(Vol. 23, No. 22)
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Insights ‘Pygmalion’ Comparables: Why Data from the ‘Center’ Does Not Apply for the ‘Periphery’ The author examines the effect of using comparables from countries such as the U.S. and the U.K. to calculate taxable income of companies operating in countries where wage shares are lower. He concludes that the use of these ‘‘Pygmalion’’ comparables leaves taxpayers vulnerable, tax administrations liable for arbitrary, capricious and unreasonable behavior, and analysts searching for an ideal.
BY EDNALDO SILVA, ROYALTYSTAT, WASHINGTON, D.C. n Book 10 of Ovid’s Metamorphosis, Pygmalion said to Venus, ‘‘Gracious goddess, grant me a woman to wed who is like my statue.’’ His wish was granted. Unfortunately, the Organization for Economic Cooperation and Development is not Venus, and analysts operating in countries on the ‘‘Periphery’’—in this context, say, Mexico, Greece or Poland—are not going to find appropriate comparables from countries in the ‘‘Center’’—for purposes of this article, the U.S. and the U.K. In other words, when taxable income from relatedparty transactions is based on purported comparables from the Center, the Periphery suffers. The U.S., in creating two methods based on comparables in its 1994 transfer pricing regulations, succeeded in defining ‘‘arm’s length’’ transactions as
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Ednaldo Silva, Ph.D., is founder and executive director of RoyaltyStat in Washington, D.C. He was a drafter of the 1994 U.S. transfer pricing regulations and the first economist in the Internal Revenue Service’s Advance Pricing Agreement Program.
‘‘comparable’’ transactions. The OECD, in issuing its 1995 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, adopted the new methods—the comparable profits method (CPM), which it termed the ‘‘transactional net margin method (TNMM) in its guidelines, and the profit split method. Because the OECD also inherited the U.S. axiom of defining arm’s-length transactions as comparable transactions, a number of practical problems, principally the lack of local comparables, have surfaced in many OECD countries. The current comparability standards, including a list of the comparability factors, are provided in the 2010 OECD guidelines at paragraphs 1.33-1.63. These factors are the characteristics of the property or services, functional analysis, contractual terms, economic circumstances and business strategies, and they mimic the factors described in the U.S. provisions at Regs. §1.4821(d)(3). The difficulty of finding comparables was already apparent at the IRS. Notice 88-123, 1988-2 C.B. 458, also known as the transfer pricing white paper, stated at Chapter 4(A) that ‘‘the section 482 regulations rely heavily on finding comparable goods, services, and intangibles to determine whether an arm’s length price has been used. . . . Where no comparables can be found, or where similar items are only distantly comparable, the regulations leave the Service [IRS], the taxpayers, and the courts with little guidance.’’ This problem worsens because the OECD aims to extend a local, U.S.-based axiom, to Periphery countries in which comparables cannot be found. Lack of local comparables can lead to inconsistent— that is, arbitrary, capricious and unreasonable— behavior by some tax authorities in the Periphery, in which they both assert and deny the use of comparables from the Center. From experience, while they do not allow taxpayers to use comparables from the Center, the tax authorities themselves use them to impose transfer pricing assessments. The issue is not whether the entities are comparable to the tested party, but the location of the entities used as comparables. These tax authorities assert in a capricious and arbitrary manner that only local comparables can be used in order for the taxBNA TAX