Application of the Berry Ratio in Transfer Pricing Analyses
As Berry points out in his article,20 the key insight to be drawn from the DuPont case is that the Berry ratio is merely a variant of the cost-plus method. Indeed, if one were to think of the gross margins earned by a distributor as analogous to a firm's total revenues available to a distributor, and the operating expenses incurred to distribute products as analogous to the firm's total costs, then the ratio of gross margin to operating expenses would capture the markup on operating expenses that is afforded to the distributor. Conceptually, the Berry ratio represents a return on a company's value added functions and assumes that those functions are captured in its operating expenses.21 In other words, the Berry ratio can be a useful measure of the markup earned on a distributor's distribution activities. In that context, it may be useful to further deconstruct the Berry ratio to understand the implications of its use in specific situations.
When evaluating distributors, given that the ratio has gross profit in the numerator and operating expenses in the denominator, a profitable distributor would invariably show a Berry ratio greater than one, if shown in units, or 100 percent, if shown in percentage. If that is not the case and the Berry ratio is less than one unit or 100 percent, as the case may be, there may be some evidence of excessive operating expenses that need to be curtailed in the long run. In essence, any distributor or service provider with a Berry ratio of less than one unit or 100 percent cannot sustain its operations indefinitely.
As mentioned previously, the Berry ratio also can be applied to service providers, as it can also be conceptualized as the markup earned on the costs of provision. To better understand that relationship, it may be prudent to reduce the Berry ratio in terms of operating profit by subtracting one from the Berry ratio expressed in unit terms as follows:
Berry ratio - 1 = GP/OE - 1
= (GP-OE)/OE
= OP/OE
wherein GP = gross profit; OP = operating profit; and OE =
operating expenses.
The above result -- the ratio of operating profit to operating expense -- is merely an alternative way to conceptualize the Berry ratio as the markup on operating expenses, and is analogous to the ROTC used for service providers. That is best illustrated by deconstructing the ROTC as follows:
ROTC = OP/TC ROTC = OP/(COGS+OE) wherein COGS = cost of goods sold.
In the above ratio, the COGS generally can be excluded from the cost base in the denominator, because for distributors COGS indicates the measure of the value of the product distributed, rather than the costs incurred for distribution. In the case of service providers, unlike manufacturers, the COGS may not even be applicable, or may relate to costs other than service provision. In that event, the ratio becomes analogous to the ratio of operating profit to operating expenses, or the markup on operating expenses alone. Therefore, for service providers, assuming that the COGS = 0, ROTC = OP/OE.
Therefore, as illustrated in the above formulae, the Berry ratio can be applied to both distributors and service providers, as long as the cost categories are demarcated and classified appropriately. In fact, transfer pricing economists with the U.S. IRS and other OECD member tax administrations, such as the CRA, have routinely begun applying the Berry ratio to test the margins of distributors as well as service providers, and to conclude APAs with taxpayers.22
Revisiting the Misuses of the Berry Ratio
Although the Berry ratio is a conceptually simple profitability measure, it is probably one of the most misused ratios in the context of transfer pricing analyses. Its misuse stems primarily from the failure to understand its limitations when evaluating different types of entities. On a fundamental level, the Berry ratio relies on the fact that there is some consistency between the level of gross margins and operating expenses (that is, the greater the operating expenses, the greater the gross profit needs to be to sustain a similar level of operating profit). Nonetheless, that consistency can be expected only if the operating expenses capture all of the value added of the functions performed by the distributor. In other words, the Berry ratio simply captures the markup that should be earned on operating expenses, assuming that those expenses reflect all of the value added by a distributor.
For that precise reason, the Berry ratio cannot be applied to integrated distributors (that is, distributors that also perform manufacturing functions), as the Berry ratio would not be able to capture the additional return earned by the manufacturing functions. In addition, when integrated distributors are concerned, given the accounting conventions and flexibility of classifying costs between the costs of goods sold and operating expenses, the cost base used in the Berry ratio (the operating expenses) also may contain costs related to manufacturing, which is certainly a perversion of the original intent of the Berry ratio.
Therefore, when applying the Berry ratio to evaluate distributors, care should be taken to apply the ratio only to distributors that perform only routine distribution functions, and do not engage in any additional value-added assembly or manufacturing functions. Needless to say, that limitation must be kept in mind when considering both the tested party and the third-party comparables to ensure that functionally similar entities are being compared. In essence, the Berry ratio is best applied to test routine distributors, and only when there is a high degree of functional comparability between the tested party and the third-party comparable companies.
