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Borys Ulanenko
CEO of ArmsLength AI
![Working Capital Adjustments in Transfer Pricing: Complete Guide [2025]](/_next/image?url=%2Fimages%2Fblog%2Fworking-capital-adjustments-guide%2Fworking-capital-adjustments-guide.png&w=3840&q=75)
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Working capital adjustments account for differences in trade receivables, inventory, and payables between your tested party and comparables. The standard formula:
Adjustment = (WC Intensity[Tested Party] − WC Intensity[Comparable]) × Interest Rate
Then: Adjusted PLI = Unadjusted PLI + Adjustment
Apply this to each comparable before calculating your interquartile range. But before you adjust anything, ask: does this adjustment actually improve comparability? are explicit—WCA should not be performed routinely or mandatorily.
For transfer pricing purposes, working capital means trade working capital—the operational capital tied up in day-to-day business activities:
Working Capital = Trade Receivables + Inventory − Trade Payables
| Component | What It Represents |
|---|---|
| Trade Receivables | Money owed by customers (cash tied up waiting for payment) |
| Inventory | Value of goods held for sale or production (cash tied up in stock) |
| Trade Payables | Money owed to suppliers (effectively supplier financing) |
Exclude: Cash, short-term investments, loans, tax receivables/payables, and provisions. Unless consistently available and justified, stick to trade-related items only.
Working capital differences affect profitability because of the time value of money. A company that offers 90-day payment terms to customers (high receivables) has more capital tied up than one offering 30-day terms—and that capital has a financing cost.
The Economic Logic:
Consider two identical distributors with the same operations, but:
Distributor A has more capital tied up in receivables. In a competitive market, it should charge higher prices to compensate for the financing cost—resulting in higher margins. Without adjustment, Distributor A would appear "more profitable" even though the underlying business is identical.
WCA neutralizes these differences by converting working capital variations into margin-equivalent adjustments.
Working capital intensity expresses WC as a percentage of sales (or costs, depending on your PLI):
Sales-Based (for Operating Margin): WC Intensity = (AR + Inventory − AP) ÷ Revenue
Cost-Based (for Net Cost Plus): WC Intensity = (AR + Inventory − AP) ÷ Total Costs
Match the base to your PLI denominator. If you're using Operating Margin (profit ÷ sales), use sales-based intensity. If using Net Cost Plus (profit ÷ costs), use cost-based intensity.
Adjustment = (WC Intensity[Tested Party] − WC Intensity[Comparable]) × Interest Rate
Direction Logic:
The adjustment "moves" the comparable toward the tested party's working capital position.
Adjusted PLI = Unadjusted PLI + Adjustment
Apply this to every comparable in your set, then calculate your IQR using the adjusted PLIs.
Many practitioners find it intuitive to work in "days" rather than percentages:
WC Intensity = (AR Days + Inventory Days − AP Days) ÷ 365
Where:
This directly shows your cash conversion cycle—more intuitive for explaining to stakeholders.
The OECD Annex to Chapter III indicates that "in most cases a commercial loan rate will be appropriate."
The key principle: use a short-term rate consistent with the nature of working capital financing (typically < 1 year).
| Framework | Description | Best For |
|---|---|---|
| A: Tested Party Borrowing Cost | Use the tested party's actual short-term borrowing rate (revolving facility, overdraft) | When rate is well-evidenced and not distorted by group support |
| B: Risk-Free Proxy | Use government bond or interbank short-term reference | Cross-company consistency; simpler to document |
| C: Hybrid | Short-term benchmark plus modest credit spread | Balances neutrality with economic reality |
| Currency | Typical Benchmark | 2024 Range |
|---|---|---|
| USD | 1-year US Treasury | 4.0–5.0% |
| EUR | 1-year German Bund | 2.5–3.5% |
| GBP | 1-year UK Gilt | 4.0–5.0% |
| INR | 1-year G-Sec | 6.5–7.5% |
The 2022–2024 interest rate increases have materially changed WCA calculations. With short-term rates rising from near-zero to 4–5% in major currencies, the same working capital difference now produces adjustments 4–5× larger than during the low-rate environment.
