The controlled transaction (Part 1 of the comparability analysis) serves as the basis for the comparison you must make against uncontrolled transactions to determine the arm's length price.
In Part 2 of the comparability analysis, you should identify comparable transactions (establish the basis for comparison). You use this basis to determine the arm's length price. When setting or testing the arm's length price, you should use the pricing method that is most appropriate considering the transaction as delineated. Determining the arm's length price depends on finding information about comparable transactions.
Select the tested party
Delineating the controlled transaction and conducting the FAR analysis will often reveal that you can use one of the parties in the transaction as the basis for comparison. This is referred to as selecting the tested party. The OECD guidelines recommend selecting the party in the controlled transaction that is the least complex as the tested party. The less complex party is the one with the simplest conditions, taking into account the functions it performs, the assets it contributes, and the risks it assumes in connection with the transaction.
When you select the tested party, you will use information about this party in a comparison with an independent third party that has comparable transactions.
Selecting the tested party is necessary if you are to apply the cost-plus method, the resale price method, and the transactional net margin method (TNMM).
Example: Company B in the value chain is a manufacturer for Company A. It has a limited function as a contract manufacturer for Company A and can be compared to independent contract manufacturers. This is referred to as the tested party or the less complex party. It is possible to find key figures for such companies through database searches.
Company A owns intangibles used in the production of product X. Company A orders product X from Company B. Company B manufactures product X but uses intangibles belonging to Company A. Company B performs only basic manufacturing functions based on orders.
Establish a basis for comparison
You establish a basis for comparison to determine the price of a comparable transaction between independent parties.
Establishing a basis for comparison involves:
identifying comparable uncontrolled transactions
making adjustments to increase the degree of comparability
The next step is to identify comparable transactions. You use the five comparability factors to assess whether the transactions are comparable.
It is usually challenging to identify a specific transaction to compare with. You may need to identify multiple comparable uncontrolled transactions to determine the arm's length price of the controlled transaction. Typically, you find the price within a range of prices, referred to as the arm's length range.
First, you establish a basis for comparability, which includes potential comparable transactions, whether internal or external. If you identify internal comparable transactions, there is no need to identify external comparable transactions.
The delineated controlled transaction, particularly the identified comparability factors, defines the standard/reference point for the search for comparable uncontrolled transactions. It is uncommon to identify identical comparable uncontrolled transactions, and this is not a requirement. The transactions should be sufficiently similar; see Conditions for comparability.
The process of establishing a basis for comparison depends on the information and data you have available and can be accessed. For more details, refer to the sections How to find information on external comparables and Adjustment.
In practice, you rarely find data on independent comparable transactions. In such cases, you must rely on comparing transactions at an aggregated level. When referring to a basis for comparison, this can include comparable transactions or comparable results from comparable companies with comparable transactions.
This is a comparable uncontrolled transaction
A comparable uncontrolled transaction is a transaction between two independent parties that is comparable to a controlled transaction.
It is common to distinguish between internal comparables and external comparables
An internal comparable transaction is:
a transaction between one of the parties to the controlled transaction and an independent party
a transaction between a company that the parties to the controlled transaction have a common interest with, and an independent party
An external comparable transaction is:
a transaction between two independent parties
For example, consider a situation where you sell a product to both a sister company and an independent company. The transaction with the independent company qualifies as an internal comparable transaction. If two independent companies sell the same product to each other, this qualifies as an external comparable transaction.
Examples 1 and 2 below illustrate internal and external comparable transactions to a controlled transaction.
Example 1:
Parent company A and subsidiary B are in a community of interest. Company 1 and Company 2 are independent entities, meaning they are not part of a community of interest.
Transaction 1 between parent company A and subsidiary B is the controlled transaction, which refers to a transaction between two parties that are in a community of interest.
In the figure, you can see three comparable uncontrolled transactions. Transactions 2 and 3 occur between one of the parties in the controlled transaction and an independent party. Therefore, these transactions are internal comparable transactions.
