term project
[Company Name] Transfer Pricing Analysis Fiscal year ended December 31, 2020
Contents 1. INTRODUCTION .................................................................................................................... 5
1.1. PURPOSE OF REPORT .................................................................................................................. 5
2. BUSINESS DESCRIPTION .................................................................................................... 6
2.1. ORGANIZATIONAL STRUCTURE .................................................................................................. 6
2.2. GENERAL OVERVIEW ................................................................................................................. 6
Group’s Overview ................................................................................................................ 6
2.3. INDUSTRY ANALYSIS.................................................................................................................. 7
Overview ............................................................................................................................. 7
Customers ............................................................................................................................ 8
Competitive Situation and Market Share............................................................................... 8
Industry Trends .................................................................................................................... 8
2.4. SUMMARY OF INTERCOMPANY TRANSACTIONS .......................................................................... 8
Provision of Intercompany Services ..................................................................................... 8
3. FUNCTIONAL ANALYSIS – THE SERVICES TRANSACTION ..................................... 10
3.1. COMPANY A’S METHODOLOGY ................................................................................................ 10
3.2. OVERVIEW OF COMPANY A’S DEPARTMENTS ........................................................................... 10
Executive ........................................................................................................................... 11
Strategic Planning and Business Development .................................................................... 11
Accounting / Tax................................................................................................................ 11
Legal .................................................................................................................................. 12
4. TRANSFER PRICING ANALYSIS – THE SERVICES TRANSACTION ......................... 13
4.1. OVERVIEW OF U.S. TRANSFER PRICING RULES ......................................................................... 13
Benefit Test........................................................................................................................ 13
Transfer Pricing Services Transaction Methods .................................................................. 13
4.2. SELECTION OF METHOD ........................................................................................................... 14
Services Cost Method......................................................................................................... 14
CUSP Method .................................................................................................................... 15
GSM Method ..................................................................................................................... 16
Cost of Services Plus Method ............................................................................................. 16
Profit Split Method ............................................................................................................. 17
CPM / TNMM ................................................................................................................... 18
4.3. TOTAL SERVICE COSTS ............................................................................................................ 18
Page 3
4.4. APPLICATION OF THE CPM ....................................................................................................... 19
Overview ........................................................................................................................... 19
Selection of Tested Party .................................................................................................... 19
Selection of Years for Comparison ..................................................................................... 19
Selection of Comparable Companies .................................................................................. 19
Selection of Profit Level Indicator / Net Profit Indicator ..................................................... 21
Accounting Adjustments .................................................................................................... 23
Capital Adjustments ........................................................................................................... 23
Analysis and Results .......................................................................................................... 24
5. CONCLUSION ...................................................................................................................... 26
Page 4
Appendices
Appendix F: Capital Adjustments
Appendix G: Financial Analysis of Comparable Manufacturing Companies
Appendix H: Search Matrix For Comparable North American Service Providers
Appendix I: Financial Analysis of Comparable North American Service Companies
Appendix J: Search Matrix For Comparable European Service Providers
Appendix K: Financial Analysis of Comparable European Service Companies
Introduction
Page 5
1. Introduction
1.1. Purpose of Report Specifically, this update report covers the following transactions:
• The provision of management services by Company A to Company B (the “Service Transaction”).
The analysis contained in this report is for tax purposes only and considers the regulations under the standards of the U.S. transfer pricing documentation rules of Treasury Regulation Section 1.6662 (the “U.S. transfer pricing regulations”).
Business Description
Page 6
2. Business Description
2.1. Organizational Structure Company A was established over fifty years ago as Hydro-Air and through a number of mergers and acquisitions has become one of the top companies in the building components industry. Company B, a wholly owned subsidiary of Company A, holds shares of numerous, but not all foreign subsidiaries. The relevant legal entity organizational structure as of FY 2019 is as follows:
Figure 1 - Abbreviated Organizational Chart of the Relevant Entities
[ORG. CHART TO BE INCLIDED]
2.2. General Overview
Group’s Overview Headquartered in New York, the Group is the world's leading supplier of state-of-the-art, engineered metal plates for the building construction industry.
Its primary business involves designing, manufacturing, and selling connector plates for trusses, a pre-built structural support component used in the construction of roofs and floors. A roof truss is a rigid, strong frame -work made up of wood members, such as 2” x 4”s, fastened and held together by metal connector plates, such as those manufactured by the Group. This framework accounts for the shape of a building’s roof and supports the roofing materials.
The Company manufactures connector plates for the wood truss industry in over 180 different designs and sizes. The Company also sells engineered building products, and equipment used by truss builders, and provides its customers with a software package to assist with truss construction and related professional services. Specifically, it performs the following activities:
• Manufactures truss connector plates, which are pre-punched metal-toothed connectors located at the joints and splices of a truss, designed to hold the forces that occur at those locations.
• Develops, markets, and supplies truss engineering software packages that provide layout, design, and engineering capabilities for the fabrication of trusses, and provides technical support for this software.
• Manufactures computer-driven truss fabricating machinery and equipment, including, but not limited to, saws, presses, roller beds, and receivers.
