Inventec carried out manufacturing activities in the electronics industry on behalf of its parent company. It took formal title to the raw materials, but considered that its role was limited to assembly, without assuming risk or adding value to the materials. Inventec therefore used ROVAC (return on value added costs – not including cost of materials) as a profit level indicator (PLI) in its transfer pricing analysis. The tax authorities disagreed with the choice of PLI and considered ROTC (return on total costs – including materials) to be more appropriate. An appeal was filed by Inventec, which ended up before the Regional Court, which in its decision no. 29 Af 91/2019-147 found that the tax authorities had not taken into account Inventec’s FAR profile and that the alternative choice of profit level indicator – ROTC instead of ROVAC – had therefore not been sufficiently justified. On this basis, the court quashed the assessment and remitted the case to the tax ... Read more

Inventec carried out manufacturing activities in the electronics industry on behalf of its parent company. It took formal title to the raw materials, but considered that its role was limited to assembly, without assuming risk or adding value to the materials. Inventec therefore used ROVAC (return on value added costs – not including cost of materials) as a profit level indicator (PLI) in its transfer pricing analysis. The tax authorities disagreed with the choice of PLI and considered ROTC (return on total costs – including materials) to be more appropriate. An appeal was filed by Inventec, which ended up before the Regional Court, which in its decision no. 29 Af 91/2019-147 found that the tax authorities had not taken into account Inventec’s FAR profile and that the alternative choice of profit level indicator – ROTC instead of ROVAC – had therefore not been sufficiently justified. On this basis, the court quashed the assessment and remitted the case to the tax ... Read more

“Bedding Textile Sp. z o.o.” (A) is a producer of bedding textiles which is sold to a related party C. Following an audit, the tax authorities concluded, inter alia, that the pricing of the controlled transactions between A and C was not at arm’s length. This conclusion was based on a benchmark study which showed that the profit earned by A (1.61% ROTC) was lower than the net profit earned by unrelated comparables. The interquartile range for the transaction in question was determined to be between 4.20% and 9.22%, with a median of 5.23% (after rejecting extreme results), and since the profit reported by A was outside the interquartile range, the tax authorities adjusted to the median of 5.23%, i.e. the value that most closely approximates the market value. An appeal was filed by A with the Administrative Court. Judgement The Administrative Court upheld the decision of the tax authorities in regards of the transfer pricing adjustment. Excerpts in English ... Read more

Sabic India is a subsidiary of the Sabic group and provided marketing services to other companies in the group. For purposes of pricing the controlled transactions, the TNMM had been chosen with a cost based PLI as well as a Berry ratio. Following an audit for FY 2015 and 2016, the tax authorities (the TPO) rejected the method and issued an assessment based on an “other method”. A complaint was filed Sabic India and the assessment was later overturned by the Income Tax Appellate Tribunal. An appeal was then filed by the tax authorities with the High Court. Judgment The High Court upheld the judgment of the Tribunal and found in favour of Sabic India. Excerpts “Undeniably, Rule 10AB of the Rules does permit determination of the ALP by simulating the price that would have been charged in similar uncontrolled transactions under similar circumstances having regard to all relevant facts. However, the recourse to this method would be available only ... Read more

In the case of Alliance One Tobacco Kenya Limited, the Tribunal addressed several tax issues, but a key area of contention was the treatment of transfer pricing adjustments in relation to declared sales under Corporate Income Tax (CIT) and Value Added Tax (VAT). Alliance One Tobacco argued that the Full-Cost-Mark-Up (FCMU) transfer pricing adjustments had created variances between CIT and VAT declarations. These adjustments, made in line with its transfer pricing policy, typically occurred after VAT returns had been filed, and since they related to export sales, they were zero-rated and excluded from VAT returns. Alliance One Tobacco claimed that these adjustments had been properly documented and explained to the tax authorities, and further contended that the tax authorities had, during the objection stage, accepted the legitimacy of these adjustments as reconciling items. Judgment of the Tax Tribunal The Tribunal found that Alliance One Tobacco failed to submit the actual transfer pricing policy or sufficient supporting documents. Despite references to ... Read more

