“In regard to the controlled transaction for transportation freight services we observed that it was selected the Return On Capital Employed as a profit level indicator; considering that, the economic activity is in fact, the rendering of services, explain the reason for not using a return on total costs.” (The Other Firm)
– Spasm. Lightly trembling. This is it. We are going down. What happened? It was so clear during kickoff and feedback meeting. I can’t recall anything that was said. Oh my God I should have been a dentist! Can I go to jail for this? Stop! Take a deep breath. Count to ten. You are so intense…as the analyzed party. Asset intensive, was that it? Action
Background
In practice, being questioned by the external auditor about the most adequate transfer pricing method might come as rutinary as having a haircut but questioning the Profit Level Indicator (PLI) not so much. In terms of tax compliance, Ley de Impuesto Sobre la Renta (LISR), requires a sound description of the criteria considered for the selection of the best transfer pricing method nonetheless, if enough evidence leads you to applying the Transactional Net Margin Method (TNMM), the law only mentions the possibility of choosing from a variety of ratios based on assets, sales, costs, expenses, or cash flows, basically, the world is your oyster.
As embarrassing as it may be, a common road leading to presenting the wrong PLI, is temptation. If the analyzed party´s result is not found in the interquartile range, the analyst might try another way, a more alluring one, as we would say in Mexico, you might find yourself choosing an alcahuete PLI. An alcahuete is someone who covers for us…when being mischievous.
Another approach when getting the PLI wrong, is choosing a legend PLI; traditionally thought to be right, passed from mouth to mouth, unquestioned, generally because a higher-level member of the firm once thought (and said) so. The thing with the legend PLI is that it might have started as correct considering the specific characteristics of the transaction, business model of the analyzed party, or economic situation for a given period, but is not meant to be repeated for every situation. A third approach may be the One size fits all PLI. That is, a routinely computed financial indicator for a certain industry, a certain type of economic activity, that comes straight from a textbook as part of Example 1.6. as shown in page 347. (This is intended to be a joke, please, do not look for page 347; relax, this article is only 2.5 pages long). It is comfortable to point somewhere or someone with the finger but, given the changing environment for almost every industry nowadays we must learn to manage by analyzing, giving prove and/or justifying, always based on principles, standards, or models proposed by greater minds.
Hopefully, for the practice’s own good, the most common mistake would be an untrailed or loose PLI. It was given thought, tested, and chosen correctly but, this process was not disclosed as part of the transfer pricing documentation. Specialization sometimes leads you to creating instinct and intuition. We must be reminded that the transfer pricing study must stand on its own feet and take the reader step by step until reaching conclusion. How do we get from point A to point B? In theory, through functional analysis.
Much ado about nothing…
If an analyst doesn’t want to be found lost in the forest once questions are raised, the functional analysis must not only present relevant information of the economic activity or analyzed party, but truly create information, interpret, and reach solid conclusions about the business model. Describing the company’s risk (any risk for that matter) as: little, minimum, moderate, high, yes, or no, does not really help to establish criteria for selecting comparables or making necessary adjustments. If possible, risks must be quantified.
To defend our PLI selection, which was not documented in the transfer pricing study, we had to rebuild our documentation process and recall what had been done. The team’s approach was based on anecdotal evidence, intuition, and general knowledge about, in this case, the Transportation Industry. Therefore, the job was to demonstrate what we knew (or thought we knew).
The OECD Transfer Pricing Guidelines set out five characteristics to consider when searching for comparables, which are basically replicated in article 179 of LISR. It is the second characteristic enlisted that we believe might not be getting enough attention: The functions performed by each of the parties to the transaction, taking into account assets used and risks assumed, including how those functions relate to the wider generation of value by the multinational enterprise (MNE) group to which the parties belong, the circumstances surrounding the transaction, and industry practices.
Especial consideration could be spent to the last two words. What is typical in the industry? How to quantify it to build a benchmark and evaluate where the analyzed party is standing.
Risks Assumed
When studying about identification and recognition of risks assumed to be presented in functional analysis, the Transfer Pricing Guidelines pay special attention on risks associated with the contractual terms of controlled transactions. Considering we are in TNMM habitat, we may want to turn to more general, less transaction specific, kinds of risk, for example: operating and/or financial risk, usually explained as leverage.
It has been studied that there is a strong relation between profitability and operating leverage. When sales are growing, fixed costs do not increase at the same rate as sales such that higher operating leverage leads to higher profitability. On the other hand, in a contraction, these fixed costs have the opposite effect as mentioned by Brown (2017). This higher sensitivity to changes in sales may be classified as risk.
