Solid benchmarking begins with the right comparables, not necessarily the obvious ones. On today’s episode of ‘The Fiona Show’ podcast, CrossBorder Solutions’ Chief Economist Mimi Song and Senior Transfer Pricing Analyst Michael Quirk: discuss the finer points of benchmark analysis. Learn how solid benchmarking studies can prove arm’s length transactions – and also, teach you a thing or two about your own business.
Mimi Song: Michael, it’s great to have you on the podcast and before we dive into the ins and outs of transfer pricing, let’s learn a little bit about you. So did you ever learn about transfer pricing in university?
Michael Quirk: Honestly, not really. I don’t think I even heard the term. So I applied here. I studied economics down at Virginia Tech but I definitely don’t think we’ve covered anything related to transfer pricing. When I came in to interview I did a little research and something about it sounded interesting that I would want to learn more about. And here I am now!
Mimi Song: So what is it that you like about transfer pricing?
Michael Quirk: I think one of things about transfer pricing is that it’s kind of always changing and developing in different ways and kind of keeps things interesting. Cause even though it’s kind of the same thing over again, there’s always little wrinkles: whether it becomes to clients or certain country regulations – they’ve got to change. So it keeps things interesting.
Mimi Song: So, if you were to imagine yourself 10 years from now, how do you think your career would have developed?
Michael Quirk: I think 10 years from now, I think I first see myself just becoming more knowledgeable in the subject and just growing my knowledge base and I’m kind of a go with the flow kind of guy. So I don’t know exactly where that career ends up, but I hope it kind of sticks to transfer pricing!
Mimi Song: Good. Any advice for young professionals actually considering a career in transfer pricing?
Michael Quirk: Yeah, I think you just have to be ready and kind of roll with the punches. I think things change based on, depending on the client or depending on the certain situation, it’s not always going to be the same thing. You have to be ready to adapt to every situation.
Mimi Song: Right. And I actually think that hasn’t even changed since I started in transfer pricing, to be honest. Which is a little bit before you started, but just a little bit. [Laughs.]
So let’s get down to business. Last week we actually talked about profit based economic analysis and in order to perform a profit base economic analysis, we as transfer pricing practitioners have to do a comparable search or otherwise also known as a benchmarking study. So can you first explain to us what is a benchmarking study? What is a comparable search?
Michael Quirk: Right, so a benchmarking study, when we say that in terms of pricing, it just means that it’s the set of comparable observations – which could be companies or agreements – that we use in transfer pricing documentation to support the intercompany transaction that we’re testing.
Mimi Song: And then we did touch upon that last week too because really, in a profit based analysis, we end up benchmarking one side of the transaction, right? A tested party.
Michael Quirk: Right. So the tested party is the side of the transaction that we were testing. Usually it goes that we aim for the more simple side where the profits that it’s recording is more directly tied to the transaction itself. Cause you don’t want to choose the more complicated side where the profits, where you can’t really tell where the profit is coming from. It makes it harder to support the arm’s length, the nature of that transaction.
Mimi Song: Which is a nice reiteration of what we learned last week. So why exactly is a benchmarking study even necessary?
Michael Quirk: To start: it’s obviously necessary, just because it’s legally required by most countries. It’s definitely the most important part of the local documentation, the local file, because it supports – as I said earlier – it supports the arm’s length nature of the transaction. So without that you’re kind of just talking about the transaction and not really saying, “we’re not really showing how it is arms length…”
Mimi Song: I know a lot of countries actually require you to perform a benchmarking analysis in the application of certain methods. But there’s also an aspect about this is that benchmarking is pretty important, not only for transfer pricing method purposes, but also can be pretty important to an organization. Would you agree?
Michael Quirk: Yeah, I definitely agree. I mean, when we create benchmarks here, it’s not always just for the purpose to put it into a local file. You can always provide a company’s benchmarks for other reasons such as a planning or just to get to help them get the sense of the market at the current time. Maybe they want to see a certain localized region so they can help create a benchmark for that purpose too!
Mimi Song: And so, enlighten our audience here. What are the types of things you have to think about before you actually perform a benchmarking study or, and then what are the types of things you have to think about as you’re going through the process?
Michael Quirk: So when we start creating a benchmark study here at CrossBorder, we usually want to have a good understanding of the functions of the tested party, the assets that it holds and the other kind of risks that they assume, because that really helps center to the search strategy to companies that we would deem comparable.
And then once you have that kind of search strategy in place, you would go into the database, which we use a lot of different ones here. But once you go into the database, you would try to find the ones out of that database that you would determine to be the best available comparables within that database.
Mimi Song: And what would make a company a good comparable?
