Taxation And Finance

Posts Tagged ‘Tax’

Tax authorities in different jurisdictions are likely to allocate individual multinational firms’ consolidated income across countries in different ways. This statement would be true even if tax authorities utilized the same transfer pricing methodology, given the sensitivity of one’s results to the particular “comparable companies” included in one’s sample (and, in the case of the CPM, the particular profit level indicator used).

However, as a practical matter, tax authorities are likely to use different transfer pricing methodologies in analyzing a given case.Most countries endorse the arm’s length standard in principle, and the U.S. and OECD provisions contain the same specific set of transfer pricing methodologies . However, the IRS has a clear predilection to use one particular profits-based method (the CPM), while OECD countries prefer transactions-based methods.

Different approved methodologies will generally produce different allocations of income, because the assumed unifying foundation across methods—primarily the basic concept of market equilibrium—does not in fact apply. The large number of cases handled by the competent authorities of different countries attests to this conundrum, which in turn creates the potential for double taxation on a significant scale.

Individual multinational corporations cannot accurately anticipate their country-specific tax liability in the absence of an Advance Pricing Agreement.Corporate taxpayers and tax authorities, respectively, also frequently utilize different firm samples and/or transfer pricing methodologies to determine their tax liability (taxpayers before an audit and tax authorities during an audit). Because the use of different samples and/or methods will often produce inconsistent results, firms acting in good faith may report substantially less income in a given jurisdiction than the tax authority in that jurisdiction believes is warranted.

Accounting analyses present a snapshot of firm performance at a point in time, or generally over a relatively short period of time, to facilitate “mid-course corrections” and incremental decision-making on the part of management and shareholders. Accounting rates of return are computed as the ratio of operating profits to total assets, fixed assets or some other measure of the book value of resources committed by the firm.

Costs are measured by explicit expenditures only, and one attempts to match revenues and the expenditures necessary to generate them on a year-by-year basis. As such, assets are depreciated over their useful lives, in lieu of deducting investment outlays in full when they are made. Firms generally do not maximize their accounting rates of return (or their ratios of operating profits to revenues or costs, or gross profits to cost of goods or operating expenses), because such courses of action will not result in the highest possible shareholder value.

Therefore, as noted, there are no market mechanisms at work to equalize these profit level indicators across firms, and, by implication, no particular reason to expect similarly situated firms to earn the same accounting rates of return, operating margins or operating markups, as noted. The use of accounting measures of profit to determine multinational firms’ country-specific income tax liabilities under profits-based methods has several important practical implications, enumerated below.

The fields of economics and accounting serve very different purposes. Microeconomic and financial theories seek to explain the allocation of resources in an economy through firm, consumer and investor behavior and market mechanisms.Economic profits drive firm behavior and lead to the maximization of shareholders’ wealth (and, thereby, their lifetime consumption).

The calculation of such profits reflects the actual timing of investments (rather than smoothing out periodic capital expenditures via depreciation) and incorporates all costs, including the cost of equity capital (and, potentially, other opportunity costs). The economic profit rate is defined as that rate which equates (a) the discounted present value of forecasted after-tax free cash flows generated by a given investment project with (b) the initial outlays required.1 It is extremely difficult, if not impossible, to quantify a firm-wide economic profit rate as a practical matter.

Under conditions of free entry and exit, and absent financing constraints, firms will continue to enter a given market until the net present value of market participation (that is, the present value of projected after-tax free cash flows, discounted at the opportunity cost of capital and reduced by the initial investment required) is driven to zero. Until this point is reached, incumbent firms will earn positive economic profits (i.e., profits in excess of a “normal” return), and shareholders’ wealth will be increased thereby. Through the process of market entry, additional resources are dedicated to the manufacture of those products that consumers value more highly than the resources necessary to produce them.