The case of Volkswagen Argentina S.A. concerns whether the company’s income for FY 1999 – 2001 had been determined in accordance with the arm’s length principle. For the purposes of its transfer pricing analysis, Volkswagen Argentina (VWA) had included in its profits an extraordinary gain resulting from the waiver of a loan granted by Volkswagen Argentina Holding S.A., and on this basis had concluded that the results were at – or even above – arm’s length. The tax authorities disagreed with the adjustment made to VWA’s profits and found that the company had not been remunerated at arm’s length and an assessment of additional taxable income was issued. An complaint was made to the Tax Court, which ruled in VWA’s favour. The tax authorities then filed an appeal with the Court of Appeal, which was dismissed in December 2019. The case went on to the Supreme Court. Judgment The Supreme Court ruled in favour of the tax authorities. Click here ... Read more

The Administrative Court had annulled an income assessment issued by the tax authorities to Yazaki Bulgaria in FY 2014, 2015 and 2016. An appeal was filed by the tax authorities with the Supreme Administrative Court for annulment of the judgment. In the assessment, the tax authorities had accepted the comparability analysis carried out by Yazaki Bulgaria in respect of transactions relating to the manufacture of automotive products, including the calculated interquartile range of market values established on the basis of data for 25 comparable companies. According to the benchmark study the Net Cost Plus margins of the comparable companies for the three-year period were as follows: 2014 weighted average Net Cost Plus – lower quartile 2.27%, median 4.16% and upper quartile 7.02%; 2015 weighted average Net Cost plus 2015 – lower quartile 1.68%, median 4.31% and top quartile 6.80%; 2016 weighted average Net Cost plus for 2016 – lower quartile – 2.22%, median 3.95% and top quartile 7.66%; The actual ... Read more

In 2020 “Mineral Export SA” received a tax assessment for FY 2010 after the Peruvian tax authorities (SUNAT) had made two large transfer pricing adjustments: (i) an uplift of the remuneration it had received for its business activities (export of mineral concentrates to related parties), and (ii) an uplift of the price at which it had sold a controlling shareholding to a another group company. “Mineral Export SA” appealed to the Peruvian Tax Court. Judgement The Court partially upheld the adjustment concerning remuneration of the activities carried out, but it set aside the adjustment related to the price of the shares it had sold. In determining the remuneration for the activities carried out, the tax authorities had disallowed five comparability adjustments, discarding most of the taxpayer’s comparables, and recalculated the profit margins. The Court agreed that the comparability adjustments made by “Mineral Export SA” were unsupported and that the tax authorities could restrict the sample to two comparables. But according ... Read more

Sanofi-Aventis De Colombia S.A. filed a tax return for FY2013 in which it concluded that its related party transactions had been conducted at arm’s length. Transfer prices had been determined using a TNMM with the operating margin over operating costs and expenses (ROTC) as the profit level indicator (PLI). Following an audit, the Colombian tax authorities issued a notice of additional taxable income. The notice was based on an assessment, where the CUP method had been used instead of the TNMM. An appeal was filed with the Administrative Court, which later ruled in favour of Sanofi-Aventis. The tax authorities then appealed to the Council of State. Judgement of the Court The Counsel of State upheld the decision of the Administrative Court and dismissed the tax authorities’ appeal. Excerpts in English “…the Chamber states that, although in the case analysed the application of the CUP method cannot be completely ruled out, the DIAN applied it incorrectly because it did not make ... Read more

