If transfer pricing documentation (TPD) were a movie, the benchmarking analysis would be the plot. A well-crafted plot bears weight on the quality of a movie as much as a well-prepared benchmarking analysis bears weight on the quality of a TPD.
Knowing that benchmarking analysis is a crucial part of any TPD, what does one need to consider to get the benchmarking analysis right and withstand the scrutiny of the Bureau of Internal Revenue (BIR)? Let’s first start by understanding the nature and purpose of a benchmarking analysis.
What is benchmarking analysis?
In simplest terms, benchmarking analysis is a method of determining whether related party transactions are undertaken at arm’s length. It compares the controlled transaction of a related party with the transactions conducted by independent third parties based on a list of specified criteria, as provided in Revenue Memorandum Order No. 1-2019, following the transfer pricing guidelines laid out by the Organisation for Economic Co-operation and Development (OECD).
In searching for comparable independent third parties, the criteria are classified into two, namely, general review and financial review. A general review filters candidate companies based on the entity’s status as active or dormant, corporate structure, availability of financial information, nature of business activity, independence, and consecutive losses, among others. A financial review, on the other hand, filters candidate companies based on level of revenue, level of research and development expenses, and level of intangible assets.
In a benchmarking analysis, the arm’s length range, ideally the interquartile range, usually presents a range of arm’s length profit or mark-up price from third-party comparable companies deemed to be similar or nearly similar to the related party in a controlled transaction.
How to prepare a reliable benchmarking analysis?
Coming up with the most reliable benchmarking analysis is not an exact science and requires a certain degree of professional judgement. The 4Cs presented as follows, detail the important guidelines in preparing a benchmarking analysis.
1. Capture the proper characterization of the related party involved in a controlled transaction
In reference to our previous article “Fundamentals of entity characterization in TPD”, entity characterization is the result of analyzing the functions, assets, and risks involved in a controlled transaction. It identifies the type of entity of the related party with respect to the economic benefits and risks of the controlled transaction. For instance, if a company is engaged in the manufacturing of computer parts based on pre-agreed design and quantities solely for the related party, performing limited manufacturing functions is characterized as a contract manufacturer. To avoid distortion of arm’s length range, it follows that the third-party companies to be selected as comparable companies are those that are characterized as contract manufacturers.
By its very nature, controlled transactions have different characteristics which may lead to a difference in the market values. Such differences are to be accounted for and considered in analyzing the entity characterization of the related party.
2. Choose the most appropriate database, transfer pricing method and profit level indicator (PLI)
The process of screening, verifying, and selecting candidate comparable companies depends largely on the availability of a database wherein relevant data on such companies can be extracted. Electronic commercial databases, though sometimes costly, often provide a wide source of information. Other sources include but are not limited to databases from government or regulatory agencies (e.g., Securities and Exchange Commission, Department of Energy, Philippine Economic and Zone Authority) and business organizations. Understanding the controlled transaction helps narrow down the type of database to be used. For instance, for leasing transactions, published rates from property managers could be appropriate.
With respect to transfer pricing method, transfer pricing rules do not lean on any preference. Out of the five transfer pricing methods and as discussed in our previous article “Understanding transfer pricing methodologies”, the chosen method for benchmarking depends on what is to be benchmarked and how benchmarking is used. For instance, if the controlled transaction is selling petroleum products like gasoline, diesel, and kerosene, the appropriate method could be the Comparable Uncontrolled Price (CUP) method wherein comparable data between controlled and uncontrolled transactions are required to be highly similar in order for prices to be considered comparable, using either external CUP (e.g., published prices of gasoline, diesel, and kerosene) or internal CUP (e.g., gasoline, diesel and kerosene prices offered to third party customers).
On the other hand, in our previous article “The concept of profit level indicator in TPD”, the selection of an appropriate PLI depends on the facts and circumstances of the controlled transaction such as availability of comparable data and entity characterization. The Resale Price Method, Cost Plus Method and Transactional Net Margin Method (TNMM) use PLI to determine whether the related party transaction involved is carried out at arm’s length. For instance, if the controlled transaction is the provision of back-office support services, under the TNMM, the appropriate PLI could be the net mark-up or full cost plus, which is computed as operating profit divided by the total costs, because costs are the relevant profit drivers and indicators of the value of the functions performed, assets used and risks assumed by the related party in a controlled transaction.
