Transfer pricing: regulations, determination principles, methods and requirements for documentation
On 21 July 2012 the amendments to the Taxes and Duties Act were adopted, according to which mandatory requirements for documentation of transfer pricing were introduced starting 1 January 2013.
The concept of the market value (arm’s length) of transactions was implemented already in 1995 within the Corporate Income Tax Act, but the interest regarding transfer pricing issues have been rising after Latvia’s accession to the European Union. Most of the EU member states have introduced transfer pricing documentation requirements up to some degree, thus adapting such changes are valued as a positive step for the organisation of transfer pricing norms.
The aim of the article is to deal with the basic issues of transfer pricing: principles for determination, methods, documentation requirements before and after the changes in the law have come into force.
What is transfer pricing and what is the market value of transactions?
A number of terms are used within the meaning of a transaction between related persons, including “transfer pricing”, “market value of transactions”, “controlled transaction” or “arm’s length principle”. Although legislation acts have brought order to these terms, they still sometimes are used with various meanings.
Transfer pricing, according to changes in the Taxes and Duties Act is the price (value) of goods or services that is applied within the transaction between the persons (companies) involved, one of which is a foreign company. Thus, the concept “transfer pricing” denotes the actual price that is applied in a controlled transaction, this price may or may not be consistent with the market value.
“The market value of a transaction” – this term is used in the Article 12 of the Corporate Income Tax Act and in paragraphs 83 – 93 of the Cabinet of Ministers regulation No.556 “Regulations for application of the Corporate Income Tax”, nevertheless the laws and regulations do not provide a comprehensive definition of the term. The principle of the market value of a transaction is established in Article 9 of the model convention of Organisation for Economic Co-operation and Development (OECD). “(..) in either case conditions are made or imposed between the two (related) enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises (mutually unrelated), then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.” In other words, to define market value for a transaction between the related persons, this transaction value (transfer price) must comply to value of such transaction that:
- has been carried out between unrelated persons (uncontrolled transaction)
- essentially is analogical or similar (comparable) to such transaction
- has been carried out in analogical (comparable) conditions
The definition of market value transaction results into a number of important conclusions, most important of which is that for the purposes of the transfer pricing analysis the comparability criteria: the subject of the transaction, industry analysis, industry’s, business strategies, business activity’s functions and risks, as well as contractual arrangements, should have to be analysed.
Another important conclusion arises from the definition, one that is often misunderstood in practice, meaning, as a result of transfer price analysis one indisputable market value is not set. The result of determining transfer pricing will always be series of price or profit indexes – range that includes values that meet market value.
Concept “transfer pricing” in every-day life is also understood as a process – analysis and justification of market value for a controlled transaction’s value.
Why is transfer pricing important?
The main task of transfer pricing is to avoid unjustified flowing of profit outside of Latvia or its redirection to a Latvian commercial undertaking that uses tax relief or rights to transfer the losses to a group, thus reducing income liable to tax.
In dealings between independent companies the profit level depends on the market laws, whereas, in controlled transactions, Latvian taxpayer has to prove that it has observed the principle of market price. If the price or value in case of goods or services acquisition in a transaction with the related person is higher than the market value, but in case of sale or service supply– lower than market price, the taxpayer has to adjust income liable to enterprise income tax for the prices of related transaction and market price difference, increasing it accordingly.
Transfer pricing compliance to the market value is important within the commercial law as an instrument for the defence of a commercial undertaking and their board against possible requirements from minority shareholders or third interested persons.
Furthermore, transfer pricing principles are also used for planning business activity functional models for example, by making service centres, including accountancy, IT, intellectual property and other companies.
Transfer pricing laws and regulations
Transfer pricing is regulated by both local and international laws and regulations. When applying them the hierarchy of laws and regulations should be remembered, meaning, international laws and regulations have a higher legal force and thus, are being preferred.
Latvian laws and regulations
- Article 12 of the Corporate Income Tax Axt establishes the principle of the transaction’s market value and subjects addressed by these requirements, whereas Article 1 contains definitions of the related companies and persons related to the company.
- Paragraphs 83 – 93 of the Cabinet of Ministers regulation No.556 “Regulations for application of the Corporate Income Tax (hereinafter – “Regulations of CM”). Regulations of CM is a justified act for the Corporate Income Tax, they define methods for establishing the market values of transactions and their comparability factors that should be taken into account when applying the methods.
- Article 23.2 of the Taxes and Duties Act anticipates cases in which the State Revenue Service is entitled to verify the value of transaction prices, lists factors that could influence the price changes and approaches that the State Revenue Service could use during a tax audit, and it defines criteria for comparison of goods and services. Note that for defining the transaction prices this law is only applicable as far as it does not contradict the norms of the Corporate Income Tax Act.
- Article 15.2 of the Taxes and Duties Act (takes effect on 1 January 2013) anticipates obligation to provide information on transactions with related persons.
International sources of law
- The principle market value (arm’s length) principle of transactions is enforced by the Article 9 of the convention adopted by the Republic of Latvia for the avoidance of the double taxation and tax evasion (hereinafter – “Convention”). If the related company is in a country that has signed the Convention, the Model convention commentaries and other OECD statements on transfer pricing could be applied in order to determine the arm’s length value.
- The OECD Committee on Fiscal Affairs statement “Transfer pricing guidelines for multinational enterprises and tax administrations” (hereinafter – “OECD Guidelines”) is the most important methodical material. The OECD Guidelines is a relatively big document outlining principles for determination of market value transactions, comparability factors, methods for determination of market value transactions, administrative procedures, requirements for processing transfer pricing documentation and it provides special provisions for intellectual property (intangibles) transactions, as well as, requirements for evaluation of group’s services. OECD Guidelines is an internationally recognised standard for preparing transfer pricing analysis and documentation.
- On 27 June 2006 the European Council verified the code of conduct on transfer pricing documentation (hereinafter – “Code of Conduct”). The Code of Conduct divides the responsibility of drawing up the documentation among the group’s main company and its subsidiary companies in various countries and it determines that drawing up the transfer pricing is carried out within the group when drawing up the basic document, and within the subsidiary company when drawing up the local documentation.
In which transaction transfer pricing rules apply?
According to the Article 12 of the Corporate Income Tax Act, the taxpayer has to adjust the taxable income by the difference between the transaction’s actual value and market value if the transaction is carried out with:
- A related foreign company
- With an individual related to the company
- Commercial undertaking that has been relieved from the corporate income tax or uses other income tax reliefs or rebates defined in the laws of the Republic of Latvia
- A related company with which it establishes a group of companies for transfer of tax loss
- A commercial undertaking or a person, if they are located in, set up or established in low tax or tax-free countries or zones.
According to the definition provided in the Corporate Income Tax Act, related companies are two or more commercial undertakings or cooperative societies if:
- They are the parent and subsidiary companies
- One commercial undertaking’s or cooperative societies’ stakes in the other commercial undertaking or cooperative society are between 20% to 50% (without majority voting rights)
- More than 50% of capital asset value in each of these companies is owned by or the contract ensures the substantial influence in these companies:
- To one person and this person’s relatives up to 3rd degree or to this person’s spouse, or to people in affinity up to 2nd degree;
- No more than 10 of the same persons;
- A Company, in which, a physical entity (or their relatives up to 3rd degree, or spouses, or to people in affinity up to 2nd degree) directly or indirectly owns more than 50% of the commercial undertaking’s capital asset or a part of values, or the cooperative society’s debenture value.
- The same person or the same persons have the majority voting rights in the management institutions of these companies
- Additionally to the contract on the specific transaction, these companies have an agreement of any kind (including agreement that has not been made known) on any additional compensation to those stated in the contract, or these companies carry out other conforming acts for decreasing tax.
Group of companies
Group of companies consists of the parent company and all of its sub-companies for the purpose of transfer of tax loss (Article 14 of the Corporate Income Tax Act.
The parent company and the subcontractors are residents in Latvia, other EU/EEA country or in a country that Latvia has signed a tax convention with. A group of companies is established if no less than 90% of the subcontractor is owned (shares and rights to vote) by:
- Parent company
- One or more sub-companies of the parent company
- The parent company and one or more of its sub-companies in any combination
If the Latvian members of the group of companies are entitled to transfer the tax losses, then the transaction between these companies has to comply with the market value. Note that within transactions between Latvian companies, the transaction market principle is applicable only in a case that these companies make a group and it does not matter that the companies have used their rights to transfer the tax losses.
