Taiwan transfer pricing decree on bilateral APAs takes sensible approach

 By Dr. J. Harold McClure, New York City

Taiwan’s Minister of Finance issued a decree with respect to the negotiation and implementation of bilateral advance pricing agreements (BAPA) on June 24. BAPAs facilitate cooperation between tax authorities on both sides of an intercompany transaction, which hopefully avoids disputes and double taxation.

The decree illustrates how BAPAs may be implemented using an example of a Taiwanese distribution affiliate where the transfer pricing with its foreign parent is evaluated by an application of the transactional net margin method (TNMM) that sets the operating margin for the Taiwanese affiliate.

The appropriate profit margin for sales and marketing affiliates of life sector multinationals has traditionally been a controversial issue.

Let’s consider a hypothetical US-based biopharmaceutical multinational that relies on a Taiwanese affiliate to distribute its products over 2021–2025. Its forecast suggests sales will average $200 million per year while Taiwanese operating expenses are expected to average $40 million per year.

The multinational initially proposed that the intercompany policy be set such that the distribution affiliate receive a 25 percent gross margin, which would suggest that expected operating profits would be 5 percent of expected sales. While the Minister of Finance would prefer an 8 percent operating margin, the IRS might argue that the operating margin should be only 3 percent.

The negotiation and implementation of a BAPA poses two difficulties for the multinational and the tax authorities. One issue is how one establishes an acceptable range of operating margins. Most applications for BAPAs are accompanied by a taxpayer prepared TNMM that provides a set of comparable third party distributors. The example in the decree suggested such an analysis concluded that the range of operating margins should be between 3 percent and 8 percent.

The implementation of a BAPA has to address the prospect that actual sales and expenses may vary over the five-year period covered in the BAPA. Sales in some years may fall short of $100, while in other years they may exceed $100 million. During periods where sales were weak, the operating expense to sales ratio will rise so the operating margin declines as long as the gross margin remains at 25 percent. During periods where sales were strong, the operating expense to sales ratio will fall so the operating margin increases.

The decree sensibly notes that different tax authorities may take different approaches to addressing the implications of such variability. For example, the decree notes that the tax authorities should consider:

Whether the operating net profit margin of Company A falling within the aforementioned arm’s length range (3% to 8%) could be examined either by checking the margin for each year from 2021 to 2025, or by checking the simple average of the margin for those five years.

The IRS often asserts that gross margins should be adjusted annually if the variation in the operating expense to sales ratio causes the operating margin to fall outside what is seen as the acceptable range. Other tax authorities, however, would argue for a fixed gross margin as long as operating profits over the entire five year period represent a reasonable return to sales over the entire period.

The decree suggests a sensible and flexible approach by the Ministry of Finance. We have illustrated the decree’s example using a US-based biopharmaceutical multinational. If the Taiwanese affiliate has not created local marketing intangibles by incurring the upfront marketing expenses, the 3 percent to 8 percent operating margin range is likely reasonable.

Taiwan’s other major imports from the US include aircraft, oil, and semiconductors. The distribution affiliates for multinationals in these sectors tend to have lower functions than distribution affiliates in the biopharmaceutical sector. As such, a properly performed TNMM analysis would yield a lower range of appropriate operating margins.

Taiwan’s major exports to the US include computers, semiconductors, steel products, and telecommunication equipment. The Taiwanese multinationals in these sectors usually have US distribution affiliates that perform very modest functions. A properly performed TNMM analysis that focused on the US affiliate as the tested party would similarly yield a range of modest operating margins.