TP News

Denmark: ROCE Not a Good PLI for Contract Manufacturer

On 20 April 2018 a decision of the Danish Tax Court (Landskatteretten) in a transfer pricing case was published (reference SKM2018.173.LSR). In short, the case concerns the choice of transfer pricing method for a contract manufacturer and the application of benchmark results. Two interesting points raised in the case are discussed below.

1. Choice of method and PLI

First the facts: A Danish company had set up a contract manufacturer in a foreign country. According to the value chain analysis, the role of the contract manufacturer was mainly limited to standard production while the Danish company was responsible for inter alia production development, purchasing, daily production planning, quality control, marketing, sales and distribution. Furthermore, the Danish company developed and owned all production related intangibles. The Danish company would also have to approve new investments of the contract manufacturer.

The parties had concluded a long-term agreement and the Danish company was the only customer of the contract manufacturer. The Danish company was obliged to purchase all products manufactured.

To determine the arm’s length compensation for the contract manufacturer the parties had chosen the transactional net margin method, using Return on Capital Employeed (ROCE) as the profit level indicator (PLI).

The Danish tax administration disagreed with this choice of PLI because the actual return depends too much on the book value of the assets. Instead, the tax administration determined the arm’s length compensation under the transaction net margin method, using return on total cost (ROTC) as the PLI.

The Tax Court approved of this approach while referring to paragraph 7.40 of the OECD Transfer Pricing Guidelines which mentions contract manufacturing as an example where a cost based method can be applied.

2. Sanity check and minimum return for contract manufacturer

The taxpayer argued a very interesting point, namely that the compensation for the contract manufacturer could not be lower than the risk-free return for the country where the contract manufacturer was located, e.g. measured as the return on government bonds. This test should be applied as a sanity check when applying the benchmark for the mark-up on total costs. A sanity check on the outcome of applying the transactional net margin method, using a mark-up on total cost as the PLI was also consistent with the transfer pricing guidelines issued by the Danish tax administration.

The tax administration somewhat acknowledged the usefulness of applying such economic reference, subject to reviewing the return over the life time of the asset. However, the Tax Court firmly rejected the argument by stating that the OECD Transfer Pricing Guidelines conceptually do not support the pricing of goods or services based on benchmarks for the return on financial investments.

3. One more point

Finally, it is noteworthy that the Tax Court found that the risk of production closure was not assumed by the contract manufacturer despite the wording in the intercompany agreement to this end. The decision is therefore also an example of the (future) conduct of the parties prevailing over an intercompany agreement.