Challenging the reliability of comparables under profit-based transfer pricing methods

Abstract

Under profit-based transfer pricing methods, the selection of comparable companies is essential if detection of transfer price manipulation is to be reliable. Comparative advantage as embedded in internalisation theory argues that foreign-controlled companies (FCCs) should, in the long run, display greater profitability than domestic-controlled companies. In high-tax host countries, transfer pricing manipulation theory predicts an opposite effect on profitability. Applying a refined set of tests to a large sample of firms operating in a high-tax country such as Italy offers strong support for the internalisation prediction. Furthermore, the analysis of the interquartile range of our measure of profitability indicates that only a low percentage of FCCs would be subject to fiscal enquires, as implied by the Organisation for Economic Co-operation and Development guidelines, under the suspicious of transfer pricing manipulation. These results suggest that current comparability tests are likely to fail the identification of transfer pricing practices in countries where the comparative advantage of FCCs is particularly pronounced and question the reliability of these tests.