Wednesday, 30 May 2012

Swedish court gives important guidance on the application of the TNMM

On 27 April 2012, the Administrative Court of Appeal in Stockholm (hereinafter referred to as the Court) gave its ruling in an important case regarding the application of the Transactional Net Margin Method
("TNMM") (case nr 2400-2404-11). Several questions addressed in the judgment are interesting from a transfer pricing perspective:

  •  Should the estimation of whether the pricing is arm’s length be made on a single entity basis, or may the results of related entities involved in the value chain be consolidated and measured on a combined basis?   

The question regarded whether Michelin Nordic AB’s profitability should be measured on a standalone basis, or if foreign related sales agents should be taken into account when determining whether the prices are arm’s length. Michelin Nordic AB held that the combination of the functions performed by the company itself together with the functions performed by the related sales agents, constituted the complete function of a distributor. Hence, Michelin Nordic AB said that the profitability of the entire distribution function should be measured through a May 30, 2012 consolidation of the net margins on a Nordic level. The Court ruled that the measurement of the net margin should not include the sales agents but should be computed solely at the level of Michelin Nordic AB.

  • May certain years when the business was restructured be excluded from the evaluation of whether the net margin is in line with the arm’s length principle?   

The question regarded whether the year when the business was restructured should be taken into consideration when evaluating whether the average net margin upholds the arm’s length principle, or if this year may be excluded from the evaluation.  Long established Swedish case law has allowed for the measure of an acceptable arm’s length price to be not only for a single year basis but has also accepted set-off prices from year to year, i.e. allowed the measure of arm’s length prices to be taken over a
multiple year period. Michelin Nordic AB argued that the year of the restructure should be excluded since the restructure resulted in organizational difficulties and inefficiencies. The Court found that the year of the restructure should be taken into account when calculating the average net margin.  

  • Which range should be considered as upholding the arm’s length principle when using the TNMM?   

The Michelin Group targeted a 2% net margin for Michelin Nordic AB to achieve. However, Michelin Nordic AB held that the targeted net margin level should not be binding and instead any net margin within the inter-quartile range should be accepted, i.e. no adjustment should be made if the achieved net margin was above the lower quartile range of the benchmark. The Swedish Tax Agency, on the other hand,
held that the final outcome should be a net margin of 2%, since the way in which the Michelin Group had applied the 2% policy should be regarded as equivalent to an agreement between two unrelated parties. Even though the Court held that net margins within the inter-quartile range should be accepted, it found that the targeted net margin of 2% should be regarded as the remuneration level that would be deemed
to uphold the arm’s length principle for Michelin Nordic AB.  

  • How can an analysis of gross margins be combined with the TNMM?   

Michelin Nordic AB compared its own gross margins with those achieved by comparable entities, and held that since the gross margins were in-line with the comparable results, the prices should be considered to be at arm’s length.  The Court did not agree with this view since Michelin Nordic AB had not proved that costs had been accounted for in the same way in the comparable companies as within Michelin Nordic AB. The judgment stated that such a review is necessary to allow for an appropriate comparison of gross margins.  

Source & more info: PKN