RoyaltyStat Blog

Transfer Pricing Memoir

Posted by Ednaldo Silva

When we started (1988) in transfer pricing from academia, the IRS dominant paradigm was forcing single point estimates of gross profits indicators in audit, including gross profit margin for controlled inbound distributors, and gross profit markup for controlled outbound manufacturers and service providers. The Berry ratio (gross profits/XSGA), which was introduced by Charles Berry in Du Pont, was an unspecified “fourth” method. When we started, IRS transfer pricing economics was not bachelor's degree level, and we suspect that it has not advanced to Masters degree. See United States Court of Claims. E. I. Du Pont de Nemours and Company v. The United States, Nos. 256-66 & 371-66, April 18, 1978. (Cite as: 1978 WL 3449 (Ct. Cl. Trial Div.)). 

Another method introduced by Irvin Plotkin in Du Pont  was based on return on assets, but without using comparables. His multi-industry return on assets was not used to establish arm's length profits; instead it was used to test the reasonableness of gross profits methods. Plotkin used net profits before tax (i.e., pretax net profits after interest deductions) from large samples of multi-industry enterprises. This pretax net profits assay method was morphoned into the BALRM (basic arm's length return method) on the well-researched White Paper (1988), but it was rejected in the 1994 US regulations inspite the ITC (International Tax Counsel) heroic but unsuccesfull efforts to make it live. We were instrumental driving the BALRM's coffin nails.

In the 1968 US transfer pricing regulations, ruling when we started, three primary methods were specified: (1) comparable uncontrolled price (CUP), (2) resale price (gross profit margin), and (3) cost plus (gross profit markup). During IRS audit, gross profit industry-level indicators were used from RMA Annual Statement Studies or from MANA Surveys, and until our contribution no enterprise-level comparables were used by IRS audit economists. See https://www.rmahq.org/annual-statement-studies/

We introduced Standard & Poor's Compustat enterprise-level financials to find comparables inspired (during our prior graduate economics teaching) by the profit research of Dennis Mueller, “Persistence of Profits Above the Norm,” Economica, New Series, Vol. 44, No. 176 (Nov., 1977). Later we discovered that Plotkin used Compustat enterprise-level financials in Du Pont, but not to find comparables, as we did at IRS to determine arm's length operating profits of controlled importers or exporters. See Mueller on Stable URL: https://www.jstor.org/stable/2553570 

In IRS audit of controlled distributors that imported foreign goods for resale in US, we discovered that profit shifting was not restricted to overcharged Purchases recognized in COGS. We verified persistent profit shifting in operating expenses (XSGA), including undisclosed leakages such as taking excess tax deductions for controlled professional, scientific, and technical services, for management and administrative support services, for royalties, and for advertising expenses. After acquiring more audit skills, we discovered hidden royalties and management fees embedded in COGS or XSGA unstructured schedule accounts.

Because of verified double-dipping, we introduced a new transfer pricing method (called CPI [comparable profits interval] then CPM [comparable profits method] in US and copied as TNMM in OECD) based on operating profits because we could correct profit shifting under COGS or under XSGA. After the introduction of the CPM in US or TNMM in OECD, gross profits methods, including the Berry ratio, were debunked and became legacy baggage. We also introduced statistical intervals to test comparable operating profit indicators (instead of then prevailing point estimates) and requirements to demonstrate reliable estimates of arm's length taxable income.

Excess advertising expenses led to specific rules regarding “assistance provided to the legal owner of intangibles,” which have been undermined by updates to US transfer pricing regulations. Legal brain drain combined with credulous reliance on incompetent economic advice (lack of checks and balance) have impaired the capacity of the IRS Office of Chief Counsel to write intelligent transfer pricing regulations, write improved updates to existing regulations, or hold its position in Tax Court litigation.

IRS transfer pricing compliance is a labyrinth of solitude: Mismanaged Cost-Sharing § 1.482-7 and Services § 1.482-9 regulations reveal untrained minds at work. IRS leadership better learn from Niccolò Machiavelli that adulators don't provide sound advice, and learn from Maynard Keynes that ill-trained economists can't produce sustainable tax assessments. 

Here is some dirty laundry from repeated clique behavior: Although a member, we were not invited to speak at NABE transfer pricing conferences in Washington DC; and our efforts to speak were rejected without explanation. NABE's annual transfer pricing conference organizers disregard our merit, and have little concept of diversity. 

Published on Nov 11, 2018 4:40:36 PM

Ednaldo Silva (Ph.D.) is founder and managing director at RoyaltyStat. He helped draft the US transfer pricing regulations and developed the comparable profits method called TNNM by the OECD. He can be contacted at: esilva@royaltystat.com

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