The comparable profits method (CPM) is a transfer pricing method relying on the principle that similarly situated taxpayers tend to earn similar returns over time. The CPM determines transfer prices by comparing entity-level operating results with those of uncontrolled taxpayers engaged in similar activities under similar circumstances. Typically, the operating results of one party to the transaction—the tested party—are determined based on the CPM analysis, and the residual profits are allocated to the other party. The tested party is the functionally simpler of the two parties—typically a distributor or a “contract manufacturer”—and the residual party is generally the entity that is responsible for strategic decision making and that owns the technology, brands, and other valuable intangible property.
This item examines the evolution of the CPM, from its beginnings to its current status as the dominant method used by multinational companies today, and discusses its adoption in connection with recent legislative and regulatory changes.
Emergence of Profitability-Based Transfer Pricing Methods
The original U.S. transfer pricing regulations, published in 1968, prescribed a variety of “transactional” pricing methods, which focused on the price of an intercompany transaction or group of transactions (TD 6952). In practice, these methods often fell short of government expectations due to the unavailability of comparable data and taxpayers’ advantage of having access to more information than the government. Differences in volume, markets, branding, and terms and conditions all had an impact on transfer prices, and it was believed that taxpayers were cherry picking the information that they used in support of their transfer prices, to the government’s disadvantage.
In response to these concerns, the Service began employing profitability-based transfer pricing approaches as tests of reasonableness. For example, in E.I. DuPont de Nemours & Co., 608 F2d 445 (Ct. Cl. 1979), the U.S. parent company incorporated DuPont International S.A. (DISA) in Switzerland to serve as a distributor of DuPont products in Europe. Evidence introduced in court indicated that DuPont planned to sell its goods to DISA at prices below fair market value so that on resale most of the profits would be reported in a foreign country having lower tax rates than the United States. Because DISA performed no significant special services for either DuPont or its customers to support such income on economic grounds, the IRS reallocated much of this profit back to the U.S. parent. In support of its position, the government introduced expert testimony at trial comparing DISA’s operating results to those of a group of 21 comparable distributors and to those of 1,133 companies representative of the industry as a whole. Based on this evidence, the court sustained the Service’s allocations. Similar approaches were used in Eli Lilly & Co., 84 TC 996 (1985), and G.D. Searle and Co.,88 TC 252 (1987), among other cases. Despite the IRS’s use of profitability-based approaches to test the results of taxpayers’ transfer pricing, taxpayers continued to use the transactional pricing methods in accordance with the 1968 regulations.
Profitability-Based Pricing Methods in the United States
In response to the government’s rising concerns over taxpayers’ use of transactional transfer pricing methods to improperly shift income outside the United States, the Service reexamined the U.S. transfer pricing regulations and recommended that a profitability-based approach should be formally adopted as a transfer pricing technique (Notice 88-123). In 1994, Treasury published regulations setting forth this approach as a prescribed method called the comparable profits method (TD 8552). In addition, the regulations provided that taxpayers could affirmatively use the CPM (and other methods) to report the results of intercompany transactions on a tax return “based upon prices different from those actually charged” (Regs. Sec. 1.482-1(a)(3)).
Because the arm’s-length standard is the international norm, a potential for disputes over primary taxing jurisdiction would exist if the United States unilaterally adopted a transfer pricing method that violated the world’s view of arm’s-length principles. To avoid the resulting confusion and disruption to international trade, the Organisation for Economic Co-operation and Development (OECD) issued transfer pricing guidelines in 1995 that introduced the transaction net margin method (TNMM), a method analogous to the CPM (OECD, Transfer Pric ing Guidelines for Multinational Enterprises and Tax Administrations (1995)).
Although OECD guidelines do not have the authority of law, they nonetheless have great influence among both OECD member nations and nonmember nations. Most member nations have expressly or implicitly adopted the TNMM or some variation thereof in their tax systems. Many nonmember nations, wishing to provide their resident industries and treasuries with a level playing field, have followed suit. For example, the People’s Republic of China, citing the OECD guidelines, recently directed tax administrators to apply a profitability-based transfer pricing approach to evaluate profits (or losses) of foreign controlled manufacturing plants operating in China (Guoshuihan, No. 236 (2/28/07)).
