Transaction Pairs and the Choice of Tested Party for Indian Applications of TNMM

This is a guest post by Harold McClure, a New York City-based independent economist with 26 years of transfer pricing and valuation experience. (One of several that he has written for us.) His starting point for the article was our recent piece on 'transaction pairs'. Looking at this from the perspective of the Transactional Net Margin Method, he considers three recent TP litigation cases in India, and the question of whether the ‘tested party’ should be the manufacturer or the distributor.

Paul Sutton recently noted that “transaction pairs” is the basic unit of transfer pricing:

"A transaction pair is a pair of associated entities which enters into a transaction – in other words, agrees to exchange value of some description. Usually (but not always), the ‘value’ provided by one party to the transaction is a payment. In which case, defining the transaction involves being clear about:

• which counterparty will receive the payment
• how the payment is to be calculated
• what the payment is for (e.g. services, goods, IP)
• how that benefits the paying party."

Several Indian litigations have debated whether the related party manufacturer or the related party distributor should be selected as the tested party for purposes of applying the Transactional Net Margin Method (TNMM). This note reviews two of these litigations and an upcoming litigation as an illustration of this transaction pair concept.

I argue that a starting point is the consolidated profits of the relevant related parties, including third party sales received by the distribution affiliate, the expenses incurred by the manufacturer, and the expenses incurred by the distributor. The allocation of consolidated profits among the related parties is a function of how expenses are allocated among the two affiliates and how the transfer pricing policies allocated revenues. TNMM properly applied to a tested party would grant this party with only a routine return for its functions. If consolidated profits include residual profits, that is profits above the distributor’s routine return plus the manufacturer’s routine return, an inquiry needs to be made as what are the intangible assets generating these residual profits and whether the distribution affiliate of the manufacturing affiliates owns these intangible assets.

Kellogg India and the Sale of Pringles

Kellogg purchased the rights to Pringles from Procter and Gamble in 2012 for almost $2.7 billion. Kellogg India Private Limited is its Indian distribution affiliate, which purchases Pringles from Pringles International Operations SARL, a Singapore affiliate that owns the Asian intangible assets with respect to Pringles. The Singapore affiliate relies on a third party contract manufacturer to produce Pringles, which are sold by Kellogg India Private Limited.

The transfer pricing policy set the intercompany price paid by the Indian affiliate at the cost paid to the third party contract manufacturer plus a 5% markup. Such a policy implicitly granted the Singapore affiliate with an embedded royalty for the use of the Pringle intangible assets. The Indian affiliate acted as a distributor and would often be seen as the tested party for an application of the Transactional Net Margin Method (TNMM). As we note below, the Indian tax authorities approached this issue in this manner.

The Taxpayer’s Approach in Kellogg India

On February 16, 2022, the Income Tax Appellate Tribunal – Mumbai issued a decision in favor of the taxpayer. The Tribunal decision noted the competing applications of TNMM by the taxpayer versus the tax authority. The decision noted:

"Kellogg India characterised itself as a distributor of Pringles products and is responsible for the strategic and overall management of Pringles business in India. Singapore AE, being the least complex entity, was selected as the tested party for benchmarking the international transaction of import of finished goods. Kellogg India conducted a search in the Asia Pacific region to identify manufacturers and based on benchmarking analysis carried out, an arithmetic mean of 14 comparable companies with Gross Profit / Direct and Indirect Cost as the Profit Level Indicator (PLI) was determined at 50.07%."

Several problems exist with the taxpayer’s approach, starting with this premise that a 50% markup over a subset of production costs has any meaning even had the Singapore affiliate conducted manufacturing operations. As the facts show, the Singapore affiliate was not a manufacturer but simply an entity owning the product intangibles while relying on a third party contract manufacturer. That the Tribunal accepted this questionable application of TNMM is puzzling.

A Proposed Consolidated Income Statement

Before turning to the tax authority’s application of TNMM using the Indian distribution affiliate as the tested party, I attempt to construct an illustrative consolidated income statement based on the very limited information in the Tribunal decision. One table in the Tribunal decision notes sales and operating expenses for the Indian affiliate. Sales were almost 30 million rupees, which would translate into approximately $500,000 using exchange rates for 2014. Operating expenses were almost 12.5% of sales.

Table 1 assumes that the cost of goods purchased from the third party contract manufacturer was 80% of sales or $400,000. Consolidated profits would therefore be $37,500 or 7.5% of sales. These profits would be allocated between the Indian distribution affiliate and the Singapore affiliate based on the transfer pricing policy. Table 1 presents the taxpayer’s policy as well as two other potential transfer pricing policies.

