The Future of Shipping Transfer Pricing—Part 2—Benchmarking

In a previous article, we reviewed the nature of the shipping sector noting certain proposals with respect to the future of its international taxation. We briefly explored a few transfer pricing structures. This article addresses the benchmarking for the profitability of affiliates under these structures.

The Logistics Controversy in India

Table 1 presents an illustration similar to the example presented by Bilaney. Consider a two way flow where tea is shipped from India to U.K. customers and beer is shipped from the U.K. to Indian customers. On the first leg of this round trip shipping tea, the Indian affiliate is the origin company and the U.K. affiliate is the destination affiliate. On the other leg of the trip shipping beer, the U.K. affiliate is the origin company and the Indian affiliate is that destination affiliate. For the round trip, the logistics multinational collects $105 million in gross revenues and must pay third-party shippers and local logistics companies $80 million. As such, its net revenues are $25 million. The Indian affiliates incurs $10 million in value-added expenses (VAE) and the U.K. affiliate incurs $10 million in value-added expenses. Consolidated profits are $5 million. These profits represent a 25% markup over VAE, but if expressed in relationship to total costs (TC)—the sum of third-party costs and VAE—the markup over total costs is only 5%. If net revenues and VAE are both split evenly, the profits would be split evenly with each affiliate receiving $2.5 million, which represents a 25% markup over VAE for both affiliates.

Table 1 also presents a transfer pricing policy where the U.K. affiliate receives 70% of the profits as it receives 54% of the net revenues and incurs only half of the value-added expenses. Note, a net revenue split is not necessarily the same thing as a profit split. The 54/46 net revenue split might be consistent with arm’s-length pricing if the routine return for logistics represented a 15% markup over VAE and if the U.K. affiliate owns all of the valuable intangible assets.

Table 1: Illustration of a Net Revenue Split for a Logistics Multinational

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:

“the 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.” (“Benchmarking the Profitability of a Distribution Hub: A Critique”, Journal of International Taxation, September 2016.)

The tax authority in Net Freight (India) Pvt. Ltd argued that its 2.56% operating margin was too low on the basis of a TNMM analysis using the return to sales for seven companies. These operating margins ranged from 3.61% to 13.68% with a median of 7.17%. While a 7.17% operating margin is equivalent with a 7.72% markup over total costs, the affiliate’s 2.56% operating margin is equivalent to a return to total costs of only 2.63%. We should note, however, that if the affiliate’s pass through costs represented a higher percentage of total costs than the tax authority’s alleged comparables, then the comparison in terms of returns to value added expenses would be more favorable in terms of justifying the intercompany pricing policy.

Table 2 illustrates the potential used of TNMM using financials drawn from the litigations involving Agility Logistics Private Limited and 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 (PTC). We present the financials as common size income statements as the two Indian court decisions often presented only financial ratios and not the actual financials for either the affiliate or the third-party logistics companies.

Table 2: Common Size Financials for 6 Third-Party Logistics Companies and 2 Indian Affiliates

The Indian tax authority argued that the 2.04% return to total costs was below the return to total costs for third-party logistics companies. The taxpayer, however, argued that comparisons should be made on the basis of the return to value added expenses. The taxpayer presented six alleged comparables where the average return to value added expenses was less than 20%. Two of the six companies reported operating losses, while three had markups higher than that of the affiliate. The reported markup for Hindustan Cargo Ltd, which is a privately held logistics company, was 18.6%.

The tax authority was not convinced by this application of TNMM arguing that some of the companies used by the taxpayer were not appropriate comparables. We have reported the relative financials for Blue Dart and Patel on Board, which often appear as potential comparables in these Indian logistic litigations. Patel on Board’s pass through costs represented 86.4% of its total costs similar to the 90% ratio for the affiliate. Its 3.7 markup over total costs similarly understates its return to value added expenses. When compared in terms of returns to value-added expenses, Patel on Board suggests that the taxpayer’s markup is still low. For Blue Dart pass-through costs represented 63.7% of its total costs. Note its return to total costs was significantly higher than that of the affiliate in part because more of these costs represent value expenses and in part because it return to value added was more than twice that of the tested party. We should caution, however, that our discussion is not an endorsement of using these two companies as comparables.

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%. Its TNMM analysis relied on a set of alleged comparables that did not include Om Logistics and Sheryas Relay Systems Ltd. The tax authority included these companies as well as companies such as All Cargo and Arshiva. Table 2 provides an illustration of the financials for the affiliate as well as these four alleged comparables. The return to total costs for the four alleged comparables was universally higher than 7.7% and the percent of total costs attributable to pass through costs was from 84.6% to 94.2%. As such the return to value added expenses ranged from 63.6% to 148.5%.