Finding the most adequate proxy to assess operating leverage might be a challenge. An ideal situation would be to have access to information about variable and fixed costs, but it is rarely disclosed by companies and analysts will want to be consistent and able to replicate for other industries.
Furthermore, the Toolkit on Comparability issued by the OCED state that diagnostic ratios can also be used to improve the reliability of a potential set of comparables and that the use of this ratios depend on various factors related to the nature of the business (2017).
O’Briend and Vanderheiden explain that high ratio of fixed assets causes fixed costs and present that total assets to expected sales is a good proxy for capital intensiveness (1987).
Chen et al . support that Selling, General and Administrative (SG&A) to Sales is a good proxy for measuring operating leverage (2019). However, we find certain inconsistency in companies including depreciation and/or amortization (D&A) as part of SG&A. Although some analysts defend that, since D&A is not cash-sensitive it would not lead to default and it may not be relevant regarding risks considerations (Schönenberger, 2014), it could also be said that the provision accounted through D&A will be important for future replacement of the operating assets considering the lifetime of the ongoing concern. Besides, the intention of this exercise was not evaluating default risk but business models.
Benchmarking
Based on the aforementioned, the following premises were considered for this exercise:
Transportation Freight Industry presents higher levels of operating leverage than the median of ten different industries.
Property, Plant and Equipment (PP&E) To Revenues would be an adequate proxy to assess operating leverage.
The following chart presents the obtained results:
Source: Financial information obtained from Securities and Exchange Commission. Financial ratios calculated by Basteris Reyes. Information as of October, 2021.
As the Transfer Pricing Guidelines establish: The PLI selected when using a TNMM should be one which reflects the core value-adding activities (and hence profitability in the open market) of the tested party. In this case, the analyzed party presented PP&E To Revenues of 78.0%, even higher than the Transportation Freight Industry’s upper quartile.
A heterogeneous industry
It would be interesting to mention that the type of assets employed by the industry’s players are changing (have been changing for over a decade actually), from owning or leasing transport equipment to flexible outsourcing and investing their capital on developing technological platforms and better IT capabilities. Haussmann et al. express that Technological progress will require companies to make conscious choices about their asset intensity and investment program to avoid the “asset trap” (2015).
Therefore, new questions might arise: what if we were evaluating an old, or even worse, obsolete business model? It could be asset intensive for sure, but what kind of assets? Is it the same core value adding activity? Should my comparable companies be players of the industry? What kind of comparability adjustments could be made?
Conclusions
Choosing the most adequate PLI involves not only knowing the analyzed party’s core value adding activities but the industry’s practices and trends as well. Once this knowledge is achieved, it should become part of the transfer pricing documentation. This knowledge would be better supported by a quantitative analysis. Even in an asset intensive industry, measuring the analyzed party’s profitability, taking into consideration its higher than industry level of operating leverage, through a Return on Total Costs may be tricky, and it may mislead the analyst. As for the initial questioning on Return On Capital Employed, other elements were taken into consideration, for this specific analyzed party, for not choosing a ROA or Return on Fixed Assets. This approach has, off course, many opportunity areas for improvement, but it has come to our attention that many firms, Big4, Big10, medium and boutique (sounds fancier than small) including us, have let this aspect of documentation unattended.
Foot Notes
PP&E considers a company’s operating assets, whether owned or through lease contracts.
References
- Schönenberger, F. (2013). Operating Leverage — Is Cost Structure rigidity a Characteristic of Risk? The Impact of Cost Structure Rigidity on Returns under Consideration of BM Ratio and Size. University of St. Gallen, Business Dissertations, 1–213;
- Chen, Z., Harford, J., & Kamara, A. (2019). Operating Leverage, Profitability, and Capital Structure. Journal of Financial & Quantitative Analysis, 54(1), 369–392. https://doi.org/10.1017/S0022109018000595;
- Brown, S. (2017). The ins and outs of operational leverage. Finweek, 19.;
- Haussmann et al. (2015) Pathway to Value Creation: A perspective on how transportation and logistics businesses can increase their economic profit. McKinsey & Company. https://www.mckinsey.com/~/media/mckinsey/industries/travel%20transport%20and%20logistics/our%20insights/creating%20value%20in%20transportation%20and%20logistics/pathway%20to%20value%20creation.pdf
- A Toolkit for Addressing Difficulties in Accessing Comparables Data for Transfer Pricing Analyses (OECD);
- OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations;