Inside Tax : Issue 13 - Benchmarking Analysis in Transfer Pricing Documentation
What are the challenges?
The arm's length principle represents the golden rule by which tax authorities evaluate and regulate transfer pricing. Thus, it is never repetitive or superfluous to assert that an important aspect of determining the arm's length price is the comparability analysis. This involves performing a robust functional analysis (see Inside Tax article of 29 July 2013) to identify economically relevant characteristics of a controlled transaction which will form the basis for searching for information on potentially comparable uncontrolled transactions.
Regulation 9 of the Nigerian Transfer Pricing (TP) Regulations requires taxpayers to ensure that their controlled transactions are comparable with similar or identical transactions between two independent persons carrying on business under sufficiently comparable conditions for the purpose of determining whether the prices or conditions of such transactions are at arm's length.
The process of searching for comparable information and comparing such with controlled transaction of a tested company is known as benchmarking analysis. It is noteworthy that most TP disputes between tax authorities and taxpayers are triggered due to disagreement in determining arm's length prices. However, the process is generally transparent where the taxpayers and tax authorities use information on reliable comparables as a basis for establishing such arm's length price.
In determining the arm's length price to be applied by taxpayers, tax authorities usually compare the prices adopted by comparable companies. However, every taxpayer strives to differentiate its business to somewhat gain a comparative advantage within its market and expects to be rewarded with commensurate profits. In view of the foregoing, taxpayers and tax authorities usually encounter challenges in determining appropriate transfer price using comparable companies as benchmarks.
For effective benchmark analysis, it goes without saying that a clear understanding of what the tested party (i.e. the least complex party in a controlled transaction) is doing and how it does what it does, is necessary. It is important for this understanding to be documented for it to be used in searching for comparable companies and data during benchmarking studies. Most companies have unwritten pricing policies. Thus, giving tax authorities the upper hand during a dispute resolution. This gives credence to the saying that “what is not written, is not done”.
There are various sources of information that can be used to identify comparables. A common source of information is commercial databases, which have been developed by private companies. These databases rely on publicly available information, which are presented in electronic format suitable for searches and statistical analysis. Examples of these databases are Orbis Global, Amadeus, TPSmart, etc. However, the use of commercial databases is recommended where there are no reliable internal comparables.
This manifests the first challenge in benchmarking analysis for developing countries like Nigeria. This is the challenge of insufficient publicly available information on commercial database for one to obtain data on comparable companies. For effective benchmark analysis, it is important to source for companies with similar functions, operations and risk profile to the tested party. With the absence of publicly available information, tax authorities are compelled to use foreign databases that feature information on foreign companies and therefore, do not capture the peculiarities of doing business in developing countries.
In view of the above, the profit ratios of these comparable companies would need to be adjusted in line with the risk profile (including country risk) of the tested company for any meaningful deduction to be made. This adjustment process introduces subjectivity, as the tax authorities' perception of the tested company's functions, operations and risk profile might differ from reality and/or taxpayer's view.
Another potential challenge to benchmarking analysis is the extent of the burden and cost that taxpayers bear to identify potential comparables and obtain detailed information. The cost of information is generally recognized as a real concern for most small to medium sized businesses that are affected by the requirements to prepare TP documentations.
Taxpayers should note that adopting a standard documentation of activities, transactions and prices is not sufficient for benchmarking purposes. The effect of natural and man-made disasters such as civil unrests, terrorism, floods, etc. on a taxpayer's operations need to be adequately documented and considered when benchmarking against companies who have not felt the effect of these disasters.
Tax authorities and taxpayers may also be faced with difficulty in comparing financial statements of comparables when applying profit ratios. The data spooled from available databases would need to be adjusted where the accounting standards applied by the comparables differ from that the tested company for ease of comparison. The implementation of the International Financial Reporting Standards (IFRS) has made financial comparison easier in Nigeria, but this may not completely eliminate this challenge. This is especially so where the tested company is neither a public limited company nor public interest company, thus not required to prepare IFRS compliant financial statements.
Fortunately, FIRS appreciates the foregoing challenges around benchmarking and what impact these would have on the results of benchmark studies. The challenges are not excuses for taxpayers not to put in place the TP policy or documentation as required under the TP Regulations. This is especially that FIRS may be consider and/or accept European comparables for benchmarking purposes.