Poor Comparability Analysis and Incorrect Profit Allocation

A transfer pricing analysis depends heavily on the quality of its comparables.

Using companies that perform materially different functions or operate under very different economic conditions can produce an unreliable result. The same problem can arise when a company fails to make appropriate adjustments for differences in functions, assets, risks, markets, or other relevant factors.

Profit allocation can also become problematic when the allocation does not reflect the actual economic activities of the related companies.

A strong analysis should therefore:

• Select comparables that are relevant to the transaction.
• Identify important differences between the tested company and the comparables.
• Make appropriate and supportable adjustments where necessary.
• Explain how the selected profit level indicator or pricing measure was chosen.
• Ensure that the final allocation is consistent with the functions performed, assets used, and risks assumed.
• Keep the intercompany agreement, actual conduct, financial results, and transfer pricing study consistent with one another.

The IRS has emphasized the importance of connecting the functional analysis, risk analysis, intercompany agreements, comparables, and selected transfer pricing method.