When the Accounting Perspective Meets the Tax Perspective in Court Proceedings

2, Introduction

In Transfer Pricing analysis, the selection of a method is one of the important steps in determining whether an affiliated transaction has satisfied the Arm's Length Principle (Prinsip Kewajaran dan Kelaziman Usaha, PKKU). However, selecting a method alone is not enough. When the Transactional Net Margin Method (TNMM) is used, the next question is: which profit level indicator (PLI) is most appropriate to use?

This question becomes interesting in the Transfer Pricing dispute of PT YZN for the 2020 Fiscal Year. To test the affiliated transaction in the trading segment, both parties used TNMM. The difference lies not in the method, but primarily in how the PLI is viewed and used, particularly Gross Profit Margin (GPM) and Return on Sales (ROS).

This case offers one important lesson: GPM and ROS should not always be positioned as two mutually exclusive choices. Under certain conditions, the two can instead provide different perspectives on the same transaction.

2. Characteristics of the Transaction Being Tested

PT YZN operates in the communication equipment industry, including test and measurement, information technology, and communication systems. The company has two business segments, namely the services segment and the trading segment. During the audit, the affiliated transaction in the services segment was declared to satisfy the Arm's Length Principle and was therefore not the subject of the dispute. The dispute then focused on the affiliated transaction in the trading segment.

In determining the Transfer Pricing method for the trading segment, TNMM was selected as the most appropriate method. The Taxpayer then used two profit level indicators, namely Gross Profit Margin (GPM) and Return on Sales (ROS).

The selection of these two indicators offers a fairly interesting approach, because each looks at the company's performance at a different level.

Read Also: TNMM and the Selection of the Profit Level Indicator: The Urgency of GPM in Rescuing ROS

3. Understanding GPM and ROS

3.1 Gross Profit Margin (GPM)

GPM is the ratio between gross profit and sales. In this case, GPM is used to examine the size of the margin obtained by the company after taking into account the cost of goods sold.

Simply put:

GPM = Gross Profit ÷ Sales

In the context of the transaction being tested, the Taxpayer used GPM to examine the size of the margin obtained from the purchase of inventory from the affiliated party. Accordingly, GPM provides a focus that is relatively close to the purchase transaction and the cost of goods sold.

The question then becomes: if the company purchases goods from an affiliated party, does the purchase price produce a gross margin that is at arm's length compared to independent companies?

3.2 Return on Sales (ROS)

Unlike GPM, ROS looks at profit after taking into account operating expenses.

Simply put:

ROS = Operating Profit ÷ Sales

In this case, the Taxpayer used ROS to examine the company's performance after taking into account operating expenses. The Taxpayer also stated that operating expenses did not include any cost relating to transactions paid to the affiliated party.

Accordingly, ROS provides a broader perspective than GPM, because it does not stop at gross profit, but looks at the operating result after operating expenses.

4. The Nature of GPM and ROS in Evidentiary Terms

In understanding the nature of GPM and ROS, one question can be posed: “What do GPM and ROS actually measure?”

The difference between the two can be illustrated simply.

5. Benchmarking Results for GPM and ROS

The benchmarking results for GPM and ROS tell a different story.

In this case, the tax authority accepted four comparable companies and rejected one comparable company because it engaged in wholesale and service activities. The four comparable companies used were I Telecom Co., Ltd.; Kyoungnam Corporation; Promaster Technology Corporation; and Shingi C & S Co., Ltd.

The benchmarking results show that the GPM interquartile range is 5.55%–16.07% with a median of 7.18%, while the ROS interquartile range is 1.37%–2.10% with a median of 1.46%.

Meanwhile, the Taxpayer's actual GPM is 30.16%, while the Taxpayer's actual ROS is 1.73%.

Accordingly, the Taxpayer's GPM is far above the comparable GPM range, while the Taxpayer's ROS falls within the comparable ROS range.

From the Taxpayer's perspective, both indicators lead to a consistent conclusion that there is no indication of profit shifting through the purchase transaction from the affiliated party.

6. The Important Role of GPM in a TP Documentation Context

GPM in this case provides fairly direct information regarding the purchase transaction. The Taxpayer has a GPM of 30.16%, while the interquartile range of the comparable companies is only 5.55%–16.07%. This means that, after taking into account the cost of goods sold, the company still generates a relatively high gross margin compared to the comparable companies. This became the basis for the Taxpayer's argument that the purchase price from the affiliated party does not indicate any profit shifting.

In its considerations, the Tax Court also stated that, based on the profit level of the comparable data, the Taxpayer's GPM was above the arm's length range, so it could be concluded that the purchase from the affiliated party was made at an arm's length price level.

