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Preface

Transfer Pricing
ADIT 3.03 Module Textbook

StarTax Education; Borys Ulanenko (c)

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StarTax Education; Borys Ulanenko (c)

 www.startaxed.com 0. Preface

Transfer Pricing
ADIT 3.03 Module Textbook
First Edition

by

Borys Ulanenko

StarTax Education

StarTax Education; Borys Ulanenko (c)

 www.startaxed.com 0. Preface

StarTax Education
www.startaxed.com

© 2020 Borys Ulanenko

All rights reserved. No part of this publication may be reproduced or transmitted in any
form or by any means, electronic or mechanical, including photocopying, recording, or
any information storage or retrieval system, without prior permission in writing from the
publishers. While every care has been taken to ensure the accuracy of this work, no
responsibility for loss or damage occasioned to any person acting or refraining from
action as a result of any statement in it can be accepted by the authors, editors or
publishers.

ISBN: 978-83-958552-0-7

StarTax Education; Borys Ulanenko (c)

www.startaxed.com Chapter 8. Comparability Analysis Overview

Chapter 8. Comparability Analysis Overview

In this chapter, we are going to cover the following topics:

1. Comparable transactions vs comparable companies

2. OECD comparability factors
3. Comparability analysis: goal and process steps
4. Use of internal comparables
5. Use of external comparables

ADIT Syllabus items covered:

V Comparability

A. Significance of comparability and factors determining comparability

B. Performing a comparability analysis
C. Dealing with the lack of comparable data
D. Sources of information: internal/external comparables; “secret
comparables”, foreign comparables
E. Timing and compliance issues in comparability

Introduction
8.1 In this chapter, we are going to start the discussion about comparability
analysis. Comparability analysis is a cornerstone of the application of the
arm's length principle. Firstly, we will look at the theoretical background
around comparability factors and approaches. The next chapter will
continue the discussion and will focus on the application of comparability
analysis in practice.
8.2 The ADIT exam requires a fundamental understanding of comparability
analysis. However, it is less probable that you will be required to conduct
an end-to-end comparability analysis, as the necessary data for a full
review of even a simple transaction is too extensive. Therefore, the study
material provides the level of detail that should be sufficient for
successfully sitting the ADIT exam.
Comparable transactions or comparable companies?
8.3 As you will recall from the discussion about transfer pricing methods, the
only method that directly compares price is the comparable uncontrolled
price method. Other methods look at the profit (measured using profit
level indicator) of transactions and compare it with the profit arising from
uncontrolled transactions (either internal or external).

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www.startaxed.com Chapter 8. Comparability Analysis Overview

8.4 Internal comparables, where they exist, provide valuable information for
the application of traditional methods, like CUP, resale price, or the cost
plus method. However, if there are no internal comparables identified, the
scope of these methods becomes very limited. This is due to the high
comparability requirements of these methods, and accounting policy
differences discussed in previous chapters. Moreover, detailed
information is required for the reliable application of traditional methods.
8.5 In practice, reliable transactional information for external comparables
is often unavailable. Therefore, non-transactional data is commonly used
in practice as an external comparable.
8.6 Nontransactional data is information on statutory accounts of other
companies, usually aggregated at an entity level. This information
includes P&L and balance sheet details of private and public companies
operating in comparable geographic and industry conditions. This
financial data is available in commercial databases that collect and
publish financial accounts information.
8.7 Therefore, the word "comparable" can mean:

• A comparable uncontrolled transaction for the purpose of using

traditional transfer pricing methods (usually CUP), and

• Comparable third-party companies whose financial accounts are

used as an arm's length reference for the purpose of applying one-
sided profit-based methods.
8.8 The use of both comparable uncontrolled transactions and comparable
third-party company data will be demonstrated below.
OECD comparability analysis process
8.9 As we know from previous chapters, controlled and uncontrolled
transactions are considered comparable if (1) there are no material
differences between the transactions; (2) where such differences do
exist, reasonably accurate adjustments can be made to mitigate them.
Therefore, comparability does not require transactions to be
identical. Instead, if differences exist, they should not materially impact
the price or margin being tested, or if the differences do substantially
affect the tested parameter (price or margin), reasonably accurate
adjustments should be made.
8.10 Comparability analysis is, therefore, a process of identifying all the
economically significant factors of the controlled transaction and making