Business Description
Page 7
2.3. Industry Analysis1
Overview The fabricated structural metal manufacturing industry in which the Group operates consists of three categories: (i) fabricated structural metal products, (ii) pre-fabricated metal buildings; and, (iii) fabricated metal plate work products. Of these categories, fabricated structural metal products is the largest and accounts for an estimated 67.8 percent of industry revenue. This segment has increased as a share of revenue over the last five years. The products under this category include metal bar joists and concrete reinforcing bars used by commercial, industrial, municipal and residential developers, contractors and utility companies. The pre-fabricated metal buildings category accounts for approximately 15.7 percent of industry revenue and includes products used to construct farm buildings, greenhouses, homes, silos, utility buildings, warehouses and more. Within this segment, the share of revenue also increased over the last five years, particularly due to the rising popularity of prefabricated metal buildings. The fabricated metal plate work products category accounts for approximately 16.5 percent of revenue and includes products such as airlocks, baffles, bins, casings, chutes, covers, culverts, cyclones, ducting, flumes, hoppers, liners, piping, smoke stacks, sterilizing chambers, truss plants and tunnel lining, among others. These products are applicable to various type of projects in bridges, highways, railways and other transportation infrastructure. The portion of total revenue derived from this segment has declined slightly over the past five years.
The industry is heavily tied to the level of activity within the residential and nonresidential construction markets. A small proportion of demand is also derived from manufacturing businesses that use plate work as inputs. In addition, demand for products from the industry is heavily influenced by current conditions within downstream industries, particularly those in construction. Simultaneously, demand is adversely affected primarily by import competition and, secondarily, by competition from substitute (non-metal) product manufacturers. More specifically, in recent years, the structural metal product manufacturing industry faced significant import penetration from low-cost competitors such as China, further contributing to the declining revenue experienced by the industry. One major buyer of structural metals is the commercial construction industry, which is comprised of different segments that are influenced by diverse demand factors. For example, office construction is primarily determined by speculative developer activities, growth in the service sector and growth in foreign investment inflow. Additionally, retail building construction, which includes shopping malls, big-box stores and gas stations, is determined by consumer spending, shopping preferences and population growth rates. Other commercial building construction is determined by urban spread, tourism activity, population growth and growth in leisure time.
In this industry, demand is inelastic with respect to price when demand conditions are favorable and when global demand exceeds global supply. This inelasticity has been present during the last five years to 2016, as economies across the world recover and resume their commercial, transport and utility construction projects. Consequently, this economic recovery has allowed operators to pass on rising metal prices to downstream markets without compromising revenue.
Nevertheless, the increasing prominence of Chinese imports may be influencing growth, as low-cost imports exert competitive pricing pressures on domestic operators and limit their ability to pass on metal price increases. Additionally, competition from nonmetal (substitute) products such as wood and plastic may lessen the demand for industry products, though to a more negligible extent, since nonmetal products do not carry the same durability and strength attributes of metal. As a whole, IBISWorld2 estimates that the industry grew by an annualized rate of 2.3 percent over the five years to 2016.
1 Source: IBISWorld Industry Report, Structural Metal Product Manufacturing in the U.S. (March 2016). 2 IBISWorld is a market research firm that provides industry market research analysis, reports, and publications on a variety of industries.
Business Description
Page 8
Overall, industry performance is expected to improve over the next five years. Demand for products will be driven by consistent nonresidential construction as well as improving steel prices. Consequently, IBISWorld estimates annualized revenue growth of 3.1 percent through to 2021. This performance will depend on demand from the residential and commercial construction industries, as well as demand originating from public infrastructure projects. Fortunately for the structural metal product manufacturing industry, construction output is set to grow over the next five years. In particular, private nonresidential construction is projected to grow at an average annual rate of 3.5 percent. This will be the lynchpin for industry growth over much of the next five years.
Customers Company A’s customers tend to be small to medium sized roof truss fabricators (both residential and commercial) and timber frame house builders.
Competitive Situation and Market Share The fabricated structural metal manufacturing industry can be very competitive. Competition within the industry depends on the product. There are many different products manufactured in the industry. Some of these products are generic while others are made to order. For more generic and standardized products, the main drivers of competition are price and reliability. Given the prevalence of common products within the industry, branding is also a useful way for manufacturers to differentiate their product from competitors. Other important factors include offering a diverse product line with products at various price points, as well as quick turnaround. Due to the relative ease with which these products may be substituted for one another, they tend to have rather tight profit margins. Projects requiring more specialized, non-standard parts from this industry are likely to go to the large producers, which have the engineering resources and manufacturing capacity to fulfill special orders. In order for companies to remain competitive in the industry, bundling product with software, branding, consistently high quality and responsive service are the means available to a manufacturer to distinguish itself within the industry.
Industry Trends The industry has experienced moderate levels of globalization, with the trend increasing over time. Most industry players have a small market share and operate mostly on a local scale. However, over the last five years, industry globalization has increased thanks to growth in international trade as well as acquisitions and expansions into offshore operations by larger operators in the industry. Globalization is forecasted to increase further over the next five years through 2021. IBISWorld projects that international trade will expand, with double-digit growth expected in imports, as the construction market fully revives in the United States.
2.4. Summary of Intercompany Transactions
Provision of Intercompany Services
U.S. Services Transaction During FY 2019, Company A provided various headquarter and management services to Company B. These services include, but are not limited to, acquisitions, planning, accounting, budgeting, finance, legal, administration, and technical services.
Business Description
Page 9
Pursuant to the intercompany services agreement between Company A and Company B, Company B reimburses Company A for the respective expenses, costs, charges, and disbursements made or incurred in rendering services to Company B under the agreements plus a mark-up of five percent. During FY 2019, the intercompany service charge paid by Company B to Company A equaled approximately USD 300,000. Company A periodically issues invoices, at least once annually, for services rendered. The invoice is payable by Company B within 60 days of receipt thereof.
