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Use and Abuse of TNMM in Indian Litigations Involving Provision of Certain Services—Part 2

Nov. 10, 2020, 8:01 AM

The transactional net margin method (TNMM) is both often used and heavily criticized. There are numerous issues that must be addressed before one decides that TNMM provides any insights with respect to the transfer pricing issue being addressed.

Consider as an illustration a multinational that manufactures mobile phones in China for distribution to Indian customers. Should the transfer price be evaluated in terms of the markup that the Chinese manufacturing affiliate receive under a contract manufacturer approach? If the multinational generates significant operating profits on this line of business, this version of TNMM would result in substantial profits received by the Indian distribution affiliate. TNMM applied to the Indian affiliate, however, would imply a much higher price leaving the Indian affiliate with only modest profits are the routine return for distribution.

The key issue in such a situation is what are the valuable intangible assets? While the product and process intangibles are likely owned by affiliates outside of India, the Indian tax authorities could reasonably assert that the Indian affiliate owns the marketing intangibles. As such, another method such as the Residual Profit Split approach would be more appropriate than a naïve application of TNMM.

Even if TNMM applied to a particular affiliate is an appropriate method, there are also numerous issues with respect to the applications of TNMM. The Indian courts have seen numerous litigations where TNMM has been applied to the Indian affiliate by both the tax authority and the taxpayer. In an earlier article, I praised the use of “well articulated TNMM approaches” in certain Indian litigations (“Indian Transfer Pricing Cases: Good News for Well-Articulated TNMM Approaches”, Journal of International Taxation, March 2013). Section I discusses the application of TNMM in two litigations involving logistics multinationals. Section II reviews the litigation involving Cheil Worldwide, which is an advertising agency multinational. Section III explores the detail issues involved in a litigation involving the provision of engineering services. Section IV offers a few concluding comments.

Logistics Litigations in India

In my recent discussion of transfer pricing for shipping multinationals, I noted various Indian litigations involving logistics multinationals (The Future of Shipping Transfer Pricing—Part 2—Benchmarking”, Bloomberg BNA Transfer Pricing Report, Oct. 27, 2020):

“We review the litigations between multinationals and the Indian tax authority, which often turn on applications of the transactional net margin method (TNMM) with the Indian affiliate as the tested party. While multinationals have often argued for certain applications of the comparable uncontrolled price approach or profit split approaches to justify the net revenue splits, the Indian tax authorities have questioned the reliability of these approaches preferring to rely on what are often tortured abuses of TNMM.”

Whether markups should be viewed in terms of markups over total costs (TC) or markups over value added expenses has been a key controversy. I noted this issue in an earlier publication (“Benchmarking the Profitability of a Distribution Hub: A Critique”, Journal of International Taxation, September 2016):

“[T]he ratio of operating profits to total costs (z) overstates the ratio of operating profits to value-added costs (m) depending on the proportion of pass-through costs relative to total costs (p), while the ratio of operating profits to operating expenses (w) understates the return to value-added costs if cost of goods sold includes certain value-added expenses (s > 0): m = z/(1 – p) and m = w[(1 – s - p)/(1 – p)]. Transfer pricing practitioners who assert that the appropriate profit-level indicator for service providers is the return to total costs are implicitly assuming that their comparable companies have no pass-through costs (p = 0). This assumption, however, is often not valid.”

As an example, imagine an Indian logistic affiliate that incurs $75 million in pass-through costs and $25 million in value added expenses (p = 0.75). If its intercompany revenue is $107.5 million, then the return to total costs (z) is only 7.5% but the return to value added expenses (m) is 30%. Also imagine that the Indian tax authority suggested an alleged comparable company where the return to total costs is 10% but its pass-through costs represent 60% of total costs. In this case, the return to value added expenses is only 25%. Let’s also imagine that the taxpayer suggested an alleged comparable company where the return to total costs is only 4% but its pass-through costs represent 90% of total costs. In this case, the return to value added expenses is 40%.

Table 1: Common Size Income Statements for Two Indian Logistic Affiliates

Table 1 presents an illustration of the application of TNMM to the financials for Agility Logistics Private Limited and for DHL Danzas Lemuir Pvt. Ltd. Agility’s affiliate had a return to total costs of 2.04%, but its return to value added expenses was 18.69% since over 89% of its total costs represented pass-through costs. While the Indian tax authority focused on the low return to total costs, the taxpayer argued that the 18.69% return to value added was reasonable. DHL Danzas Lemuir Pvt. Ltd. and the Indian tax authorities both used TNMM with the return to value added expenses as the profit level indicator but disagreed over what companies should be used as comparables. The taxpayer’s return to total costs was only 7.7% but pass-through costs represented over 78.8% of total costs so the return to value added expenses exceeded 36.3%.

