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Borys Ulanenko
CEO of ArmsLength AI
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The tested party is the entity in a controlled transaction whose profitability is benchmarked against independent comparables. Select the entity with the less complex functional profile—typically the one performing routine functions, bearing limited risks, and owning no unique intangibles.
Selection Framework:
| Factor | Tested Party (Less Complex) | Non-Tested Party (More Complex) |
|---|---|---|
| Functions | Routine (distribution, contract manufacturing, back-office services) | Strategic, unique (R&D, product design, brand development) |
| Intangibles | None owned; may use IP licensed from affiliate | Owns valuable IP (patents, trademarks, proprietary technology) |
| Risks | Limited, often contractually mitigated | Bears significant entrepreneurial risks (market, product, inventory) |
| Decision Role | Operational execution; follows strategies set by others | Strategic decision-maker; controls key business choices |
| Comparables | Many independent companies with similar profiles exist | Few or no comparables (unique business model) |
For detailed guidance on applying this framework, see our Benchmarking Study Guide and PLI Selection Guide.
The tested party is the participant in a controlled transaction selected for analysis under one-sided transfer pricing methods like the Transactional Net Margin Method (TNMM) or Comparable Profits Method (CPM). Its financial results—typically a profit level indicator such as operating margin or net cost plus—are compared against those of independent companies to determine whether the intercompany transaction is priced at arm's length.
: The tested party is generally the party to which the method can be applied most reliably and for which the most reliable comparables can be found—and it will most often be the less complex party. Paragraph 3.19 illustrates why entities with unique and valuable intangibles are usually not suitable tested parties.
One-sided methods focus on one side of the transaction. By testing the routine party's profitability, you establish its arm's length return first. Mechanically, once the tested party's arm's length result is set, the counterparty's result becomes the residual in the model—though this doesn't by itself prove the counterparty is entitled to all residual returns. This approach:
At the heart of tested party selection is the principle that you should test the routine side of the transaction. This is the entity more closely resembling an independent service provider, distributor, or contract manufacturer.
The main reason is comparability. A less complex entity's activities can be matched with independent companies because routine functions and limited risks are common in many businesses. For example, independent distributors and contract manufacturers are prevalent, and their profit margins serve as arm's length references.
In contrast, a high-complexity entity owning a valuable patent might have no true comparables—making benchmarking unreliable or impossible.
The US regulations explicitly codify this principle. Treasury Reg. §1.482-5(b)(2)(i) provides that the tested party will be the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data regarding uncontrolled comparables can be located.
The regulation further states: "Consequently, in most cases the tested party will be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables."
Determining the tested party requires systematic evaluation. Use this checklist after completing your functional analysis:
| Criterion | Question to Ask | Impact on Selection |
|---|---|---|
| Functions | Does the entity perform only routine functions, or unique/high-value functions? | Routine functions → strong tested party candidate. Unique functions (R&D, strategy) → likely not the tested party |
| Intangible Assets | Does the entity own or develop unique intellectual property? | No unique intangibles → can be tested party. Owns valuable IP → avoid as tested party |
| Risks | Does the entity bear significant business risks, or are risks limited/mitigated? | Limited risk (guaranteed margins, cost coverage) → good tested party profile. Major risks → not ideal |
| Decision-Making | Is the entity's role mainly execution, or does it make strategic decisions? | Operational role → favor testing. Strategic control → likely the principal, not tested party |
| Dependency | Does the entity depend on the counterparty for key assets/instructions? | High dependency on affiliate → routine role, likely tested party |
| Criterion | Question to Consider | Impact |
|---|---|---|
| Comparable Data | Can you locate reliable external comparables for this entity's activities? | If yes → viable tested party. If no comparables exist → cannot reliably test |
| Financial Segmentation | Can you isolate the financial results for the specific transactions? | If yes → okay to test. If mixed transactions can't be separated → problematic |
| Accounting Consistency | Are the tested party's financials consistent with potential comparables? | High consistency → more reliable comparison. Major differences requiring many adjustments → less reliable |
| Multi-Year Data | Is multi-year financial data available? | If yes → improves reliability through trend analysis |
Practical Application: Create a comparison table for both parties showing functions, assets, risks, and data availability. The entity with more routine characteristics across all factors is your tested party.
Certain functional profiles appear frequently as tested parties. Understanding these archetypes helps identify the appropriate entity in your transaction.
Characteristics:
Benchmarking: Operating margin compared against independent distributors. An LRD earning a 3% operating margin would be benchmarked against similar distributors in the industry.
Characteristics:
Benchmarking: Cost-plus or net cost plus mark-up compared against independent contract manufacturers.
Characteristics:
Benchmarking: Cost-plus fees compared against tolling service providers or contract manufacturers with similar limited scope.
