Q: We are a U.S. parent selling finished goods to Australia customers via a limited function Australian distribution affiliate. Our current transfer pricing policy is to grant the Australian affiliate a gross profit margin equal to 10% as our typical operating expense to sales ratio is 8%. IRS Examination has informed us that they believe that the implied 2% operating margin is as high as they would accept given the limited functions of the Australian entity and the fact that its working capital is modest relative to sales. We understand that the Australian tax authorities have identified four publicly traded Australian distributors that they accept as potential comparables for a TNMM analysis. Which companies are these and would their financials support the position we have taken?
A: Two of the four companies – Dank and CPI Group Limited – have been acquired. The original set of four is down to two companies – Conventry Group Limited and Supply Network Limited. Over the 2007 to 2011 period, the operating margin for Conventry Group Limited averaged 9.8%, while the operating margin for Supply Network Limited averaged 7.4%. If the Australian tax authorities considered only these two distributors and used the operating margin as the profit level indicator without any consideration for comparability differences with respect to the related party distributor, it would expect a much higher operating margin that was deemed acceptable by the IRS. We should note, however, that both of these publicly traded Australian distributors have very high operating expenses relative to sales (29.7% for Conventry Group Limited and 37.7% for Supply Network Limited) as well as higher relative amounts of working capital than the tested party. A capital adjusted Berry ratio approach would likely yield a result closer to the expectations of the IRS although it is entirely possible that the results would still yield an expected gross margin above the 10% that is both the intercompany policy and what the IRS would accept.
Having only two publicly traded Australian comparables may not be sufficient to resolve this issue. If an analysis were to rely upon publicly traded companies, companies from other regions would have to be accepted. If the analysis were to rely on local comparables, then private companies would have to be accepted as potential comparables. The question remains whether the financial information for private companies would be sufficient to perform an analysis that took into consideration the fact that this Australian affiliate had limited functions and assets.
This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.