Comparability Issues in Benchmarking Hi-Tech Distribution Affiliates

February 08, 2021 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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Much has been written about the Australian Tax Office’s increased scrutiny of large technology multinationals in recent years, but its Oceanic neighbor’s similar “campaign” to reign in profit shifting also poses an interesting case.

In a December 2020 article for New Zealand Reseller News, Rob O’Neill reported on transfer pricing disputes between the Inland Revenue Department of New Zealand (NZIR) and certain hi-tech multinationals, including Oracle:

The Inland Revenue Department has billed Oracle NZ a total of NZ$20.3 million for the 2013 to 2015 tax years. The company was originally assessed for tax related to its transfer pricing arrangements … Oracle NZ, Cisco NZ and Microsoft NZ are known to have been the subjects of transfer pricing probes…

Oracle's accounts show a small lift in revenue during the year, from $146.5 million to $147.6 million. Net profit after tax increased from $1.5 million to $2.1 million. Payments to related parties, mainly Oracle NZ's parent, increased from $107.7 million in 2019 to $120 million over the year. The bulk of the inter-company expenses, and the year-on-year increase, related to software license and hardware support fees.

The rather large assessment is worth exploring. Multinationals typically benchmark arm's length profits for distribution affiliates using the Transactional Net Margin Method (TNMM or Comparable Profits Method in the US). Based on the modest financial information provided by O’Neill, it is likely that NIZR has a case in challenging Oracle's transfer pricing policy, but unclear how NZIR could come to this figure by challenging Oracle’s application of TNMM on its merits.

Case: Oracle v. NZIR

Oracle provides products and services that address enterprise information technology environments, generating just over $39 billion in worldwide revenues, with:

  • 55% from US customers
  • 29% from EMEA customers
  • 26% from APAC customers

Cisco, Microsoft, and Oracle established cost sharing arrangements between the U.S. parent and a foreign principal affiliate over a generation ago. Oracle’s Irish affiliate incurs all intangible development costs, cost of services, and cost of goods sold while its distribution affiliates incur selling expenses for foreign operations. These selling expenses are approximately 20% of sales for each region, while operating costs borne by the Irish principle are approximately 50% of sales. As such, the consolidated operating margin is 30%.

The table below provides an illustration of the transfer pricing issues for Oracle New Zealand under the assumption that:

  • Sales = NZ$150 million and
  • Selling expenses = NZ$30 million per year.

We also illustrate a potential challenge to the taxpayer’s policy under TNMM and an arm's length scenario that takes into account certain comparability issues. 

Tabele 1: Oracle NZ Income Statement Under Three Transfer Pricing Policies (in NZ$ millions)

 

Taxpayer

Arm's Length

NZIR

Sales

$150

$150

$150

I/C Price

$118.5

$116.25

$114

Gross Profits

$31.5

$33.75

$36

Gross Margin

21%

22.5%

24%

Selling Expenses

$30

$30

$30

Operating Profits

$1.5

$3.75

$6

Operating Margin

1%

2.5%

4%

 

Comparability Issues in Benchmarking a Hi-Tech Distributor

Table 1 assumes that the New Zealand affiliate of Oracle is initially receiving a 21% discount, which means its operating profits were limited to only 1% of sales. This is low even for a commission affiliate, as profits would represent a mere 5% return to selling expenses. Transfer pricing practitioners often try to defend such low returns by an appeal to the ratio of operating profits to total costs for service companies like advertising agencies.

As I wrote about in a November 2020 peice in Bloomberg Daily Tax Report, one key issue this contention fails to consider is that the total costs of advertising agencies include a substantial amount of pass-through costs.

The other issue involves the appropriate return to working capital. While commission agents hold no working capital, third-party distributors often hold working capital that represents 40% of sales. 

