Using economics in transfer pricing

Examining the use of economics in transfer pricing by advisors, in-house specialists and tax authorities, and why it is important

Why economics in transfer pricing is important

Following the interest generated on the topic during KPMG’s spring transfer pricing (TP) conference in London, this article is the first in a series on the use of economics in transfer pricing. And by that we don’t mean benchmarking or working with comparables, much as they are important, but instead the use of a much wider and deeper ‘economics toolkit’. Why is this relevant? After all, plenty of professionals work in transfer pricing, and many of them are economists already, right? And you still need accountants, lawyers and people from other backgrounds to bring different perspectives too? Of course. But there are at least four very good reasons why it’s a good idea to have an economist or two at your disposal in transfer pricing, possibly more so now as the discipline matures.

Why use economists in transfer pricing?

First, there are plenty of areas in TP where comparables on their own do not provide a complete answer. The profit split method is one obvious example, but there are other instances where finding reliable comparables is difficult or impossible. In those circumstances, other approaches and techniques can usefully be applied, sometimes as the primary method, but often as a second or corroborating method. And then there is industry analysis and value chain analysis, where concepts borrowed from economics – more specifically what is known amongst economists as industrial economics (the study of firms, markets and industries) – form the bedrock to TP analyses, even if we do not always realise it.

Second, economists bring with them a mindset that turns itself naturally towards thinking about the hypothetical bargain between two parties, options realistically available, risk, and what factors might influence all of these things. And as transfer pricing economists are all too fond of reminding people, economists were familiar with options realistically available long before the concept was introduced in transfer pricing, albeit under the name of opportunity cost.

Third, transfer pricing often involves building and/or working with extensive datasets or spreadsheets. Economists (and rather obviously quite a few others) often have very useful skills in building spreadsheets and complicated models, pulling out useful data from them, and/or identifying and marshalling patterns or trends within data that might otherwise remain hidden amongst the trees.

Finally, HMRC have a dedicated team of economists and corporate finance specialists, many of whom have advanced degrees in the field. Other tax authorities have dedicated teams or specialists too. This potentially raises the bar. And that brings us onto the next question. How do HMRC use their transfer pricing economists and corporate finance specialists, and what does this mean? 

How do HMRC and other tax authorities use economists in transfer pricing?

Based on our experience, HMRC use specialists in this area primarily in a consulting role, rather than tying them to a specific office or team like Large Business, Mid-Size or Business, Assets & International. Their input may be linked to where taxpayers or advisers have relied on technical economics or modelling in their analyses, the issues involved are complex or contentious, the sums involved are large, or a combination of these factors. They may be consulted on enquiries, Advanced Payment Agreements (APAs), Profit Diversion Compliance Facility (PDCF) reports or Mutual Agreement Procedure (MAP) applications, or be full members of case teams. From what we see, their role is often to test, validate and, where necessary, challenge the analyses of taxpayers and/or advisers. But they may also bring new approaches to bear – profit-splits, game theory, finance, valuation, etc.

Is this the same picture in other jurisdictions? In the US, the IRS have very good economists working in different areas of transfer pricing, although the emphasis is perhaps placed a little more on comparables. Other tax authorities have economists and corporate finance specialists too, and sometimes in roles a little bit like those at HMRC.

It’s worth noting too that HMRC and tax authorities in several other countries use economists as experts in litigation involving transfer pricing.

What does this mean?

What does all of this mean for those of us on the other side of the table? Doesn’t it just make life more complicated? The answer to this is – not necessarily at all. Rather, it often means that you can have good, sensible discussions between specialists that speak the same analytical language. However, you will need to make sure technical arguments focused on economics are well grounded and built on secure footings.

To conclude

In conclusion, you don’t always need advanced economics in transfer pricing. But our experience of working with transfer pricing specialists with this sort of background is that it can be of huge value where the answers are not easy to come by, contentious, or further corroboration is needed. And that provides the setting for the next article in the series, which will explore what is in the transfer pricing economists’ toolkit. This article will be published in a future edition of Tax Matters Digest.