Factors affecting arm’s length price or profit

The main objective of a benchmarking analysis in a Transfer Pricing Documentation (TPD) is to determine the arm’s length range of price or return. As discussed in our previous article “Capitalizing the 4Cs of a TP benchmarking analysis”, arm’s length range is the arm’s length range of price, mark-up or profit obtained from third-party independent companies or transactions which are reasonably comparable to the related party controlled transaction.

In this article, we will discuss the major factors that affect the determination of the arm’s length price, mark-up or profit.

Characteristics of product or service

The specific characteristics of the product or service is one of the factors that have significant impact on the arm’s length price. Under Revenue Regulation (RR) No. 2-2013, characteristics of products or services that need to be assessed include the following:

a. For transfer of goods – physical features, the quality and reliability, and the availability and volume of supply of the goods;

b. For provision of service – nature and extent of the services;

c. For intangible property – the form of transaction, the type of intangible, the duration and degree of protection, and the anticipated benefits from the use of property.

For example, an entity manufacturing recreational vehicles (e.g., travel trailers) with more features will demand a higher price than another entity manufacturing regular commercial vehicles (e.g., sedan). Another example would be an entity providing unique services or highly technical such as engineering design, healthcare will usually charge a higher price than another entity providing general and routinary services like back-office support, administrative support and customer service.

Functions performed, assets employed, and risks borne

The price of the product or service or level of profit of the entity is directly correlated to the functions performed, assets used and risks assumed.

As a rule, if the entity performs more functions (e.g., procurement, research and development, production, logistics, sales, marketing, client generation, and after-sale services), uses more assets (e.g. land, buildings, equipment and machineries, intangible assets, employees and technology), and bears higher risks (e.g., market risk, foreign exchange risk, product liability risk, credit risk, liquidation risk, general business risk), then the price of the product or service or the level of profit of the entity is higher as well.

For example, a product with a warranty is expected to have a higher price or earn a higher return compared to a similar product without a warranty. The difference in selling price or profit is due to the additional function performed and risk borne in providing a warranty for the product.

Likewise, a branded product is expected to have a higher price or earn a higher return compared to similar product without the branding. The difference in the selling price or profit is due to the additional asset (in this case, trademark or research and development) employed in enhancing the value of the product. A perfect example of this is the price of branded medicines which are more expensive than generic ones.

Moreover, the price or profit is also affected by contractual terms and conditions such as payment terms, delivery terms, and discounts. An example is the selling price for buyers who purchase in greater quantity is typically lower than the selling price for buyers who buy smaller quantities because of the volume discounts. On payment terms, businesses normally give discounts to those who pay early.

Furthermore, price or profit differs whether the transaction is conducted under normal business or under special business conditions. The price of goods is set at regular price under normal business conditions while it is discounted during year end sale, clearance sale, holiday sale, or liquidation sale.

Hence, the analysis of functions, assets and risks (FAR) is important in determining the appropriate price or profit level as discussed in our previous article “How FAR are you in transfer pricing documentation?”

In addition, the result of the FAR analysis becomes the foundation of entity characterization which, in turn, affects the level of profit. To know more about how the level of profit is affected by entity characterization, you may revisit our previous article “Fundamentals of entity characterization in TPD”.

Market factors

Supply and demand, competition, and economic conditions greatly influence the price of the product or service. For example, most products or services with high demand and low supply will yield a higher price compared to products or services with low demand and high supply. For instance, the shortage of pork supply due to African Swine Flu (ASF) and onion drove up the prices of these commodities.

Generally, less competitors in a market could lead to higher prices of products and services because companies in such a market have little incentive to lower the prices of its products and services since the consumers have few alternatives for the products or service.

Economic conditions such as the inflation rate also affect the pricing of products and services. Another example is the economic conditions during the COVID-19 pandemic wherein various businesses suffered losses or reported reduced levels of profit.

Geographic location

The prices of products and services may vary depending on the geographic location. The pricing is affected by variations in costs to produce the product or perform the services, cost of shipping, and local market size and conditions, among others.

Lower costs and expenses incurred in producing the products or performing the services will lead entities to decrease the price. As an example, an entity manufacturing a product may incur lower costs to produce the same product in the Philippines due to cheaper labor as compared to another entity manufacturing a similar product in another country with a higher labor cost.

Regulatory factors

Government policies and regulations may affect the pricing of products or services. In general, government affects the market prices in the form of price controls, interest rates, foreign exchange, subsidies, etc.

Business strategies

Pricing also accounts for various factors including the entity’s business strategies about its operations, innovation and product development, and product portfolio or diversification, among others.

For instance, an entity in a start-up phase may incur higher costs (e.g., pre-operating and organization costs, marketing and promotional expenses) and result in a lower level of profit. Moreover, an entity that is planning to increase its market share as its business strategy may charge a price for its products or services that is below the price that is charged by another comparable company in the same market.

Takeaway

Characteristics of the product or service, FAR analysis, market factors, geographic location, regulatory factors and business strategies are some of the major factors that affect the price or profit. In preparing the benchmarking analysis, these factors are important to consider in order to judge whether any adjustments should be made to account for the differences.

Stay tuned for our next transfer pricing article.

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 27 June 2023