Mechanical Applications of the Comparable Profits Method are Unreliable

July 13, 2021 by Harold McClure
About the Author
Harold McClure
is an economist with over 25 years of transfer pricing and valuation experience.
Dr. McClure began his transfer pricing career at the IRS and went on to work at several Big 4 accounting firms before becoming the lead economist in Thomson Reuters’ transfer pricing practice. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983.
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The Comparable Profits Method (CPM) can be a useful approach for well-defined transfer pricing issues, such as the appropriate profitability of a sales affiliate, so long as it is applied properly. Unfortunately, CPM is often applied mechanically without regard for economic principles and functional comparability.

One transfer pricing (TP) group promotes a mechanical application of the CPM to determine interquartile ranges of profit indicators by industry in order to identify taxpayers that should be subject to transfer pricing audit. In a June 2021 piece in Tax Notes, the partners of this group presented operating margins derived from Compustat for 19 companies in the oil sector (See Cook & Cook (2021)). In the same piece, the authors state the group has been contracted to perform its “preliminary analysis” for nine US state departments of revenue over the past 19 years. Their presentation of these financials appears to be an update on an analysis for British Petroleum North America (BPNA), which I critiqued in a 2013 piece in BNA Transfer Pricing Report.

While establishing “safe harbors” as a risk analysis tool is a common practice among tax authorities, they are not a replacement for a diligent transfer pricing analysis, and the set of 19 companies in question had such diverse functions that it would be impossible to reliably evaluate a tested party in the oil industry using them.

We review their results after presenting a stylized version of what an analysis of BPNA might be for the 2014 to 2018 period this TP group purported to evaluate. Our review will be limited to their selection of alleged comparable companies, reasons for rejecting certain companies and the presentation of financials for the few companies that should be included in a CPM analysis of BPNA.

The Profit Margin for a Refinery Affiliate

BPNA incurred an operating loss near 2% of sales in 2007. The TP group asserted a sizeable transfer pricing adjustment using a flawed application of CPM similar to the “preliminary analysis” suggested in its recent paper. My 2013 critique noted multiple problems with their analysis, some of which were unique to the 2007 period. During this period, oil prices were rapidly rising, squeezing the gross margins of third-party refineries such that many had similar operating losses. The basic critique of my 2013 paper was that their application of CPM failed to take into account the market environment at the time.

The 2014 to 2018 period did not witness a spike in oil prices. While there was modest price volatility, the average price of a barrel of oil was approximately $60. Table 1 presents the income statement for a hypothetical U.S. refining affiliate that purchases oil from a foreign parent as well as third-party producers of oil under two transfer pricing policies. The key assumptions are that the US Affiliate:

  • Purchases 7.25 million barrels of oil from its foreign parent and another 7.25 million barrels of oil from third-party suppliers.
  • Pays $60 per barrel of oil to both the third-party suppliers and to its foreign parent, resulting in a total cost of goods equaling $870 million.
  • Refines the purchased oil into gasoline, which it sells to third parties for $1 billion.
  • Incurs operating expenses of $65 million.
  • Incurs depreciation expenses of $20 million.

Under arm’s length pricing, gross profits (sales minus cost of goods) represent 13% of sales, while the sum of operating expenses and depreciation represent 8.5% of sales, which implies that the operating margin equals 4.5%.

Table 1: Financials for a Refinery Affiliate Under Two Transfer Pricing Policies (in Millions)

 

Arm's length

Tax authority

 

Sales

$1000

$1000

 

Cost of Goods

$870

$825

 

Gross Profits

$130

$175

 

Gross Margin

13%

17.5%

 

Operating Expenses

$65

$65

 

Depreciation

$20

$20

 

Operating Profits

$45

$90

 

Operating Margin

4.5%

9%

 

 

This intercompany price is arm’s length since the intercompany price of oil is consistent with prices paid to third-party suppliers. One could also cast the arm’s length nature of the intercompany pricing policy using the Resale Price Method (RPM), as the gross margin for the related-party transaction is the same 13% gross margin received on uncontrolled transactions.

While an appropriate application of CPM should also confirm the arm’s length nature of this intercompany pricing policy, a tax authority that relied on the results of the “preliminary analysis” presented by this TP Group might insist that this refinery affiliate receive a 9% operating margin, which would require that the gross margin be increased to 17.5%. A 17.5% gross margin would require that the price of oil be lowered from $60 per barrel to $56.9 per barrel for both controlled and uncontrolled transactions. This suggestion is at odds with market pricing.

