comparable exists or for commodities with deep, liquid markets.
- (b) Resale Price Method
  - Compares resale margins; less used due to accounting classification issues.
- (c) Cost Plus Method
  - Compares mark-up on costs; important to define cost base precisely.
- (d) Transactional Net Margin Method (TNMM)
  - Benchmarks net profit margin (PLIs: ROS, ROA, ROCE, ROC, Berry ratio).
  - One-sided; suitable when tested party is routine.
- (e) Transactional Profit Split Method
  - Allocates combined profits based on expected independent split; used when operations are highly integrated or both parties contribute unique/value-driving intangibles.

### Key guidance
- All five methods have equal standing; CUP preferred when equally reliable.
- Once the most appropriate method is identified it should not be discarded solely for imperfect comparables — judge relative reliability and imperfections.

### Commodity pricing and prescriptive ("sixth method") approaches (2.4.2)
- “Sixth method” characteristics:
  - Rely on quoted commodity prices; may mandate specific pricing dates or quotation periods.
  - May be enacted by law/regulation or applied flexibly with comparability adjustments and taxpayer opt-out.
- Pros and cons:
  - Advantages: certainty and simplicity where markets are transparent and liquid.
  - Risks: over/under-taxation if approach misaligns with actual transaction characteristics.
- Toolkit recommendation: further work to develop commodity-specific methods and adjustments (e.g., netback approaches, Section 5.4.4).

### Process of method selection (2.4.3)
- Consider:
  - Strengths/weaknesses of methods.
  - Delineated transaction and functional analysis.
  - Availability and reliability of uncontrolled comparables data.
  - Degree of comparability and feasibility of comparability adjustments.
- Tax administration may replace taxpayer’s selected method if not the most appropriate given facts.

---

### H3: Data sources, comparables search, and geographic considerations (3.4; 4.1)

### Internal vs external comparables
- Internal comparables: transactions between taxpayer/associated enterprise and unrelated parties; use only where products/services/functions are comparable.
- External comparables: domestic or foreign; subject to geographic, functional, and market comparability assessments.

### Typical comparables search process (Box 7)
1. Industry/business classification codes (SIC, NACE, NAICS).
2. Geography/region — prefer same market; consider integrated regions or similar markets.
3. Keywords related to activity.
4. Availability of financial information — exclude if ≥ two years missing.
5. Level of revenues/size — compare similar size; examine continuous losses.
6. Independence — eliminate group-affiliated entities (see Appendix 7).
7. Type of financial accounts — consolidated vs statutory care.
8. Active/inactive screening.
9. Screening for functional comparability — diagnostic ratios (see section 6.3.1).
10. Additional manual screening reviews.

### Reviewing taxpayer searches and country practices (Box 8)
- Many tax administrations start with taxpayer material; some (South Africa, Mexico, New Zealand) critically review or replicate searches and perform own functional analyses; others often perform their own benchmarking (Australia).

### Commercial databases and public administrative data
- Commercial databases and statutory filings are common comparables sources (Appendix 3 lists providers).
- Information held by tax authorities (tax returns, customs) may be comprehensive but often confidential — “secret comparables” debate:
  - Country positions vary: China allows use; Austria and the United States strongly oppose; many countries prohibit or refrain from using secret comparables.
- Customs data: useful for physical characteristics and shipment dates but coded data may lack details for transfer pricing comparability.

### Appendix 4 — available comparable records by country groupings (number of independent records with revenue and net margin)
- =<10 (Quantity: 106) — examples: Afghanistan (AF), Albania (AL), Algeria (DZ), ... Zambia (ZM)
- 10-100 (Quantity: 30) — examples: Azerbaijan (AZ), Bahrain (BH), Belarus (BY), ... Zimbabwe (ZW)
- 100-1000 (Quantity: 28) — examples: Argentina (AR), Bangladesh (BD), Brazil (BR), ... Vietnam (VN)
- 1000-10,000 (Quantity: 13) — examples: Australia (AU), Austria (AT), Canada (CA), ... Thailand (TH)
- 10,000-100,000 (Quantity: 20) — examples: Belgium (BE), China (CN), Germany (DE), ... United States of America (US)
- >=100,000 (Quantity: 11) — examples: Bulgaria (BG), France (FR), Italy (IT), ... Ukraine (UA)
- Note: table summarises voluntarily shared information from private providers; may be incomplete.

---

### H3: Comparability adjustments, working capital adjustments, and accounting differences (Section 5)

### General principles for adjustments
- Make adjustments only where material differences exist and where reasonably accurate adjustments are possible.
- Adjustments can introduce subjectivity; cautious application advised (the “comparability adjustment paradox”).

### Common adjustment types
- Working capital adjustments (WCA) — Section 5.2 / Box 13
  - Purpose: account for opportunity cost of holding inventories/receivables/payables not captured in EBIT metrics.
  - Working capital definitions:
    - Working capital = current assets -/- current liabilities
    - or Working capital = [accounts receivable + inventory] -/- accounts payable
  - Practical issues:
    - Choice of interest rate: commercial loan rate or borrowing rate; midpoint between deposit and lending rates may be plausible.
    - Timing: year-end vs averages where seasonality exists.
    - Mechanical precision can mask larger comparability problems.
  - See Appendix 9 (formulas), Appendix 10 (example).

- Accounting differences (Section 5.3)
  - Timing differences, permanent differences, classification differences can materially affect PLIs.
  - Practical mitigations: use multiple-year data; apply TNMM at net margin to minimise classification effects.
  - Appendix 11: example gross-up for stock-based compensation:
    - Enterprise B disclosed $ 3.25 million after tax; gross-up: $ 3.25/(1-0,35) = $ 5 million before tax.
    - Operating margin example moved from 11% to 6% after adjustment.

- Country risk adjustments (Section 5.5; Appendix 13 and Appendix 14)
  - Two broad approaches:
    - Add premium/discount to PLI (e.g., use long-term government bond yield spreads; WACC differences).
    - Use WCA as proxy for country risk (two-step WCA formulas in Appendix 14).
  - Appendix 13 Example 1:
    - CompCo operating assets 100; government bond yield gap 4% → CompCo operating profit adjusted from 30 to 34 (100 * 4% = 4).
  - Appendix 14 two-step formulas:
    - Equation 1: ∆AR_T = (0 − Comparables Days AR) * Sales / 365
    - Equation 2: ∆Sales_T = ∆AR_T * i_inon−domestic / (1 + (i_inon−domestic * Comparables Days AR / 365))
    - Equation 3: ∆AR_LT = (Target Comparables Days AR − 0) * Adjusted Sales / 365
    - Equation 4: ∆Sales_LT = ∆AR_LT * i_local

### Netback approaches for commodities (5.4.3; Box 15 & 16)
- Netback concept: net back from known arm’s length price at downstream valuation point by deducting transport/processing costs and allowances.
- Box 15 numerical example:
  - Market price refined Commodity M at refinery: 100 c.u./tonne.
  - Refining yield: 1 tonne refined requires 2 tonnes unrefined (50% yield).
  - Refining & transport cost: 15 c.u./tonne.
  - Price of unrefined Commodity M: (100 * 50%) - 15 = 35 c.u./tonne.
- Freight/netback considerations: require comparable time period, cargo type, vessel size; reliable freight data necessary.

---

### H3: Statistical approaches, arm’s length ranges, diagnostic ratios, and build-up approaches (Section 6; Appendix 15, 16–18)

### Arm’s length range and statistical methods
- Arm’s length range: set of financial indicator figures from comparable uncontrolled transactions considered equally reliable.
- Interquartile range (IQR) is commonly used where comparables are heterogeneous; Appendix 15 provides Excel steps:
  - =QUARTILE(range,1) and =QUARTILE(range,3); IQR = Q3 - Q1.
- Example (Box 18: Sugar Producer):
  - Initial set: 33 comparables with PLI range 1.2% to 14.7%.
  - Interquartile range identified: 6.1% to 8.8%.
  - Company A actual PLI negative; taxable profit adjusted to an appropriate point within IQR (median used).

### Diagnostic (financial) ratios
- Purpose: refine potential comparables and improve comparability (avoid cherry-picking).
- Examples include: intangibles over total assets; days inventory; days receivable; turnover per employee; fixed assets over total assets; operating expenses to sales; inventory to total assets.
- Appendices 16–18 provide formulas, acronyms, and common ratios.

### Build-up approaches
- Break down enterprise activities into components; determine arm’s length return for each component and sum.
- Useful when combined comparables for integrated assembly+sales functions unavailable.
- Cautions: avoid double counting, ensure sum-of-parts is commercially sensible, hypothesise internal transfer prices where needed.

---

### H3: Dealing with lack of (local) comparables — policy options and operational responses (Part III; 4.1; Section 5 transactional profit split)

### General approaches when local comparables scarce (5.5; Part III)
- Use foreign comparables where justified; distinguish “other markets data” vs “foreign comparables” (latter demonstrated comparable).
- Empirical evidence: no general rule on reliability of foreign data; country selection should weigh geographic/market differences against other comparability factors.
- Countries often emphasise geographic proximity or similar country credit ratings/economic structures.

### Transactional profit split (Section 5)
- Appropriate where both/all parties make unique and valuable contributions or operations highly integrated.
- Can rely on internal data and operational analysis where external split data unavailable.
- Requires detailed combined profits and information from associated enterprises; judgements can be subjective — taxpayer engagement important.

### Safe harbours for transfer pricing (4.1)
- Definition: simplification measure, typically law/regulation/guidance specifying eligible transaction categories, method, and level/range of PLI.
- Two types considered:
  - “Safe harbour for TP”: specifies method and level/range of financial indicator.
  - “TP Safe harbour on process”: specifies a process that produces an acceptable result.
- Transactions suitable:
  - Manufacturing (toll/contract) with no valuable intangibles or significant risk.
  - Sales/distribution entities with routine functions.
  - Provision of routine services.
- Design considerations:
  - Opt-in vs opt-out regimes; opt-out allows taxpayers to demonstrate alternative arm’s length outcomes.
  - Benchmarks/margins should be set via benchmarking; periodic review recommended.
  - Confidential tax-administration data can inform safe harbour setting if confidentiality preserved; publish aggregated methodology for transparency.
- Operational benefits:
  - Reduce compliance costs; focus audits on eligibility rather than re-benchmarking.
- Risks and mitigation:
  - If set incorrectly may cause tax loss or double taxation; mitigate via opt-outs, alignment with treaty access to MAP, and restricting safe harbour to prices reflected in financial accounts.
- Example: Australia ATO “Simplified Transfer Pricing Recordkeeping” eligibility and specified margins:
  - Eligibility test: international related-party dealings ≤ 2.5 percent of total turnover for the Australian economic group; various exclusions and other tests.
  - Specified margins: Distributors EBT ratio minimum 3%; Intra-group services mark-ups 7.5% (≤ or ≥ depending on provided/received); Management/admin services 5% (≤ or ≥); Technical services 10% (≤ or ≥); Low-level loans inbound: interest rate no more than Reserve Bank of Australia indicator lending rate for small business.

### International aggregated database proposal (Call to action)
- Proposal A: create an international aggregated database derived from tax-administration-held information, published in aggregated form retaining confidentiality.
  - Uses: establish safe harbour margins; test foreign comparables; test foreign party to a transaction.
  - Verification: independent internal audit and publication of collection processes recommended.
  - Access: centralised database for tax administrations and potentially taxpayers; aggregated by category of transaction per country.
- Complementary actions:
  - Increase country registration and electronic availability of company financial accounts.
  - Improve developing-country access to commercial databases and capacity building.
  - Further research on cross-country profitability differences and use of foreign data.
  - Develop guidance and training on method selection and safe harbour design, with special focus on natural resources and commodities (refine quoted-price frameworks and netback adjustments).

### Measures to protect tax bases where transfer pricing infeasible (paragraph 9)
- Explore measures for systemic high-risk cases where transfer pricing cannot be applied:
  - Example: limitation on interest deductibility based on ratio of net interest to EBITDA (BEPS Action 4).
  - Other possible measures: limitations on royalty deductions (e.g., ratio of royalties payable to EBITDA) and limitations on other high-risk base-eroding payments.

---

### H3: Case studies and stylised examples (Boxes & Cases)

### Box 3: Stylised Case — PenCo (accounting and TNMM scenarios)
- PenCo Manufacturing:
  - Sales revenue: 1,000
  - Total Costs: 850
  - Operating Profit: 150
- PenCo Sales:
  - Sales revenue: 1,500
  - Total Costs: 1,200 (includes purchase price of 1,000 for pens)
  - Operating Profit: 300
- Total profit: 450
- Scenario 1 — PenCo Manufacturing as tested party (TNMM, PLI = mark-up on full costs)
  - Benchmark: 10 percent mark-up on full costs.
  - PenCo Manufacturing profit per benchmark: 850 * 10% = 85
  - Remaining profit to PenCo Sales: 450 - 85 = 365
- Scenario 2 — PenCo Sales as tested party (TNMM, PLI = return on sales)
  - Benchmark: 5 percent net margin on sales.
  - PenCo Sales profit per benchmark: 1,500 * 5% = 75
  - Remaining profit to PenCo Manufacturing: 450 - 75 = 375
- Lesson: choice of tested party materially affects allocation; functional analysis determines appropriate tested party.

### Case Study 1: Thermal Coal (high-level conclusions)
- A Co (mine/processor) vs B Co (low-tax jurisdiction purchaser/reseller).
- Contractual fees: B Co receives 7% commission; B Co pays A Co service fee (cost plus 8% mark-up).
- Functional evidence: A Co performs mining, customer-finding, contract negotiation, inventory/delivery management; B Co performs limited routine services.
- Delineation: A Co controls most risks and has financial capacity; risks contractually allocated to B Co reallocated to A Co for TP purposes.
- Method: B Co tested party under TNMM with full costs PLI; adjustment equals difference between comparability result and B Co actual profits.
- Numerical illustration: arm’s length mark-up 5% on costs with cost base 600 → total transfer price 600 * 1.05 = 630; cost base ≈ 95.2% of transfer price (600/630), mark-up 4.8% (30/630).

### Case Study 2: Construction (XYZ Group)
- XYZ (M) in Country M: 15 employees; significant losses 2012–2016; recharged costs from XYZ (S) at pay plus 40% mark-up.
- Audit found control and financial capacity resided with XYZ (S); XYZ (M) did not exercise entrepreneurial control.
- Delineation: risks allocated to XYZ (S); XYZ (M) characterised as low-risk service provider.
- Method: mark-up on cost with XYZ (M) as tested party; adjustment reduces deductible fee.

### Case Study 3: Gold Production and Sales
- A Co mines doré; sells to related B Co (Europe) which refines and sells refined gold; B Co benefits from corporate tax exemption on gold trading.
- A Co annual gross revenue: around USD 400 million.
- B Co annual gross revenue: around USD 425 million.
- A Co paid handling fee retained by B Co: 5.4 percent of the value of each bar.
- Functional analysis: B Co performs refining, manages price risk, owns refining assets; A Co operates mine, arranges delivery.
- Method/benchmarking: refined gold market is highly liquid; TNMM with sales as PLI used; benchmarking against European precious metals refineries showed B Co profitability substantially above comparable range → conclusion A Co over-remunerates B Co.

---

### H3: Operational recommendations and calls to action (summary)

- Encourage adoption of a rigorous, data-driven comparability analysis process with:
  - Accurate transaction delineation and functional analysis (use Appendix 1 questionnaire; Appendix 2 characterisations).
  - Method selection driven by delineation and data availability (Section 2.4).
  - Use of diagnostic ratios (Appendices 16–18) and statistical techniques (Appendix 15) to handle heterogeneous comparables.
- Where local comparables are scarce:
  - Use foreign comparables only after careful economic-market and functional comparability assessment; consider country risk and WCA proxies (Appendices 13–14).
  - Consider safe harbours or prescriptive approaches for routine functions with clear eligibility and opt-out provisions (Section 4.1; Appendix 19; Appendix 20 country examples).
  - Consider transactional profit split where parties make unique/value-driving contributions and comparables unavailable (Section 5).
- Data and capacity actions:
  - Explore feasibility of an international aggregated database of tax-administration-derived data presented in aggregated form to preserve confidentiality and support safe harbour setting, comparability testing, and research.
  - Increase national requirements and central registration for company financial accounts; improve access to commercial databases for developing countries; provide capacity building and regional cooperation.
  - Conduct further research on cross-country profitability heterogeneity and on refining commodity pricing approaches (e.g., netback frameworks).
- Consider protective measures where transfer pricing is infeasible and systemic base erosion risk exists (e.g., limitations on interest or royalty deductions tied to EBITDA ratios).

*Source: pr1715transferpricing - PART I: INTRODUCTION - ADDRESSING THE DIFFICULTIES IN PERFORMING COMPARABILITY (PDF).*

### PART   I: INTRODUCTION - ADDRESSING   THE   DIFFICULTIES   IN   PERFORMING   COMPARABILITY

### PART I: INTRODUCTION - ADDRESSING THE DIFFICULTIES IN PERFORMING COMPARABILITY ANALYSIS

### Scope and structure
- Establishes the overall framework for the document and situates the detailed guidance that follows in Parts II–IV and the Appendices.
- Provides a roadmap of major thematic areas addressed in subsequent parts including: issues in comparability analysis, approaches when comparables are absent, and summary conclusions and calls to action.
- Table of contents entries indicate detailed coverage across 5 major Parts, multiple numbered sections, and 20 Appendices, with page references such as "5" (Part I) through "126" (References).