The taxpayer’s policy would set the intercompany purchase price for the Pringles at $420,000, which would have allowed the distribution affiliate to retain a 16% gross margin. Since operating expenses represent 12.5% of sales, operating profits represent 3.5% of sales or a 28% markup over operating expenses. I note below that such a policy may have afforded the Indian distribution affiliate with a portion of intangible profits.

Table 1: Illustrative Income Statements Under Three Transfer Pricing Policies

Possible Issues with the Tax Authority’s Application of TNMM

The tax authorities applied TNMM with the Indian distribution affiliate as the tested party. The Tribunal noted the eight companies chosen as alleged comparables and their operating margin. The median operating margin was approximately 4.3%. If the gross margin were raised from 16% to 16.8%, the distributor’s operating profits rise from $17,500 to $21,500 to reflect the operating margin = 4.3%, which represents a 34.4% markup over operating expenses.

Consolidated profits represent 7.5% of sales. The original transfer pricing policy set the profits of the Singapore affiliate at 5% of the cost of goods, which is equivalent to 4% of sales or $20,000. This transfer pricing adjustment lowers Singapore’s profits from $20,000 (5% of costs and 4% of sales) to only $16,000 (4% of costs or 3.2% of sales).

Wholesale distributors of food have operating margins between 3.5% to 4.3% only if they perform more extensive functions than what appears to be the functional responsibility of Kellogg India as it sold Pringles. Many of the companies chosen as alleged comparables in this litigation performed more than wholesale distribution functions and owned what could be seen as valuable intangibles.

In my discussion of distribution margins and Pillar One’s Amount B, I note the financials for seven US wholesale distributors of food over the 2015 to 2017 period.[1] Markups over operating expenses from 28% to 34.4% would be reasonable only if the distribution affiliate owned marketing intangibles. The last two columns of our table assume a 15% gross margin, which would result in operating profits that represent 2.5% of sales or a 20% markup over operating expenses. The financials for one of my seven US wholesale distributors of food – United Natural Foods – were consistent with this assumption. Under this transfer pricing policy, the Singapore affiliate’s profits would represent 6.25% of costs or 5% of sales. In other words, if the routine return for distribution functions represent 2.5% of sales, then residual profits represent 5% of sales.

The transfer pricing report from the taxpayer suggested that Kellogg India incurred marketing expenses, which raises the possibility that this affiliate deserved a portion of residual profits. As such, the Indian tax authorities could argue for a gross margin above 15% on the basis of a Residual Profit Split approach. The original 16% gross margin would grant the Indian affiliate with both the routine return = 2.5% of sales but also one-fifth of these residual profits. The position of the Indian tax authority that the operating margin should have been 4.3% would be consistent with the Indian affiliate receiving 36% of residual profits.

This controversy could be recast in terms of an arm’s length royalty rate. The original transfer pricing policy effectively granted the Singapore affiliate with profits = 4% of sales. If the routine return for distribution represents 2.5% of sales, then residual profits = 5% of sales. As such, the original transfer pricing policy set the effectively royalty rate at 80% of residual profits. The position of the Indian tax authority would lower the effective royalty rate to 3.2% of sales or 64% of residual profits.

Ranbaxy Laboratories Limited

Ranbaxy Laboratories Limited is an Indian based manufacturer of pharmaceuticals. The Indian parent is responsible for all R&D and owns the product intangibles. Its distribution affiliates are located in the US, the UK, Germany, Ireland, Netherlands, Romania, Brazil, Peru, Egypt, Morocco, Nigeria, South Africa, China, Hong Kong, Malaysia, Thailand, and Vietnam. While the Indian tax authorities attempted to use an application of TNMM with the manufacturer as the tested party, the Indian courts agreed with the taxpayer that the tested party should be the distribution affiliates.

The actual application of TNMM with the distribution affiliates, however, was problematic in several ways. Even though the taxpayer’s representatives correctly noted that distributors with high functions would tend to receive higher operating margins, the analysis did not identify either the operating expense to sales ratio for the distribution affiliates or their gross margins. The reported operating margins exhibit considerable variability. The US distribution affiliates had operating margins just over 10%, while some affiliates had much higher operating margins and other affiliates had operating margins less than 2%. No explanation of why these operating margins varied so widely was presented.

The defense of double digit operating margins relied upon a very questionable application of TNMM that concluded that the median of eight observed operating margins was almost 15%. The actual eight companies offered as alleged comparables included five companies that both design and manufacture pharmaceuticals. Only three of the companies offered as alleged comparables were distributors – United Drug PLC, Priority Healthcare Corporation, and Caremark. The operating margins for these three companies were closer to 5%.