Practical Implications:
| Impact | Low-Rate Era (2020-2021) | Current Environment (2024-2025) |
|---|---|---|
| 10% WC intensity difference | ~0.1% PLI adjustment | ~0.4–0.5% PLI adjustment |
| Materiality threshold | More WCAs were immaterial | More WCAs now exceed materiality |
| Audit scrutiny | WCA often overlooked | Tax authorities more likely to challenge rate selection |
| Documentation burden | Light touch acceptable | Rate justification increasingly important |
What This Means for Practitioners:
Multi-Currency: Match the rate to the currency that drives WC financing (usually the tested party's functional currency). If comparables operate in different currencies, consider normalizing to a single benchmark—and document your reasoning.
OECD Position:
"Selecting the point in time for comparing balance sheet items is crucial. Year-end figures may not be representative if working capital levels are seasonal."
| Situation | Recommended Approach |
|---|---|
| Non-seasonal business | Year-end balances acceptable |
| Seasonal business | Average of opening + closing balances |
| Highly seasonal | Quarterly averages (if data available) |
| Comparables with incomplete data | Use whatever is consistently available |
Average Balance Formula: Average WC = (Opening WC + Closing WC) ÷ 2
If year-end balances don't represent typical WC and averages aren't available, consider not making WCA and document why.
warn that "a significantly different level of relative working capital between the controlled and uncontrolled parties may result in further investigation of the comparability characteristics of the potential comparable." Sometimes large WC differences mean you have a bad comparable, not something to "fix" with math.
| Situation | Why Avoid |
|---|---|
| Data Unreliable | Comparable doesn't disclose AR/AP/Inventory separately |
| Business Model Mismatch | Tested party has fundamentally different WC profile |
| Immaterial Impact | Adjustment < 0.25% of PLI |
| Seasonality + Year-End Only | Year-end balances don't reflect average WC |
| "Fixing" Poor Comparables | Large WCA indicates deeper non-comparability |
Scenario: Comparable has negative WC (AP > AR + Inventory)—common in retailers with strong supplier financing (the "Walmart model").
Options:
| Approach | When Appropriate |
|---|---|
| Include in analysis | If tested party also has negative WC or similar business model |
| Investigate cause | Always assess if negative WC reflects business model vs. anomaly |
| Exclude comparable | If negative WC indicates structural non-comparability |
If only the comparable has negative WC (tested party positive), this is a red flag for comparability—investigate the business model difference before deciding.
Scenario: EU distributor benchmarked against 5 comparables
Tested Party:
Interest Rate: 4%
| Comparable | EBIT Margin | AR Days | INV Days | AP Days | WC Intensity | Adjustment | Adj. Margin |
|---|---|---|---|---|---|---|---|
| C1 | 2.50% | 45 | 25 | 60 | 2.74% | +0.38% | 2.88% |
| C2 | 3.20% | 70 | 20 | 40 | 13.70% | −0.05% | 3.15% |
| C3 | 4.10% | 55 | 35 | 30 | 16.44% | −0.16% | 3.94% |
| C4 | 5.00% | 30 | 15 | 50 | −1.37% | +0.55% | 5.55% |
| C5 | 6.00% | 80 | 40 | 20 | 27.40% | −0.60% | 5.40% |
IQR Impact:
| Metric | Unadjusted | Adjusted |
|---|---|---|
| Q1 (25th) | 3.20% | 3.15% |
| Median | 4.10% | 3.94% |
| Q3 (75th) | 5.00% | 5.40% |
Interpretation: C1 and C4 carry significantly less working capital than the tested party—their PLIs are adjusted upward. C5 carries much more—adjusted downward.
Scenario: Contract manufacturer tested with NCP (Net Cost Plus)
Tested Party:
Interest Rate: 5%
| Comparable | NCP | WC Intensity | Adjustment | Adj. NCP |
|---|---|---|---|---|
| M1 | 6.00% | 8.00% | +0.25% | 6.25% |
| M2 | 7.00% | 12.50% | +0.03% | 7.03% |
| M3 | 9.00% | 2.22% | +0.54% | 9.54% |
| M4 | 10.00% | 5.45% | +0.38% | 10.38% |
Note: When using NCP as your PLI, calculate WC intensity using costs (not sales) as the denominator to maintain consistency.