INDEGA filed a tax return for FY2011 in which it concluded that its related party transactions had been conducted at arm’s length. Transfer prices had been determined using a TNMM with the operating margin over operating costs and expenses (ROTC) as the profit level indicator (PLI). Following an audit, the Colombian tax authorities issued a notice of additional taxable income. The notice was based on an assessment, where they had used return on capital employed (ROCE) instead of ROTC as the PLI. An appeal was filed with the Administrative Court, which later ruled in favour of INDEGA. The tax authorities then appealed to the Council of State. Judgement of the Court The Counsel of State upheld the decision of the Administrative Court and dismissed the tax authorities’ appeal. Excerpt in English “The adjustments that may be made in the context of the application of the transfer pricing regime do not entail disregarding the accounting reality of the applicant as the ... Read more

The Irish tax authorities considered that the cost of employee share options (stock-based compensation) should have been included in the cost basis when determining the remuneration of “Service Ltd” for services provided to its US parent company and issued an assessment of additional taxable income for FY2015 – FY2018. Service Ltd lodged an appeal with the Tax Appeals Commission. Decision The Tax Appeals Commission ruled in favour of “Service Ltd” and overturned the tax authorities’ assessment. Excerpts “271.The Commissioner notes that the nature of the comparability analysis performed for purposes of applying the TNMM necessitates comparing “like with like”. Paragraph 1.6 of the OECD Guidelines refers to the comparability analysis as “an analysis of the controlled and uncontrolled transactions”. The Commissioner notes paragraph 1.36 of the OECD Guidelines provides that: “…in making these comparisons, material differences between the compared transactions or enterprises should be taken into account. In order to establish the degree of actual comparability and then to make ... Read more

Checkpoint Technologies used the Transactional Net Margin Method (TNMM) with net cost plus margin as the profit level indicator to determine the pricing of controlled transactions with its parent company. The benchmark study showed an arm’s length range (interquartile range) of 4.9% to 7.3% with a median of 5.5%. However, the agreement between Checkpoint Technologies and its parent company only provided for a mark-up rate of 5%. The tax authorities conducted an audit for FY2017-2020 and found that Checkpoint Technologies should have used the median in its benchmark study. As there was a discrepancy between the mark-up applied (5%) and the median mark-up of 5.5%, an additional income assessment was issued. Checkpoint Technologies appealed, arguing that it was not required to adopt the median position. If the reported taxable income (5%) is within the arm’s length range of 4.9% to 7.3%, there is no legal basis for adjusting the income. Decision The Tax Appeal Tribunal found in favour of Checkpoint ... Read more

Terex Italia s.r.l. is a manufacturer of heavy machinery and sold these products to a related distributor in the UK. The remuneration of the distributor had been determined based on application of the TNM-method. Following an audit for FY 2009 and 2010 the tax authorities served Terex a notice of assessment where adjustments was made to the taxable income in respect of a transfer pricing transaction, and in particular contesting the issuance of a credit note, in favour of the English company GENIE UK with the description “sales prices adjustment” recorded in the accounts as a reversal of revenue, in that, according to the Office, as a result of the adjustment made by the note, Terex would have made sales below cost to the English company, carrying out a clearly uneconomic transaction. In the same note, the non-deductibility of costs for transactions with blacklisted countries was contested. Terex lodged appeals against the assessments, but the Provincial Tax Commission upheld them ... Read more

SAS Itron France (a manufacturer and distributor of water, electricity and gas meters) was the subject of a tax audit for the financial years 2012 and 2013, which resulted in an assessment. The tax authorities considered that the transfer pricing applied by the group had resulted in an understatement of taxable income in France and a transfer of profits to a Hong Kong-based distributor of the group. An appeal was filed by SAS Itron France and in a ruling handed down on 2 December 2021, the Administrative Court annulled the assessment. The tax authorities filed an appeal against this ruling. Judgement of the Court The Administrative Court of Appeal dismissed the appeal and decided in favor of SAS Itron France. Excerpt in English “…In order to calculate the transfer price to be set by SAS Itron France in its relations as a producer with its group distributors, the tax authorities followed the profit-sharing method defined at group level, applicable to ... Read more