### Major topics introduced (as reflected in the document structure)
- Core challenges in performing comparability analysis for transfer pricing (leading into Part II).
- The need to delineate transactions accurately and to identify economically significant characteristics (see Part II, section 2 and subsections 2.1–2.4).
- The role and types of data relevant for comparability analyses, including commercial databases and identification of potential comparables (Part II, section 3; subsections 3.1–3.4).
- Methods for making optimal use of available data and wider selection strategies (Part II, section 4; subsections 4.1–4.2).
- Determination of and making comparability adjustments, including working capital and accounting differences (Part II, section 5; subsections 5.1–5.5).
- Interpretation and use of collected data to determine arm’s length remuneration, including statistical approaches, ranges, and build-up methods (Part II, section 6; subsections 6.1–6.4).
- Approaches when comparables are unavailable, covering increasing data availability, testing benefits received, safe harbours, transactional profit split, valuation techniques, advance pricing arrangements, and anti-avoidance measures (Part III, sections 2–8).
- Summary, conclusions, and a call to action synthesizing findings and recommendations on safe harbours, data availability, and a framework for method selection and application (Part IV, sections 1–3).

### Analytical emphasis signaled for practitioners and authorities
- Detailed procedural guidance: delineation of transactions, functional analysis, and selection of the most appropriate transfer pricing method (Part II, section 2 and subsection 2.4).
- Data-centric focus: explicit treatment of the role of data, sources, commercial databases, and identification/selection of comparables (Part II, section 3 and subsections 3.1–3.4; Appendices 3 and 12).
- Adjustment mechanics: methods and formulas for comparability adjustments, including working capital adjustments and accounting differences (Part II, section 5; Appendices 9–11).
- Statistical and range-based inference for arm’s length outcomes, with methods to determine ranges or points and build-up approaches when direct comparables are weak or absent (Part II, section 6; subsections 6.1–6.4; Appendix 15).
- Policy alternatives in the absence of comparables: safe harbours, prescriptive rules, transactional profit split, valuation techniques, and advance pricing arrangements (Part III, sections 3–7; Part IV conclusions on safe harbours).

### Practical tools and supplemental material indicated
- Case studies illustrating application: Case Study 1: Thermal Coal (page 71); Case Study 2: Construction (page 75); Case Study 3: Gold Production and Sales (page 77).
- Questionnaires and characterization aids for functional analysis (Appendix 1, page 83) and business model characterizations (Appendix 2, page 90).
- Listings and examples of commercial databases and classification codes (Appendix 3, page 91; Appendices 5–6, pages 95–96).
- Operational aids and technical appendices: independence criteria (Appendix 7, page 97); comparables search process factors (Appendix 8, page 99); formulas and worked examples for working capital adjustments and accounting differences (Appendices 9–11, pages 101–105); country risk adjustments and two-step formulas (Appendices 13–14, pages 112–115).
- Reference material: financial ratios and acronyms, ratios measuring functions/assets/risks, illustrative safe-harbour legislation and country practices, and a full References section (Appendices 16–20, pages 118–123; References, page 126).

### Intended outcomes and call to action (as framed by the document structure)
- Encourage adoption of a rigorous, data-driven comparability analysis process with clear delineation of transactions and economically significant characteristics (Part II focus).
- Provide practical methods and adjustments to improve comparability and to deal with lack of local comparables (Part II, sections 4–5).
- Offer policy-level alternatives and safeguards for situations where comparables are not available, including safe harbours and other prescriptive approaches (Part III and Part IV conclusions).
- Summarize actionable conclusions and issue a "Call to action" to stakeholders (Part IV, section 3, page 67).

*Source: pr1715transferpricing - PART I: INTRODUCTION - ADDRESSING THE DIFFICULTIES IN PERFORMING COMPARABILITY (PDF).*

### PART I: INTRODUCTION - ADDRESSING THE

### PART I: INTRODUCTION - ADDRESSING THE DIFFICULTIES IN PERFORMING COMPARABILITY ANALYSES

### Role and risk of transfer pricing
- A transfer price is a price employed in a transaction between associated enterprises.
- Transfer pricing is a legitimate and necessary feature of multinational enterprise commercial activity, but when prices do not accord with internationally applicable norms or with the arm's length principle under domestic law, they can distort profit allocation among countries.
- When transfer pricing artificially shifts profits out of a country it denies the country essential tax revenue and may undermine perceived fairness and compliance across taxpayers.

### Purpose and function of the arm’s length principle
- The arm’s length principle:
  - Provides broad parity of tax treatment between associated-enterprise transactions and independent-enterprise transactions.
  - Seeks to replicate market results and level the playing field using an international standard.
  - Is incorporated in most domestic transfer pricing rules and in most double tax treaties as the basis for allocating profits (and taxes) between associated enterprises.
- Transfer pricing rules aim to ensure tax liabilities of associated enterprises are not distorted by related-party status by requiring reporting of taxable profit that would be expected under arm’s length conditions and by granting tax administrations authority to make adjustments where arm’s length conditions are not adopted.

### Nature and focus of comparability analyses
- Comparability analyses are required whenever the arm’s length principle is implemented and involve comparing controlled transactions (between associated enterprises) with comparable uncontrolled transactions (between independent enterprises).
- Comparability analyses are not always primarily focused on transaction prices; they often:
  - Consider whether a transaction occurred at all, or occurred in a way materially different from contract descriptions;
  - Use data on profit margins rather than direct market prices;
  - Consider economic or commercial factors to measure relative value contributions and inform profit splits. (See Section 5 of Part III of this Toolkit.)
- Tax administrations and taxpayers face uncertainties and difficulties in conducting comparability analyses, including scarcity of financial data in parts of the world, affecting compliance costs and tax revenue.

### Alternatives and scope of toolkit
- Unitary taxation or formulary apportionment approaches are sometimes proposed as alternatives to the arm’s length principle and need not rely on comparables, but they are unlikely to be implemented globally in the foreseeable future; this toolkit focuses on practical short- to medium-term measures.
- The toolkit was catalyzed by the Report to G20 Development Working Group on the Impact of BEPS in Low Income Countries (OECD, July 2014).
- The toolkit’s aims:
  - Address challenges of accessing comparables data.
  - Make the best use of available data (Part II).
  - Consider approaches when adequate independent-party data are not available, including safe harbours and prescriptive approaches, and use of tax-return data while preserving confidentiality (Part III).
  - Outline further work and conclusions (Part IV).
- Practical tools provided include commonly used profit level indicators, a sample functional analysis questionnaire, and a step-by-step screening template for potential comparables.

### Impact on extractive/commodity sectors (Box 1)
- Special emphasis on extractive industries and commodity sectors because of their importance to many developing countries.
- Sections particularly relevant to extractive/commodity sectors:
  - Part II, Section 2.4.2 on using quoted prices to determine an arm’s length price for a commodity
  - Part II, Section 3.3.1 on accessible price databases and publications
  - Part II, Section 5.4.1 on (examples of) adjustments for physical characteristics
  - Part II, Section 5.4.4 on (examples of) netback approaches
  - Part III, Section 4.3 on suggestions of prescriptive rules
  - Supplementary work on mineral product pricing (gold, thermal coal, iron ore, copper)
- The toolkit emphasises fact-specific analysis: while some illustrations conclude a local associated enterprise conducts 'routine' activities and should receive relatively low returns, this is not a presumption; in some cases the local enterprise may assume all economically significant risks and thus be entitled to entrepreneurial profit or loss (see Case Study 1).
- NOTE: Illustrations and case studies are illustrative only and limited in facts; they do not have applicability beyond illustrating toolkit topics.

### Key definitional and conceptual points entering Part II
- Controlled transactions: transactions between associated enterprises (often members of the same group).
- Uncontrolled transactions: transactions between independent enterprises; may involve sale/transfer of goods (including agricultural commodities, mineral products, manufactured goods), or transfers of physical/financial assets, intangibles, services, or rights to services.
- Accurate delineation of the controlled transaction is necessary to apply the arm’s length principle: understand commercial/financial relations, establish economically relevant features, select the most appropriate transfer pricing method, and identify potential uncontrolled comparables.
- An uncontrolled transaction is comparable to a controlled transaction when there are no differences that could materially affect pricing, or when such differences can be eliminated by reasonably accurate comparability adjustments.

### Five economically relevant comparability characteristics (per OECD and UN guidance)
- The toolkit reiterates the five factors to consider when assessing comparability:
  - The contractual terms of the transaction;
  - The functions performed by each party, taking into account assets used and risks assumed, and how those functions relate to the wider generation of value by the MNE group, the circumstances surrounding the transaction, and industry practices;
  - The characteristics of the property transferred or services provided;
  - The economic circumstances of the parties and of the market in which the parties operate; and
  - The business strategies pursued by the parties.
- The relative importance of these factors depends on case circumstances; further detail is available in Section D.1 of the OECD Transfer Pricing Guidelines and in Chapter 5 of the UN Practical Manual on Transfer Pricing.

### Summary process for performing a comparability analysis (mapping to OECD/UN steps)
- Typical process steps and references presented in the toolkit:
  - Broad-based analysis of the taxpayer's circumstances — See Part 2.1; Steps 1 and 2 in Chapter III; Paragraph 5.3.1 (UN Practical Manual).
  - Accurate delineation of the transaction — See Part 2.2; Step 3 in Chapter III; Paragraph 5.3.2-3 (UN Practical Manual).
  - Initial review of possible sources of comparables information — See Part 2.3; Steps 4 and 5 in Chapter III; Paragraph 5.3.4 (UN Practical Manual).
  - Select the most appropriate transfer pricing method — See Part 2.4; Step 6 in Chapter III; Paragraph 5.3.6 (UN Practical Manual).
  - Identification of potential comparables — See Part 3.4; Step 7 in Chapter III; Paragraph 5.3.4 (UN Practical Manual).
  - Comparability adjustments (where appropriate) — See Part 5; Step 8 in Chapter III; Paragraph 5.3.5 (UN Practical Manual).
  - Interpretation — See Part 6; Step 9 in Chapter III; Paragraph 5.3.7 (UN Practical Manual).
- Undertaking a broad-based analysis of the taxpayer’s circumstances may include analysis of industry, competition, economic and regulatory factors, and other environmental elements (see Part A of Examples 1, 2, and 3).

*Source: PART I and introductory sections of PR1715 Transfer Pricing Toolkit (IMF).*

### 2.2  Accurate  delineation  of  the  actual  controlled transaction—focus  on  the

### 2.2  Accurate  delineation  of  the  actual  controlled transaction—focus  on  the 
economically significant characteristics

### Overview
- After gathering background and contextual information, the next step is to accurately delineate the controlled transaction.
- The five economically relevant characteristics or comparability factors are normally considered in the analysis as they allow for the accurate identification of the features of a controlled transaction that will be the starting point for the comparability analysis.
- The accurately delineated transaction drives (a) the selection of the most appropriate transfer pricing method and (b) the parameters of the search for comparables.

### Principle of substance over form; verification of contractual terms
- Verify contractual terms by reference to the conduct of the parties.
- There is a clear priority of substance over form where the two are misaligned.
- Written agreements alone generally do not provide sufficient information to identify economically significant activities, responsibilities, assets used or contributed, and risks assumed.
- In some cases, contract terms or other written agreements may be the only indication of certain aspects of a transaction.
- To the extent related party contracts do not fully delineate the transaction, or they conflict with actual conduct, the latter will prevail.

### Functional analysis (foundation of transfer pricing analysis)
- A key element of a comparability analysis is the functional analysis, which identifies all important features of a controlled transaction, including critical functions, key assets utilised, and the assumption of economically significant risks.
- Appendix 1 provides an example of a functional analysis questionnaire (questions must be tailored to facts and circumstances).
- The OECD Transfer Pricing Guidelines consider the assumption of risks to be a crucial part of the functional analysis and delineation of a transaction.

### Detailed analysis of risks — steps (as set out in OECD Transfer Pricing Guidelines paragraph 1.60)
- 1. The identification of specific, economically significant risks;
- 2. The determination of how the specific, economically significant risks have been contractually assumed;
- 3. Gather information on the conduct of the parties, i.e. how the associated enterprises that are parties to the transaction operate in relation to assumption and management of the specific, economically significant risks, and, in particular, which enterprise or enterprises perform control functions and risk mitigation functions; encounter upside or downside consequences of risk outcomes (e.g. greater or lower than anticipated revenues or costs); and have the financial capacity to assume the risk;
- 4. (i). The determination of whether the contractual assumption of risk is consistent with the conduct of the associated enterprises (i.e. whether the associated enterprises follow the contractual terms);
- 4. (ii). The determination of whether the party assuming the risk [as determined in 4(i)] exercises control over the risk and has the financial capacity to assume the risk based on the information gathered in Step 3. If so, this party is regarded as assuming the risk and Step 5 need not be considered;
- 5. If the party assuming risk does not control the risk or does not have the financial capacity to assume the risk, allocate the risk to the party that does control it and has the financial capacity to assume it.

### Pricing implications and transaction disregarded in specific circumstances
- The accurately delineated transaction should be priced taking into account the financial consequences of risk assumption, as appropriately reallocated (if necessary), and appropriately compensating risk management functions, as understood in OECD Transfer Pricing Guidelines.
- The international standard on transfer pricing allows, in specific circumstances, for a transaction to be disregarded.
  - The effect of disregarding a transaction is that the taxable profit of the enterprise involved is adjusted to what it would have been if the transaction had not occurred at all, or, if appropriate, adjusted to what it would have been if the transaction had been structured in a commercially rational manner.

### Practical progression to methods and comparables
- Once a transaction has been accurately delineated, the process of determining the most appropriate method and identifying relevant comparables can commence.
- The accurately delineated transaction will drive the selection of the most appropriate method and determine the parameters of the search for comparables.
- See Part B of Examples 1, 2, and 3; Appendix 2 for characterisations based on typical business models.

### Box 2: Sugar Producer — simplified example illustrating comparability analysis
- Company A produces raw cane sugar in Country A and sells it in bulk to associated enterprises only.
- Raw cane sugar is a commodity product.
- Terms and conditions of the controlled transaction have been agreed upon (type and quality of sugar, quantity, commercial and contractual rights, and obligations, etc.), and a transfer price of USD 0.08 per pound of sugar has been determined by Company A in its transfer pricing analysis.
- The accurate delineation showed:
  - Company A purchases sugar cane from local producers and processes it into raw cane sugar.
  - The associated enterprise packages, sells and distributes it to third party wholesalers and retailers, under a well-known trademark.
  - At arm’s length, the associated enterprise would have the right to a return from the exploitation of that trademark.
  - Company A carries out functions (and uses assets and assumes risks) typical of independent sugar cane processors.
  - The associated enterprise conducts functions (and uses assets and assumes risks) typical of an independent enterprise that packages, distributes and sells sugar.
- Additionally, a market price of the same type of sugar sold between independent parties under comparable conditions is available.
- On the basis of the accurate delineation of the transaction and the availability of information on comparable transactions, the taxpayer concluded that a Comparable Uncontrolled Price method is the most appropriate method.
- Comparable products (such as identical sugar) need to be identified depending on availability and reliability of information and terms and conditions of the controlled transaction. Having identified reliable comparable products and their market prices, these are to be compared to the transfer price of USD 0.08 per pound to conclude if the latter complies with the arm’s length principle.

### Role of tax authorities and opportunistic behaviour
- Many income tax systems are based on self-assessment, under which the taxpayer chooses the transfer pricing method.
- Tax authorities must be alert to the possibility of opportunistic behaviour in this choice.
- Authorities need to scrutinise presumed risk assumptions presented by the taxpayer and delineate the transaction according to the actual facts and circumstances.

