CHAPTER IV - Comparability Analysis

4.1.1 Every taxpayer should endeavour to determine its transfer pricing for tax purposes in accordance with the arm's length principle, based upon information reasonably available at the time of the determination. Hence, the arm's length price should be determined by comparing the results of a controlled transaction with the results of uncontrolled transactions that were undertaken or carried out during the same year as the year of the taxpayer's controlled transaction.

4.1.2 This requirement is made on the basis that the arm's length principle must be complied with contemporaneously, on a year by year basis. A contemporaneous uncontrolled transaction should provide the most reliable comparable as it is carried out in an economic environment that is the same as or similar to the economic environment of the taxpayer's controlled transaction.

4.1.3 Depending on the industry concerned and the circumstances of the case, there may be cases where data in a particular financial year does not provide the most reliable comparison. For instance, if a tested party's accounting period ends at 31 March 2010, data from a company in the same industry with a financial year end at 31 December 2009 is considered a better comparable to another company with financial year end at 31 December 2010. This is because the economic environment for the company with year ending 31 December 2009 would be more relevant to that of the tested party

4.2.1 The purpose of analyzing multiple year data is to identify whether the outcome of a particular year is influenced by abnormal factors. However, the use of multiple year data does not imply the use of multiple year average

4.2.2 In order to obtain a complete understanding of the facts and circumstances surrounding a controlled transaction, it is useful to examine data from both the years after the year under examination and prior years. The use of data from past years will show whether a taxpayer's reported loss on a transaction is part of a history of losses on similar transactions, a result of a particular economic condition in a prior year that caused an increase in cost in the subsequent year, or a reflection of the fact that a product is at the end of its life cycle.

4.3.1 An arm's length range refers to a range of figures that are acceptable in establishing the arm's length nature of a controlled transaction. The range is derived from applying the same transfer pricing method to multiple comparable data. It is established that transfer pricing is not an exact science, and that the application of the most appropriate transfer pricing methodology may produce a range of results. The facts and circumstances of a case are therefore important in determining a range, or the point in a range, that is the most reliable estimate of an arm`s length price or allocation

4.3.2 The arm`s length range should be constructed using only comparable uncontrolled transactions that have, or have been adjusted to, a high level of reliability in comparison to the controlled transactions. A substantial deviation among points or between the data in the range (e.g. upper quartile and lower quartile) may indicate that comparables used are not reliable, and that material differences exist in terms of FAR which warrant comparability adjustments. In such cases, the reliability of comparable data must be carefully assessed, and adjustments made for the material differences in comparability analysis and the methodology should be reviewed

4.3.3 If every effort has been made to exclude data that have a lesser degree of comparability, but some comparability defects remain and cannot be adjusted, it may be appropriate to make transfer pricing adjustments to a value that best reflects the facts and circumstances of transactions between associated persons. This value may be derived from utilising statistical tools depending on the specific characteristic of the data set.

4.4.1 To obtain the most precise approximation of an arm`s length price or profit allocation, the arm`s length principle should ideally be applied on a transaction-by-transaction basis. However, depending on the circumstances of the case, transfer pricing may sometimes need to be dealt with at the level of a product line or business unit rather than at the level of each particular transaction.

4.4.2 In establishing transfer prices, taxpayers should set prices separately for each transaction they enter into with an associated person. However, where transactions are so closely linked (or continuous) that they cannot be evaluated adequately on a separate basis, determination of transfer price based on bundled transactions may be considered. This is provided it can be demonstrated that it is the normal industry practice to set one price for a combination of transactions (e.g. goods and the associated intangible property) or where it may not be reasonable to expect to find quality data available to set the price for separate transactions. Lack of reliable data on comparable transactions may be due to the complexity of the dealings or the relationships between the parties. Therefore, the total amount may be on an aggregate basis.

4.4.3 It is generally acceptable to group intangibles associated with the product or service provided if comparable independent transactions also have these various transactions which cannot be disaggregated and are bundled into a package deal with all the associated costs being included in the price of the product.

Other examples include:

Aggregation of transaction involving tangible and intangible products that are highly integrated

A company that licenses manufacturing know-how and supplies vital components that are highly integrated to an associated party may find it more reasonable to assess the arm's length price for these two activities as an item instead of separately.