TRMSB is a company incorporated in Malaysia and part of the Thomson Reuters Group. Thomson Reuters Global Resources (“TRGR”) entered into the Local Distribution Agreement with TRMSB. Pursuant to the agreements, TRMSB was appointed to market and sell TRGR’s products in the form of “Information Services” and “Dealing Services” in Malaysia. The arm’s length remuneration for its distribution activities was determined to an operating margin of 2% by applying the TNMM where nine companies had been selected as comparables. Following an audit, the tax authorities (DGIR) rejected five of the nine selected companies and replaced them with three new comparables. The tax authorities also rejected TRMSB’s target operating margin of 2% by including SG&A costs in the calculation of TRMSB’s margin. Not satisfied with the assessments, TRMSB appealed to the Special Commissioner of Income Tax (SCIT). It argued that paragraph 2.80 of the OECD Guidelines provides that non-operating income and expenses should be considered as “exceptional and extraordinary” and should ... Read more

“Electric Component Manufacturing KtF” is a Hungarian subsidiary of a global group that distributes electronic components in more than 150 countries worldwide. The tax authorities had conducted a comprehensive tax audit of the Hungarian company for the period from 1 October 2016 to 30 September 2017, which resulted in an assessment of additional taxable income. The transfer pricing issues identified by the tax authorities were the remuneration received by the Hungarian company for its manufacturing activities and excessive interest payments to a group company in Luxembourg. Judgement of the Supreme Court The Supreme Court set aside the judgment of the Court of Appeal and ordered the court to conduct new proceedings and issue a new decision. In its decision, the Court of Appeal had relied on an expert opinion, which the Supreme Court found to to be questionable, because there were serious doubt as to its correctness. Therefore, according to the order issued by the Supreme Court, the Court of ... Read more

The main activity of Promet Stiel EAD was the production of hot rolled pig iron from ordinary and special steels and the company was part of METINVEST, an international group in the steel and mining sector. Following an audit, the tax authorities identified various transfer pricing issues and issued an assessment of additional taxable income. Not satisfied with the assessment, Promet filed an appeal with the Administrative Court, which later ruled in favour of Promet. In its decision, the Court stated that the OECD Transfer Pricing Guidelines were inapplicable and had no legal effect in Bulgaria. The tax authorities then appealed to the Supreme Administrative Court. Judgement of the Supreme Administrative Court The Supreme Administrative Court upheld the decision of the Administrative Court as regards the annulment of the assessment of additional taxable income, but concluded as follows as regards the legal status of the OECD Transfer Pricing Guidelines “The conclusions of the AC – Burgas [Administrative Court] on the ... Read more

Inventec carried out manufacturing activities in the electronics industry on behalf of its parent company. It took formal title to the raw materials, but considered that its role was limited to assembly, without assuming risk or adding value to the materials. Inventec therefore used ROVAC (return on value added costs – not including cost of materials) as a profit level indicator (PLI) in its transfer pricing analysis. The tax authorities disagreed with the choice of PLI and considered ROTC (return on total costs – including materials) to be more appropriate. An appeal was filed by Inventec, which ended up before the regional court. Judgement The regional court found that the tax authorities had failed to take into account Inventec’s FAR profile and that the alternative choice of profit level indicator – ROTC instead of ROVAC – had therefore not been sufficiently justified. On this basis, the court quashed the assessment and remitted the case to the tax authorities for reconsideration ... Read more

In addition to the profit level indicators provided in § 1.482-5(b)(4), a profit level indicator that may provide a reliable basis for comparing operating profits of the tested party involved in a controlled services transaction and uncontrolled comparables is the ratio of operating profit to total services costs (as defined in paragraph (j) of this section) ... Read more

The reliability of the allocation of costs, income, and assets between the relevant business activity and other activities of the tested party or an uncontrolled comparable will affect the reliability of the determination of operating profit and profit level indicators. If it is not possible to allocate costs, income, and assets directly based on factual relationships, a reasonable allocation formula may be used. To the extent direct allocations are not made, the reliability of the results derived from the application of this method is reduced relative to the results of a method that requires fewer allocations of costs, income, and assets. Similarly, the reliability of the results derived from the application of this method is affected by the extent to which it is possible to apply the profit level indicator to the tested party’s financial data that is related solely to the controlled transactions. For example, if the relevant business activity is the assembly of components purchased from both controlled ... Read more

