Presented By: Prof A Venter CA(SA)

1. Presented By: Prof A Venter CA(SA) Transfer Pricing Year Course Lecture 13 Comparability Analysis III Adjustments

2. Comparability AdjustmentsBASIC QUESTIONS • Does the difference have a material impact on the profit of loss? • Can the difference be quantified accurately to increase reliability?

3. Comparability Adjustments • Adjustments based on: • Commercial practices • Economic Principles • Statistical Analysis

4. Comparability AdjustmentsAdjustment based on Commercial Practices A: Clothing Co B: compensated on a commission basis (standard industry practice) 5% plus 1% for every additional services: product testing, vendor qualification, freight consolidation (max 8%) B: Buying Agent

5. Comparability AdjustmentsAdjustment based on Commercial Practices A: Clothing Co A: Clothing Co C: 5% plus 1% for testing and 1% for vendor qualification: 7% B: NO VALUE ADDED SERVICES 5% B: Buying Agent C: Controlled Buying Agent Adjust B’s rate with 2%

6. Comparability AdjustmentsAdjustment based on Economic Principles • Profits Methods: controlled distributor lower Inventory/Sales ratio than controlled A • Best PLI: operating profit/sales • Account for differences in Inventory/Sales ratio’s effect on PLI: • Imputing interest to A for higher level of inventory in excess of inventory carried by comparable • Basic Economic Principle: return on capital employed (including investment in inventory)

7. Comparability AdjustmentsAdjustment based on Statistical Analysis A: Radio Manufacturer • Need to know the estimated effect of the difference in configuration on the price • Determine what the price to uncontrolled buyer would have been if the radios had that specific configuration • Regression Analysis: formal statistical methodology frequently utilised in empirical economic analysis Sells radios in uncontrolled sales: 10 different features Price depends on the features of the radio Circumstances the same as uncontrolled sales, except Differently configured than radios in uncontrolled sales B: Controlled

8. Comparability Adjustments TYPES OF DIFFERENCES Comparability factors: functions, risk, economic conditions, features of the product/services, contractual terms • Adjustment relevant to TP method • CUP: similarity of product • RPM: • Inventory levels • Turnover rates • Cost structures • Business experience • Management efficiency

9. Comparability Adjustments TYPES OF DIFFERENCES • Cost Plus: • Complexity of manufacturing and assembly • Cost structures • Business experience • Management efficiency • Profit Methods: • Resources employed • Cost structures • Business experience • Management eficiency • Levels of AP • Levels of AR

10. Comparability Adjustments TRANSACTION BASED METHODS • Compare price or gross margin • Need for adjustments: • Transaction based: higher level of comparability needed • Questions: • How similar does it have to be? • If not sufficiently similar, can adjustment for observed difference be made? • How is the adjustment made • How much confidence can be placed in the assumption that adjustments are accurate?

11. Comparability Adjustments TRANSACTION BASED METHODS • If a material difference is identified: • Question: do you make the adjustment or use a more forgiving method? • General: more accurate method used – expectation of higher sensitivity to comparability differences • There are often note enough information available to compare each comparability factor (almost always use imperfect info) – keep in mind when making decision on adjusting or using another method

12. Comparability Adjustments TRANSACTION BASED METHODS Product Specific Factors A: US distributor of washing machines Method: RPM (product nor similar enough to use CUP) OTHER ISSUES…. B: Related foreign manufacturer High end models HE label C: US Unrelated manufacturer Low end models LE label

13. Comparability Adjustments TRANSACTION BASED METHODS Product Specific Factors: BUNDLING • Products are offered for sale with other products or services, to enhance competitiveness • Buyer may not want additional products or services, but buy package since the main product is sough after • Common techniques: support services, warranties, quality assurance • Must recognize the value of the additional products/services

14. Comparability Adjustments TRANSACTION BASED METHODS Product Specific Factors (Bundling) Approach: - Use LE as benchmark for main product, find additional benchmarks for services - Warranty liability risk: justifies a higher return - Alternatively: base value of warranty on costs to perform service A: US distributor of washing machines B: Related foreign manufacturer High end models HE label C: US Unrelated manufacturer Low end models LE label More complex if Intangibles are involved…. Include warranty and service plan Standard warranty provided by unrelated, manufacturer

15. Comparability Adjustments TRANSACTION BASED METHODS Product Specific Factors : VOLUME DISCOUNTS • Reflect efficiencies realized by producers in selling large volumes – the cost saving is shares through volume discounts • Mainly the result of the allocation of fixed costs • NB question: WOULD UNRELATED PARTIES OFFER THE VOLUME DISCOUNT? (not always shared) • May use estimations: possible cost saving for a third party by extrapolation • Be careful: cost saving that give rise to discount may diminish at very large volumes