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further comparisons of these factors with the characteristics of

comparable uncontrolled transactions. The goal of comparability
analysis is to find the most reliable comparables.
8.11 OECD suggests a nine-step process for comparability analysis. This
process is considered good practice, but it is not compulsory. The
process is summarised in the table below:
Comments and most
Step Description important factors to
consider
Step 1 Determination of years to be covered. • Whether to test results
of controlled
transactions from one
year or multiple years
• Whether to use
comparable data from
one year or multiple
years
In practice, this step can
be performed after Step
7 or later.
Step 2 Broad-based analysis of the taxpayer's • Functional analysis,
circumstances. industry analysis,
review of all available
sources of information
Step 3 Understanding the controlled transaction(s)
under examination, based on particulars of
functional analysis, in order to: • Functional analysis,
industry analysis,
• choose the tested party,
review of all available
• choose the most appropriate transfer
sources of information
pricing method,
• Forming a hypothesis
• choose the financial indicator that will be
about the method and
tested (PLI),
PLI.
• identify the significant comparability
factors that should be taken into account.
Step 4 Review of existing internal comparables, if any. • Analysis of contracts
and transactions with
non-group companies.
Step 5 Determination of available sources of • Consideration of
information on external comparables, where available databases
such comparables are needed, taking into and other sources of
account their relative availability. information.
Step 6 Selection of the most appropriate transfer • Based on the
pricing method and, depending on the method, hypothesis formed in
determination of the relevant financial indicator. Step 3 and
considering the data
available (Steps 4-5).

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www.startaxed.com Chapter 8. Comparability Analysis Overview

Comments and most

Step Description important factors to
consider
Step 7 Identification of potential comparables:
• A detailed review of
determining the key characteristics to be met in
internal and/or
order to be regarded as being potentially
external comparables.
comparable, based on the relevant factors
Selection of the most
identified in Step 3 and in accordance with the
reliable comparables.
five comparability factors.
Step 8 Determining and making comparability
• Making comparability
adjustments where appropriate.
adjustments to
improve comparability.
Step 9 Interpretation and use of data collected, • Calculation of arm's
determination of the arm's length remuneration. length range,
conclusion regarding
the arm's length
nature of the
controlled transaction.

Step 1: Determination of years to be covered

8.12 It may be generally useful to examine data from both the year under
examination (the year when the transactions took place), as well as prior
years. It could be the case that transactions under review are part of a
long-term arrangement or project and considering the results of one year
may be inappropriate. Also, it could be well the case that the products
transferred are affected by product life cycle factors or economic cycles.
Therefore, considering several years in aggregation may be appropriate.
8.13 Similar consideration should be given to the period of analysis of
comparable transactions or comparable companies' financial results.
Examples in the next chapter will demonstrate practical considerations
for the selection of the period.
Steps 2-3: Broad-based analysis of the taxpayer's circumstances,
functional analysis, and other comparability factors. Forming the
hypothesis about the method, tested party, and the PLI.
8.14 Before making comparisons with uncontrolled transactions, it is important
to assess the relevant characteristics of the controlled transactions. The
OECD Guidelines provides five comparability factors (discussed in
Chapter 2) that need to be considered:

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www.startaxed.com Chapter 8. Comparability Analysis Overview

OECD G. Comparability Sources of

reference What is analyzed information
factor
D.1.1 Contractual
• Form of consideration • Contracts
terms of the
transaction charged or paid • Communication
• Sales or purchase volume between the
• Scope and terms of parties
warranties • Actual conduct
• Rights to updates, • Invoices
revisions, or modifications • Annual report of
• Duration of the agreement the company
• Collateral services, if any • Website of the
• Credit and payment terms company
D.1.2 Functions, • Functions performed by • Contracts
assets, and both parties • Communication
risks • Risks of the parties between the
(refer to • Assets owned and used by parties
Chapter 3) the parties • Functional
• Other circumstances interviews
surrounding the • Annual report of
transaction the company
• Industry practices • Website of the
company
• Other sources