Other profit level indicators not described in this paragraph (b)(4) may be used if they provide reliable measures of the income that the tested party would have earned had it dealt with controlled taxpayers at arm’s length. However, profit level indicators based solely on internal data may not be used under this paragraph (b)(4) because they are not objective measures of profitability derived from operations of uncontrolled taxpayers engaged in similar business activities under similar circumstances ... Read more

Financial ratios measure relationships between profit and costs or sales revenue. Since functional differences generally have a greater effect on the relationship between profit and costs or sales revenue than the relationship between profit and operating assets, financial ratios are more sensitive to functional differences than the rate of return on capital employed. Therefore, closer functional comparability normally is required under a financial ratio than under the rate of return on capital employed to achieve a similarly reliable measure of an arm’s length result. Financial ratios that may be appropriate include the following – (A) Ratio of operating profit to sales; and (B) Ratio of gross profit to operating expenses. Reliability under this profit level indicator also depends on the extent to which the composition of the tested party’s operating expenses is similar to that of the uncontrolled comparables ... Read more

The rate of return on capital employed is the ratio of operating profit to operating assets. The reliability of this profit level indicator increases as operating assets play a greater role in generating operating profits for both the tested party and the uncontrolled comparable. In addition, reliability under this profit level indicator depends on the extent to which the composition of the tested party’s assets is similar to that of the uncontrolled comparable. Finally, difficulties in properly valuing operating assets will diminish the reliability of this profit level indicator ... Read more

Profit level indicators are ratios that measure relationships between profits and costs incurred or resources employed. A variety of profit level indicators can be calculated in any given case. Whether use of a particular profit level indicator is appropriate depends upon a number of factors, including the nature of the activities of the tested party, the reliability of the available data with respect to uncontrolled comparables, and the extent to which the profit level indicator is likely to produce a reliable measure of the income that the tested party would have earned had it dealt with controlled taxpayers at arm’s length, taking into account all of the facts and circumstances. The profit level indicators should be derived from a sufficient number of years of data to reasonably measure returns that accrue to uncontrolled comparables. Generally, such a period should encompass at least the taxable year under review and the preceding two taxable years. This analysis must be applied in accordance ... Read more

The tested party’s operating profit must first be adjusted to reflect all other allocations under section 482, other than adjustments pursuant to this section ... Read more

For purposes of this section, the tested party will be the participant in the controlled transaction whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data regarding uncontrolled comparables can be located. Consequently, in most cases the tested party will be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables ... Read more

... Read more

Under the comparable profits method, the determination of an arm’s length result is based on the amount of operating profit that the tested party would have earned on related party transactions if its profit level indicator were equal to that of an uncontrolled comparable (comparable operating profit). Comparable operating profit is calculated by determining a profit level indicator for an uncontrolled comparable, and applying the profit level indicator to the financial data related to the tested party’s most narrowly identifiable business activity for which data incorporating the controlled transaction is available (relevant business activity). To the extent possible, profit level indicators should be applied solely to the tested party’s financial data that is related to controlled transactions. The tested party’s reported operating profit is compared to the comparable operating profits derived from the profit level indicators of uncontrolled comparables to determine whether the reported operating profit represents an arm’s length result ... Read more

... Read more

The comparable profits method evaluates whether the amount charged in a controlled transaction is arm’s length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances ... Read more

Under Illustration 3, if a controlled transaction is performed as in case 1 while the third party “comparables” are operating as in case 2, and assuming that the difference in the capacity utilisation is not identified due to insufficiently detailed information on the third party “comparables”, then the risk of error when applying a gross margin method could amount to 16 (2% x 800) instead of 50 (5% x 1000) if a net margin method is applied. This illustrates the fact that net profit indicators can be more sensitive than gross mark-ups or gross margins to differences in the capacity utilisation, depending on the facts and circumstances of the case and in particular on the proportion of fixed and variable costs and on whether it is the taxpayer or the “comparable” which is in an over-capacity situation ... Read more