This consideration is important. In other words, in this case GPM was not merely a supporting figure, but became part of the Panel's consideration in assessing the arm's length nature of the purchase transaction.

Read Also: Transfer Pricing Compliance: When Documentation Becomes an Evidentiary Instrument

7. How ROS Became the Point of Dispute

If GPM already shows a high margin, why did a correction still occur? The answer lies in ROS.

In the Taxpayer's calculation, the operating profit of the trading segment was Rp678 million with an ROS of 1.73%. However, the tax authority did not take into account Other Income of Rp5.4 billion. As a result, operating profit became approximately negative Rp4.75 billion, and the ROS changed to -12.14%. Meanwhile, the ROS range of the comparable companies was 1.37%–2.10%, with a median of 1.46%.

Because the -12.14% ROS fell below that range, the tax authority concluded that the Taxpayer's profit level did not satisfy the Arm's Length Principle and used the median of 1.46% to determine the profit level deemed to be at arm's length. The correction was then attributed to the cost of goods sold, amounting to Rp5.3 billion.

Accordingly, the dispute was no longer merely about whether the ROS fell within or outside the arm's length range. The main issue became: was that -12.14% ROS the appropriate ROS to use in the testing?

Read Also: When Numbers Are Not Enough: An Evidentiary Analysis in Transfer Pricing Disputes

8. Other Income: The Figure That Changed the Conclusion

The difference between an ROS of 1.73% and -12.14% mainly stemmed from the treatment of Other Income amounting to Rp5.4 billion.

According to the Taxpayer, the Other Income was the result of a reclassification of expense accounts carried out during the financial statement audit process. Accordingly, if this line item is excluded from operating profit, then the impact of the expense account that gave rise to the reclassification should also be taken into account.

In other words, the issue of the PLI turns out to be inseparable from the quality and substance of the financial data used to calculate the PLI. Ultimately, a PLI will produce a relevant conclusion only if the figures used within it are also relevant to the transaction being tested.

9. TNMM: GPM or ROS

TNMM testing generally uses net operating profit as the basis for calculation, so that ROS, from this perspective, more accurately reflects TNMM as it should be applied.

However, the Taxpayer quite carefully mitigated risk from the outset, anticipating that the TP documentation would be audited by the relevant tax authority. The selection of more than one PLI is not regulated under the OECD Transfer Pricing Guidelines or the transfer pricing regulations applicable in Indonesia.

Rather than using only one PLI, namely ROS, the Taxpayer added another PLI, namely GPM, to demonstrate that the affiliated purchase transaction produced an arm's length gross margin. On the other hand, the Taxpayer emphasized that ROS relates to the company's operational performance after operating expenses (in its explanation, there were no related-party transactions within operating expenses). The Taxpayer also asserted to the Panel of Judges that PT YZN was functionally a fully-fledged distributor bearing full market risk, such that the 2020 operating profit was closely linked to market conditions under the influence of Covid-19.

In this case, a GPM of 30.16% shows that the Taxpayer's gross margin is above the comparable range, indicating an arm's length gross margin. Meanwhile, an ROS of 1.73% (based on the TP Documentation) and -12.14% (based on the audit) indicate a condition related to market circumstances, not merely profit shifting.

Accordingly, the two indicators actually provide complementary perspectives. Furthermore, the Tax Court also took into account the Taxpayer's GPM being above the arm's length range as a basis for concluding that the purchase from the affiliated party was made at an arm's length price level.

10. Conclusion

The PT YZN case shows that the selection of the Profit Level Indicator (PLI) in TNMM is not merely a choice between GPM and ROS, but must be based on an understanding of what each indicator measures and its relevance to the characteristics of the transaction being tested. In this case, TNMM was agreed upon as the appropriate method for the trading segment, with GPM used to assess the margin on inventory purchases and ROS used to measure performance after operating expenses. The Taxpayer's actual GPM of 30.16% was above the comparable range of 5.55%–16.07%, while the ROS of 1.73% fell within the comparable range of 1.37%–2.10%, with the difference in calculation mainly relating to the treatment of Other Income of Rp5.4 billion. The Tax Court then held that the Transfer Pricing correction of Rp5.3 billion could not be upheld because it was not supported by adequate evidence, while the Taxpayer was able to prove the arm's length nature of the transaction through its Transfer Pricing documentation. Accordingly, the selection of a PLI must not be based solely on the indicator that produces the most favorable conclusion for the Taxpayer, but must be explained economically, be consistent with functions and risks, and be supported by financial data, benchmarking, and documentation that can be traced. Ultimately, the quality of a Transfer Pricing analysis is determined not by how attractive the margin figures are, but by the strength of the relationship between the transaction, functions and risks, financial data, the PLI, benchmarking, and a conclusion of arm's length that is built comprehensively.