RoyaltyStat Blog

Using a distributed lag model to determine arm’s length profits in transfer pricing

Posted by Ednaldo Silva on Feb 11, 2018 6:24:46 PM

Most empirical research in transfer pricing lack valid economic principles, relying instead on ad hoc specification. This faulty practice is somewhat permitted by misconceived transfer pricing regulations based on the OECD model.

US and OECD method for computing arm’s length profit margin is flawed

Posted by Ednaldo Silva on Dec 20, 2017 2:41:57 PM

We analyzed the statistical relation between operating profits and net sales for a large group of US listed companies using RoyaltyStat’s online database of company financials. The results of this study have led us to conclude that the OECD and US transfer pricing guidance on the comparable profits method (TNMM) does not produce the most reliable measure of an arm’s length operating profit margin and that other more informed measures should be considered. Instead of simple regulatory prescription, we apply economics and statistics to reach these conclusions.

Surplus Bargaining and the Effect of Contract Redaction on Royalties

Posted by Alan Kwan & Gaurav Kankanhalli on Dec 9, 2017 10:43:30 AM

We find little empirical work in academia about the determinants of royalty rates covering intellectual property (IP) licensing transactions. Beyond the exchange of intellectual property itself, licensing transactions play an important role to market practitioners. Market practitioners benchmark their own pricing terms based on prior royalty rates transactions. Royalty rates are also important for those analyzing IP for transfer pricing and patent litigation, where comparable transactions are recognized by tax authorities and courts as benchmarks of value.

OECD Inventory Adjustment to Profits is Spurious

Posted by Ednaldo Silva on Nov 11, 2017 3:37:05 PM

In transfer pricing, a frequent “comparability adjustment” to (gross or operating) profits involving inventories is spurious. The OECD is wrong disseminating misconceived guidance about “working capital” adjustment that includes inventories. The inventory adjustment to profits is bogus because inventory is included in cost of goods sold (COGS); thus, the same inventory variable appears on both sides of the adjustment equation, making the proposed adjustment false. Follow at your peril: OECD, Comparability Adjustments (July 2010), ¶¶ 16-17: http://www.oecd.org/tax/transfer-pricing/45765353.pdf 

The IRS has published similar argy-bargy: https://www.irs.gov/pub/irs-apa/study_guide_exhibit_d.pdf

Adjusted COGS is a Proxy for Purchases

Posted by Ednaldo Silva on Oct 30, 2017 5:40:59 PM

Adjusting cost of goods sold (COGS) to remove the effect of one-year changes in inventory is important before determining the arm’s length gross profits resulting from crossborder related-party purchases of goods and services. Adjusted COGS produce also a more reliable measure of the operating profits of the tested party (audited taxpayer) and the selected comparable companies.

Hard-to-Value Intangibles?

Posted by Ednaldo Silva on Jun 26, 2017 7:38:26 PM

Unlike the debutant affection of the OECD, we discourage using projected cash flows for hard to value intangibles (HTVI) calculations because this method is speculative and based on numerous impeachable assumptions.

Value of Intangibles Based on Historical Payroll

Posted by Ednaldo Silva on Apr 21, 2017 10:42:59 AM

We can utilize payroll and determine the value of intangibles. In David Ricardo (1772-1823), Principles of Political Economy, Cambridge University Press, 1951 [1817], the price of a commodity produced in period t is determined by a profit markup equation:

     (1)     Pt = (1 + r) w Lt

Arm’s Length Profit Margin

Posted by Ednaldo Silva on Apr 20, 2017 3:19:07 PM

We estimated the equilibrium OMAD [operating (profit) margin after depreciation] of certain U.S. retailers using an autoregressive (AR(1)) model built-in RoyaltyStat. RoyaltyStat uses the Gauss run-time engine, so the regression estimates are reliable.

Equilibrium Arm’s Length Profit Ratios

Posted by Ednaldo Silva on Mar 31, 2017 5:53:43 PM

In several blogs, we postulated that an autoregressive (AR) model can produce more reliable measures of comparable company profit ratios (operating margin over revenue or profit rate over assets) than the naive profit model prescribed by the OECD transfer pricing guidelines. We prefer to work with profit margins because they are pure numbers, unlike profit rates over assets of different vintages. Here, we show the fixed-point equilibrium and the variance of an AR(1) model allowing the computation of a comparable profit ratio interval to benchmark related party transfers of goods and services.

Company Profits in Transfer Pricing

Posted by Ednaldo Silva on Mar 24, 2017 5:09:38 PM

It's useful to model company profits using a first-order autoregressive AR(1) process. However, “duality” (invertibility) between an AR(1) model and a weighted sum of random errors tempers theoretical or long-term ambitions. Duality is a metamorphosis from one dynamic process to another such that an AR(1) model can be converted into a moving average of random errors model. Moving average models lack X-factors explanation.