Consequently, enterprises performing different functions may have a wide range of gross profit margins while still earning broadly similar levels of net profits. For instance, business commentators note that the transactional net margin method would be less sensitive to differences in volume, extent and complexity of functions and operating expenses. On the other hand, the transactional net margin method may be more sensitive than the cost plus or resale price methods to differences in capacity utilisation, because differences in the levels of absorption of indirect fixed costs (e.g. fixed manufacturing costs or fixed distribution costs) would affect the net profit but may not affect the gross margin or gross mark-up on costs if not reflected in price differences, as illustrated below. Illustration 3: Effect of a difference in manufacturers’ capacity utilization The example below is for illustration only and is not intended to provide any guidance on the selection of the transfer pricing method or of comparables, or on arm’s ... Read more

Under Illustration 2, if a controlled transaction is performed as in case 1 while the third party “comparables” are operating as in case 2, and assuming that the difference in the level of risks is not identified due to insufficiently detailed information on the third party “comparables”, then the risk of error when applying a gross margin method could amount to 60 (6% x 1 000) instead of 10 (1% x 1 000) if a net margin method is applied. This illustrates the fact that, depending on the circumstances of the case and in particular of the effect of the differences in the level of risks on the cost structure and on the revenue of the “comparables”, net profit margins can be less sensitive than gross margins to differences in the level of risks (assuming the contractual allocation of risks is arm’s length) ... Read more

Under Illustration 1, if a taxpayer is operating with an associated manufacturer as in case 2 while the third party “comparables” are operating as in case 1, and assuming that the difference in the extent and complexity of the marketing function is not identified because of for instance insufficiently detailed information on the third party “comparables”, then the risk of error when applying a gross margin method could amount to 120 (12% x 1 000), while it would amount to 20 (2% x 1 000) if a net margin method was applied. This illustrates the fact that, depending on the circumstances of the case and in particular of the effect of the functional differences on the cost structure and on the revenue of the “comparables”, net profit margins can be less sensitive than gross margins to differences in the extent and complexity of functions. Illustration 2: Effect of a difference in the level of risk assumed by a distributor The ... Read more

[See Chapter II, Part III, Section B of these Guidelines for general guidance on the application of the transactional net margin method. The assumptions about arm’s length arrangements in the following examples are intended for illustrative purposes only and should not be taken as prescribing adjustments and arm’s length arrangements in actual cases of particular industries. While they seek to demonstrate the principles of the sections of the Guidelines to which they refer, those principles must be applied in each case according to the specific facts and circumstances of that case. Furthermore, the comments below relate to the application of a transactional net margin method in the situations where, given the facts and circumstances of the case and in particular the comparability (including functional) analysis of the transaction and the review of the information available on uncontrolled comparables, such a method is found to be the most appropriate method to be used.] It is recognised that the transactional net margin method ... Read more

As discussed in these Guidelines, there are concerns regarding the use of the transactional net margin method, in particular that it is sometimes applied without adequately taking into account the relevant differences between the controlled and uncontrolled transactions being compared. Many countries are concerned that the safeguards established for the traditional transaction methods may be overlooked in applying the transactional net margin method. Thus, where differences in the characteristics of the transactions being compared have a material effect on the net profit indicators being used, it would not be appropriate to apply the transactional net margin method without making adjustments for such differences. See paragraphs 2.74-2.81 (the comparability standard to be applied to the transactional net margin method) ... Read more

The facts are the same as in paragraph 2.42. However, the amount of the warranty expenses incurred by Distributor A proves impossible to ascertain so that it is not possible to reliably adjust the gross profit of A to make the gross profit margin properly comparable with that of B. However, if there are no other material functional differences between A and B and the net profit of A relative to its sales is known, it might be possible to apply the transactional net margin method to B by comparing the margin relative to A’s sales to net profits with the margin calculated on the same basis for B ... Read more

