The return on assets (ROA) is misused to determine the tested party’s operating profits in transfer pricing. ROA is unreliable because multiple (ill-defined) denominators are employed. Only the composite asset property, plant & equipment (PPENT) is consistent with well-received economic theory. If book (accounting) PPENT is the denominator (explanatory variable), ROA is still unreliable because of varied accumulated depreciation.
I wanna rock your soul. Van Morrison (1970), “Into the Mystic”
A legal strategy in transfer pricing is to dismember the controlled distributors or retailers of integral management or purchase functions to report reduced profit margins.
This legal fiction (no comparable third-party) is made more incongruous by booking a large fraction of the corporate group’s advertising expenses as the tax deductions of the stripped distributors or retailers.
Also, operating loss enterprises are selected as supposed comparables to the forced-invalid distributors.
Triple crown winners are rare.
Here, I test the effect of advertising on enterprise-level sales (revenue) and show that marketing intangible producing activities such as advertising expenses cannot coexist with the legal concept of limited function distributor or retailer.
Hereafter, my exegesis is focused on a group of large US retailers.
To grasp the legalese of my initial encounters with the 1968 US transfer pricing regulations (under section 482 published in the Federal Register (33 FR 5848), April 16, 1968), I translated the three specified transfer pricing methods (CUP, resale price and cost plus) into algebra and found a multiplier formula tying them together.
I created a two equation system including an accounting equation and a stochastic equation, and obtained the reduced-form equation to estimate the price (CUP) or the selected gross profit indicator. Using the same multiplier procedure, I developed the CPM/TNMM in 1989.
Le secret d’ennuyer est celui de tout dire. Voltaire (1694-1778)
The Berry ratio is vulnerable to the flexible accounting allocation of costs and expenses among the tested party and its comparables.
You better stop the things you do. Jay Hawkins (1929-2000), “I Put a Spell on You.”
US-listed retailers data show that a simple formula can be used to provide reliable estimates of a controlled retailer’s operating profits for transfer pricing purposes.
To enhance tax certainty, I recommend that US state tax authorities allow retailers to use the profit margin based on this formula as a transfer pricing safe harbor.
The regression method proposed here can be applied to any industry, including to provide safe harbors for inbound controlled wholesale distributors or to provide safe harbors for outbound controlled suppliers or for outbound controlled service providers.
Quem mostrá esse caminho longe? Sung by Cesária Évora (1941-2011).
Corporate profits should concern policymakers, including tax legislators and tax administrators.
In economic theory, high profits converge toward an entrepreneurial average because of the expected inter-industry flow of investments. According to Stigler’s (1963, p. 54) hyperbole: “There is no more important proposition in economic theory than that, under competition, the rate of return on investment tends toward equality in all industries.”
Again the restless orb (orphan, blind) his toil renews, and sweat descends in dews. Homer, Odyssey, Book 11, 740-741.
The capital asset pricing model (CAPM) is widely used to calculate the expected return of equity shares, considering their risk relative to a stock market portfolio. The CAPM is ill-suited to valuing assets that lack stock’s spot market price volatility. Thus, I argue that the CAPM should not be used to determine the arm’s length remuneration for the intra-group transfer of intangibles.
“We shall renounce . . . the subterfuges.”
Y si pretendes remover las ruinas que tú mismo hiciste ...
Cenizas sung by Toña La Negra. Bolero lyrics by Wello Rivas (1913-1990).
We suggested on prior blogs that operating assets (measured by property, plant & equipment) are endogenous and that structural equation estimates of return on assets produce biased coefficients. Here, we provide another alternative from biased estimates of return on assets than using exotic algorithms like two-stage least squares.
Models should have mathematical beauty (they must be parsimonious).
Paraphrasing Paul Dirac (1955), Physical laws should have mathematical beauty, quoted in Abraham País, Maurice Jacob, David Olive, Michael Atiyah, Paul Dirac (The Man and his Work), Cambridge University Press, 1998, p. 46.
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