Third party logistics companies in North American tend to have significant pass-through costs. While some transfer pricing practitioners assert that these companies have single digit markups, these markups are calculated on a return to total costs basis. When properly calculated as a return to value added expenses, the markups display wide variability. As such, the selection of which publicly traded companies are comparable to the logistics affiliate is a key element of a TNMM analysis even when the markups are properly presented.

Cheil’s Indian Advertising Affiliate

DCIT v. Cheil Communications India Pvt. Ltd. involved the appropriate markup over costs for an Indian affiliate providing advertising services. Cheil Communications India Pvt. Ltd. is a subsidiary of Cheil Worldwide, a Korean-based advertising agency. Agencies facilitate the placement of ads with print and electronic media and in doing so make payments to third parties on behalf of their customers. Thus, a portion of their costs represents pass-through expenses that are recovered from their customers in the form of gross billings. The accounting for companies such as Cheil Communications can be performed in terms of either (1) gross billing with costs that include not only value-added expenses but also pass-through costs, or (2) net billings with costs that include only value-added expenses.

An informative discussion of this litigation noted (“Delhi ITAT: Pass through costs should not be considered while computing net cost plus margin”—transferpricingnews.blogspot.com/2010/12/delhi-itat-pass-through-costs-should.html):

“The issue in this case is regarding Profit Level Indicator (‘PLI’), i.e. while determining denominator for the purpose of computation of net cost plus mark-up for transfer pricing analysis, whether Gross Cost needs to be considered or Cost net of ‘pass through costs’ needs to be considered (‘Operating Profit/ Total Cost’ vs. ‘Operating Profit/ Value Added Expenditure’). The taxpayer contented that it should be ‘Operating Profit/ Value Added Expenditure’ and the tax authorities was of the view that it should be ‘Operating Profit/ Total Cost’.”

“[Total Cost = Value Added Expenditure + Pass Through Cost]

[Total Receipts = Agency Commission + Pass Through Cost]

[Operating Profit = Total Receipts – Total Cost = Agency Commission – Value Added Expenditure]”

“In light of the OECD guidelines and facts of the case, Delhi ITAT observed that a mark-up is to be applied to the cost incurred by the taxpayer in performing agency function and not to the cost of rendering advertising space on behalf of its associated enterprises i.e. ‘Operating Profit/ Value Added Expenditure’.”

Table 2 presents the 2017-2019 financials for Cheil Worldwide. Sales represent gross billings including third party payments or pass-through costs (PC). Pass through costs represent over 72% of total costs (TC). Over this three-year period, operating profits (OP) represented a 20% markup over value added expenses (VAE) but only a 5.58% return to total costs.

Table 2: Cheil Worldwide Income Statement—2017 to 2019

Table 3 presents the key financials in this litigation. Cheil India’s pass-through costs represented over 92% of its total costs. While its return to total costs was only 3.93%, the markup over value added expenses exceeded 50%.

The Indian tax authority selected two advertising agencies as potential comparables for a TNMM analysis: Contract Advertising (India) Pvt. Ltd and Portland India Outdoor Advertising Pvt. Ltd. Portland India’s pass-through costs were almost 92% of its total costs. Its return to total costs was only 3.72% but its return to value added expenses was 44.76%. By either metric, the Cheil India had a slightly higher level of profitability.

Table 3: Key Financial in the Cheil Litigation

The return to total costs for contract advertising was over 10%. Based on the average return to total costs for its two alleged comparables companies, the Indian tax authority argued that Cheil India should have had a markup over total cost just over 7%. Note, however, that pass-through costs represented only 60% of total costs for Contract Advertising. When properly evaluated, the return to value added expenses for Contract Advertising was only 25.8%. As such, the profitability of Cheil India was above the relative profitability of both companies when viewed in terms of markups over value added expenses.

Provision of Engineering Services

Basell Polyolefins India Private Limited v. Asst. CIT involved the provision of project, engineering and polyolefins product related services by an Indian affiliate on behalf of its parent. Both the tax authority and the taxpayer used TNMM with this affiliate as the tested party. Both also used the return to total costs as the metric for comparison but they disagreed not only on how to calculate this ratio for the tested party and alleged comparables but also on what companies should be used as comparables.

