. 7 Tse eCCCCCCCoooooo PRACTITIONERS’ CORNER Comparability in Transfer Pricing: The Elusive Mirror Image by Santino Di Libero Santino Di Libero is a senior director with the Transfer Pricing and Competent Authority Group of Gowling Lafleur Henderson LLP in Montreal. The views in this article are entirely those of the author and may not represent the views expressed by any other person of body. The author would like to thank Nathan Boidman of Davies Ward Philips and Vinederg LLP for his noteworthy and valuable suggestions. TT ton ne in ay ante ring ae thrive et the mos reasonable sm’ length price possible for intercompany transactions undertaken Foros international bosders The arm’sengch principle isthe pillar that is tcied on i any attempt at arving zr that reasonable estimate, Bach ofthe methods laid ut by the OBCD — the comparable uncontrolled pce method, resale price method, cos-plos method, Eansactional net margin method, and the proftsplit thethog relies on the arm's-lengih prinape. In ap- Fiving the principe, the busines community searches far something that coselysesombles the target transac fon, The dificlt question to answer is how much of a feemblaace must be achieved to pass the txt of com ality so thatthe taxing authorities are comfortable fvih the resol Searching for comparables to use in the transfer pricing equation is not easy. As the OECD has clearly indicated and to which most taxing authorities have agreed, the better the comparability, the more reliable the results, Having access to information that would ‘permit a mirror image would be the best outcome, but the reality is that a perfect fit is rarely achieved. Perfect comparables are rate. Unless transactions thin the same entity are conducted with arm’s-length rd parties as well as related parties (internal CUPS), n 2 search for external comparables must be under- taken, When comparable searches are made and com- ‘panics transacting in similar products or services are identified, adjustments will almost always be made to pot both the related party transaction (tested party) and the comparable on the same footing, Comparability Adjustments “The OBCD guidelines contain many provisions con- cerning the use of comparability adjustments both in the context of general principles (the arm's Length prin- tiple) and specific methods (both traditional trensac- tional methods and profi-based methods). ‘The main consideration when making comparability adjustments is that adjustments must be customized according to the specific facss of the particular case. As each transaction is undertaken in light of the particular circumstances encountered, adjustments must be tai- Jored to the Farticular circumstances. As one can imag- ine, an analyst's judgment plays 2 critical role. If there are material differences between the two transactions, adjustments must be made if the effect of the differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results, In trying t achieve comparability, any a¢- justment to be made to the zesults of the arm's-length ‘comparable should be based on sound commercial practices and current economic principles. The extent TAX NOTES INTERNATIONAL ‘APRIL 27, 2009 * 293 jouy x01 (9) ‘008, yeuy xe “pontosas ew f i 3 : 3 i :PRACTITIONERS CORNER and relizbility of the adjustments will greatly affect the overall reblity of the final tense posing analy and results, Generally, adjustments should be made if the rela tive magnitude of the adjustment can be first identified, then quantified, and finally eliminated with sufficient accuracy that the overall reliability of the application Of the method is increased. Example of Differences ‘As a simple example of a common situation, as sume both Company A and Company B manufacture chewing gum, Assume also that they both manufacture a line of 12 chewing gum squares per box that they package and distribute, Just on these facts alone, one could easily conclude that the products would be very similar in that they both come in a convenient package of relatively the same size, same number of chewing gum squares, with a similar shape. However, circum: stances may dictate that the similarities stop there. ‘The differences may include the following examples: # Company A may sell at 2 premium to a standard brand because it contains less sugar, requiring ‘mare research and development to be more health ‘© If Company A has been around for 30 years and Company B is a relatively new company, one would expect that a chewing gum package with a knowa brand would sell for more than an un- knowa brand, even if the quality of the two were identical + Other things being equal, consumers would be expected to prefer the gum with an established reputation for taste. + A multicolored package may sell for more (or less) than an equivalent neutral package, depend. ing on the extent to which consumer preference is influenced by packaging. ‘These characteristics are not exhaustive. Even so, they illustrate the extent to which even superficial dif ferences, such as exiernal coloring, can influence price, If Company A was to usc the CUP method as a basis for determining its transfer pricing to a related distribu- tor for tex purposes, it would first have to identify all of the differences between its products and those of the jependent manufacturer, and determine whether these differences are likely to have a material effect on. price. Factors to Consider In any situation, when comparing two distinct trans- actions, differences will be encountered. Perfect compa- ability is quite rare. To be able to confirm that the two are similas, the following factors may have to be ad- dressed so that the two transactions could reasonably be refereed to as comparable. 