*Source: pr1715transferpricing — 2.2 Accurate delineation of the actual controlled transaction—focus on the economically significant characteristics.*

### 2.4 Select the most appropriate transfer pricing method

### 2.4 Select the most appropriate transfer pricing method

### 2.4.1 Overview of the transfer pricing methods
- Purpose: identify the most reliable transfer pricing method for establishing, or testing, arm’s length conditions; selection must first depend on the delineation of the transaction and on the availability of potential comparables.
- The OECD Transfer Pricing Guidelines and the UN Practical Manual on Transfer Pricing describe five methods:
  - (a) Comparable Uncontrolled Price (CUP) Method
    - Compares the price charged in a controlled transaction to the price charged in a comparable uncontrolled transaction.
    - Most often applied:
      - where an internal comparable is available;
      - for commodities, particularly those with deep, liquid markets (pricing data from commodities exchanges may be available, but adjustments may be necessary);
      - for financial transactions (for example, interest rates for loans, guarantee fees);
      - for licensing of some intangibles, particularly where the license is not unique and valuable, to benchmark a royalty rate.
  - (b) Resale Price Method
    - Compares the resale margin that a purchaser in a controlled transaction earns from reselling that property or services with the resale margin earned in comparable uncontrolled purchase and resale transactions.
    - Most often associated with sales and distribution functions that do not involve significant risk or exploitation of unique and valuable intangibles (often used when internal comparables are available, perhaps for a different product, but with comparable functions, assets, and risks).
    - Other resellers with limited value-adding functions where external comparables in the same industry and geographic market are available.
    - In practice it is seldom used because consistency between controlled and comparable uncontrolled transactions in determination of gross margins can be undermined by accounting flexibility (e.g., items accounted as cost of goods sold or operating expenses).
  - (c) Cost Plus Method
    - Compares the mark-up on costs directly and indirectly incurred in supply in a controlled transaction with the mark-up on those costs in a comparable uncontrolled transaction.
    - Most often associated with manufacturers and service providers that do not assume significant risk or exploit unique and valuable intangibles (for example, contract manufacturers).
    - The determination of the appropriate cost base can be of greater importance than the amount of the mark-up, particularly where activities are relatively low value-added.
    - Applied at a gross profit level; same cautions about reliable application as the resale price method.
  - (d) Transactional Net Margin Method (TNMM)
    - Compares the net profit margin relative to an appropriate base (profit level indicator; for example, costs, sales, assets) that an enterprise achieves in a controlled transaction with the net profit margin relative to the same base achieved in comparable uncontrolled transactions.
    - Bears similarities to cost plus and resale price methods but applied at a net profit margin level rather than a gross profit margin level.
    - A one-sided method benchmarking only the “tested party”; suitable where the tested party has relatively routine (i.e. benchmarkable) functions, assets, and risks.
    - The profit level indicator (PLI) selected should reflect the core value-adding activities of the tested party. Typical PLIs include:
      - Return on Sales (ROS) for distributors/resellers of tangible products where no unique and valuable contributions are made by the tested party;
      - Return on Assets (ROA) and Return on Capital Employed (ROCE) for asset-intensive industries, such as manufacturing (where no unique and valuable contributions are made by the tested party). A return on assets basis may also be useful where assets are a key profit driver but other PLIs are not available or cannot be reliably applied;
      - Return on Costs (ROC), in practice often also called a (full) cost plus for service providers, including toll manufacturers and contract R&D;
      - Berry ratio for limited risk intermediary enterprises with no intangibles (a Berry ratio is a ratio of gross profit to operating expenses).
  - (e) Transactional Profit Split Method
    - Allocates to each associated enterprise participating in a controlled transaction the portion of common profit (or loss) that an independent enterprise would expect to earn from engaging in a comparable uncontrolled transaction.
    - Unlike one-sided methods, a profit split considers the appropriate split of combined profits due to each party.
    - May be most appropriate where:
      - the business operations of the associated enterprises are highly integrated; and/or
      - both parties make unique and valuable contributions, including where both parties have a right to the returns from the exploitation of unique and valuable intangibles.
    - Often applied by splitting actual combined profits between associated enterprises on an economically valid basis (for example, based on relative contributions). It can be applied in the absence of comparables.
- Comparative note: although all five methods have the same methodological standing, no single method is suitable in every situation. Where a CUP method and another transfer pricing method can be applied equally reliably, the CUP method is to be preferred because it is more direct.
- Guidance: once a method is determined to be most appropriate given the nature of the transaction, it should not be easily dismissed due to “imperfect” comparables — judge relative reliability, extent of imperfections, and likely imperfections affecting other methods.

### Financial indicators used in transfer pricing methodologies
- Relevant financial indicators by method:
  - For the comparable uncontrolled price method — a price;
  - For resale price method — a gross margin on sales;
  - For cost plus method — a mark-up on direct and indirect costs of supply of goods or services;
  - For transactional net margin method — a margin of operating profit (generally before interest and taxes) as a proportion of total costs, sales revenue or value of assets employed (other margins related to operating profit may also be available);
  - For the transactional profit split method — division of profit between the parties to the transaction.

### 2.4.2 Commodity pricing and prescriptive approaches
- Some countries prescribe approaches to pricing certain transactions (notably commodities), often referred to as “sixth method” approaches.
- Broad characteristics of “sixth method” approaches:
  - Rely on quoted prices from commodities markets to price the transaction and may resemble a CUP method.
  - Common features: prescription of a particular quoted price for each category of transactions; some versions mandate a particular pricing date (such as date of shipment) and/or quotation period.
  - Approaches differ across countries in:
    - whether prescribed in law, regulation or decree;
    - whether applied uniformly or allowing comparability adjustments based on facts and circumstances;
    - types of transactions to which the approach applies.
  - Some versions allow taxpayers to “opt out” where they can provide evidence that the counterparty has sufficient economic substance (the 'opt out' clause puts the onus on the taxpayer to demonstrate the economically significant characteristics of the actual transaction).
- Pros and cons:
  - Advantages: greater certainty and simplicity where criteria for application are clear.
  - Risks: may result in over- or under-taxation and hence double taxation or non-taxation where the approach does not consider actual characteristics of the controlled transaction or where transactions differ significantly from those underlying the quoted price.
  - Most reliable when there are transparent, deep, and liquid markets for the target products and the approach is in line with industry practices.
  - Prescriptive approaches set out in legislation may misalign with industry practices over time; more flexible approaches allowing comparability adjustments and taxpayer “opt out” reduce risk of inappropriate taxation.
- Toolkit recommendation:
  - Proposes work to determine the feasibility of further developing these types of methods to increase reliability and address risks of imposing non-arm’s length pricing (for example, developing specific approaches for particular commodities and incorporating a framework for adjustments such as netback approaches described in Section 5.4.4 of Part II).
- Cross-reference: See also the section on prescriptive approaches in Part III, Section 4.3.

### 2.4.3 Process of selecting the most appropriate method
- OECD guidance: selection should take account of:
  - respective strengths and weaknesses of the methods;
  - appropriateness of the method in view of the nature of the controlled transaction, determined in particular through a functional analysis;
  - availability of reliable information (in particular on uncontrolled comparables) needed to apply the selected method and/or other methods;
  - degree of comparability between controlled and uncontrolled transactions, including the reliability of comparability adjustments that may be needed to eliminate material differences.
- Additional points:
  - The delineation of the transaction provides much of the information needed to determine the most appropriate method; where functional analysis reveals one party is relatively more “routine” and the other’s contribution more significant, a one-sided method may be used and the tested party will generally be the more “routine” entity (see paragraphs 3.18-3.19 of the OECD Transfer Pricing Guidelines (2016)).
  - Country transfer pricing rules based on the arm’s length principle would normally allow a tax administration to replace a taxpayer’s selected method where the selected method is not the most appropriate one taking into account facts and circumstances.

*Source: pr1715transferpricing - 2.4 Select the most appropriate transfer pricing method*

### Box 3. Stylised Case: PenCo

### Box 3. Stylised Case: PenCo

### Illustration of the accounting position and overall profit
- PenCo Manufacturing
  - Sales revenue: 1,000
  - Total Costs: 850
  - Operating Profit: 150
- PenCo Sales
  - Sales revenue: 1,500
  - Total Costs: 1,200 (includes purchase price of 1,000 for pens)
  - Operating Profit: 300
- Total profit to the two enterprises from the manufacture and sale of pens: 450 (i.e. 1500 - 850 - 200)

### Scenario 1 — PenCo Manufacturing as tested party (TNMM with PLI = mark-up on full costs)
- Selected transfer pricing method: TNMM with a PLI of a mark-up on full costs (Cost Plus analogue applied at a net margin level).
- Benchmark result from comparables: 10 percent mark-up on full costs.
- Calculation:
  - PenCo Manufacturing profit per benchmark: 850 * 10% = 85
  - Remaining combined profit allocated to PenCo Sales: 450 - 85 = 365
- Notes:
  - The cost plus method could have been selected, but reliable comparables at a gross margin level were not available.

### Scenario 2 — PenCo Sales as tested party (TNMM with PLI = return on sales)
- Selected transfer pricing method: TNMM with a PLI of a return on sales (Resale Price analogue applied at a net margin level).
- Benchmark result from comparables: 5 percent net margin on sales.
- Calculation:
  - PenCo Sales profit per benchmark: 1,500 * 5% = 75
  - Remaining combined profit allocated to PenCo Manufacturing: 450 - 75 = 375
- Notes:
  - The Resale Price method could have been selected, but reliable comparables at a gross margin level were not available.

### Key lesson from the stylised example
- The choice of tested party has a very significant impact on the profit allocation between associated enterprises, even when the same broad method family (TNMM) is used.
- The choice of method and the choice of tested party can be more significant than the precise value of the chosen financial indicator (in this case, full-cost mark-up or return on sales), because they determine how the arm’s length transfer price is deduced:
  - Scenario 1: transfer price deduced from the benchmarked net profit margin of PenCo Manufacturing.
  - Scenario 2: transfer price deduced from the benchmarked net profit margin of PenCo Sales.
- The same issues would arise with other methods, such as CUP or a transactional profit split.

### Functional analysis and selecting the tested party
- It is essential to consider the functional analysis (assets used and risks assumed) of each enterprise to determine which scenario best fits the actual transaction.
- Illustrative functional considerations:
  - If PenCo Manufacturing undertook routine manufacturing activities to the order of PenCo Sales while PenCo Sales was the ‘entrepreneur’ and had developed a unique and valuable brand for the sales of the Pens, Scenario 1 is more likely to be appropriate.
  - If PenCo Sales undertook routine distribution and sales activities of high-end designer pens developed and manufactured by PenCo Manufacturing, Scenario 2 may be more appropriate.
- Where an enterprise assumes economically significant risks, including those associated with a unique and valuable intangible, it is unlikely that a reliable comparable can be identified for it, and a one-sided method testing that enterprise’s return will not be appropriate.

### Conclusions on method selection (context from the box)
- There is no hierarchy in the selection of transfer pricing methods.
- Depending on the accurate delineation of the transaction:
  - A transactional profit split can be more appropriate than a CUP or a one-sided method, and vice-versa.
  - If it is possible to benchmark a return for one of the parties (normally a routine party without unique/value-adding contributions), a one-sided method (cost plus, resale price, or TNMM) may be appropriate.
  - If parties are highly integrated and/or both make unique and valuable contributions, a one-sided method may not be reliably applicable; a transactional profit split might be more appropriate.
- The choice of the most appropriate method is often a very significant determinant of the allocation of profit between enterprises.

*Source: Box 3. Stylised Case: PenCo*

### 3.4 Identification of potential comparables

### 3.4 Identification of potential comparables

### Internal comparables
- Information regarding transactions between the taxpayer (or an associated enterprise of the taxpayer) and unconnected parties may be available; an analysis is needed to determine whether these transactions are comparable to the transaction(s) under review.
- Box 4. Chocolate Bar Manufacturer (simplified example):
  - Company A manufactures chocolate bars and other confectionary products and sells the chocolate bars to Company C.
  - Company A also manufactures a special granola bar, physically different from the chocolate bars and to which no reliable adjustments can be made to make it comparable, and sells the granola bars to unrelated parties.
  - The granola bars are not comparable products to the chocolate bars; the Comparable Uncontrolled Price method is not appropriate in this case.
  - The accurate delineation of the transactions shows functions performed, assets used, and risks assumed by Company A in manufacturing chocolate bars and granola bars are very similar, if not identical.
  - Implication: the reward to the functions related to manufacturing granola bars may be used as the internal comparable to the reward to the functions related to manufacturing chocolate bars.
  - A profitability return can be attributed to each function based on the selection of the most appropriate transfer pricing method.
  - Conclusion: the internal comparable may be used to determine the arm’s length nature of the controlled transaction by comparing the profitability of each production line.

### External comparables
- When no potential internal comparables are identified, external comparables need to be considered and identified.
- External comparables can be sought from domestic and/or foreign sources of information depending on facts, circumstances, and comparability factors.
- Appendix 3 presents an overview of available sources of public data (as referenced).
- Box 5. Sugar Producer (simplified example):
  - Company A produces a commodity product traded with associated enterprises only and made an operating loss in the relevant period.
  - Company A purchases sugar cane from independent producers, processes it into raw cane sugar, and sells the sugar to associated enterprise Company B, which packages and distributes under its own trademark.
  - Under an agreement, Company A produces sugar only to the order of Company B; Company B is obliged to purchase all sugar produced and does so.
  - Company B makes all decisions about production volume and scheduling; Company A has no unique and valuable intangibles and does not make material contributions to intangibles owned by associated enterprises.
  - Conclusion: inventory risk and market risk are assumed by Company B; Company A is most accurately characterised as a "contract manufacturer" on behalf of Company B.
  - The most appropriate method: a Transactional Net Margin Method, using Company A as the tested party and operating profit/full costs as the PLI.
  - No internal comparables available → commercial electronic database used to identify potential comparables.
  - Search criteria: independent manufacturers of commodity food products in Country A that did not exploit unique and valuable intangibles, did not conduct material sales and marketing activities, and did not have other business lines.
  - Initial search identified 45 such manufacturers; manual review rejected 12 companies, leaving 33 potential comparable manufacturers (“potential comparables”).
  - Result: comparables used to benchmark a return for Company A, in line with its routine functions and very limited risks.
- Geographic considerations:
  - Starting with local geographic market comparables generally minimises potential material differences.
  - If local comparables are scarce, foreign comparables may be considered; must examine whether market differences materially affect the condition under examination.
  - Where the transaction occurs in a truly global market, geography may not make a material difference.
- Box 6. Different Geographical Markets (simplified example):
  - Tax administration in Country X delineated a controlled transaction as provision of manufacturing services under a contract manufacturing agreement.
  - The subsidiary performed routine manufacturing services using its own assets and certain intangibles owned/developed by its associated enterprise; it did not undertake significant R&D or sales and marketing activities.
  - Search for comparable contract manufacturers in Country X unsuccessful; available independents had significant R&D and/or sales and marketing functions and appeared to have unique and valuable intangibles.
  - Audit team sought potential comparables from other geographic markets with similar economic conditions; independent contract manufacturers from other markets were found and reviewed.
  - Based on thorough analysis, data from independent contract manufacturers with a similar range of functions, assets, and risks from another jurisdiction provided a more reliable comparison than any local manufacturers.

### 3.4.1 The comparables search process
- Typical comparables search process (assumes controlled transaction accurately delineated and a one-sided method is most appropriate).
- Box 7. A Typical Process to Screen for Comparables:
  1. Industry/business activity qualification codes
     - Common starting point: industry/business activity classification codes (most common codes presented in Appendix 5; list of other countries’ codes in Appendix 6).
     - Commonly used: Standard Industry Classification (SIC), Nomenclature of Economic Activities (NACE), North American Industry Classification System (NAICS); guidance provided in Part C of Case Study 3.
  2. Geography/region/country/market
     - Prefer potential comparables from same geographic market as tested party initially.
     - If market is key comparability factor, define as a country, region, or group of countries considered (a) a single or largely integrated market; or (b) sufficiently similar to the market of the tested transactions.
     - See Section 5.5 on use of foreign data.
  3. Key words related to the business activity
     - Identify and search for key terms related to the tested party’s business and activities under review.
  4. Availability of financial information
     - Screen out potential results if two or more years of information are missing.
  5. Level of revenues (or other indicators of size, such as assets or number of employees)
     - Compare entities of similar size; examine companies with continuous losses more carefully.
  6. Independence
     - Seek to eliminate entities that belong to a multinational group; see Appendix 7 for independence criteria.
  7. Type of financial accounts
     - Identify entities providing consolidated or statutory financial accounts; care when using consolidated accounts—usable only if functions of consolidated group equate to those of tested party.
  8. Active/inactive entities
     - Inactive entities usually screened out.
  9. Screening for functional comparability
     - Refine keyword search by screening financial account amounts indicating existence/absence of functions or assets (e.g., exclude entities with non-negligible R&D expenses if tested party undertakes no R&D).
     - See discussion of diagnostic ratios in section 6.3.1.
  10. Additional manual screening reviews
     - Additional criteria critical to review at a manual level; see Part C of Case Study 3 for an example.

### 3.4.2 Reviewing a comparables search process using commercial databases
- Tax administrations may critically analyse the comparables search undertaken by the taxpayer rather than undertaking a full search themselves.
  - This may be appropriate if the tax administration lacks access to a database, or for taxpayers engaged in low-risk transactions or with strong compliance history.
  - A typical process for reviewing a comparables search is presented in Appendix 8 (as referenced).
- Box 8. Country Practices (summary of practices from OECD interviews, May 2016):
  - Some countries start analysis with information provided by the taxpayer (transfer pricing documentation, supplemented by taxpayer questionnaires).
  - South Africa: always starts with taxpayer material; discuss disagreements with taxpayer and seek solutions; if total disagreement, perform own comparability analysis.
  - Mexico: starts with taxpayer’s comparability analysis and reviews/replicates the search; assesses whether all comparability analysis steps were properly performed; corroborates the taxpayer’s functional analysis; may perform its own search if inconsistencies.
  - New Zealand: always reviews taxpayer information using experience to analyse reliability.
  - Norway and Colombia: typically start with taxpayer analysis; Colombia always does its own functional analysis (including company visits and interviews); if taxpayer comparables not reliable, select others.
  - Australia: usually undertakes its own benchmarking, often based on common sets of potential comparables for particular transactions, then modifies based on facts and taxpayer information.

### 4. Making optimal use of available data — 4.1 Other sources of information
- Commercial databases and statutory filings are commonly used sources for transfer pricing comparability when available.
- 4.1.1 Information in the hands of the tax authority
  - In many developing countries, information collected by tax administrations through tax filings or customs may be the most comprehensive domestic source of data on potential comparable uncontrolled transactions.
  - Such information is typically covered by tax secrecy rules and not available to taxpayers.
  - Customs data is unlikely to be directly applicable to a transfer pricing analysis.
  - The UN Practical Manual on Transfer Pricing and the OECD Transfer Pricing Guidelines caution against use of this kind of information for transfer pricing comparability purposes (“secret comparables”), unless requisite information can be disclosed to taxpayers within limits of domestic confidentiality rules.
  - Countries’ positions on use of secret comparables vary:
    - China: explicit provisions allowing use of non-public information.
    - Austria and the United States: strong opposition to their use.
    - Most, but not all, countries either specifically prohibit the use of secret comparables or refrain from using them in practice.
  - Footnote references:
    - “Secret comparables” definition: paragraph 1.6.13 of the UN Practical Manual on Transfer Pricing (2013) or paragraph 3.36 of the OECD Transfer Pricing Guidelines (2016).
    - For court cases on secret comparables, see Muyaa, E. September/October 2014. Transfer Pricing Comparability Adjustments: The Pursuit of “Exact” Comparables.

