Need of Working Capital Adjustment in TP

7/26/2019 Need of Working Capital Adjustment in TP

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THE NEED FOR WORKING CAPITAL ADJUSTMENTS IN A TRANSFER PRICING

SETTING: A THEORETICAL NOTE

Jamal Hejazi, PhDChie! E"#$#mi%&

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INTRODUCTION

Transfer pricing involves the price that a member of amultinational group charges a related party operating in a dierent taxjurisdiction for goods, services and intangibles. Within this context, the

transfer pricing discipline attempts to assign one or more of theserelated parties (herein referred to as the tested party) with armslength returns determined from a group of third party comparablecompanies.

To achieve this goal, economists must !nd a set of comparables(based on a set of criteria) that resembles the tested party. The needto perform wor"ing capital adjustments increases when the testedparty exhibits diering levels of wor"ing capital intensities relative tothe comparables. While the issue of performing wor"ing capitaladjustments has not received much attention in the transfer pricing

literature, economists routinely struggle with the issue of whether toperform them. #t will be the purpose of this paper to show that in aneconomic environment dominated by perfect competition, wor"ingcapital adjustments should be the rule and not the exception.

NEED FOR WORKING CAPITAL ADJUSTMENTS: AN OVERVIEW

While many economists, including myself, believe in the need foradjustments, there are those who do not share in this view. $ome

argue that utili%ing wor"ing capital adjustments are not warranted asthey may result in extreme income adjustments. &thers argue thatfrom a theoretical point of view, it is possible for a tested party tohave wor"ing capital intensities that do not fall within a rangedetermined by a set of comparables. With respect to the si%e of anypotential adjustment, # believe that as professional tax practitioners,due diligence would dictate that we perform any adjustments thatimproves the comparability between the tested party and thecomparables, irrespective of how extreme the adjustments may be.'y real concern surrounds theoretical argument against performingsuch adjustments. nless the mar"et is characteri%ed by a monopoly,

wor"ing capital adjustments, given the assumptions of basic economictheory relating to competitive mar"ets, dictate that adjustments are anecessary condition.

'y focus for the remainder of this paper will be to provideevidence supporting the use of wor"ing capital adjustments. To do this,# will !rst go through an intuitive exercise illustrating why wor"ing


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capital adjustments are needed. # will then venture into developing atheoretical rationale supporting the use of such adjustments.

AN INTUITIVE EXPLANATION

Wor"ing capital adjustments should be utili%ed when a testedparty exhibits dierent wor"ing capital intensities relative to a set ofcomparables. To develop this further, # will divide wor"ing capitaladjustments into two "ey areas

i I$3e$*- a$+ a""#)$&% *e"ei3a4le a+j)%&me$&%5 a$+

ii A""#)$&% a-a4le a+j)%&me$&%

#f our tested party, a distributor for illustrative purposes, has alower intensity of accounts receivable or inventories to sales relative toa set of comparables, then this would imply that the comparables in

*uestion were providing its customers with a valuable function thatshould be compensated for through higher prices. To correct for thefact that the given comparables are performing more value addedfunctions than the tested party, the returns given by the comparablesmust be adjusted downward in order to assign the tested party withaccurate pro!t margins. #f on the other hand the comparables in*uestion have a higher level of accounts payable to sales relative toour tested party, then this would suggest that these comparables werereceiving a valuable !nancing function from their suppliers and wouldli"ely be charged a higher price. #n order to improve comparability, thereturns given by the comparables must be adjusted upward in order toassign the tested party with a more reliable return. While this is anintuitive explanation for why we need to perform wor"ing capitaladjustments, the theory behind industrial organi%ation provides a solidtheoretical argument supporting the use of such adjustments.

