Relation Between Country Rating and Firm’s Profitability: Implications for the Application of the Arm’s Length Principle

In a globalized economy, transfer pricing estimations are key in valuing international transactions between related entities of multinational corporations (MNCs) and the use of uncontrolled comparables methods are widespread. In the absence of uniform guidelines on the optimal identification for comparable companies, however, it remains a concern that poor selection choices may lead to biased estimates, which in turn may systematically bias international revenue flows. Using a sample of uncontrolled companies operating in the food processing industry, this paper provides some initial empirical evidence that entities located in countries with higher sovereign risks exhibit higher profitability levels vis-à-vis comparable entities in lower sovereign risk countries. After controlling for sovereign risks, the geographical region in which the company is incorporated does not seem to play a role. The current findings imply that the search for foreign independent comparable companies should be organized by sovereign credit rating risk rather than geographic proximity. From a taxation perspective, our findings also suggest that insufficiently controlling for country-level sovereign risk biases high-risk countries’ corporate tax revenues downwards.