*Source: pr1715transferpricing - 3.4 Identification of potential comparables*

### Box 9. Country Practices: The Use of Secret Comparables

### Box 9. Country Practices: The Use of Secret Comparables

### Overview
- The box summarizes country practices and positions regarding the use of non-public or "secret" comparables in transfer pricing analyses.
- It also connects to related discussion on the use of customs data, non-public administrative information, and broader data selection and comparability adjustment approaches in transfer pricing work.

### Country positions on secret comparables
- Austria: The use of secret comparables is seen as a potential violation of fundamental taxpayer rights in Austria. According to Austrian law, every taxpayer has the right to defend its position before an adjustment is made and this right would be undermined by the use of secret comparables.
- China: Circular 2/200951 explicitly states that the tax authorities may use non-public information.
- South Africa: Practice Note 7 states that SARS does not intend to use secret comparables, but does not rule out the possibility.
- Mexico: A domestic law provision specifically allows the use of secret comparables by the SAT provided that disclosure of the details of the comparables is made to elected “representatives” of the taxpayer under examination.
- Turkey: “When determining transfer pricing-related assessments, Turkish tax auditors would highly tend to use their own ‘secret comparables’ to which only they have access, by virtue of their public authority.” (Özlem G.A. and Mehmet D.A. 2011. IBFD Transfer Pricing Database Turkey Chapter).
- United Kingdom: HMRC does not rely on secret comparables, except as a basis for rejecting a potential comparable.
- United States: The IRS strongly opposes the use of secret comparables and routinely objects to their use in mutual agreement procedures. (Andrus, J. 2008. IBFD Transfer Pricing Database United States chapter).

### Customs data as a potential source of comparables
- Customs valuation data is collected by customs authorities at the time of import and is confidential and not typically publicly available at the transaction level.
- In most countries, customs valuations to determine customs duty liability are determined in accordance with domestic legislation based on the WTO Valuation Agreement (1979). In such cases, the transaction value, being the price actually paid or payable with respect to the sale that resulted in the export, is the starting point and is the method required to be applied wherever possible (in general used for over 90 percent of imports).
- Customs valuation rules allow methods other than the transaction value where it is demonstrated that the relationship between importer and exporter has influenced the price, or where no sale has taken place. Alternative methods must be applied in strict hierarchical order and rely on availability of information (identical or similar goods, industry margins etc.).
- Customs data are typically classified by codes/nomenclature that may not provide sufficient detail to ascertain characteristics relevant for transfer pricing (quality, branding), functions, assets and risks, or terms of trade.
- In some cases customs data may be useful to supplement other information, particularly regarding physical characteristics of goods or precise shipment dates.

### Coordination and guidance on customs and transfer pricing
- OECD, WBG, and WCO have been developing practical tools for closer co-operation between customs officers and transfer pricing auditors, focusing on mutual understanding of rules and better use of available information.
- The WCO, working with OECD and WBG, has produced a guide that provides background on customs and transfer pricing methodologies, areas of overlap, and examples of national practices.

### Role of non-public administrative information
- Non-public administrative information can be highly relevant in practice and is typically the main source for designing benchmarks for risk assessment and guiding audit selection.
- Tax return information can be used to review taxpayer performance against industry benchmarks and other structural risk indicators; usually supplemented with publicly filed accounts, chamber of commerce or business registry data, private databases, or media reports.
- Data published on industry-specific performance are useful for risk assessment but problematic to support actual transfer pricing assessments because industry averages are broad and often include controlled transactions.
- Administrative information may be used to design safe harbour rules and to set reliable safe harbour ranges without breaching taxpayer confidentiality (discussed further in Section 4 of Part III).

### Wider selection of data and practical screening considerations
- Loosening initial screening filters can increase the pool of information for comparability studies but risks loosening comparability; balance is required.
- Use of data from other industries with similar functional profiles can be considered; more effective when applying one-sided methods relying on a net profit measure (i.e., TNMM), since accounting classification differences between industries/countries are more likely to reduce reliability of gross profit comparisons.
- Example (Box 10: Broadening Search Criteria): A tax administration auditing a local subsidiary of a large MNE in construction and mining machinery could:
  - Search for local, functionally similar wholesale marketer/distributors of other types of plant, equipment, and machinery and other goods.
  - Search for functionally similar wholesale distributors of construction and mining machinery and related goods in foreign markets with similar economic conditions (particularly levels of capital investment) to those experienced in Country A over the audit period.
- Some countries may consider less rigid independence requirements (e.g., tolerating certain minority shareholdings) where strict ownership screens yield no comparables; pragmatic approaches may help in highly concentrated markets or where joint ventures are common.

### Determination of and making comparability adjustments (Step 8)
- Comparability adjustments should be considered only where material differences exist and only if reasonably accurate adjustments can be made to eliminate such differences.
- Adjustments can introduce complexity and subjectivity and should be made only if expected to increase reliability of results and not applied automatically.
- It is important to assess whether an adjustment is likely to improve reliability or whether unadjusted results may be more reliable.

### Illustrative example: when unadjusted results may be preferable (Box 11)
- Company J (a distributor of consumer goods) proposed adjustments to independent distributor comparables to account for costs of producing transfer pricing documentation included in the taxpayer’s operating costs but not in comparables.
- Tax authority concluded that other unobserved costs (negotiation with suppliers, other tax compliance costs) likely offset documentation costs and that the taxpayer’s proposed adjustment would more likely reduce reliability; therefore the unadjusted EBIT/Sales results were preferred.

### Common types of comparability adjustments
- The most commonly used comparability adjustments are:
  - working capital adjustments (see Section 5.1);
  - adjustments for accounting differences (see Section 5.2);
  - country risk adjustments (see Section 5.5.3).
- Other types of adjustments are discussed in Section 5.4.

### Country practices and caution on adjustments (Box 12)
- Many countries adopt a cautious approach to comparability adjustments and note the “comparability adjustment paradox”: small adjustments will not materially alter an arm’s length range, while large adjustments may mask more fundamental comparability differences.
- Some countries express concern that adjustments may not improve reliability and can add subjectivity; some hesitate to make adjustments due to lack of experience or knowledge.
- South Africa and Australia, for example, focus more on qualitative analysis rather than mechanical comparability adjustments.

### Working capital adjustments (WCA) — purpose and mechanics (Section 5.2 and Box 13)
- Working capital adjustments are the most commonly applied comparability adjustments and are typically performed when applying the TNMM, though they may also be relevant for cost-plus and resale price methods.
- Rationale: holding working capital (inventories, receivables, payables) entails an opportunity cost and notional finance cost not captured in profit-and-loss measures; WCA adjusts the profit level indicator accordingly.
- Working capital definitions/formulas:
  - Working capital = current assets -/- current liabilities
  - or Working capital = [accounts receivable + inventory] -/- accounts payable
- A higher net working capital would be expected to be associated with a higher EBIT versus an otherwise similar entity with lower net working capital, reflecting the cost of holding the additional working capital or interest income forgone.
- By performing WCA, operating profit measures that exclude explicit interest revenues and costs (such as EBIT) can be corrected for implicit interest embedded in sales and cost of goods sold to increase comparability.

### Practical difficulties and considerations in applying WCAs
- Choice of interest rate to apply to working capital items:
  - Transfer pricing guidelines refer to a commercial loan rate or borrowing rate (depending on the perspective of the tested party) as the interest rate to be used.
  - The midpoint between the deposit rate and the lending rate can be a plausible estimation of the operating earnings effects of holding different levels of inventory.
- Timing of balance sheet comparisons:
  - Determination of the point in time for comparing receivables, inventory, and payables (e.g., last day of the (calendar) year) may not be representative if working capital is seasonal; averages might be used where they better reflect the year.
- Mechanical nature and apparent precision of WCA can mask larger questions about comparability or appropriateness of adjustments; WCAs may add costs and complexity disproportionate to any reliability gain.
- Appendix references: formulas on accounts receivable, inventory, and accounts payable adjustments are elaborated in Appendix 9; an example of a WCA is provided in Appendix 10.

*Taken from World Bank Group (2016): Transfer Pricing and Developing Economies: A handbook for policy makers and practitioners.*

### Box 14. Country Practices

### Box 14. Country Practices

### Country practices on comparability and working capital adjustments (WCAs)
- WCAs are the most used comparability adjustments in practice.
- The United States commonly makes WCAs.
- South Africa and New Zealand do not often make WCAs; according to these countries, such adjustments only make minor differences when reliable comparables have been selected.
- These countries note that when a significant difference is calculated, it raises concern that the difference may be due to issues wider than merely a difference in the level of working capital.
- Source of country information: OECD interviews with country representatives, May 2016.

### 5.2.1 Working capital as a proxy for a functional adjustment
- Working capital‑type adjustments are sometimes proposed to adjust for differences in functions, assets, and risks, particularly in relation to inventories or business strategies (for example, provision of finance to customers).
- Such adjustments may be applied where independent manufacturers or distributors that hold inventories are proposed as comparables for manufacturers or distributors that do not.
- The working capital adjustment may be applied to adjust both the tested party and the comparables to “zero” working capital (accounts receivable, inventory, and accounts payable, or in some cases, just inventory).
- The reliability of these adjustments must be carefully considered; practical issues previously noted are equally or more relevant here.

### 5.3 Adjustments for accounting differences
- Despite the use of international accounting standards such as IFRS, accounting differences remain between countries, industries, and entities; an investigation of material effects on comparables is important.
- Three broad types of accounting differences:
  - Timing differences: e.g., inventory write‑offs, different depreciation or amortisation methods, goodwill amortisation.
  - Permanent differences: differences in revenue‑recognition, recognition of expenses.
  - Classification differences: the manner in which costs (such as depreciation) are measured and presented; interest, taxes, foreign exchange, non‑recurring and extraordinary items, share option expenses, differences in accounting treatment of rebates, capitalisation of certain expenditures, inclusion in cost of goods sold; classification of certain items as operating/non‑operating when the PLI being tested is at the operating profit level.
- Due to limited detailed information, reliable adjustments for accounting differences can be difficult, but practical solutions include:
  - Mitigating timing differences by using multiple year data.
  - Eliminating or minimising some permanent and classification differences by applying the TNMM on a net margin level.
- An example of an adjustment for accounting differences is provided in Appendix 11.

### 5.4 Other adjustments — selection and reliability principles
- The list below is a selection of commonly used adjustments (not exhaustive).

- 5.4.1 Adjustments for physical characteristics
  - When a CUP method is appropriate, adjustments may be necessary for material differences between physical characteristics of goods sold or transferred and those in uncontrolled transactions (often relevant for commodities).
  - Adjustments are most reliable when consistent with arm’s length industry practices (example: proportional adjustment for iron content differences relative to a common industry reference price).
  - Exercise greater caution the larger the size of the adjustment relative to the price being adjusted, particularly where reliable guiding information is lacking.
  - Reliability varies by product: some adjustments can be made with confidence; others may push toward margins where magnitude is uncertain; some risk “black box” adjustments without sufficient information on direction or magnitude.
  - Adjustments may change over time (example: price penalties for impurities in copper concentrate may fall or disappear if concentrate markets are tight).
  - Revenue authorities should keep up to date on industry practices via in‑house expertise, networks with other revenue authorities, or external expert assistance.

- 5.4.2 Contract and payment terms
  - Adjustments may be needed for material differences in contract terms between the controlled transaction and potentially comparable uncontrolled transactions.
  - Example: if a commodity price is quoted FOB but the transaction is CIF, an adjustment for the different shipping terms is likely necessary; the adjustment can be made by way of a netback adjustment (see Box 15).
  - Differences in payment terms can be adjusted with a working capital adjustment (Paragraph 5.2).

- 5.4.3 Netback approaches — adjustments for differences in the valuation point of commodities
  - A netback approach adjusts the price of a commodity where a known arm’s length price exists at a different point in the value chain; it “nets back” costs between the two valuation points to determine the upstream price.
  - The netback method identifies relevant costs incurred between the relevant valuation point and the market pricing point, and makes an adjustment for those costs (including an allowance for capital expenditure where relevant).
  - Simple netbacks adjust for transportation cost between locations (see Box 15).
  - More complex netbacks account for differences in physical characteristics or processing (e.g., conversion ratio or yield from known market pricing point to relevant valuation point, processing and transportation costs, allowance for capital expenditure, and possible time differences).
  - Reliable freight information must cover a comparable time period, same cargo type (e.g., bulk cargo), and ship size; actual freight rates may be used if an unrelated third party delivered the product.

### Box 15. General Example on Netback Approach (simple numerical example)
- Market price for refined Commodity M at the refinery: 100 currency units (c.u.) per tonne.
- Controlled transaction: sale of unrefined Commodity M at the mine gate between associated enterprises.
- Refining yield: 1 tonne refined requires 2 tonnes unrefined (i.e., a yield of 50 percent).
- Arm’s length price for refining and transportation (from the mine to the refinery): 15 c.u. per tonne.
- Price of unrefined Commodity M calculation: (100 * 50%) - 15 = 35 c.u. per tonne.

### Box 16. Use of a Netback Approach for Freight Costs (simplified example and practical considerations)
- Revenue authorities commonly adjust for differences in delivery terms (e.g., FOB vs CFR/CIF) using netbacks to establish comparable prices at different geographical locations.
- Netbacks often rely on published estimates of freight costs between various ports worldwide; these costs vary by product, date of transport, and vessel size.
- FOB definition: seller delivers goods on board the vessel nominated by the buyer at the named port of shipment or procures the goods already so delivered; risk passes when goods are on board the vessel, and buyer bears costs from that moment.
- CFR definition: seller delivers goods on board the vessel or procures the goods already so delivered; risk passes when goods are on board the vessel; seller must contract for and pay costs and freight necessary to bring goods to the named port of destination.
- To use the netback approach, reliable freight information is required for the comparable time period, same cargo type, and ship size; actual freight rates may be used if an unrelated third party performed the shipping service.

*Source: OECD interviews with country representatives, May 2016.*

### 5.5 Dealing with a lack of (local) comparables

### 5.5 Dealing with a lack of (local) comparables

### General
- Uncontrolled transactions from markets other than that of the tested party can constitute reliable comparables, or be accepted and used as the best available comparables in the absence of local market comparables.
- Reliance on other markets data is common in both developing and developed countries, including many OECD economies.
- Selection of foreign comparables requires weighing potential differences in geographic markets against other economically relevant characteristics.
- Distinction:
  - “other markets data” = data from companies located in a different country to the tested party that has not been demonstrated to have satisfied the requisite standard of comparability with respect to economic circumstances.
  - “foreign comparables” = data from companies located in a different country to the tested party that has been demonstrated to have satisfied the requisite standard of comparability.
- There is no specific, widely accepted guidance on how to assess differences in economic market conditions or how to conduct potential adjustments; OECD Transfer Pricing Guidelines and the UN Practical Manual only require assessment and adjustment where appropriate.
- Common selection practice:
  - Emphasise geographic proximity (e.g., pan-European, Nordic, Iberian, Benelux, pan-Asian).
  - Consider similar country credit ratings and/or economic structures (legal and regulatory systems, dominant industries).
- Empirical evidence is inconclusive on the reliability of foreign data; a 2004 study (Meenan et al.) endorsed pan-European data while a 2008–2014 replication suggests notable heterogeneity in profitability ratios even within Europe.
- Conclusion: no general rule is provided; the use of foreign data is widespread but would benefit from further study.

### Adjustments for differences in geographic market
- There is no widely accepted method for adjusting for market differences; approaches are varied and exposed to methodological challenges.
- Potential proxies for country-specific effects are not readily available; practitioners must weigh country-specific differences against other differences in available local data and proceed with adjustments where they improve reliability.
- Approaches discussed include country risk adjustments and working capital adjustments as proxies.

### Adjusting for country risk by adding a premium (or a discount) to the PLI
- Country risk is defined as risk induced by the country location of a business activity (political or economic environment) rather than the fundamental nature of the activity.
- Most proposals add a premium/discount to comparables’ results to account for differences in risks (competition, credit, foreign exchange, product liability, technological obsolescence).
- Example adjustment methods cited:
  - Use of spread in countries’ long-term government bond yields applied to operating assets (Büttner (2012)).
  - Adjustments to operating profit based on differences in weighted average cost of capital (WACC) between tested party and comparables (Gonnet et al. (2014)).
- Little empirical evidence exists on the reliability of these approaches; careful consideration required whether these approaches can account for differences in expected profitability.

### Adjusting for country risk by using a working capital adjustment as a proxy
- Argument: differences in working capital employed reflect differences in economically relevant factors such as country risk (differences in interest rates for short-term debt, credit terms, credit risks).
- Working capital adjustment (WCA) for comparables involves:
  - Step 1: Adjust accounts receivable of Country A comparables to zero and apply a Country A interest rate to the differential → results in lower revenues for comparables and a lower profit margin.
  - Step 2: Adjust accounts receivable of comparables from zero to the level of the tested party in Country B and apply a Country B interest rate → increases revenues for comparables and results in a higher profit margin.
- Formulas for these calculations are provided in Appendix 14.

