Contents - AL-Tax

16 3 Overview and Critique of Existing Transfer Pricing MethodsVery few product markets were competitive in the strict sense when the basictenets of microeconomic theory were first put forward by Alfred Marshall circa1891. However, the discrepancy between archetype and economic reality was notas marked then as it is now. Firms have become progressively larger, verticallyintegrated and both horizontally and geographically diversified. Products other thancommodities are routinely differentiated along numerous dimensions (trademarks,functionality, levels of customer service and technical support, product quality,etc.). As such, the pure competitive market model has become largely a figment ofthe imagination (with the exception of securities markets and commodity marketsin some instances). In fact, relatively few product markets are competitive in thebroader sense described above. While this statement is probably more obviouslyapparent vis-a-vis consumer product markets, it is often true of producer productmarkets as well. Switching costs are relatively common among producer products,as is product differentiation in certain forms.Moreover, the traditional concept of long-run equilibrium is a theoretical construct,rather than a description of real product markets at any point in time. Itimplies a stasis in the number of firms operating in a given market, the types ofproducts they produce, the technologies they utilize, the terms of competition,etc. In most markets, new product introductions are the norm, firms continuouslystrive to improve their production technologies and techniques, barriers to foreigncompetition (e.g., quotas and tariffs) are revisited, competitors merge, and regulatoryrequirements change. Hence, even supposing that product markets weregenerally competitive, economic rates of return would only be equalized in the longrun, not on a year-by-year basis. Product markets are almost invariably in a stateof disequilibrium.Two other shortcoming with the use of accounting rates of return in a transferpricing context also bear noting, the second of which is widely recognized:1. Affiliated manufacturers’ accounts receivables and affiliated distributors’accounts payables reflect intercompany pricing. As such, their asset bases,inclusive of working capital, will potentially be distorted by intercompanypricing and cannot reliably be used for purposes of evaluating such pricing.2. The book value of assets, as shown on financial statements, reflects particularaccounting conventions, over which firms have a certain amount of discretion. Ifunaffiliated firms utilize different conventions (e.g., different depreciation methods),all other things equal, their accounting rates of return will differ for thisreason alone. Moreover, accounting rates of return will be strongly influencedby the age of operating assets through two mechanisms: (a) the price paid forindividual assets at the outset (in that prices vary over time) and (b) the extent towhich the assets have been written off. Lastly, individual firms rely on intangibleassets to widely differing degrees. 1010 Certain of the limitations noted above regarding accounting rate of return measures are acknowledgedin the U.S. Regulations, and one is cautioned to consider them in evaluating comparability.However, as a practical matter, the potential for distortions is so great as to preclude the use of