Company A
Payment of Service Fee
Provision of Services
Company B
Functional Analysis – The Services Transaction
Page 10
3. Functional Analysis – The Services Transaction
3.1. Company A’s Methodology The Company identified Company B and other foreign affiliates as the beneficiary of Company A’s services. The Company identified the following departments that provide services:
• Executive; • Strategic Planning and Business Development; • Accounting / Tax; and, • Legal. According to the U.S. Transfer Pricing Regulations, where the amount of arm’s length charge for services is determined with reference to the costs or deductions incurred with respect to such services, the charge should take into account all direct and indirect costs related to the service performed (i.e., fully loaded costs). According to Company personnel, each department includes the direct costs associated with the provision of the services, including compensation of employees directly engaged in performing such services and materials and supplies directly consumed in rendering the services (“Direct Costs”). Indirect costs such as utilities, occupancy, supervisory and clerical compensation, and other overhead burden (“Indirect Costs”) are allocated to the departments.
Where the activity results in a benefit for more than one recipient, and amount charged is determined under a method that makes reference to costs, the costs must be allocated to the members of the controlled group based on an allocation key that reflects the reasonably anticipated benefit to the recipient.
The Company undertook the following steps in the allocation of corporate expenses to Company A:
• Determined the fully-loaded costs base for each department; • Identified non-allocable costs (i.e., stewardship or duplicative activities); • Allocated the allocable costs to Company B using the following methods:
o Direct charge method (i.e., services benefit a specific entity (e.g., Company B) and the Company can reliably identify the costs incurred for Company B).
o Indirect charge method (i.e., services benefit a group of recipients and the Company cannot reliably identify the costs incurred for Company B, the fully loaded costs are allocated to Company B using a reasonable allocation key). In this instance the fully loaded costs of the Company A departments are allocated based on time spent.
• Determined whether the services provided are eligible to be priced at cost, and if not, determined a reasonable markup on costs to be applied.
3.2. Overview of Company A’s Departments The following sections provide an overview of each department’s functions and the nature of the services rendered.
Functional Analysis – The Services Transaction
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Executive The executive management department is comprised of the Chief Executive Officer (“CEO”) and his executive administrative assistant.
The CEO is primarily involved in corporate governance activities, including interaction with foreign subsidiaries to ensure they comply with local country quality as well as complying with applicable U.S. quality standards. The CEO also interacts with suppliers and customers and is directly involved in negotiating and reviewing customer and supplier contracts, participating in conference calls, contacting potential new customers, performing business and budget reviews, and conducting market intelligence.
Strategic Planning and Business Development This department is comprised of salary and other costs associated with the vice president (“VP”) of strategic planning and business development. The functions performed by the strategic planning and business development department include:
• Feasibility Determination: After an acquisition is proposed, the strategic planning department assesses how the acquisition will be structured and whether the company is financially capable of completing the deal.
• Due Diligence: The department collects information about the company to be acquired in order to evaluate the target company or its assets.
• Business Valuation: The department puts a value on the targeted company’s business functions and assets. This value is used as a basis for the purchase offer made to the target company’s shareholders. Several methods of business valuations are commonly used, including analyzing the target company’s historical and projected cash flows and valuing its assets.
• Post-Acquisition Plan: After an acquisition, the strategic planning department prepares a pro-forma profit and loss statement for the combined entities that reflect cost savings and/or increased revenues that will result from the acquisition.
Accounting / Tax The accounting / tax department is comprised Company A’s chief financial officer (“CFO”), corporate controller, tax manager, and the assistant corporate controller. The functions performed by the accounting / tax department include:
• Assisting the strategic planning department with respect to reviewing the target company’s financial statements and to financing the deal;
• Managing compliance activities by overseeing and monitoring compliance with relevant federal, provincial/state, and local legislation for the Group, including employee handbooks, privacy rules, and anti-trust guidelines;
• Providing general accounting advisory services to all departments and regions; • Implementing and managing all insurance policies and practices with respect to all global departments
and subsidiaries; • Consolidating financial and accounting data from all subsidiaries and departments; • Providing additional financial services including budgeting, forecasting, audit, and financial statement
analysis; and • Ensuring each region is filing taxes in accordance with the local tax laws and processing tax schedules
and payments according to prescribed laws and regulations and gathering information from accounting records for use in preparation of income, provincial, state, local or other tax returns,
Functional Analysis – The Services Transaction
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Additionally, the CFO provides high-level strategic and financial direction to Company B and is involved in the strategic planning process. The CFO activities include determining when to make capital investments and expenditures, whether to build products in-house or outsource production, reviewing and assessing potential customers and suppliers and reviewing the financial performance of the company.
Legal This department is comprised of the Secretary and General Counsel, Assistant General Counsel and a paralegal that supports the department. The functions performed by the legal department include:
• Drafting contracts, managing and litigating insurance claims, dealing with property rights infringements issues and registering new subsidiaries;
• Engaging local third parties professional services firms for the provision of legal services to protect the firm in a suit or any other legal battle;
• Responsibility for participating in the day-to-day intellectual property protection functions for all of Group’s products with a particular emphasis on (i) invention identification; and (ii) securing of rights for these inventions by understanding and reviewing appropriate reporting mechanisms and the preparation and prosecution of patent applications teaching and claiming the inventions;
• Providing support services including but not limited to providing guidance, support and legal advice regarding licensing, government contracts, copyright, and trademark activities;
• Communicating complex intellectual property legal concepts and principles in a manner that non- lawyers will understand and comply with; and
• Maintaining an understanding of intellectual property law and relevant technologies that will allow prompt if not immediate analysis of complex fact patterns and issues involving mixed questions of law and fact.
