Today, I decided to do something different and address all of you in English rather than Spanish. There’s no particular reason behind it – just the mood – and the desire to share some thoughts with a broader audience.
Those who have read some of my previous articles have probably noticed how much I always emphasize the relevance of the comparability and functional analysis when it comes to setting transfer prices[1]. As the OECD Transfer Pricing Guidelines state[2]:
«“Comparability analysis” is at the heart of the application of the arm’s length principle. Application of the arm’s length principle is based on a comparison of the conditions in a controlled transaction with the conditions that would have been made had the parties been independent and undertaking a comparable transaction under comparable circumstances. There are two key aspects in such an analysis: the first aspect is to identify the commercial or financial relations between the associated enterprises and the conditions and economically relevant circumstances attaching to those relations in order that the controlled transaction is accurately delineated; the second aspect is to compare the conditions and the economically relevant circumstances of the controlled transaction as accurately delineated with the conditions and the economically relevant circumstances of comparable transactions between independent enterprises».
In line with the above, it is not surprising that most transfer pricing cases worldwide are closely tied to the comparability and functional analysis. This is because, at the end of the day, we are comparing facts (i.e. transactions, remunerations, functions, risks, etc…) that are highly influenced by subjectivity. This is, therefore, also the most robust and objective analysis, making it more likely to succeed in Court.
To illustrate this point, I put forward the following decisions from the Italian Supreme Court:
- In July 2024[3], the Court rejected the tax authorities’ approach on automatically excluding loss-making companies[4] that were potentially comparable for the purpose of transfer pricing benchmarks. Companies with some years without financial data recorded in the database were also automatically excluded by the tax authorities. The Court considered this as a practice inconsistent with the OECD Transfer Pricing Guidelines arm’s length principle.
The case concerned a taxpayer providing call center services to a foreign related party under an agreed cost plus 5% mark-up remuneration. Following the approach already mentioned, the tax authorities argued for a 7.42% mark-up based on a benchmark analysis that excluded companies with losses or incomplete data without further justification. The Court held that excluding these companies was unjustified, as loss-making or low-profit potential comparable entities can still be considered valid comparables if their business strategies include incurring losses or lower profits aimed at future growth. As a result, the Court validated the approach taken by the taxpayer on the remuneration agreed as part of the aforementioned related party transaction.
- Last month[5], the Court supported tax authorities’ approach on the transfer pricing method to be used in the analysis of a related party transaction between a machine manufacturer and the companies in charge of their distribution and sale to the group’s third-party clients. According to the Italian taxpayer (i.e. the machine manufacturer company), the CUP method[6] should be used to set intra-group prices in this case. However, the tax authorities argued that, due to the low risk associated with the sale of machines within group companies, the CUP method does not support comparing intra-group transactions with higher-risk machine resale to third parties. Therefore, the CUP method cannot be applied in this case, instead the TNMM method[7] should be used. It is also important to mention that the Supreme Court highlighted in its resolution that the OECD Transfer Pricing Guidelines cannot be considered part of a states’ legal framework, unless it is specifically included in its legislation (which it is not the case of Italy, where OECD Transfer Pricing Guidelines are considered merely as general principles)[8].
These court cases demonstrate that, when analyzing a related-party transaction, the parties must understand, on the one hand, each other’s actual functions, assets and risks and, on the other hand, ensure that a third party, in a similar transaction, would agree to comparable terms and conditions. In transfer pricing practice, it is common for both taxpayers as well as tax authorities to adopt automatic approaches. Sometimes, this is simply the result of following a (erroneous) standard approach when analyzing a particular type of transaction or when, by default, it is assumed that international, well-accepted guidelines (such as the OECD Transfer Pricing Guidelines) are binding at a global level. However, the differences arise in the finer details, potentially resulting in transfer pricing challenges.
[1] See for instance “Youtubers, precios de transferencia y otras cosas” (post in Spanish).
[2] Paragraph 1.33 – OECD Transfer Pricing Guidelines (January 2022 edition)
[3] Decision 19512 dated on July 16, 2024.
[4] The Italian Tax Authorities rejected potential comparable companies with losses in at least two out of the three years.
[5] Decision 26432 dated on October 10, 2024.
[6] Comparable Uncontrolled Price Method
[7] Transactional Net Margin Method
[8] This topic is further analyzed in the post “La OCDE también puede jugarnos una mala pasada…a todos” (post in Spanish).
