The following article has been kindly contributed by Dr Harold McClure, a New-York based economist who has over 25 years of transfer pricing experience. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983 and began his transfer pricing career at the IRS. He later worked at several Big 4 accounting firms, Law and Economics Consulting Group, and was the lead economist in Thomson Reuters’ transfer pricing practice.
Dr. McClure’s engagements have included the valuation of intangible assets, the interplay between transfer pricing and enterprise valuation, arm’s length royalty rates, intercompany loans, intercompany factoring, intercompany leasing rates, the analysis of a related party distributor’s gross margin under a market share strategy, various aspects with respect to contract manufacturing, and the coordination between customs valuation and transfer pricing.
Dr. Monika Laskowska recently discussed a public consultation launched by Poland’s Ministry of Finance on an explanatory note addressing taxpayers’ ability to make year-end, self-initiated, transfer pricing adjustments. She noted Poland’s proposal for a price-setting approach for transfer pricing, which the German tax authorities considered but did not adopt.
We review the Polish discussion as well as the prior discussions in Germany as detailed by Susann van der Ham and Karin Ruëtz. We also consider the key issues in terms of a German customs valuation case as well as a Polish income tax litigation.
Germany’s flirtation with the price-setting approach
Susann van der Ham and Karin Ruëtz pose the key question:
Should information be used for determining and documenting transfer prices that is available at the time when the intercompany transaction takes place (ex-ante or price setting approach)? Or should the actual outcome of the transaction between related parties be used when demonstrating whether the conditions actually comply with the arm's-length principle (ex-post or outcome testing approach)?
Consider a German distribution affiliate purchasing goods from its Japanese parent for sale to its customers. The classic transfer pricing debate is whether the intercompany contract should target a gross margin for the distribution affiliate versus specify its operating margin. Susann van der Ham and Karin Ruëtz note the following issues:
Which financial data of the transaction partner(s) should be used in determining and testing transfer pricing? In case of the first approach, budget figures based on information of the economic and market conditions including financial projections at the time of the transaction need to be applied, whereas under the latter, actual figures on revenues and cost structures are already available … German tax authorities argue that unrelated parties would not agree on retroactive adjustments to their profits but instead only accept changes to the pricing and this only based on a forward-looking basis. It is claimed that a guaranteed profit in the form of a fixed net margin, as often agreed on (for example, limited-risk distributors), would not be observed between third parties.
Consider a situation where a German distribution affiliate is expected to sell $1 billion in goods and incur $200 million in operating expenses. A 24 percent gross margin would afford this distribution affiliate with an expected operating margin equal to 4 percent as the expected operating expense to sales is 20 percent.
The traditional benchmarking approach is to examine the operating margins of comparable third party distributors under the Transactional Net Margin Method (TNMM). If a TNMM analysis suggested that a 4 percent operating margin was consistent with the arm’s length standard, then this analysis would support this policy as long as the actual operating margin was reasonably close to this 4 percent expected operating margin.
The dilemma is what would be the appropriate remedy if the actual operating expense to sales ratio unexpectedly changed. For example suppose that a period of weak sales led to a temporary increase in the operating expense to sales ratio such that it was 23 percent. A price setting approach might be seen as maintaining the 24 percent gross margin, which would allow the operating margin to fall to 1 percent. An outcomes based approach would maintain the 4 percent operating margin but lowering the intercompany price such that the gross margin would increase to 27 percent. Conversely a period of strong sales could lead to a temporary decrease in the operating expense to sales ratio such that it was 17 percent. A price setting approach might be seen as maintaining the 24 percent gross margin, which would allow the operating margin to rise to 7 percent. An outcomes based approach would maintain the 4 percent operating margin but lowering the intercompany price such that the gross margin would increase to 21 percent.
The Hamamatsu customs valuation case
Hamamatsu Photonics is a Japanese manufacturer of various optical devices, which are sold in Europe by Hamamatsu Photonics Deutschland GmbH (HPD). HPD obtained an Advance Pricing Agreement (APA) with the German and Japanese tax authorities that targeted an operating margin. On December 20, 2017, the Court of Justice of the European Union (CJEU) issued a ruling objecting to this targeting of an operating margin when HPD lowered its transfer pricing, where the actual financial results showed an operating margin below the targeted margin.
Yanan Li and I noted:
While the economic analysis prepared for an APA application may provide useful information, two caveats apply. This first, that not all transfer pricing analyses are informative on what an appropriate pricing policy would be. The second caveat is that the issue of post-importation may involve a different question, which customs officials often allude to by reference to “industry standards”. Much of income tax transfer pricing addresses technical issues with respect to the benchmarking of a distributor’s margin based on its function and assets, while many of the customs issues revolve around implementation issues. Third party distributors negotiate an appropriate gross margin based on its functions and assets involved in carrying out its responsibilities as the distributor of a manufacturer’s products. The deductive value method is fundamentally equivalent to the use of a Transactional Net Margin Method (TNMM) to construct the appropriate gross margin. Customs authorities often insist on a fixed gross margin approach arguing that third party distributors do not target operating margins. Interestingly tax authorities in Germany and Japan have often made similar arguments. Some transfer pricing practitioners, however, insist that distribution affiliates be seen as “limited risk” and argue for targeting operating margins. APA agreements are often written in terms of a band for an acceptable operating margin. Temporary variations in the operating expense to sales ratio would likely not lead to variability in the gross margin under arm’s length pricing.
