"The true theorist in economics has to become at the same time a statistician."
– Ragnar Frisch (1930), p. 30.
Many transfer pricing reports (against Ragnar Frisch’s advice) are devoid of economics or statistics principles. Here, I show that the usual transfer pricing application of "return on assets" (ROA) is disreputable.
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:
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.
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 practices.
“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.
Return on assets (ROA also called ROIC) is ill-defined and the 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 definitions provided by US 26 CRF 1.482-5(b)(4)(i) and (d)(6) are misconceived because they aggregate heterogeneous accounts disrespecting short-versus long-term assets (acquisition dates), assets associated and not associated with interest deductibility, different economic cycle dynamics, and different depreciation schedules.
