RoyaltyStat Blog

The CAPM is Misapplied in Transfer Pricing

Posted by Ednaldo Silva

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, we argue that the CAPM should not be used to determine the arm’s length remuneration for the intra-group transfer of intangibles.

The CAPM is postulated in a simple linear fashion:

     (1)     R = μ + β (M – μ)

where R denotes the one-period return of the selected company stock and M denotes the one-period return of the reference (benchmark) stock market index, such as the Standard & Poor’s 500 Index. The intercept μ denotes a country specific default risk-free sovereign interest rate, and the slope β is regarded as an equity risk-coefficient.

The (“capital gain”) stock price return R = LN(P/P(−1)), where P is the selected company stock price; and the market index return M is defined in similar logarithm calculation.

Controversy Aside, IKEA on Solid Economic Footing in Royalty Dispute

Posted by Harold McClure

European affiliates of multinationals such as IKEA face scrutiny from a variety of agencies including the European Union (EU), which issued EU Council Directive 2011/16 also known as DAC6. The stated purpose of DAC6, which became effective on June 25, 2018, is to provide transparency and fairness in taxation. DAC6 applies to cross-border tax arrangements between EU affiliates and tax havens. One of these cross-border tax arrangements is intercompany royalty payments from EU affiliates to affiliate in tax havens such as Liechtenstein. Such intercompany payments by European affiliates of IKEA are being challenged by the European Commission in a State Aid inquiry, which was initiated on December 18, 2017, according to an EC press release:

Creating Defensible Transfer Pricing Reports

Posted by Ednaldo Silva

“We shall renounce . . . the subterfuges.”

Translating Credit Ratings into Credit Spreads in Intercompany Financing

Posted by Harold McClure

The Organization for Economic Cooperation and Development (OECD) released its Transfer Pricing Guidance on Financial Transactions on February 11, 2020 just before the COVID-19 crisis mushroomed. Some commentators have noted that U.S. affiliates may have to rely on intercompany financing from their foreign parents just as tax authorities and multinationals are reviewing what this new guidance implies in terms of the pricing of intercompany loans.

Return on Assets When Assets are Exogenous

Posted by Ednaldo Silva

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.

The Standard Measure of Return on Assets is Biased

Posted by Ednaldo Silva

Economic models must 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.

Safe Harbors for U.S. Retailers

Posted by Ednaldo Silva

Después de tanto soportar la pena de sentir tu olvido … y si pretendes remover las ruinas que tú mismo hiciste

Cenizas in the poignant voice of Toña La Negra. Classic bolero lyrics by Wello Rivas (1913-1990).

Transfer Prices Based on EBITDA, not EBIT

Posted by Ednaldo Silva

In 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.

Transfer Pricing Methods Based on Operating Profits

Posted by Ednaldo Silva

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

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

The “Return on Assets” Excludes Self-Developed Intangibles

Posted by Ednaldo Silva

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.