294 » APRIL 27, 2009 ‘These factors include: «© Product Characteristics, Important differences in product characteristics can lead to significant dif. ferences in prices. The way a product is sold also hhas an effect on price. If the product is sold in lange volume, this may support lower prices given volume rebates or discounts. Some important tan- gible elements to consider include the physical features of the propery, its quality and reliability, and the availablity and volume of supply. When considering services, comparability would lie with ‘the nature and extent of the services. In the case of intangible property, one would have to look at the form of transaction (for example, licensing or sale), the type of property (for example, patent, trademark, or know-how), the duration and de- ‘gree of protection, end how the user would ben. efit from the use of the intangible ‘© Functions. Functions such as R&D, product des and engineering, manufacturing, production, ex traction, installation, assembly, purchasing and materials procarement, marketing, advertising = promotion and dismibution functions, inventor, ‘management, warranty administration and servi ing, transportation and warchousing, strategic ‘operational management, legal, accounting an. finance functions, credit and collection, trainin: and personnel management services must be ic== tified, and one should ensuse that the functic are consistent in both of the entities being com: pared. ‘Risk, Risk is an important factor that is eval during a comparability review. Many differe factors must be identified to ensure compare the clement of market risk, including fluctua: in cost, demand, pricing, inventory, and obsoie cence; the risks associated with the success o: ‘ure of R&D activities and the financial risks cluding fluctuations in interest and foreign currency rates of exchange; and risks associe:- ‘with credit and collection, product liability, = ‘overall capital isk. The transactions to be com pared should be in a relatively similar risk tion to be truly comparable. ‘© Contractual Terms. The manner in which tr tions are negotiated also plays an imports: in how two transactions can be comparat! following elements all play a vital sole in ability: the form of consideration charged paid; sales or purchase volume; the scop= = ‘erm of warranties provided; rights to w: revisions, or modifications; the duration o evant license, contract, or other agreem: tion or renegotiation rights; collateral sa==~ (or ongoing business relationships betw buyer and the seller, including arrangem the provision of ancillary or subsidiary the tight to sublicense the product or ‘TAX NOTES INTERNSeting and distribution; and payment terms, ns. The components most diffi and adjust are economic Participation of economists and in- 2x esential in ariving ata proper tarehen ing result. Aspects that must be considered in the comparability study inciude the following: differ” size and the extent of the overall economic devel: opment in each market; the trade level of the sarket (for example, wholesale or retail), the rele event market shares for the products or services ‘ransferred; the location-specific costs of the fac- Ors of production and distribution; the extent of competition in each market regarding the products or services concerned: the economie condition of the particular industry, including whether the mare keris in contraction or expansion; and the alter. ‘satives realistically available to the buyer and seller Jnsangibles. When comparing transactions, one ‘must also isolate any possible existence of intan- gibles embedded in the property or services being ‘wansferred. As noted in the chewing gum ex. ample, the reputable company will in most cases benefit from its long-standing track record and Teputation, which will be reflected in a higher Price being charged to the end consumer, Depend ing on the characteristics of the transactions being compared, the possible effect of intangibles must be isolated, evaluated, and eliminated so that comparability is reliable. Although the list of possible adjustments is over- whelming, depending on what is selected as a tronsfer Pricing method, one must be satisfied that the degree of comparability is suficient, If material differences in comparability are identified, one must also decide ‘whether the Comparison is more accurate using the chosen method and making comparability adjustments, ot whether the method should he abandoned and com: figetation given to a more relaxed, although potentially less accurate, method The Glaxo Canada Decision One of the most controversial decisions of the courts in Canada on the question of comparability was rendered on May 30, 2008. The Tax Court of Canada ruled on the transfer pricing issue in GlaxoSmithKline Inc. The case involved the reassessment of Glaxo. *GiaxoSmithine Ine» The Queen, 98:2UET)G. PRACTITIONERS’ CORNER ‘SmithKline Inc's income tax retums for 1990 to 1993, Glaxo Canada is the distributor in Canada for the re. lated Swiss company Adechsa S.A, The issue involved treatment drug. The Minister of National Revenue (MNR) alleged that Glaxo Canada paid C $1,600 per ‘Glogram (US $1,356) for the active ingredient, a price {hat was almost five times the amount that similar ge- eric drag companies paid for a similar ingredient to arm’s-length partics, The MNR reassessed Glano Ganeda and increased its income by C $51 million (US $43 million), ‘The court agreed with the MNR and held that GlaxoSmithKline overpaid