Characteristics:
Benchmarking: Operating profit to operating cost (cost-plus markup) compared against independent service companies in the same field.
The counterparties to the profiles above are generally not suitable as tested parties:
Why not tested: No reliable comparables exist for entrepreneurs with unique IP—their returns vary widely based on intangible value.
Why typically not tested: As a rule of thumb, a tested party will usually not be the entity that owns unique and valuable intangibles, because finding sufficiently reliable external comparables is often difficult. US regulations state that "in most cases" the tested party will not own valuable intangible property (§1.482-5(b)(2)(i)).
Why not tested: Complex profile makes benchmarking unreliable; its profit depends on unique know-how and risk assumption.
Key Principle: An entity that performs all the critical functions, assumes most of the risks, and/or owns unique and valuable assets is usually not a good candidate for one-sided methods—consider testing the other party or applying a profit split where both sides make unique contributions.
Sometimes neither party is clearly routine. What do you do when both entities perform significant functions or own valuable intangibles?
caution that if each party makes unique and valuable contributions, a one-sided method like TNMM is unlikely to be reliable. Instead, a profit split method is generally more appropriate.
1. Profit Split Method
When both sides have unique intangibles or critical functions, split profits based on their relative contributions. This treats both parties symmetrically rather than forcing a single tested party.
2. Relatively Less Complex
If one party is 70% complex and the other 30%, you might designate the less-complex one as tested party—acknowledging reduced reliability and documenting the approximation carefully.
3. Test Both Sides (Practitioner Diagnostic)
As a practical diagnostic (not an OECD/IRS-endorsed requirement), some practitioners perform two one-sided analyses as a sanity check. If both cannot be satisfied simultaneously, it's evidence that profit split may be needed.
Example: A French company provides a patented component to its US affiliate, which integrates it with proprietary software to sell a final product. Both contribute unique IP. Testing either side under TNMM would undervalue the other's contribution. Profit split—allocating based on R&D investment or similar metrics—is appropriate.
Even if functional analysis points to one party as less complex, practical issues may prevent using it as tested party:
You've identified the subsidiary as less complex, but its business is so specialized that no independent companies do exactly the same thing. Continuing to test this entity would violate the "most reliable comparables" requirement.
The less complex party's financial data for controlled transactions isn't separately available—perhaps it also sells to third parties and can't segment intercompany results.
Always document your attempts and the reasons for any change in approach.
While the arm's length principle is universal, jurisdictions have practical preferences. Note that practical enforceability and verification concerns often drive tax authority preferences, even where no formal rule exists.
No legal requirement to test the local German entity or use local comparables, but tax authorities prefer local comparables. German auditors often prefer German comparables; where not feasible, European comparables are commonly used. A comparable set with no local companies may face comparability challenges during audit.
India has substantial litigation on "foreign tested party" positions. Indian rules don't explicitly define "tested party," but Rule 10B mechanics have been interpreted differently across tribunals. The GE Money Financial Services case saw Indian authorities reject a foreign affiliate as tested party under a literal reading of the rules. However, case law is mixed—some tribunal decisions reject foreign tested parties as lacking statutory sanction, while other decisions have accepted them. The risk profile for using a foreign tested party in India is materially higher than in many OECD jurisdictions.
UK (HMRC) guidance on benchmarking focuses heavily on data quality and management of ranges (including when statistical tools like the IQR are appropriate, and how to choose an adjustment point if results are outside the arm's length range). HMRC guidance indicates that if the filed position is outside the arm's length range, the median is often the best adjustment point where comparability defects remain. This guidance relates to range management rather than tested party selection specifically.
No prohibition on testing a foreign entity as long as data quality is good. The IRS focuses on reliability of the result, not nationality of the tested party. similarly notes the tested party may be domestic or foreign, provided sufficient information exists to apply the method and allow review.
Once you've selected the tested party, document the rationale thoroughly as part of your transfer pricing documentation:
| Element | Content |
|---|---|
| Functional profiles of both parties | Comparative summary of functions, assets, and risks for each party |
| Statement of selection | Explicitly state which entity was selected and why, citing or local equivalent |
| Complexity assessment | Document specific factors showing one side is more complex (unique IP, strategic functions, entrepreneurial risks) |
| Intangibles ownership | Clarify who owns valuable intangibles; if tested party has none, state so explicitly |
| Data availability confirmation | Note that separate financials were available and that comparable companies were found |
| Why not the other party | Briefly address why the other party was not tested (e.g., "owns unique IP making comparables analysis unreliable") |
"ManufacturingCo was selected as the tested party because it performs routine contract manufacturing functions, does not own any product intangibles, and bears limited risk under its manufacturing agreement with ParentCo. ParentCo owns the product designs, patents, and brand, and bears entrepreneurial risk including market demand and product liability. This selection is consistent with , which directs that the tested party should be the entity to which a method can be applied most reliably. Independent contract manufacturers with similar profiles are readily available in commercial databases."
