Contents - AL-Tax
Contents - AL-Tax Contents - AL-Tax
14 3 Overview and Critique of Existing Transfer Pricing Methodseconomic circumstances and business strategies should be considered in selectingsample companies.3.1.2 Circumstances when CPM and TNMM Are AppliedAs originally conceived, the CPM and TNMM were to be used only when the comparabilitystandards applied under other methods could not be satisfied or accountingambiguities precluded their use. OECD member countries often take a dimview of the CPM/TNMM. However, it is very widely applied in the United States,accounting for the substantial majority of transfer pricing cases analyzed by IRSagents in the field, and almost all of the Advance Pricing Agreements negotiatedamong companies, the National Office of the IRS and tax authorities in other jurisdictions.(For the sake of decorum, the methodology may be referred to differentlyin the accompanying documentation, such as a resale price method with adjustmentsfor higher-than-normal operating expenses.)There are at least two reasons for the CPM’s widespread use in the United States.First, as a practical matter, IRS agents in the field and National Office personnelhave tended to apply higher comparability standards under the resale price and costplus methods than a strict reading of the regulations would appear to require, significantlylimiting their applicability. Moreover, the CPM is amenable to “cookiecutter”analyses that apply across a range of transactions and industries. As such, itis cost-effective for corporations and the IRS alike. (Hence, if history is a reliableguide, U.S. practitioners will also frequently resort to the CPM to establish arm’slength services fees when the services cost method, which provides for a cost-basedfee, cannot be used.)3.1.3 Underlying Economic RationaleThe CPM and TNMM depend on the following key assumptions for their economiclegitimacy:1. Product markets are generally competitive and in equilibrium;2. For this reason, accounting rates of return (defined in the U.S. regulations asoperating profits divided by operating assets) are equalized across manufacturingor distribution firms in broadly similar product markets;3. Service markets are generally competitive and in equilibrum; and4. Under these circumstances, operating markups over total cost are equalizedacross service providers rendering broadly similar services.Such reasoning has also been generalized, to some degree, to the other profit levelindicators used in applying the CPM to transactions in tangible and intangible property.However, in principle, greater functional comparability is required when usinga financial ratio other than accounting rates of return under the U.S. regulations.
3.1 Comparable Profits Method and TNMM 15One might argue that the CPM and TNMM are not based on economic notionsof equilibrium and specific market structure assumptions. Admittedly, the draftersare not explicit on this point, beyond asserting (inaccurately) that “[a]n operatingprofit represents a return for the investment of resources and assumption of risks”(thereby equating accounting profits per annum with the discounted present value offree cash flows), 8 and sanctioning comparisons of accounting rates of return acrossfirms. However, if one determines the tax liabilities of individual affiliated companiesby imputing to them accounting rates of return realized by similarly situatedunaffiliated companies, there must be some expectation that accounting rates ofreturn (and other profit level indicators) will be uniform across firms. Other thanan unvarnished assumption to this effect (which is belied by the wide arm’s lengthranges that one routinely observes in practice), or the belief that affiliated companiescan legitimately be likened to a “median” unaffiliated firm for purposes of determiningtheir tax liabilities, an economic rationale is all that remains.3.1.4 Critique of Economic ReasoningAs previously noted, in theory, economic rates of return, as distinct from accountingrates of return, are equalized, albeit only in competitive markets and in equilibrium. 9There are no market mechanisms at work to equalize accounting-based profit levelindicators across firms, and, by implication, no reason to expect similarly situatedfirms to earn the same accounting rates of return, operating margins or operatingmarkups, even in competitive markets.The corollary assumptions that product markets are generally competitive andnormally in long-run equilibrium are equally invalid. “Perfect” competition is characterizedby (a) a large number of incumbent firms, each of which sells an undifferentiatedproduct, makes up a very small share of the total market and can thereforetake selling prices as fixed (that is, independent of its own output decisions); (b)potential entrants do not face barriers to entry (or existing firms, impediments toexpansion); (c) buyers are numerous, knowledgeable and can obtain the undifferentiatedproduct from a number of different suppliers without bearing additional costs;and (d) buyers themselves are indistinguishable from the perspective of producers.As a consequence of these characteristics, product prices will be equalized and, overtime, firms will be forced to utilize the (same) most efficient technology available.More loosely speaking, product markets can generally be considered competitiveif products are homogenous, incumbent firms can readily expand or new firms canenter (even if only with the investment of potentially significant resources and overa potentially long period of time), buyers are well informed as to their alternativesources of supply, and switching suppliers is not excessively costly.8 See Treas. Reg. Section 1.482-5(c)(2)(ii).9 However, as noted, the economic rate of return is a much more difficult magnitude to measurethan an accounting rate of return, particularly on a firm-wide basis.
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14 3 Overview and Critique of Existing Transfer Pricing Methodseconomic circumstances and business strategies should be considered in selectingsample companies.3.1.2 Circumstances when CPM and TNMM Are AppliedAs originally conceived, the CPM and TNMM were to be used only when the comparabilitystandards applied under other methods could not be satisfied or accountingambiguities precluded their use. OECD member countries often take a dimview of the CPM/TNMM. However, it is very widely applied in the United States,accounting for the substantial majority of transfer pricing cases analyzed by IRSagents in the field, and almost all of the Advance Pricing Agreements negotiatedamong companies, the National Office of the IRS and tax authorities in other jurisdictions.(For the sake of decorum, the methodology may be referred to differentlyin the accompanying documentation, such as a resale price method with adjustmentsfor higher-than-normal operating expenses.)There are at least two reasons for the CPM’s widespread use in the United States.First, as a practical matter, IRS agents in the field and National Office personnelhave tended to apply higher comparability standards under the resale price and costplus methods than a strict reading of the regulations would appear to require, significantlylimiting their applicability. Moreover, the CPM is amenable to “cookiecutter”analyses that apply across a range of transactions and industries. As such, itis cost-effective for corporations and the IRS alike. (Hence, if history is a reliableguide, U.S. practitioners will also frequently resort to the CPM to establish arm’slength services fees when the services cost method, which provides for a cost-basedfee, cannot be used.)3.1.3 Underlying Economic RationaleThe CPM and TNMM depend on the following key assumptions for their economiclegitimacy:1. Product markets are generally competitive and in equilibrium;2. For this reason, accounting rates of return (defined in the U.S. regulations asoperating profits divided by operating assets) are equalized across manufacturingor distribution firms in broadly similar product markets;3. Service markets are generally competitive and in equilibrum; and4. Under these circumstances, operating markups over total cost are equalizedacross service providers rendering broadly similar services.Such reasoning has also been generalized, to some degree, to the other profit levelindicators used in applying the CPM to transactions in tangible and intangible property.However, in principle, greater functional comparability is required when usinga financial ratio other than accounting rates of return under the U.S. regulations.
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