Centre for Tax Policy and Administration Workshop on Transfer Pricing and Exchange of Information Guatemala 2 – 5 May 2011 Wolfgang Büttner OECD Use of Foreign Comparables and Comparability Adjustments for Economic (Market) Differences

© OECD Typical Process for a Comparability Analysis (para. 3.4 TPG) Step 1:Determination of years to be covered. Step 2:Broad-based analysis of the taxpayer’s circumstances. Step 3:Understanding the controlled transaction(s) under examination, based in particular on a functional analysis, in order to choose the tested party (where needed), the most appropriate transfer pricing method to the circumstances of the case, the financial indicator that will be tested (in the case of a transactional profit method), and to identify the significant comparability factors that should be taken into account.

© OECD Typical Process for a Comparability Analysis Step 4:Review of existing internal comparables, if any. Step 5:Determination of available sources of information on external comparables where such external comparables are needed taking into account their relative reliability. Step 6:Selection of the most appropriate transfer pricing method and, depending on the method, determination of the relevant financial indicator (e.g. determination of the relevant net profit indicator in case of a transactional net margin method).

© OECD Typical Process for a Comparability Analysis Step 7:Identification of potential comparables: determining the key characteristics to be met by any uncontrolled transaction in order to be regarded as potentially comparable, based on the relevant factors identified in Step 3 and in accordance with the comparability factors set forth at paragraphs Step 8:Determination of and making comparability adjustments where appropriate. Step 9:Interpretation and use of data collected, determination of the arm’s length remuneration.

 Whenever reliable internal comparables exist, it may be unnecessary to search for external comparables in databases (para TPG)  Commercial databases may provide the most reliable source of information, howeve r  Independent transactions may be scarce in certain markets and industries  Commercial databases are not available in all countries Limitations in Available Comparables

 Assess the relative importance of missing information before rejecting a potential “comparable”  A pragmatic solution may need to be found on a case-by- case basis Limitations in Available Comparables

1) Broadening the search and using information on uncontrolled transactions taking place in the same industry and a comparable geographical market, but performed by third parties that may have different business strategies, business models or other slightly different economic circumstances 2) Information on uncontrolled transactions taking place in the same industry but in other geographical markets 3) Information on uncontrolled transactions taking place in the same geographical market but in other industries 4) A Profit Split Method might – in appropriate circumstances - be considered without comparable data Limitations in Available Comparables - Possible Pragmatic Solutions -

 The geographic market is an economic circumstance that can affect comparability  Where the economic circumstances in different countries are in effect reasonably homogeneous, it may be appropriate to rely on a multiple-country comparability analysis  Where an MNE group offers significantly different ranges of products or services in each country, and/or performs significantly different functions in each of these countries, and/or where its business strategies and/or economic circumstances are found to be significantly different, multiple-country approach may reduce reliability Market Differences and Multi-Country Analyses

Foreign Markets: What Adjustments Need to be Made?  Accounting consistency  Segmentation  Geographic market difference  Country risk  Efficiency  Foreign exchange risk

3. Geographic Market Difference (1)  Purpose: Eliminate the effects of geographic market differences on observed prices or margins between the target company and the comparables.  Is there a difference between the local and foreign market prices and margins in the sector in which the target company and comparables operate?

 Can a price or margin difference be traced primarily to a different cost of capital in the respective market?  Is a market difference caused by natural market conditions that are measurable and that relates to price? e.g. different level of competitiveness.  Is a market difference caused by government intervention? 3. Geographic Market Difference (2)

4. Country Risk  Purpose: Account for the material effects of country risk on operating profits caused by the differences in the risk between the target company and the comparables.  Modern financial practices:  a higher risk requires a higher return  a higher growth rate requires a lower return  Would a lower expected return be acceptable as compensation for taking on fewer risks when compared to independent companies?

 New paragraph 3.35 OECD TP Guidelines  Foreign source or non-domestic comparables often used where insufficient data available at the domestic level and/or in order to reduce compliance costs where several entities of an MNE group have comparable functional analyses  Non-domestic comparables should not be automatically rejected just because they are not domestic  Whether non-domestic comparables are reliable has to be determined on a case-by-case basis and by reference to the extent to which they satisfy the five comparability factors. Foreign Source or Non-domestic Comparables

Case Study on Foreign Comparables and Comparability Adjustments for Economic (Market) Differences

Comparability Adjustments for Economic (Market) Differences (1) Example:  Tested party: contract manufacturer in Guatemala  Comparable: contract manufacturer in Mexico

Comparability Adjustments for Economic (Market) Differences (2) Tested Party Guatemala Comparable Party Mexico Sales Total costs8090 Operating profit2030 Operating assets10 Financial Data

Comparability Adjustments for Economic (Market) Differences (3) Comparability adjustment for country differences based on the average long-term rate for government bonds: GuatemalaMexico Average long term government bond yield 9%5% Government bond yield gap 4%

Comparability Adjustments for Economic (Market) Differences (4) Geographical adjustment: Operating assets (comp)10 Interest gap4% = Additional Operating Profit (comp)0,4

Comparability Adjustments for Economic (Market) Differences (4) GuatemalaMexico Operating Profit without geographic adjustment 2030 Operating Profit with geographic adjustment 2030,4 Geographical adjustment: Operating assets (comp)10 Interest gap4% = Additional Operating Profit (comp)0,4