PRACTICAL VALUATION OF RISK TRANSFER IN ADVANCE PRICING AGREEMENTS

A recently published paper argues that Advance Pricing Agreements adopting the Comparable Profits Method or the Transactional Net Margin Method, overlook the risk transferred from the tested party (subsidiary) to the party related to the transaction (parent) - a shift caused by fixing the profitability of the tested party. In this paper, we propose a practical implementation methodology to estimate the model parameters and discuss the theoretical and practical reasons for our proposed method. Finally, we also provide numerical examples demonstrating the miss-allocation of profits and taxes. According to our examples, fixing the profitability level of a manufacturer equals a shift of 0.5% of its profitability, while fixing the profitability of a management entity means a shift of 0.85% of its profitability. These amounts can be significant on aggregate levels.