A similar approach may be required when there are differences in functions performed by the parties being compared. Assume that the facts are the same as in the example at paragraph 2.44 except that it is the comparable independent enterprises that perform the additional function of technical support and not the associated enterprise, and that these costs are reported in the cost of goods sold but cannot be separately identified. Because of product and market differences it may not be possible to find a CUP, and a resale price method would be unreliable since the gross margin of the independent enterprises would need to be higher than that of the associated enterprise in order to reflect the additional function and to cover the unknown additional costs. In this example, it may be more reliable to examine net margins in order to assess the difference in the transfer price that would reflect the difference in function. The use of net margins ... Read more

By way of illustration, the example of cost plus at paragraph 2.59 demonstrates the need to adjust the gross mark-up arising from transactions in order to achieve consistent and reliable comparison. Such adjustments may be made without difficulty where the relevant costs can be readily analysed. Where, however, it is known that an adjustment is required, but it is not possible to identify the particular costs for which an adjustment is required, it may, nevertheless, be possible to identify the net profit arising on the transaction and thereby ensure that a consistent measure is used. For example, if the supervisory, general, and administrative costs that are treated as part of costs of goods sold for the independent enterprises X, Y and Z cannot be identified so as to adjust the mark up in a reliable application of cost plus, it may be necessary to examine net profit indicators in the absence of more reliable comparisons ... Read more

A situation where Berry ratios can prove useful is for intermediary activities where a taxpayer purchases goods from an associated enterprise and on-sells them to other associated enterprises. In such cases, the resale price method may not be applicable given the absence of uncontrolled sales, and a cost plus method that would provide for a mark-up on the cost of goods sold might not be applicable either where the cost of goods sold consists in controlled purchases. By contrast, operating expenses in the case of an intermediary may be reasonably independent from transfer pricing formulation, unless they are materially affected by controlled transaction costs such as head office charges, rental fees or royalties paid to an associated enterprise, so that, depending on the facts and circumstances of the case, a Berry ratio may be an appropriate indicator, subject to the comments above ... Read more

The selection of the appropriate financial indicator depends on the facts and circumstances of the case, see paragraph 2.82. Concerns have been expressed that Berry ratios are sometimes used in cases where they are not appropriate without the caution that is necessary in the selection and determination of any transfer pricing method and financial indicator. See paragraph 2.98 in relation to the use of cost-based indicators in general. One common difficulty in the determination of Berry ratios is that they are very sensitive to classification of costs as operating expenses or not, and therefore can pose comparability issues. In addition, the issues raised at paragraphs 2.99-2.100 above in relation to pass-through costs equally arise in the application of Berry ratios. In order for a Berry ratio to be appropriate to test the remuneration of a controlled transaction (e.g. consisting in the distribution of products), it is necessary that: The value of the functions performed in the controlled transaction (taking account ... Read more

“Berry ratios” are defined as ratios of gross profit to operating expenses. Interest and extraneous income are generally excluded from the gross profit determination; depreciation and amortisation may or may not be included in the operating expenses, depending in particular on the possible uncertainties they can create in relation to valuation and comparability ... Read more

Other net profit indicators may be appropriate depending on the facts and circumstances of the transactions. For instance, depending on the industry and on the controlled transaction under review, it may be useful to look at other denominators where independent data may exist, such as: floor area of retail points, weight of products transported, number of employees, time, distance, etc. While there is no reason to rule out the use of such bases where they provide a reasonable indication of the value added by the tested party to the controlled transaction, they should only be used where it is possible to obtain reliable comparable information to support the application of the method with such a net profit indicator ... Read more