Michael Quirk: There’s a lot of different schools of thought on that. I think you can kind of base it off of a lot of different factors such as function or industry. I think the best way to do is focus on function rather than industry because as long as it’s the similar functions such as like contract manufacturing, the markup should be similar regardless of the industry.
Mimi Song: Yeah. And it’s a, it’s a return based on the functions actually being performed. And the level of risk assumed and the assets employed. So, and this is basic economics. You studied economics, right?
Michael Quirk: I did. [Laughs.]
Mimi Song: But when I started in transfer pricing, I actually think that this is the first time where I actually came to the realization of what an appropriate economic return would be and how that plays into the in a real world scenario.
Michael Quirk: Exactly, yeah. I think that’s kind of one of the more interesting parts of this too, right? Because I know, when I have conversations with you about a lot of different scenarios that I’ve faced more dealing with clients, you’ll kind of say to me, “Hey, you’ve got to think about what actually is being performed here. So even though they say it’s a distributor, they might actually be performing distribution functions. They might be doing a little something else.”
Mimi Song: And that’s actually a really important point too, because companies might tell you, “Hey, we perform functions A, B, C” but then what happens? It might be that you do a function interview and a company will tell you the function. Then you say, “Actually you perform functions D, E, F, right?” “Right.”
Michael Quirk: Yeah, I definitely say that a lot when it comes to, uh, intercompany agreements. They have these intercompany agreements hashed out with certain kinds of functions. But then when you have to do the interview itself, you find out that they don’t really do that. They do more of something else.
Mimi Song: So we talked a little bit about the idea of benchmarking and the criteria you’re going to be exploring when we do a benchmarking study. Now where do we get the data?
Michael Quirk: Where do we get comparable company data? Right. So we have a lot of different sources of data that we use here to start off. I guess we have Standard and Poor’s, which is a public database. So that’s one of the main sources of data, but then we have a lot of data that kind of fills in the gaps.
Mimi Song: We have a lot of private company databases such as Enos, which would focus on the emerging markets regions. And to be honest, that database was not available when I was doing transfer pricing studies.
Michael Quirk: Yeah. I should say there’s definitely now a lot of different databases. Um, we also have a private databases. This is specific to Russian comparables such as SPARK, uh, Indian comparables such as PROWESS or Capitaline. We also have an Australian database called [inaudible]. And then when it comes to, um, not, uh, comparable companies. Oh, searches, boom. He searched for a comfortable loans or bonds. We have a tool called refinity IV definitive icon. [inaudible]
Mimi Song: Yeah, that was actually the old lone connector database. So there’s a lot of available data sources for transfer pricing practitioners and truthfully, you know, not all practitioners use the same databases. Now a lot of feedback, and I’m sure you get this all the time too, Michael, is where customers or Andrew or prospects actually say, do you have this database or do you have that database? And I’ve heard that this country has a preference for a certain type of database. How do you address that question?
Michael Quirk: Right? Yeah, I definitely heard some clients come to us with like requests or questions about what database is preferred by tax authorities. Well, while tech stories may have a preference for like a local database, there’s definitely no regulation mandating that specific database. So as long as the data is reliable and sufficient enough to create a benchmark study, it doesn’t particularly matter. For example, all public company data is publicly available information. So regardless of the database you’re using relative to the brand name of the database, it’s going to be the same exact information.
Mimi Song: What about private company data? We get this question a lot. What do you think?
Michael Quirk: Right. Private company data comes from credit rating agencies and other public registries. So it’s kind of similar to the public companies where the data is gonna be the same regardless of the particular database provider. And it doesn’t really affect the outcome of the benchmarks.
Mimi Song: Right. I actually think that, you know, when, when, when tax authorities or companies sort of focus on the database as opposed to the outcome of the comparable search. I kind of think that’s a red herring at times.
So let’s ask me Fiona, for the first time this podcast: Fiona, how often do benchmarking studies have to be updated?
Fiona: Every year, Mimi. And it’s a good thing to do anyway so that you can keep up with market conditions.
Mimi Song: So, Mike, you know, in your experience, what, what are some of the biggest mistakes that you’ve seen companies, um, companies have in their benchmarking studies?
Michael Quirk: I think one of the bigger mistakes, uh, I see Mimi is, uh, companies using these PR, uh, generic regional searches that don’t really adjust the search strategy to meet the local guidelines of the tax jurisdiction that the report be filed in. Uh, just because when you alter the search strategy to the local localized regulations, you might come with a little different outcome, but more importantly, you’ll appease the tax authority and they won’t throw out the throw out your benchmark and create their own.
Mimi Song: Yeah. And there are a lot of times where we still have customers who actually want a regional search versus a country specific search.
Michael Quirk: I think there is a, a bit of value to regional benchmarks. It gives you, um, a greater sense of the market. I think, you know, you get a, a wider view of it per se. Uh, but I definitely think for compliance purposes that the localize benchmark that, uh, matches the regulations of the tax authority is the better approach.
