RoyaltyStat Blog

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.

Después de tanto soportar la pena de sentir tu olvido.

Cenizas sung by Toña La Negra. Bolero lyrics by Wello Rivas (1913-1990).

Major U.S. retailers (considered to be comparables to an inbound “tested party”) are claimed to have operating profit margins that vary from 0.5% to 1.5% of their net sales. This interquartile range (IQR) varying from 0.5% to 1.5% does not reflect the reported operating profit margins of the purported comparables, but instead is obtained by unreliable asset intensity adjustments. Unreliable because the proposed asset adjustments are not supported by economic principles, and the statistical significance of the relevant parameters is not ascertained.

"Come to places where opponents give no thought." Sun Tzu, The Art of War, Alfred Knopf (Everyman’s Library), 2018, p. 62.

Applying the comparable profits method (CPM) in the U.S. or the “transactional” net margin method (TNMM) in other OECD countries, many transfer pricing analysts assume that the depreciation rate of property, plant, and equipment is the same among the individual comparables and the tested party.

L’un fece il mundo e l’altro l’ha distrutto.

(Unattributed quote in Meditaciones del Quijote (1914), by José Ortega y Gasset)

Here, we discuss transfer pricing methods based on operating profits (“net profit indicators”) under the U.S. comparable profits method (CPM) and the OECD “transactional” net margin method (TNMM). Gross and operating profit indicators express aggregated company accounts; thus, the OECD “transactional” modifier to the “net profit method” is an affectation.

The CPM (which we created while working at IRS) was divulged in the U.S. 1994 transfer pricing regulations under Treas. Reg. § 1.482-5. The TNMM was released one year after in the 1995 OECD transfer pricing guidelines (TPG). See OECD 2017 TPG, ¶ 2.62 et. seg.

The “return on assets” is an unsatisfactory profit level indicator (PLI) for the “transactional” net margin and comparable profits methods in transfer pricing because (among other major defects) self-developed intangibles are excluded from the assets base denominator. Assets are also composed of heterogeneous balance sheet accounts with different depreciation rates.

Operating assets are “solid, massy, hard” and cannot be moved from one company to another within the same industry (horizontal market consolidation) or across companies in different industries (vertical market consolidation), without a time-consuming assets purchase agreement. Moreover, if the intra-company assets transfers are large, anti-trust regulatory impediments may occur.

The idea that “return on assets” is a superior PLI because of its fluent or gravitation properties is not consistent with reality. This dubious return on assets sobriquet is posited as a matter of faith because to our knowledge economics is devoid of rigorous demonstrations of the conditions required for such gravitation to occur in actual industries dominated by oligopoly groups.