The CPM has long been the most widely used transfer pricing method among large multinational companies. This is evidenced in part by Treasury’s annual report on its advance pricing agreement (APA) program (Announcement 2007-31). (An APA is a formal agreement between the IRS (or sometimes a foreign tax authority) and a taxpayer regarding the taxpayer’s transfer pricing methods.) Of the APAs concluded in 2006, over 80% of those involving tangible product sales used the CPM as the primary transfer pricing method, and over 60% of those involving intercompany services used it as the primary transfer pricing method. The report states:
The CPM is frequently . . . [used] because reliable public data on comparable business activities of independent companies may be more readily available than potential [transactional] data, and comparability of resources employed, functions, risks, and other relevant considerations are more likely to exist than comparability of product.
Today, many smaller multinational companies are adopting the CPM to enjoy its many benefits.
The benefits of the CPM as the basis for a company’s global transfer pricing system include:
- Tax savings: Because the CPM effectively ensures tested party profitability over the long term, the method is effective in avoiding stranded net operating losses, which provide no current tax benefit. Accordingly, the adoption of the CPM frequently results in a reduction of worldwide income taxes.
- Risk reduction: Because profitability-based methods have garnered widespread global support, the risk of a government adjustment on one side of the transaction is reduced. The potential costs of a government-initiated adjustment may be enormous because the amount of an adjustment is effectively taxed twice—once in each jurisdiction. Correlative relief from double taxation is not assured and may be unavailable depending on the treaty relationship between the two taxing jurisdictions.
- Administrative ease: Because the methodology is applied at the entity level (rather than the transaction level), companies realize increased flexibility, simplicity, and administrative ease.
- Compliance with FIN 48 and tax return preparer penalty rules: Given the CPM’s widespread acceptance and use, taxpayers adopting it generally will be in a better position to comply with Financial Accounting Standards Board Interpretation No. 48 (FIN 48), Accounting for Uncertainty in Income Taxes, and the new tax return preparer penalties under Sec. 6694.
Although the advantages of the CPM are great, there are issues and risks associated with adopting it as a global transfer pricing method.
- Transfer pricing risk related to pre-adoption years: Any change of transfer pricing method presents the risk that the newly adopted method may shed light on past deficiencies. Such exposure may be more readily understood and accepted by shareholders, tax authorities, and other constituents to the extent that a method change can be coordinated with a business change, the adoption of FIN 48, or other external event.
- Foreign tax variations: Although some countries have embraced profitability-based transfer pricing methods without exception, many countries maintain formal or informal variations in their tax laws and practices. For example, Canada is averse to markups on costs incurred to render intercompany administrative services. An understanding of foreign tax law and practice, as well as flexibility, are required to avoid conflicts with foreign tax authorities.
- Operational changes: Various operational issues may arise when the transfer pricing method is changed. For example, long-standing intercompany transactions may need to be replaced by new transactions, resulting in changes to intercompany agreements and operating and accounting procedures.
- Management support: It is important that both domestic and foreign management understand the benefits of the CPM to the global enterprise and support its adoption. For example, bonus plans that are based on entity-level operating profits may need to be modified to adjust for the CPM’s effect on bonus pools.
- Customs duties: Although importation tariffs on many products have been reduced or eliminated under the General Agreement on Tariffs and Trade (GATT), some products still bear significant duties, especially in many developing countries. The effect of any transfer pricing changes on importation duties should be considered.
The CPM has emerged as the dominant transfer pricing method among multinational companies today due to its widespread acceptance by taxing authorities around the world, its administrative ease of use, and, often, opportunities for tax rate reduction. Recent changes in accounting for uncertainty in income taxes (FIN 48) and tax return preparer penalties (Sec. 6694) provide both reasons and contexts for adopting the CPM now. Companies considering adopting the CPM should seek the advice of an experienced practitioner to ensure that potential issues are identified and addressed.
Nick Gruidl, CPA, MBT, Managing Director, National Tax Department, RSM McGladrey, Inc., Minneapolis, MN
Unless otherwise indicated, contributors are members of RSM McGladrey, Inc.
If you would like additional information about these items, contact Mr. Gruidl at (952) 893-7018 or firstname.lastname@example.org.