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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


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


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payers to meet the burden of proof that their intercompany transactions are arm’s-length. As a practical solution, comparables are obtained from the U.S. or from the U.K., depending on which Center country is the leading trade partner of the Periphery, to assess related-party income tax liability in the Periphery. Often regional comparables also are used; however, in the desperate effort to find comparables, analysts often mix together entities from countries with Center and Periphery characteristics—for example, they mix in the selection of comparable companies from Australia, Japan, Indonesia, Malaysia, and the Philippines. Or they include among pan-European comparables companies from Greece, Poland, France and Germany. The author suggests that using OECD Center-based comparables is harmful to the Periphery because, in general, cross-country profit rates do not equalize. As a result, following the OECD axiom, countries in the Periphery are likely to collect less controlled corporate income taxes, all other things being equal, than if they were to use safe harbor rules based on local taxpayer filing data. The author further suggests that the U.S. and OECD standards of comparability, which are based on qualitative factors—including functions performed, risks assumed, contractual terms and geographic market—lack an identifiable economic framework. The argument put forward in this article is that the OECD comparables paradigm must be reconsidered and a more practical solution must be sought to encourage voluntary tax compliance, reduce profit shifting and avoid double taxation. Although this issue must be explored further, the author suggests that safe harbors based on local taxpayer filing information would make controlled corporate tax compliance more certain for both taxpayers and tax administrations. Safe harbors also may be more practical and less intrusive than formulary apportionment. For safe harbors (which may include outbound limits on the tax deductibility of specific intercompany expenses, including management fees, royalties and interest), tax authorities need to review the financial accounts of the tested party. In contrast, for formulary apportionment, review of the financial accounts of the party and its counterparty is required. Recognizing this point, on May 16, 2013, the OECD Council approved the revision of Section E on safe harbors in Chapter 4 of the OECD guidelines, which ‘‘provides opportunities for countries to relieve some compliance burdens and to provide greater certainty for cases involving smaller taxpayers or less complex transactions.’’1 Although the Brazilian authorities opted out of the OECD approach and selected a system of safe harbors,2 a major problem with the Brazilian implementation is that the safe harbors are based on gross profit margins. This is unwise because gross profits depend on the level of operating expenses. Thus, the Brazilian regime is more or less inflexible and may not work with complex tax cases. Further discussion of safe harbors is beyond the scope of this article. Rather, this article will establish 1

Available at 22 Transfer Pricing Report 369, 7/25/13. See subchapter 10.2, ‘‘Brazil Country Practices,’’ of the United Nations’ Practical Manual on Transfer Pricing for Developing Countries, available at http://www.un.org/esa/ffd/ documents/UN_Manual_TransferPricing.pdf. 2

INSIGHTS that the widespread use of comparables from the Center to analyze transactions in the Periphery is flawed.

Theory: Profit Rate Depends on Two Factors (ω and β) Following the U.S. regulations (1968 and 1994), the OECD provides several factors to establish comparable transactions. The OECD guidelines at paragraph 1.36 mention the following comparability factors: s characteristics of the property or services transferred, s functions performed by the parties (taking into account assets used and risks assumed), s contractual terms, s economic circumstances (including geographic location) and s business strategies pursued by the parties. Except for intangible license and other agreements, contractual terms are seldom disclosed in annual reports of aggregate transactions. Most factors are vague, without a discernible economic framework, and attempts to comply with the U.S. and the OECD comparability standards have created a nursery school of gamers—one might say Pygmalions— selecting ‘‘comparables’’ that cannot sustain audit scrutiny. In fact, pervasive game playing is a major discredit to the arm’s-length principle based on comparables. No research program can eliminate the need for subjective judgment. However, the often sneering claim that the ‘‘selection of comparables is more art than science’’ reflects fuzzy transfer pricing principles. It is the flawed principles that must be replaced in order to permit a better demarcation between defensible claims about ascertaining tax parity between controlled and uncontrolled transactions and posturing in the name of art. According to mathematics and science philosopher Imre Lakatos, a theory is ‘‘accep or ‘‘scientific’’ only if it has corroborated excess empirical content over its predecessor or rival—that is, only if it leads to the discovery of novel facts.3 This condition can be expressed as two clauses: s that the new theory has excess empirical content (acceptability 1), and s that some of this excess content is verified (acceptability 2).4 The author proposes a model in which—in contrast to the approach in the OECD and the U.S. progenitor regulations—the determinants of the profit rate are conceptually simpler and based on two measurable factors. To expound this simpler, quantitative model, let added value per industry or per country, described by the variable (Y), be equal to the sum of the compensation of employees (W, representing wages and salaries) and the gross operating surplus (profits, gross of depreciation).5 (1) Yi = Wi + ri Ki 3 The Methodology of Scientific Research Programmes, Cambridge University Press, 1978, Chapter 1, pp. 31-32. 4 See also E. Gombrich, Art and Illusion, New York, Pantheon Books, 1960, Chapters 2 (Truth and the stereotype) and 3 (Pygmalion power). 5 Herein, profits are synonymous with the ‘‘gross operating surplus’’ in the United Nations’ System of National Accounts

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INSIGHTS (2) ri = (1 – ωi) / βi, where 0 < ω < 1 and β > 0. The i-th index 1, 2, 3, . . ., M counts the specific goods or services (commodities), industry or country, depending on the level of data aggregation available to the analyst. In Equation (1) or (2) above, Yi = pi qi (basic price × quantity of a particular i-th good shipped, or service provided to customers) is the known value added, Wi is the known wages and salaries, ri is the unknown profit rate on the invested capital stock and Ki is the known value of the capital stock (inventories plus property, plant and equipment). In practice, the capital stock is measured in monetary units and thus is dependent on a profit rate. In general, using the capital stock to determine a profit rate is circuitous. One way of avoiding this problem is to use the incremental capital/output ratio (ICOR) based on capital expenditure (investment) flows. Capital stock can be computed using a standard perpetual inventory (PIM) equation: Kt = (1 − δ) Kt− 1 + It where δ is the depreciation rate, K is the computed real (inflation adjusted) capital stock in years t and t − 1, and I is the real capital expenditure (investment) in year t.6 However, the amount of labor involved in using PIM was too great, and thus ICOR was computed for the sampled countries described in the preliminary empirical research. Equation (1) or (2) contains the profit rate as the only unknown variable to be determined. The Greek ω (omega) denotes the wage share in value added, and β (beta) denotes the capital/value added ratio, which is a standard input/output measure of technology.7 A higher β denotes a higher level of technology and, for a given wage share, a lower profit rate. Equation (2) yields two basic analytical results. First, the profit rate depends on two factors, ω and β, and not on the vague factors asserted by the OECD. (It should be noted that not all OECD comparability factors are vague. For example, geographic market is clear and important.) Second, the profit rate varies inversely with the wage share. The capital/output ratio measures the slope of this inverse r(ω) relationship. Equation (1) or (2) is definitional (accounting identity), without an implicit behavioral assumption (tes hypothesis). To convert this accounting identity to a theory of the profit rate, a hypothesis is posited that β is constant during a certain audit period such that the profit rate becomes proportional to the wage share. This assumption of a constant capital/output ratio may not hold in the longrun because technical progress may increase β. Applying Equation (2) will require considering two separate cases. For this purpose, consider one country the Center and a second country the Periphery. The case in which the profit rate is equal in the Center and Periphery is special because the likelihood that both (SNA) or EBITDA in corporate income statements. See http:// data.un.org/Explorer.aspx?d=SNA. 6 See Dan Usher (ed.), The Measurement of Capital, Chicago University Press, 1980, Equations 5 and 6. 7 Equation (2) is obtained by dividing (1) by Y. The wage share ω = W/Y and the capital/value added ratio β = K/Y, which is also known as the capital/output ratio. See Ernst Helmsta ¨dter, ‘‘The Long-Run Movement of the Capital-Output Ratio and Labour’s Share,’’ in James Mirrlees and Nicholas Stern (eds.), Models of Economics Growth, New York, John Wiley & Sons, 1973.