### Country practices (Box 17)
- Developing countries often rely on foreign comparables; country-specific risk adjustments can be particularly important.
- Judgement is required in country risk adjustments:
  - Australia tends to avoid such adjustments.
  - Colombia considers it lacks sufficient knowledge on when/how to use country risk adjustments.
  - South Africa always uses foreign comparables (no local comparables): selects countries with the same risk profile or applies country risk adjustments when profiles differ.
  - Mexico often uses U.S. and Canadian comparables due to close market connections and often considers geographic market adjustments; may search for comparables from similar economies (example: India and Malaysia) under proper circumstances.
  - Canada often uses U.S. comparables; adjustments are sometimes considered necessary but are hard to quantify.

### Interpretation and use of data collected; determination of the arm’s length remuneration
- Application of the most appropriate transfer pricing method may produce a “range” of financial indicators that are equally reliable. The OECD Transfer Pricing Guidelines recognises that such ranges arise because arm’s length application is an approximation.
- Common practice: calculate an arm’s length range and determine whether the tested transaction’s indicator lies within it; if not, taxpayer or tax authority adjusts taxable profit to place the indicator within the range.
- Some countries explicitly define an arm’s length range and allow statistical techniques where a range cannot be identified.

### Arm’s length range
- Definition: a range of relevant financial indicator figures produced by applying the most appropriate method to a number of uncontrolled transactions that are all comparable and equally comparable to the controlled transaction.
- If controlled transaction results fall within the arm’s length range, no adjustment warranted.
- An arm’s length range should normally be relatively narrow; commercial database searches without refinement are unlikely to yield an arm’s length range due to qualitative differences.
- Example regulatory provision: a country may limit the concept to relatively small ranges (illustrative cap example: the highest point in a range may not exceed a percentage, say 25 percent, of the lowest point); where exceeded, a statistical approach may be stipulated.

### Statistical approaches
- Where comparability of potential comparables is uncertain (e.g., commercial database), transfer pricing rules may require a statistical technique.
- Interquartile range is the most common statistical technique; Appendix 15 explains how to calculate it.

- Example (Box 18: Sugar Producer):
  - TNMM used with operating profit/full costs as the PLI.
  - Database search produced 33 potential comparables with PLI ratios ranging from 1.2% to 14.7%.
  - Due to uncertainty in comparability and a wide initial range, a statistical approach was used in accordance with domestic legislation.
  - Interquartile range identified: 6.1% to 8.8%.
  - Company A’s actual PLI was negative; taxable profit was adjusted so Company A’s operating profit/full costs ratio reached an appropriate point within the interquartile range—specifically, the median point was used.

### Determining an arm’s length range or point from potentially comparable results
- Alternative to comparability adjustments: select different points in the range to reflect differing levels of functions, assets, and risks.
  - Lower point for a distributor with relatively limited functions, assets, and risks.
  - Higher point for a distributor with relatively more functions, assets, and risks.

*Source: pr1715transferpricing - 5.5 Dealing with a lack of (local) comparables*

### Box 19. Country Practices

### Box 19. Country Practices

### Country practices on range concepts and point selection
- U.S. regulations describe both an “arm’s length range” concept and an interquartile range concept.
- One or the other may be used depending on:
  - the quality of the comparables (i.e., how similar are they to the controlled transaction), and
  - the consistency of the comparables (i.e., how similar are the comparables to each other).
- When comparables are both high quality and very consistent:
  - an arm’s length range may be used that includes all of the comparables and a result within the range is considered an arm’s length result.
- When comparables are of lower quality or less consistent:
  - they may be used to construct an interquartile range that omits the lowest and highest 25% of the comparables.
  - Results that fall outside the interquartile range are generally made to the median of the range.
- Rationale quoted: the adoption by the United States of these range concepts is based on a recognition that statistical methods (such as an interquartile range) may appropriate to improve the reliability of the analysis in cases where the comparables are not of the highest quality or best consistency and material differences cannot be sufficiently accounted for using comparability adjustments that increase the reliability of the comparison.
- Norway: also sees a trend in selecting a different point in the range as an alternative for comparability adjustments.

*Source: OECD interviews with country representatives, May 2016.*

### Diagnostic (financial) ratios — usage and examples
- Purpose:
  - Improve the reliability of a potential set of comparables.
  - Help distinguish results from transactions with differing degrees of comparability.
  - Potentially eliminate comparables with a lower degree of comparability from the potential comparable set.
- Application:
  - One or a combination of diagnostic ratios may be used as an additional screen to narrow a range where comparability defects remain and would otherwise produce an overly wide range.
  - Ratios can be used to refine an arm’s length range based on comparables with similar levels of a specific activity (example given: marketing and advertising intensity).
  - Diagnostic ratios may also be used to analyse and interpret data from a potential comparables set.
- Examples of diagnostic ratios often used:
  - intangibles over total assets
  - days of inventory (average)
  - days receivable (average)
  - days payable (average)
  - turnover per employee
  - fixed assets over total assets
  - inventory over sales
  - operating assets to total assets
  - fixed assets to total sales
  - fixed assets to number of employees
  - operating expenses to sales
  - cost of sales to sales
  - inventory to total assets
- Choice of ratio depends on:
  - the nature of the business and key value drivers identified in the business,
  - data availability,
  - a proper functional analysis and good understanding of the business to avoid “cherry picking” or subjective uses of such techniques.
- Reference to additional materials: Appendices 16, 17, and 18 on common financial ratios and acronyms and ratios measuring functions, assets, and risks.

### Build-up approaches — concept and illustrative example
- Definition:
  - A build-up approach divides the activities of an enterprise into component parts and determines or tests an arm’s length return for each component.
  - The combined return is the sum of the returns for each component.
- Australia:
  - The build-up approach may be applied in some circumstances by Australia, usually in conjunction with other transfer pricing methods/approaches.
- Illustrative example (Company X):
  - Facts:
    - Company X (Country X) assembles products from components and markets and sells the finished product to third-party customers.
    - Company X purchases Component A from Company Y (Country Y); Component A is the most technically complex and embodies intangibles allocated to Company Y.
    - Company X also purchases other components from related and unrelated suppliers.
    - In assembly, Company X does not utilise valuable intangibles nor assume significant risk.
    - Company X sells the finished products to unrelated customers and undertakes functions, uses assets, and assumes risks similar to third-party distributors in similar circumstances; it retains legal ownership of finished products until sale.
  - Comparability analysis outcome:
    - A one-sided method is most appropriate, with Company X as the tested party.
    - Independent comparable enterprises performing the same combined assembly and sales functions under the same conditions cannot be identified.
    - Information on independent assemblers and independent distributors is available, so a build-up approach can approximate returns for assembly and sales functions.
  - Determining returns:
    - Assembly function: may be determined using independent assemblers or low-risk manufacturers as comparables; cost-plus method or return on assets basis may be appropriate.
    - Sales function: may be determined using independent buy/sell distributors as comparables; gross margin method basis or net margin basis (operating profit/sales or operating profit/operating expenses) may be appropriate.
  - Combining results:
    - Results of both analyses are combined to arrive at the total arm’s length remuneration for Company X.
    - Essential cautions:
      - Ensure the combined analysis makes sense; the sum of parts is not always a reliable measure of the whole, particularly where significant synergistic benefits exist between component parts.
      - Avoid double counting a reward for functions, assets, and risks common to both components.
      - Combining results for two links in the value chain often creates a need to hypothesise an internal transfer price from the first link to the second.

### Part III — context, limits of comparability data, and approaches where comparables are lacking
- Context and reality:
  - Developing countries often face insufficient data to undertake a reliable comparability analysis.
  - It is often extremely difficult, especially in some developing countries, to obtain adequate information to apply the arm’s length principle.
  - Comparability data only rarely provide a well-defined measure of the arm’s length price or result; often they provide only an approximation or pointers.
  - Parties should be realistic about comparability analyses and recognize that flexibility is often needed to determine a principled answer.
  - Some countries mitigate by negotiating with taxpayers to reach a sensible arm’s length result; many developing countries prefer to avoid settlement and may lack capacity to negotiate.
- Actions discussed to address lack of data:
  - Taking measures to increase the amount of primary source data available, particularly publicly available information from financial accounts of independent enterprises.
  - Exploring other data sources that may inform the arm’s length nature of the transaction.
  - Using safe harbours or other prescriptive rules.
  - Using the transactional profit split method.
  - Using anti-avoidance measures.

### Approaches to increase availability of primary comparables data
- Determinants of company information availability:
  - Macro determinants, policy approaches, and administrative practices.
  - Relationship between the size of a country’s economy and the number of companies.
  - Structural factors: market dominance by a few large MNEs, significant state ownership in some sectors, importance of smaller or informal operators.
- Regulatory and administrative choices affecting information availability:
  - Regulatory framework for preparing and filing financial accounts (who is required to prepare and lodge accounts).
  - Central registries may be absent or have limited functionality; data may not be available electronically or may be shared only in aggregated form.
  - Convenience and cost of accessing records influence commercial database providers’ acquisition strategies; some countries charge for access, others do not; bulk data costs vary.
  - Compliance and enforcement: lack of compliance and weak enforcement can constrain data availability; underrepresentation of some large economies in public databases may be driven by compliance behaviour and enforcement strategies.
  - Fines for not submitting financial information differ dramatically across jurisdictions.
- Policy implication:
  - The importance of publicly available records for smooth implementation of transfer pricing regimes should be considered in corporate reporting requirement reforms.
  - Several initiatives (EU, International Financial Institutions) aim to strengthen accounting and auditing practices, but important barriers remain.

### Approaches that focus on the arm’s length nature of a transaction
- Accurate delineation of a transaction remains significant even in the absence of comparables.
- Testing the benefits received:
  - Particularly relevant for payments between associated enterprises for services or rights to use valuable intangibles.
  - For services: OECD Transfer Pricing Guidelines state that whether a service has been rendered should depend on whether the activity provides economic or commercial value to enhance or maintain business position; determined by whether an independent enterprise in comparable circumstances would have been willing to pay for the activity or would have performed it in-house.
  - For intangibles/royalties: key questions include whether the licensee needs to use the intangible in its business; whether the licensee benefits from the use and to what extent; and whether the licensor would, at arm’s length, have a right to impose a royalty.
  - These questions are important in determining whether, or the extent to which, a payment for a royalty meets the arm’s length principle.

### Safe harbours, fixed margin and other prescriptive approaches
- Definition and purpose:
  - A safe harbour is a simplification measure that applies to a defined category of taxpayers or transactions and relieves eligible taxpayers from certain obligations otherwise imposed by general transfer pricing rules.
  - A well-framed safe harbour can reduce the need to find comparables and perform benchmarking in every case.
  - General guidance on safe harbours provided in Section E in Chapter IV of the OECD Transfer Pricing Guidelines.
- For this toolkit, two types of safe harbour are considered:
  - “Safe harbour for TP”: a mechanism allowing a tax administration to specify an appropriate transfer pricing method, and an associated level or range of financial indicators, that it considers fulfils transfer pricing requirements for a defined category of transaction.
  - “TP Safe harbour on process”: specification by a tax administration of a process that, when applied to a defined category of transaction, is considered to produce a result that fulfils transfer pricing requirements.
- Both types provide potential benefits to tax administrations and taxpayers; many considerations that apply to one type also apply to the other.

*Source: OECD interviews with country representatives, May 2016.*

### 4.1 Safe harbours for TP

### 4.1 Safe harbours for TP

### Definition and forms
- A safe harbour for TP is typically specified in tax law, regulations or guidance.
- Safe harbours enshrined in law provide greater certainty to taxpayers but cannot be easily adjusted; their terms must be very carefully considered.
- Regulations and administrative guidance provide greater flexibility; one model is: establish entry conditions and applicable method by regulation, publish applicable range or result in administrative guidance to be updated periodically.
- Typical regulatory specification elements:
  - a category of transaction that falls within the safe harbour’s scope;
  - a transfer pricing method that is expected to be applied to such transactions;
  - a level (or range of levels) of a financial indicator (e.g., price, gross profit margin, net profit margin) to be used in applying that method.
- Example: a safe harbour may specify a cost-plus method and a margin of say 5 percent for certain defined services.

### Transactions most suitable for safe harbours
- Safe harbours are most suitable where transactions can be benchmarked and where functions do not use valuable intangibles or assume significant risk (typically functions of the “tested party” under a one-sided method).
- Transactions for which safe harbours may be appropriate include:
  - Manufacturing (including toll manufacturers or contract manufacturers) where no right to valuable intangibles and no significant risk assumed.
  - Sales and distribution entities, including sales agents, where functions do not exploit valuable intangibles or assume significant risk.
  - Provision of services that do not involve exploitation of valuable intangibles or assumption of significant risk.

### Design considerations and eligibility
- Defining the category of eligible transactions is critical because the safe harbour allows results within scope to be treated as arm’s length.
- Examinations of transactions where a safe harbour has been applied should focus on eligibility rather than re-testing results.
- Safe harbours may be:
  - “Opt-in”: taxpayer chooses to opt-in to benefit; those who do not opt-in must apply transfer pricing rules and document application.
  - “Opt-out”: taxpayer required to apply the specified method unless they opt out; those who opt out must apply transfer pricing rules and document application. A taxpayer that opts out generally bears the burden of proof that its chosen method meets the arm’s length principle.
- An “opt-out” regime can reduce administrative costs and may be a more straightforward option for many developing countries.

### Operational benefits
- Eliminates the need for a taxpayer to conduct a full comparability analysis and benchmarking study in determining or testing transfer pricing and in preparing documentation (for safe harbour on method).
- Relieves tax administrations of conducting comparability and benchmarking during audits; audits typically restricted to verifying transaction falls within safe harbour scope.
- Advantages:
  - For taxpayers: reduce compliance costs and provide some certainty of treatment.
  - For tax administrations: reduce enforcement costs and free resources from auditing routine and low-risk issues; audits focus on eligibility checks.

### Risks and mitigation measures
- Risks if margin or scope set incorrectly:
  - If too low or scope too broad, tax revenue may be lost and MNEs may gain a tax advantage; could operate like a tax incentive and attract profits that should be taxable elsewhere (“sheltered” by safe harbour).
  - If too high, and opt-out available, taxpayers may opt out; where applied, it could create double taxation and/or requests for compensating adjustments from the counterparty’s tax administration.
- To reduce risk of double taxation or double non-taxation:
  - ensure margins approximate the arm’s length position;
  - allow taxpayers to opt out of mandatory safe harbours where they can demonstrate an alternative arm’s length outcome;
  - where a treaty is in place, transfer pricing set according to a safe harbour should fall within scope of the treaty, giving access to MAP or other measures to eliminate double taxation; ideally safe harbours could be agreed between treaty partners;
  - safe harbour should apply only to prices reflected in financial accounts and should not allow a “downward adjustment” to profit from the accounts position to the measure of taxable profit (such adjustment may give rise to double non-taxation).

### Benchmarking, data sources, and frequency
- Setting a safe harbour price or margin that approximates arm’s length requires a benchmarking exercise using data on comparables.
- Such benchmarking would typically be carried out at most once a year (to set price or margin), sometimes less frequently.
- Where data on comparables is scarce, use of data already in the hands of the tax administration (primarily tax return information) is a solution; confidentiality must be preserved while specifying appropriate price or range.
- Good practice: make publicly available a detailed description of the analysis, including criteria used in selecting data for inclusion and/or aggregated results.
- Regional or international cooperation can help build an aggregated dataset from tax administrations that retains taxpayer confidentiality and provides transparency of process.

### Regional and bilateral cooperation
- Bilateral safe harbours: agreed between two (or more) countries; significantly reduce risk of double taxation; suitable where bilateral treaties exist and there are many transactions between associated enterprises in the partner countries.
- Regional cooperation in unilateral safe harbours:
  - aligned approach may be helpful to business;
  - aligned pricing or margins reduces risk of tax competition between countries;
  - peer support may assist countries in designing and implementing safe harbours.
- Regional and international cooperation also facilitates pooling of tax administration data for setting safe harbour margins and testing returns to foreign associated enterprises.
- Follow-up action on building shared data is recommended in Part IV of the toolkit.

### Operational note on verification and transparency
- To verify reliability of benchmarking derived from confidential tax return data, tax administrations may publish detailed descriptions of their analyses and/or aggregated results without revealing taxpayer identities.

### Box 21. Country practice: Australia (selected elements)
- Australia considers safe harbours can reduce compliance costs for taxpayers and tax administrations; a properly constructed safe harbour should yield a net gain to the tax administration (reduced resource costs greater than lost tax revenue).
- The Australian Taxation Office (ATO) has a “Simplified Transfer Pricing Recordkeeping” initiative that allows eligible entities to opt into simplified recordkeeping requirements. The ATO developed safe harbour values through industry benchmarking and risk sensitivity analyses using taxpayer-lodged information.
- Eligibility criteria include:
  - taxpayers’ total international related-party dealings (expense or revenue) represent less than or equal to 2.5 percent of total turnover for the taxpayers’ Australian economic group;
  - the taxpayer does not have related-party dealings with entities in “specified countries”;
  - the taxpayer does not have related-party dealings involving royalties, licence fees or research and development arrangements;
  - the taxpayer has assessed its compliance with the transfer pricing rules.
- Other criteria: taxpayer has not derived sustained losses (for three consecutive years), has not undergone a restructure within a year, and has no specific service-related party dealings greater than 15 percent of the turnover.
- Specified safe harbour margins (as provided):
  - Distributors EBT ratio of minimum 3%
  - Intra-group services Mark-up on costs of the relevant services either:
    - 7.5% or less for services received
    - 7.5% or more for services provided
  - Management and administrative services Mark-up on costs of the relevant services of either:
    - 5% or less for services received
    - 5% or more for services provided
  - Technical services Mark-up on costs of the relevant services of either:
    - 10% or less for services received
    - 10% or more for services provided
  - Low-level loans (inbound): Interest rate is no more than the Reserve Bank of Australia (RBA) indicator lending rate for small business; variable; residential-secured term. The funds actually provided under the loan are Australian dollar funds and this is reflected in the loan agreements. Associated expenses are paid in Australian dollars.