A THEORETICAL ARGUMENT FOR WORKING CAPITAL ADJUSTMENTS

AND ITS IMPLICATIONS

'ultinational organi%ations can operate in three main industrytypes. 'ar"et structures can range from perfectly competitive (wherethe mar"et is characteri%ed by signi!cant competition) to a monopolywhere no competition exists. &ligopolies fall somewhere in between,characteri%ed by fewer competitors that have some mar"et power. +smy analysis will show, theoretical support for wor"ing capitaladjustments is strongest for the case of perfect competition.


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THE PERFECTLY COMPETITIVE ENVIORNMENT: ASSUMPTIONS AND

IMPLICATIONS FOR WORKING CAPITAL ADJUSTMENTS

#n order to illustrate why wor"ing capital adjustments arere*uired on theoretical grounds, # must !rst outline the basic

assumptions of the perfectly competitive model.


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Assumptions

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Imli"a&i#$: N# #$e !i*m "a$ a!!e"& ma*6e& *i"e &h*#)(h a "ha$(e i$

%)l-

. P*#+)"&% &ha& a*e %#l+ 'i&hi$ &hi% m#+el a*e e*!e"& %)4%&i&)&e% 7#* 3e*-

%imila*8Imli"a&i#$: A$- *i"e +i%"*ea$"- &ha& e9i%&% 4e&'ee$ "#me&i*% 'ill

*e%)l& i$ &he !i*m "ha*(i$( a hi(he* *i"e l#%i$( ma*6e& %ha*e

2 Fi*m% ha3e a""e%% &he %ame &e"h$#l#(-

Imli"a&i#$: N# #$e !i*m 'ill ha3e a &e"h$#l#(i"al a+3a$&a(e #3e* &he

#&he* A% a "#$%e)e$"e, &he *#+)"&i#$ *#"e%% &ha& ea"h !i*m !#ll#'%'ill 4e i+e$&i"al

; Ne' !i*m e$&*- i% $#& *e%&*i"&e+ 4- 4a**ie*% e$&*-Imli"a&i#$: I! e"#$#mi" *#!i&% e9i%& i$ &he %h#*& *)$ $e' !i*m% 'ill e$&e*

a$+ elimi$a&e all e"#$#mi" *#!i&% i$ &he l#$( *)$

What Are The Implications of This Model For The WorkingCapital Adjustments Debate?

The !rst implication of this model is that all !rms must charge thesame price. +ny !rm charging a price that diers from what the mar"etdictates will either lose mar"et share or go insolvent (given they willsell the products below cost). +s our previous discussion illustrated,

dierent wor"ing capital intensities across !rms imply that these !rmsare receiving or providing valuable functions that a pro!tmaximi%ing!rm, operating at arms length, would recoup through higher prices.This situation, however violates the basic assumptions of the modeloutlined above. #n order to correct the apparent contradiction betweeneconomic theory and practice, wor"ing capital adjustments must beperformed to ensure that capital intensities across !rms are the same.

'athematically, suppose that prices that a particular !rm (a distributorfor illustrative purposes) can charge its customers is a function of thefollowing three wor"ing capital intensities, namely

R!" #!" I! $%&

Where these variables represent receivables to net sales, payables tonet sales and inventory to net sales respectively.

The *uestion then becomes how will these dierent wor"ing capitalintensities across !rms behave in the long run in our perfectly


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competitive mar"et place- iven !rms are price ta"ers, the price thateach !rm charges will e*ual the price charged by other !rms. Thismeans that factors that aect price, including capital intensities, mustbe the same. We can formuli%e this e*uilibrium condition with thefollowing e*uation

#%'$R!&%" $#!&%" $I!& %()#*'$R!&*" $#!&*" $I!&*()++ #n'$R!&n"$#!&n"$I!&n(" $*&

Where / denotes price charged by a speci!c !rm in *uestion and ndenotes the 0nth !rm1 in the mar"et. 2rom (3), if prices charged by!rms are the same, then all factors that aect price, including wor"ingcapital intensities must be the same as well. #f wor"ing capitalintensities are not the same therefore, then wor"ing capitaladjustments must be performed.