its Swiss affiliate for the etive ingredient and found that an arm's length price for the ingredient was closer to that paid by gencric companies to their suppliers. ‘The MNR relied on two generic companies" pur- chases for its argument — Apotex and Novopharm’s Purchases of the ingredient from third-party manufse- turers. It was alleged by the MINR that these arm's. lenge purchases were comparable transactions to Glaxo Canada’s purchase of the same ingredient from its related party, Adechsa Glaxo Canada contested the MNR’s argument and claimed that the generics were not an appropriate com- parable: * Glaxo Canada’s actual business circumstances Were wholly different fiom those of Apotex and Novopharm, such that the transactions were not comparable within the meaning of subsection 69(2) of the act and therefore the CUP method was not applicable. + The zanitidine Glaxo Canada purchased from Adechsa was manufactured under standards of ‘good manufacturing practices established by Glaxo's worldwide group of companies, granu lated to Glaxo's standards, and produced in 2c cordance with Giaxo’s health, safety, and environ mental standards. * Independent third-party licensees in Europe, which porchased the same ranitidine under the same set of business circumstances as Glaxo Canada, were the best comparators. Glaxo sub- smitted that both the supply agreement with Adechsa and the license agreement with its par- ent, Glaxo UK., should therefore be considered, and that failure to do so would not reflect the eco- nomic realities of Glaxo Canada. ‘The MNR argued that the two agreements were to be looked at separately and that the only transactions elevant to the case were those with Adechsa, The MNR therefore disregarded the license agreement with the parent, TAX NOTES INTERNATIONAL ‘APRIL 27, 2009 + 295 a 5 ‘649 Budoo ures jou soap sifteuy xeL ‘ponioo, ayy,PRACTITIONERS’ CORNER ‘The Tex Court concluded that CUP was the method best suited and that the arm’s-iength transactions under- taken by the generic comparable companies were t0 be considered comparable in the circumstances. The Glaxo decision illustrates the importance of clearly substantiating the factors surrounding compa- rable transactions, Although an ingredient may be simi- lax, contractual obligations and control and quality standards can create disparities, It seems thet the court completely disregarded these factors in its decision. One could argue that all the pertinent facts were not brought forth in the case and subsequently considered by the court. Certainly, not having produced such pert nent factors would unquestionably give unfavorable results. Given that the case has been appealed to the Federal Court of Appeal, it will be interesting to see how a higher court deals with the comparability issue. In each case, proper judgment must be used to de- termine the critical factors that have 2 material impact on the price of the product. Ultimately, this decision depends entirely om the facts and circumstances sur- rounding the transactions and on the availability of information for analysis. Information is often not avail- able in sufficient detail to compare every possible com- parability factor. As previously mentioned, to proceed with adjust- ments, one must frst identify chem, quantify any differ. cences, and adjust the comparable data, Relying on pub- lic databases such as Standard and Poor's Compustat to identify the possible comparables is only the first step; being able to identify differences will require an extensive and complete review of the public financial reports such as the 10K or 10Q filings prepared for the Securities Exchange Commission in the United States This is a lengthy and complex function to undertake, but one that is nevertheless critical Conclusion. Comparability adjustments in transaction-based methods depend on the specific facts of each case. ‘Many comparability factors may have to be evaluated in a transfer pricing analysis. For adjustments in transaction-based methods, comparability adjustments are essential. Being an art rather than a science, rans- fer pricing requires that one look for a third-party mir- ror image of a related-party transaction, Any distor- tions in the image may cause tax administrations to seview the transactions and recreate the image to their king. + duly 26 Is Coming. | Governor David A. Paterson signed into law ‘an accountancy reform bil that sighiticantly changes the regulation end practice of publie | accountancy in New-York State. | The new law wil take effect July 26, 2009, and the New York State Education Department |. (GED)is now developing regulations for its implementation. ‘The navr law will affect EVERY CPA tax practitioner who | does business in New York Stat. The new law does the following: | * Broadens the definition of the regulated scope of | Dracice of public accountancy to include tax services | # Requires New Yorklicensed CPA tax practitioners to register triennial with the SED and to complete | annual continuing professtonal education | ¢ Removes the exemption from mandatory continuing | education for CPAs employed in private industry, government, and academia * Changes the continuing education reporting year to | acalendar year—beginning Jaruary 1, 2002—rom the former September 1 to an August 31 reporting | period | + Provides the Board of Regents withthe ascipinary | authority over CPAs who practice tax services in New York The New York State Soy of Certfec Public Accountants has information about carping wit the naw i Visit wwwe.nysscpa.org. ee atic et 296 * APRIL 27, 2009 ‘TAX NOTES INTERNATIONAL