Choosing the more complex party (e.g., the IP owner) because it's the local entity or has easier data access. This produces unreliable results and is vulnerable to challenge.
Fix: Always ground selection in functional analysis, not convenience.
Failing to recognize that the tested party has some intangibles or significant risks, then treating it as fully routine. Tax authorities may catch this discrepancy.
Fix: Be thorough in functional analysis. If the tested party has any non-routine features, either adjust for them or explain why they're not material.
Picking a tested party solely because comparables are easier to find, even though it's not the less complex entity functionally.
Fix: Start with functional analysis. Data availability is important but secondary to the core principle.
Testing Party A in one year and Party B the next for the same transaction without explanation. This appears arbitrary or manipulative.
Fix: Maintain consistency unless facts genuinely changed. Document any changes thoroughly.
Simply stating "Company X is the tested party" without explaining why. This invites auditor challenge.
Fix: Always include a section explaining the selection with reference to functional analysis and regulatory guidance.
Benchmarking Guides:
Documentation Guides:
Glossary:
This article is based on guidance from the OECD Transfer Pricing Guidelines (2022):
→ Search the full OECD Guidelines
The tested party is the entity in a controlled transaction whose financial results (e.g., operating margin) are compared against independent benchmarks to determine arm's length pricing. Under one-sided methods like TNMM or CPM, you analyze the tested party's profitability and compare it to uncontrolled companies with similar functions and risks. The tested party is typically the less complex entity—the one without unique intangibles and with routine functions—because its activities are easier to match with independent comparables.
Start with functional analysis: identify the party with less complex functions, no unique intangibles, and limited risks. The OECD says to select the entity for which "the most reliable comparables can be found" (). US Treasury Regulations similarly specify choosing the party whose results "can be verified using the most reliable data." Practically, list both parties' functions, assets, and risks in a comparison table—the entity with more routine characteristics across all factors is your tested party. Also verify that comparables data and segmented financials are available for that entity.
In most cases, no. Testing an IP owner is discouraged because finding comparables for unique situations is extremely difficult—comparables would need to own similar unique IP, which creates comparability problems. US regulations state that "in most cases" the tested party will not own valuable intangible property (§1.482-5(b)(2)(i)), and illustrates why IP owners are usually not suitable tested parties. Instead, test the other party (e.g., the routine manufacturer or distributor), and the IP owner's return will be the residual after the tested party's arm's length return is established.
If both entities own unique intangibles or perform critical functions, one-sided methods (TNMM/CPM) may not be reliable. The OECD recommends using a profit split method in such cases (), which analyzes combined profits and allocates them based on each party's contributions. Alternatively, if one party is relatively less complex (say, 30% complex vs. 70%), you might still designate it as tested party with careful documentation—but acknowledge reduced reliability. The key is not to force a tested party approach when it doesn't fit the facts.
No—the tested party can be in any jurisdiction. The arm's length principle doesn't mandate testing the local entity, and explicitly discusses situations where the tested party may be domestic or foreign. However, practical considerations apply: some tax authorities prefer local tested parties because they can verify local data and use local comparables. Germany, for instance, prefers local comparables. India has mixed case law on foreign tested parties—some tribunals accept, others reject—creating materially higher risk than in many OECD jurisdictions. If you test a foreign entity, ensure you have robust comparables and be prepared to defend the choice thoroughly.
If the initially selected tested party yields no reliable comparables, reconsider your approach. Options include: (1) broaden the search geographically or by industry, (2) evaluate whether the other party can be tested instead (if it has a more common profile), or (3) consider an alternative method entirely (CUP, profit split). The transfer pricing process is iterative—if one route fails, document that you attempted it, explain why it was unworkable, and justify your alternative approach. Never proceed with a benchmarking study that has no valid comparables.
Include: (1) functional profiles of both parties showing functions, assets, and risks, (2) explicit statement of which entity was selected and why, citing or local rules, (3) explanation of why the tested party is less complex (routine functions, no unique IP, limited risks), (4) confirmation that comparables data is available, and (5) brief note on why the other party wasn't tested (e.g., "owns unique intangibles, making comparables unreliable"). This narrative, supported by your functional analysis, demonstrates a principled, defensible approach. Lack of documentation invites auditor challenge.
Yes, if the entity has multiple transaction types with genuinely different profiles. For example, a subsidiary that both distributes products (routine) and provides specialized consulting (potentially complex) might be the tested party for distribution but not for consulting. However, be cautious—switching tested parties between transactions involving the same company raises questions. Document thoroughly why the facts justify different treatment. If the same entity is consistently routine across all transactions, test it consistently.