Transfer Pricing Analysis – The Services Transaction
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4. Transfer Pricing Analysis – The Services Transaction
4.1. Overview of U.S. Transfer Pricing Rules
Benefit Test The U.S. Services Regulations provide specific rules for determining whether an activity results in a benefit to a related party (i.e., the benefit test). A benefit exists if the activity performed by one related party directly results in a reasonably identifiable increment of commercial or economic value that enhances the recipient’s commercial position, or is reasonably anticipated to do so. An activity is considered to confer a benefit if an uncontrolled taxpayer in circumstances comparable to those of the recipient would be willing to pay an uncontrolled party to perform the same or a similar activity, or be willing to perform for itself the same or similar activity.
The U.S. Services Regulations provide guidance concerning application of the benefit test to the following circumstances:
• Shareholder activities: an activity is not considered to provide a benefit to a related party if the primary effect of that activity is to protect the renderer’s capital investment in the recipient or in the other members of the controlled group, or if the activity primarily relates to compliance by the renderer with reporting, legal, and regulatory requirements imposed on a renderer that controls every other member of the group.
• Duplicative activities: if an activity performed by a controlled taxpayer duplicates an activity that is performed, or may be reasonably anticipated to be performed by another controlled taxpayer on or for its own account, the activity is not considered to provide a benefit to the recipient, unless the duplicative activity itself provides additional benefit to the recipient.
• Remote activities: an activity is not considered to provide a benefit if the probable benefit to the recipient is so indirect or remote that the recipient would not be willing to pay a third party to perform such service or would not be willing to perform such an activity by itself.
• Passive association: a member of a controlled group that obtains a benefit solely on account of its status as a member of the group is generally not considered to receive a benefit.
The U.S. Services Regulations provide that the above activities do not confer a benefit to the recipients and therefore do not give rise to a charge for such activities.
Transfer Pricing Services Transaction Methods The U.S. Services Regulations provide six “specified” methods for determining an arm’s length amount charged in a controlled service transaction. Rules are also provided for the application of “unspecified methods.” Whether the transfer pricing result derived from the application of any of these methods constitutes the most reliable measure of an arm’s length result must be determined by considering the degree of comparability and the quality of data and assumptions used, as described above. The six specified methods are as follow:
Transfer Pricing Analysis – The Services Transaction
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• Services cost method (“SCM”); • Comparable uncontrolled services price (“CUSP”) method; • Gross services margin (“GSM”) method; • Cost of services plus method; • Profit split method; and, • Comparable profits method (“CPM”).
4.2. Selection of Method
Services Cost Method
General Description The U.S. transfer pricing regulations include a cost safe harbor that provides for certain services to be charged out at cost without a markup. This safe harbor is called the SCM. Services may qualify for the SCM by being included in the list of “specified covered services.” The list of specified covered services includes back office, clerical, or administrative services, such as compiling and recording billing. IRS Announcement Rev. Proc. 2007-13 identifies 101 types of support service activities in 20 service categories as the initial list of specified covered services. If a service is not a “specified covered service,” it may still qualify for the SCM if it is a “low-margin covered service.” To determine whether services are low-margin covered services, a taxpayer must establish an interquartile range of arm’s length markups on total services costs and determine whether the median markup is less than or equal to seven percent. In addition, the regulations also preclude the following services from the application of the SCM: (a) manufacturing; (b) production; (c) extraction, exploration, or processing of natural resources; (d) construction; (e) reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement; (f) research, development, or experimentation; (g) engineering or scientific; (h) financial transactions, including guarantees; and, (i) insurance or reinsurance.3
The taxpayer must also conclude reasonably in its business judgment that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the controlled group (the “business judgment test”). The taxpayer must also maintain adequate books and records with regards to the service. If a service does not qualify for the SCM, the taxpayer must apply the best method rule to determine the arm’s length charge for the service.
The figure below illustrates the steps for determining whether the SCM is applicable to a service transaction.
3 Treas. Reg. § 1.482-9.
Transfer Pricing Analysis – The Services Transaction
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Process to qualify to use the SCM
Applicability The SCM is an elective method at the option of the taxpayer, and evaluates whether the amount charged for covered services is arm’s length, by reference to the total services costs with no markup. Services are not covered services unless the taxpayer reasonably concludes in its business judgment that the covered services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the controlled group, as defined in Treas. Reg. § 1.482-1(i)(6). Based on the facts provided, Company A management did not elect to apply the SCM because the services rendered by Company A contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure of Company B.