Aggregation of transactions where one product complements the other

Aggregation of transactions may also be appropriate in situations where a taxpayer is required to carry an unprofitable product or line of products which are auxiliary to the profitable items and where there is sufficient profit available to provide an adequate return from the complete product range to reward the assets, functions and risks of the enterprise. Common types of bundled products that fall under this category include printers with cartridges, and razors with blades

Disaggregation of transactions where the nature of transactions are substantially different

Company M was established in Malaysia to handle the distribution, sales, after-sales service, repair and maintenance services of the X group vehicles consisting of trucks, buses and coaches which are 100% imported from its parent company in Country X. Company M is also the regional hub for X in South East Asia, covering markets such as Singapore, Thailand, Vietnam and Indonesia. This regional office also houses the regional training centre where mechanics, technicians, driver trainers and managers from the Asia Pacific region are trained to provide X's group customers in the region

Ordinarily, in this situation, the various kinds of activities should not be aggregated and Company M is required to prepare segmental accounts as follows, in order to enable the evaluation of the arm's length nature of the controlled transactions on a transactional basis:

  • Sales and distribution
  • Repair and maintenance services
  • Regional service

4.5.1 Examination of a controlled transaction ordinarily should be based on the transaction actually undertaken by the taxpayer insofar as these are consistent with the methods described in the Guidelines. However, when reviewing an agreement between associated persons, consideration is not only on the terms of the agreement but also the actual conduct of the parties.

Therefore, in determining an arm's length price, the IRBM may disregard and re-characterize a controlled transaction under the following circumstances:

  1. where the economic substance of a transaction differs from its form; or
  2. where the form and substance of a transaction are the same; the arrangements made in relation to the transaction, when viewed in their totality, differ from those which would have been adopted by independent persons behaving in commercially rational manner and this actual structure practically impedes the IRBM from determining an appropriate transfer price.

4.5.2 The need to re-characterize a transaction is based on the rationale that the character of the transaction is derived from the relationship between the parties and is not determined by normal commercial conditions. The controlled transaction may have been structured by the taxpayer to avoid or minimise tax. This is supported by the fact that -

  1. associated persons are able to enter into a greater variety of contracts and agreements compared to independent persons because the normal conflict of interest which exist between independent parties is often absent;
  2. associated persons often conclude arrangements of a specific nature that are not, or very rarely, encountered between independent persons; and
  3. contracts under a controlled transaction are quite easily altered, suspended, extended, or terminated according to the overall strategies of the multinational group as a whole and such alteration may even be made retroactively

4.5.3 The above principle can be demonstrated in the following examples extracted from the OECD Guidelines:

Example 4

An investment in an associated enterprise in the form of interest-bearing debt would not be expected to be structured in the same way had it been conducted at arm's length, given the economic circumstances of the borrowing company. In this case, it might be appropriate for a tax administration to characterize the investment in accordance with its economic substance where the loan may be treated as subscription of capital

Example 5

A sale under a long term contract, for a lump sum payment, gives unlimited entitlement to the intellectual property rights arising as a result of future research for the term of the contract. While it may be proper to respect the transaction as a transfer of commercial property it would nevertheless be appropriate for a tax administration to conform the terms of that transfer in its entirety to that which might reasonably have been expected between independent persons. Thus, in the case described above, it might be appropriate for the tax administration, for example, to adjust the conditions of the agreement in a commercially rational manner as a continuing research agreement.

Where the DGIR has found that a price in a controlled transaction is not at arm's length, he may make an adjustment to reflect the arm's length price or interest rate for that transaction by substituting or imputing the price, or interest, as the case may be. In such instances, the adjustment will also be reflected by a corresponding adjustment upon request of the other party of the controlled transaction. Adjustments will be made where:

  1. For the supply of property or services, the consideration is less than the consideration that would have been received or receivable in an arm's length arrangement;
  2. For the acquisition of property or services, the consideration is more than the consideration that would have been given or agreed to be given in an arm's length arrangement; or
  3. No consideration has been charged to the associated person for the supply of property or services.

4.7.1 Enterprises incur losses for a variety of economic and business reasons such as start up losses, market penetration strategies, and research and development failure. However, an independent enterprise would not endure continuous losses without taking appropriate measures to correct the situation within reasonable time, as it would contradict fundamental business objectives of making profits. The fact that an associated enterprise continuously suffers losses may be an indication that it is not being compensated fairly.

4.7.2 In determining whether the losses are acceptable, it is important to ensure that the controlled transaction entered into is commercially realistic and make economic sense. A taxpayer needs to also establish that the losses are commercial in nature within the context of its characterization. In this regard, a taxpayer is expected to maintain contemporaneous documentation which outlines the non-transfer pricing factors that have contributed to the losses.

4.7.3 A contract or toll manufacturer that only carries out production as ordered by a related party, without performing functions such as operational strategy setting, product R&D and sales, is expected to maintain a consistent level of profitability. Should the manufacturer suffer from losses, it must prove that these losses are not a result of its transactions with a related party.