Contents - AL-Tax

3.1 Comparable Profits Method and TNMM 13In a second series of steps, one (a) computes accounting rates of return (or oneof several other profit level indicators) for each sample company 4 ; (b) applies theresulting arm’s length profit level indicators to the tested party’s correspondingdenominator (operating assets, sales, total cost, etc.); (c) establishes a range of thetested party’s potential arm’s length results thereby (the “arm’s length range”); (d)determines the interquartile range of such results; and (e) generally selects a profitlevel contained in the interquartile range. This level of profitability directly determinesthe tested party’s tax liability; its affiliated counterparty’s operating incomeand tax liability are determined as a residual. 5Application of the CPM to establish arm’s length services fees entails essentiallythe same steps, except that the sample selection criteria (or “comparability requirements”)differ, and the U.S. Temporary Regulations favor a different profit levelindicator. The Temporary Regulations emphasize accounting consistency for sampleselection purposes under the CPM as applied to services, rather than resourcesemployed and risks assumed. 6 The use of similar intangible assets in performingthe subject services, if any, is also an important sample selection criterion. Whereasan accounting rate of return is the profit level indicator of choice under the CPMvis-a-vis intra-group tangible or intangible property transfers, operating profits overtotal cost is the preferred profit level indicator vis-a-vis services. This preferencepresumably reflects the fact that services providers often employ limited assets, anddo not consistently report cost of services separately from total cost.The OECD Guidelines’ TNMM closely resembles the CPM, although the Guidelinesdo not favor the use of statistical tools, such as the interquartile range, to selecta particular value within the arm’s length range. Rather, the Guidelines focus oncomprehensive comparability analyses (a point forcefully reiterated in the seriesof Draft Issue Notes released by the OECD’s Center for Tax Policy and Administrationon May 10, 2006). 7 More generally, the OECD Guidelines take a lessformulaic approach to comparability standards and differentiate between methodsin establishing comparability criteria to a lesser extent. In all cases, the character ofthe property or service, the functions performed by the parties, contractual terms,4 Under the U.S. regulations, an accounting rate of return is the preferred profit level indicator forpurposes of applying the CPM to transfers of tangible or intangible property. Other profit levelindicators include operating profits to sales or total cost, gross profits to operating expenses, etc.5 Application of the CPM to establish arm’s length royalty rates reflects the proposition, incorporatedinto the U.S. transfer pricing regulations, that an unaffiliated licensee would not retain anyincome attributable to the licensed intangible asset. Rather, all such income would be transferredto the licensor by means of royalty payments. See Treas. Reg. Section 1.482-(4)(f)(2).6 However, the examples given in Treas. Reg. Section 1.482-9T(f)(3) to illustrate how the comparabilityrequirements should be applied indicate that the CPM is the preferred method when onecannot ascertain whether unaffiliated companies follow the same accounting conventions as thetested party.7 See Comparability: Public Invitation to Comment on a Series of Draft Issue Notes, CenterforTax Policy and Administration, Organization for Economic Cooperation and Development, May10, 2006.