The Economist's Toolkit in Transfer Pricing

The arm’s length principle which underpins transfer pricing has its foundation in economics. Going back decades, economists have been central to framing transfer pricing problems through policy setting, guidance and interpretation, as well as solving those problems through technical economic analysis. In some cases, the economic analysis required in our work follows a well-established pattern, perhaps relying on a search for benchmarked data. This benchmarking informs arm’s length pricing by identifying comparable independent arrangements between unrelated parties. But transfer pricing often encounters more complex or nuanced intra-group situations where comparables alone are insufficient to provide a complete answer or reliable comparable data are unavailable. The economist's toolkit addresses these situations by supplementing and supporting traditional transfer pricing methodologies or determining alternative approaches.

The previous article in this series discusses the role of economics in transfer pricing generally. Now we discuss specific quantitative and qualitative methods included in the economist's toolkit. Successful application of the toolkit is built upon an analytical mindset, confidence in accessing and interpreting sources of data, good knowledge of applicable finance and economic theory, and sometimes an open mind to walk the road less travelled.

Bargaining power, options realistically available, barriers to entry and value drivers can influence the relative negotiating position of transacting parties. Many transfer pricing practitioners already apply these from their toolkit. But more can be done, both with these foundational concepts, and the additional components of the economist’s toolkit such as quantitative techniques and economic models. These can be useful in resolving particularly tricky and contentious transfer pricing questions. In fact, many of these economic models and quantitative techniques have long been used within other commercial applications such as finance, valuation, business decision making, the sciences, and even obscure aspects such as the allocation of airport landing fees or digital marketing expenditure.

Examples include the Shapley Value, a form of cooperative game theory which seeks to share the ‘payoffs’ of working together based on what each participant would have earned on its own or with others – utilising options realistically available.  Also valuable is Monte Carlo analysis, which is used extensively in finance. This predicts a set of outcomes based on simulating a model thousands of times with this data being analysed and interpreted. Monte Carlo analysis, in particular, is useful in measuring risk and volatility, topical questions in transfer pricing.

The economist’s toolkit can be used for both price setting and testing in a wide variety of industries and situations. It lends itself particularly well to supplementing the more traditional transfer pricing methods or approaches. Broadly, KPMG has applied the economist’s toolkit in four different buckets:

1. Solution – using a methodology as the primary methodology to set or test the transfer pricing;
2. Analytical framework – using the economist’s toolkit and applying the principles for a framework e.g. bargaining and options realistically available, including for dispute support and resolution;
3. Corroboration – using the economist’s toolkit to corroborate the main transfer pricing methodology e.g. using a Shapley Value analysis to corroborate profit splitting factors or allocation keys. One such profit split involved both functions and assets; and
4. Sensitivity analysis – in particular with statistical techniques such as Monte Carlo analysis and Econometrics, to test the outcome and impact of the transfer pricing methodology. An example is Monte Carlo/bootstrapping analysis to assess the split of returns for a reinsurance agreement.

There is a range of tools that transfer pricing economists may use to solve transfer pricing problems. These can be qualitative in nature, to help support the primary transfer pricing methodology, all the way to using more advanced quantitative techniques based on economic principles to resolve otherwise intractable transfer pricing problems. Additional support rooted in advanced finance and economic techniques can help to ensure that support for arm’s length pricing is more technically robust in areas that could be highly contentious and otherwise open to challenge.

We will continue this series of articles with exploring Shapley Value analysis in further depth, including practical examples. Stay tuned.

For further information please contact:

• Mitesh Patel
• Graham Poole