Person related to the company
Person related to the company is a physical entity that themselves, their relatives up to 3rd degree or spouses, or people in affinity up to second degree owns more than 50% of commercial undertaking’s capital assets or part of shares, or which has the deciding influence according to a contract or otherwise within the commercial undertaking. Note that a person related to the company can be both a resident and non-resident of Latvia.
Principles for establishing market price
The basis for analysis of transfer pricing is a comparison of related company’s transactions with transactions carried out by unrelated market members. In each transaction, the goods price or service value is established by a number of factors. Thus, analysis of factors affecting pricing should be done at first to identify those unrelated person’s transactions that can be compared, meaning they are similar enough that the influence of difference would be possible to be corrected as a result of a mathematical calculation.
OECD Guidelines define five comparable factor groups.
Characteristics of goods or services
OECD Guidelines recommend viewing of such transaction subject factors:
- In case of a tangible property – property’s physical qualities, quality and reliability, accessibility and volumes of delivery
- In case of services – characteristic and range of service
- In case of an intellectual property – type of transactions (for example, sale or licensing), type of property (patent, trade mark, know-how), duration and degree of defence of the intellectual property as well as the potential benefits from such property
The OECD Guidelines state that in transactions between independent companies the price of transaction usually reflects the functions of each company (including the risks undertaken and assets used). Because of this, for determination of comparing the transaction has to be done by function comparison of the controlled company’s functions with other, unrelated companies.
Functions of commercial activities contain design, manufacturing, assembly, research and development, related services, purchases, distribution, marketing, advertisements, funding and management.
Whereas the comparable risks include market risks, as fluctuations of expenses and prices, investment or property, or fixed asset risk of loss; risks related to investments into research and development, currency exchange fluctuations, a risk of loss, credit risk, etc.
Functional analysis is the cornerstone of the transfer pricing analysis, guided by its results, a decision is made for the selection of a method and comparable data to establish the transaction’s market value.
A contract serves as interest security of the employer between independent companies, whereas in a controlled transaction, the contractual provisions of division may be ignored, thus it is important to detect if they are observed and, if the actual actions are not as in the formal contract, it is important to analyze these actual contractual relationships.
Additionally, it has to be set out that the agreement between the related persons may exist not only in written form in the contract but also in correspondence/communication between them. In a case of absence of written contract, contractual provisions have to be concluded based on economic principles that are usually agreed on by independent companies.
The OECD Guidelines recommend analysis of economic circumstances for a transaction, in which a transaction with a related person is carried out. It is important to analyse factors such as geographical location, market size, competition volume, and merchants and buyers’ position of competitiveness, the existence of substitute goods, level of supply and demand within the market both generally and within separate regions. If necessary, the purchasing power of the customers, a degree of state regulation of market, manufacturing expenses including costs on land, workforce and capital, transportation costs, type of sales (e.g. wholesale or retail), location and time of division, etc.
By defining comparability between controlled or uncontrolled transactions, it is sometimes important to view the business strategy.
Such aspects of the company have to be analysed within business strategy, as goods’ innovations and development, diversification, risk management, reaction to political changes, changes in work legislation and other aspects influencing everyday commercial activity management. Business strategies may also reflect the company’s attitude towards the market, for example, market conquest structures, e.g. short-term price deduction. Taxpayer who plans to enter a new market may have higher costs (for example, because of outstanding marketing expenses).
Methods for establishing market values of transactions
OECD transfer pricing guidelines, as well as Regulations of CM (Items 84.-89.) describe five methods for establishment of transfer pricing: comparable uncontrolled price, resale minus, cost plus, transactional net margin and profit split.
Preference in both OECD transfer pricing guidelines and Regulations of CM is given to the first three (based on transactions) methods of transfer pricing, whereas methods based on profit, has to be applied only if it is impossible to apply the aforementioned methods.