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factors are equal, compared pairwise (that is, ω1 = ω2 = ω and β1 = β2 = β) is extremely low. This special case nullifies the distinction between the Center and the Periphery, such that if comparables exist they can be obtained from either location. However, to respect the facts and circumstances of the audit, as provided in paragraph 1.55 of the OECD guidelines, the comparison of the wage shares and capital/output ratios can be postulated as case-specific hypotheses subject to empirical testing. The paragraph states that the facts and circumstances of the particular case will determine whether differences in economic circumstances—which would include geographic location—have a material effect on price, and whether reasonably accurate adjustments can be made to eliminate the effects of such differences.

Case 1: Unequal profit rates from differences in wage shares Assuming the same or similar capital/output ratios in the Center and Periphery, unequal profit rates can arise from differences in the wage shares. Chart 1 shows that, for the same β, as ω increases from zero toward 1 (its theoretical limits), the profit rate decreases towards zero. Thus, given a uniform technology in the Center and the Periphery (β1 = β2 = β), the inequality in wage shares ω2 < ω1, implies the reverse inequality of the profit rates, such that r2 > r1. In this case, comparables from the Center cannot be used to determine the taxable income of related parties in the Periphery, unless ‘‘location savings’’ adjustments are made to reflect the lower wage share and higher profit rate of the Periphery. According to Equation (1), taxable income is a fraction of the gross operating surplus (Profits), Si = ri Ki of the tested party. According to Equation (2), comparables are selected to determine the profit rate, ri = (1 – ωi)/βi, of the tested party, which, after multiplying by its capital stock, would determine the profit base from which income tax is assessed. The effect of this ‘‘location savings’’ adjustment is to increase the taxable income of the Periphery to reflect the differences in wage shares. The OECD guidance on transfer pricing aspects of intangibles, published Sept. 16, 2014, is provided at paragraph 1.84: When reliable local market comparables are not present, determinations regarding the existence and allocation of location savings among members of an MNE group, and any comparability adjustments required to take into account location savings, should be based on an analysis of all of the relevant facts and circumstances, including the functions performed, risks assumed, and assets used of the relevant associated enterprises.8


Available at 23 Transfer Pricing Report S-185, 9/18/14. BNA TAX


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Chart 1: Profit Rate Inversely Related to Wage Share

Thus, assuming the same technology in the Center and Periphery, such as the case of cars built for export in Mexico, using comparables from the U.S. to determine r1 to assess the tax liability of the subsidiary in Mexico would be damaging to the Mexican fiscal authority, because the wage share in Mexico is much lower than in the U.S. Thus, selecting purported comparables from the Center to determine the arm’s-length profit rate of the Periphery produces lower taxable income in the Periphery, because r(ω1) is lower than r(ω2).

Case 2: Unequal profit rates from differences in wage shares and capital/output ratios A more realistic case is when the wage share and the capital/output ratios are different in the Center and Periphery. In this case, comparables from the Center cannot be used to determine the taxable income of related parties in the Periphery. Chart 2 shows that the taxable income of the Periphery must be higher than that of the Center because the Periphery is characterized by a lower wage share and a lower capital/output ratio.