CUSP Method4
General Description The CUSP method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the amount charged in a comparable uncontrolled service transaction. Under the CUSP, similarity of the services rendered and of the intangibles (if any) used in performing the services in the controlled and uncontrolled transactions will generally have the greatest effect on determining comparability. Also, because even minor differences in contractual terms or economic conditions could materially affect the amount charged in an uncontrolled transaction, comparability under this method depends on close similarity with respect to these factors, or adjustments to account for any differences. The results derived from applying the CUSP generally will be considered the most direct and reliable measure
4 Treas. Reg. § 1.482-9(c).
Service is a “specified covered service”
Service is a “low margin covered service”
Service is one of the specifically excluded transactions
Service contributes key competitive advantages, core capabilities, or
fundamental risks of success or failure
Evaluate applicability of five specified methods other than SCM
Evaluate applicability of five specified methods other than SCM
Evaluate applicability of five specified methods other than SCM Eligible to elect SCM
No
Yes
Yes
No
Yes
No
No
Yes
Transfer Pricing Analysis – The Services Transaction
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of an arm’s length price for the controlled transaction if an uncontrolled transaction has no differences from the controlled transaction that would affect the price, or if there are only minor differences for which adjustments are made.
Applicability It was not able to identify sufficient information for a reliable application of the CUSP method for Company A’s provision of management and administrative services because Company B does not employ third parties to provide similar services and Company A does not provide similar services to third parties. Therefore, there are no internal comparable transactions available for analysis. Furthermore, based on our experience, it is highly unlikely to find transactions and sufficient reliable data about external comparable transactions that would satisfy the stringent comparability requirements of the CUSP method.
GSM Method5
General Description The GSM evaluates whether the amount charged in a controlled service transaction is arm’s length by reference to the gross services profit margin realized in comparable uncontrolled transactions that involve similar services. This method is typically applied when a controlled taxpayer performs services or functions as an intermediary or agent in connection with an uncontrolled transaction between a member of the controlled group and an uncontrolled taxpayer. The appropriate gross services profit equals the applicable uncontrolled price multiplied by the gross services profit margin in comparable uncontrolled transactions.
Comparability under the GSM method is particularly dependent on similarity of services or functions performed, risks borne, intangibles (if any) used in providing the services or functions, and contractual terms, or adjustments to account for the effects of any differences.
Applicability Company A and Company B do not provide similar services to unrelated parties or receive similar services from unrelated parties. Therefore, no internal comparable transactions are available to apply the GSM. In addition, Company A does not function as an intermediary or agent in its role as a management service provider. In our experience, it is highly unlikely to find transactions and sufficient reliable data about external comparable transactions that would satisfy the comparability requirements of the GSM method.
Cost of Services Plus Method6
General Description The cost of services plus method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the gross services profit markup realized in comparable uncontrolled transactions. The cost of services plus method measures an arm’s length price by adding the appropriate gross services profit to the controlled taxpayer’s comparable transactional costs. The appropriate gross services profit equals the controlled taxpayer’s comparable transactional costs multiplied by the gross services profit markup, expressed as a percentage of the comparable transactional costs earned in
5 Treas. Reg. § 1.482-9(d). 6 Treas. Reg. § 1.482-9(e).
Transfer Pricing Analysis – The Services Transaction
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comparable uncontrolled transactions. The cost of services plus method is ordinarily used in cases where the controlled service renderer provides the same or similar services to both controlled and uncontrolled parties.
Applicability Company A and Company B do not provide similar services to unrelated parties. Furthermore, obtaining consistent cost information relevant for determining gross profits of third parties (including the transactional cost of services) is difficult due to the lack of publicly available data. Accordingly, this analysis did not apply the cost of services plus method.
Profit Split Method7
General Description The profit split methods evaluate whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The relative value of each controlled taxpayer’s contribution to the success of the relevant business activity is determined in a manner that reflects the functions performed, risks assumed, and resources employed by each participant in the relevant business activity. This method largely incorporates the profit split rules in Treas. Reg. § 1.482-6.
The regulations include the following two specified profit split methods:8
• Comparable Profit Split Method Transfer prices are based on the division of combined operating profit between uncontrolled taxpayers whose transactions and activities are similar to those of the controlled taxpayers in the relevant business activity. Under this method, the uncontrolled parties’ percentage shares of the combined operating profit or loss is used to allocate the combined operating profit or loss of the relevant business activity between the related parties.
• Residual Profit Split Method This method involves two steps. First, operating income is allocated to each party in the controlled transactions to provide a market return for their routine contributions to the relevant business activity. Second, any residual profit is divided among the controlled taxpayers based on the relative value of their contributions of any valuable intangible property to the relevant business activity. The residual profit split method is ordinarily used in controlled services transactions involving a combination of non-routine contributions by multiple controlled taxpayers.
Applicability Profit split methods are generally applied when both controlled parties own certain intangible property, which is not the case in this transaction. Specifically, Company A does not own valuable intangibles used in their provision of management services to Company B. Therefore, the profit split methods are not applicable.
7 Treas. Reg. § 1.482-9(g). 8 Treas. Reg. § 1.482-6.
Transfer Pricing Analysis – The Services Transaction
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CPM / TNMM
General Description The CPM evaluates whether the amount charged in a controlled transaction is at arm’s length by comparing the profitability of one of the parties involved in the controlled transaction (the “tested party”) to that of companies that are similar to the tested party. In most cases, the tested party is chosen to be the simpler of the two parties involved in the controlled transactions. In particular, the tested party should not use intangible property or unique assets that distinguish it from unrelated comparable companies.
The degree of comparability between the tested party and the comparable companies affects the reliability of the CPM analysis. Reliability may be adversely affected by varying cost structures, differences in business experience, or differences in management efficiency. However, less functional comparability is required for reliable results under the CPM method than under the CUSP method. In addition, less product similarity is required for reliable results than under the CUSP method.
Adjustments that may be required include those for differences in:
• Accounting classifications; • Credit terms; • Inventory; • Currency risk; and, • Business circumstances.