D.1.3 Characteristics For tangible property: • Contracts

of the property • Physical features • Invoices
or services • Quality and reliability • Price lists,
• Availability and volume of offers, proposals
supply • Annual report of
For services: the company
• Nature of the services • Company
• The extent of the services website
For intangible property: • Other sources
• Form of transaction (sale
or license)
• Type of property (patent,
trademark, know-how)
• Duration and degree of
protection
• Anticipated benefits from
use

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www.startaxed.com Chapter 8. Comparability Analysis Overview

OECD G. Comparability Sources of

reference What is analyzed information
factor
D.1.4 Economic • Geographic location • Functional
circumstances • Market size interviews
• Barriers to entry • Market and
• Level of the market industry analysis
(wholesale, retail, etc.) • Professional and
• Competition scientific
• Existence and availability publications
of substitutes • Annual report of
• Location-specific costs the company
• Government regulation • Company
• Economic condition of the website
industry
• Economic, business, or
product cycles
D.1.5 Business Business strategy of the • Functional
strategies parties, such as: interviews
• Market penetration • Annual report of
• Market development the company
• Product development • Company
• Diversification website
• Others

8.15 Not all comparability factors are equally important in every transaction.
For example, the characteristics of a property can be a dominating factor
in transactions in which a commodity or highly standardised product is
being sold. Imagine you are interested in buying a one-ounce silver coin
for investment purposes. It is highly likely that you will be indifferent to
where to buy it (as long as the source is reliable, and you have no
concerns that the coin is not fake). Now, let's look at a less commoditised
product, like a cup of coffee. For most of the customers, the quality of the
product is only one of many factors, while the brand, location of the coffee
shop, loyalty programs, and other features may play an even more critical
role.
8.16 Therefore, the type of product or service, as well as the transfer pricing
method applied, will significantly shift the focus in comparability analysis.
For example, differences in the characteristics of products or services are
more likely to have a material impact on the price and are important when
applying the CUP method. However, such differences may have less
material impact on gross or net profit margins and, therefore, may not

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materially affect comparability for the purposes of applying the cost plus
method, resale price method, or transactional net margin method. For
these methods, functions, risks, and assets are of greater importance
(while FARs are less relevant for the CUP method).
8.17 After gathering, analysing, and summarising the information on
comparability factors of the controlled transaction, it is usually possible to
form the hypothesis about the applicable TP method, tested party, and
the PLI to be used. The example below demonstrates this logic for
service transactions.
Example 8.1: Outcomes of Steps 2-3 for a hypothetical service transaction

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8.18 After the broad-based analysis of the taxpayer is complete, controlled

transactions are analysed (considering the five comparability factors).
Once the assumption about the transfer pricing method and the tested
party has been made, it is time to move to the next steps.
Steps 4-7: Identification and analysis of potentially comparable
transactions or companies
Internal comparables
8.19 As discussed in Chapter 5, internal comparables are comparable
transactions between one party to the controlled transaction, and an
unrelated party. For example, if the company is selling similar goods to
both related and unrelated parties, transactions with unrelated parties
can be used as internal comparables for testing related party
transactions.
8.20 Internal comparables have several advantages over external ones as
they often have a more direct relationship to the controlled transactions.
Internal transactions with third parties are also usually more comparable
than external ones as one party to the transaction is the same in both
controlled and comparable transactions. This may solve any potential
issues with accounting standards differences, which is vital for the
application of resale price and cost plus methods.
8.21 The information on internal comparables is usually thorough and readily
available.
8.22 However, this does not mean that internal comparables are automatically
preferred to external comparables. Internal transactions should be
carefully assessed using five comparability factors and comparability
adjustments must be made if necessary.
8.23 The example below presents a set of potentially comparable internal
transactions and demonstrates how these can be assessed:

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www.startaxed.com Chapter 8. Comparability Analysis Overview

Example 8.2: Internal comparables review

Company A is located in Country A and is a manufacturer of ceramics. Company A produces a wide range of
tableware, including plates, teacups and jugs and sells them to Company B, a related distributor in Country B.
The table below summarises the controlled transactions between Company A and Company B for tax year X:
Product Volume Price, USD Amount

