Once a pricing structure is chosen, arm’s-length prices need to be computed. To do this it is necessary to conduct a comparables search, as it is only through comparable transactions that a business can objectively establish a clear basis on which to defend its transfer prices. Chapter 3 discussed the methods of determining transfer prices that are consistent with the OECD Guidelines. The following example illustrates how the process of selecting and evaluating comparables might work.
Example
Fishy Fish KK (Fishy Fish) is a Japanese company that manufactures, develops and distributes fishing rods, reels and tackle in Japan and internationally. Fishy Fish distributes its products within the US through its US subsidiary, Fishy Corp. (Fishy US). Fishy Fish has to determine whether the transfer price for which it sells its products manufactured in Japan to Fishy US to distribute within the US market is at arm’s length. After a thorough functional analysis has been carried out, it has been determined that Fishy US is a distributor that conducts limited additional marketing activity, similar to what an independent distributor would conduct. Fishy US is also determined to take on certain limited business risks, such as product liability risk, market risk and credit risk, but Fishy Fish is assessed to be the primary entrepreneur of the group, and therefore the primary risk-taker of the operation.
Further, it is determined that the fishing products are successful in the US market primarily because of the design and quality of the fishing equipment. Both of these attributes are the responsibility of Fishy Fish, the parent.
Fishy Fish now wishes to identify comparables that can be used to determine and support transfer prices between the manufacturing activity in Japan and the distribution activity in the US by Fishy US.
The preferred method of determining the price for this transaction is the comparable uncontrolled price (CUP) method. There are three methods of identifying a CUP for this transaction:
• The Japanese parent may have sold the same fishing equipment to an unrelated distributor in the US;
• The US subsidiary may have purchased the same fishing equipment from an unrelated manufacturer; and
• An entirely separate operation, Company A, may have manufactured identical fishing equipment and sold it to Company B (unrelated to Company A), which serves as its distributor in the US.
Rarely do transactions such as these exist due to the stringent product comparability requirements. However, if it is possible to identify such transactions, it would be necessary to determine whether they could be applied directly or whether adjustments must be made to the CUP to account for elements of the CUP that differ from the related party transactions (see section 304).
In the event that a CUP cannot be found, the most likely method that would be used in this example is the resale price method. To apply this method, it is necessary to identify distributors of fishing equipment (or, if these cannot be found, other sporting goods) in the US. These distributors must purchase their sporting goods from unrelated manufacturers. If these types of transactions are identified, income statements for the distributors need to be obtained and the gross margin (sales less cost of sales) for the distributors calculated. Adjustments must be made to the gross margin if there are substantial differences between Fishy Fish’s relationship with its subsidiary and the relationship between the unrelated parties involved in the comparable transaction. It should be recognised that Fishy Fish may sell fishing equipment to unrelated distributors within the US. In this event, it may be possible to use these relationships
to determine an arm’s-length discount to apply the resale price method. (While the CUP method would not apply because of differences in market prices across the US, distributor margins are frequently very similar across the US.)
In this example, the resale price method would be the next option to be sought. However, there may be difficulties in using what may appear to be an obvious solution. These include the following:
• There may be no published accounts for comparable distributors; • If accounts are available, they may not disclose the gross margin; and
• If gross margin is disclosed in the accounts, it cannot be analysed with sufficient certainty to enable reliable comparisons to be made with Fishy US’s gross margin. When these obstacles to using the resale price method cannot be overcome, as is often the case, the transactional net margin method (TNMM) under the OECD Guidelines or the comparable profits method (CPM) in the US transfer pricing regulations, discussed in chapter 3, would most likely be applied. When using the CPM/TNMM, the degree of functional comparability between the tested party and the uncontrolled distributors is less than that required under the resale price method to obtain a reliable result. To search for comparables under the CPM/TNMM, a search for external comparable independent distributors with broadly similar functions as the tested party (i.e. Fishy US) using information obtained from the functional analysis, is conducted. Once this set of comparable companies is established, the profitability results of the distribution business of Fishy US are benchmarked against the profitability results of the uncontrolled distributors. If Fishy US profitability results fall within the range of profitability results established by independent distributors, Fishy Fish should be treated as having reasonably concluded that its transactions with Fishy US were at arm’s length.