16. Comparability Adjustments TRANSACTION BASED METHODS Product Specific Factors : PREPARATION • Packaging: distributors may purchase in bulk and package in-house to save the weight of transport costs • Price: recover packaging/finishing product for sale • Adjustments for packaging: RPM: value the product packaging function plus a GP mark-up (third party would require a profit on packaging services • Cost and mark-up on service (packaging)

17. Comparability Adjustments TRANSACTION BASED METHODS Contractual Terms • Rights, privileges, and restrictions on entities • Or allocation of transaction costs • Adjustment: reallocation of costs to be similar to what uncontrolled terms would be • Allocation of risks: very difficult to estimate • NB: delivery terms, payment terms, exclusivity

18. Comparability Adjustments TRANSACTION BASED METHODS Contractual Terms: DELIVERY • Differences in delivery may impact transportation, insurance, handling • Adjustment: measurement of delivery terms • Example: Convert a FOB destination price to a FOB origin price • FOB: US and other countries differing interpretations • FOB: when risks and rewards of ownerships are transferred from buyer to seller; AND who are responsible for what transport from that point onwards

19. Comparability Adjustments TRANSACTION BASED METHODS Contractual Terms: Payment Terms • Time allowed for payment (can be that interest is charged beyond that pint in time or not) • Standard Industry Practices • Any delay in payment: as a finance cost and credit risk for the seller – prompt payment discounts as incentives to be earlier • Adjustment: days difference x interest rate • Alternative: adjustment of AR and AP (profit methods)

20. Comparability Adjustments TRANSACTION BASED METHODS Contractual Terms: Exclusive Condition • Common: Exclusive selling rights related to a geographical area; and exclusive licensing • Buyer would generally be willing to pay a higher price for exclusive selling rights or licensing

21. Comparability Adjustments TRANSACTION BASED METHODS Market Factors: Market Level • Most challenging part of Comparability Adjustments • Base adjustment on economic principles or guidance by the law • Different levels in supply chain • Each level adds value and increase the price • Not the same for all industries, products or geographical locations • Example…

22. Comparability Adjustments TRANSACTION BASED METHODS Market Factors: Level of Market B: Toy company selling o US market Operate manufacturing facilities in China Adjustment: - Comparison: compare to same level in market - Each level increase the price to compensate for additional input by level owner A: Distribution Company Sell to retailers or smaller regional wholesaler

23. Comparability Adjustments TRANSACTION BASED METHODS Market Factors: Geographic Location • Foreign Exchange differences • Profit margin differences: different level of competition or local business risk – lead to higher/lower profit • Shipping costs, government restrictions, border taxes, different supply and demand levels • Only transportation and transactions costs: quantify and adjust • Where the difference is due to supply and demand: more complex: look at income levels, preferences, levels of competition

24. Comparability Adjustments PROFITS METHODS Background • Value of Inventory/Sales ratio • AR/Sales ration • AP/Sales ratio • Difference: balance sheet difference between tested party and comparable interpreted in reference to business “function” to which they correspond • Example: Seller: credit extension function is recorded under AR on balance sheet • Each function is valued based on rate of return on balance sheet amount associated with function

25. Comparability Adjustments PROFITS METHODS Background • Value: market interest rate (standard practice amoung analysts) • Assume everything else remain the same, and that the profit can be altered directly by the implied valuations\ • Adjustment become less precise as magnitude and number of adjustments increase • NB: understand the facts and underlying pattern

26. Comparability Adjustments PROFITS METHODS Background • Factors to consider: • Comparability adjustment vs. selection criteria (goal is the fewest adjustments: rather better selection than more adjustments • Comparability Adjustments and PLI selection: use PLI denominator for adjustment • Functional vs. Efficiency Adjustments: • Comparability adjustments reflect balance sheet or cost ratios, interpreted as measures of the intensity of the functions performed • High level of AR: high intensity of credit extension • Note: higher level of assets: not always due to higher intensity of function – often a symptom of business problems (unplanned or unwanted levels of debtors or inventory not sold (slow-moving) • True higher intensity of function justifies return on investment

27. Comparability Adjustments PROFITS METHODS Inventory, AR and AP adjustments • TNMM: frequently working capital adjustment when tested party is a distributor or another type of seller • Two basic functions of a distributor is extension of credit and carrying inventory • “Intensity” of these functions: measured by assets/sales • Higher ratio = higher “intensity” • Credit adjustments: credit extended (AR) and credit received (AP)

