RoyaltyStat Blog

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.

Unlike the debutant affection of the OECD, we discourage using projected profits or cash flows to measure hard-to-value-intangibles (HTVI) for transfer pricing purposes because this method is speculative and based on several impeachable assumptions.

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

An autoregressive (AR) model can produce more reliable measures of comparable company profit ratios (operating margin or profit rate) 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 a fixed-point equilibrium and variance of an AR(1) model allowing the computation of a comparable profit ratio interval to benchmark related party transfers of goods and services. This AR(1) model can be used also to benchmark routine functions (manufacturing, distribution, retail) under the residual profit split method.

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.

The claim that it is impossible to find comparable royalty rates and that from the start we should use the residual profit split method for high-value intangibles needs revisiting. This claim is made prima facie without regard for the license agreements available in curated databases such as RoyaltyStat, which as of today contains over 17,875 unique and unredacted license agreements. Also, adopting the residual profit split method, when separate tested party methods such as the TNMM could suffice, creates unwarranted costs and audit management challenges for both the taxpayer and the tax administration.

We can consider a first-order autoregressive (AR(1)) model to determine an arm’s length profit margin of a “tested party” subject to transfer pricing audit compliance: