Why size is important in Transfer Pricing comparables company searches?
RoyaltyRange
Size is one of the critical factors in Transfer Pricing comparable company searches as it ensures the accuracy and reliability of the arm’s length principle, which is the cornerstone of Transfer Pricing regulations.
Comparable company searches are fundamental to the Transactional Net Margin Method (TNMM), which is the most frequently applied approach in Transfer Pricing policies. However, these searches are complex tasks. Perfectly comparable companies – those mirroring the tested party in every characteristic – do not exist, necessitating selective compromises. Practitioners must sometimes overlook certain attributes of the tested party, such as opting for comparable companies in different, yet seemingly similar, geographies. This means practitioners assume, often without empirical testing, that these disregarded characteristics have minimal impact on the profitability of independent companies.
One aspect that is frequently neglected is the size of comparable companies. The prevailing approach is to exclude very small companies (those with a turnover below 1 million EUR) and assume that beyond this threshold, size is irrelevant. Consequently, it is often seen, that small to medium-sized companies are being used to benchmark significantly larger subsidiaries of multinational enterprises (MNEs) in Europe.
According to OECD Guidelines, size should always be considered when conducting a comparable company search in this sector and geography to enhance the comparability between the selected data and the tested party. This consideration can occur during the selection process of comparable companies or afterward, through comparability adjustments.
Larger manufacturing companies in Europe tend to exhibit higher profitability. According to the OECD Guidelines, it is crucial to consistently consider company size when conducting comparable company searches in industries where size-related profitability differences are evident. This consideration enhances the comparability between the chosen data and the tested party. This can be addressed either during the initial selection of comparable companies or through subsequent comparability adjustments. The existing practice of using small companies to benchmark large MNEs needs to be updated.
While size is an important consideration, practitioners must also take into account these other factors to ensure accurate and reliable transfer pricing analyses:
- Industry and Geography Specificity: Data may not apply universally across all industries and geographies. Therefore, it is essential to conduct case-by-case analyses.
- Industry Sub-Groups Variability: The size effect varies within industry sub-groups.
- Multiple Influencing Factors: While data highlight size as a crucial factor in comparable company searches, it is not the only one. A company’s profitability is influenced by a range of internal and external factors, including its geographical location, maturity, competitive environment, market size, working capital policy, and access to financing, among others.
It is not unexpected that companies with specific characteristics may be overrepresented or underrepresented, potentially leading to sample selection biases.
In Transfer Pricing comparable company searches, matching companies of similar size ensures a more accurate reflection of the arm’s length principle by considering factors such as revenue, cost structure, market influence, risk profiles, regulatory impact, geographical presence, and business models. This alignment is crucial for compliance with transfer pricing regulations and defending Transfer Pricing policies during tax audits.
Sources:
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3298727
https://kluwerlawonline.com/journalarticle/Intertax/51.4/TAXI2023024
https://www.elibrary.imf.org/display/book/9781475539660/ch003.xml