28. Comparability Adjustments PROFITS METHODS Inventory, AR and AP adjustments • Mechanics: • Step 1: difference in ratio (between tested party and comparable) (ratio: balance sheet item/ denominator (PLI) normally sales, but can be operating expenses) • Step 2: Value: difference x interest rate • Step 3: Value x net sales (comparable) to adjust AFS figures • Step 4: PLI recomputed

29. Comparability Adjustments PROFITS METHODS Inventory FORMULA ( (AINV/S)C – (AINV/S) TP ) x i x SC • AINV = Average Inventories • S = Net Sales • i = Interest Rate • C= items from Comparable • TP= items from Tested Party • Interpretation: • - Positive value: value of additional inventory carrying function by comparable related t tested party • - Negative value: Comparable did not perform this function/ less intense

30. Comparability Adjustments PROFITS METHODS Accounts Receivable FORMULA ( (AAR/S)C – (AAR/S) TP ) x i/(1+i) x SC • AAR = Average AR • S = Net Sales • i = Interest Rate (diminished interest factor used in formula) • C= items from Comparable • TP= items from Tested Party Interpretation: - Positive value: value of additional credit extension function by comparable related t tested party (decrease comparable’s net sales to compare)

31. Comparability Adjustments PROFITS METHODS Accounts Receivable FORMULA ( (AAP/S)C – (AAP/S) TP ) x i/(1+i) x SC • AAP = Average AP • S = Net Sales • i = Interest Rate (diminished interest factor used in formula) • C= items from Comparable • TP= items from Tested Party Interpretation: - Positive value: if the comparable did not perform this function, it could have accepted a lower price for its goods

32. OECD: Comparability Adjustments • Purpose: elimination of comparability differences • Example: similar transactions, but one bears a currency risk: make adjustments to eliminate the risk (add back the portion off the purchase price attributable to the bearing of the risk) • Differences usually due to: accounting inconsistencies, and differences in capital, assets, risk and functions. • When? If it will increase the reliability of the result, with regards to materiality, quality of information and purpose of the adjustment.

33. OECD:Comparability Adjustments • Indian cases: several decisions on comparability adjustments: reliability and purpose • Working Capital Adjustment: fairly common in practice – does not mean that it should be a routine adjustments or is mandatory (especially in TNMM): • Focuses on time value of money and rectifies the time gap from investing to collecting cash. • Profit level indicator chosen should be the base (assets, turnover or costs)

34. Comparability AdjustmentsWorking Capital Adjustment

35. Comparability Adjustments Foreign Exchange Adjustments • One Comparability Factor: FOREX RISK (fluctuations in rates of exchange • Questions: which taxpayer bears the particular risk? • Example: S (in UK) sells to P (US) and the invoice/contract price is USD, then S bears the FOREX risk. • Risk allocation will be respected if: • S has adequate financial capacity to bear risk (incl hedging of all or part of the risk) • Conduct of S and P are consistent with terms of contract (contract price not adjusted to reflect exchange movements)

36. Comparability Adjustments Foreign Exchange Adjustments Transactional Exchange Risk • Comparability Adjustments frequently made for transactional FOREX risk (due to fluctuations on Forex movement) • More general type of risk: • Example: S & P: long term depreciation of the dollar against EURO. S’s profit margin will shrink because cost in USD value increases. • Alternatively: S & P use a TP method to maintain target profit level of S: P’s profit margin will be affected (especially if P cannot pass on higher costs to customers due o competition (us competitors may buy in USD))

37. Comparability Adjustments Foreign Exchange Adjustments Economic substance • Economic substance must be considered in deciding who actually bears the FOREX risk • Example: contractual terms may include a mechanism to effectively split the effect of the FOREX movement; or allocating risk to one party by tying it to contract price • Example….

38. Comparability Adjustments Foreign Exchange Adjustments Economic substance FP: UK Manufactures macinery • In year under review: USD depreciated against the EURO: negatively affecting USSUB’s GP • TEST TP: uncontrolled UD distributors: RPM (no currency risk since they purchase and sell in USD) • USSUB results: should be measure over multi-year period to determine if a sufficiently higher return is experienced in other years to set-off current losses • CAPM: estimate return Price expressed in EURO Bears the FOREX risk US SUB: Exclusive distributor in US

39. Comparability Adjustments Case Law • Volkswagen Argentina case (Case 26,991-I, 12 July 2010) • Extraordinary occurrences: comparability • Axalto Cards case: (ITA No 4015/Del/2007, 3 February 2010) • Comparability: exclusive distribution rights can’t be quantified; different risk profiles; storage • Indian case: ITA 2000 (no internal CUP, use profit split) • Indian case: ITA 712 (net profit excluding reimbursements) • Indian case: ITA5224 (Internal comparable)