An Economic Framework For Identifying The Tested Party

The comparable profit method is a standard method for transfer pricing, particularly when the intracompany transactions are entirely between two related parties and third-party prices are therefore not readily observable. A necessary first step in the CPM is identifying the ''tested party'' — the related party whose profits will be determined through the CPM. For example, if entity A sells to entity B, and entity B is the tested party, the revenue to A and costs to B will be the same and set to generate B's level of profit as determined by the CPM.

The regulations under section 482 define CPM in general:

The comparable profits method evaluates whether the amount charged in a controlled transaction is arm's length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances.1

Reg. section 1.482-5(b)(2)(i) provides guidance on the choice of tested party:

For purposes of this section, the tested party will be the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data regarding uncontrolled comparables can be located. Consequently, in most cases the tested party will be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables.

The OECD guidelines provide similar guidance:

A one-sided method (traditional transaction method or transactional net margin method) may be applicable in cases where one of the parties makes all the unique contributions involved in the controlled transaction, while the other party does not make any unique contribution. In such a case, the tested party should be the less complex one.2

A key issue immediately presents itself: What does it mean to be ''the least complex'' party? Several pending Tax Court cases highlight the controversy over how to answer that question.3 As discussed below, the taxpayers in those cases are disputing substantial adjustments resulting from the IRS's determination to ''flip'' the tested party.

We believe economic principles provide the proper approach to the tested party issue, particularly the complexity question. It is consistent with the relevant provisions of U.S. tax law, as well as the OECD transfer pricing guidelines.

Economic Theory Underlying the CPM

The premise of the CPM is that companies performing similar functions and assuming similar risks should earn similar returns. The underlying economic assumption is that, in the long run, competition will drive out inefficient companies or those with high marginal costs and that the remaining companies will have the same or a similar marginal cost.4 Otherwise, the theory goes, the more efficient incumbent companies could lower prices and capture the market shares of the less efficient companies. As a result, each company should be charging its marginal cost, which should be the same or similar.

Of course, it will never be so perfect that each company has the exact same cost. There are always differences, such as those between the particular markets served or company-specific events in a given year, that may lead to higher or lower profitability. But with a sample of similar companies and more than a year's worth of data, a reasonable estimate of profitability is possible.

This approach is not dissimilar to the market multiples method for valuation. One identifies similar companies or transactions and looks at the ratio of company value (typically enterprise value) to specific income statement or balance sheet measures. Assuming those companies' operations and profitability are comparable (that is, selected financial measures can be converted into company value at roughly the same rate), using those multiples for the valuation target will give a good estimate.

Both the code and the OECD guidelines recognize that one of the key assumptions required for the CPM to hold true is that competition will drive companies to earn similar profits.

The OECD guidelines provide:

Economic circumstances that may be relevant to determining market comparability include the geographic location; the size of the markets; the extent of competition in the markets and the relative competitive positions of the buyers and sellers; the availability (risk thereof) of substitute goods and services; the levels of supply and demand in the market as a whole and in particular regions, if relevant; consumer purchasing power; the nature and extent of government contract.5

Reg. section 1.482-1(d)(3)(iv) states:

Determining the degree of comparability between controlled and uncontrolled transactions requires a comparison of the significant economic conditions that could affect the prices that would be charged or paid, or the profit that would be earned in each of the transactions. These factors include —

The similarity of geographic markets; The relative size of each market, and the extent of the overall economic development in each market; The level of the market (for example, wholesale, retail, etc.); The relevant market shares for the products, properties, or services transferred or provided; The location-specific costs of the factors of production and distribution; (The extent of competition in each market with regard to the property or services under review; The economic condition of the particular industry, including whether the market is in contraction or expansion; and The alternatives realistically available to the buyer and seller.6 From an economic perspective, the degree of competition is a critical component of the tested party determination. Without assessing the competitiveness of the markets, one cannot conclude that the economic assumptions necessary...

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