In cases where the net profit is weighted to assets, the question arises how to value the assets, e.g. at book value or market value. Using book value could possibly distort the comparison, e.g. between those enterprises that have depreciated their assets and those that have more recent assets with on-going depreciation, and between enterprises that use acquired intangibles and others that use self-developed intangibles. Using market value could possibly alleviate this concern, although it can raise other reliability issues where valuation of assets is uncertain and can also prove to be extremely costly and burdensome, especially for intangible assets. Depending on the facts and circumstances of the case, it may be possible to perform adjustments to improve the reliability of the comparison. The choice between book value, adjusted book value, market value and other possibly available options should be made with a view to finding the most reliable measure, taking account of the size and complexity of the transaction ... Read more

Returns on assets (or on capital) can be an appropriate base in cases where assets (rather than costs or sales) are a better indicator of the value added by the tested party, e.g. in certain manufacturing or other asset-intensive activities and in capital-intensive financial activities. Where the indicator is a net profit weighted to assets, operating assets only should be used. Operating assets include tangible operating fixed assets, including land and buildings, plant and equipment, operating intangible assets used in the business, such as patents and know-how, and working capital assets such as inventory and trade receivables (less trade payables). Investments and cash balances are generally not operating assets outside the financial industry sector ... Read more

The use of budgeted costs can also raise a number of concerns where large differences between actual costs and budgeted costs result. Independent parties are not likely to set prices on the basis of budgeted costs without agreeing on what factors are to be taken into account in setting the budget, without having regard to how budgeted costs have compared with actual costs in previous years and without addressing how unforeseen circumstances are to be treated ... Read more

Depending on the facts and circumstances of the case, actual costs, as well as standard or budgeted costs, may be appropriate to use as the cost base. Using actual costs may raise an issue because the tested party may have no incentive to carefully monitor the costs. In arrangements between independent parties, it is not rare that a cost savings objective is factored into the remuneration method. It can also happen in manufacturing arrangements between independent parties that prices are set on the basis of standard costs, and that any decrease or increase in actual costs compared to standard costs is attributed to the manufacturer. Where they reflect the arrangements that would be taken between independent parties, similar mechanisms could be taken into account in the application of the cost-based transactional net margin method. See paragraph 2.58 for a discussion of the same issue in relation to the cost plus method ... Read more

Where treating costs as pass-through costs is found to be arm’s length, a second question arises as to the consequences on comparability and on the determination of the arm’s length range. Because it is necessary to compare like with like, if pass-through costs are excluded from the denominator of the taxpayer’s net profit indicator, comparable costs should also be excluded from the denominator of the comparable net profit indicator. Comparability issues may arise in practice where limited information is available on the breakdown of the costs of the comparables ... Read more

In applying a cost-based transactional net margin method, fully loaded costs are often used, including all the direct and indirect costs attributable to the activity or transaction, together with an appropriate allocation in respect of the overheads of the business. The question can arise whether and to what extent it is acceptable at arm’s length to treat a significant portion of the taxpayer’s costs as pass-through costs to which no profit element is attributed (i.e. as costs which are potentially excludable from the denominator of the net profit indicator). This depends on the extent to which an independent party in comparable circumstances would agree not to earn a mark-up on part of the costs it incurs. The response should not be based on the classification of costs as “internal” or “external” costs, but rather on a comparability (including functional) analysis. See paragraph 7.34 ... Read more

Cost-based indicators should only be used in those cases where costs are a relevant indicator of the value of the functions performed, assets used and risks assumed by the tested party. In addition, the determination of what costs should be included in the cost base should derive from a careful review of the facts and circumstances of the case. Where the net profit indicator is weighted against costs, only those costs that directly or indirectly relate to the controlled transaction under review (or transactions aggregated in accordance to the principle at paragraphs 3.9-3.12) should be taken into account. Accordingly, an appropriate level of segmentation of a taxpayer’s accounts is needed in order to exclude from the denominator costs that relate to other activities or transactions and materially affect comparability with uncontrolled transactions. Moreover, in most cases only those costs which are of an operating nature should be included in the denominator. The discussion at paragraphs 2.86-2.91 above also applies to ... Read more