“If we are consistent, the ultimate test is the arm length test, and not the existence of a necessarily incomplete example or some arbitration rule that gives a mistaken aura of precision to what is inherently an inexact and highly judgmental process“.

Charles H. Berry

This month of September, we remember ten years of the physical disappearance of Charles H. Berry.  The main contribution attributed to this notable economist is the creation of the Berry Ratio or Index, used in the late seventies in the DuPont case (I.E. DU PONT DE NEMOURS & CO. V. UNITED STATES) and whose arguments constituted the gateway for economists to the world of transfer pricing.

Dupont case

According to the ruling of this case, the U.S. Tax Administration (Internal Revenue Service) questioned the prices agreed by an American manufacturing company of the DuPont Group in its sales of products to a Swiss trading subsidiary for the fiscal years 1959 and 1960.  At this time, the U.S. regulations contained in section 482 of the US tax code (Internal revenue Code or IRC) contemplated only the so-called traditional transactional methods, i.e. the Comparable Uncontrolled Price Method (CUP), the Resale Price Method (RPM) and the Cost Plus Method-(CP).  However, it also considered what it called “any other appropriate method,” also known as “the fourth method.”  The taxpayer based his entire case on the use of the RPM to justify the allocation of income to his related party in Switzerland, which was not considered economically realistic by the Commissioner of Internal Revenue.

Essentially, as the sentence mentions, the RPM reconstructs a fair arm’s length market price by discounting the reseller´s selling price by the gross profit margin.  However, the vital prerequisite of this method is the existence of comparable uncontrolled resellers.  According to the U.S. regulations in force at the time, for the determination of comparable resales operations, the factor to be considered were: i) the type of property, ii) the functions, III) use of intangibles, and iv) similarities of geographic markets. The standard also requires substantial comparability for its application.

The judgement explains that the parties agreed that there was no known existence of independent organizations that fulfilled and performed marketing functions similar to that of the Swiss entity. However, the taxpayer supplied a group of twenty-one (21) distributors similar to the Swiss entity but there was no information that could establish similarity of products or comparability of functions or geographical markets, on the contrary the records suggested significant differences.

The ruling also points out the lack of a significant resale comparable is highlighted by the taxpayer’s failure to suggest by any means to adjust the differences between the Swiss entity and uncontrolled resellers.

For its part, the tax administration had used in the past taxpayer income statistics to estimate net benefits, not gross margins, regardless of which implied to contradict the regulations or simply an attempt to apply the Fourth Method mentioned above.

According to the ruling, two economic indices that supported the reallocation of the commission were presented, one of the indices compared the gross income to operating costs (expenses) for 32 companies dedicated to advertising, consultancy services and distribution.  The other index was not supported by functional similarities, but in a comprehensive study of the return rates of more than a thousand companies.  Regardless of whether they were measured from the viewpoint of similar functional or the return of capital, the benefits of the Swiss entity were significantly higher.

The aforementioned analysis approaches were subsequently addressed in a report called called “A Study of Intercompany Pricing” (also known as el Section 482 White Paper), prepared by the U.S. Tax Administration and U.S. Treasury in the year 1988 which would serve as the basis for the reform of the transfer pricing regulations contained in section 482 of the US tax code.

The Chapter 5 Analysis of the fourth method under section 482 of this study in section C. “Rates of Return: Income to Expenses Ratios” mentions that the courts have used other methods to justify transfer pricing adjustments and that two of these methods are illustrated in the Dupont Case.  The first method was computing  the ratio of gross income to operating costs (expenses), also known as the Berry Ratio for being used for the first time by Dr. Charles Berry as an expert witness from the government.  The second approach, developed by Dr. Irving Plotkin, was to compare the return on capital obtained by the Swiss entity with the profitability of 1133 companies.

The study mentions that the Berry Ratio and the analysis of the return rate found in the Dupont case are interesting, that it should be kept in mind that the court may have seen favorably this evidence, in part because it indicated that even after the determination, the Swiss trading entity gained greater profits than almost any other corporation, regardless of whether they were comparable or not.  This study also highlighted that these methods were not used directly to make an adjustment, but to support the reasonableness of the determination made by the tax administration.

The conclusions and recommendations of the aforementioned chapter from this study highlight, among other, that the ratios used in the Dupont case provide some reasonable basis for the allocation of profits (income) and determine the transfer prices in the absence of “comparables“. However, these methods have not been sufficiently developed by the courts to close the gap in the analysis left by the Regulations of section 482 when uncontrolled comparable transactions cannot be located.

 Beyond the Dupont case

The Dupont case established the precedent to be able to develop in greater detail what used to be considered other methods, giving rise to so-called profitability-based methods such as profit Split method and the Transactional net Margin method (TNMM) in the OECD Guidelines or its version in section 482 (Comparable Profits Method – CPM) that would become the “last resort” method used in 90% of the cases.

 Other analysis approaches

In addition to the contribution of economists in developing what would become the profit-based methods in both the US regulations and the OECD guidelines, under certain circumstances, econometric techniques have been used (regression analysis) to obtain functions that allow estimating uncontrolled values or prices (dependent variable) through the behavior of other variables that could represent the terms of the transaction (independent variables), when there is sufficient public and reliable information of these variables relating to transactions between independent third parties and a causal relationship of the independent variables with respect to the dependent can be established

 Final considerations

With the implementation of the BEPS Action Plan (Base Erosion and Profit shifting), specifically the report of actions 8, 9 and 10 entitled “Aligning transfer Pricing outcomes with Value Creation“, new horizons for economists to continue making important contributions to this discipline are opened, especially in this context in which the goal is to sustain the compliance with the arm’s length principle with the value creation process of the companies.

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