Comparable uncontrolled pricing method
The comparable uncontrolled pricing method is a preferred method in comparison with all other methods. By applying this method, the transfer price applied in a mutual transaction between the related companies is compared with this related company’s and with it unrelated company’s comparable transaction price (internal comparable uncontrolled price) or with other unrelated trader’s comparable transaction price (external comparable uncontrollable price) in comparable circumstances.
Regulations of CM define that this method is applied to goods delivery or service provision transactions, prices of which are comparable with prices of transactions made by unrelated traders or in cases when it is possible to carry out precise enough corrections to adjust the influence of difference of transaction on transaction value (goods, product or service price).
Application of this method is limited as it is hard to find the uncontrolled transaction, differences from the related company’s transaction of which would not influence the price. Usually, this method is used in cases the company sells identical goods or provides identical services to both related and unrelated company.
In practice this method is applied to such comparable data:
- Provision of services – hourly rates for experts
- Royalty (trademark, patents, etc.) – rate set out in percentage from licensee’s turnover or other economically justified base size
- Loans – interest rates of comparable loans
- Mediation in transactions – commission fee from the value of goods sold in mediation, etc.
- Lease and rent of immovable property – rental per square meter
Resale minus method
By applying this method, the calculation is started with a price that the goods or services purchased from a related company, are resold to an unrelated company. This price is reduced by gross profit from which the reseller covers administration and sales costs, thus obtaining a price that the related company should buy goods for resale.
Resale’s method could be characterised with such example.
Lithuanian manufacturer LTCo sells goods to the Latvian distributor LVCo for 400, LVCo resells these goods to an unrelated person for 450. By carrying out a comparable resellers’ data analysis, it is found that the gross profit index has to be at least 30%, meaning the gross profit of LVCo should be at least 450 x 30% = 135. Because of this, the purchase price from a related company should be no more than 450 – 135 = 315. Thus, LVCo has to increase the taxable income.
This method is applied by the reseller (distributor) when purchasing goods from a related company and reselling it to an unrelated person, without significantly increasing the value of goods and maintaining its identity. Typically this method is applied when determining the profit margin for a wholesaler, who purchases the goods from the related company, planning to sell it to unrelated companies.
Cost plus method
By applying this method, the market price of the transaction is determined by adding expense markup appropriate to expenses of related company’s sold production or provided service that would be applied by the supplier in a comparable transaction with an unrelated trader.
Example. LVCo sells manufactured production for Lithuanian related company LTCo for 600, but the goods manufacturing costs are 500. By carrying out analysis of comparable independent companies, it is determined that gross profit markup rate is at least 30%. Meaning the market value of the transaction has to be – 500 x 130% = 650, meaning the transaction occurred below market value.
According to Regulations of the CM, this method is applied to goods’ (products) supplier’s (manufacturers) or service provider’s transactions if the subject matter of the transaction does not include an important and unique non-material property.
Transactional net margin method
Transaction value (price of goods, product or service) is determined for the direct and indirect expenses by adding (operative) profit markup of base activity.
A method is applied similarly to resale’s price method or expense inclusion method and its application is shown with an example:
Latvian trader LVCo manufactures and sells goods to foreign related company LTCo. The Transfer pricing of the transaction is 1050 EUR.
LVCo profit and loss calculation
|Expenses of manufacturing of the sold production
|Profit or loss before tax
|Markup of total expenses (profit before taxes / total expenses * 100%)
Direct and indirect LVCo goods expenses are 1020 EUR, total expense markup 2.9%. When carrying out comparable company research, it has been found out that the total expense markup has to be at least 5%. Meaning the market value of the goods has to be 1020 x 105% = 1.071.
This method allows disabling the influence of additionally carried out functions on finance results as the expenses usually related to taking on additional functions are reflected in expenses of business activities, meaning both direct and indirect expenses, except interests and taxes.
Nevertheless, this method has a number of disadvantages. Firstly, base activity’s profit level is influenced by administrative costs that could be subjective, thus SRS shall definitely verify justification for expense base. Secondly, this method cannot be applied if the company of a group has various transactions within the group (e.g. goods purchase, recycling and successive sales to the related company).