Olympic Medical Systems

Olympus Medical Systems is a Japanese based manufacturer of medical equipment. Its Indian affiliate is responsible for selling and serving imported equipment purchased by Indian customers. The Indian affiliate reported losses in 2012 and 2013, which prompted a transfer pricing audit by the Indian tax authorities.

In an April 2022 ruling by the Income Tax Appellate Tribunal – New Delhi, the Indian tax authority was able to compel the multinational to provide certain financial information required to analyze the intercompany transactions. The arguments presented by both parties disagreed on the role of marketing expenses incurred by the Indian affiliate as well as the transfer pricing method. While the multinational argued that a Resale Price Method should focus on the appropriate gross margin, the tax authority suggested a Residual Profit Split approach should be used.

We shall speculate on what information might be provided and how this information conditions the type of analysis that might be used to evaluate the issues. Since Olympus Medical Systems files annual reports, we know at least its worldwide profitability. Over the five-year period ending March 31, 2016, average annual sales were $7.75 billion or less than $8 billion. Cost of goods sold were just over 42% and operating expenses were just over 48%, so consolidated profits were less than 10% of sales. The operating margin for the first two years were near 4.5% but exceeded 10% for each of the last three years. Table 2 presents a possible representation of the financials relevant to the Indian litigation that makes various assumptions including Indian sales represented $1 billion per year. Cost of goods sold borne by the Japanese manufacturer are assumed to be 42% of sales with overall operating expenses assumed to be 48% of sales, implying a consolidated operating margin of only 10%.

Table 2: An Illustration of the Olympus Medical Systems India Transfer Pricing

Table 2 assumes that the Indian distribution affiliate has been afforded with a 45% gross margin and typically incurs operating expenses equal to 40% of sales. The Japanese affiliate incurs production costs = 42% of sales plus operating expenses = 8% of sales. Overall operating expenses include any R&D costs borne by the parent corporation, selling costs borne by the Indian affiliate, servicing costs borne the Indian affiliate, and marketing costs. Let’s further assume that selling costs represent 25% of sales, and servicing costs represent 10% of sales.

The key remaining issue is how to deal with marketing costs. Let’s assume that the Indian affiliate also bears these expenses which in an average year represent 5% of sales. Marketing costs, however, often represent a much higher percentage of sales during the early years of a product launch. The low consolidated profit margins for Olympus Medical Systems for fiscal years ended March 31, 2012 and March 31, 2013 might be due to temporary increases in the marketing expense to sales ratio. If the Indian affiliate bore these expenses, then it would incur temporary losses with a 45% gross margin.

How might such situations be resolved? One could imagine a transfer pricing policy where the distribution affiliate receives a 40% gross margin to cover its selling and servicing costs and receives separate reimbursement for any ongoing contract marketing expenses. This approach is consistent with the Indian tax authority’s “bright line” approach. Another arm’s length approach would allow the distribution affiliate to receive a premium gross margin that could cover the marketing expenses over the long term, which is effectively a market share approach. A residual profit split approach is a third alternative where the marketing expenses incurred by the distribution affiliate has created a marketing intangible.

Given the modest worldwide profitability of Olympus Medical Systems, it is unclear how the overall allocation of profits would compare across these alternative transfer pricing structures. Given the lack of information provided by the taxpayer to the tax authority, how each party would present the facts and financials in any litigation is impossible to discern. The representatives of Olympus Medical Systems would be wise to carefully prepare a coherent story with respect to the transaction pairs involved in its intercompany structure as it also prepares the financial information requested by the Indian tax authorities.

Concluding Comments

Transfer pricing litigations often turn on applications of TNMM to evaluate the routine return of one of the two affiliates involved in the intercompany transaction. In two of the litigations we discussed the taxpayer and the tax authority disagreed which entity – the manufacturer versus the distributor – should be the tested party for the application of TNMM.

In both litigations, a case can be made that the related party distributor should be the tested party if all intangible assets were owned by the manufacturer affiliate. Even if there was a consensus on which entity represented the tested party, the actual application of TNMM must be performed with care to insure an appropriate evaluation of the tested party’s routine return is captured.

The Olympus Medical Systems litigation is ongoing as the tax authority awaits the key financial data for purposes of the transfer pricing analysis. The Indian tax authority appears to be asserting that the Indian distribution affiliate has incurred the cost and risk of historical upfront marketing. As such, the Indian affiliate may own marketing intangibles while the Japanese affiliate owns the product intangibles. As such, an appropriate analysis would require a review of consolidated financials as well as how the various expenses and revenues for the consolidated operations were allocated.

[1] “Distributor Margins: Is Pillar One’s Amount B Helpful or Even Needed?” Tax Management Transfer Pricing, December 3, 2021.