Mimi Song: Why? Well, better from a protection perspective. So along those lines, they explain exactly what exactly do you mean by, you know, a local comparable versus a regional comparable? What and, and tell us a little bit more about that. I mean, you know, are you even able to find companies?
Michael Quirk: A local comparable would just be, uh, a comparable company that comes from the country that you will be filing in. And then a regional one would just become, we coming from a region such as Europe or Africa. There’s definitely a preference for tech stories to use local comparables just because it limits the factors that vary between three countries in the region, such as marking conditions or other kinds of financial conditions. But the idea of expanding a search for the region is still not unheard of just because you’re still limited by the data itself. So if there’s no data available, you’ll have to expand out. Even though there’s definitely a lot more countries now mandating will comfortables sometimes expanding outwards is necessary.
Mimi Song: Right. If you think about it in the public company space, for example, there’s a very finite number of publicly available companies. And so if you’re trying to find publicly available companies in a certain geographic market performing the same functions that you’re trying to benchmark your now even further limiting the availability of data.
Michael Quirk: Yeah, definitely. So, I mean, at that point, if you, if the data’s that limited, some kind of adjustment needs to be made, whether it’s the search strategy or adjustments to the comparables themselves.
Mimi Song: And you know, adjustments, right? We adjustments are definitely an important part of performing a benchmarking study. What kind of adjustments are typically applied.
Michael Quirk: So when we say adjustments in regards to transfer pricing in regards to the comparables. Usually what we’re referring to is working capital adjustments, which is an attempt to kind of adjust a comparable to similar balance sheet items of a tested party, such as like inventory or accounts receivable or accounts payable. The theory is that having different levels of those three categories may affect the profitability of the company. So we try to standardize that to tested party to create a more reliable profitability outcome.
Mimi Song: The way that I would think about it then, in the most simplest terms, is that let’s just take one component of let’s like inventory for example: A company that holds a high level of inventory could potentially have held a high level of inventory because they were able to get a significant volume discount on the purchase of that inventory at that moment in time. So their purchase price is lower, but that inventory is held on the balance sheet until they actually sell the inventory. And the idea here is that their cost of goods sold would get adjusted based on the fact that if your tested party held a different level of inventory versus a potentially comparable company, their cost of goods sold would look very different.
Michael Quirk: Yeah. I definitely think the theory behind is very interesting with the way that these adjustments are, how they’re supposed to work and how they, how they do work.
Mimi Song: Another different benchmarking requirement is actually single year versus multiyear analysis. Can you explain to our audience the difference?
Michael Quirk: The single year analysis just means that you take the most recently available year of data and use that as your comparable data and you compare your tested party’s profitability with that year. But the multi-year analysis just means you take the data from the comparable companies for a certain set of years. Usually it’s three to five years, depending on the tax story. And then you would just take the weighted average of those to create the arm’s length range of a profit level indicators.
Mimi Song: Tax authorities typically use multi-years of data because there’s this idea or concept of business cyclicality, right? So – because of business cycles, because of seasonality and things of that nature – looking at multi-years of data helps to smooth out any differentiation related to business cycles. Australia is one of the more extreme cases where they like to look at five years of data versus three years of data. But on average, I think the industry standard is to look at three years of historical data, which I always find it very strange that certain countries only look at a single year of data. I feel like looking at just one year doesn’t really account for business decisions and business decisions that can have an overall impact to the operating framework of a company.
Fiona, countries often mandate an interquartile range or a full range. What do they mean in terms of benchmark requirements?
Fiona: Are you going to start asking any actual challenging questions anytime soon? The results of comparable transactions produce a range of results. If you remove the top quarter in the bottom quarter, you get that interquartile range. A full range means you can use the full range comparisons. Canada is a good example of that and many countries across the world specify whether they want an entire quarter mile range in their benchmarking.
Michael Quirk: Usually comparisons are calculated using Excel, a formula for interquartile range except for the U.S. which has its own calculations, the IRS interquartile range.
Mimi Song: They like to make it a little bit different. Another interesting little piece of benchmarking.
Also, what would you say? Between fresh benchmarking searches every year versus a “roll forward to financial data”, every country has different requirements. But Mike, what do you think about those two approaches?
Michael Quirk: Just to define them real quick: the “roll forward method” is kind of just using the same comparable companies, but updating the financials and then the other one having just a new conference every year. It would mean you have to go through the whole search strategy and the whole reviewing all the companies process. As you were saying, I think it depends on what country you are filing in to determine what kind of approach you want to take.
Mimi Song: What about the idea of a simple average versus a weighted average? I mean, these are mathematical concepts, not necessarily transfer pricing concepts. Can you explain what the differences between the two averaging a purchase?