Profit split method
Profit split method for establishing transfer pricing is used in cases when related companies carry out mutually related transactions or take part in consecutive transactions within goods delivery or service provision cycles that cannot be divided and evaluated separately and when a unique intellectual property is involved in the transaction.
By applying this method, the total profit acquired as a result of mutual transactions of related companies is determined. This profit is divided among companies, according to such economically justified profit division that unrelated traders would have agreed on.
For illustrating the profit division method, an example of Regulation of the CM is set out here. In the example, three traders from various companies – SIA A, B and C are related companies that are developing (inventing), manufacturing and trading household electrical devices. Manufacturing of electrical devices includes the use of modern electronic process technology use and manufacturing of product’s main component. This component is invented and manufactured by Latvian SIA A, and then it is delivered to a related company B in another country that designs and develops the rest of the product. Afterwards, the product is distributed by another related company C. In the transaction between B and C, the market value is established by using resale’s method. It is impossible to find an appropriate comparable transaction for the transaction between SIA a and related company B because both SIA A and related company B invests significant non-material property value in manufacturing of the goods by doing research and development functions
SIA A and related company B’s profit and loss calculation before profit correction (in Lats):
||Related company „B”
|Expenses for acquisitions
|Research and development expenses
Comparable company research establishes that the unrelated comparable manufacturer earns 10% for the carried out manufacturing function (operative profit index in relation to manufacturing costs), thus the manufacturing profit is:
- SIA A: 1.5 EUR = 15 x 10%
- Company B: 2.0 EUR = 20 x 10%
SIA A and related company B’s total base activity profit is 10 (0+10), subtracting total profit of SIA A and its related company B for manufacturing company – 3.5 (1.5+2.0), thus receiving total remaining profit – 6.5 EUR (10-3.5), that is divided among SIA A and related company B, based on each trader’s investment for achievement of this profit. These 6.5 EUR in its essence is profit that is generated for the companies by additional research and development costs.
SIA A expenses on research and development are 15 EUR, whereas related company B’s research and development expenses are 10 EUR, meaning both traders use a total of 25 EUR (15 + 10) in costs for research and development. The total remaining profit between SIA A and related company B is defined in relation – 15/25 SIA A and 10/25 for related company B. Thus, the remainder profit of SIA A is 3.9 EUR (6.5*15/25), but related company B’s remainder profit is 2.6 EUR (6.5*10/25). As a result of profit division, profit for SIA A is 5.4 EUR (1.5+3.9) and related company B has a profit of 4.6 EUR (2.0+2.6).
The rest of the profit in the mentioned example is divided based on the investment of each company for research and development of the goods. But, depending on transaction’s type and division of functions, the remainder of the profit may be divided based on other indexes, for example, non-material investment, a division of capital assets or assets among the companies of the group.
Note that in the hierarchy of transfer pricing determination, this method is the lowest and it should be applied only if no other method is applicable.
Transfer pricing documentation requirements
Regulation up to 31 December 2012
A question often asked is “Do the current laws and regulations oblige one to draw up transfer pricing documentation?” Often enough it is said that the acts of legislation do not provide for it. But even now laws and regulations oblige drawing up transfer pricing documentation although its form was never defined up till now.
The Article 12 of Corporate Income Tax Act obliges tax payer to observe the transaction’s market price principle. Whereas Regulations of the CM states methods for determination of transaction’s market value. Furthermore, Regulations of the CM state that by applying market price’s or transaction value’s determination methods to determine comparable transactions or comparable performers of economic activity, determines:
- Functions carried out within related company’s transaction or transaction sequence, and related risks’ comparability to the functions carried out within similar transactions of an independent economic activity operator in the mentioned commercial activity industry and similar geographical market, and risks related to them, and assets used, as well as other factors influencing transaction prices.
- Transaction subject’s comparability, meaning, comparison of related company’s delivered/received goods/services with the relevant transaction subject’ of an unrelated trader.
Comparable transaction or company is chosen if the differences between comparable transactions or between traders carrying out these transactions, cannot significantly influence the price in unlimited competition circumstances or can carry out mathematical calculations and supposedly precise finance data corrections to adjust the significant influence of determined differences.
