Contents - AL-Tax

84 5 Intercompany Sale of DiamondsFor the same reason, this is not the case when sample distributors are distinguishablefrom the tested party by virtue of the fact that they employ more or fewer assets perdollar of sales. In this instance, the fact that some sample companies have developed(or license) intangible assets, and all carry far lower inventories and have far loweraccounts receivables per dollar of sales than the tested party, is problematic evenunder the comparable profits method. As such, under the current transfer pricingregime, one should adjust for these differences to the extent possible.U.S. practitioners routinely adjust standalone sample companies’ results of operationsfor differences in inventory, accounts receivables and accounts payables(per dollar of sales or assets, depending on the profit level indicator), relative tothe tested party, by means of the “asset intensity adjustment.” Conceptually, thisadjustment presupposes that higher-than-normal inventories or accounts receivablesreflect strategic decisions on the part of firms to better serve their customers byproviding just-in-time delivery and/or extended payment terms. As such, the argumentgoes, firms adopting such strategies build the added financing costs into theirproduct pricing. 29 Quantitatively, the asset intensity adjustment entails: Imputing to each sample company the tested party’s ratio of (i) inventories plusaccounts receivables less accounts payables (an approximation of working capital)to (ii) sales or assets (depending on the profit level indicator used); Applying a reasonable cost of capital thereto; and, Adjusting the sample companies’ profit level indicators upward or downward toreflect differences between their imputed cost of working capital and their actualcost of working capital.To the extent that one can estimate the per-period income generated by particularintangible assets employed by the sample distributors in this case, their profit levelindicators should also be reduced by this income (less the associated developmentcosts).In the instant case, we compute asset intensity adjustments (which reflect differencesin both (a) inventories and accounts receivables, and (b) USS’ lower inventoryfinancing costs), but do not attempt adjustments to reflect intangible asset values andcosts. (The margin of error on such adjustments probably exceeds the adjustmentsthemselves.) We find that USS should earn an operating margin of approximately5.5%–8.0% on its resales of generic polished stones. Given this arm’s length margin,coupled with FP’s resale margin on the sale of rough stones to IS, the latter’s arm’slength income on generic polished stones sold to USS is determined as a residual.(In the event, USS’ operating margin is less than 5.5%, indicating that IS’ pricingof non-proprietary stones exceeds arm’s length prices.)29 While true in the instant case, in many other instances, higher inventories and accounts receivablesmay simply reflect overly optimistic sales projections, adverse economic conditions or customers’difficulties in paying their bills. Upward adjustments in margins in these instances, toreflect suppliers’ intentionally higher cost of capital, would not be warranted. I would like to thankJoseph Boorstein, Ph.D., for his insights on this point.