The Role of Cluster Analysis in Assessing Comparability under the U.S. Transfer Pricing Regulations

Article excerpt

INNOVATIVE APPLICATION OF A STATISTICAL TECHNIQUE PROMISES SIGNIFICANT IMPROVEMENTS IN ANALYSIS

Transfer prices are non-market prices at which property is exchanged between firms under common control. How they are set has important implications for the cross border allocation of multinational income. Transfer pricing analysis requires the identification of comparable, unrelated parties in order to establish benchmarks for price setting. This article contrasts cluster analysis with conventional methods that require the analyst to specify arbitrary parameters for purposes of locating comparable firms. Cluster analysis also has value in the service of market approaches to the establishment of business enterprise value.

Cluster analysis is an empirical tool consisting of a variety of mathematical and statistical techniques, the purpose of which is to classify a sample of entities or attributes into relatively homogeneous sets. Business economics applications of this technique consist of market research, market segmentation studies, market approaches to business appraisal, corporate strategy and decision-making, and rate setting in regulated, public utility environments. Cluster analysis is also employed in the social sciences, particularly psychology and sociology, and is used, as well, as a tool for performing taxonomy in the biological sciences. However, cluster analysis has not been employed in transfer pricing contexts.

This article addresses the potential role and utility of cluster analysis in transfer pricing practice in accordance with the following plan: First, a brief explanation of the role of comparability in transfer pricing is provided in the next section. Next, cluster analysis is compared with the practice of screening as a means of locating comparable entities or transactions in transfer pricing practice. After this, examples are provided of the use of cluster analysis in conjunction with two commonly employed transfer pricing methods--the comparable profit method and the comparable uncontrolled transaction method. The examples focus on the process of conducting a cluster analysis of transfer pricing. Thus, the cluster analysis methods used are left undefined in the illustrations. Subsequent sections explain these methods and address methodological issues in the application of cluster analysis to transfer pricing practice.

Comparability in Transfer Pricing

Transfer prices are non-market, internal prices at which goods, intellectual property, and services are exchanged between firms under common ownership and control. In the absence of a corporate tax system, such prices might be set in order to promote efficiency, structure managerial incentives, or accomplish any number of other corporate goals. However, in the presence of a corporate tax system, transfer prices may also serve to shift income from one tax jurisdiction to another and thus have important implications for the cross border allocation of multinational income.

Transfer pricing practice, in general, consists of set ting related party prices, establishing operating returns, or allocating shares of total profits earned on both sides of a transaction in accordance, respectively, with the prices charged, returns earned, or profits shared by comparable, unrelated parties engaged in similar market activities. The behavior of unrelated parties defines the international norm for transfer pricing known as the "arm's length standard," and different countries apply this norm in accordance with specific rules and methodologies established through statute and/or regulation. For example, the comparable uncontrolled price method in the U.S. transfer pricing regulations ([sections]482) is a transaction based, tangible property method that applies the arm's length standard through a comparison of the price charged in a con trolled transaction with the price charged in an uncontrolled transaction concerning the same or similar property. …