Contents - AL-Tax

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.