By Dr. Harold McClure, New York, NY
In their February 11 MNE Tax article, Erik Koponen and Madeleine Thörning analyze a successful challenge by the Swedish tax agency with respect to the transfer pricing between Puma SE and its Swedish distribution affiliate Puma Nordic AB.
The authors summarize the facts of the case as follows:
Swedish company Puma Nordic AB is a wholly-owned subsidiary to the German parent company PUMA SE of the PUMA Group, selling sports products under the brand “PUMA”. Puma Nordic AB acts as a distributing company with the main functions of marketing and selling PUMA branded products on its local market. Puma Nordic AB has two main intra-group flows, namely, the purchase of products from its affiliated sourcing company in Germany for resale on its local market and the use of the brand “PUMA” and related marketing material prepared by PUMA SE. Puma Nordic AB pays a cost-based fee for the products to the German sourcing company as well as a license fee based on external revenue to PUMA SE for the use of the PUMA brand and related marketing material. The applied transfer pricing model resulted in continuous losses in Sweden for Puma Nordic AB.
The Swedish tax agency successfully challenged Puma Nordic’s transfer pricing by comparing its operating margin to the operating margins of third party distributors, which is an application of the transactional net margin method (TNMM).
A similar transfer pricing structure was at issue in Columbia Sportswear USA Corp. v. Indiana Department of Revenue (taxpayer in the Columbia Sportswear domestic transfer pricing litigation prevailed using a similar approach.
However, in my view, while TNMM may prove a useful tool, simply looking at the operating margin for a distribution affiliate is insufficient for evaluating the transfer pricing issues involved in both cases.
However, in my view, while TNMM may prove a useful tool, simply looking at the operating margin for a distribution affiliate is insufficient for evaluating the transfer pricing issues involved in both cases.
While Columbia Sportswear prevailed, its transfer pricing defense was, at best, an incomplete analysis of its transfer pricing issues. There are several different possible interpretations of the Puma Nordic litigation.
The Columbia Sportswear transfer pricing decision
Columbia Sportswear designs, markets, and sells outdoor and active lifestyle apparel, footwear, accessories, and equipment, which are sourced from third-party contract manufacturers in China and Vietnam.
Columbia Sportswear USA Corp. v. Indiana Department of Revenue involved the transfer pricing payments for its domestic sales affiliate. This distributor purchases its products from a third-party vendor and makes two intercompany payments: commission payments to its Hong Kong procurement affiliate and intercompany payments to the parent corporation.
This litigation between the taxpayer and the Indiana Department of State Revenue could have involved a review of whether these two intercompany payments were arm’s length. The court noted:
Columbia Sportswear, in response, presented three Transfer Pricing Studies as evidence that its Intercompany Transactions were conducted at arm’ s-length rates . . . . Columbia Sportswear also maintains that its Indiana source income was fairly reflected because ‘[m]ost of the value inherent in the Products [was] derived from [CSC and Mountain Hardwear’s out-of-state] research, design, sourcing, manufacturing, and advertising activities[,]’ and not derived from Columbia Sportswear’s in-state distribution and sale activities as evidenced by, among other things, the Transfer Pricing Studies … In this case, the Department’s Trial Rule 30(B)(6) witness testified that the Department did ‘not take exception to’ the comparable profits method that was utilized in the Transfer Pricing Studies …. [T]he Department merely alleged that the Standard Sourcing Rules must have distorted Columbia Sportswear’s Indiana source income because of the ‘big variance’ between the percentages of gross profit for the consolidated group in comparison to Columbia Sportswear.
In other words, the taxpayer presented its position on whether intercompany prices were arm’s length, while the tax authority failed to challenge the taxpayer’s position.
In my discussion of the Columbia Sportswear litigation (“Rent-A-Center v. Indiana: ColorTyme as a CUT?”, Journal of Multistate Taxation and Incentives, May 2016), I noted the following: domestic sales were USD 1.2 billion; overall cost of goods sold = 54.5 percent of sales; and overall operating expenses = 36.5 percent of sales. In other words, overall gross profits = 45.5 percent of sales and overall operating profits = 9 percent of sales.
Much of the operating expenses incurred represented design and marketing expenses incurred by the parent corporation and certain expenses incurred by the Hong Kong procurement affiliate. My discussion assumed that the distributor’s operating expenses represented 20 percent of sales and noted:
Our model assumes that the transfer pricing policy affords the distributor a 23 percent gross margin, which leads its operating margin to be 3 percent. The gross margin of the distributor is lower than the overall gross margin for two reasons:
-
- The parent and its other affiliates bear a significant portion of the overall operating expenses.
- The parent and its other affiliates have captured two-thirds of overall operating profits.
The taxpayer’s justification for having the distributor’s profits being less than overall profits would likely be the theme of its report based on the Comparable Profits Method (CPM). The underlying assumption of these reports is usually that the parent and the other affiliates own all intangible assets associated with design, sourcing, and advertising. The CPM report then compares the profitability of the distribution affiliate with its functions and assets as compared to comparable third party distributors.
