Practical aspects on transfer pricing

Transfer pricing and the inherent arm’s length principle has been around for some time now and many African countries have implemented transfer pricing regulations. In Africa, only about five countries had transfer pricing legislation in place before 2000, now in 2019, only about five countries do not have any arm’s length or anti-avoidance provisions in place dealing with transfer pricing. Out of these countries approximately 40 countries in Africa have some sort of formal transfer pricing documentation requirements, be it in the form of formal submission or retention requirements. 

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Comparability adjustments – Accounts Receivable

ComparabilityWhen performing a comparability analysis, i.e. comparing a company (usually referred to as the “tested party”) to that of similar companies (usually referred to as “comparables”) we may want to perform a comparability adjustment in order to refine the results. It is important to mention that a comparability adjustment should only refine the results and should not be used to make a non-comparable, comparable. In other words if we need to make an adjustment to a company so that it is considered comparable, we should probably reject the company altogether.

For example we would perform comparability adjustments where comparables come from countries with significantly different economic conditions than the tested party and we can accurately adjust for those differences.

In this blog post we will look at a working capital adjustment. If you are not too familiar with what a working capital adjustment is, it usually just means that we would adjust one or more of the following:

  • Accounts Receivable
  • Accounts Payable
  • Inventory

As mentioned by the OECD, comparability adjustments should not be performed on a routine or mandatory basis but rather on a case by case basis depending on the facts and circumstances.

To keep this blog post manageable we will only look at an Accounts Receivable adjustment but please note that an adjustment for Accounts Payable or Inventory would work in a similar way.

First we need to establish why we would want to adjust Accounts Receivable. As you will see from the below example it may take some time to do comparability adjustments (depending on how many comparables there are) and if we are not certain that it will actually refine our results it may not be worth the hassle.

In order to discuss the reason for performing an Accounts Receivable adjustment and how to perform the actual adjustment let’s look at the following example:

A multinational corporation (“MNC”) has a subsidiary in South Africa (or other developing countries) which acts as its distributor. As you may be aware South Africa does not have a local database to determine an arm’s length margin for distribution activities and as such we have to look for comparables on other databases. Most likely this will be European Databases such as Orbis / Amadeus (This is similar for most developing countries). However, the problem with using European companies to compare to a tested party situated in a developing country is as follows:

European comparables operate in ‘safer’ environments when compared to companies in developing countries. In general the company in a developing country faces a higher level of market (i.e. economic), credit and political risk. Further, the European comparables would most likely have already established long standing relationships which usually means there are less bad debts and a faster collection of Accounts Receivable when compared to companies in developing countries which are still trying to establish good client relationships. From the above we can see that the tested party in South Africa has a higher risk profile than the comparables in European countries and as such it is economically justifiable to perform comparability adjustments.

In order to perform the comparability adjustment we will adjust the comparables’ results in a two-step approach. Firstly, we will adjust the comparables’ Accounts Receivable to 0 applying the relevant interest rate for that country which will result in a lower margin (due to lower risk i.e. no more Accounts Receivable = lower income) and secondly we will then adjust the Accounts Receivable from 0 to the tested party’s level applying the relevant interest rate for the that country i.e. South African prime rate. As you have rightly guessed this will increase the revenue for the comparables and therefore the margins achieved.

Please note this is the most common way even though one could adjust the tested party to the comparables or both the comparables and the tested party to 0.

Now that we have the theory out of the way let’s look at the formulas:

Step 1a: Adjusting comparable to 0 – Balance Sheet adjustment

AR(0) = (0 – Current days AR) * (Sales / 365)

Where:

  • AR(0) is the change in Accounts Receivable
  • Current days AR is current Accounts Receivable days for the comparable
  • Please note the 0 is target days receivable and is used to remove the impact of days receivable

Step 1b: Adjusting comparable to 0 – Income Statement adjustment

Adj. Sales = AR(0) * (interest / (1+(interest*Current days AR/365))

Where:

  • Adj. Sales is the adjustment to sales after removing the Accounts Receivable impact
  • AR(0) is as per the Balance Sheet calculation
  • Interest is the interest rate applicable in the comparable’s country
  • Current days AR is current Accounts Receivable days for comparable

The above will bring our comparable to a 0 Accounts Receivable balance, Step 2 below will adjust the Accounts Receivable level from 0 to the tested party’s level. As you have guessed the formulas are very similar but now deal with the tested party information.

Step 2a: Adjusting comparable to tested party – Balance Sheet adjustment

AR(X) = (Current days AR – 0) * (Adjusted Sales / 365)

Where:

  • AR(X) is the change in Accounts Receivable to the tested party’s Accounts Receivable days
  • Current days AR is current Accounts Receivable days for tested party
  • The 0 is the target days receivable of the comparable and is coming from Step 1

Step 2b: Adjusting comparable to tested party – Income Statement adjustment

Adj. Sales = AR(X) * interest

Where:

  • Adj. Sales is the adjustment to sales after adjusting the Accounts Receivable in line with the tested party’s Accounts Receivable
  • AR(X) is as per the Balance Sheet calculation
  • Interest is the interest rate applicable in the tested party’s country

Comparability2Depending on the comparables the above adjustment may result in a material variance. Please note I have not used numbers to elaborate on the above further as the numbers I would use are fabricated and as such do not add much more value. If you would like me to go through a numerical example feel free to provide me with some numbers and we will do that in my next blog post.

Lastly, I just wanted to mention that a significantly different level of relative working capital between the controlled and uncontrolled parties may result in further investigation of the comparability characteristics of the potential comparable. In short the comparables may not actually be comparable.

Benchmarking of corporate guarantees and/or performance guarantees

One of the readers of the blog asked to discuss an appropriate and practical methodology for benchmarking corporate and/or performance guarantees. Further the reader states: Pen

“From the material I have been able to read till now, the interest saving approach discussed in the GE Canada judgment is one way to do it. Theoretically, the risk of loss approach also sounds plausible. However, I am not too convinced with the formula that ought to be used for computing the risk of loss for the guarantor. The formula broadly reads as follows:

Return on capital at risk = Probability of default*Amount guaranteed*Guarantor’s cost of capital.”

The reader’s concern is that “if the guarantor is a large multinational company, the cost of capital would be really high and availing of guarantee would not seem like a good option from the subsidiary’s perspective, as it would just be better to borrow from the market.”

Therefore the reader is concerned whether “the formula mentioned above would actually be useful for computing a guarantee fee in a real life benchmarking scenario.”

Please note the above are the comments of a reader of the blog and are not mine, however, as the topic is very interesting I thought I share it here and get everyone’s input.

In relation to the above I would like to note that a corporate guarantee and a performance guarantee are two very different guarantees and require a different approach.

From the GE Canada case it was held that a “yield approach” is the correct methodology to be applied for the specific facts and circumstances in the case (this was in relation to a corporate guarantee). The yield approach is meant to estimate the total potential interest rate savings achieved by the borrowing entity as a result of the explicit guarantee. The yield approach is applied in two steps – 1.) estimating the stand-alone credit rating and then notching that credit rating for the affect of the parent-subsidiary relationship and 2.) looking at the spread in corporate bond yields between the parents credit rating and the estimated credit rating of the subsidiary.

From a performance guarantee perspective there are different approaches which may have some estimations. I will do some more research before commenting on this in detail but I hope to get some more information from all of you out there in relation to the above.

Please continue sending your comments and concerns for any transfer pricing topics and hopefully we can have many more blog posts like this.