Determining an arm’s length profit indicator (aka profit ratio) requires two equations, and not one equation, as prescribed in financial statement analysis textbooks. E.g., Bernstein (1993), Drake & Fabozzi (2012). An accounting critique of univariate profit ratios is found in Whittington (1986).
U.S. transfer pricing regulations about the “rate of return on capital employed” (ROA) are misconceived because they rely on untested assumptions. For example, 26 CFR 1.482-5(b)(4)(ii), states:
Asset intensity adjustments to operating profits, which I reviewed performing audit assistance, lack economic or statistical merit and are inconsistent with guidance provided in the transfer pricing regulations.
The company-level operating profit markup can be estimated as a power function or a linear function between Net Sales (SALE) and Total Cost = XOPR = COGS + XSGA. The difference between Net Sales and Total Cost (measured by XOPR) is OIBDP (operating income [profit] before depreciation and amortization, or EBITDA). Some analysts include DP (depreciation and amortization) in total cost; however, DP is subject to substantial accounting discretion (such as including acquisition related impairment charges), which can prejudice cross-section comparisons.
As a transfer pricing practitioner with many years' experience across many industries and transactions, I’ve heard many reasons for making working capital adjustments (WCA). I’ve seen it described as ‘standard’ or ‘automatic’, as well as ‘unreliable’ and ‘rarely to be performed’. I’ve also heard some describe it as an adjustment they ‘believe in’, or an economic factor that an arm’s length party would ‘always’ take into account in their pricing. To untangle this knot, I’ve set out below some of the issues that I would consider before undertaking a WCA.
The OECD Transfer Pricing Guidelines (2017, ¶ 6.192) makes a perfunctory reference to multi-year data analysis covering intangibles. The guidance about using multi-year analysis of profit indicators is described on ¶ 3.75 to ¶ 3.79 (“examining multiple year data is often useful in a comparability analysis, but it is not a systematic requirement.”). One expects more competence in economics and statistical principles from the OECD Guidelines, instead of the misleading quote. Unsystematic requirement is nonsense.
Here, I show that the return on operating assets (ROA) can be specified as the return on investment (ROI).
Economic time series may have one-period autoregressive errors (AR(1)).
Before Newey-West, the Cochrane-Orcutt or the Prais-Winsten AR(1) error correction was pervasive in applied research. Estimating time-dependent economic variables, such as the individual company’s (tested party and comparables) return on operating assets, without the AR(1) error correction will result in inefficient parameter estimates, and the standard errors will be inconsistent. Hence, the unaware reader can begrime the arm’s length range of comparable return on operating assets.
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.
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