Comparability Issues Are a Slippery Slope in Transfer Pricing

December 14, 2020 by Harold McClure
About the Author
Harold McClure
is an economist with over 25 years of transfer pricing and valuation experience.
Dr. McClure began his transfer pricing career at the IRS and went on to work at several Big 4 accounting firms before becoming the lead economist in Thomson Reuters’ transfer pricing practice. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983.
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Comparability is a key issue in transfer pricing that is often not fully appreciated. However, comparability issues are hardly uncommon in transfer pricing controversies and can create a trickle-down effect of sorts that leads to major taxation issues.

In this discussion, we explore how a tripartite dispute with double taxation implications for the taxpayer could have been avoided by selecting comparable companies with similar functions to the tested party. 

The Case: Transfer Pricing for a Limited Function Salmon Distributor Using High-Function Comparable Companies

Chile exports almost $5 billion of salmon each year, with its two major foreign markets being the US and Japan. Our case surrounds a Chilean salmon multinational (MNE) with a transfer pricing policy that affords its US distribution affiliate (tested party) a 6% gross margin, which resulted in a 2% operating margin -- or 50% markup over operating expenses. 

For reasons we’ll address later, the transfer pricing report led the Chilean tax authority (Servicio de Impuestos Internos or SII) to reasonably assert that this 6% gross margin was too high, and the U.S. tax authority (IRS) to argue for a 4% operating margin (or 8% gross margin), creating a potential double taxation issue.

First, however, we illustrate the parties’ respective assertions in the table below, which presents consolidated financials of a Chilean MNE related to salmon exports to the U.S., as well as three transfer pricing scenarios. We have assumed:

  • Sales = $500 million;
  • Chile’s cost of production = 82% of sales;
  • Consolidated operating expenses = 8% of sales, which are evenly split between the Chilean supplier and the distribution affiliate.

Consolidated operating profits are 10% of sales, which are allocated between the Chilean parent and the distribution affiliate according to the transfer pricing policy.

Table 1: Three Transfer Pricing Positions for the Gross Margin of a Salmon Distribution Affiliate (Millions)

 

  

SII

Taxpayer 

IRS 

  

Consolidated 

US 

Chile 

US 

Chile 

US 

Chile 

Sales 

$500 

$500 

$0 

$500 

$0 

$500 

$0 

I/C price 

$0 

$475 

$475 

$470 

$470 

$460 

$460 

Cost of production 

$410 

$0 

$410 

$0 

$410 

$0 

$410 

Gross profits 

$90 

$25 

$65 

$30 

$60 

$40 

$50 

Gross Margin

 

5%

 

6%

 

8%

 

Operating expenses 

$40 

$20 

$20 

$20 

$20 

$20 

$20 

Operating profits 

$50 

$5 

$45 

$10 

$40 

$20 

$30 

Operating Margin

 

1%

 

2%

 

4%

 

Markup

  

25% 

  

50% 

  

100% 

 

 

Taxpayer’s Position

The original report relied upon the Comparable Profits Method (CPM or TNMM) using third- party distributors with much higher functions than the tested party and targeted markup over operating expenses (Berry Ratio) as a profit indicator.

Their CPM analysis returned a range from 20% to 50%. The author of the report reasoned that because the 6% gross profit margin corresponded to the 50% markup on the higher end of the range, the IRS should accept it. 

SII’s Position

The Chilean tax authority on the other hand asserted that the CPM evidence supported a gross margin of only 5%, which corresponds to a 25% markup on the lower end of the range. 

IRS Position

Meanwhile, the IRS rejected the profit indicator as unreliable and argued for targeting the operating profit margin. The central tendency of the operating margin for the selected comparables was 4%, which would equate to a 100% markup in our example scenario. 

The IRS assertions about problems with the Berry Ratio relate to two potential issues:

  1. Whether operating expenses properly capture value-added expenses. For our distribution affiliate, operating expenses do fully capture its value added expenses, but it is often the case that the financials for comparable companies found in commercial databases have classified some of the value added expenses in the cost of goods sold. The classification of expenses problem may explain why some of the third party distributors have high reported markups over operating expenses. 
  2. The possibility that some or all of the alleged comparables either carry significant tangible assets or own valuable intangible assets. 

This disagreement was eventually settled through the US Advanced Pricing Agreement program, but we posit that the entire saga could have been avoided.

Solution: Better Comparables

These considerations suggest a different set of comparable companies with limited functions, like our tested party, could have made the dispute over the use of operating margin versus a markup over operating expenses less crucial. Table 2 presents the markup, gross margins, operating margin and operating expense to sales ratio for two wholesale distributors of groceries and a typical Japanese trading company.

Table 2: Key Financial Ratios for Three Publicly Traded Distributors

 

Amcon

Core-Mark

Marubeni

Gross margin

7.99%

6.72%

5.00%

Expenses/sales

7.11%

6.07%

4.00%

Operating margin

0.88%

0.65%

1.00%

Markup

12.38%

10.71%

25.00%

 

The operating margins for the two wholesale distributors of groceries are lower than 1% even though their operating expense to sales ratios exceed that of the distribution affiliate. Their low markups over operating expenses are reflective of their very low net working capital to sales ratios.

Notably, Japanese trading company Marubeini reports financials that are similar to those of our distribution affiliate under the transfer pricing policy advocated by the Chilean tax authority. A full analysis of this issue would have to specify the balance sheet of the tested party in order to take into account any potential asset intensity adjustments between the third party distributors and the distribution affiliate.

Any appeal to the US Advance Pricing Agreement program would likely require a larger set of comparables. Similar considerations would be needed to appropriately benchmark the gross margin for the Japanese affiliate. Our essential message, however, remains the same. If third-party distributors with similar functions as the tested party can be located, then the debate over the appropriate financial ratio becomes less critical.

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