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.
In a previous blog post we reviewed a suggestion published in TaxNotes International to downplay the role of the Comparable Uncontrolled Transaction (CUT or CUP) approach. We also noted that in one of the litigation examples brought to illustrate pervasive issues with the CUT approach, the application of the method was not the primary point of controversy:
A recent TaxNotes piece called for a substantial rewrite of Section 1.482-4, which addresses the transfer of intangible assets. The author, Ryan Finley, suggests that the Comparable Uncontrolled Transaction (CUT/CUP) approach should be relegated to a much more limited role. While many of the his assessments are fair, we would urge caution before relegating CUT too far to the backbench. There are certainly situations where CUT approaches are not only useful, but necessary as part of a larger framework to capture the issues and facts of the specific intercompany issue, examples of which we note later on.
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.”