RoyaltyStat Blog

When we started (1988) in transfer pricing from academia, the IRS dominant paradigm was forcing single point estimates of gross profits indicators in audit, including gross profit margin for controlled inbound distributors, and gross profit markup for controlled outbound manufacturers and service providers. The Berry ratio (gross profits/XSGA), which was introduced by Charles Berry in Du Pont, was an unspecified “fourth” method. When we started, IRS transfer pricing economics was not bachelor's degree level, and we suspect that it has not advanced to Masters degree. See United States Court of Claims. E. I. Du Pont de Nemours and Company v. The United States, Nos. 256-66 & 371-66, April 18, 1978. (Cite as: 1978 WL 3449 (Ct. Cl. Trial Div.)). 

The OECD, UN, and United States transfer pricing rules recognize that tax administrations and controlled MNE (multinational enterprise) groups must consider location savings adjustments when uncontrolled comparable enterprises operate in different geographical markets from the tested party. Location savings adjustments are needed when we can measure (in different geographic markets; e.g., UK versus Nigeria or South Africa or US versus Brazil or Mexico) significant differences in wage shares and adopted technology measured by incremental capital/output ratios.

A practice in transfer pricing is to select a “net profit indicator” (such as operating profit margin or return on assets) and calculate quartiles among i = 1, 2, …, N selected enterprise-level comparables. This practice produces unreliable profit indicators that can’t survive audit scrutiny. A major fallacy of this practice is to estimate structural equations when reduced-forms should be estimated. In this blog, we discuss and solve this fallacy.

We discuss three contending transfer pricing models. Let P = “Net” profits, S = Sales, and A = Assets: For simplicity, we don’t consider profit markup on total costs, and exclude random errors:

In DuPont’s profit identity, “return on assets” (profit rate) is equal to profit margin multiplied by asset turnover. Using DuPont’s profit formula, combined with an assumption that profit margin and asset turnover (measures of economic performance and adopted technology) are independent, we showed on a prior blog that the coefficient of variation of return on assets is greater than of the profit margin. It follows that profit margin is more reliable (has a lower coefficient of variation) than return on assets. In science, coefficient of variation is an accepted method of determining the reliability of a selected variable.

Transfer pricing tax compliance is devoid of external CUP (comparable uncontrolled prices). Therefore, we must select (under the TNMM and under the Profit Split Method) the most appropriate “net” profit indicator (NPI) from comparable uncontrolled enterprises. Most appropriate is the most reliable among competing profit indicators. In economics and statistics, reliability is measured by the coefficient of variation (standard deviation / mean) of the selected variable.

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.

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.

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

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.