Plates, 22 cm 1,350 15 20,250

Plates, 27 cm 800 22 17,600

Tea cups 2,000 6 12,000

Total - - 49,850

During Step 3 of comparability analysis (refer to the table in paragraph 8.11), the following facts were identified:
Contractual terms: Company A and Company B have a long-term contract that prescribes delivery terms
(Company A, as a seller, is responsible for delivering goods to the Company B warehouse), the minimum
product volumes that Company B is obliged to buy (at least 500 items of each product annually), and payment
terms (30 days pre-payment). The contract assumes that Company B will place an order and will allow 30 days
for Company A to produce and deliver. Prices are not stipulated by the contract and are agreed upon by the
parties when the order is placed.
Functions, assets, and risks: During functional interviews and a review of internal correspondence, it was
identified that Company A and Company B, while agreeing on the prices for the tableware, would usually base
the price on expected sale price minus a margin of 20%. Taking into account the pricing terms and other facts
not discussed in the case, Company B can be characterised as a limited risk distributor.
Characteristics of property: Company A produces high-end premium tableware. The plates and cups sold to
Company B are high-quality hand painted products with unique features.
Economic circumstances: Company A operates in Country A, which is a stable market economy with a
developed infrastructure and labour market. Country B, where Company B operates, is a developing country
with a growing premium product market.
Business strategies: Companies A and B are seeking to expand and maintain the sales in Country B. This is
a standard business strategy with no unique attributes that could materially affect the price in the transaction.
Under Step 4 of comparability analysis, the following transactions were identified as potentially comparable,
where Company A sells tableware to unrelated parties:
Counterparty (country) Product Volume Price, USD Amount

Tea Cup Saucer, 12 cm 300 9 2,700

Company X (Country X) Pizza Plate, 38 cm 150 34 5,100

Espresso Cups 500 5 2,500

Plates, 27 cm 200 25 5,000

Company Y (Country Y)
Tea Cups 300 8 2,400
Plates, 22 cm 800 16 12,000
Company Z (Country Z)
Plates, 27 cm 600 23 12,000

Company B does not buy any products from unrelated parties.

From the list of potentially comparable transactions, it is evident that Company A sells similar products to
Companies Y and Z (Plates, 22 and 27 cm). Company A also sells broadly comparable products to Company
X. Now, every potentially comparable transaction should be analysed using the five comparability factors. The
summary of the analysis is presented below.

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 Counterparty Characteristics of Economic
Contractual terms Functions, assets and risks Business strategies
(country) property circumstances
Company X is an independent
distributor that is trying to
Products sold to Country X is a
Company X is an independent maximise its profit. Company
One-off sale contract, Company X are developed market with
distributor of premium ceramics A, in transactions with
payment 30 days after the broadly comparable a stable economy.
Company X (Country X) and tableware in Country X. Company X, makes spot sales
delivery, delivery organised (premium ceramics), Growth rates of
Company X distributes products at the maximum possible
by buyer. but not exactly the premium tableware
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of multiple brands. price. Since the volumes are

same. market are modest.
not large, Company A sells
from inventory.
Company Y is an independent
distributor that is trying to
Company Y is an independent Country Y is a
maximise its profit. Company
One-off sale contract, retail network of premium developed market with
A, in transactions with
payment 30 days after the ceramics and tableware in a stable economy.
Company Y (Country Y) Same products Company Y, makes spot sales
delivery, delivery organised Country Y. Company Y Growth rates of
at the maximum possible
by buyer. distributes products of multiple premium tableware
price. Since the volumes are
brands. market are modest.
not large, Company A sells

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from inventory.
Long-term contract, 30-day Company Z is an independent
pre-payment, prices agreed distributor of Company A's
Country Z is a Company Z works in close
for each transaction products. It does not distribute
developing country cooperation with Company A
separately. No minimum any products of other brands.
Company Z (Country Z) Same products with a growing and is trying to expand and

StarTax Education; Borys Ulanenko (c)

purchase volume assumed. While negotiating the pricing
premium product maintain the sales in Country
Company Z is an exclusive with Company Z, Company A
market. Z.
distributor of Company Z will usually take into account
products in Country Z. expected final sale price.