We also noted two other possibilities for the decline in the operating margin of the German distribution affiliate. One possibility is that a relative price decline from exchange rate variability may have lowered the gross margin for the distribution affiliate. In this case, a gross margin target would have allowed the transfer pricing adjustment requested by the multinational. We also suggested:
Permanent increases in the operating expense to sales ratio may emanate from function creep, that is, the distribution affiliate taking on more responsibilities. If the operating expense to sales ratio increased from function creep, a case can be made for lowering the transfer price to increase the gross margin commensurate with the new functions.
Susann van der Ham and Karin Ruëtz similarly noted:
Looking at the regulations regarding relocation of functions, German tax authorities take quite the opposite view. Under section 1 paragraph 3 of the Foreign Tax Code it is refutably assumed that third parties would have agreed on retroactive price adjustments under such circumstances. Therefore, in cases where the transaction parties have not agreed on a specific price adjustment clause, the regulation stipulates that tax authorities may assume price adjustments within a 10 year period. This shows that retroactive adjustments are not a priori rejected by German tax authorities. However, overall German tax authorities strongly prefer the price setting approach over the outcome testing approach and allow only under specific circumstances that transfer prices are adjusted retroactively.
In our example where the operating expense to sales ratio rose from 20 percent to 23 percent, if the increase in the operating expense to sales ratio was due to an increase in functions and thus could be seen as permanent and not transitory, then a higher gross margin could be warranted.
Poland’s Ministry of Finance is considering the price setting approach for reasons similar to what the German tax authorities were articulating. Dr. Monika Laskowska noted several arguments but we shall note only a few considerations.
under Polish law, year-end adjustments cannot be made to introduce arm’s length conditions to controlled transactions, but to make “minor” adjustments to prices already set in accordance with arm’s length principle. To make these transfer pricing adjustments, several conditions must be met. First, the controlled transaction must be compliant with the arm’s length principle. Second, there must be a change of relevant circumstances that have an impact on the transactional conditions or a taxpayer must gain new information on actually incurred costs (if the transfer price was set on budgeted costs) or on actually attained revenue in the controlled transaction.
We have noted that a third party supplier and distributor would not adjust an agreed upon arm’s length gross margin from temporary variations in the operating expense to sales ratio but would allow for an increase in the gross margin if increases in functions led to a permanent increase in the operating expense to sales ratio. This portion of Polish law is consistent with these considerations.
Dr. Monika Laskowska also noted:
Another controversial area of interpretation involves the availability of a transfer pricing adjustment in cases where there is no direct transaction to be adjusted. For example, according to the explanatory note, an adjustment is permitted between a limited risk distributor and the principal of a company even there is no suitable and direct transaction between these two. The explanatory note states that a transfer pricing adjustment is permitted to adjust the controlled entity’s profitability, no matter what document is used. When there is no direct transaction, a correcting note is a satisfactory document to adjust the entity’s profitability. Through this explanation, the Ministry of Finance was aiming to address the ongoing debate on transferring residual profit between limited risk entities and principal entities through inadequate forms of intra-group agreements.
K.sp. z o.o. is a Polish company belonging to an international group. The main activity of K is local sale of goods purchased from a intra group supplier. K is best characterized as a limited risk distributor and as such should achieve an certain predetermined level of profitability as a result of its activities. In order to achieve the determined level of profitability, the group had established that, if the operating margin actually achieved by the distributor during a given period is less or more than the assumed level of profit, it will be adjusted. The year-end adjustment will not be directly related to the prices of goods purchased from the intra-group supplier and will be made after the end of each financial year.
The court rejected such year-end adjustments.
A litigation involving a Polish distribution affiliate
The court decision noted the following provisions of the intercompany contract:
The European (local) companies in the group, including the applicant, have been integrated into a centralised model and operate as distributors of the supplier's goods, with limited business risk; the supplier sells its products to its local distributors in each country; the distributors take the goods from the supplier's warehouse and resell them to final customers; the supplier remains the owner of the goods while they are in stock and the applicant, as a distributor, acquires ownership of the goods from the supplier when the products are delivered to the final recipients; the supplier treats the sale as domestic sales and issues an invoice to the Complainant including VAT at the appropriate rate; the applicant also handles the supplier's goods in the warehouse, providing him with a comprehensive logistics service, as well as handling the sale and purchase process. The supplier's services to the distributor also include assisting in the performance of contractual obligations, granting a limited right to use the trade mark, and repurchasing fully sold products sold by the distributor and returned by customers.
