Companies falling into the UK’s transfer pricing rules are required to apply arm’s length pricing in transactions with connected parties. In addition, such companies should have documentary evidence to support the arm’s length nature of the pricing adopted.
In many instances, arm’s length intercompany pricing is often determined by way of a benchmarking report. Such a report essentially considers what a supportable arm’s length price may be when taking into account various factors and will generally contain the following sections.
- An introduction setting out the transactions being considered and the parties to the transactions.
- A functional analysis which considers the functions performed (taking into account assets used and risks assumed) by the parties to a transaction. This analysis is important as it provides an understanding of the relative contributions of the parties to the transaction and their roles in overall value creation.
- A consideration of the potential transfer pricing methods (please see my blog of 19 July 2018) which may be used in determining the arm’s length price for the transactions at issue. This would include the reasons why particular methods were not considered to be relevant and the conclusion as to why a specific method was considered most appropriate.
- It is then necessary to consider how the actual arm’s length price may be derived. This will depend upon the transactions at issue and the transfer pricing methodology which is considered appropriate.
- The report may for instance, depending upon the transfer pricing method adopted (and the following approach is most likely to be of use where the transactional net margin method is to be used), obtain details of comparable companies and their accounting results from searches of commercially available databases. Such searches may result in potentially large numbers of companies and from these it is necessary to sort the companies into a, usually, much shorter list of companies undertaking similar transactions with third parties to those which are at issue.
- The results of the companies in this shortlist may then give guidance on the arm’s length pricing position but it is necessary to review these results to consider whether comparability adjustments, such as removing the impact of exceptional items, need to be made.
Different transfer pricing methods may lead to a different way of obtaining third party comparable results to the example above. For example, if royalty rates were being considered, it may be that the third-party information used was obtained from publicly filed royalty agreements.
It should be noted that the use of a benchmarking report is not obligatory in the UK if another method or approach can be used to determine arm’s length pricing. For instance, if a company was undertaking identical transactions with an unconnected party, it is possible that these transactions would a good indication of the arm’s length price and the documentation requirements would be greatly reduced.