Chart 2: Different Wage Shares and Capital/Output Ratios

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Cross-Country Profit Rates Do Not Equalize In ideal economic models, it is customary to assume that r1 = r2 = r, which implies that both the wage shares and capital/output ratios are equalized in the Center and Periphery—that is, ω1 = ω2 = ω, and β1 = β2 = β. These heroic assumptions need to be tested on a caseby-case basis because they are likely to be falsified by actual data. These ideal assumptions also may fail inside a country such as the U.S., where the index i = 1, 2, . . ., M would represent M industries with disparate wage shares and capital/output ratios. Indeed, it is difficult to identify an economic mechanism that would lead to the equalization of the capital/output ratios across different industries within a country. Instead of empirics, the equality of the profit rate assumption is based on ad hoc notions of gravitation or factor mobility. (The economic literature is not rich regarding the process of economic gravitation toward equal profit rates within and across countries, and often an appeal to the nebulous ‘‘invisible hand’’ is invoked. Since classical economics—see Adam Smith, David Ricardo, Karl Marx—equalization of the profit rates is assumed such that, using a more recent interpretation, the eigen vector of prices and the assumed single eigen value profit rate are determined simultaneously. One source states, amid the dense mathematics, ‘‘It is presumed that capitalists tend to shift their capital from one industry [or from one country] to another until the resulting scarcity relationships have established a price system where rates of return of all capitals are equalized: r1 = r2 = . . . = rM = r.’’9) An ad hoc notion of gravitation or factor mobility would be the notion that property, plant and equipment, as balance sheet elements of the capital stock, are mobile from one industry or from one country to another. This is implausible, because they do not flow like hydraulic dynamics from one industry or country to another irrespective of disparities in profit rates. Capital expenditure (investment flow) may be mobile, but it is unlikely that a company will systematically invest outside of its core activities in the conduct of its trade or business in order to gravitate to a higher profit rate. (A company may acquire another entity outside of its core business to achieve vertical integration, but redirecting capital expenditure in a given period outside of its core activities is unlikely.) In any event, the profit rate is based on accumulated capital expenditures, which flow over time into a capital stock, and not on the capital expenditure flow of a specific year.

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the Center and Periphery, including the BRICS (Brazil, Russia, India, China, and South Africa). The UN’s Practical Manual on Transfer Pricing for Developing Countries, approved Oct. 15, 2012, states at section 1.10.7, ‘‘Overall, it is quite clear that finding appropriate comparables in developing countries for analysis is quite possibly the biggest practical problem currently faced by enterprises and tax authorities alike.’’ Overall, Chapter 10 of the UN Manual describes the transfer pricing practices of Brazil, China, India and South Africa. For example, regarding South African practice, section provides: The main challenge that South Africa encounters in determining arm’s length profits is the lack of domestic comparables. The pursuit of the perfect comparable remains an elusive and almost unattainable feat. It is thus accepted that the most reliable comparables will suffice. The problem in South Africa is that this compromise is extended even further given that there are no databases containing South African-specific, or for that matter African-specific, comparable data. As a result, both the tax administration and taxpayer rely on European databases to establish arm’s length prices or levels of profitability.10 The OECD provides historical information on value added (Y), compensation of employees (W) and gross fixed capital formation (capital expenditures or investment, I) for several countries. With such data, it is possible to determine the wage share, the incremental capital/output ratio (‘‘ICOR’’), and the profit rate in such countries. Chart 3 shows the wage share, Chart 4 shows the ICOR, and Chart 5 shows the profit rate for the selected countries. See the Appendix to this article regarding the ICOR.

Chart 3: Wage share (ω)

9 Yasuo Murata, Mathematics for Stability and Optimization of Economic Systems, New York, Academic Press, 1977, §4.4 (Price systems of Leontief type). What is quoted is the short paragraph above Murata’s equation 105, p. 145 (emphasis added, and Murata’s symbol of the profit rate was changed to conform the symbol used on this article. Murata’s allusion to ‘‘scarcity’’ when dealing with produced goods and services is erroneous because by definition produced commodities cannot be scarce).