From the facts above, we can make the following conclusions:

Transactions with Company X: Even though the products sold to Company X are broadly comparable with the products in the controlled transactions, there are significant
differences in contractual terms, functions, assets, and risks, business strategies, and economic circumstances. Transactions with Company X will not serve as good comparables
for the application of the CUP method (precisely due to product differences). Differences in functions, assets, and risks, as well as in other comparability factors, will not allow for
the application of the RPM or Cost Plus methods, as these differences may have a material effect on the gross profits of the parties involved in the transaction. Therefore, transactions
with Company X should not be used as internal comparables.
Chapter 8. Comparability Analysis Overview
 Transactions with Company Y: Company A sells the same products to Company Y, which could potentially indicate that the prices in transactions with Company Y can be used
as direct comparables for the application of the CUP method. However, contractual terms, the functional profiles of the companies, economic circumstances, and business strategies
are very different and may have a material effect on prices. There is a low chance that reliable comparability adjustments can be made to prices to account for such differences.
Similarly, these factors have a material effect on the gross profits of the parties involved in the transaction. Therefore, transactions with Company X should not be used as internal
comparables.

Transactions with Company Z: All five comparability factors in transactions with Company Z are broadly comparable with those in controlled transactions. Consideration should
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be given to how these smaller differences affect the price and gross margin of parties to the transaction, however; the following conclusions can be preliminarily made on the use
of transactions with Company Z as internal comparables:

CUP method – can be potentially applied for Plates 22 and 27 cm. Further analysis should be conducted to identify the factors that lead to differences in the prices. There
is a chance that the differences are due to specifics of the transaction, variations in customer prices in Country Z vs Country B, etc. If no objective reason is identified for
differences in the prices, it can be concluded that prices in controlled transactions are below arm’s length level.

Resale price method – can be potentially applied using the resale margin (gross margin) of Company Z to assess the 20% gross margin applied by Company B. There is
a good chance that small differences in functional profiles, contractual terms, and economic circumstances will have no material effect on gross margins (in contrast with
prices). Also, Company B is the less complex party in the controlled transaction, so its result should be tested. One potential difficulty in the application of the internal resale
price method to this case is a limitation of information, as Company Z may refuse to share the details of its gross margin. Also, careful consideration should be given to

136
potential differences in accounting standards and practices applied by Companies Z and B.

Cost plus method – can be potentially applied using the gross mark-up of Company A in transactions with Company Z to assess the gross mark-up of Company A in
transactions with Company B. Similar to the resale price method, there is a good chance that small differences in functional profiles, contractual terms, and economic
circumstances will not have a material effect on gross mark-ups. Also, there is no need to rely on third-party data for the application of the cost plus method, as thorough

StarTax Education; Borys Ulanenko (c)

information is already available. The only potential downside of cost-plus application to this case is that Company A is a complex entrepreneurial entity and it is usually
advisable to test the less complex party in one-sided methods.

In practice, before making a final selection of the method, we recommend executing testing using all three of the abovementioned methods.
Chapter 8. Comparability Analysis Overview
www.startaxed.com Chapter 8. Comparability Analysis Overview

Internal comparables and TNMM

8.24 Internal comparables will not usually be used for the TNMM, because if
sufficiently comparable internal transactions exist, the resale price
method or cost plus method will be applied.
Internal comparables and PSM
8.25 PSM can be applied using internal comparables. However, this rarely
happens in practice as profit split is usually applied to situations in which
either operations of the parties are highly integrated, and/or parties make
unique and valuable contributions to the transaction. It is, therefore, rarely
the case that such transactions exist between independent parties, and
even rarer for the entity to have such an arrangement with related and
unrelated parties at the same time.
External comparables
8.26 It is often the case that no internal comparables are available. In such
cases, it is necessary to assess and apply external comparables.
8.27 As discussed in paragraphs 8.3-8.8 of this chapter, both transactions and
companies can be used as comparables. It will, therefore, be the case
that both potentially comparable transactions and potentially comparable
companies should be assessed, depending on the facts and
circumstances of the case.
8.28 Some transactions would commonly be tested using transactional
information, while others would usually rely on comparable companies'
data:

• Commodity transactions – often tested via CUP using

transactional information (quoted price) from commodity exchanges
(e.g., crude oil, metals, grain, etc.).

• Financial transactions - usually tested via CUP using transactional

information on third-party loans and bonds.

• Royalty payments – often tested via CUP using transactional

information on third-party licensing agreements.