Many domestic transfer pricing issues center on whether the sale affiliate’s gross margin is sufficient to cover its operating expenses and provide for a reasonable return to its functions and assets.
Given the fact that the tax authority failed to challenge the taxpayer’s position, it was no surprise that the court ruled in favor of the taxpayer.
We should caution, however, that the claim that the distributor received appropriate compensation does not address directly either one of the two transfer pricing issues. It is entirely possible that the commission payments to the Hong Kong procurement affiliate were well above what would be considered arm’s length with the payments to the parent corporation being less than what should be considered arm’s length. I addressed transfer pricing for procurement affiliates in Transfer Pricing for Far East (China) Procurement Companies (Journal of International Taxation, July 2008).
The parent corporation deserves compensation for the ownership of design and marketing intangibles, which one would imagine would come in the form of an arm’s length royalty. State tax law in the US has seen many states deeming intercompany royalties as tainted income, which often triggers a denial of deductions on legal grounds.
The parent corporation deserves compensation for the ownership of design and marketing intangibles, which one would imagine would come in the form of an arm’s length royalty. State tax law in the US has seen many states deeming intercompany royalties as tainted income, which often triggers a denial of deductions on legal grounds.
As such, representatives of taxpayers call these types of intercompany payments compensation for management services. The popularity of CPM reports may be due to the fact that such a simple approach glosses over these issues.
Puma Nordic transfer pricing decision
Puma has a similar business structure. The German parent designs shoes, which are sourced from Asian contract manufacturers.
Puma Nordic sells the products to Swedish customers and incurs two intercompany transactions: commission payments to the procurement affiliate; and intercompany royalties to the German parent for the use of design and marketing intangibles.
Koponen and Thörning did not provide any financial data for the Swedish affiliate or the intercompany payments. They simply described the Swedish tax agency position as follows:
The Swedish tax agency stated that Puma Nordic AB should be appropriately compensated for its distribution activities performed in Sweden. Puma Nordic AB performs its main functions upon the strategies and directions of PUMA SE and is not involved in any decisions concerning product development, sourcing, design, nor overall marketing strategies. In analysing important the risks, the Swedish tax agency followed the six-step approach stated in the OECD transfer pricing guidelines where two key value drivers for the Puma Group were identified based on information from the group’s annual report and the transfer pricing documentation. These elements were the ability to maintain a strong brand globally and the ability to develop new and innovative products. To these key value drivers, the Swedish tax agency tied the most important risks for the Puma Group (i.e., market and product risk). The Swedish tax agency found the market and product risks were contractually assumed by Puma Nordic AB, while other affiliates that had all decision-making functions and, therefore, the capacity to assume the risks. The fact that Puma Nordic AB had local marketing know-how was, according to the Swedish tax agency, not sufficient to deem Puma Nordic AB capable of assuming significant market risks. The Swedish tax agency, therefore, argued that Puma Nordic AB should be considered a distributor that performs less strategic and complex functions in comparison to its counterparties. Thus, it should not carry the risk of being loss-making over several years. Based on the conclusion that Puma Nordic AB should be considered a distributor only capable of assuming limited risks, the Swedish tax agency considered the applied intra-group pricing to be not in accordance with the arm’s length principle. The Swedish tax agency applied the transactional net margin method and performed a comparability study according to which Puma Nordic AB’s results were adjusted to the lower quartile of the study.
The annual report for Puma presents its worldwide financials, which indicates that cost of goods sold is approximately 52 percent of sales, while over operating expenses represent 41 percent of sales. As such, worldwide operating profits represent 7 percent.
Three transfer pricing scenarios are possible, based on the premise that sales in Sweden = USD 100 million per year and the consolidated operating profits for operations related to Swedish sales = USD 7 million.
Each scenario is based on the following allocation of operating costs related to Swedish sales: the Swedish distributor pays third party suppliers USD 52 million, the Swedish distributor incurs USD 30 million in distribution expenses, the Swedish distributor also pays a third party advertising agency USD 5 million, the sourcing affiliate incurs USD 2 million in expenses, and the German parent incurs USD 4 million in design costs.
The allocation of the USD 7 million in operating profits depends on the two intercompany policies. The following table provides three alternative versions for these two transfer pricing policies.
