RoyaltyStat Blog

Transfer Pricing Profit Indicators Using All Available Data

Posted by Ednaldo Silva

Consider two aspects of statistical reliability principles. First, reliability can be measured by the ratio of the selected parameter estimate divided by its standard error.  We want this reliability ratio to be as high as possible. Second, reliability depends on sample size such that larger samples produce more reliable estimates.

Transfer pricing rules recognize that statistical estimates of the selected profit indicator must consider multiple-year analysis to achieve a reliable measure of arm’s length taxable income. See OECD (2017), ¶¶ 3.75-3.79 and US Treas. Reg. § 1.482-1(f)(2)(iii).

The Profit Margin of US Retailers in Transfer Pricing

Posted by Ednaldo Silva

Segue a reliable method to determine the arm's length profit margin of each selected comparable company to benchmark the tested party. For each selected comparable company, we measure Total Costs (Lato) = COGS + XSGA + (DP – AM). In Standard & Poor's Global (Compustat) mnemonics, COGS is cost of goods sold, XSGA is operating expenses, DP is the depreciation of property, plant & equipment (PPENT), including AM that is the amortization of acquired intangibles. Denote C as Total Costs (Lato) and S as Net Sales, which for each selected company is the sum of the unit price of the individual goods and services offered by the enterprise during the fiscal year multiplied by the respective quantity supplied:

     (1)     S(t) = C(t) + P(t)

for t = 1 to T fiscal periods.

The Profit Markup Model in Transfer Pricing

Posted by Ednaldo Silva

We have well-specified “return on assets” showing that we must estimate reduced-forms (instead of structural) equations and ran away from using this scrappy financial ratio to determine arm’s length profits subject to corporate income taxes. However, criticism is valid if we can provide a better substitute that can satisfy two conditions: First, the new alternative theory (markup pricing) resolves certain knotty issues of the old theory (such as avoid the cloudy base of “return on assets”); and second, the new theory provides more reliable measures of arm’s length profits. We hold that markup pricing-based profits are superior to “return on assets” respecting these two conditions.

Another Look at Using ROA in Transfer Pricing

Posted by Ednaldo Silva

Assets are heterogeneous making cross-companies comparisons difficult. We may get relief knowing that the specific assets composing the “perpetual inventory” dynamic equation of company growth rates can be restricted to property, plant & equipment (PPE); however, different start or acquisition dates (called vintages) and different depreciation rates make PPE also difficult to compare across companies.

Return on Assets Using Adaptive Expectations IN tRANSFER pRICING

Posted by Ednaldo Silva

In transfer pricing, certain analysts prefer using “return on assets” even for businesses such as wholesale or retail trade in which assets are not expected to have a significant impact on operating profits. These analysts postulate a simple linear relationship between operating profits and accounting assets (variously defined) and calculate quartiles without respite. The econometric model underlying the single-variable computation of the quartiles of “return on assets” can be written as:

(1)     P(t) = β K(t) + U(t)

for t = 1 to T years of each selected comparable.

Alternative Functional Forms of Comparable Profits in Transfer PRICING

Posted by Ednaldo Silva

We can test several bivariate (X, Y) regression functions to obtain the most reliable estimate of comparable operating profits. The explanatory variable X can be sales, costs or assets of the selected comparable companies. The dependent variable Y can be sales or operating profits before or after depreciation; and the slope coefficient is an estimate of the comparable operating profit indicator:

     (1)     Linear: Y = α + β X, slope = β

Selecting Reliable Profit Indicators in Transfer Pricing

Posted by Ednaldo Silva

Selecting a reliable profit indicator is not trivial (reliability is an important metric in transfer pricing). A basic function in algebra represents a straight line, such as the prescribed profit indicator model of the OECD in which the expected value of enterprise profits is a linear function of sales, costs or assets:

     (1)     Y =f(X) = β X

where the coefficient β is the slope of the line of the joint pairs X and Y representing a profit indicator.

Profit Margin Using Koyck Transform in Transfer Pricing

Posted by Ednaldo Silva

We posit that enterprise profits (P(t) = EBITDA(t)) depend on the same period sales (S(t)) and on previous period sales such that the weights of past period sales decline as a power function. This means that enterprise profits depend on a weighted sum of current and past sales whose parameters we can estimate using the Koyck transform equation:

Return on Assets (ROA) is An Unreliable Profit Indicator in Transfer Pricing

Posted by Ednaldo Silva

Return on assets (ROA) is ill-defined and selection of this profit indicator in transfer pricing can lead to intractable controversy between the tax administration and corporate taxpayers. Assets (which combine liabilities and equity) are an accounting quagmire. The nebulous definitions provided by the OECD Transfer Pricing Guidelines (2017), ¶¶ 2.103 and 2.014 create more pain than relief. Likewise, the vague definitions provided by US 26 CRF 1.482-5(b)(4)(i) and (d)(6) are misconceived because they aggregate heterogeneous elements disrespecting short- versus long-term assets vintages (acquisition dates), assets associated and those not associated with interest deductibility, economic cycle dynamics, and different depreciation schedules.

Location Savings Adjustment to Profits in Transfer Pricing

Posted by Ednaldo Silva

The OECD, UN, and United States transfer pricing rules recognize that tax administrations and controlled MNE (multinational enterprise) groups must consider location savings adjustments when uncontrolled comparable enterprises operate in different geographical markets from the tested party. Location savings adjustments are needed when we can measure (in different geographic markets; e.g., UK versus Nigeria or South Africa or US versus Brazil or Mexico) significant differences in wage shares and adopted technology measured by incremental capital/output ratios.