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8 2 Economic vs. Accounting Profit Ratesequity capital (and, potentially, other opportunity costs). The economic profit rateis defined as that rate which equates (a) the discounted present value of forecastedafter-tax free cash flows generated by a given investment project with (b) the initialoutlays required. 1 It is extremely difficult, if not impossible, to quantify a firm-wideeconomic profit rate as a practical matter.Under conditions of free entry and exit, and absent financing constraints, firmswill continue to enter a given market until the net present value of market participation(that is, the present value of projected after-tax free cash flows, discounted at theopportunity cost of capital and reduced by the initial investment required) is drivento zero. Until this point is reached, incumbent firms will earn positive economicprofits (i.e., profits in excess of a “normal” return), and shareholders’ wealth willbe increased thereby. Through the process of market entry, additional resources arededicated to the manufacture of those products that consumers value more highlythan the resources necessary to produce them.Accounting analyses present a snapshot of firm performance at a point in time, orgenerally over a relatively short period of time, to facilitate “mid-course corrections”and incremental decision-making on the part of management and shareholders.Accounting rates of return are computed as the ratio of operating profits to totalassets, fixed assets or some other measure of the book value of resources committedby the firm. Costs are measured by explicit expenditures only, and one attempts tomatch revenues and the expenditures necessary to generate them on a year-by-yearbasis. As such, assets are depreciated over their useful lives, in lieu of deductinginvestment outlays in full when they are made. Firms generally do not maximizetheir accounting rates of return (or their ratios of operating profits to revenues orcosts, or gross profits to cost of goods or operating expenses), because such coursesof action will not result in the highest possible shareholder value. Therefore, asnoted, there are no market mechanisms at work to equalize these profit level indicatorsacross firms, and, by implication, no particular reason to expect similarlysituated firms to earn the same accounting rates of return, operating margins oroperating markups, as noted.The use of accounting measures of profit to determine multinational firms’country-specific income tax liabilities under profits-based methods has severalimportant practical implications, enumerated below.(1) <strong>Tax</strong> authorities in different jurisdictions are likely to allocate individual multinationalfirms’ consolidated income across countries in different ways. Thisstatement would be true even if tax authorities utilized the same transfer pricingmethodology, given the sensitivity of one’s results to the particular “comparablecompanies” included in one’s sample (and, in the case of the CPM, the particularprofit level indicator used). However, as a practical matter, tax authorities arelikely to use different transfer pricing methodologies in analyzing a given case.1 In this context, free cash flow, constituting income that actually accrues to investors, is definedas the after-tax cash flows earned by the legal entity under consideration, assuming that it had nodebt.
2 Economic vs. Accounting Profit Rates 9Most countries endorse the arm’s length standard in principle, and the U.S.and OECD provisions contain the same specific set of transfer pricing methodologies(discussed at length in Chapter 3). However, the IRS has a clearpredilection to use one particular profits-based method (the CPM), while OECDcountries prefer transactions-based methods. Different approved methodologieswill generally produce different allocations of income, because the assumedunifying foundation across methods—primarily the basic concept of marketequilibrium—does not in fact apply. The large number of cases handled by thecompetent authorities of different countries attests to this conundrum, which inturn creates the potential for double taxation on a significant scale.(2) Individual multinational corporations cannot accurately anticipate theircountry-specific tax liability in the absence of an Advance Pricing Agreement. 2Corporate taxpayers and tax authorities, respectively, also frequently utilizedifferent firm samples and/or transfer pricing methodologies to determinetheir tax liability (taxpayers before an audit and tax authorities during anaudit). Because the use of different samples and/or methods will often produceinconsistent results, firms acting in good faith may report substantially lessincome in a given jurisdiction than the tax authority in that jurisdiction believesis warranted.(3) The current transfer pricing regime produces inequitable results. Because theexisting transfer pricing laws and regulations are not based on defensible economicprinciples, or on transparent rules that all countries apply uniformly,they produce arbitrary results. Arbitrary apportionments of multinational firms’income across the countries in which they operate are inherently inequitable.