{"id":804,"date":"2020-07-08T22:31:16","date_gmt":"2020-07-08T22:31:16","guid":{"rendered":"https:\/\/qcgtransferpricing.com\/en\/?p=804"},"modified":"2025-03-16T13:42:14","modified_gmt":"2025-03-16T19:42:14","slug":"impact-of-localization-on-profit-margins-developed-countries-vs-emerging-markets","status":"publish","type":"post","link":"https:\/\/qcgtransferpricing.com\/en\/blog\/impact-of-localization-on-profit-margins-developed-countries-vs-emerging-markets\/","title":{"rendered":"Impact of Localization on Profit Margins: Developed Countries vs. Emerging Markets"},"content":{"rendered":"\n

When evaluating a company for transfer pricing purposes, it is common to find that there are no functionally comparable companies located in the same country. As a result, foreign companies with similar functions are often used as comparables. Given this, the idea of making additional adjustments to account for structural differences between comparable companies and the analyzed company has been a persistent recommendation\u2014even by the OECD (2018). A broad set of factors, such as the legal and tax framework, human capital, natural resources, and geographical location, can influence the profit margin a company can achieve and cause it to vary depending on the country where it operates.<\/p>\n\n\n\n

However, it is of interest to determine whether there are significant differences in profit margins depending on the country in which companies are located. If not, it would be sufficient to consider companies with the same functions as comparables without requiring any additional jurisdiction-based adjustments.<\/p>\n\n\n\n

For example, Meenan (2004) conducted a statistical analysis to assess whether the interquartile ranges of net margin distributions for companies in developed European countries differ significantly from those of individual countries within the same region. The study concluded that, in most cases, the differences were statistically insignificant.<\/p>\n\n\n\n

The following sections will discuss some key points related to this topic, and a model will be proposed to evaluate whether a company’s country of operation is a sufficiently relevant variable to justify a country risk adjustment in transfer pricing analysis.<\/p>\n\n\n\n

RISK-RETURN TRADEOFF<\/strong><\/h3>\n\n\n\n

The risk-return tradeoff hypothesis suggests a positive relationship between expected returns and asset risk. This is because investors will only be willing to invest in a riskier asset if they expect higher returns compared to a less risky asset. As a result, investment options that compensate for higher risk with a premium in expected returns will persist in the market.<\/p>\n\n\n\n

Merton (1980) highlights that, in practical terms, there is a positive relationship between the mean and variance of the market portfolio, referring to expected returns and risk, respectively. However, various econometric analyses have produced mixed results regarding this proposed relationship between risk and return.<\/p>\n\n\n\n

For instance, Campbell (1985) finds a negative relationship between risk, measured using conditional variance, and returns. Similarly, Baillie (1990) employs GARCH-in-mean models with data at different frequencies to study the relationship between portfolio returns and their conditional variance or standard deviation, consistently finding a weak relationship between the two variables.<\/p>\n\n\n\n

Conversely, Guo (2001) finds that market return variance has a strong predictive power for excess market returns\u2014i.e., the spread between portfolio returns and the risk-free rate. Engle (1987), using a series of ARCH models, confirms the theoretical relationship between the conditional variance of a long-term bond and its return.<\/p>\n\n\n\n

It is important to note that risk, in quantitative terms, is an unobservable variable. This has led to a wide variety of models designed to measure asset risk. Consequently, empirical analysis of the risk-return relationship is challenging, as risk is not a condition that can be perceived entirely subjectively by economic agents, unlike the observable returns obtained from an asset or economic unit.<\/p>\n\n\n\n

DEVELOPED VS. EMERGING COUNTRIES<\/strong><\/h3>\n\n\n\n

Another topic of analysis in recent years has been the contrast between developed and emerging markets. The question arises as to whether there are significant differences in investment performance between these two groups. Emerging markets are generally characterized by social, economic, and institutional conditions that make them perceived as riskier investment destinations compared to developed countries.<\/p>\n\n\n\n

Given that emerging countries may be structurally riskier than developed ones, the risk-return tradeoff hypothesis suggests that emerging markets should offer higher returns to compensate for the additional risk.<\/p>\n\n\n\n

In this regard, Salomons and Grootveld (2003) find a significant difference in the risk premium (the return over the risk-free rate) between emerging and developed markets in financial assets. They also observe that this difference follows a cyclical pattern rather than being associated with structural changes.<\/p>\n\n\n\n

However, it is crucial to recognize that these analyses are often based on financial market asset prices, which reflect market expectations about companies rather than solely their actual profitability. Nevertheless, real company performance also plays a crucial role in how their equity securities are valued by economic agents.<\/p>\n\n\n\n

COUNTRY ADJUSTMENTS IN COMPARABILITY ANALYSIS<\/strong><\/h3>\n\n\n\n

In the context of transfer pricing, the implications of the discussed concepts relate to fundamental differences in profit margins between similar companies due to the different risks they face in different countries. This could mean that an adjustment is necessary when incorporating a foreign company as a comparable for a company being analyzed.<\/p>\n\n\n\n

For example, Starkov, Gonnet, and Pletz (2014) conduct two case studies. In the first, they adjust the margins of comparable companies located in Europe to analyze a related entity in Sub-Saharan Africa using an adjustment based on working capital and accounts receivable levels. In the second case, they adjust margins based on the cost of capital for two emerging markets (China and India) while using U.S. companies as comparables.<\/p>\n\n\n\n

In both cases, due to the higher risks faced by the analyzed companies compared to the comparables, the adjusted profitability range is higher than the initial range before applying the adjustment.<\/p>\n\n\n\n

DATABASE DESCRIPTION<\/strong><\/h3>\n\n\n\n

The database was constructed using TP Catalyst data and is described as follows (updated as of March 2019):<\/p>\n\n\n\n