*Source: pr1715transferpricing - 4.1 Safe harbours for TP*

### 5. Transactional profit split method

### 5. Transactional profit split method

### Definition and purpose
- A profit split method determines or tests the results of a transaction between related parties by reference to a division of profits between them.
- The profit division should be determined with reference to the split that would have been expected had the parties not been related.
- Data on the profit split found in any comparable uncontrolled transactions are relevant, but such data may be difficult to identify or not exist.
- Profit splits may be made on another economically valid basis, such as an analysis of economic and business processes used to determine respective contributions to profit of each party.
- Such analyses do not necessarily apply or require data from comparable uncontrolled transactions.

### When profit split is most appropriate
- Where reliable comparables are not available because both (or all) parties make unique and valuable contributions and/or their operations are highly integrated, profit split may be the most appropriate method.
- Unique and valuable contributions frequently derive from:
  - the utilisation of valuable scarce contributions, including those from intangibles; and
  - the assumption (including the control and management) of the key business risks.
- Selection of a profit split method purely on the basis of a lack of data (absent the factors above) risks leading to a significant departure from the arm’s length outcome.

### Use of internal data and operational analysis
- When the profit split method is the most appropriate method and no external data is available on how combined profits should be split, internal data can be used.
- The use of internal profit splitting factors requires knowledge of the operations of the taxpayer and the relevant related enterprises.
- Generally involves an examination of the contribution by each party to the value chain.
- Interviewing employees can help evaluate significant contributions of each enterprise to the overall value chain and determine reliable allocation criteria.
- Judgements can be subjective; it is very important to engage with the taxpayer.
- Application of the method requires detailed information, including the combined profits of the enterprises involved; information from the other associated enterprise(s) under consideration needs to be obtained.

### Guidance reference
- Section C, Chapter II of the OECD Transfer Pricing Guidelines gives additional guidance on the use of the (transactional) profit split method.

*Source: pr1715transferpricing - 5. Transactional profit split method*

### 1. Consider  the  feasibility  of  setting  up  an  international  database  of  data  derived  from

### Consider the feasibility of setting up an international database of data derived from information in the hands of tax administrations

### A. International aggregated database — purpose and design
- Establish an international database of data derived from information in the hands of tax administrations, presented publicly in an aggregated format that retains taxpayer confidentiality, and subject to transparency of process.
- Potential uses:
  - Establish safe harbour margins or ranges.
  - Test the validity of using potential comparables from a specific foreign market.
  - Test a foreign party to a transaction.
- Individual-country analysis:
  - Countries could seek to identify arm’s length profit margins of taxpayer enterprises operating in their countries.
  - The analysis would be restricted to certain profit level indicators of independent enterprises conducting specific types of business.
- Verification and transparency:
  - A mechanism for verifying the accuracy and relevance of the information should be considered—for example, an independent internal audit and/or publishing the processes used in collecting data.
- Database composition and access:
  - Country data could be used to form a centralised database, accessible to tax administrations and, potentially, taxpayers.
  - The database would consist of financial data, drawn from information available to tax administrations (including from tax returns), aggregated at the level of category of transaction in each country.

### B. Increasing registration and data availability
- Explore actions to increase the number of countries that require the central registration of financial accounts of private and public companies, thus providing data for inclusion in commercial and other databases.

### C. Improving access to commercial databases
- Consider means by which developing countries can be supported in acquiring commercial databases, and building the skills to use them effectively.
  - Capacity building and sharing of best practices on the efficient and effective use of databases could be provided as part of other technical assistance initiatives supporting transfer pricing administration, through regional co-operation, or expert deployments.
- Explore opportunities for regional and international co-operation for acquiring and using commercial databases.

### D. Effective use of existing data
- Undertake further research and spread available good practices on measures that may be taken to use existing data more effectively.
  - Guidance might include the challenges and options for using data from foreign markets, the use of data drawn from widened search criteria, and the use of comparability adjustments.
- Note limited evidence on the impact of geographic differences on profitability; further research is recommended.
- The mechanism for increasing the pool of data described in section A may provide data to support such research.

### E. Selection and application of methods; safe harbours
- Develop further guidance and training for developing countries on the selection and application of the most appropriate method.
- Further develop guidance on the use of safe harbours in the application of the one-sided methods, including best practices.

### F. Natural resources and commodities sectors
- Recognising the significance of the natural resources and other commodities sectors to many developing countries, conduct further work to refine measures such as those based on quoted prices (such as “sixth method” approaches).
- Examine development of a framework for adjustments such as those based on “netback” approaches.
- Aim to develop approaches that apply the arm’s length principle in a workable and efficient way.

*https://www.imf.org/-/media/files/news/press-release/pr1715transferpricing.pdf*

### 9. Consider the feasibility and the advantages and disadvantages of measures designed to

### 9. Consider the feasibility and the advantages and disadvantages of measures designed to 

### Measures to protect tax bases where transfer pricing is infeasible
- Context: Protect tax bases of developing countries in cases with both a systemic high risk of tax loss and an inability to apply transfer pricing and other measures due to lack of information or gaps in capacity.
- Example measure cited: proposed limitation on the deductibility of interest based on a ratio of net interest to EBITDA set out in BEPS Action 4.
- Other measures that could be explored:
  - Limitations on royalty deductions (for example, based on a ratio of royalties payable to EBITDA).
  - Limitations on other high-risk base eroding payments.

### Addressing difficulties in accessing comparables data for transfer pricing analyses
- The source highlights the importance of reliable comparables when routine functions are remunerated (for example, using TNMM or cost-plus approaches).
- Key issues in comparability selection include geographical relevance, industry classification, company size, data availability, and independence of potential comparables.

### Case Study 1: Thermal Coal — delineation, functions, assets, risks, and comparability
- Industry practice: Thermal coal is a bulk commodity, sold directly to final users or via traders; coal varies by grade.
- Audit facts:
  - A Co: joint venture in Country A; mines, processes, and prepares coal for shipment; producing for six years; returns small profits and sometimes small losses.
  - B Co: subsidiary in a low-tax jurisdiction; purchases coal once ready for shipment, never takes physical delivery, sells directly to third-party customers, contractually responsible for marketing and obliged to purchase 100 percent of A Co’s marketable production.
  - Contractual service fee: B Co receives a 7 percent commission on sales achieved.
  - B Co pays A Co a service fee (based on cost plus a mark-up of 8 percent) for marketing support activities.
  - B Co appears very profitable but has very low payroll (staff) costs.
- Evidence from interviews and conduct:
  - A Co finds customers, invites customers at least once a year, negotiates final purchase terms on B Co’s behalf, and manages inventory and delivery.
  - B Co provides limited, routine services (market reports, arranging meetings, translation, administrative tasks).
  - B Co purchases coal and typically instantaneously resells to third-party customers; final contracts are between B Co and customers.
- Functional/asset assessment:
  - A Co performs mining, finds customers, negotiates and manages contracts, and manages inventory/delivery risks.
  - B Co performs limited sales and marketing functions; owns only coal inventories and rents office space.
  - Long-term contracts and customer relationships are legally owned by B Co but A Co made significant DEMPE contributions; intangibles likely low value given commoditisation of coal.
- Economically significant risks:
  - Strategic/marketplace risks (e.g., substitution to gas or renewables).
  - Infrastructure/operational risks (delivery delays, production costs, inventory management).
  - Financial risks (price fluctuations).
  - Transactional risks (exchange rate, credit risk).
- Delineation conclusion:
  - A Co controls most risks and has financial capacity; risks contractually allocated to B Co should be allocated to A Co for transfer pricing purposes.
  - B Co is akin to a low-risk service provider (commissionnaire) rather than an entrepreneur.
- Comparability and method:
  - Tax auditor uses B Co as the tested party and selects the transactional net margin method (TNMM) with full costs as the profit level indicator.
  - Adjustment to A Co’s deductible sales commission expense equals the difference between the comparability result and B Co’s actual profits.
  - Illustrative note: example calculation referenced where an arm’s length mark-up of 5% on costs determined through comparability with a cost base of 600 yields a total transfer price of 600 * 1.05 = 630; cost base accounts for around 95.2% of total transfer price (600/630), mark-up 4.8% (30/630).

### Case Study 2: Construction — delineation, conduct, and tax adjustment
- Organisational facts:
  - XYZ Group provides consultancy, design and project-management services; ultimate parent in Country F.
  - In 2012 the Group set up XYZ (M) in Country M to oversee engineering services for an oil refinery project expected to last four years with completion in 2016.
  - XYZ (M) employs approximately 15 employees in Country M.
  - XYZ (M) engages personnel from sister company XYZ (S); costs recharged at pay plus a mark-up of 40 percent.
  - XYZ (M) shows significant losses for all years from 2012 to 2016.
- Audit findings on conduct:
  - Initial contract negotiated in 2012 by Country F head office personnel; renegotiation in 2014 led by Country F head office personnel.
  - Management of specialist personnel deployment was undertaken by project managers engaged by XYZ (S); XYZ (M) employees were not suitably qualified to manage the project.
  - XYZ (S) has sufficient financial capacity to assume project risks.
- Delineation conclusion:
  - Although XYZ (M) was contractually allocated entrepreneurial risks, it did not exercise control over them; control and financial capacity reside with XYZ (S).
  - Risks allocated to XYZ (S) for transfer pricing delineation; XYZ (M) characterized as providing low-risk services.
- Transfer pricing method and adjustment:
  - Country M applied a mark-up on cost method with XYZ (M) as tested party and conducted benchmarking to find suitable comparables.
  - Effect: recognise a profit in XYZ (M) for tax purposes; adjustment is a reduction in the deductible fee paid by XYZ (M) to XYZ (S).

### Case Study 3: Gold Production and Sales — functions, assets, risks, benchmarking
- Industry practice: Gold mines recover gold from ore, produce unrefined gold bars (doré), which are refined and sold on world gold markets.
- Organisational facts:
  - A Co in Country A mines and sells doré to related B Co in Country B (Europe).
  - B Co has an established refinery operating for over 10 years and sells refined gold to third parties.
  - Country B provides a corporate income tax exemption for gold trading.
  - A Co annual gross revenue: around USD 400 million.
  - B Co annual gross revenue: around USD 425 million.
  - Group headquartered in Country C.
- Contractual arrangement:
  - Purchase agreement: B Co buys all doré from A Co and refines and sells the refined product; B Co takes legal title when doré delivered to refinery.
  - B Co purchases and maintains all refining equipment and bears payroll and operational costs of refining; B Co manages refining operations.
  - Pricing to A Co: A Co is paid for the weight of gold in each doré bar referencing the LBMA daily gold price for the day of delivery to B Co.
  - A Co pays costs of refining each bar, environmental taxes incurred by B Co, and delivery costs.
  - A Co receives revenue based on sale of each doré bar minus a “handling fee” of 5.4 percent of the value of each bar retained by B Co.
  - B Co’s net revenue sources: handling fees, net gains from price changes between purchase and sale, and a small margin from commemorative coin sales.
- Audit findings:
  - B Co records substantial profits driven by its contractual arrangement with A Co.
- Functional and asset assessment:
  - B Co functions: refining, selling via over-the-counter sales, managing price risk (refine/on-sell quickly and hedging where necessary), testing and assay, waste disposal, producing ceremonial products.
  - B Co assets: all refining process assets and laboratory equipment.
  - B Co risks: refining losses, customer-finding and delivery risks, price change risk between purchase and resale, credit and counterparty risks.
  - A Co functions/assets: owns mine assets, operates mine, produces doré to agreed annual target, procures inputs, arranges and pays for delivery to B Co, maintains mine assets.
- Transfer pricing method and benchmarking:
  - Refined gold is highly commoditised with a highly liquid international market; B Co’s core business confirmed as metals refining.
  - Gold sales judged routine and to be routinely remunerated using TNMM with sales as the profit level indicator.
  - Benchmarking against other precious metals refining companies in Europe indicates B Co’s profitability is substantially above the range of comparable refineries; conclusion that A Co over-remunerates B Co for refining and on-selling functions.
- Benchmarks identification process (step process highlights):
  - Step 1: selecting the database (see Appendix 3).
  - Step 2: geographical screening — (Pan) Europe.
  - Step 3: industry code screening — NACE Code 2441 - Precious metals production.
  - Step 4: selecting company size — eliminate very small or start-up companies.
  - Step 5: text screening — e.g., gold, refinery, refining, production, nonferrous, precious, metals.
  - Step 6: financial data availability — require operating profit/loss and turnover for at least two of the years from 2013 through to 2015; require turnover figures of at least EUR 5 million in at least one of the years from 2013 through to 2015.
  - Steps 7–11: independence screening categories (A+, A, A-, B+, B, B-, U with Category A (< 25%) usually accepted), manual screenings, selection of unconsolidated accounts, active company screening, and manual functional comparability analysis.
- Classification codes for gold refining:
  - Europe: NACE code 2441 (Precious metals production).
  - North America: SIC code 3339 (Primary smelting and refining of nonferrous metals); NAICS code 331419 (Nonferrous metal (except aluminium) smelting and refining).

*Italic source: pr1715transferpricing - 9. Consider the feasibility and the advantages and disadvantages of measures designed to*

### APPENDIX 1

### APPENDIX 1

### Questionnaire: functional analysis
- Source: IRS 2006, exhibit 4.61.3-4
- Purpose: Guidance for performing a functional analysis of a business through a generic questionnaire to understand functions, risks, and intangibles. The list is not intended to be exhaustive and should be tailored to the specific business entity being reviewed.

### Analysis of functions — structure and focus areas
- I. Manufacturing
  - A. Materials purchasing — questions 1–12 covering what is purchased, suppliers (including related companies), purchasing processes, decision makers, approvals, consignment, and "What are your major risks?"
  - B. Inventory — questions 1–9 covering inventory location and control, computer systems, consignment, "How many days of inventory are on hand?", excess/obsolete inventory, and "What are your major risks?"
  - C. Production equipment — questions 1–11 covering budgeting, negotiation, maintenance, expenditure authority, specifications, suppliers (including related companies), discretion to modify equipment, head office approvals.
  - D. Production scheduling — questions 1–8 covering responsibility, decision factors and timing, computer systems, approvals, major risks, and whether the distributor buys everything manufactured.
  - E. Manufacturing and process engineering — questions 1–7 covering product design and ownership of technology, process origin and improvements, productivity comparisons, and use of third-party producers.
  - F. Package and labeling — questions 1–4 covering what, where, decision-making authority, and autonomy.
  - G. Quality control — questions 1–8 covering type of quality control, standards, performers/cost bearers, equipment provision, product loss rates, major risks, and approvals.
  - H. Shipping of products — questions 1–10 covering freight charges, arrangements, shippers, destinations and methods, shipper selection, shipping deadlines, major risks, and approvals.
- II. Research and development — questions 1–14 covering R&D carried out, use of related companies or third parties, product design locations, distributor input, importance of patents, owned patents and unpatented know-how, budget formulation, license agreements, and cost sharing agreements (including "Provide a copy of the cost sharing agreement and the relevant details.")
- III. Marketing
  - A. Strategic — questions 1–13 covering in-house marketing, market surveys, approvals, competitors, demand assessment, risks, budget formulation, distributor behavior, use and control of third-party distributors.
  - B. Advertising, trade shows, etc. — questions 1–8 covering marketing forms, advertising and who pays, trade show organization and payment, samples, brochure production, marketing assistance, and approvals.
- IV. Sales and distributions
  - A. Sales — questions 1–16 covering sales mechanisms, invoicing, projections and targets, locations of order receipt, responsibility for sales targets, contract negotiation autonomy, sales to related companies, exports and export responsibility, and foreign selling risks.
  - B. Quality control — questions 1–9 mirroring manufacturing quality control topics with customer rejections and cost allocation.
  - C. Freight — questions 1–8 covering freight charges, arrangements, destinations and methods, shipper selection, deadlines, risks and approvals.
  - D. Inventory — questions 1–9 mirroring manufacturing inventory topics including days on hand and obsolete inventory cost bearer.
  - E. Installation and after-sales services — questions 1–6 covering installation, after-sales service description, repair responsibility and cost bearers, product guarantees, and warranty cost bearer.
- V. Administration and other services
  - A. General administration — questions 1–5 covering scope of administration, use of related companies, approvals, and administrative codes of practice responsibility.
  - B. Pricing policy — questions 1–5 covering pricing determination, policy for goods and services, major risks, and approvals.
  - C. Accounting — questions 1–9 covering accounting functions and location, financial report preparation, bank accounts, signatory authority and limits, credit risk on sales, and insurance premium payers/arrangers.
  - D. Legal — questions 1–3 covering legal responsibility and approvals.
  - E. Computer processing — questions 1–5 covering local vs. outsourced processing, software development and charges, expenditure authority, and approvals.
  - F. Finance/loans/credit — questions 1–7 covering intercompany loans and interest, trade credit terms, interest for exceeded credit periods, borrowing responsibility, major risks, and approvals.
  - G. Personnel — questions 1–11 covering compensation with overseas affiliates, positions held, training, training length, on-the-job training, management training location, staff turnover rate, payroll status, employment responsibility, and approvals.
  - H. Use of property / leasing — questions 1–3 covering property ownership/lease with affiliates and responsibility for function.
- VI. Executive — questions 1–9 covering reporting lines of the general manager, other reporting lines to parent, responsibility for government agency dealings, regulatory requirements, parent-imposed procedures, manufacturing site selection, source of corporate decision impetus, and approvals.

