Transfer Pricing Seminar for Medium-sized corporations in Japan

(This is the 10th article of this seminar series composed of 11 articles)

(Part 10) Selection of the comparable companies and calculation of the profitability range

The selection of comparable companies, within the practice of transfer pricing, is one of the core parts and is highly technical. We will explain the standard approach for selecting comparable companies using a corporate information database. This is a common practice in transfer pricing.

1. Procedure for Selecting Comparable Companies

The selection of comparable companies through the use of a corporate information database is as follows:

  • Select prospective comparable companies (around 50 – 100) by narrowing down the list of companies in the database using criteria such as market (country or region), industry, etc.
  • Obtain the financial data on the prospective comparable companies from the corporate information database.
  • Screen the prospective comparable companies with quantitative and qualitative criteria (refer to Sections 2 and 3 of this article).
  • Select a certain number of companies (around 5 – 15) as comparable companies.

Corporate information database

    • Databases widely used in the practice of transfer pricing:
      • Compustat provided by Standard & Poor’s
      • Orbis provided by Bureau Van Dijk
    • Databases that might be adopted in the future:
      • Local databases provided by the various Chambers of Commerce and Industry in the country where the tested party is located

2. Screening – Quantitative Criteria

In general, the prospective comparable companies are screened on the basis of quantitative criteria as follows:

  • Sufficiency of financial data

Statistically, sufficient financial data is required in order to ensure comparability. It is common to select companies with financial data for the previous three to five business years (according to the circumstances).

  • Sufficiency of profits

Companies with negative operating profits are rejected since there would be issues with the arm’s-length price.

  • Appropriateness of company size

It is better to select companies that are similar in sales, assets, number of employees, etc., to the tested party in order to ensure comparability. The so-called “double or half criteria” may be adopted when assessing excessive executive compensation. This refers to applying the standard of similar companies in the same industry under Japanese domestic law. The fractional calculation is permitted when necessary up to around ten times maximum and one-tenth minimum if the required number of comparable companies cannot be found.

  • Criteria for the ratio of R&D and other expenses

Companies with a high ratio of R&D expense to sales are difficult to use as comparable companies because it is highly likely that they own intangible assets that are affecting profits.

  • Criteria on the ratio of export sales

Companies with a high ratio of export sales are rejected in order to eliminate distortions from the overseas sales market.

3. Screening – Qualitative Criteria

Once the list of prospective comparable companies has been narrowed down to a certain number (around 20 – 40) by quantitative screening, the remaining companies are typically screened by qualitative criteria. The following sources are often used to collect information: corporate websites, securities reports, and corporate IR department information, as well as the information published in the previously mentioned databases.

  • Sufficiency of corporate information

There must be information sufficient to assess the companies using qualitative criteria.

  • Similarity of products, merchandise, and services

Companies with products that have much different profit margins from those of the tested party are rejected.

  • Similarity of transactional level

Companies at similar level of the transaction are selected, since profit margins differ by industry and sales method. For example, it is important whether companies are distributors or retailers, store-based or internet-based.

  • Similarity of functions

When selecting manufacturing companies, for example, a preliminary assessment is necessary to determine whether the comparable companies should be full-fledged manufacturers with all the accompanying risks or contract manufacturers without them.

  • Similarity of business strategies

Companies are also assessed using other criteria, for example, whether they adopt a low-price strategy to gain market share or whether they have a brand name strategy with significant advertising expenses to increase market visibility.

  • Criteria for independence

Companies that have parent corporations or subsidiaries with a shareholding ratio of 50% or more are rejected in order to eliminate the impact of controlled transactions within the comparable companies.

4. Setting a Profit Margin Range

Today, the Transaction Net Margin Method (TNMM) is the method usually employed to calculate the arm’s-length price. Unlike the traditional transaction methods, the TNMM emphasizes the similarity of the functions performed by the parties in the transaction instead of focusing on the products (sacrificing the similarity of the products slightly). The TNMM selects comparable companies from a wider range of companies by using the corporate information database. Hence, in setting the range of profit margins, it is common to adopt the interquartile range, in which the data falling between the first and third quartiles of the total data is considered valid. This is done in order to improve statistical accuracy.

The table below shows how to calculate the interquartile range of operating margins. The weighted averages of the ratio of operating profit to net sales for the comparable companies over the previous three to five business years are used as the base data.

  • Example with 5 data points
Comparable Companies Operating Profit (weighted average) Interquartile
Company A 3.5% minimum 3.5%
Company B 4.0% quartile 25% 4.0%
Company C 4.5% median 4.5%
Company D 5.0% quartile 75% 5.0%
Company E 5.5% maximum 5.5%

The 1st quartile = (3×1+1×5 (number of data points)) / (1+3) = 2 (the 2nd data point)

The 2nd quartile = (2×1+2×5 (number of data points)) / (2+2) = 3 (the 3rd data point)

The 3rd quartile = (1×1+3×5 (number of data points)) / (3+1) = 4 (the 4th data point)

Interquartile Range 4.0% ~ 5.0%

(The next article of this ‘Transfer Pricing Seminar Series for Medium-sized Corporations in Japan’ shall be published next month.)

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