The Appropriate Selection of Comparable Refineries and Presentation of Financials

As stated, the TP group selected 19 North American publicly traded companies in the oil sector and claimed to have presented their income statement for the 5-year period from 2014 to 2018. Their reported operating margins ranged from 4.2% to 19%. Their reported interquartile range was from 6.1% to 13.3%, while the reported median operating margin was 8.1%.

The companies with the highest operating margins had significant upstream operations that explored and produced oil. The ten companies with upstream operations include Suncor Energy, Valero LP, Exxon Mobil, Imperial Oil, Frontier Oil, ConocoPhillips, ChevronTexaco, Hess, Marathon Oil, and Murphy Oil. Meanwhile, Calumet Specialty Products Partners and Chevron Phillips Chemicals manufacture products. None of these 12 companies should be seen as functionally comparable to a refinery affiliate.

The other 7 companies reported by the TP Group are or were refineries but their reliance on Compustat (S&P Global) led to certain anomalies, which would have been discovered had they examined the companies’ original 10-K filings. For example, the revenues in the analysis reported for Sunoco were actually the revenues for its parent corporation Energy Transfer Partners, which operates various segments in the provision, transportation, and distribution of fuels.

United Refining became a privately owned company in 2016 and hence has not reported 10-K filings after 2016. Tesoro Petroleum and Western Refining were acquired by Marathon Petroleum, which is a publicly traded refinery that is independent of Marathon Oil. Alon USA Energy was acquired by Delek, which is another publicly traded refinery.

Table 2 presents the average 2014 to 2018 financials for HollyFrontier and Valero Energy, Delek and Marathon Petroleum. The financials were derived from their 10-K filings rather than Compustat in order to segment any operating expenses normally recorded in cost of goods sold from cost of products (purchases). Table 2 reports sales, cost of products, all operating expenses, and depreciation with operating profits defined as sales minus cost of products minus operating expenses minus depreciation.

Table 2: 2014 to 2018 Income Statements (5-Year Averages) for Four Publicly Traded Refineries (in Millions)

 

Delek

HollyFrontier

Marathon Pet.

Valero Energy

 

Sales

$6620.0

$15100.8

$80899

$101064

 

Cost of Products 

$5734.5

$12400.5

$70101

$89147

 

Operating Expenses

$554.4

$1345.3

$5272

$5216

 

Depreciation

$142.5

$384.0

$1887

$1896

 

Operating Profits

$188.6

$971.0

$3639.00

$4805.00

 

Gross Margin

13.38%

17.88%

13.35%

11.79%

 

Operating Margin

2.85%

6.43%

4.50%

4.75%

 

 

The central tendency for the operating margins of these publicly traded refineries supports the 4.5% operating margin for the refinery affiliate. In fact, the central tendency for the gross margins supports the 13% gross margin received by the refinery affiliate. An appropriate application of CPM concurs with the Comparable Uncontrolled Price (CUP) approach and the RPM affirming the arm’s length nature of the intercompany pricing policy.

Concluding Remarks

Technology can be a useful aid in carrying out certain routine tasks in the evaluation of whether a taxpayer’s intercompany pricing policies are arm’s length. Technology, however, cannot be a substitute for understanding the basic economics of any particular intercompany issue.

This TP group advertises its approach, including the selection of alleged comparables, as merely a preliminary analysis. During the BPNA controversy, however, the entire set of third-party companies including the integrated oil companies were used to argue for an absurdly high profit margin. These integrated oil companies would need to be removed from the set of comparables because they derive significant profits from the exploration and production of oil, while a refinery affiliate would not be expected to earn such profits under the arm’s length standard.

 

References

Eric Cook and Nancy Cook, “$2.7 Billion 2018 Northeastern State Transfer Pricing Tax Gap,” Tax Notes State, June 21, 2021. 

Harold McClure, “States Should Learn from Transfer Pricing History, but Focus on The Right Lessons,” EdgarStat Blog, February 25, 2021.

Harold McClure, “A Fatally Flawed Analysis: Examining the Application of CPM by Chainbridge Software in the BP Products Case,” BNA Transfer Pricing Report, March 21, 2013.

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