53.7% %

United Kingdom

52.8% %

United States


R Russia




South Africa


Brazil 36.1%

Poland India

Preliminary Empirical Checking Although more research is needed, herein the author provides preliminary evidence that both the wage share and capital/output ratios are different (that is, ω2 < ω1 and β2 ≤ β1 ) for a representative sample of countries in



28.5% 27.0%

Data for Charts 3, 4 and 5 reflect most recent years for which information is available. Data are from 2013 for Russia, South Africa, Turkey, United Kingdom and United States; from 2012 for Mexico and Poland; from 2011 for China; and from 2009 for India and Brazil.11 10

UN Practical Manual, note 2, above. Data extracted on November 11, 2014 from http:// stats.oecd.org/index.aspx?DatasetCode=SNA_TABLE1, except for Brazil. Brazilian data are available from http:// www.ibge.gov.br/home/estatistica/economia/contasnacionais/ 2009/tabelas_pdf/tab04.pdf. 11



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Chart 4: ICOR (β) 5.2

United States 4.5

Poland 4.1

United Kingdom 3.3

Mexico R Russia



3.0 2.8


Appendix: Incremental Capital/Output Ratios


South Africa T key Tur




As a result, r2 > r1, putting into question the widespread notion of cross-country profit rate equalization. Chart 5 shows that profits rates are unequal and, as expected, lower in the Center compared to the Periphery.

Chart 5: Profit rate (r) Turkey T India Mexico Brazil South Africa China R Russia Poland United Kingdom United States

The OECD, recognizing this problem, solicited comments in a March 2014 paper.12 As this article suggests, the profit rates vary with the wage share and capital/output ratio, and the profit rates do not equalize between countries in the Center and Periphery. In the absence of reliable adjustments for location savings, use of supposed comparables from the Center to assess controlled tax liability in the Periphery is untenable. Also, massive adjustments for ω and β may challenge the reliability of the proposed arm’s-length results.

4 % 46.7 34.3% 22.0% 20.2% 20.1% 17.7% 15.9% 14.3% 11.1% 9.0%

Conclusion This article has established that defining arm’slength taxable income by reference to comparable transactions is difficult to apply in the Periphery because of the limited number of comparables. As a result of this general problem, which affects many countries— including some developing country members of the OECD—there is a systematic gap, or lack of tax parity, unfavorable to income tax collection in the Periphery when purported comparables from the Center are used.

The system of national accounts (SNA) Equation (1) can be defined in terms of the capital stock. To simplify the preliminary findings of fact (preliminary empirical investigation), the incremental capital/output ratios (ICOR) were computed using the standard formulae: (1a) Ki = β Yi, as defined on equation (2); (2a) Δ Ki = β Δ Yi, assuming the coefficient β to be a constant and taking the first-difference represented by the Greek delta symbol, Δ . Investment flow can be defined by the identity Ii = ΔKi, and thus the author made this substitution into equation (2a), and computed the ICOR using the simple formula: (3a) β = Ii/ ΔYi for ΔYi > 0, such that β > 0. The ICOR results are disclosed on Chart 4, which are used to compute the profit rates, using Equation (2), written on Chart 5.13

12 ‘‘Transfer Pricing Comparability Data and Developing Countries,’’ available at http://www.oecd.org/ctp/transferpricing/transfer-pricing-comparability-data-developingcountries.pdf. Comments to the OECD, including the author’s, may be found at http://www.oecd.org/tax/transfer-pricing/ public-comments-received-tp-comparability-data-anddeveloping-countries.htm. 13 For PIM estimates of the capital stock, see Michael Ward, The Measurement of Capital (Methodology of capital estimates in OECD countries), Paris, OECD, 1976; and T. Hill, Profits and Rates of Return [1955-1976], Paris, OECD, 1979. See also Michael Berlemann and Jan- Erik Wesselho ¨ ft, ‘‘Estimating Aggregate Capital Stocks Using the Perpetual Inventory Method’’ [2014], at http://www.review-of-economics.com/ download/Berlemann_Wesselhoeft_2014.pdf, and the Kiel Institute for the World Economy (Germany), ‘‘Database on Capital Stocks in OECD Countries,’’ at https://www.ifw-kiel.de/ academy/data-bases/netcap_e/database-on-capital-stocks-inoecd-countries/view?set_language=en.

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Profile for Ednaldo Silva

Ednaldo silva pygmalion comparables (20150313)  

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 op...

Ednaldo silva pygmalion comparables (20150313)  

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 op...


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