A taxpayer has to be able to justify the choice of transaction’s market value determination method with the requirements set out in the Regulations of the CM. If the taxpayer is unable to do so, the SRS may recalculate the prices according to the information available to them. As a result, the conclusion is that Latvian tax payers have to have documents justifying transfer pricing already, but the form of these documents up until now was left to the tax payer.
Regulation starting from 1 January 2013
According to the amendments in the Taxes and Duties Act a company, turnover of which exceeds 1 430 000 EUR and the value of transactions with a related company exceeds 14 300 EUR, shall be obliged to draw up a full transfer pricing documentation.
Requirement for justification of transaction’s (price) compliance to market price (value) shall relate to the enterprise income tax payers who carry out transactions with the subjects mentioned in the law, that are in their essence, the same as those stated in Article 12 of Corporate Income Tax Act (see: Section “In which cases must market value be observed”).
Transfer pricing documentation has to state the following information:
- General description of tax payer’s area of activity – short presentation of the tax payer’s activity during the last years, including:
- Information on the industry (development tendencies, most characteristic features) in which the taxpayer works,
- Analysis of those economical and legal factors which influence the determination of the taxpayer’s goods and services price,
- Characterization of the relevant business activity environment (competition, realisation possibilities and other market factors),
- Description of non-material investment that could potentially influence the transaction between tax payer and the members’ of the transaction mentioned in part one of this Article price (value) determination,
- Information on functions carried out in the transactions, risks undertaken and assets used (involved).
- Mutual connection of organisational and legal structures of the tax payer and groups of persons related to them
- Information on activity strategy of the tax payer – market strategy, production (service) distribution, sales strategy and management strategy that could influence determination of prices for transaction with a related person
- Information that interprets processes of the related persons’ mutual economic activity – functions of members of related group of persons, risks associated with it and assets used as well as role and liability of the members involved in the transactions, information on tax payer’s activity reorganization which results into related persons being handed down or they would have economical activities’ functions, assets or risks compensation corresponding to market price, taken over from them
- Description of transaction subject regarding the mentioned transaction with persons mentioned in first part of this article
- Contractual provisions in transactions with related persons
- Forecast of the taxpayer’s further operations according to the transaction with a related person
- Description of method chosen to determine compliance of transaction price (value) to market price (value)
- Depending on the method selected – analysis of comparable unrelated traders finance indexes or unrelated traders comparable transaction prices (values) and analysis of applied appropriate transaction price (value)
Other documents justifying the applied prices (values) in transactions with related persons have to be drawn up with the documentation – mutual contracts, documents justifying expenses, decisions of company’s board, council, shareholders, members’ meetings.
Transfer pricing documentation has to be stored for 5 years and be submitted to the SRS within a month after request. Not submitting the documentation shall result in SRS being entitled to calculate prices according to information available to them.
Advance pricing arrangement with the State Revenue Service
Amendments to the Taxes and Duties Act provide that the tax payers, when starting transactions with a related foreign company, have a chance to sign a previous agreement with the SRS on determination of transaction’s market value for the mentioned transaction or transaction type if the value of transaction or planned transaction with the related person exceeds 1 million Lats per year.
If the taxpayer has acted according to the terms of previous agreement and its economic activity has not changed in a way that it would contravene with this previous agreement, the tax administration has no rights to specify within the tax revision (audit) for the mentioned transaction or transaction type, the established market price (value).
The order and fees for the conclusion of an advance pricing arrangement are established by the regulations of the Cabinet of Ministers that are, during the writing of this article, in development.
As the project for these terms shall most likely be amended, we do not give it in detail here. But it is worth mentioning that to conclude a previous agreement, the tax payer shall have to gather and submit information to the SRS that is/is not less than the requirements of the amendment in the law, most likely, it shall be more. It has to be also noted that this procedure is continuous (up to 1 year) and for now, the compensation for the conclusion of this agreement, is planned to be 8 000 LVL.
Structure of transfer pricing documentation
The transfer pricing documentation sections are usually structured in a logical sequence from general to separate and it contains such sections: industry analysis, company’s (transactions) analysis, functional analysis and economic analysis (choice of method and analysis of comparable data selection).