The case harks back to early discussions of the UK Diverted Profits Tax (or "Google Tax"). In a 2015 piece in Journal of International Taxation, Saumyanil Deb and I considered the transfer pricing issues for the UK sales affiliate for Google where we assumed its selling expenses equaled 20% of income:

The first allocation of income affords the U.K. affiliate operating profits equal to 2% of sales. This allocation would be the result of a commission affiliate structure where the U.K. affiliate was granted commission income equal to 110% of its expenses. The second income allocation assumes that the U.K. affiliate is a distributor that has received a 23% gross profit margin. In this income allocation, the U.K. affiliate profits represent 3% of sales. This additional 1% of sales from the first allocation to the second represents a reasonable return to the working capital that would be held by a distributor.

Counterarguments to Oracle’s Transfer Pricing Policy

Let’s expand on this discussion as it relates to a potential challenge by NZIR to Oracle's TNMM transfer pricing policy based on a set of third-party distributors as comparables. Here is brief overview of what one would expect in terms of the following key financial ratios for typical distributors:

  • Gross margin = 24%.
  • Selling expenses = 20% of sales.
  • Net working capital = 40% of sales.

If the return to working capital is 5%, a commission agent that holds no working capital should receive a 21% discount if its functions were the same as the third-party distributor. We implicitly assumed that a conversion from the UK being a commission agent to being a distribution affiliate would mean that its working capital to sales ratio would rise to 20% of UK sales.

If the third-party distributors used as alleged comparables have the same selling expenses to sales ratio as the distribution affiliate, the choice between a return on sales versus a return on selling expenses as the profit level indicator is immaterial.

If NZIR were to accept the basic premise of TNMM with the distribution affiliate as the tested party and agree to a set of third-party distributors with the same selling expenses to sales ratio, it could potentially take the position we posit in Table 1, with the 24% gross margin equating to a 4% operating margin.

However, such a position ignores the fact that Oracle NZ may not hold any inventory and would thus have a significantly lower working capital to sales ratio than the third-party distributors. If we assume a working capital to sales ratio of 10%, a properly performed analysis would implement capital adjustments to account for this distribution. As our table notes, the arm’s length gross margin would be 22.5%.

Issues with NZIR’s Adjustment

The difference between a 21% gross margin and a 24% gross margin is only NZ$4.5 million in additional income per year or NZ$1.26 million in taxes per year given New Zealand’s 28% tax rate. O’Neill’s discussion noted that the tax authority’s position would represent an adjustment that is over 5 times that amount.

Is the tax authority rejecting TNMM in favor of a position that would grant the New Zealand affiliate with over half of consolidated profits? In our discussion of Google UK, we noted:

The transfer pricing model in this article asserts that 90% of consolidated profits, which is 27% of sales, is attributable to the intangible assets of the hi-tech multinational. The OECD BEPS Action Plan, Action 8 (Intangibles) addresses transfer pricing aspects of intangible assets. Its main point is that it is necessary to identify the key intangible assets and which legal entity owns them. Google's intangible assets include its proprietary technology and its brand. Its technology is developed by R&D personnel in California but their expenses are funded through a cost sharing arrangement between the U.S. parent and its Irish affiliate. Thus, the U.K. affiliate is not entitled to the profits from this technology. At best, it could be argued that the U.K. affiliate contributed to the value of the brand, but even this assertion is likely not Google's position as most hi-tech multinationals would argue that all intangible assets are owned either by the U.S. parent or its cost sharing affiliate.

Even if the tax authority could plausibly assert that Oracle New Zealand owned the marketing intangibles, a transfer pricing policy that left the distributor with most of consolidated profits would be an extreme application of the Residual Profits Split Method.

 

References

Rob O’Neill, “Taxman bills Oracle New Zealand $20.3M for shortfalls”, New Zealand Reseller News, December 23, 2020.

Harold McClure, “Use and Abuse of TNMM in Indian Litigations Involving Provision of Certain Services—Part 2”, Bloomberg Daily Tax Report, November 10, 2020.

Harold McClure and Saumyanil Deb, “The Google Tax: Transfer Pricing or Formulary Apportionment?”, Journal of International Taxation, June 2015.

 

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