This description notes that the distribution affiliates are responsible for both selling and logistics activities. It also suggests that the distribution affiliates hold very modest levels of inventories. The court also noted the following from the intercompany agreement:
The parties agreed in the agreement that the settlement between them will take place on the basis of equalisation of profitability to the established level of net operating margin, which is to ensure that an appropriate level of margins and profits is achieved in relation to costs incurred, resources employed and risks incurred. If the operating margin actually achieved by the distributor over a given period is less or more than his remuneration, the parties to the distribution agreement may align the purchase price in order to achieve the level of the net operating margin … the net operating margin (EBIT) achieved by the applicant after the year-end was generally set at 4.5% for 2016 and 3.5% for 2017 of revenues from external sales of products, after deducting the bonuses and discounts it will itself grant to customers and an additional cost plus 7% of total logistics costs, as remuneration for logistics services.
Consider a situation where a Poland distribution affiliate is expected to sell $1 billion in goods an incur $190 million in selling expenses plus $70 million in logistic expenses. The 7 percent markup for logistics expenses is roughly consistent with expected profits equal to 0.5 percent of sales. Let’s also assume that a TNMM analysis supports expected operating profits for selling activity equal to 3.5 percent of sales. Our example is consistent with expected operating expenses equal to 26 percent of sales and expected operating profits equal to 4 percent of sales. A price setting approach would establish a 30 percent gross margin. The taxpayer’s expressed transfer pricing approach, however, targeted the operating profit margin.
The court made several statements with respect to the issue in the litigation as well as Polish law including:
The legal problem examined in this case relates to the use by the applicant company of a mechanism applied in economic practice, in group settlements, referred to as a ‘compensating adjustment’. Generally speaking, that mechanism consists in an upward (true-up) or downward (true down) adjustment of the price between the supplier and the distributor, depending on whether the latter obtains income from sales to third parties which exceeds or is less than the margin fixed in the agreement between those entities. In the present case, the essence of the dispute concerns the tax consequences, in terms of corporation tax, of offsetting the net operating margin downwards (true down), under an agreement concluded by the applicant with the controlling company (the supplier). That means that the applicant (distributor) transfers funds to the supplier at an amount corresponding to the excess of the margin set in the contract concluded previously by those entities.
If the operating expense to sales ratio for the distribution affiliate fell from 26 percent to 24 percent maintaining a 30 percent gross margin would have the actual operating margin rise to 6 percent. A compensating adjustment under a policy where the operating margin is pegged at 4 percent would lower the gross margin to 28 percent, which would mean the Polish affiliate would pay the related party supplier additional compensation equal to 2 percent of sales.
The Polish tax authority, however, argued that this compensating adjustment is inconsistent with the arm’s length standard. Their argument is the price setting approach where the parties would agree to a 30 percent gross margin. The court was less than explicit on which approach was consistent with Polish law noting:
On the other hand, in the legal status in force before 2019, a typical transfer pricing arrangement concerned settlements between related companies for the direct supply of goods or services. For the sake of order, it should be recalled that until the end of 2018 the legislator, both in the Corporate Income Tax Act, the Personal Income Tax Act and the Value Added Tax Act, did not use the term “transfer prices” but used the term “transaction prices”…The situation has fundamentally changed as of 1 January 2019, due to the amendment of, inter alia, the Corporate Income Tax Act as of that date. In art. 11a sec. 1 point 1, the definition of the transfer price has been established (a broader scope than the concept of a transaction price within the meaning of art. 3 point 10 of the Corporate Income Tax Act). ), and in art. 11e of the C.C.P.I.P. there are certain possibilities and rules of making transfer price adjustments. However, the considerations in this respect go beyond the limits of this case.
The Ministry of Finance’s proposal for an explicit endorsement of the price setting approach may have been motivated by the ambiguous statement in this court decision.
The debate between price setting approaches versus outcomes based approaches is relevant for intercompany transactions other than the compensation for distribution affiliates. We have focused on distribution affiliates in Germany and Poland as the distinction between gross margins versus operating margins have been debated internationally for over 25 years. The German and Polish tax authorities have recently proposed the price setting approach, which in our context equates to targeting gross margins.
Some tax authorities, however, insist on targeting operating margins. The IRS is particularly stubborn on this viewpoint. Targeting operating margins is a popular approach for practitioners who establish operational transfer pricing systems. Making operational transfer pricing easier, however, may lead to problems elsewhere especially when customs valuations often require targeting gross margins. The concern of double taxation is also present if the tax authority for the supplying affiliate takes a different approach from the approach adopted by the tax authority for the distribution affiliate.
 “Poland tax guidance confirms controversial position on year-end transfer pricing adjustments”, November 5, 2020 - mnetax.com/poland-tax-guidance-confirms-controversial-position-on-year-end-transfer-pricing-adjustments-41255
 “Arm's length price setting versus outcome testing approach”, June 22, 2014 - www.internationaltaxreview.com/article/b1f9k18pwgvklg/german-insights-on-price-setting-versus-outcome-testing-approach
 “CJEU denies the Hamamatsu Photonics Retroactive Transfer Pricing Adjustment”, August 24, 2018, tax.thomsonreuters.com/blog/cjeu-denies-the-hamamatsu-photonics-retroactive-transfer-pricing-adjustment
 January 2020, Supreme Administrative Court, Case No II FSK 191/19 – Wyrok