Transaction 4 takes place between two independent parties and is thus an external comparable transaction.
Example 2:
Parent company A, subsidiary B, and subsidiary C are in a community of interest. Parent company D and subsidiary E are also in a community of interest.
Transaction 1 is the controlled transaction, taking place between two parties in a community of interest. Transaction 2 is an uncontrolled comparable transaction. This is an internal comparable transaction because it takes place between a party that is in a community of interest with the party in the controlled transaction. Transaction 3 is not a comparable uncontrolled transaction, even though it takes place between external parties. This is because it takes place between external parties that are in a community of interest.
Conditions for comparability
A controlled transaction is comparable to an uncontrolled transaction if one of two conditions are met:
There are no differences between the controlled and uncontrolled transactions that are significant enough to affect price discrepancies. There are differences in the transactions, but adjustments can be made to minimise the impact of those differences. The different pricing methods impose different requirements for comparability.
Contractual terms
There may be differences in the contractual terms between the controlled and uncontrolled transactions regarding:
Duration of the contract
Termination clauses
Warranty obligations
Quality of what is transferred between the parties
Volume of what is transferred between the parties
Characteristics of the transferred item in the transaction
There may be differences in the characteristics of the product or service transferred in the controlled and uncontrolled transactions. For example, this could apply to both the content and scope of the product or service. The sale of products with associated services is not comparable to transactions where only products are sold.
Functions, assets, and risks (FAR) factors
There may be differences in the functions performed, assets used, and risks assumed by the parties involved. For instance, the controlled transaction may be characterised as contract manufacturing between company A and B, which involves limited risk for the producer. The selection of transactions in the comparison base should have the same type of risk.
Economic circumstances related to the parties or markets they operate in
Transactions conducted by a large entity with a dominant market share are not necessarily comparable to transactions conducted by a small entity attempting to enter the market.
Transactions carried out in one geographic area may not always be comparable to transactions in another geographic market. Regulatory, economic, and political conditions can all affect prices in a market.
Adjustment
In practice, it is challenging to find transactions that are identical to the controlled transaction. You must consider whether you can adjust for any differences in the comparison base so that these differences do not significantly impact the price.
Differences between the controlled transaction and a specifically identified comparable transaction
These may consist of differences in the characteristics of the transaction, such as variations in product quality or the inclusion of different products in the transaction. Such differences may exclude the use of the CUP method but may allow for the use of methods like the resale price method.
Differences in comparability factors
This may, for example, involve issues such as variations in contract terms, how functions are performed, which assets are used, and the risks associated with the transactions.
Differences in the comparison base built on the analysis of comparable companies
Here, the same differences in transaction items or comparability factors mentioned above may be relevant and could provide a basis for adjustments.
Differences in the use of accounting standards and practices
There may be differences in how the tested party in the transaction and the independent parties you choose to compare with maintain their accounting records. Differences due to varying accounting standards and practices may result from discrepancies in both the income statement and balance sheet items.
If you need to perform extensive or complex adjustments, this may indicate that you should exclude the relevant uncontrolled transaction/company, as it will be difficult to determine if it is sufficiently comparable.
Adjustments should enhance the reliability of the basis of comparison, and you should only adjust if it results in a more reliable outcome.
It is important that you can document what you adjust, how you perform the adjustments, and explain why the adjustments increase the reliability of the pricing.
How to find information on external comparables
You can find external comparables in publicly available information about the market, industry, or competitors. You can use industry knowledge and search for similar data in public registers to identify potential comparable transactions.
Although the OECD guidelines focus on comparison at the transaction level, it will often be challenging to find information on uncontrolled transactions. In practice, many analyses will involve comparing results at the company level. This is particularly relevant if you do not have internal comparable transactions. An alternative is to search for comparable companies through database searches.
Comparison at the company level involves comparing financial key ratios, comparability indicators, for parties (companies) in the controlled transaction with financial key ratios from comparable companies that have comparable transactions.