(4) Multinational and domestic firms are not treated uniformly for tax purposes.In the abstract, the arm’s length principle appears to ensure that domestic andmultinational firms will be treated uniformly for tax purposes, essentially bydefinition. However, individual standalone competitors in a given market oftenreport markedly different operating results in the same reporting period. Byrequiring individual members of a multinational group to report gross margins,markups or accounting rates of return that are contained in the interquartilerange of third parties’ results (a U.S. regulatory provision that the OECD Guidelinesdo not endorse), multinational firms are treated more favorably for taxpurposes than a subset of their domestic counterparts, and less favorably thanothers.Inequity is inherently problematic, and uncertainty is costly, both for tax authoritiesand individual corporations and from an economy-wide perspective. Explicitcosts, from tax authorities’ perspectives, include costs incurred in conducting auditsand analyzing transfer pricing issues, and in resolving conflicts over income allocationswith their opposite numbers in other tax jurisdictions. Moreover, to reduce the2 An Advance Pricing Agreement, as the term suggests, is a vehicle for tax authorities and firms toagree well in advance of an audit on a particular transfer pricing methodology and the way that itwill be applied, thereby minimizing disputes at a later date.
Page 2 and 3: Transfer Pricing and Corporate Taxa
Page 4 and 5: Elizabeth KingBeecher Consulting, L
Page 6 and 7: AcknowledgementsI have worked with
Page 8 and 9: xContents3.5.3 SummaryandPracticalI
Page 10 and 11: xiiContents8.3 Analysis Under Exist
Page 12 and 13: Part IEconomic and Accounting Rates
Page 16 and 17: 10 2 Economic vs. Accounting Profit
Page 18 and 19: 12 3 Overview and Critique of Exist
Page 56 and 57: Chapter 4Some Alternative Approache
Page 58 and 59: 4.1 Modified Comparable Uncontrolle
Page 60 and 61: 4.3 Required Return on Debt and Equ
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4.3 Required Return on Debt and Equ
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4.3 Required Return on Debt and Equ
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4.6 Franchise Model 63relationship
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Part IIICase Studies
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68 5 Intercompany Sale of Diamonds5
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70 5 Intercompany Sale of Diamonds
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72 5 Intercompany Sale of Diamondsa
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74 5 Intercompany Sale of Diamondsh
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76 5 Intercompany Sale of Diamondsw
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78 5 Intercompany Sale of DiamondsI
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80 5 Intercompany Sale of Diamondss
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84 5 Intercompany Sale of DiamondsF
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86 5 Intercompany Sale of DiamondsT
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88 5 Intercompany Sale of Diamonds
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90 6 Intercompany Sale of Medical D
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Chapter 7Performance of Intercompan
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7.1 Summary of Key Facts 103orders,
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7.3 Value of Customer Relationships
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7.4 Analysis Under Existing Regime
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7.5 Analysis Under Alternative Regi
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Chapter 8Replication of Internet-Ba
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8.1 Summary of Key Facts 117in a se
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8.3 Analysis Under Existing Regime
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8.4 Analysis Under Alternative Regi
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8.5 Conclusions 123USP should also
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126 9 Sale of Assets with Embedded
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138 10 Provision of CDN Services to
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146 11 Global Trading of Commoditie
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162 12 Decentralized Ownership of I
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Chapter 13Concluding ObservationsTh
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13 Concluding Observations 185The r
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Chapter 1IntroductionNational tax a
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2 1 Introductionof specific transfe
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4 1 Introductionvenues. The propose
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188 IndexBusiness Judgment Rule, 28
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190 IndexFamily-owned, 81FASB, see
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192 IndexNumerical standards, 51-52
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194 IndexSwing lines, 149, 154, 158
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