Transfer pricing practitioners fell in love with the concept of a “limited risk distribution” (LRD) on the hope that they could convince tax authorities in high tax jurisdictions to accept the premise that the local distribution affiliate should be happy with a low operating margin. This pandemic, however, has generated a lot of new transfer pricing advice that appears to contradict the original LRD argument.
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:
“We shall renounce . . . the subterfuges.”
Y si pretendes remover las ruinas que tú mismo hiciste ...
Cenizas sung by Toña La Negra. Bolero lyrics by Wello Rivas (1913-1990).
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.
Models should 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.
Después de tanto soportar la pena de sentir tu olvido.
Cenizas sung by Toña La Negra. Bolero lyrics by Wello Rivas (1913-1990).
Major U.S. retailers (considered to be comparables to an inbound “tested party”) are claimed to have operating profit margins that vary from 0.5% to 1.5% of their net sales. This interquartile range (IQR) varying from 0.5% to 1.5% does not reflect the reported operating profit margins of the purported comparables, but instead is obtained by unreliable asset intensity adjustments. Unreliable because the proposed asset adjustments are not supported by economic principles, and the statistical significance of the relevant parameters is not ascertained.
"Come to places where opponents give no thought." Sun Tzu, The Art of War, Alfred Knopf (Everyman’s Library), 2018, p. 62.
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.
L’un fece il mundo e l’altro l’ha distrutto.
(Unattributed quote in Meditaciones del Quijote (1914), by José Ortega y Gasset)
Here, we discuss transfer pricing methods based on operating profits (“net profit indicators”) under the U.S. comparable profits method (CPM) and the OECD “transactional” net margin method (TNMM). Gross and operating profit indicators express aggregated company accounts; thus, the OECD “transactional” modifier to the “net profit method” is an affectation.
The CPM (which we created while working at IRS) was divulged in the U.S. 1994 transfer pricing regulations under Treas. Reg. § 1.482-5. The TNMM was released one year after in the 1995 OECD transfer pricing guidelines (TPG). See OECD 2017 TPG, ¶ 2.62 et. seg.
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.
We take another look that computing profit indicators using restricted data samples can lead to unreliable measures of arm’s length taxable income to benchmark controlled inter-group transactions. To produce reliable measures, we must change the pervasive transfer pricing practice of considering three-years of data, and consider as many individual company financial data as available.