Puma Nordic’s income statement under three alternative transfer pricing policies
|
Millions |
A |
B |
C |
|
Sales |
$100.0 |
$100.0 |
$100.0 |
|
Cost of product |
$52.0 |
$52.0 |
$52.0 |
|
I/C commission |
$5.2 |
$2.6 |
$2.6 |
|
Advertising costs |
$5.0 |
$5.0 |
$5.0 |
|
I/C royalty |
$8.0 |
$8.0 |
$6.0 |
|
Gross profits |
$29.8 |
$32.4 |
$34.4 |
|
Distribution costs |
$30.0 |
$30.0 |
$30.0 |
|
Distributor profits |
-$0.2 |
$2.4 |
$4.4 |
|
Sourcing profits |
$3.2 |
$0.6 |
$0.6 |
|
Parent profits |
$4.0 |
$4.0 |
$2.0 |
|
Markup |
-0.67% |
8.00% |
14.67% |
|
Commission |
10% |
5% |
5% |
|
Royalty rate |
8% |
8% |
6% |
Policy A represents our first interpretation of how Puma Nordic incurred operating losses. The intercompany (I/C) commission rate is 10 percent of the cost of goods sourced, which results in a payment equal to USD 5.2 million, leaving the procurement affiliate with USD 3.2 million in operating profits.
The intercompany royalty rate = 8 percent, which grants the German parent with USD 4 million in operating profits. We have defined gross profits for the distributor as sales minus cost of the product minus advertising costs minus these two intercompany payments. Under policy A, the gross margin is only 29.8 percent, while distribution costs represent 30 percent of sales.
Policy B lowers the commission rate for the procurement affiliate from 10 percent to a more reasonable 5 percent, which lowers this intercompany payment to USD 2.6 million. This change in the intercompany policies reducing the profits for the procurement affiliate to only USD 0.6 million while raising the gross margin to 32.4 percent.
The profits for the distribution affiliate rise from negative USD 0.2 million to $2.4 million. Operating profits relative to distribution costs represent an 8 percent markup, which could be seen as the implications of TNMM for a limited risk distributor.
The taxpayer’s position, however, was not that the Swedish affiliate had limited risk. As such, the Swedish tax agency could have argued for a higher operating margin for the distribution affiliate, especially if there is no compelling case that the intercompany royalty rate should be as high as 8 percent.
Policy C considers a reduction in the royalty rate from 8 percent to 6 percent, which raises the distribution affiliate’s profits from USD 2.4 million to USD 4.4 million. This higher operating margin is consistent with markup over distribution costs equal to 14.67 percent.
Our three scenarios in the above table assume that the financials for the Swedish market reflect the overall financials for Puma. We shall offer an alternative explanation for the continuing losses for Puma Nordic, which does not necessarily imply non-arm’s length transfer pricing.
Consider this Australian litigation in SNF (Australia) Pty Ltd v. Commissioner of Taxation ([2010] FCA 635 Middleton). The Australian distribution affiliate purchased chemical products from its French parent at the same price that third party distributors paid for these products.
Over the 1998 to 2004 period, the gross profits received by the distribution affiliate were just over 17 percent while operating expenses were more than 28 percent of sales. The Australian Tax Office used an application of TNMM to suggest that the arm’s length gross margin should be near 30 percent. The court rejected this use of TNMM on the grounds that the losses were the result of commercial issues, including competition, poor management, and underperforming staff.
The court reasoned that actual operating expenses may have exceeded normalized operating expenses (see Harold McClure, “The SNF Australia Decision and the Modified Resale Price Method”, BNA Transfer Pricing Report, March 22, 2012).
Some observers have suggested that the Australian affiliate was engaged in a market share strategy, incurring more functions than the third-party distributors. The implications of this alternative approach was not examined by either the ATO or the taxpayer.
Could the Puma Nordic issue have similar issues?
Temporary losses may occur for a distributor under arm’s length pricing. Of course, continuing losses are more difficult to justify.
Puma Nordic was not only responsible for distribution activities, but it also incurred the market expenses. The scenarios developed in the table above implicitly assumed a mature Swedish market where the distribution affiliate was simply paying for local advertising performed on behalf of the German parent.
An alternative scenario that could explain continuing losses would be to assert that the Swedish affiliate was engaged in a marketing share strategy.
The Swedish tax agency would rightfully expect compensation for the upfront marketing costs as well as risks borne by Puma Nordic. Note, however, TNMM is not an appropriate approach for analyzing these types of issues.
Concluding comments
TNMM is a useful tool, but it has its limits when applied to structures such as those present in the Columbia Sportswear and Puma Nordic litigations.
At best, this tool can inform us as to the routine return that a distribution affiliate should receive in normal times. The taxpayer successfully argued that the distribution affiliate’s three percent operating margin was consistent with its function and assets in the Columbia Sportswear litigation. This realization, however, does not directly address the appropriate commission rate or the appropriate compensation for the design and marketing intangibles owned by the parent corporation.
The TNMM approach used by the tax authority in the Puma Nordic litigation can be similarly critiqued.
The tax authority’s insistence that the distribution affiliate is limited risk may have led to a position that underestimated the routine return. While the TNMM attributes the losses for this distribution affiliate to excessive payments in terms of procurement services and/or royalties for the use of the intangible assets, we note the possibility that operating expenses were temporarily inflated or, alternatively, that the distribution affiliate was engaged in a market share strategy. In this case, these alternative explanations for the operating losses suggest that the TNMM, by itself, cannot tell the whole story.
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