Comparability and Economic Adjustments

Transcription

1 Comparability and Economic Adjustments ABA Panel Discussion Transfer Pricing Moderator: E. Miller Williams Michael Aarstol, John Wills, Jeffrey Bethard February 17, 2012 Circular 230 Disclosure Any U.S. tax advice contained in this presentation was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

2 Comparability and Economic Adjustments This panel will discuss economic adjustments in light of turbulent and divergent global economic conditions. US and OECD principles espouse economic adjustments to be made to improve comparability, and the reliability of arm s length result. Panel discussion of various types of adjustments, the rationale (and evidence) in support of an adjustment, as well as the circumstances were adjustments may not be warranted. The panel will also consider the standard economic adjustments made by the IRS Advance Pricing Agreement (APA) Program. The information or ideas set forth in these slides reflect the personal opinions of Michael Aarstol and do not necessarily represent the views of the IRS or the APA Program The information or ideas set forth in this presentation reflect the personal opinions of the moderator and the presenters and not necessarily views of their companies or firms

3 Treasury Regulations Section 482-1(d) (2) Standard of comparability In order to be considered comparable to a controlled transaction, an uncontrolled transaction need not be identical to the controlled transaction, but must be sufficiently similar that it provides a reliable measure of an arm's length result. If there are material differences between the controlled and uncontrolled transactions, adjustments must be made if the effect of such differences on prices or profits can be ascertained with sufficient accuracy to improve the reliability of the results. For purposes of this section, a material difference is one that would materially affect the measure of an arm's length result under the method being applied. If adjustments for material differences cannot be made, the uncontrolled transaction may be used as a measure of an arm's length result, but the reliability of the analysis will be reduced. Treasury Regulations Section 482-1(e)(2)(iii) (B) Adjustment of range to increase reliability. If there are no uncontrolled comparables described in paragraph (e)(2)(iii)(a) of this section, the arm's length range is derived from the results of all the uncontrolled comparables, selected pursuant to paragraph (e)(2)(ii) of this section, that achieve a similar level of comparability and reliability. In such cases the reliability of the analysis must be increased, where it is possible to do so, by adjusting the range through application of a valid statistical method to the results of all of the uncontrolled comparables so selected. The reliability of the analysis is increased when statistical methods are used to establish a range of results in which the limits of the range will be determined such that there is a 75 percent probability of a result falling above the lower end of the range and a 75 percent probability of a result falling below the upper end of the range. The interquartile range ordinarily provides an acceptable measure of this range; however a different statistical method may be applied if it provides a more reliable measure.

4 Treasury Regulations Section 482-1(d)(2) Generally, such adjustments must be made to the results of the uncontrolled comparable and must be based on commercial practices, economic principles, or statistical analyses. The extent and reliability of any adjustments will affect the relative reliability of the analysis. See Sec (c)(1) (Best method rule). In any event, unadjusted industry average returns themselves cannot establish arm's length results. Examples: Asset Intensity Adjustments Working Capital Adjustments (Account Payable, Accounts Receivable and Inventory Adjustments) Inventory Valuation Method Adjustment, Currency Adjustment Operating Leverage, Turbulence, and Comparability

5 The importance of operating leverage Exhibit 6 Rationale Behind Operating Leverage Adjustment Revenues $ } Margin Total Costs Variable Costs Fixed Costs Breakeven Point Output What matters when selecting comparables? We randomly selected 68 firms in 8 industries (4 manufacturing and 4 distribution) Computed PLI for each firm, both for each year and for a 3-year period Grouped them in 3 different ways: By industry By size of total revenues By growth rate

6 The 8 industries considered Manufacture of computers Manufacture of motor vehicle parts and accessories Manufacture of printed circuit boards Manufacture of refrigeration and heating equipment Distribution of pharmaceuticals Distribution of electronic components Distribution of industrial machinery Distribution of hospital and medical equipment Testing the data For each potential grouping we tested the following null hypothesis: The firms in every group are drawn from the same underlying population. If true (i.e., if we cannot reject this null hypothesis), then grouping the firms in this way adds no explanatory power. The firms within any group are no more comparable to each other than they are to firms outside their group.

7 What is the evidence for distributors? (PLI = operating margin) Can we reject the null hypothesis? When Grouped by Industry When Grouped by Size When Grouped by Growth Rate 2006 No No Yes 2005 No No No 2004 No No No 3-Year Average No No Yes What is the evidence for manufacturers? (PLI = return on invested capital) (F test for differences across groups) When Grouped by Industry When Grouped by Size When Grouped by Growth Rate Year Average

8 Measuring operating leverage Output Fixed Variable Total % change profit / Level Costs Costs Costs Revenues Profit Margin % change revenues 1 $10 $9 $19 $14 ($5) % % % % % % % % 1.29 Comparability and economic adjustments in turbulent times US regulations recognize the business conditions must/should be taken into consideration in evaluating comparability (and in testing arm s length results). What about when there is extreme or excess volatility?

9 6.00% Comp Bus Cycle- Industry X 5.00% 4.00% 3.00% Median RoS, Comps 2.00% 1.00% 0.00% Per US regulations, a multi-yr. period of analysis may be applied to improve comparability/ reliability What is the appropriate period to consider? Should analysis be limited to 3 yr., 5yr., or entire cycle?

10 What is the cycle here? 8.00% Comp Bus Cycle- Industry Y 7.00% 6.00% 5.00% Median RoS, Comps 4.00% 3.00% 2.00% 1.00% 0.00% How do we measure the cycle: Peak to peak? Trough to trough? In an APA context, if historical data is to be applied prospectively cycle is important. If cycle range is applied- should it be static or dynamic?

11 6.00% Comp Bus Cycle- Industry X 5.00% 4.00% 3.00% Median RoS, Comps Tested Party 2.00% 1.00% 0.00% Should APA results be determined annually or over the cycle? What if APA period is shorter than cycle? What if tested party and comparables are out of phase?

12 Comp Bus Cycle- Industry Y 10.00% 8.00% 6.00% 4.00% Median RoS, Comps Tested Party 2.00% 0.00% -2.00% -4.00% A Down Economy (DE) Adjustment That Focuses on Comparable Selection Just one of many possible approaches to a DE adjustment Fact pattern Years to be covered in APA include 2008 and 2009 Tested party has general risk profile similar to a number of public co. s that are functionally similar and suitable for use as comps in normal conditions (the normal times comps ) A fairly large set of comps is available to benchmark APA years other than Tested party experienced DE effects (fall in demand) in 2008 and 2009 more severe than those experienced by most of the normal times comps Tested party did not anticipate or quickly adjust to the conditions in System profits in relevant system containing tested party fell in due to DE effects Potential DE adjustment Identify the subset of the normal times comps (the DE comps ) that (1) Experienced a decrease in sales during 2008 and 2009 similar to tested party (2) Experienced an increase in SG&A/Sales ratios similar to tested party Create a DE benchmark for years using the 2-year average financial results of the DE comps in

13 Some Prelim. Thoughts on Adjustment for Japanese Earthquake / Tsunami (JET) One potential issue is lost system profits within the relevant group of companies, e.g., due to supply chain disruption problems caused by JET Insurance? Risk allocation? Measurement of impact of JET on system profits? Another potential issue is assets such as PP&E destroyed or impaired by JET These assets are on the books of specific entities within the relevant group of companies Insurance? Risk allocation? What can we learn from data from comparables impacted by JET? What can we learn from data from multinationals subject to JET? Other issues? A Standard But Not Universally Known APA Program Adjustment The APA Intangibles Adjustment This adjustment is discussed in the context of CPM analysis and profit level indicators used in CPM analysis on pp of the APA Study Guide on the IRS.GOV website This is an accounting comparability adjustment to improve the reliability of comparisons of (i) companies that grew internally and (ii) companies that grew by acquisition Description of APA Intangibles Adjustment Balance sheet don t count intangible assets as operating assets Income statement don t count amortization of intangible assets as an operating expense Impact on profit level indicators Rationale for the APA Intangibles Adjustment Assumptions underlying the APA Intangibles Adjustment

14 E. Miller Williams, Jr E. Miller Williams, Jr. is the SESA Transfer Pricing Controversy Leader. Mr. Williams consults with multinational corporate clients on a national basis regarding complex transfer pricing matters with an emphasis on international transfer pricing controversy, advanced pricing agreements (APA), competent authority, and intercompany planning and structuring. Mr. Williams has over 20 years of transfer pricing consulting experience (5 with the government and 15 in private practice) with companies in a variety of industries. Prior to joining Ernst & Young, Mr. Williams headed the Southeast transfer pricing practices of a previous Big 5 Firm and of one of the current Big 4 Firms in Atlanta. Prior to private practice, Mr. Williams served as a Senior Attorney in the Office of Associate Chief Counsel (International) for the IRS in Washington D.C working on a variety of transfer pricing and international tax matters. As a member of that office, he worked in the APA Program where he acted as lead attorney on many APA cases and as advisor to the Director on APA procedures. Mr. Williams received his LLM in Taxation from Emory University, his J.D. from Stetson University College of Law and his undergraduate degree from Vanderbilt University. Prior to working for the IRS, Mr. Williams served as an officer and attorney in the United States Army Judge Advocate General's Corps where he held positions as a prosecutor, defense attorney and administrative law attorney. Michael Aarstol Michael.P.Aarstol@IRSCOUNSEL.TREAS.GOV Michael Aarstol is currently a Senior Economist working in the San Francisco office of the Advanced Pricing Agreement program in Chief Counsel IRS. Prior to that, he was an economist in the Economist Field Specialist group of the IRS and the Transfer Pricing Practice of Deloitte & Touche. He also taught for several years in the Department of Economics at the University of Georgia. He received his PhD in Economics from Stanford University in 1996.

15 John Wills John Wills was formerly a partner in Ernst & Young s San Jose, California office. Since retiring from Ernst & Young last year, John continues to consult on a part-time basis. A Ph.D. economist, John has focused on transfer pricing since He has numerous times been named one of the World s Leading Transfer Pricing Advisers by International Tax Review. John s practice is heavily oriented toward technology companies with particular focus on transactions in intellectual property and intangibles, including the design and implementation of R&D cost sharing arrangements. John s work has ranged from planning to controversy, including work as an expert witness in arbitration proceedings, audit and appeals controversy, APA negotiation, and work with Competent Authorities. A frequent speaker at conferences and symposia, John has published widely on transfer pricing issues. Recent articles addressed the definition of intangible assets, economic underpinnings of the Income Method, discount rates and disaggregation of cash flows and the measurement of intangible asset lives. Jeffrey Bethard Bethard_Jeffrey@Allergan.com Jeff Bethard is Director, Tax Economist with Allergan, Inc., where he is responsible for global transfer pricing issues. Jeff is involved in tax planning, U.S. and foreign audits, transfer pricing documentation, and APA and Competent Authority negotiations. Prior to joining Allergan, Jeff was a senior manager with Ernst & Young s West Coast transfer pricing practice, where Jeff was involved in tax planning, restructuring and transfer pricing audits and documentation in a variety of industries including semiconductors, pharmaceuticals, medical devices, and automobiles. Jeff has over ten years of experience in transfer pricing and economic consulting. Jeff received his B.A. in quantitative economics and his M.A. in economics from the University of California, San Diego. Jeff has also completed the CFA program.