### Analysis of risks — categories and key questions
- I. Market risk
  - 1. What are the market risks?
  - 2. Do you bear the market risks? If not, who does?
  - 3. How significant are the market risks?
- II. Inventory risk
  - 1. Does inventory become obsolete?
  - 2. Who bears the cost of obsolete inventory?
  - 3. Do you provide warranties in relation to finished goods?
  - 4. Who bears the cost of returns under warranty?
- III. Credit and bad debt risk
  - 1. What credit terms are given and received?
  - 2. Do you bear the cost of bad debts? If not, who does?
  - 3. Is this a significant risk?
- IV. Foreign exchange risk
  - 1. Are you exposed to foreign exchange risk? If so, explain the risks.
  - 2. How significant is the risk?
  - 3. What steps do you take to minimize foreign exchange risk?
  - 4. Do you have a manual that outlines your procedures/policies for dealing with foreign exchange risk? If so, provide a copy.
  - 5. Do you engage in hedging of foreign exchange risk? If so, provide an explanation of your hedging activities.

### Analysis of intangibles — manufacturing and marketing
- I. Manufacturing
  - A. Research and development — questions 1–3 on product development, uniqueness, and manufacturing processes importance/uniqueness.
  - B. Manufacturing processing/technological know-how — questions 1–4 on possession, nature, importance, and uniqueness of know-how.
  - C. Trademarks/patents, etc. — questions 1–2 on ownership and significance.
  - D. Product quality — comparative self-assessment versus competitors.
  - E. Other — request for other manufacturing intangibles and "Request copies of all licensing agreements."
- II. Marketing
  - A. Trademarks/trade names — questions 1–2 on ownership and significance.
  - B. Corporate reputation — questions 1–3 on existence, nature, and significance.
  - C. Developed marketing organization — question on presence of a developed marketing organization.
  - D. Ability to provide service to customers — comparative self-assessment of service quality versus competitors.

### APPENDIX 2 — Characterisation based on typical business models
- Purpose: Summarise functional analysis by characterising the tested party based on typical business models; warns that labels are shorthand and should not substitute for a detailed functional analysis.
- Sales function characterisations (examples)
  - fully-fledged distributor: performs full buy-hold-sell functions including marketing and sales; has assets such as warehouse, inventory, and logistics system; assumes associated risks.
  - sales agent: sells on consignment; performs limited sales functions on behalf of another entity; has limited or no assets and assumes limited risks.
- Manufacturing characterisations (examples)
  - fully-fledged manufacturer: undertakes full manufacturing functions; has assets including property, plant and equipment, and inventory; assumes associated risks; may include research and development and forecasting, procurement, and production scheduling.
  - contract manufacturer: manufactures to order.
  - toll manufacturer: performs manufacturing services to order but does not procure or own inputs, work in progress or outputs.
- Note: Characterisations help select methods or profit level indicators and comparables, but vague functional analysis can mislead.

### APPENDIX 3 — Examples of commercial databases used for transfer pricing
- Note: Annex taken from World Bank Group (2016): “Transfer Pricing and Developing Countries: A handbook for policy makers and practitioners.” List not intended to be exhaustive.
- Selected providers, databases, geographical coverage, and content (preserve names and groupings as listed)
  - Bloomberg 101 — Bloomberg Reference Data Services — Worldwide — Financial markets data
  - Bureau van Dijk 102 — Osiris, Orbis, Amadeus, Oriana, Aida, Bel-First, Dafne, Diane, Fame, Icarus, Odin, Mint Korea, Reach, Ruslana, Sabi, Sabina, Zephyr — Worldwide; Europe; Asia-Pacific; Italy; Belgium-Luxembourg; Germany; France; UK and Ireland; US and Canada; Nordic and Baltic; Korea; Netherlands; Russia, Ukraine and Kazakhstan; Spain and Portugal; Austria; Worldwide — Company financial information (listed) / Company financial information (private and listed) / Mergers and acquisitions information
  - Capital Market Publishers India — Capitaline TP 103 — India — Company financial information (private and listed)
  - Centre for Monitoring Indian Economy 104 — Prowess 105 — India — Company financial information (private and listed)
  - Dun & Bradstreet Company360 106 — Australia — Company information (private and listed)
  - Mergent Million Dollar Directory 107 — US — Company information (private and listed)
  - Hedge Fund HFR Database — US — Hedge fund information
  - IBISWorld — IBISWorld — Australia — Company financial information (private and listed)
  - InfoCredit Teigil — Poland — Company financial information (private and listed)
  - Intangible Spring 108 — Intangible Spring — Worldwide (US & Canada) — Invotex Group — Intangibles license agreements (sourced from US SEC)
  - Interfax SPARK — Russia, Ukraine, and Kazakhstan — Company financial information (private and listed)
  - Invotex Group 110 — Royalty Connection — Worldwide (US) — Intangibles license agreements (sourced from US SEC)
  - KIS-Line 111 — South Korea — Company financial information (private and listed)
  - Kompass 112 — Worldwide — Company information (private and listed)
  - ktMine 113 / ktMine IP 114 — Worldwide (US) — Intangibles license agreements and royalty rates
  - Moody’s Analytics 115 — RiskCalc Plus — Worldwide (29 models) — Risk of default models (credit score)
  - Rimes 116 — Worldwide — Financial markets data, commodities, hedge funds and properties/REITs
  - RoyaltyRange 117 — RoyaltyRange — European — Intangibles license agreements and royalty rates
  - Onecle 118 — Business Contracts — US — Business contract filings (SEC)
  - Royaltystat 119 — Licence Agreements Database — Worldwide (US) — Intangibles license agreements (sourced from US SEC)
  - RoyaltySource — RoyaltySource — Worldwide (US) — Intangibles license agreements (sourced from US SEC)
  - Standard and Poor’s — Capital IQ - Financials 120; Compustat - North America; Compustat Global; Credit Analytics — Worldwide / North America / Worldwide / Worldwide — Company financial information (private and listed); Company financial information (listed); Risk of default models (credit score)
  - Thompson Reuters 121 — Dealscan 122; Eikon; Lipper — Worldwide public company data; Worldwide private company data; Worldwide intangibles data; Financial transactions data (loans); Financial markets data; Fund management data; Company financial information (listed) / (private and listed) / Intangibles license agreements and royalty rates
- Footnotes and URLs are preserved in the original listing where provided.

*Italic line: Source: pr1715transferpricing - APPENDIX 1*

### APPENDIX 4

### APPENDIX 4

### Countries with available data from potential comparables meeting minimum requirement for application of the arm's length principle

- Number of independent records with revenue and net margin information — country groupings:

  - =<10 (Quantity: 106)
    - Afghanistan (AF), Albania (AL), Algeria (DZ), Andorra (AD), Angola (AO), Anguilla (AI), Antigua and Barbuda (AG), Armenia (AM), Aruba (AW), Bahamas (BS), Barbados (BB), Belize (BZ), Benin (BJ), Bhutan (BT), Brunei Darussalam (BN), Burkina Faso (BF), Burundi (BI), Cambodia (KH), Cameroon (CM), Cape Verde (CV), Central African Republic (CF), Chad (TD), Comoros (KM), Congo (CG), Congo, Democratic Republic of (CD), Costa Rica (CR), Côte d'Ivoire (CI), Cuba (CU), Curaçao (CW), Djibouti (DJ), Dominica (DM), Dominican Republic (DO), East Timor (TL), El Salvador (SV), Equatorial Guinea (GQ), Eritrea (ER), Ethiopia (ET), Fiji (FJ), Gabon (GA), Gambia (GM), Georgia (GE), Gibraltar (GI), Grenada (GD), Guatemala (GT), Guinea (GN), Guinea Bissau (GW), Guyana (GY), Haiti (HT), Honduras (HN), Kiribati (KI), Korea, Democratic People's Republic of (KP), Kosovo (KV), Kyrgyzstan (KG), Lao People's Democratic Republic (LA), Lesotho (LS), Liberia (LR), Libya (LY), Liechtenstein (LI), Macao (MO), Madagascar (MG), Malawi (MW), Maldives (MV), Mali (ML), Mauritania (MR), Micronesia, Federated States of (FM), Monaco (MC), Mongolia (MN), Mozambique (MZ), Myanmar/Burma (MM), Namibia (NA), Nauru (NR), Nicaragua (NI), Niger (NE), Palau (PW), Papua New Guinea (PG), Paraguay (PY), Rwanda (RW), Saint Kitts and Nevis (KN), Saint Lucia (LC), Saint Vincent and the Grenadines (VC), Samoa (WS), San Marino (SM), Sao Tome and Principe (ST), Senegal (SN), Seychelles (SC), Sierra Leone (SL), Sint Maarten (SX), Solomon Islands (SB), Somalia (SO), South Sudan (SS), Sudan (SD), Suriname (SR), Swaziland (SZ), Tajikistan (TJ), Tanzania, United Republic of (TZ), Togo (TG), Tonga (TO), Turkmenistan (TM), Tuvalu (TV), Uganda (UG), Uzbekistan (UZ), Vanuatu (VU), Vatican City, State/Holy See (VA), Yemen (YE), Zambia (ZM)

  - 10-100 (Quantity: 30)
    - Azerbaijan (AZ), Bahrain (BH), Belarus (BY), Bolivia (BO), Botswana (BW), Ecuador (EC), Ghana (GH), Iran, Islamic Republic of (IR), Iraq (IQ), Jamaica (JM), Kenya (KE), Lebanon (LB), Marshall, Islands (MH), Mauritius (MU), Moldova, Republic of (MD), Montenegro (ME), Morocco (MA), Nepal (NP), Nigeria (NG), Palestinian Territories (PS), Panama (PA), Qatar (QA), Syrian Arab Republic (SY), Trinidad and Tobago (TT), Tunisia (TN), United Arab Emirates (AE), Uruguay (UY), Venezuela (VE), Virgin Islands (British) (VG), Zimbabwe (ZW)

  - 100-1000 (Quantity: 28)
    - Argentina (AR), Bangladesh (BD), Bermuda (BM), Brazil (BR), Cayman, Islands (KY), Chile (CL), Cyprus (CY), Egypt (EG), Hong Kong (HK), Indonesia (ID), Israel (IL), Jordan (JO), Kazakhstan (KZ), Kuwait (KW), Macedonia (FYROM) (MK), Malta (MT), Mexico (MX), New Zealand (NZ), Oman (OM), Pakistan (PK), Peru (PE), Philippines (PH), Saudi Arabia (SA), Singapore (SG), South Africa (ZA), Sri Lanka (LK), Switzerland (CH), Vietnam (VN)

  - 1000-10,000 (Quantity: 13)
    - Australia (AU), Austria (AT), Canada (CA), Denmark (DK), Iceland (IS), India (IN), Ireland (IE), Lithuania (LT), Luxembourg (LU), Netherlands (NL), Slovenia (SI), Taiwan (TW), Thailand (TH)

  - 10,000-100,000 (Quantity: 20)
    - Belgium (BE), Bosnia and Herzegovina (BA), China (CN), Colombia (CO), Croatia (HR), Czech Republic (CZ), Estonia (EE), Finland (FI), Germany (DE), Greece (GR), Japan (JP), Korea, Republic of (KR), Latvia (LV), Malaysia (MY), Poland (PL), Serbia (RS), Sweden (SE), Turkey (TR), United Kingdom (GB), United States of America (US)

  - >=100,000 (Quantity: 11)
    - Bulgaria (BG), France (FR), Hungary (HU), Italy (IT), Norway (NO), Portugal (PT), Romania (RO), Russian Federation (RU), Slovakia (SK), Spain (ES), Ukraine (UA)

- Note:
  - "Please note that this table summarises information shared voluntarily by several private database providers. It may therefore not be a complete summary of globally available information."

*IMF — APPENDIX 4 (pr1715transferpricing - APPENDIX 4)*

### 3. These operating profits reflect the more comprehensive financing function of TestCo.

### 3. These operating profits reflect the more comprehensive financing function of TestCo.

### Working capital adjustments — observations and alternatives
- Timing issue for Receivables, Inventory and Payables comparisons:
  - Example compares levels on the last day of the financial year; this may not be representative.
  - In such cases, averages might be used if they better reflect the level of working capital over the year.
- Selection of appropriate interest rate(s):
  - Rate(s) should generally be determined by reference to the rate(s) of interest applicable to a commercial enterprise operating in the same market as the tested party.
  - In most cases a commercial loan rate will be appropriate.
  - If the tested party’s working capital balance is negative (that is Payables > Receivables + Inventory), a different rate may be appropriate.
  - The example uses the rate at which TestCo is able to borrow funds in its local market.
  - The example assumes the same interest rate is appropriate for payables, receivables and inventory, but notes this may not hold in practice; where different rates apply, the calculation may be considerably more complex.
- Purpose and scope of adjustments:
  - The purpose of working capital adjustments is to improve the reliability of the comparables.
  - There is a question whether working capital adjustments should be made when the results of some comparables can be reliably adjusted while the results of some others cannot.
- Alternative approaches:
  - Adjust the tested party’s result to reflect those of the comparables.
  - Adjust both the tested party and the comparables’ results to reflect zero working capital.

### Appendix 11 — Example of adjustment for accounting differences: Employee stock-based compensation
- Premise:
  - Employee stock-based compensation is a form of employee remuneration (i.e. similar to wages and bonuses).
  - Non-uniform accounting treatment can materially affect financials (for example, net margin) and may require adjustment.
- Numerical example comparing Enterprise A (tested party) and Enterprise B (comparable):
  - Enterprise A has booked employee stock option compensation as an expense.
  - Enterprise B disclosed awarded stock-based compensation during the relevant year of $ 3.25 million after tax, but no expense has been booked.
  - Assume statutory tax rate of 35%.
  - Gross-up: $ 3.25/(1-0,35) = $ 5 million before tax.
- Income statement impact for Enterprise B:
  - Revenue 100  → 100
  - Cost of goods sold -65  → -65
  - Gross profit 35  → 35
  - Selling, general and administrative expenses -19  → -24
  - Depreciation -5  → -5
  - Operating profit 11  → 6
  - Operating margin 11%  → 6%

### Appendix 12 — Limited empirical support for reliance on non-adjusted foreign market data
- Objective:
  - Revisit Meenan et al. (2004) approach to test whether pan‑European comparable data provide different arm’s length ranges from country-specific samples in a 2008-2014 sample.
- Empirical strategy:
  - Let Fi(r) denote cumulative distribution of firm profitability in country i; aggregate F(r)=w1F1(r)+w2F2(r)+...wN FN(r), where wi is share of firms in country i.
  - Use non-parametrical chi square statistics to test homogeneity of interquartile ranges.
  - Determine critical values r* and r** based on the aggregate distribution F(x) with:
    - (1) F(r*)=0.25, and F(r**)=0.75
    - Test whether (2) Fi(r*)=0.25 and Fi(r**)=0.75 for all i.
  - Note: benchmark uses weighted aggregate; alternative benchmarks excluding the country being tested would be more likely to reject equality. For comparability with Meenan et al. (2004), use (1).
  - Chi-square test decomposition:
    - Joint test with one chi-square variable with 2N degrees of freedom (strategy pursued).
    - Alternative: 2N chi-square variables with one degree of freedom each (as in Meenan et al. (2004)).
- Sample selection:
  - Data source: ORBIS (Bureau van Dijk).
  - Sectors: manufacturing and retail (Nace Rev 2. Main Sections C and G).
  - Years: 2006-2014.
  - Restricted to independent firms per Meenan et al. (2004).
  - Baseline sample roughly 600,000 European firms.
  - Six-step sample narrowing (Table 1 summary):
    - Step 0 Initial sample 592,069 firms (100% of initial sample)
    - Step 1 At least 6 profitability observations per firm 301,069 firms (51% of initial sample; 51% of prior step)
    - Step 2 Sales > EUR 2,000,000 65,633 firms (11% of initial sample; 22% of prior step)
    - Step 3 Remove outliers 62,986 firms (11% of initial sample; 95% of prior step)
    - Step 4 Main industries 5,189 firms (1% of initial sample; 8% of prior step)
    - Step 5 10 firms per country 5,066 firms (1% of initial sample; 98% of prior step)
  - Outlier bounds recorded at 2.5 and 97.5 percentiles:
    - Manufacturing bounds (-0.02,0.24)
    - Retail bounds (-0.04,0.18)
  - For Meenan replication, restrict to four industries: Automotive manufacturing, electronics manufacturing, chemicals distribution, and electronics distribution.
- Descriptive statistics and profitability measures:
  - Profitability measures:
    - Manufacturing: Return on Assets (ROA) (three-year averages).
    - Distribution: Operating Profit Margin (OPM) (three-year averages).
  - Table 2 — NACE Rev. 2 group definitions and number of firms:
    - Automotive Manufacturing NACE Codes 3091, 3099, 3320, 2910, 2892, 2920, 3311, 2932, 2822, 3101, 3317 — Number of firms 1,124
    - Electronics Manufacturing NACE Codes 3320, 2823, 2620, 6209 — Number of firms 661
    - Chemicals Distribution NACE Codes 4612, 4615, 4675, 4676 — Number of firms 1,779
    - Electronics Distribution NACE Codes 4651, 4665, 4666, 4652 — Number of firms 1,502
  - Table 3: Profitability Distribution in 2008 and 2014 (three-year averages)
    - Automotive Man.:
      - 2008 1st Quartile 0.024; Median 0.046; 3rd Quartile 0.081; Interquartile range (3rd - 1st) 0.057
      - 2014 1st Quartile 0.021; Median 0.047; 3rd Quartile 0.09; Interquartile range 0.069
    - Electronic Man.:
      - 2008 1st Quartile 0.028; Median 0.054; 3rd Quartile 0.096; Interquartile range 0.068
      - 2014 1st Quartile 0.03; Median 0.061; 3rd Quartile 0.107; Interquartile range 0.077
    - Chemicals Dist.:
      - 2008 1st Quartile 0.015; Median 0.031; 3rd Quartile 0.063; Interquartile range 0.048
      - 2014 1st Quartile 0.015; Median 0.03; 3rd Quartile 0.055; Interquartile range 0.040
    - Electronic Dist.:
      - 2008 1st Quartile 0.017; Median 0.035; 3rd Quartile 0.068; Interquartile range 0.051
      - 2014 1st Quartile 0.011; Median 0.027; 3rd Quartile 0.054; Interquartile range 0.043
  - Observations:
    - Automotive interquartile range narrower and shifted downwards compared to Meenan et al. (2004) (Meenan reported (0.036,0.118) with median 0.069).
    - Electronics manufacturing median ROA 5.4 percent in 2008; some decline compared to 2004.
    - Retail interquartile ranges (0.015, 0.063) and (0.017, 0.068) indicate somewhat more profitable in 2008.
    - Between 2008 and 2014:
      - Manufacturing interquartile ranges broadened (Span increases).
      - Distribution sector profitability ranges narrowed slightly.
- Results (Table 4 — chi-square tests):
  - Joint test probabilities (null hypothesis that country-specific distributions correspond to aggregate quartiles):
    - Automotive Man. 2008 <0.001; 2014 <0.001
    - Electronic Man. 2008 0.005; 2014 <0.001
    - Chemicals Dist. 2008 <0.001; 2014 <0.001
    - Electronic Dist. 2008 <0.001; 2014 <0.001
  - Interpretation:
    - For none of the industries examined is there statistical evidence for comparable distributions across countries.
    - Electronics manufacturing had a residual probability of 0.5 percent (2008) that country-specific distributions are comparable; for 2014 this declines to less than 0.1 percent.
  - Country-level separate tests report lists of countries where H0 is rejected and where H0 is not rejected for each industry and year (as detailed in Table 4).

