Contents - AL-Tax

58 4 Some Alternative Approaches to Transfer PricingThese recommended methods of estimating subsidiary-specific betas for valuationpurposes apply equally in a transfer pricing context. It should also be noted thatinsurance underwriters generally require insurance brokers representing individualcompanies to perform comprehensive risk assessment analyses of the latter. Theseanalyses are a useful means of identifying key operations-related risks.As previously discussed, firms that are functionally similar—a somewhat nebulousconcept to begin with—may earn widely divergent accounting rates of return,gross margins, gross markups, etc. However, firms with similar systematic risks—aprecisely defined concept—should have similar betas. Therefore, the comparabilityanalyses that would be necessary under the proposed required return methodology,absent mutual agreement by taxing authorities to permit the use of industry-widebetas, are more narrowly defined, and more purposeful, than the comparability analysesrequired under the current transfer pricing regulations.4.3.1.2 Measures of the Risk-Free Rate and the Price of RiskThe risk-free rate is generally equated with the yield on Treasury bonds, because theU.S. Government is very unlikely to default on its debt. However, some academicsand practitioners believe that Treasury yields understate the risk-free rate as a resultof several factors, among them (a) the fact that financial institutions are required tohold a certain amount of Treasury bills and bonds to satisfy regulatory requirements,artificially inflating demand for these instruments, and (b) Treasury instruments arenot taxed at the state level, whereas other very low-risk investment vehicles aresubject to state tax. In view of these considerations, some valuation specialists andmarket participants favor swap rates over Treasury bond rates as measures of therisk-free rate. 7The price of risk (equivalently, the market risk premium) is conventionally measuredas the difference between the expected rate of return on the market portfolioand the risk-free rate. The expected rate of return on the market portfolio, in turn, iscomputed as the long-term historical average realized rate of return. 8There is some (albeit limited) room for disagreement about appropriate risk-freerates and market risk premia. For this reason, it would make sense to have tax authoritiespublish these rates.4.3.1.3 Fair Market Value of Equity CapitalFor the same reason that betas for individual group members cannot be directlyestimated, market-determined values of individual group members’ equity capital7 See Hull, John, Mirela Predescu and Alan White, “Bond Prices, Default Probabilities and RiskPremiums,” Journal of Credit Risk, September 2004, Vol. 1, No. 2, pp. 53–60.8 A geometric average, defined as the compound rate of return that equates beginning and endingvalues, is generally considered preferable to an arithmetic average for this purpose.