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Transfer pricing is a fundamental principle used by multinational enterprises (MNEs) to determine the pricing of transactions between related parties, ensuring these are in line with the arm’s length standard. To achieve comparability between controlled (related party) and uncontrolled (independent party) transactions, certain adjustments may be necessary. Comparability adjustments refine the data by eliminating the impact of differences between the transactions, thereby increasing the accuracy and reliability of the arm's length analysis.
In this article, we explore the meaning of comparability adjustments, the adjustments commonly made, and their practical application in various transfer pricing scenarios as discussed in FTA’s Transfer Pricing Guide.
Comparability Adjustments
Comparability adjustments in transfer pricing are modifications made to align transactions between related entities (controlled) with those between independent entities (uncontrolled). These adjustments address differences in accounting practices, business segmentation, working capital cycles, and risk profiles, ensuring an accurate comparison of profitability and financial data. For example, when entities use different accounting standards, adjustments ensure consistency in financial reports. Additionally, differences in functions performed, risks assumed, and capital levels (like working capital cycles) require adjustments to avoid distorting results, ensuring that intercompany transactions comply with the arm’s length principle.
Common Adjustments
Several transfer pricing methods require comparability adjustments. The Comparable Uncontrolled Price (CUP) method, Resale Price Method (RPM), and Cost Plus Method (CPM) all utilize adjustments to align controlled and uncontrolled transactions more closely.
In its guide, the FTA has elaborated the concept of comparability adjustments with the help of various examples discussed below.
Example 1: Internal CUP Method
Consider a UAE-based furniture manufacturer, Company A, which sells products to both a related party (Company B) and an unrelated party (Company X). The sale to the related party is at AED 500 per unit, while the sale to Company X is at AED 450 per unit after a discount for large orders. Since the difference in quantity materially impacts price comparability, a comparability adjustment can be made to neutralize this effect. By adding back the 10% discount offered to Company X, the adjusted price per unit aligns at AED 500, ensuring effective comparability between the transactions.
Example 2: RPM and Functional Adjustments
In another case, Company A, a free zone entity, sells goods to a related mainland party, Company B, at AED 450 per unit, while an independent entity, Company X, buys similar goods for AED 400. Both entities resell at AED 500. However, Company A performs additional logistics functions reflected in its price. Company X incurs logistics costs as operating expenses. By adjusting Company X’s financial data for logistics costs, the gross resale margin of both companies aligns at 10%, thus achieving comparability.
Example 3: CPM and Capital Adjustments
In applying the CPM, Company B sells goods to its parent, Company A, at a 5% markup. Comparability analysis reveals that independent manufacturers earn a markup ranging from 10% to 16%. However, since Company B incurs significant freight and insurance costs (AED 800), a comparability adjustment is necessary. Once this adjustment is made, the markup increases to 14%, falling within the acceptable range, ensuring the transaction is at arm’s length.
Conclusion
Comparability adjustments are indispensable in transfer pricing, particularly when controlled transactions diverge from independent comparables due to differences in accounting, functions, risks, or capital. They help bridge these differences, ensuring compliance with the arm’s length principle and safeguarding against tax disputes.
Needless to say, all comparability adjustments must be adequately documented to justify the need and the manner of making the adjustment.
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