Scenario: Service provider with minimal WC differences
Calculation:
Conclusion: A 0.015% adjustment on a 3–5% margin context is immaterial—less than 0.5% relative to PLI. Document immateriality and proceed without WCA.
| Column | Description |
|---|---|
| B | Revenue / Sales |
| C | Trade Receivables |
| D | Inventory |
| E | Trade Payables |
| F | Operating Profit |
Key Cells:
$K$2 = Tested Party WC Intensity (as decimal, e.g., 0.1233)$K$3 = Interest Rate (as decimal, e.g., 0.04)Working Capital:
WC Intensity (Sales-Based):
Adjustment Factor:
Adjusted PLI (Operating Margin):
AR Days:
Inventory Days:
AP Days:
Net WC Days:
After applying WCA to all comparables:
Q1 (25th Percentile):
Median:
Q3 (75th Percentile):
| Jurisdiction | Stance | Key Points |
|---|---|---|
| OECD | Allowed if it increases reliability | Explicit: "performed on a routine or mandatory basis" () |
| US (IRS) | Accepted, common under CPM | Emphasis on rate appropriate for short-term debt |
| UK (HMRC) | Accepted | No specific WCA formula; follows OECD principles |
| Germany | Generally accepted | BMF follows OECD; no dedicated formula |
| India | Frequently disputed | Heavy case law; TPOs challenge methodology, rates, negative WC |
| Australia | Accepted | Follows OECD; emphasis on comparability (ATO TR 97/20) |
| China | Restrictive | SAT Notice 6 limits WCA; document carefully |
China Alert: Practitioner alerts consistently flag China as more restrictive on WCA than "pure OECD" practice. If applying WCA for Chinese entities, document carefully and consult local guidance.
The Mistake: Mechanically applying WCA to every benchmarking study because "that's what we always do."
Why It's Wrong: explicitly states WCA should not be routine or mandatory. Automatic application suggests you're not actually assessing whether the adjustment improves reliability.
Fix: Document why WCA is appropriate for each specific analysis. If differences are immaterial or data quality is poor, state that no WCA was applied and why.
The Mistake: Applying the tested party's long-term borrowing rate, group treasury rate, or a rate from the wrong currency.
Why It's Wrong: Working capital is short-term by nature (< 1 year). Long-term rates, group rates, or mismatched currencies distort the adjustment.
Fix: Use a short-term rate (1-year or less) in the tested party's functional currency. Document your source and rationale.
The Mistake: Using year-end balances for some comparables and averages for others, or mixing IFRS and local GAAP without adjustment.
Why It's Wrong: Comparability requires consistency. Mixed treatment introduces noise that may exceed the differences you're trying to correct.
Fix: Apply the same data treatment to all comparables. If data quality varies, consider excluding comparables with unreliable or inconsistent data.
The Mistake: Mechanically adjusting a comparable with negative WC (AP > AR + Inventory) without investigating the cause.
Why It's Wrong: Negative WC often signals a different business model (retailer with supplier financing, prepaid services). This may indicate structural non-comparability, not a timing difference to adjust away.
Fix: Investigate why WC is negative before adjusting. If the tested party has positive WC and the comparable has negative, question whether it's truly comparable.
The Mistake: Calculating and applying adjustments of 0.02% because "the methodology requires it."
Why It's Wrong: Immaterial adjustments add complexity without improving reliability. They also create audit exposure—you're inviting questions about methodology for no practical benefit.
Fix: Establish a materiality threshold (e.g., 0.1–0.25% of PLI). If the adjustment falls below this, document immateriality and proceed without WCA.
The Mistake: Using estimated or imputed balance sheet figures when comparables don't disclose AR/AP/Inventory separately.
Why It's Wrong: An adjustment based on unreliable data may introduce more error than it corrects. The OECD requires adjustments to be "reasonably accurate" to improve comparability.
Fix: Only apply WCA when you have reliable, verified data. If key components are missing or estimated, document the limitation and consider not adjusting.
The Mistake: Adjusting individual comparable PLIs but then using the unadjusted IQR for the arm's length range.
Why It's Wrong: The entire point of WCA is to improve the benchmark. Using unadjusted ranges after adjusting PLIs defeats the purpose.