The second implication of the model involves economic pro!ts alleconomic pro!ts will e*ual %ero in the long run. iven no barriers toentry exist in a perfectly competitive environment, any pro!ts that arereali%ed in the short run will lead to new !rms entering the mar"et,increasing supply and reducing prices. /rices will change from theshort to long run such that the new price will exhausts all economicpro!ts. 2or this condition to hold in the long run, prices will need toconverge to some point such that economic pro!ts e*ual %ero

'athematically

#ro,t%) # $R"#"I& - .$/"0& 1 W0 1R/) #ro,t*) # $R"#"I& - .$/"0& 1

W0 1R/ ) +) #ro,tn) # $R"#"I& - .$/"0& 1 W0 1R/)2$3&

4owever, if wor"ing capital intensities were dierent across !rms, thenprices that each !rm could charge would also dier, violating our %eropro!t condition given in (5).

The implications of the above theoretical analysis is that if our testedparty operates in a perfectly competitive environment, wor"ing capitaladjustments must be performed to our set of comparables to ensurethat wor"ing capital intensities, and hence prices, remain the same.

2ailure to perform these wor"ing capital adjustments would betheoretically incorrect and would violate the very foundation on whichthe model used to describe economic activity was built.

DOES THIS ANALYSIS HOLD FOR AN OLIGOPOLY?

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#li(##l- The maj#* +i!!e*e$"e 4e&'ee$ a$ #li(##l- a$+ a e*!e"&l- "#me&i&i3e ma*6e&

i% &ha& i$ a$ #li(##l- *#+)"&% a*e %)!!i"ie$&l- +i!!e*e$& &ha& !i*m% "a$ j)%&i!- "ha*(i$(

+i!!e*e$& *i"e%, e3e$ i$ &he l#$( *)$ Gi3e$ *#+)"&% a*e $#& e*!e"& %)4%&i&)&e%, !i*m%"a$ "ha*(e +i!!e*e$& *i"e% i! "#$%)me*% 4elie3e &ha& *#+)"&% #!!e*e+ a*e %)!!i"ie$&l-

+i!!e*e$& i$ %#me 'a- 7)ali&- "#$%i+e*a&i#$% !#* i$%&a$"e8 a$+ a*e *ea*e+ a- !#* i&

H#'e3e*, i! "#$%)me*% 4elie3e &ha& &he +i!!e*e$"e i$ *i"e i% $#& 'a**a$&e+ &he$"#$%)me*% 'ill %)4%&i&)&e a'a- !*#m &he m#*e e9e$%i3e (##+ &he le%% e9e$%i3e #$e

While *i"e "#$%i+e*a&i#$% a*e m#*e im#*&a$& i$ a e*!e"&l- "#me&i&i3e e$3i*#$me$&,

&he !a"& &ha& *i"e +#e% ma&&e* i$ a$ #li(##li%&i" %e&&i$( %)((e%&% &ha& '#*6i$( "ai&al

i$&e$%i&ie%, 'hi"h a!!e"&% *i"e, "a$$#& 4e %i($i!i"a$&l- +i!!e*e$& a"*#%% !i*m% )$le%%

"#$%)me*% e*"ei3e a %i($i!i"a$& +i!!e*e$"e i$ &he 3al)e #! &he *#+)"&% i$ )e%&i#$

CONCLUSION:

/erforming wor"ing capital adjustments are necessary to ensure thatreturns derived from a set of comparables can be reliably applied to a

tested party operating in a nonarms length setting. There is notheoretical argument that suggests that wor"ing capital adjustmentsshould be rejected. The analysis has shown that operating in aperfectly competitive environment implies that wor"ing capitaladjustments are a re*uirement. These !ndings are supported ontheoretical grounds which are violated when dierent wor"ing capitalintensities between !rms exist. iven that !rms are assumed to bepriceta"ers, then the only way that prices charged by all !rms can bea ta"en as given is if all of the factors that aect prices, includingwor"ing capital intensities, are the same.

Need of Working Capital Adjustment in TP

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