Michael Quirk: A simple average would just be taking the observations and adding them up and then dividing it by the number of observations. But the weighted average takes components and multiplies it by a weight. Usually, it’s a percentage of to signify how much the figure matters. Then in a period we leverage it makes it so certain years count more than others, which is the kind of attitude would use here.
Mimi Song: Well actually, the period weighted average weights the years, and weights certain years more heavily. So for example, in a period weighted average: you might weight the current year as being more important than the prior two years. In transfer pricing, the weighted average we apply is actually weighted based on the volume of the comparable company financial data.
Can you explain that to us, Mike?
Michael Quirk: For an example, if a company makes 25 percent operating margin in one year where it makes $1 million of sales – versus the 5 percent operating margin in each of the other years were the analysis says sales is only a hundred dollars per year – the million dollar a year revenue with a 20 percent margin skews the weighted average operating margin to around 25 percent. Actually, 24.99 percent to be more precise. And then for comparison, a simple average of 25, five, and five would just be 12 percent.
Mimi Song: That really highlights exactly what the difference between is between a weighted average versus a simple average. And in transfer pricing, what’s more commonly used: a simple average or weighted average?
Michael Quirk: For sure the more popular choice is the weighted average for tax authorities. Some tech stories don’t explicitly say a preference. The ones that do our preference usually choose weighted average.
Mimi Song: It’s interesting and you might actually not know this little bit of history but before you started transfer pricing in India, they, well — first why don’t you tell our audience what kind of range does India calculate today?
Michael Quirk: Right. So India is definitely a peculiar one. Instead of the interquartile range, the range that they consider the arm’s length range. It would be from the 35th percentile to the 65th percent.
Mimi Song: But many years ago, India actually calculated the arm’s length range by using a simple average: the mean of all the benchmarking excepted comparable companies. And based on that mean they would allow you to add 5 percent and subtract 5 percent, and the interquartile range would be this range of 5 percent or surrounded from the mean, but clearly that has changed today, right?
Michael Quirk: Yeah. Right.
Mimi Song: Do you think that would have been simpler approach?
Michael Quirk: I mean definitely sounds simpler than calculating a bunch of different percentiles.
Mimi Song: That’s true. So when we think about uh, preparing a benchmarking study, any other factors that need to be considered that we haven’t already touched upon, Mike?
Michael Quirk: There are actually a lot of factors that you kind of all want to take into account just based off of different country regulations. As I was saying, that’s kind of one of the deadly sins of transfer pricing, just having generic regional benchmarks that don’t take into account local regulations.
So for example: There’s a lot of different criteria such as in Austria, they look for a couple of companies that are independently owned and not subsidiaries. A lot of countries have specific loss criteria, which means you can’t use companies with negative operating profits because it would sway the range. I know Belarus is kind of strict on that.
And then another one that I know off the top of my head is a Belgium, which they would require you to reject startup companies or companies that are active for less than three years because a startup companies are definitely a different than companies that have been well established in the industry.
Mimi Song: When we think about a benchmarking study versus the actual full blown transfer pricing report, is there ever a reason why a company might just do a benchmark versus a full blown transfer pricing study?
Michael Quirk: As we were discussing before, a one of the reasons we would create a benchmark for a company that doesn’t necessarily want to put it into their transfer pricing report right away is just for planning purposes. It’s a good to an idea of what the market is kind of telling you and what kind of margin or markup it you can support the current data on hand.
Mimi Song: But would benchmarking study protects you from penalties and or potential adjusts?
Michael Quirk: No, definitely not. That’s definitely one of the things that we stress here is that we can create you a benchmark, but it’s not going to kind of hold water when it comes to a tax authority.
Mimi Song: Fiona, maybe you can help us with this one. Is there or are there other situations where a company might only want a benchmarking study versus a local file?
Fiona: Finally, a tricky one! It’s generally not advisable to prepare only a benchmarking study, but there are times when it’s okay. For example, if a small company doesn’t meet a country’s threshold criteria for documentation, the company may prepare a benchmarking study to gauge competition.
Mimi Song: Mike, this has been great and I think most people would find the information you presented very informative. I’ve got one last question for you, from my side. Based on your time at CrossBorder Solutions, that clearly, you’ve done a lot of benchmarking to become a manager. How many benchmarks do you think you’ve done in benchmark studies that you think you’ve put together?
Michael Quirk: Oh man, that sounds like one of those Google interview questions. “How many pink lawn balls fit into a seven 47.”
Mimi Song: Don’t worry. You already have the job!
Michael Quirk: I mean, I couldn’t even give the guess… thousands, I guess.
Mimi Song: Thousands. You heard it here.