• Service transactions – often tested via TNMM using comparable

companies’ data (service providers as a tested party, net cost plus
as a profit level indicator).

• Transactions where one of the parties is a limited risk

distributor – usually tested via TNMM using comparable

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www.startaxed.com Chapter 8. Comparability Analysis Overview

companies’ data (limited risk distributor as a tested party, operating

(net) margin or Berry ratio as a profit level indicator).
• Transactions where one of the parties is a contract or toll
manufacturer – usually tested via TNMM using comparable
companies’ data (manufacturer as a tested party, net cost plus as a
profit level indicator).
8.29 There are multiple databases available on the market that provide
extensive transactional and non-transactional (company) data. Some of
the most often used of these are listed below. We recommend reviewing
the links contained in the table to understand each product better. We will
demonstrate the application of one of the databases in the next chapter.
Database and Transactions
Additional information (link)
provider covered
Bloomberg Financial
https://www.bbhub.io/professional/site
Reference Data transactions (bonds,
s/4/Transfer_Pricing_Fact_Sheet.pdf
Services by loans, guarantees,
Bloomberg derivatives, etc.)
ktMine IP by ktMine Intangibles, license https://www.ktmine.com/
agreements, and
royalty rates
Worldwide public Company financial https://tax.thomsonreuters.com/conte
and private information (public nt/dam/ewp-
databases by and private m/documents/tax/en/pdf/brochures/on
Thomson Reuters companies) esource-transfer-pricing-documenter-
brochure.pdf (page 2)
Multiple databases Company financial https://www.bvdinfo.com/en-
by Bureau van Dijk information (public gb/solutions-for-your-role/transfer-
and private pricing
companies)

8.30 The two examples below will illustrate the general principles of the
application of external comparables.

Example 8.3: Consideration of external comparables – commodities

TradeCo is a trading hub company of A Group, a vertically integrated oil & gas company. Its
primary role within A Group is to purchase crude oil extracted by the Upstream division of A
Group and to sell it in the international market.

The transaction under review is the sale of crude oil by UpstreamCo, the exploration and
production company of A Group, to TradeCo.

UpstreamCo does not sell crude oil to unrelated parties, and TradeCo does not usually buy
crude oil from unrelated parties. Therefore, there are no internal comparables available.
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As a general practice, quoted StarTax
prices Education;
are often Borys
used Ulanenko
for assessing
(c) the arm's length nature of
controlled transactions that involve commodities. Therefore, it is reasonable to evaluate the
applicability of quoted prices to the transaction.
www.startaxed.com Chapter 8. Comparability Analysis Overview

UpstreamCo does not sell crude oil to unrelated parties, and TradeCo does not usually buy
crude oil from unrelated parties. Therefore, there are no internal comparables available.

As a general practice, quoted prices are often used for assessing the arm's length nature of
controlled transactions that involve commodities. Therefore, it is reasonable to evaluate the
applicability of quoted prices to the transaction.

First of all, under steps 2-3 of comparability analysis (review of taxpayer's circumstances and
understanding the controlled transaction), it is advisable to look at the comparability factors
and conditions that are especially relevant for commodity transactions.

These include:

• Physical characteristics of crude oil, such as grade

• Contract date, pricing date, and delivery date
• Delivery terms, including incoterms and location
• Volume of transaction

Other comparability factors should be considered as well, as it could be the case that, for
example, the functional profiles of the parties are such that they lead to only one party assuming
all the risk. Such circumstances may lead to the conclusion that the one-sided method should
be applied instead of CUP.

UpstreamCo is located in Canada and extracts Canadian Light Sour Blend grade crude oil. It
then delivers crude oil via the pipeline to the port, where the product is loaded onto ships.

Under the contract, prices in the transactions between UpstreamCo and TradeCo are
determined based on the pricing formula.