These very high returns to value added expenses may be attributable to the third-party logistic companies owning valuable intangible assets. One could therefore question the selection of these companies as alleged comparables for a TNMM analysis. As the next section notes, similar concerns exist in how U.S. transfer pricing practitioners benchmark the appropriate markup for logistics activities.

An Integrated Shipping Multinational

Integrated shipping multinationals not only own the ships that carry goods from one port to another but also has affiliates in each port that handle loading and unloading functions. For example, Yang Ming has affiliates in Australia, China, the U.S., and several other locations that serve as ports of origination or destination ports. Consider for example a ship that delivers mining goods from Australia to China and then delivers iPhones from China to the U.S.

The affiliates in each of these ports are often compensated by the parent of the shipping multinational using a policy that sets the compensation at operating expenses plus a reasonable markup. Table 3 assumes a U.S. affiliate that incurs $40 million per year and has been afforded a 15% markup such that its intercompany revenue = $46 million per year and its profits = $6 million per year. If the parent is not located in a tax haven, this multinational might face double taxation as the parent’s tax authority might argue for a 5% markup while the IRS might argue for a 25% markup.

Table 3: U.S. Affiliate of a Shipping Multinational

The notion that the markup over operating expenses should be only 5% is promoted by some transfer pricing practitioners who utilize the return to total costs for publicly traded logistic companies even though much of these total costs represent pass through costs. When these practitioners used North American logistic companies to select their alleged comparables, the set of potential comparables often exceed 30 companies. Table 4 presents the average annual income statements using the last three years for only five companies as an illustration of the difference between reporting markups as a return to value added expenses versus a return to total costs. Single digit markups for the return to total costs are prevalent but also misleading as the ratio of pass through costs to total costs is often 75% or more. C.H. Robinson is interesting as its return to total costs is less than 6% but its return to value added expenses is almost 50% as the PTC/TC ratio is almost 90%. The return to value added expenses for Expeditors International exceeds 50% even though its markup over total costs is below 13%. The high returns to value added expenses for these two logistics companies reflects the presence of valuable intangible assets.

Table 4: Financials for Five Publicly Traded North American Logistics Companies

Old Dominion Freight has a high markup over total costs in large part because it has few pass through costs. While its return to total costs is almost 24%, its return to value added expenses is less than 29%. Knight Swift Transportation similarly has a modest PTC/TC ratio. Its return to total costs is 10.9%, while its return to value added expenses is 17.8%. Radiant Logistics has a very low return to total costs but its return to value-added expenses is 9.5%.

When properly based on the return to value added expenses, any claim that the markup should be below 10% would not be supported by evidence drawn from publicly traded North American logistic companies. Whether this markup should be closer to 15% or somewhat higher depends on which of the many potential candidate companies are deemed to be comparable to the logistics affiliate.

Centralized Leasing

Ships and containers are mobile tangible assets much in the way that airlines and oil drilling rigs are mobile tangible assets. Oil drilling rig multinationals often use a tax play where a tax haven affiliate formally owns expensive drilling rigs and leases them to operating affiliates that operate near the shores of Norway and Scotland (North Sea) or affiliates in Brazil, the U.S., or other high tax nations.

Third-party leasing is a common practice in the airline sector. In a recent paper, I note a possible tax play involving Hong Kong and Singapore leasing affiliates (“Aircraft Intercompany Leasing: Domestic Use Tax and International Tax Considerations,” Journal of Multistate Taxation and Incentives, March 2020):

“Even if a multinational airline purchased a plane, it may structure the financing such that a tax haven affiliate formally owns the plane with the operating affiliate allowed to use the plane through an intercompany lease agreement … Singapore updated its Aircraft Leasing Scheme on February 20, 2017, to allow for a concessionary tax rate of 8% on income derived from leasing aircraft. On March 10, 2017, the Hong Kong Inland Revenue Department (IRD) allowed a concessionary tax rate of 8.25% on such income. Both concessionary tax rates are approximately half the statutory rates for these two jurisdictions and are substantially lower than the corporate tax rates of other Asian jurisdictions, such as China, Japan, South Korea, and Taiwan.”

Third-party leasing is also common in the containment and shipping sector. Third-party lease payments must cover the economic costs to the owner of the leased equipment, including:

• any ongoing operating expenses borne by the owner,
• the expected economic depreciation of the equipment during the leased period, and
• the cost of capital for the owner of the equipment.

Leasing is a contractual process by which the ownership rights and the right of use of the asset are held by different parties. The lessee acquires the right to use the asset while the lessor retains the formal ownership of the property. While there may be many different ways these contractual rights can be stipulated, financial economists distinguish between financial and operating leases. A financial lease is equivalent to a long-term loan where the formal owner simply receives payments over the economic useful life of the asset. In effect, the operating entity is the economic owner of the leased asset. To the degree that this entity utilizes a substantial amount of its assets via leasing, it is effectively a highly levered operation. In an operating lease, the operating entity bears commercial risk, but the owner bears certain risks as well.