The taxpayer presented a TNMM using 14 alleged comparables to defend what it calculated as its return to total costs equal to 19.4%. The mean return to total costs for its 14 alleged comparables was 10.56%. The tax authority rejected 13 of these 14 companies agreeing that Genins India TPA Ltd. should be included as comparables. The tax authority suggested six other companies and calculated the return to total costs for these seven alleged comparables. The average markup for these companies was 16.63%.

The tax authority also noted that the financials presented by the taxpayer including reimbursements for infrastructure costs. When these reimbursement were removed from the affiliate’s financials, the correct markup over operating costs was only 10%. The tax authority asserted that the intercompany revenue be raised such that the markup over operating costs should be mean value of the markups reported for its seven alleged comparables.

The taxpayer and the tax authority continued to disagree on what represented appropriate comparables. Of the new companies suggested by the tax authority, only Spectrum Business Solutions Ltd. was retained in the final set agreed to by both parties. Four new companies were included in this final set. Table 4 presents the final six alleged comparables and the markups calculated using financials from the Prowess database. The mean markup based on these alleged six comparable companies was 15.8%.

The taxpayer objected to the use of financials drawn from the Prowess Database noting that these companies have audited financial statements. The taxpayer noted that when the audited financial data was used to calculate the return to operating costs, the reported markups were lower. Even if TNMM is an appropriate approach for this issue, the analyst for either the taxpayer or the tax authority must present reliable financial data for not only the entity selected as the tested party but also any companies deemed to be appropriate comparables.

Table 4: Markups for 6 Alleged Comparables

The use of insurance brokers as alleged comparables for an affiliate providing engineering services is certainly odd especially since publicly traded engineering service companies exist. Most of these companies hire third party subcontractors, which are a form of pass-through costs (PC). Their reported return to total costs (TC) therefore tends to overstate their return to value added expenses (VAE). One issue, however, is that several engineer services companies do not disclose their subcontract costs in their reported 10-K or 40-F filings. Tetra Tech and Stantec clearly identify their subcontractor costs in their income statement, while AECOM and Jacobs Engineering only briefly note their subcontracting costs in their notes to the financial statements. Table 5 uses the detailed financial data for these 4 companies to report gross revenues, net revenues (gross revenues minus subcontractor costs), and value-added expenses on an average annual basis for the 2017 to 2019 period.

Table 5: 2015 to 2017 Financials for 4 North American Engineering Services Companies

The return to total costs for these four companies ranges from just over 3% to just under 10%. Note, however, that pass-through costs represent more than 50% of total costs for AECOM and represent approximately 25% of total costs for the other three companies. On a return to value added expense basis, the evidence from these North American engineering services companies suggest a markup that ranges from 6.5%-12.6%.

Does this evidence provide support for the 10% markup in the intercompany transaction for this Indian engineering services affiliate? The Indian tax authority might assert that local engineering service providers in India would receive a higher markup that these North American engineering service companies. Such an assertion would require clear evidence based on reliable financial data. The use of insurance brokers as alleged comparables is questionable especially in light of the difficulty in defining operating profits to operating costs when using the Prowess database.

Concluding Comments

We have reviewed various Indian litigations where the issue was framed in terms of whether the Indian affiliate’s markup over operating costs was adequate. The Indian tax authority and the taxpayer agreed on some application of TNMM with the Indian affiliate as the tested party whether the issue was the provision of logistic services, advertising services, or engineering services.

Reliable presentations of the income statement for the tested party as well as for the alleged comparable companies is a crucial element for any TNMM analysis. For each of the types of services covered in our discussion, the distinction between value added expenses versus pass-through costs is another crucial element even if some practitioners and certain tax authorities resort to misleading return to total cost metrics.

Some practitioners and tax authorities reply on the financial information provided by commercial databases even in situations where the distinction between value added expenses versus pass-through costs requires information only found in the annual reports for the alleged comparables. The financial information provided by commercial databases should also be checked for consistency with what companies have reported in their annual reports.

A well articulated TNMM report should also provide third-party companies as alleged comparables that capture the nature of the tested party’s functions. Unfortunately practitioners and tax authorities may selected companies as alleged comparables that drives the results to an advocacy position rather than a proper reflection of the arm’s length standard.

TNMM has been used in trading company litigations by the tax authority and the Indian tax authority. A subsequent article will address the application of TNMM in these litigations.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Harold McClure has been involved in transfer pricing as an economist for 25 years.

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