A controlled transaction has to be analysed within the industry, the company acts in. The purpose of industry analysis is to identify industry peculiarities and it may include analysis of such issues:
- Description of industry (goods or services, their classification and general description)
- Peculiarities of industry (e.g. necessity of capital, workforce, investments, diversity of products, market maturity, etc.)
- Factors promoting competitiveness (necessity of innovations, ensuring quality, formation of customer relationships, sales strategy, etc.)
- Industry’s level of legislation
- Industry’s statistical indices
- Indexes of most important risks (stock risk, credit risk, innovations risk)
Results of industry analysis allow to establish industry’s sector in which the related company operates, it allows to select analogic companies that operate within the same sector, thus can be used for selection of useful comparative indices as well as factors and risks that influence price formation within the industry.
The purpose of the company analysis is to identify peculiarities of the company which influence price formation, for example, management model, business strategy and compliance structure. Typically, a company analysis contains:
- Profile of the group of company (history, facts, finance indexes)
- Company’s strategy
- Organisational structure and division of liability of the company
- Description and analysis of division of related companies
- Finance indexes, etc.
As a result of company analysis, factors characteristic to this company that influence price formation, are isolated – company’s strategy, risks characteristic to the company, etc.
The benefit of every participant of the transaction must comply with its relative investment and risks undertaken in the particular division. Thus, a functional analysis of the transaction must be carried out with the aim to identify the role of each participant of the transaction carried out between related persons.
Example. LVCo manufactures goods and sells them to related Lithuanian company LTCo. As a result of functional analysis, it is found that LVCo manufactures goods, purchases raw materials and undertakes technological risks of manufacturing. Whereas LTCo undertakes goods planning, marketing, distribution and logistical functions, undertakes risks of market, currency fluctuations and bad debts. It also carries out group’s management function. From such a division of functions, it can be deduced that LVCo acts as a manufacturer by contract that has restricted functions and risks. Such conclusion is basis for selection of comparable companies that act as manufacturers by contract.
On the basis of industry’s, company’s and functional analysis, criteria are selected that are used for choosing transaction market price method and selecting comparable indices. The goal of these criteria is to identify comparable divisions that would allow deducing market value of the transaction.
Economic analysis must contain:
- Choice and argumentation of transactions’ market value establishing method about why the corresponding price method has been chosen
- Selection and analysis of comparable data
To detect comparable data for profit norms, Bureau van Dijk database AMADEUS is usually used as it contains information on 19 million European companies. By using this database, comparable companies are selected, and their annual reports are analyzed.
As a result of selection of comparable companies, a sequence of numbers for comparable data (e.g. profit ratios) is found. To filter the indices that do not reflect the market value, while analysing comparable data, the statistical quartiles (In statistics: any of the three points that divide a sequence of numbers into four equal intervals, each of which contains 1/4 if the result value) number sequences. It is considered that transaction’s market value is reflected by all indices of the number sequence, that are located between the first and third quartile. This approach allows to ignore 25% of price’s (profit indices) range lower- and 25% of upper values, which thus allows balancing the possible offsets arising due to as an example, comparable company’s function differences, annual report differences or due to other reasons.
Example. Latvian company manufactures and sells goods to a related company by applying 5% markup to full prime cost. To establish if 6% markup rate conforms to the market value, based on industry, company and functional analysis, 10 comparable companies are selected, which operate in similar industry and carry out goods delivery to unrelated companies (that are done between unrelated persons and in analogical circumstances). Profit indexes of these companies are:
Within the selection, it is found out that these companies have applied a markup of 3% to 9%. 1st quartile of the number sequence is 4.63%, the median is 6.2%, but 3rd quartile is 7.9% (Quartiles are calculated by use of Excel functions).
Figure. Analysis of comparable companies’ profit ratios
As seen in the figure, market value is between 4.63% that is between the indices of 3rd and 4th company and 7.9% that is closer to the 8th company. The preferred profit ratio in this case is median (6.2%), however, it does not mean that this profit norm would be the only right one. As a result, it can be concluded that the profit norm 5% is within the quartiles’ range and, thus, conforms with the market value.