By Mario Ortega & Íñigo García, J&A Garrigues, S.L.P., Spain
The Spanish tax authorities published a memorandum on February 24 that sets out criteria to consider when determining the range of values used to set an arm’s length price. The guidance is intended to reduce uncertainty that has arisen in recent transfer pricing disputes.
The Spanish tax authorities have stepped up their reviews of transfer pricing matters in examinations over the past few years. Due to the subjective nature of many transfer pricing issues, this has led to a considerable increase in the number of disputes with taxpayers.
The range of values used to determine whether the transfer pricing policy applied in intercompany transactions by a taxpayer is arm’s length is one of these issues seeing increased controversy and is an important question from the transfer pricing perspective. The guidance in the memorandum is based on the OECD’s Transfer pricing guidelines and the recommendations of the EU’s Joint Transfer Pricing Forum.
Determining an arm’s length range
The memorandum begins by recognizing that, in most cases, there will be no single arm’s length value since companies operating independently in the open market may establish different prices with respect to the same transaction.
Thus, the first step when determining an arm’s length range is to select a sample of market values consisting exclusively of transactions or entities which are sufficiently comparable to the controlled operation analyzed. Any samples that are found, upon detailed analysis, to offer a lower degree of comparability should be rejected.
Once the sample has been selected, if it can reasonably be affirmed that all values included are of relatively equal and of high reliability, it can be argued that any point in the range covered by such values will be compliant with the arm’s length principle.
This situation is more likely to happen when the range of values is made up of prices and not profitability measures, such as when applying the comparable uncontrolled price method.
However, if there are comparability defects in the sample selected that cannot be identified or quantified – as is often the case when using information obtained from commercial databases – then an additional effort should be made to improve the reliability of the analysis.
In this regard, there are statistical tools that identify a central tendency, such as the interquartile range or percentiles. It is a standard practice to consider as the arm’s length range the values included between the first and the third quartiles.
In addition, where the values in the range are broadly dispersed, rejecting points that are less reliable should also be considered, as should making comparability adjustments to certain values where necessary.
Testing the value of controlled transactions
Once a proper range of independent values is set, the controlled transaction’s value must be compared with this range to determine whether it is compliant with the arm’s length principle.
If the value of the related-party transaction lies within the range determined, no adjustment should be made. By contrast, if that value falls outside the range, it must be brought within the range.
When the comparables are relatively equal and reliable such that any point in the range meets the arm’s length principle, the tax authorities will adjust the value of the related-party transaction to the nearest point in the range.
However, if the comparables are not relatively equal and reliable, the tax authorities – having concluded that comparability defects remain – will adjust the value of the related-party transaction, as a general rule, to the median value of the range.
This is unless, following an exhaustive analysis of the facts and circumstances of the case, the taxpayer (or the tax authorities) can present sufficient evidence to demonstrate that the value should be adjusted to a different point in the range.
In particular, if the taxpayer (or the tax authorities) can demonstrate that the party analyzed takes on a volume of functions, assumes a level of risk, or uses a series of assets, which are relatively high or low in relation to the comparables considered, an adjustment to another point in the range is possible. An example is provided in this respect relating to the level of marketing functions undertaken by a distributor vis-a-vis its comparables.
It is also worth noting that recent case law in Spain is aligned with the reasoning and methodology detailed in the memorandum. The Spanish tax authorities have not duly followed this methodology in these recent cases, which is one of the reasons why this memorandum has now been released.
For example, on March 6, 2019, the Spanish National Appellate Court rejected the adjustment carried out by the tax authorities to the median of the range in a case in which a wholesale distributor had obtained results below the lower quartile in the range.
In this case, the court concluded that, as no comparability defects in the taxpayer’s sample were proven by the tax authorities, the adjustment should have been made to the lowest point in the arm’s length range (lower quartile).
On the other hand, on February 4, the Spanish Supreme Court accepted an adjustment carried out by the tax authorities to the median of the range in another case in which a wholesale distributor had obtained results below the lower quartile.
By contrast to the previous case, the court accepted the adjustment because the tax authorities properly explained the reasons to apply measures of central tendency and, therefore, had met the burden of proof.
Implications
The guidance should reduce the uncertainty that taxpayers face in defining and managing their transfer pricing policies, thereby enabling them to anticipate the risks involved in applying values in their controlled transactions that fall outside the arm’s length range.
However, not all risk will be mitigated since taxpayers will still rely on the information available in the databases used to determine an arm’s length range and because there is still an inherent subjectivity related to the consideration of a range as having comparability defects.
Thus, it is strongly recommended to establish with solid arguments decisions to accept or reject comparables when performing comparative economic analyses. Taxpayers should properly assess whether comparability defects still remain in the final sample when setting the point in the range which better reflects the arm’s length price or value.
Moreover, consistency in applying the criteria in subsequent periods (i.e., to update or renew the benchmarks) is also essential.
Be the first to comment