Comparables

Identifying comparables when using the transactional net margin method (TNMM)

The TNMM examines the net profit margin relative to an appropriate base (eg costs, sales, assets) that a taxpayer realizes from a controlled transaction (or transactions if aggregated). Theoretically, TNMM is based on transactional data in the same way as, for example the resale price method, but the comparison of profit margins is made at the operating profit level instead of the gross profit level. In New Zealand, the operating profit level is usually defined as earnings before interest, tax and extraordinary items (so-called "EBITE").

The most widely available and reliable data in most countries comprises operating profit figures. Small differences in product or level of the market are likely to have a greater effect on prices and gross margins than they are on operating margins. The 1995 OECD Guidelines at paragraph 3.27 recognise this:

"The net margins may also be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins. Differences in the functions performed between enterprises are often reflected in variations in operating expenses. Consequently, enterprises may have a wide range of gross profit margins but still earn broadly similar levels of profit."

In constructing a range of arm's-length outcomes, data covering several years should be used to cover off the vagaries of business and product life cycles. Typically this means three to five years of data should be compiled. Combined with the careful selection of comparables, it should be possible to establish a range of returns which are reasonably close to what an equivalent industry participant would expect over the long run.

Functional analysis

First and foremost, a functional analysis of the taxpayer's operations needs to be carried out. It is crucial that an analysis of functions, risks and assets (especially intangibles) is undertaken before any search for comparables is commenced. In our experience, the most common process failure is a rush to an analysis of potential comparables in reliance on a familiar business description (such as "wholesale distributor" or "contract manufacturer").

Once the taxpayer's business is well understood, the selection process then involves the following:

• Identification of companies with similar types of products/services
• Identification of companies with similar functions performed in the supply chain
• Exclusion of companies which are too small (distorted due to shareholder transactions), too large, or in financial distress, and
• Exclusion of companies which have significant associated party dealings.

Finding the right data

The lack of hard data on transfer prices is a major obstacle to objective empirical work. Comparables are almost always very approximate. In New Zealand, we are forced to use small samples (where the addition or deletion of one data point can sometimes lead to huge swings in the end result) supplemented by broad industry data such as sector averages and consolidated global returns.

The "same or similar market" principle is important in New Zealand. Australia is generally recognised as our closest reference country in terms of demographics, size of economy and stage of economic development. The New Zealand economy is closely connected through the CER agreement to the Australian economy - thus, the economic results reflected in Australian data are equally likely to be felt by a New Zealand company with international trade. However, Australia too experiences problems with lack of market depth.

To find practical solutions, we often have to look beyond Australia to markets in Europe (in particular the United Kingdom) and North America where reliable data may exist. Provided the industry and functions in question are similar, less emphasis is placed on the country from which a comparable is taken, but recognition must still be given to greater economies of scale and competition as well as New Zealand's higher cost of capital and higher distribution costs resulting from low population density.

Country risk premium

Operating in New Zealand is riskier than larger and more diversified markets such as Australia, the United Kingdom and the United States. In capital markets, New Zealand pays a country risk margin of approximately 1% to 3% over other "western" economies. This risk margin needs to be factored into transfer pricing studies which rely wholly on overseas comparables.

Industry data dumps don't work

The best comparables are those that exhibit key economic characteristics closest to the targeted company or transaction. Inland Revenue policy guidelines require the consistent use of one or more reliable comparables. In this regard, "industry data dumps" do not pass muster, even if additional statistical analysis is provided using various measures of central tendency (such as interquartile ranges, medians and averages). Statistical tools may to some extent enhance the reliability of data carefully selected, but cannot enhance inappropriately selected comparables. Regression analysis too, in our experience, is only as good as the robustness of the model employed, the underlying assumptions and the data input.

Working capital adjustments

Should adjustments be made routinely for the opportunity cost of money tied up in working capital (inventory, accounts payable and receivable)? In our experience, the complex algebra is generally not worth the trouble as the resulting adjustments are very minor. The underlying assumption is that all companies are efficient profit maximisers, but poor management may be the simple reality. Rather than embarking on adjustments, questions should really be asked as to why the taxpayer or suggested comparables have material deviations in working capital levels. The answer may highlight uncommercial trade terms.

Watching out for IFRS aberrations

The wider adoption of International Financial Reporting Standards (IFRS) will assist comparability analysis in the long-term as fewer adjustments will be required to take into account country differences in accounting standards. Close scrutiny of potential comparables will be required in the transition period, however, as early adopters of IFRS have experienced numerous and material one-off adjustments.

Extreme results

Economic theory does not support the presence of extreme results in a long-run competitive scenario. This means that losses and unusually high profits should be excluded as they are unlikely to be representative of normal business conditions - rather, these results will most probably have arisen due to different levels of risk being borne than by the taxpayer under examination.

The narrower the range, the more likelihood that you have identified and selected true comparables. It may be that an otherwise perfect comparable experiences an aberrant year due to a one-off event - this single observation should be excluded, but observations for other years should not be automatically ruled out.

Regional price lists

Care is also needed in using regional price lists and trade association data. High comparability standards are required where the "comparable uncontrolled price" method is applied. Such materials generally include both controlled and uncontrolled transactions and do not provide details as to terms, conditions and risks assumed.

Date published: 14 May 2008

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