Merton Miller and Charles Upton wrote the seminal article on market pricing for leases. The Miller-Upton approach specifies a Capital Asset Pricing Model (CAPM) approach to estimating the appropriate discount rate for leasing companies. Financial economists typically estimate the cost of capital using some version of the general arbitrage pricing theory (APT). APT distinguishes between diversifiable or unsystematic risk and non-diversifiable or systematic risk. Systematic risk is that part of an asset’s risk that is attributable to market factors that affect all firms and that cannot be eliminated through diversification. Unsystematic risk is that part of an asset’s risk arising from random causes that can be eliminated through diversification. The fundamental premise of APT is that the market rewards the bearing of only systematic risk and not the bearing of risk that can be eliminated through diversification. CAPM is a variation of APT. CAPM holds that the expected return to any asset (R_j) is given by:

R_j = R_f + β_j(R_m – R_f),

where R_f = the risk-free rate, R_m = the expected return on the market portfolio of assets, and β_j = the beta coefficient for this particular asset. The beta coefficient measures the tendency of the asset’s return to move with unexpected changes in the return to the market portfolio.

The role of risks is noted in the Base Erosion and Profit Shifting (BEPS) Discussion Draft on Action 9 (paragraph 63):

“Risks should be analyzed with specificity, and it is not the case that risks and opportunities associated with the exploitation of an asset, for example, derive from asset ownership alone. Ownership brings specific investment risk that the value of the asset can increase or may be impaired, and there exists risk that the asset could be damaged, destroyed or lost (and such consequences can be insured against). However, the risk associated with the commercial opportunities potentially generated through the asset is not exploited by mere ownership.”

Miller and Upton suggest an application of CAPM for determining the premium for bearing ownership risk. Both CAPM and TNMM properly applied yield similar conclusions as to the appropriate cost of capital for a leasing affiliate, where a reasonable estimate would be the sum of the risk-free rate and a 2% premium for bearing the risk of ownership.

Transfer pricing practitioners often approximate these results using an application of the TNMM that compares the profitability of the leasing affiliate to the profitability of pure play leasing companies. Table 5 presents an illustration based on the following assumptions:

• the value of the leased ship = $120 million per year;
• the rate of economic depreciation = 4% of the value of the ship or $48 million per year;
• the leasing affiliate does not bear any of the ongoing operating expenses; and
• the lease to value ratio = 10%, so intercompany lease payments = $12 million per year.

Under this intercompany policy, profits for the leasing affiliate is $60 million or 6% of the value of the leased ships.

Table 5: Illustration of Intercompany Leasing of Ships

Table 5 also presents the approximate financials for Global Ship Lease, which is lessor of container ships. The value of leased assets = $1.2 billion and the intercompany lease revenue = $180 million per year for a lease to value ratio = 15%. Global Ship Lease incurs operating expenses = $60 million or 5% of the value of leased revenue. If we define net revenues (NR) as lease revenues minus operating expenses, Global Ship Lease’s net revenue to value ratio is 10% consistent with the net revenue to lease ratio for our ship leasing affiliate. Table 6 also reasonably assumes that economic depreciation represents 4% of the value of leased assets. The ratio of profits to the value of leased assets for this publicly traded leasing company would also be 6%.

Triton Container International Limited and TAL International Group merged in 2016 to form Triton International. Triton International leasing approximately $9 billion in equipment and has a lease value ratio near 15% of sales. GATX has traditionally been the leading global railcar lessor with leased assets in North America, Europe, and Asia. GATX also runs a shipping business for customers in the Great Lakes. Any analysis using GATX as a comparable leasing company would have to segment the financials between the leasing operations versus the shipping operations.

Multinationals in the airline and oil drilling rig sectors have their operations in high tax jurisdictions but have centralized leasing affiliates in low tax jurisdictions so as to capture the appropriate amount of leasing income an affiliate with low tax rates. Our leasing model notes that under arm’s-length pricing, the operating affiliate is entitled to a portion of expected operating profits but would also be exposed to both the upside potential of a strong shipping market and the downside risk from a weak shipping market. This allocation of risk and the premium for bearing systematic risk differs from structures where tax havens are deemed to be both the owner of the ships but also responsible for the operations of shipping.

We have addressed certain benchmarking issues that may play a role in the evaluation of the appropriate profitability for affiliates of shipping and logistic multinationals. The litigations in India stress the need to distinguish between markups over value added expenses as opposed to measuring markups over total costs. When properly measured, observed markups for publicly traded logistic companies vary widely suggesting more research is needed as to what represents reasonable comparables for TNMM analyzes. If the efforts under Pillar Two lead to situations where shipping multinationals utilized leasing structures, the above analysis for the determination of arm’s-length leasing rates would have the operating affiliate bear the commercial risk of operating the ship while the formal owner receives a modest return to the value of its assets.

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.