Applicability It was possible to identify a number of independent management and administrative service providers with publicly available financial data that perform functions and bear risks similar to those of Company A in its provision of management services. Moreover, to the extent that differences exist between the comparable service providers and Company A, in its capacity as a provider of such services, reasonable adjustments for such differences can be made.
4.3. Total Service Costs As previously noted, the total services costs are relevant for the application of the methods permissible under the Services Regulations. Company A has included all costs that can be identified directly with the act of providing services, and all other costs (“indirect costs”) reasonably allocable.9
The term “total service costs” refers to the cost base used to determine the arm’s length charge under the CPM / TNMM. Total service costs are defined as the costs of rendering those services for which total services costs are being determined, including all costs that can be directly identified, based on an analysis of the facts and circumstances, with the act of rendering beneficial services, as well as all other costs allocable to the services, except for interest expense, foreign income taxes, or domestic income taxes. The allocable costs of the identified functions of Company A related primarily to compensation, such as salaries, benefits, allowances, as well as variable compensation (incentives and bonuses) and overhead all.
9 The “reasonable method standard”, under Treas. Reg. §1.482-9(k)(2)(i), states, “Any reasonable method may be used to allocate and apportion
costs under this section. In establishing the appropriate method of allocation and apportionment, consideration should be given to all bases and factors, including, for example, total services costs, total costs for a relevant activity, assets, sales, compensation, space utilized, and time spent.
Transfer Pricing Analysis – The Services Transaction
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4.4. Application of the CPM
Overview An application of CPM requires:
• Selection of the tested party for the analysis; • Selection of years for comparison; • Selection of reliable comparable companies; • Accounting adjustments to the financial statements of the tested party and comparable companies for
differences in accounting practices, provided such adjustments are appropriate and possible; and, • Selection of a reliable profit level indicator.
Selection of Tested Party The Final Service Regulations specify that the CPM may be applied only when the renderer of the service is the tested party. Therefore, we selected Company A as the tested party for purposes of applying the CPM.
Selection of Years for Comparison Comparisons were made based on a three-year average basis (i.e., FY 2017 through FY 2019) for the tested party and the most recently available three years of data for the comparable companies.
The tested party year-ends are not always the same as the comparable companies’ year-ends. Therefore, each year-end is associated with a range of year-ends of comparable companies. For purposes of this report, the association was as follows:
Table 1: Years for Comparison
Tested Party Year- End
Comparable Year-End From
Comparable Year- End To
12/31/2019 6/01/2019 5/31/2020
12/31/2018 6/01/2018 5/31/2019
12/31/2017 6/01/2017 5/31/2018
Selection of Comparable Companies A search of the most current version of the Compustat database (June XXX) for any companies potentially comparable for FY 2019 analysis, and reviewed any potentially comparable companies based on the comparability criteria established for the search. Then, a final group of comparable companies for the FY 2019 analysis and obtained the most recently available three years of data for the comparables. The following sections describe in more detail the steps taken in updating the search for FY 2019 and the corresponding results.
Description of Search Process for the Comparable Companies The following SIC codes in which potentially comparable companies could be classified were identified:
Transfer Pricing Analysis – The Services Transaction
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Table 2: Relevant SIC Codes
SIC Codes Definition
736* Personnel Supply Services
811* Legal Services
872* Accounting, Auditing, and Bookkeeping Services
874* Management and Public Relations Services
899* Miscellaneous Services
The search resulted in the identification of XX potential comparable companies. Based on a review of the short business descriptions of these companies, the following screening criteria were applied to more closely match the functions and risks of the comparable companies with those of Company A.
Companies were eliminated if they:
• Engaged in significantly different activities (e.g., manufacturing or distribution of products); • Provided significantly different services (e.g., insurance, e-commerce, or telemarketing); • Owned significant trademarks, trade names, patents, licenses, or other valuable intangibles used in the
provision of services; • Suffered from persistent losses for the years under review; • Underwent disruption to the normal course of business (e.g., bankruptcy, merger, or acquisition); • Had significant related party transactions; or, • Lacked sufficient financial or descriptive data. Applying the above criteria, XX companies were identified for a more detailed review. The SEC Forms (e.g., 10-K) for these companies were reviewed as well. Based on a more refined review using the selection criteria describe above, it is was determined that XX companies were as functionally comparable to Company A.
• The table below contains the brief business descriptions of the XX companies that were selected as comparable.
Table 3: Comparable North American Management Service Providers
# Company Name Company Description
1 Barrett Business Svcs Inc.
The company provides professional employer and staffing services to a diversified group of customers. The company’s range of services and expertise in human resource management encompasses five major categories: payroll processing, employee benefits and administration, workers’ compensation coverage, effective risk management and workplace safety programs, and human resource administration.
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# Company Name Company Description
2 Cbiz Inc
The company provides professional business services that help clients manage their finances, employees, and technology. The company operates several segments. Its financial services segment provides accounting, tax, financial advisory, and valuation services. Its employee services segment provides group health, retirement planning, wealth management, and actuarial services. The medial management professionals segment provides billing, collection, and full-practice management services. The national practices offer technology and other services, including health care consulting, mergers and acquisitions, and government relations services
3 CRA International Inc The company provides economic, financial, and management consulting services. The company provides strategy development, risk management, and transaction support services.
4 Hackett Group Inc
The company is a strategic advisory and technology consulting firm that enables companies to achieve world-class business performance. The company's combined capabilities include business advisory programs, benchmarking, business transformation, working capital management and technology solutions, with corresponding offshore support.
5 Insperity Inc
The company is a professional employer organization (PEO) that provides a comprehensive Personnel Management System encompassing a range of services, including benefits and payroll administration, health and workers’ compensation insurance programs, personnel records management, employer liability management, employee recruiting and selection, performance management and training, and development services to small and medium-sized businesses.
6 Korn Ferry International
The company provides talent management solutions that enable clients to attract, develop, retain, and sustain talent. The company also provides leadership and talent consulting services, which include strategic and organizational alignment, leadership and executive development, and talent and performance management services.
7 Navigant Consulting, Inc.
The company provides a wide range of consulting services relating to IT, process/operations management, strategy, and marketing and sales designed to assist its clients in succeeding in the business environment of changing regulations, increasing competition, and evolving technology.
8 Resources Connection Inc.
The company is an international professional services firm, which is involved in the provision of finance, accounting, risk management and internal audit, information management, human resources, supply chain management and actuarial and legal services.
Selection of Profit Level Indicator / Net Profit Indicator
Description of the Profit Level Indicators / Net Profit Indicators
Description of Profit Level Indicators A reasonable application of CPM requires the selection of a profit-level indicator (“PLI”) / net profit indicator (“NPI”), which produces an appropriate measure of income the tested party would have earned had it dealt with related parties at arm’s length, taking into account all facts and circumstances. A PLI /
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NPI measures a company’s return for its investment of resources and its assumption of risk. The reliability of the PLI / NPI might be enhanced through a number of adjustments for differences in capital employed and functions performed.
For a CPM analysis, the U.S. transfer pricing regulations specify three PLIs / NPIs: (i) the operating margin, (ii) the return on operating expense (“Berry Ratio”) and, (iii) the return on operating assets (“ROA”), which measures the return on capital employed. However, other PLIs / NPIs may be used if they provide a more reliable basis for testing an arm’s length result. A commonly used PLI / NPI for service providers, including contract manufacturers, is the return on total costs (“Net Cost Plus Ratio”). The following describes the three specified PLIs / NPIs and the net cost plus ratio in more detail.
• Return on Operating Assets: Operating assets are defined as total assets less investments, such as those in subsidiaries and securities. Because the relationship between profit and operating assets is generally less affected by functional differences than the relationship between profit and sales or expenses, the regulations require lower functional comparability between the tested party and comparable companies in an analysis using the ROA (operating profit over operating assets) than in an analysis using financial ratios. However, in those instances in which the operating assets reported in the balance sheet do not reliably measure the capital employed or where balance sheet items do not accurately reflect the nature of the intercompany transactions, the ROA may be a less reasonable NPI than the financial ratios. Furthermore, the ROA may be less reasonable than the financial ratios when there are differences between the tested party and comparable companies in business cycles or over the course of the year. Over a business cycle the profits of a company are more closely correlated to sales than to assets (especially fixed assets and inventory). Also, if the average balance sheet does not accurately reflect the average use of capital throughout the year, the ROA may be an unreasonable NPI.
• Operating Margin: The operating margin (operating profit over net sales) is generally less reasonable than the ROA when there are functional differences between the tested party and the comparable companies. The reliability of this NPI is reduced if, because of functional differences, the companies analyzed have different asset intensities (i.e., if they employ different levels of assets to generate a dollar of sales). The reliability of the operating margin, like that of any NPI, is affected by the accuracy of the underlying data used for its computation. If income statement data is more accurate than balance sheet data, then the operating margin may be more reasonable than the ROA.
• Berry ratio: Like the operating margin, the Berry ratio (gross profit over operating expenses) is more sensitive than the ROA to functional differences between the tested party and the comparable companies. When functional differences give rise to differences in the level of capital employed relative to operating expenses, the Berry ratio is likely to be less appropriate than the ROA. Furthermore, unlike the operating margin, this NPI is sensitive to differences in the classification of costs into cost of goods sold and operating expenses. In instances where the income statement data are more accurate than the balance sheet data, the Berry ratio may be more appropriate than the ROA.
• Net Cost Plus Ratio: Unlike the Berry ratio, the net cost plus ratio (operating profit over total cost) is insensitive to differences in accounting classifications between operating expenses and cost of sales. It is sensitive, however, to differences between operating expenses and interest expenses employed by different companies, and also potentially to differences in capital intensity (i.e., the use of capital per dollar of sales).
Selection of the Profit Level Indicator / Net Profit Indicator The net cost plus mark-up was selected to evaluate the profitability of the comparable companies’ financial performance.
The ROA was found to be less appropriate than the net cost plus mark-up because detailed segmented balance sheet data relating to the Services Transaction was not available. ROA is typically used to test
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manufacturing and distribution companies and is found less reliable to test service providers because of the difficulty involved in assessing the assets employed by service providers in the provision of services.
The operating margin is most appropriately applied when a company’s sales (i.e., the denominator of the ratio) is based on sales to unrelated third parties. As testing the returns earned by Company A in the provision of management services to Company B, the sales are impacted by the transfer price and, therefore, the operating margin may not be as reliable as the net cost plus mark-up.
Costs are typically considered as the key profit driver for a service provider. However, the net cost plus mark-up was selected over the Berry ratio because of the differences that might exist between the tested parties and the selected comparable companies with respect to the classification of costs between costs of goods sold and operating expenses. The net cost plus mark-up is appropriate in this case because it considers return on total costs thus circumventing any differences in the classification of costs between the tested party and the comparable companies.
Accounting Adjustments A reliable CPM analysis requires that only profits arising from ordinary and comparable business operations of the comparable companies and the tested party be compared. Furthermore, a reliable CPM analysis should be based on the most accurate data available, and it should not be affected by differences in accounting practices that have no relationship to the actual business operations. Therefore the following adjustments to the financial statements of both the comparable companies and the tested party are performed.
Adjustments for Differences in Inventory Valuation According to U.S. GAAP, a company can elect to value inventory by a variety of methods including First- In-First-Out (“FIFO”), Last-In-First-Out (“LIFO”), Averaging and Specific Identification. Differences in the valuation of inventories can distort the profitability comparison between companies. For instance, two companies with identical operations can report different levels of operating assets (through inventories) and profit (through cost of goods sold) if they elect to value their inventories using different methods. To increase the reliability of our analysis, the financial statements of the LIFO companies were adjusted to FIFO. For this adjustment, the applicable LIFO reserves were added the opening and closing inventory balances and increased cost of goods sold by the difference between the opening and closing LIFO reserves.
Adjustments for Differences in Reporting of Intangibles The comparable companies and the tested party do not own any significant intangibles, such as patents, copyrights or trademarks. Therefore, any intangible assets on their balance sheets most likely consist only of ordinary intangibles acquired in the purchase of another company. Because similar ordinary assets developed internally are not reported in financial statements, the reported intangible assets and any related amortization distort profitability comparisons and have been removed from the balance sheet and profit and loss statements before computing profitability ratios.
Capital Adjustments Capital adjustments are necessary if differences in functions (e.g., holding inventory) or terms of trade (e.g., financing terms received from suppliers) give rise to differences in capital intensities between the comparable companies and tested parties. The nature of these adjustments for the operating margin is described below.
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• Accounts Payable Adjustment: An adjustment is necessary if a comparable company has a different level of accounts payable than the tested party. A company that purchases products from other companies and has payables outstanding, is implicitly receiving financing from its suppliers, and is presumably paying for this financing through higher cost of goods sold. The financial ratio for two companies that receive different terms but are otherwise identical will differ because the company with longer terms received will report a higher cost of goods sold and, as a result, a lower profit. Therefore, to improve the comparability of profitability measures for the tested party and the comparable companies, an adjustment is made to remove the entire interest embedded in payables from each company’s reported cost of goods sold.
• Accounts Receivable Adjustment: An adjustment is necessary if a comparable company has a different level of accounts receivable than the tested party. A comparable company with more (or less) days receivable than the tested party is implicitly providing more (or less) financing to its customers than the tested party, and is presumably being compensated through higher (or lower) sales prices. Differences in accounts receivable distort financial ratio comparisons. For instance, two otherwise identical companies that provide different levels of ordinary financing to their customers will report different sales and profits, and their financial ratios will, therefore, have different values. In order to make more reliable comparisons, we, therefore, remove the entire imputed interest on receivables from reported sales and gross profit for both the tested party and the comparable companies. As intended, this adjustment does not adjust for the credit risk assumed by the tested parties and comparable companies. It only adjusts for the difference in the carrying cost of receivables.
Inventory Adjustment: An adjustment to the financial ratios is necessary if a comparable company has a different level of inventory holding than the tested party. For example, a comparable company with more days of inventory than the tested party is providing an additional valuable inventory holding function for its customers and/or its suppliers, and is presumably being compensated through higher sales prices and/or lower cost of sales. To improve comparability, we estimate the interest cost associated with the inventory holding function and remove the entire imputed interest in inventory from reported gross profit of both the tested party and the comparable companies.
Interquartile Range
The use of a range of results in performing a benchmarking analysis helps reduce the effects of differences in the business characteristics of associated enterprises and independent enterprises. A range permits results that would occur under a variety of commercial and financial conditions.
The interquartile range represents the middle 50 percent of returns observed among the comparable companies. Use of the interquartile range increases the accuracy of the results of the comparability analysis where there is insufficient company specific information to identify, and to make adjustments to eliminate the effects of, material differences between the tested party and the comparable companies. Because there are slight differences in products and functional intensity between the tested party and the comparable companies, the interquartile range often provides a more appropriate basis for comparison than the full range.
Analysis and Results The table below details the interquartile range of the average net cost plus mark-ups earned by the comparable companies during the most recent three-year period for which data was available.
Table 4: Three-Year Average Accounting Adjusted Net Cost Plus for the Comparable Companies
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Lower Quartile Median Upper Quartile
XX% XX% XX%
The interquartile range of the three-year average unadjusted net cost plus ratios for comparable companies is between XX percent and XX percent with a median of XX percent. During the three-year period from FY 2017 to FY 2019 Company A earned a net cost plus mark-up of five percent for its provision of intercompany services to Company B, which is within the interquartile range of the results of the comparable companies. Please see Appendix B for details concerning the financial analysis.
Conclusion
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5. Conclusion
Based on the information, data, and analysis contained in this report, it is reasonable to conclude that the analysis in this report meets the specified method requirement and contains all of the principal documents required to be in existence on the return filing date, under the standards of the U.S. transfer pricing penalty regulations, Treas. Reg. § 1.6662.
Appendix A. Search Matrix For Comparable North American Service Providers
Appendix B. Financial Analysis of Comparable North American Service Providers