As an industry practice, the West Texas Intermediate (WTI) quoted price is used to establish
prices of crude oils extracted in North America, with necessary quality adjustments and
differentials to account for different product characteristics and market conditions. Now, let’s
analyse the pricing formula used by UpstreamCo and TradeCo and assess if the pricing in
controlled transactions follows the market practice is arm's length:

Assuming there are no other material factors that are not captured by the formula, we can
conclude that prices in the controlled transaction follow the arm's length principle, since:
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• The pricing formula is based on three elements, and each of them comes from
independent third-party sources;
• The use of pricing formulas and these sources of information is consistent with
www.startaxed.com Chapter 8. Comparability Analysis Overview

Assuming there are no other material factors that are not captured by the formula, we can
conclude that prices in the controlled transaction follow the arm's length principle, since:

• The pricing formula is based on three elements, and each of them comes from
independent third-party sources;
• The use of pricing formulas and these sources of information is consistent with
industry practice;
• There are no other material factors that are not captured by the formula.

As a best practice, it is a good idea to check if the pricing in actual transactions follows the
prescribed formula. If there are numerous supplies under review (e.g., UpstreamCo regularly
sells crude oil to TradeCo and hundreds of deals are executed annually), it is worth considering
selecting a sample of deals and recalculating the pricing formula using actual third-party data.
This will give peace of mind, both to the taxpayer and the tax authorities, that the company is
following the contractual terms.

Example 8.4: Consideration of external comparables – LRD

Assume the facts and circumstances are similar to those described in Example 8.2, except that
there are no internal comparables identified. In the controlled transaction, Company B acts as
a limited risk distributor of ceramics and tableware purchased from Company A, the
manufacturer.

Since the products sold by Company A to Company B are non-commoditised, it is very unlikely
that external comparables will be available for the application of the CUP method. Also, even
though the resale price method or cost-plus could potentially be applied, it is generally not
recommended to use these methods based on external comparables (due to differences in the
accounting treatment of expenses and other items).

TNMM is usually the most reliable method when applied based on external non-transactional
(company) data. Therefore, results achieved by Company B in the resale of ceramics
purchased from Company A can be tested versus the results of comparable distributors.

At this point, we need to decide what comparable companies we are going to search for. In this
case, we will most likely be looking for distributors operating in Country B selling ceramics and
tableware as their primary business.

We will then use the database that contains information about independent companies
operating in Country B and identify comparable companies using special techniques that are
discussed further in the next chapter.

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Summary
8.31 Comparability analysis is a cornerstone of the application of the arm’s
length principle. During comparability analysis, the taxpayer or tax
administration considers the five comparability factors of the controlled
transaction and compares them with the comparability factors of
potentially comparable uncontrolled transactions.
8.32 There are two main types of comparables – comparable transactions
(usually used in traditional methods, especially CUP), and comparable
companies (usually used for TNMM). When it is impossible to identify
good comparable transactions, comparable companies and their
financial accounts can serve as a reference.
8.33 Internal comparables are comparable transactions that are performed by
one of the parties to the controlled transaction with unrelated parties.
Internal comparables are usually preferable, as they have a high degree
of comparability, and information about them is easily available.
8.34 External comparables are comparable transactions or comparable
companies, information on which can be collected from freely available
sources or commercial databases. Comparable company data is not
transactional.
8.35 The transfer pricing method and the comparability approach depend on
the type of transaction and the facts and circumstances of the case.
There is no standard approach, but some transactions will often use
similar methodologies – for example, financial transactions will often be
tested using the CUP method, based on external comparables. The
following chapters will demonstrate the application of comparability
analysis in practice and will discuss standard transfer pricing
methodologies that are applicable to the most common types of
transactions.

ESSENTIAL READING
OECD (2017) Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations, 3.1-3.23 (pages 147-155)
United Nations (2017) Practical Manual on Transfer Pricing for Developing
Countries, B.2.1.1-B.2.3.4.9 (pages 65-111)

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Additional Resources
Inland Revenue Authority of Singapore (2019) Transfer Pricing Guidelines -
Special Topic - Commodity Marketing and Trading Activities (First Edition)
https://www.iras.gov.sg/irashome/uploadedFiles/IRASHome/e-
Tax_Guides/etaxguide_CIT_Commodity%20activities.pdf

CHECK YOUR UNDERSTANDING

1. What is the difference between comparable transactional data and
non-transactional data?
2. In your own words, describe the steps to be taken during
comparability analysis.
3. Name and explain each of the five comparability factors.
4. Explain how internal comparables should be assessed during
comparability transactions.
5. Give examples of sources of information for the application of
external comparables.

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