IRS ECONOMISTS REFOCUS SELECTION OF COMPANY COMPARABLES
By Robert Feinschreiber and Margaret Kent

High-ranking IRS economists are seeking to refocus the transfer pricing regulation's approach to the selection of company comparables. These economists recognize that a significant number of professionals in the private sector and the Service often undertake little analysis in selecting company comparables in the CPM context, relying instead only on SIC code classification in the public corporations context. The economists' refocus reflects their response to those practitioners and to IRS auditors.

Four economists prepared the study, with each economist having a dual specialization. The first of these economists, Joel B. Rosenberg, earned his Ph.D. from Brown University and is an Accredited Valuation Appraiser. Dr. Rosenberg in the Team Manager of the Washington D.C. Economist Group within the U.S. Internal Revenue Service. The second economist, Barbara McLennan, holds both a Ph.D. in Political Science and a JD degree. Dr. McLennan was formerly the Deputy Assistant Secretary for Trade and Information Analysis for the United States, and is now an industry economist with the Washington D.C. Economist Group within the U.S. Internal Revenue Service. The third economist, Ahmed H. Mohamed, holds a Ph.D. degree in economics and is CPA. Dr. Mohamed is an industry economist with the Washington D.C. Economist Group within the U.S. Internal Revenue Service. The fourth economist, Alan D. McInnes, holds a Ph.D. degree in economics and a JD degree. Dr. McInnes is an industry economist with the Los Angeles economist group within the U.S. Internal Revenue Service.

The positions taken by these economists do not necessarily represent the position of the IRS, but their analysis does represent forward thinking that should have important ramifications in the future for the direction of U.S. pricing. The economists' suggestions would have the effect of narrowing the number of situations in which the taxpayer or the IRS can apply CPM as the best transfer pricing method. They would put aside the almost rote shortcut approach to determine comparable companies, especially as to the indiscriminate use of Standard Industry Classification (SIC) Codes in selecting comparable companies.

The economists would have the IRS and the taxpayers begin with functional analysis of the business and then provide an enumeration of the economic functions followed by a more detailed analysis of the tested party. This detailed analysis would depend on whether the taxpayer is a manufacturer or is engaged in marketing and distribution, but many taxpayers are likely to be treated as being subject to both regimes. The economists focus on 73 specific inquiries where eight now apply to determine if the companies under review are in fact comparable to the tested party.

This transfer pricing study is actually the third piece of the transfer pricing review process. Dr. Barbara McLennan began this review process in 2001 when she published her chapter, "Finding and Applying Arm's Length Comparables under the Comparable Profits Method" in the Transfer Pricing Handbook, Third Edition, (John Wiley & Sons, Inc.) In her analysis, Dr. McLennan provides that

Both taxpayers and IRS auditors most often apply the comparable profits method (CPM) for transfer pricing purposes by selecting the relevant Standard Industry Classification (SIC) code and then using the data for companies that classify themselves in that SIC code as the comparison. This shortcut approach ignores whether the SIC classification is correct for the company or its comparables, functional analysis, risks, contract terms, economic conditions, and the like, as well as the nature of the firm being evaluated. As such, the shortcut approach deviates most strongly from the transfer pricing regulations, resulting in invalid approaches and results. The essential ingredient in applying the comparable profits method is finding and applying arm's-length comparables.

Following the publication of Dr. McLennan's study, the IRS economists, cognizant
of needing a taxpayer perspective, requested that Feinschreiber & Associates prepare a subsequent analysis addressing the same concerns, thus providing the second piece of this analysis. Robert Feinschreiber and Margaret Kent published their recommendations in "Proposals for Revising the Transfer Pricing Structure," Corporate Business Taxation Monthly, vol.3 no. 8, May 2002, p.3. The economists added the third piece, which is summarized in this analysis. The detailed analysis is published in the December 2003 issue of Corporate Business Taxation Monthly, and became available late in January 2004.

The Economists' Study

The economists revisit the determination of the best method. In so doing, they move away from the almost automatic method selection that almost always leads to the selection of the CPM. The economists recognize that the CPM is the most reliable approach given good comparables, but they assert that practitioners IRS officials and service providers rarely provide good comparables. Absent these good comparables, the CPM is the "method of the last resort."

These economists would that require practitioners and the IRS undertake a more thoughtful analysis of company comparables, including the following, in computing the CPM:

The economists failed to address the following issues, but acknowledge their existence.

The economists failed to acknowledge

Asset Intensity Adjustments

The economists recognize that inventory, accounts receivable, and accounts payable determine asset intensity, including delayed cash payments and other deferred payments.
They looked to adjusted operating profits, which they termed operating profits plus an amount that is accounts payable times interest rate. They sought to include imputed short-term interest charge on each party's accounts payable and deduct imputed interest income on the excess accounts receivable in accordance with Reg. Sec. 1.482 ­5(e).

The economists recognized that the initial focus was on three variables ­ inventory, accounts receivable, and accounts payable, but there is little agreement on the methods used to adjust these accounts. The economists suggested that a long-term rate such as a corporate bond rate be used to make the appropriate adjustments.

The economists contend that practitioners often fail to account for the liquidity values of these assets and that it is not possible to immediately convert these assets into cash or finance these activities with 100% of borrowed funds from third parties. The economists assert that it is necessary to rely on equity financing in part to cover the necessary carrying charges, but that most practitioners have generally ignored this fact. The economists suggest that an overall cost of capital be used, consistent with the "Reasonable Rate of Return" method used by valuation professionals to value closely held concerns. The proposed methodology is a variation of the "Excess Profit" method proposed by the U.S. Department of Treasury in Rev Proc 68-609.

The economists specifically consider inventory and accounts receivable an contend:

The economists diminish the potential for applying the return on capital employed as a profit level indicator. Some practitioners have argued that there is no need to adjust the tested party or the comparables for differences in inventory and accounts receivable because they are included in the operating assets of the return on capital employed equation. This return of capital employed position is contrary to a previously cited example in the 1994 regulations, regulation 1.482-5(e), example 5. The economists pointed out that the return on capital employed method has limitations because, for example, a manufacturer with a relatively new plant earns a lower rate of return on capital employed than another producer with an older plant due to the higher book value of its net fixed assets given its original investment.

The economists are concerned about the reliability of the screening process for selecting the proposed comparables, not just on the reliability of the return on capital employed.

The normalization of net fixed assets does appear to reduce, however, the reliability of return on capital employed. As an alternative, it might be desirable to rely on financial ratios even if eventually there may have to be an eventual adjustment in operating income.

The economists recognize that there has been an increasing reliance on entity-based methods to evaluate the arm's length results of related party transactions, as evidenced by the frequent application of the CPM. As a result, there is a need to digest financial and accounting information of both potential comparable companies and the tested party.

Conclusion

The economists suggest that the company under review undertake a functional analysis of the tested party as the first step in understanding and identifying potential comparables. The next steps would include the following:

@Robert Feinschreiber and Margaret Kent, 2004