### Appendix 13 — Examples on country risk adjustments
- Example 1 — Simplified country risk adjustment (TestCo in Country A; CompCo in Country B):
  - TestCo CompCo
    - Country A Country B
    - Revenue 100 120
    - Total costs 80 90
    - Operating profit 20 30
    - Operating assets 80 100
  - Average long-term government bond yields:
    - Country A 9%
    - Country B 5%
    - Government bond yield gap 4%
  - Country risk adjustment:
    - [operating assets of CompCo] * [country specific risk premium] = [100] * [4%] = 4
  - CompCo operating profit adjusted from 30 to 34.
- Example 2 — Country practice: Canada (company A is limited risk entity in Country A; comparables from Country C)
  - Final set of unadjusted comparables ROA by year (2011–2015) and Average:
    - Minimum 1.06% -0.34% 0.75% 0.56% -10.06% -1.61%
    - Lower quartile 10.16% 5.21% 5.60% 5.05% 2.21% 5.65%
    - Median 13.52% 12.21% 10.18% 7.59% 6.72% 10.04%
    - Upper quartile 16.60% 19.18% 18.67% 13.70% 10.58% 15.75%
    - Maximum 36.37% 28.98% 22.19% 21.83% 27.04% 27.28%
    - Average 13.67% 13.25% 11.66% 9.56% 6.86% 11.00%
    - ROA tested party 3.45% -6.21% 3.12% 1.25% -4.17% -0.51%
  - Country risk premium approach:
    - Use 5-10-year government bond yield as practically risk-free benchmark.
    - Calculate bond yield differential = foreign country 10-year government bond yield − home country 10-year government bond yield.
  - Calculation of Bond Yield Differential (2011–2015):
    - Home country government 10 bond yields 2011 2012 2013 2014 2015: 4.05% 4.09% 2.69% 3.60% 3.16%
    - Foreign country bonds 7.55% 5.11% 4.16% 7.53% 11.79%
    - Bond yield differential 3.50% 1.02% 1.47% 3.93% 8.63%
  - Apply bond yield differential by adding it to ROA of all comparable companies for each year.
  - Final set of country risk adjusted comparables ROA by year (2011–2015) and Average:
    - Minimum 4.56% 0.68% 2.22% 4.49% -1.43% 2.10%
    - Lower quartile 13.66% 6.23% 7.07% 8.98% 10.84% 9.36%
    - Median 17.02% 13.23% 11.65% 11.52% 15.35% 13.75%
    - Upper quartile 20.10% 20.20% 20.14% 17.63% 19.21% 19.46%
    - Maximum 39.87% 30.00% 23.66% 25.76% 35.67% 30.99%
    - Average 17.17% 14.27% 13.13% 13.49% 15.49% 14.71%
    - ROA tested party remains 3.45% -6.21% 3.12% 1.25% -4.17% -0.51%
  - Recommendation from example:
    - Adjust the tested party’s ROA to the median value for each year under consideration.

*pr1715transferpricing - 3. These operating profits reflect the more comprehensive financing function of TestCo.*

### APPENDIX 14

### APPENDIX 14

### Two-step approach to country risk — formulas and definitions

- Equation 1 - Balance sheet adjustment
  - ∆AR_T = (0 − Comparables Days AR) * Sales / 365
  - Where:
    - ∆AR_T = the change in accounts receivable when setting the target (T) days accounts receivable to zero
    - Comparables Days AR = the days in accounts receivable of the European comparables
    - 0 = the target days receivable to remove the impact of days receivable

- Equation 2 - Income statement adjustment
  - ∆Sales_T = ∆AR_T * i_inon−domestic / (1 + (i_inon−domestic * Comparables Days AR / 365))
  - Where:
    - ∆Sales_T = the adjustment to sales after removing the impact of accounts receivable
    - ∆AR_T = the impact on accounts receivable estimated as part of the balance sheet adjustment
    - i_inon−domestic = the short-term interest rate reflecting the underlying credit risk

- Note: After equation 1 + 2 the working capital is removed. The next step is to introduce the working capital related impact of operating in the more risky developing market.

- Equation 3 - Balance sheet adjustment (introducing local tested-party days)
  - ∆AR_LT = (Target Comparables Days AR − 0) * Adjusted Sales / 365
  - Where:
    - ∆AR_LT = change in accounts receivable when setting days of accounts receivable to the tested party days of receivable
    - Target Comparables Days AR = the days in accounts receivable of the tested party
    - 0 = the accounts receivable of the comparables following the above described first step of the adjustment

- Equation 4 - Income statement adjustment (local market interest)
  - ∆Sales_LT = ∆AR_LT * i_local
  - Where:
    - ∆Sales_LT = the adjustment to sales by adjusting the accounts receivable in line with the local target company
    - ∆AR_LT = the impact on accounts receivable estimated as part of the balance sheet adjustment
    - i_local = the short-term interest rate of the local market in which the target company operates

*Starkov et al (2014), Comparability adjustments pp. 9-10*

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### APPENDIX 15

### Interquartile range (IQR) — Excel steps

- Step 1: Enter your data into a single Excel column (e.g., A2 to A10). Don’t leave any gaps.
- Step 2: In a blank cell type =QUARTILE(A2:A10,1) where the “1” returns the first quartile (25 percent).
- Step 3: In a second blank cell type =QUARTILE(A2:A10,3) where the “3” returns the third quartile (75 percent).
- Step 4: In a third blank cell type =B3-B2 (adjust references as needed) to compute IQR.
- Step 5: Press “Enter” — Excel will return the IQR.
- Note: Most databases provide a tool to calculate an interquartile range.

---

### APPENDIX 16

### Financial ratios and acronyms — formulas

- Tax leverage: TLev = NP / EBT
- Financial leverage: FLev = EBT / EBIT
- Operating margin: OM = EBIT / Sales
- Total assets turnover: TAT = Sales / TA
- Asset structure: AS = TA / EBT
- Accounts receivable turnover: RecTO = Rec / Inv
- Inventory turnover: ITO = Inv / Sales
- Cash position: CP = Sales / CA
- Short term liquidity: STLiq = CA / CL
- Liability structure: LiabSt = CL / Debt
- Long term solvency: LTSol = Debt / Capital
- Financial structure and risk management: Capital / Equity

---

### APPENDIX 17

### Common acronyms — financial statements line items

- Income statement
  - Sales (Turnover) = TO
  - Cost of goods sold = COGS
  - Gross profit = GP
  - Operating expenses (Including selling, general and admin expenses, depreciating expenses often referred to as “SG&A”) = OPEX
  - Earnings before interest and tax = EBIT
  - Interest expense = Int
  - Earnings before tax = EBT
  - Net profit = NP

- Balance sheet — Assets
  - Cash and cash equivalents = Cash
  - Accounts receivables = Rec
  - Inventory = Inv
  - Other current assets = OCA
  - Current assets = CA
  - Fixed assets (net of depreciation) = FA
  - Property plant and equipment = PPE
  - Intangible assets = IA
  - Total assets = TA

- Balance sheet — Liabilities
  - Accrued expenses = AE
  - Accounts payable = Pay
  - Other current liabilities = OCL
  - Current liabilities = CL
  - Long-term debt = Debt
  - Equity = eQ

---

### APPENDIX 18

### Ratios measuring functions, assets, and risks — implications for transfer pricing

- Operational ability (Function performed driven)
  - OM = EBIT / Sales
  - Operating margin: widely used in transfer pricing analysis as a PLI under the TNMM method

- Use of sources finance to obtain leverage benefits (Function performed driven)
  - FLev = EBT / EBIT
  - Financial leverage: use of tax (timing, deferral) to obtain leverage benefits

- Tax leverage (Function performed driven)
  - TLev = NP / EBT

- Cash flow position (Function performed driven)
  - CP = Sales / CA
  - Cash position as expressed by sales to current assets, generated cash flow

- Financial structure and risk management
  - FSRM = Capital / Equity
  - Financial structure and risk management. Companies' financing decisions determine the mix of debt and equity aimed at operational funding. Important from a transfer pricing perspective, especially with the thin capitalisation rule (3:1 debt to equity).

- Activity / Assets
  - TAT = Sales / TA (Total assets turnover)

- Accounts receivables risk
  - RecTO = Rec / Inv (Accounts receivables turnover)

- Inventory risk
  - ITO = Inventory / Sales (Inventory turnover)

- Liquidity
  - STLiq = CA / CL (Short term liquidity)

- Solvency
  - LTSol = Debt / Capital (Long term solvency)

- Liability structure
  - LiabSt = CL / Debt

---

### APPENDIX 19

### Illustrative legislation/regulation for a safe harbour on routine manufacturing operations — key provisions

- Scope and application
  - Article applies where:
    - a taxpayer is party to one or more controlled transactions that compensate the taxpayer for “qualifying manufacturing activities” that it carries on in [country]; and
    - the conditions in Sub-articles 5 and 6 of this Article are met.

- Effect where article applies
  - No adjustment will be made under [section #] with respect to those controlled transactions; [and the requirements of the transfer pricing regulations will not be applicable]

- Definition of “qualifying manufacturing activity”
  - Activity consists only of:
    - i. toll manufacturing (manufacturing services on behalf of a connected person); or
    - ii. contract manufacturing (production to order for sale only to a connected person);
  - AND the taxpayer:
    - does not perform manufacturing services for unconnected persons or sell to unconnected persons;
    - has an arrangement where connected persons assume the principal business risks and agree to compensate the taxpayer at levels consistent with Sub-article 5;
    - does not engage in advertising, sales, marketing and distribution, credit and collection, or warranty administration; and does not perform functions, use assets or assume risks expected to contribute to the value of intangibles;
    - (contract manufacturing) does not retain title to finished products after they leave its factory, does not bear transportation/freight expense, does not bear risk of loss in transit;
    - does not engage in managerial, legal, accounting, or personnel management functions other than those directly related to manufacturing activities;
    - does not own, share ownership, have rights or claims to ownership, bear cost of developing/enhancing, or pay royalties for valuable product/process/marketing intangibles.

- Transactions covered
  - Contract manufacturing = sales of manufactured products
  - Toll manufacturing = service fees received for the qualifying manufacturing activity

- Condition 1 — Minimum compensation requirement
  - Contract manufacturing: minimum total compensation from sale of products = total costs of the qualifying manufacturing activity, excluding only net interest expense, currency gain or loss and any non-recurring or extraordinary costs, plus a XXX percent mark-up.
  - Toll manufacturing: minimum net income for the manufacturing service = total costs of the qualifying manufacturing activity, excluding only net interest expense, currency gain or loss and any non-recurring or extraordinary costs, plus a XXX percent mark-up.

- Condition 2 — Documentation
  - Documentation maintained and submitted to the [Tax Authority] within [45] days of a written request.
  - Documentation must include:
    - a description of the activities and consistency with Sub-article 3;
    - calculations demonstrating transactions are consistent with Sub-article 5.

- Miscellaneous
  - Where article does not apply, general rules in the Regulation apply.
  - Application is without prejudice to [Country’s] obligations under applicable international treaty.
  - The mark-ups in Sub-article 6 may be reviewed periodically by the Ministry of Finance [or tax administration], taking into account Article 3 of this Regulation.

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### APPENDIX 20

### Country practices on safe harbours for low value-adding transactions — selected entries

- OECD
  - Safe harbour margin/mark-up: 2-5%
  - Low value-adding transactions defined: Supportive nature, not part of the core business of the MNE group, not requiring use of and do not lead to the creation of unique and valuable intangibles. Non-exhaustive list of examples provided. Also, cannot be rendered to unrelated customers of the members of the MNE group.
  - Excluded transactions: Core business services; R&D services; manufacturing and production services; sales, marketing and distribution services; financial transactions; extraction, exploration, or processing of natural resources; insurance/reinsurance; services of corporate senior management.

- EU JTPF
  - Safe harbour margin/mark-up: 3-10% (often about 5%)
  - Low value-adding transactions defined: The core nature of the service is that whilst required it is of a routine nature and not generating high-value adding to either the provider or recipient. Includes services that generate high turnover as long as low-value adding.
  - Excluded transactions: Likely to be excluded are services in the nature of innovative R&D, IP, financial transactions and other services that are a significant commercial driver as well as those activities with the potential to generate a high level of reward associated with exposure to high risk.

- Australia
  - Safe harbour margin/mark-up: 7.5% (+/- 2.5%)
  - Low value-adding transactions defined: Non-core services, i.e. supporting, generally routine services not integral to the earning activities of the MNE group) and de minimis cases (totalling less than AUD 500,000 a year). Amount charged for all non-core services is not more than 15% of the total accounting expenses of the acquiring entity.
  - Note: Additional documentation may be required to substantiate higher/lower mark up. Safe harbours are subject of a bilateral arrangement between Australia and New Zealand.

- Austria
  - Safe harbour margin/mark-up: 5 – 15% margin (5% mark-up if only direct costs) or cost (no mark-up)
  - Low value-adding transactions defined: Routine services where assets are involved only on a small scale and risk taking is small. Cost only safe harbour applies to ancillary services not part of the core business.
  - Excluded transactions: Not explicitly identified.

- Hungary
  - Safe harbour margin/mark-up: 3-10%
  - Low value-adding transactions defined: Typically back office, accounting, legal, IT or HR services.
  - Excluded transactions: Not explicitly identified.

- Netherlands
  - Safe harbour margin/mark-up: Cost (no mark-up)
  - Low value-adding transactions defined: “Support services” — bookkeeping, legal issues, tax matters and human resources generally considered supporting services.
  - Excluded transactions: Primary business processes such as production, procurement, sales, marketing, product development and research & development.

- New Zealand
  - Safe harbour margin/mark-up: 7.5% (+/- 2.5%)
  - Low value-adding transactions defined: Services not integral to profit-earning or economically significant activities of the group; supportive, routine, not similar to main income-generating activities. Also applies to de minimis cases (NZD 600,000). Note: bilateral agreement with Australia.
  - Excluded transactions: Not explicitly identified.

- Singapore
  - Safe harbour margin/mark-up: 5%
  - Low value-adding transactions defined: “Routine services” supporting the group’s main business, different from main activities, not intended to be carried out for profit but required for effective group functioning; centralised within parent or group service company. Non-exhaustive list of routine services. Not offered to unrelated parties.
  - Excluded transactions: Not explicitly identified.

- US
  - Safe harbour margin/mark-up: Cost (no mark-up)
  - Low value-adding transactions defined: Services must qualify as either “specified covered services” or “low margin covered services”; may not be services that contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success/failure in trades/businesses of the renderer, recipient, or both. Specified covered services are listed in an IRS publication; currently there are 101 services. Low margin covered services = median comparable arm’s length mark-up on total services costs ≤ 7%.
  - Excluded transactions: manufacturing and production; extraction, exploration or processing of natural resources; construction; reselling, distribution, acting as a sales or purchasing agent or acting under commission; R&D or experimentation; engineering or scientific services; financial transactions, including guarantees; insurance or reinsurance.

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*IMF — pr1715transferpricing - APPENDIX 14 (source PDF).*

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_Source: https://www.imf.org/-/media/files/news/press-release/pr1715transferpricing.pdf_