Transfer pricing audit of a controlled corporate reorganization ("reorg") has two phases. First, a corporate reorg between related parties must pass an economic substance test. Second, after economic substance is ascertained, the controlled transactions resulting from the reorg must pass an arm’s length test based on comparable uncontrolled transactions. This arm's length test can be measured per transaction or in aggregate. In a prior post, we provided a test to determine if a controlled corporate reorganization shows economic substance. Here, we further illustrate economic substance.
The left hand chart shows that a controlled corporate reorganization has economic substance if it leads to lower average costs, or (which is equivalent) to a higher profit indicator. The chart on the right shows the inverse relationship between the markup (profit indicator) and average costs, according to a postulate that average price is proportional to average costs:
(1) P = M C, where M ≥ 1 is the markup factor and C > 0 is average costs;
(2) M = 1/c, where c = (C/P).
Reciprocal equation (2) means that as long as the average price of the relevant goods and services remains constant after the reorg (P1 = P2), a decrease in average costs implies a non-linear increase in the markup over costs. This shows that a controlled corporate reorganization has economic substance only if it leads to decreased average costs, i.e., a controlled corporate reorganization must lead to a higher profit indicator; otherwise, the reorg shifting business functions and risks to a different geographic location lacks economic substance, and is thus subject to disallowance by the tax administration. An arm's length test is performed only if the controlled reorg passes the economic substance test by showing an increase in the selected profit indicator after the reorg is made.
Below we provide two examples of a controlled reorg with and without economic substance. The top panel shows a reorg with economic substance measured in two equivalent ways: c1 > c2 ↔ M2 > M1. The bottom panels shows a reorg without economic substance in which the reorg resulted in increased costs of the entity shifting or exporting the functions and risks and the consequent decrease in its profit markup.
Ednaldo Silva (Ph.D.) is founder and managing director of RoyaltyStat. He helped draft the US transfer pricing regulations and developed the comparable profits method called TNNM by the OECD. He can be contacted at: esilva@royaltystat.com
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