The DuPont Case and The Berry Ratio
In the case of E.I. DuPont de Nemours & Co. v. United States, 608 F.2d 445 (Ct. Cl. 1979) ("the DuPont case"), Berry served as an expert witness on behalf of the U.S. government. At issue was the "proper," arm's length compensation that a Swiss subsidiary of DuPont, a distributor, should earn on the distribution services it performed in Switzerland on behalf of the parent.
In his analysis, Berry determined that the best method for determining an arm's length result was to compare the Swiss distributor's markup on operating expenses to the same markup earned by uncontrolled (i.e., third-party) distributors performing substantially similar functions. Berry's key insight in the case was that distributors should earn a return commensurate to the distribution services performed. The value of the products being distributed, in other words, was irrelevant. Accordingly, distributors must achieve a particular gross profit in order to compensate them for their value-adding services, the costs of which are accounted for, almost entirely, in their operating expenses. The IRS defines the ratio now, awkwardly, as the "Ratio of Gross Profits to Operating Costs".
To reflect the reality of distributors' economic significance and to provide an arm's length return to DuPont's Swiss subsidiary, Berry utilized a ratio that has since been named in his honor:
Berry Ratio = Gross Profit/Operating Expenses
The Berry Ratio remains, to this day, a mainstay of transfer pricing analysis where a distributor serves as the tested party.
Like most metrics that are based on data available in corporate accounts, the Berry ratio misses the value of the intangible of the costs needed to maintain the intangible property of a corporation. Since the non-routine income generated by intangibles is the main contributor to corporate earnings, and after taxes, to corporate profit the Berry ratio does not provide an adequate metric for the party that owns intangibles, but does show what routine functions captured in operating expenses should earn.
Read more about this topic: Charles Berry (economist)
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