Fix: Always recalculate Q1, Median, and Q3 using the adjusted PLIs. Make this step explicit in your documentation.
Tax authorities increasingly scrutinize WCA methodology, especially as higher interest rates make adjustments more material. Your documentation should address:
| Documentation Element | What to Include |
|---|---|
| Rationale for WCA | Why adjustment improves comparability (not just "it's standard practice") |
| Data sources | Where AR/AP/Inventory figures come from (database, filings, notes to accounts) |
| Interest rate selection | Source, date, and rationale for rate used |
| Calculation workpapers | Step-by-step calculation for each comparable |
| Materiality assessment | Quantified impact on IQR; why adjustment is (or isn't) material |
| Consistency statement | Confirmation that same methodology applied to all comparables |
The most common audit challenge targets interest rate selection. Prepare for these questions:
Q: "Why did you use a government bond rate instead of the tested party's actual borrowing rate?"
A: Government bond rates are more consistently available across comparables and avoid introducing credit risk differentials. Using the tested party's actual rate would require knowing each comparable's borrowing rate—data that's rarely disclosed.
Q: "Why a 1-year rate instead of 3-month?"
A: Working capital cycles typically align with annual business cycles. One-year rates better reflect the average holding period of receivables and inventory across the fiscal year. The choice is consistent with OECD Annex to Chapter III guidance.
Q: "The rate you used differs from prior years. Why?"
A: Interest rates have materially changed from [X%] to [Y%] between [Year A] and [Year B]. Using current rates reflects the actual financing cost in the period under review. Consistency in methodology (short-term government rate) is maintained—the rate change reflects market conditions, not methodology change.
| Authority Argument | Suggested Response |
|---|---|
| "WCA is not required by law" | Correct, but support comparability adjustments when they improve reliability. We've documented why adjustment is appropriate here. |
| "Your rate is too high/low" | [Provide source documentation]. The rate reflects [specific benchmark] as of [date], consistent with the tested period. |
| "Comparables with extreme WC should be excluded, not adjusted" | We assessed each comparable's WC profile. Extreme differences that suggest business model mismatch led to rejection. Remaining comparables had WC differences attributable to timing, not structure. |
| "Negative WC adjustment is inappropriate" | We investigated the cause of negative WC. For [Comparable X], it reflects [specific business reason] similar to the tested party's model. The adjustment normalizes for timing, not business model. |
Before finalizing your WCA documentation, verify:
Guides:
Glossary:
This article is based on guidance from the OECD Transfer Pricing Guidelines (2022):
→ Search the full OECD Guidelines
Use average balances where feasible—year-end can distort results, especially for seasonal businesses. If only year-end is available, document why it's still representative of typical operations. The key is consistency: use the same approach for the tested party and all comparables.
Use a short-term rate reflecting the financing value of working capital. The OECD Annex to Chapter III indicates "in most cases a commercial loan rate will be appropriate." Common practice: 1-year government bond yield in the tested party's functional currency. Be consistent and document your choice.
No. The OECD explicitly states WCA should not be "routine or mandatory" (). Apply only when it demonstrably improves comparability and the adjustment is material. Some jurisdictions are more restrictive (China) while others have extensive litigation (India).
Most implementations adjust comparables to the tested party. This keeps the tested party's actual results unchanged and adjusts the benchmark range to reflect the tested party's operating conditions. Be consistent across your entire comparable set.
Mechanically, negative values flow through the same formulas—the adjustment simply reverses direction. Substantively, assess whether negative WC reflects a business model (strong supplier financing, as in retail) vs. an anomaly. If only the comparable has negative WC while the tested party is positive, investigate whether it's truly comparable.
Options: (1) Remove those comparables from the WCA analysis, (2) Use a database with standardized balance sheet fields, (3) Limit to jurisdiction/size bands with better disclosure, or (4) Document inability to compute WCA and proceed without. Don't estimate what you can't verify.
Before. Adjust each comparable's PLI individually, then compute the IQR using adjusted PLIs. The adjusted figures form the basis for your arm's length range.
For pure service providers, inventory drops out: WC = AR − AP. The adjustment typically becomes smaller due to lower WC intensity. Check if differences are still material—if not, WCA may be unnecessary and not worth the documentation burden.