By Dr. J. Harold McClure, New York City
France’s Supreme Administrative Court, on November 23, 2020, overturned a taxpayer win before the Paris Administrative Court in a transfer pricing case involving the French distribution affiliate of Salvatore Ferragamo SPA, a luxury shoe manufacturer.
The case seems to involve, once again, a distribution affiliate that had persistent operating losses despite purporting to use arm’s length margins. This pattern was discussed in detail by Dr. Ednaldo Silva in his January 6 MNE Tax article, “The origins of transfer pricing’s comparable profits method.”
Ferragamo France’s transfer pricing dispute
In the instant case, Ferragamo France received a 25 percent gross margin for its services as a distributor in France. However, the French tax authorities determined that 19 third-party distributors’ operating expense to sales ratios were lower than the ratio applied for Ferragamo France.
Even though the French distribution affiliate incurred losses from 1996-2009, the Paris Administrative Court ruled against the tax authority on the grounds that the Italian parent did not charge the French distribution affiliate any brand royalties and that the French affiliate was profitable from 2010-2015.
France’s Supreme Administrative Court reversed, ruling in favor of the tax authority. According to the Supreme Administrative Court, the French distribution affiliate incurred higher operating expenses than the third-party distributors which were intended to increase the value of the Italian brand in this luxury goods sector.
Losses and inbound distribution
Dr. Ednaldo Silva, in his MNE Tax article, notes several US inbound distribution cases over 30 years ago where the US distribution affiliate incurred persistent operating losses despite having “supposed arm’s length gross margins.”
These losses were attributed to high operating expenses relative to sales from “non-arm’s length management fees, outbound royalties, and misallocated intangible creating expenses, such as research and development, software development, and marketing and sales,” Dr. Silva argues.
Salvatore Ferragamo’s recent litigation appears to raise these same issues.
The following table presents the key elements of Salvatore Ferragamo’s 2019 income statement both in absolute terms and as percentages of sales.
Cost of goods represented 35.1 percent of sales, and total operating expenses represented 54 percent of sales. Salvatore Ferragamo’s operating profits represented 10.9 percent of sales in 2019.
Salvatore Ferragamo’s 2019 Income Statement
|
Millions |
% of sales |
|
|
Sales |
€1377.26 |
|
|
Cost of goods |
€483.77 |
35.1% |
|
Selling costs |
€482.32 |
35.0% |
|
Design/logistic costs |
€50.29 |
3.7% |
|
Marketing costs |
€79.68 |
5.8% |
|
Other operating expenses |
€131.50 |
9.5% |
|
Operating profits |
€149.70 |
10.9% |
While the consolidated income statement for 2019 may not be a complete reflection of the French affiliate’s income statement from the period of the litigation, 1996-2015, we should note that selling costs alone that year were 35 percent of sales.
The two court decisions suggested that the parent corporation bore all intangible development and other costs without charging the French affiliate for these expenses.
We should note, however, that selling costs alone could exceed a 25 percent gross margin.
If the selling costs relative to sales for a distribution affiliate exceed its gross margin, this affiliate will incur operating losses.
The taxpayer’s defense appears to be that its gross margin was similar to the gross margin for third-party distributors in its sector.
This defense fails, however, if the functions of the distribution affiliate exceed the functions of the alleged third-party distributors.
The comparable profits method, and its OECD equivalent transactional net margin method, are a means for adjusting for functional differences that should be considered in any reasonable application of the resale price method.
Dr. Harold McClure
Dr. J. Harold McClure is a New York City-based independent economist with 26 years of transfer pricing and valuation experience. He began his transfer pricing career at the Internal Revenue Service and has worked for some of the Big Four accounting firms as well as a litigation support entity. His most recent employer was Thomson Tax and Accounting.
Dr. McClure has assisted multinational firms with both U.S. and foreign documentation requirements, IRS audit defense work, and preparing the economic analyzes for bilateral and unilateral Advanced Pricing Agreements.
Dr. McClure has written several articles on various aspects of transfer pricing including the determination of arm’s length interest rates, arm’s length royalty rate, and the transfer pricing economics for mining.
Dr. McClure taught economics at the graduate and undergraduate level before his transfer pricing and valuation career. He had published several academic and transfer pricing papers.
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