INTM514020 - Thin capitalisation: practical guidance: knowledge and negotiation: getting to know similar businesses - comparables

The basic transfer pricing legislation at TIOPA10/S147 requires that the actual provision be compared with what would happen at arm’s length. Looking at comparable businesses operating at arm’s length can give some indication as how close the transactions under review are to meeting the arm’s length standard. There is guidance on approaches and potential pitfalls with transfer pricing comparables in the chapter starting at INTM485000. In most cases it is difficult to find a single comparable which can do this, because so many factors are at work in lending and borrowing decisions, but the results of economically similar businesses can shed light on common factors affecting a particular sector or industry.

At the individual company level, it may be difficult to identify reliable comparables. This may be because:

  • comparables submitted in support of the customer’s position may include companies working with different business models, for example where data on private equity buy-outs is submitted in support of more traditional long-term businesses. In some cases commercial databases used to find comparables may not distinguish buy-outs from long term deals.
  • comparables are offered which are for businesses which, from HMRC’s’ perspective, may have the same issues as the company under review, that they are also part of a larger group and involved in funding relationships which are not arm’s length. Given that most transfer pricing work involves multinational groups, this difficulty is to be expected.
  • comparables are presented to HMRC in quantity and in a fairly superficial way, without detailed comparison of factors influencing the borrower’s.
  • a range of values drawn from comparables is presented to HMRC as an “arm’s length range”, but that range is sometimes inappropriately wide and a company’s place in that range may be determined by statistics rather than facts. If the company’s advisors produce a range for interest cover for a number of “comparables” running from 0.5:1 to 8.7:1 and opt for 4.6:1 for their client, the fact that the figure sits in the middle of the range does not necessarily make it more likely to be valid. This emphasises the risk that high numbers of superficially drawn comparables may be unhelpful and may not reflect the true arm’s length range. A more careful, selective process may be more persuasive.
  • finding another UK borrower in a similar situation at the same time may be very difficult.

If a group or company contends that the terms of connected party debt are at arm’s length, it should be prepared to demonstrate its case. It may do this by presenting comparables, and these need to be carefully analysed, tracing from start to finish the process by which the evidence was produced, examining critically the assumptions which underpin the selection and the reasons for inclusion or exclusion. The process by which comparables are produced is in practice often too superficial.

Any presentation of comparables to HMRC should be accompanied by details of

  • the sources of data - which commercial databases were used, etc
  • what search terms were employed in the selection - key words, industry codes (such as the Standard Industrial Classification (SIC) codes which allocate a four digit code to each industry type
  • how the search was limited by factors such as, for example, the credit-rating of the borrower immediately prior to the transaction, the date of the transaction, turnover andn industry sector
  • how anomalies were weeded out e.g. multinationals (whose own transfer pricing may cloud the issue, government-guaranteed debt and non-comparable business models.

All assumptions should be reviewed.

As well as looking at financial ratios, it is possible to approach the problem by creating a “synthetic” credit rating for pricing debt. This involves attributing a credit rating to the borrowing unit and then looking for comparable debt issue at that rating. This is covered at INTM524070.

Publicly available commercial databases of debt information can be used as the starting point in looking for comparables. However, some degree of expertise is needed to be able to use them effectively.

When a potential set of comparables has been found, HMRC may already have information on the companies concerned which will be helpful in determining how close the comparables really are. However, only publicly available information can be used in discussion or negotiation of cases. An internet search may confirm the availability of at least some of the information from public sources, especially in the case of large multinational groups, significant mergers and takeovers, major contracts, etc, but the greatest of care must be taken not to divulge commercially sensitive information.