Content area
Full text
The authors test the proposition that companies sharing similar characteristics should have similar profit potentials by ascertaining whether commonly used functional and financial criteria can effectively identify profit potential
(ProQuest: ... denotes formulae omitted.)
Searching for comparable companies is key to a reliable application of the comparable profits method, which is one of the most commonly used transfer pricing methods. To apply CPM, transfer pricing professionals need to identify a set of functionally comparable companies so that a defensible profit benchmark range can be calculated for the tested party. Most comparable company searches use several quantitative and/or qualitative criteria to obtain a small set of companies that are functionally similar to the tested party.
The underlying assumption of using these criteria is that companies that share similar characteristics, such as industry, business size, growth, functions and risks, should have similar profit potentials. However, little research has been done to validate this assumption, so the question arises whether these criteria indeed have significant impacts on companies' profit potentials. The authors will test this proposition by ascertaining whether certain commonly used functional and financial criteria can effectively identify companies with similar profit potentials by referring to the power of these variables in explaining the companies' profit variances.
Four Criteria
The criteria analyzed in this study are industry, size, growth, functions, and risks, which are frequently used in the application of CPM and are reflected in the regulations under Internal Revenue Code Section 482:
[T]he relevant lines of business, the product or service markets involved, the asset composition employed (including the nature and quantity of tangible assets, intangible assets and working capital), the size and scope of operations, and the stage in a business or product cycle.1
Although certain other factors, such as management strategy and market power, also are used by economists to explain profit variance, this article will focus only on the variables mentioned. One reason for this is that those other factors are less commonly used in transfer pricing and empirical studies because they are difficult for the economists to observe or quantify. Further, as discussed in the next section, these factors often are correlated with the factors analyzed in this study. For example, management strategy often is correlated with business growth because...