In our last article on the fundamentals of entity characterization in transfer pricing documentation (TPD), we highlighted the concept that our knowledge of the nature of a particular business determines the entity characterization and in turn, the entity characterization influences the direction and tone of the TPD as well as setting the direction in having a meaningful comparison of the price or level of income of the entity in a controlled transaction against the price or level of return from similar independent transactions.
Now, let’s talk about Industry Analysis (IA) and how it affects the preparation of TPD as discussed in Revenue Regulation (RR) No. 2-2013 or the Transfer Pricing Guidelines and Revenue Audit Memorandum Order (RAMO) No. 1-2019.
What is Industry Analysis?
The Transfer Pricing Guidelines provide that the details of the TPD should include the nature of the taxpayer’s business, and the industry and market conditions where it operates.
IA provides an understanding of the relevant economic circumstances or market conditions in which the taxpayer’s business operates in determining market comparability in order to make meaningful comparisons of prices or margins.
Analysis of the taxpayer’s industry shall be done with consideration to several factors, including main characteristics of the taxpayer's business and performance of the industry. By understanding the taxpayer’s industry, the expected level of price or return by the taxpayer can be known.
The profitability of an industry is influenced, among others, by any or a combination of the following forces:
- Macroeconomics (e.g., interest rates, inflation, rate of economic growth, etc.);
- Demographic (i.e., the qualities, such as age, sex, and income, of a specific group of people);
- Governmental factors (e.g., political climate, tax incentives available, war and conflicts, etc.);
- Geographical location; and
- Technological advancements.
There is a concept in economics which states that similar firms operating in the same industry would generally tend to yield similar returns over time. In layman’s term, if Company A sells the same product as with Company B, both companies should generally yield a similar level of profitability, ceteris paribus. Anchored in this concept is the transfer pricing procedure where the related party transaction will be benchmarked or compared against independent comparable companies belonging to the same industry.
For instance, Company A is rendering shared services to its related parties. Company A will be benchmarked against other companies in the business process outsourcing (BPO) industry. Companies under this industry are usually characterized as routine support service providers and normally apply a pricing model of costs plus mark-up. As a routine support service provider, there is an expectation that the level of profitability of Company A will generate and maintain a consistent level of profitability when compared with that of the other companies in the BPO industry.
The BPO industry in the Philippines, in general, can be considered as a profitable sector and companies belonging in this industry are doing well with their financials. Now, if Company A reported net loss or low level of return as expected, this may be an indication that it is not being compensated fairly. In this case, Company A needs to establish that the losses or low level of profitability are commercial in nature within the context of its characterization and industry performance and not because of the special relationship with the related party.
How does IA affect the comparability of prices and level of return?
Prices may vary across different markets even for transactions involving the same property or services. In order to make meaningful comparisons of prices or margins between entities/transactions, the markets and economic conditions in which the entities operate or where the transactions are undertaken should be comparable.
The economic circumstances that may be relevant in determining market comparability include the availability of substitute goods or services, geographic location, the market size, the extent of competition in the markets, consumer purchasing power, the level of the market at which the enterprises operate (i.e., wholesale or retail), etc.
For example, the lease rates in urban areas are usually higher than in rural areas due to the high demand for housing in the developed areas because of the convenience of living in the city, while the land area is scarce. Also, prices of commodities are more expensive in cities because of the additional costs incurred (e.g., transportation cost, storage, etc.) in bringing these goods to the city in good condition.
Another example is the pricing offered by manufacturers to wholesaler and retailers where the prices offered to the former are usually lower than that offered to the latter. This is because of the discount granted to wholesalers who procure a larger quantity of products than that procured by retailers.
In addition, government policies and regulations may have an impact on prices and margins. For example, early this year, the government put a ceiling on the price of selected medicines and drugs under the Maximum Drug Retail Price (MDRP) system. MDRP is the highest amount a retailer may charge to a consumer for a medicine placed under price regulation. Other examples are the price cap imposed by the government on COVID-19 Rapid Antigen Test and on pork and chicken. Hence, the effects of these government regulations should form part of the discussion in TPD as part of the examination for comparability of the market and economic conditions.
Sources of IA
One can refer to external sources of information, such as industry research reports, publicly available annual financial statements of the main players in the industry, data from the Securities and Exchange Commission, and other information media available through the internet or in databases can be used to gain understanding of industry trends.
There is a saying that “birds of the same feather flock together”. Seeing birds flying together in the sky is very common sight. They move, flock, and feed together. You will not see an owl flying with a flock of pigeons.
In relation to transfer pricing, knowing the behavior of the industry group where your business belongs and maintaining a comparable level of profitability with other companies belonging to the same “flock” will help your company gauge if the transfer prices with related parties follow the transfer pricing guidelines.
Stay tuned for our next month’s article as we continue to take you through the other components of transfer pricing documentation.
Let's Talk Tax is a weekly newspaper column of P&A Grant Thornton that aims to keep the public informed of various developments in taxation. This article is not intended to be a substitute for competent professional advice.
As published in BusinessWorld, dated 25 October 2022