Determining the applicable database, transfer pricing methodology, and PLI helps in the process of streamlining the line-up of acceptable comparable companies.
3. Customize the benchmarking approach
There is no one-size-fits-all approach in a benchmarking analysis, notwithstanding that the related party in a controlled transaction operates within the same industry and economic conditions of the uncontrolled transaction. Fundamentally, in seeking the most appropriate comparable companies, a certain degree of adjustment is commonly considered. For instance, one-off transactions such as natural disaster damage costs and extraordinary legal costs, identified in the financial statements of the comparable companies and the related party in a controlled transaction, are excluded in the benchmarking analysis.
In addition, general and financial review criteria may also be adjusted. Typical examples include expanding the geographical location of the search criteria if there are no or limited local comparable companies, adjusting the revenue level in reference to the size of the related party in a controlled transaction, or adjusting the ownership independence criterion provided that the related party transactions of the candidate comparable company does not exceed 20% of the relevant threshold.
Any customization should best account the facts and circumstances surrounding both the controlled and uncontrolled transactions. As such, understanding the transaction realities helps circumvent a biased approach on benchmarking analysis and yields a more reliable set of comparable companies.
4. Create a benchmarking analysis trail
Documenting the benchmarking process, from the results of each general and financial review criteria to the adjustments made in consideration of the peculiarities of the controlled and uncontrolled transactions, is crucial in providing transparent proof on how the benchmarking analysis is prepared. The extent of the details in the documentation will greatly depend on its relevance and significance. For instance, citing the business reason of out-of-range benchmarking results and providing a concise description of the primary business of the third-party comparable companies with respect to the controlled transaction adds credibility to the benchmarking analysis.
Not to mention, readily maintaining copies of supporting documents such as pricing agreements and audited financial statements of comparable companies would beef up the benchmarking analysis trail. For instance, notes to the financial statements could provide additional insight on the true nature of the company, impact of COVID-19, going concern matters, among others, and increase the reliability of the comparables.
What are the challenges in benchmarking analysis?
Considering that the methodology in creating a benchmarking analysis is neither universal nor linear by nature, the quality of the comparable companies may be open to interpretation and contention between the taxpayer and the BIR.
Some of the common challenges include the financial years of comparable companies that will be compared with the related party in a controlled transaction, the lack of standardized hierarchy in adjusting general and financial review criteria, the lack of reliable comparable companies due to the absence or scarcity of data, and the selection of favorable third-party information as final comparable companies.
Proposed solutions to some of these challenges may remain to be seen as the transfer pricing guidelines continue to be refined to adapt to the changing economic climate and technological capabilities.
How does benchmarking analysis impact BIR audits?
Benchmarking practice is not new with the BIR. Since 2006 through the issuance of Revenue Memorandum Order No. 4-2006, industry benchmarking or performance benchmarking has been part of the BIR Priority Programs, specifically to improve value-added tax and income tax collections from taxpayers.
Generally, a transfer pricing adjustment happens when the consideration for the sale of services/goods is less than the arm’s length price, the consideration for the purchase of services/goods is higher than the arm’s length price, or no consideration is charged to the related party for the supply of goods/services. A transfer pricing adjustment also occurs when the related party’s benchmarking analysis yields disputable comparable companies, leading the BIR to identify its own set of comparable companies that will be tested against the related party in a controlled transaction.
Knowing that transfer pricing audits are inevitable as discussed in our previous article “BIR transfer pricing audits – the next wave?” a well-thought-out benchmarking analysis helps minimize the risk of transfer pricing adjustments, ultimately cementing the fact that the benchmarking analysis is the backbone of a transfer pricing documentation.
Continue to journey with us as we take a deeper appreciation of the fine points of the TPD in our upcoming articles.
Let's Talk TP is an offshoot of Let’s Talk Tax, 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 April 2023