In that context, it may be worthwhile to point out that the application of the Berry ratio is not without its problems. For example, many empirical studies have shown that distributors with exceptionally low operating expense intensity (that is, operating expenses relative to sales ratios that are less than 10 percent to 15 percent) show inordinately high Berry ratios when compared with distributors with higher operating expense intensities.23 Therefore, considerable caution should be exercised when comparing the Berry ratios of distributors with low operating expense intensities and distributors with higher operating expense intensities. That problem can be corrected, however, by ensuring that only distributors that incur similar selling, general, and administrative expense-to-sales ratios as the tested party are used to develop the arm's-length range of Berry ratios (operating expense intensity screen). That would effectively ensure that any distortions to the Berry ratio analysis caused by radical differences in operating expense intensities among the comparable distributors and between the comparable distributors and the tested party are minimized. Nonetheless, it is also necessary to ensure, to the extent possible, that functional and product comparability is not sacrificed in favor of implementing an operating expense intensity screen, because ignoring the degree of functional or product comparability between the tested party and third-party comparables also could derail the spirit of the analysis.
Application of the Berry Ratio -- Some Practical Insights
In the authors' experience, the Berry ratio is rarely, if ever, applied in isolation to test routine distributors, especially in the OECD countries. In many cases in which the United States and another OECD jurisdiction are involved, taxpayers often use the "modified" resale price or cost-plus methods to test distributor or service provider margins, respectively, and to corroborate their analysis using the CPM or TNMM, as the case warrants. For example, when transactional data is unavailable for analysis, the OECD guidelines provide the option of using "modified" methods, which use external, potentially comparable companies. The analysis is performed on their aggregate-level data in a manner that is quite similar to the application of the CPM or TNMM.
Specifically, paragraph 3.2 of the OECD guidelines states: "The only profit methods that satisfy the arm's length principle are those that are consistent with the [profit-split method] or the transactional net margin method as described in these Guidelines. . . . In particular, the so-called 'comparable profits methods' or 'modified cost plus/resale price methods' are acceptable only to the extent that they are consistent with these Guidelines."
Therefore, as an example, a tested-party distributor's gross margins first may be evaluated using the "modified" resale price method by deriving the arm's-length range of gross margins of a set of comparable distributors. Subsequently, the TNMM or CPM is applied to compare the Berry ratio and ROS ratios of those comparable distributors with the tested party's Berry ratio and ROS results to corroborate the earlier gross margin analysis. Given the lack of explicit guidance in most OECD countries as to which profit indicators to use in specific cases, performing such corroboratory analyses using multiple PLIs may perhaps be the best approach to ensure that taxpayers' analyses withstand the scrutiny of the various tax administrations.
Conclusion
In sum, PLIs applied in the context of transfer pricing analyses using profit-based methods in the United States or the OECD in general should be chosen with particular reference to the economic rationale underlying their application, and with a clear understanding of the specific facts and circumstances of the related-party transaction being examined. That is especially true when applying PLIs such as the Berry ratio that require an examination of not only the type of functions performed by a distributor or service provider, but also the level of intensity at which those functions are performed. When applying such a PLI, it is also quite important to understand its limitations (which in the case of the Berry ratio is the fact that it categorically cannot be applied to distributors who perform value-added manufacturing or assembly functions).
Furthermore, it is imperative that taxpayers and practitioners carefully evaluate the type of entities chosen as third-party comparables to determine whether the PLI being used may be distorted by issues such as operating expense intensity, asset intensity, or account classification issues. In that context, it is also advisable to keep in mind that whenever possible, taxpayers should use more than one PLI to corroborate their transfer pricing analyses, especially if doing so will strengthen the results of the primary analyses. That may be especially prudent when performing transfer pricing analyses in non-U.S. jurisdictions, as profit-based methods, including the TNMM, are looked at with some disdain by many tax administrations within the OECD.
Although tax administrations may wish otherwise, taxpayers do have some leeway in their choice of methods and profit indicators to prove the arm's-length nature of their related-party transactions, although that leeway is limited, of course, by the constraints of data availability and the reliability of the data that is available. Nonetheless, such leeway should not be interpreted as carte blanche to apply transfer pricing methods, and especially PLIs, in situations where they may not be economically justified or applicable. When in doubt, taxpayers would be well advised to consider the economic fundamentals that may have motivated their choice of PLIs. Ultimately, transfer pricing is more art than science, more judgment than precision, and the final objective of any transfer pricing analysis is to prove the arm's-length principle.
To quote Berry himself, "If we are to be consistent, the ultimate test is the arm's length test, and not the existence of a necessarily incomplete example or some arbitrary rule that gives a mistaken aura of precision to what is inherently an inexact and highly judgmental process."24
FOOTNOTES
1 Organization for Economic Cooperation and Development, "Transfer Pricing and Multinational Enterprises -- Report of the OECD Committee on Fiscal Affairs," 1979 (Paris: OECD).
2 U.S. Treas. reg. sections 1.482-1 through -8.
3 Organization for Economic Cooperation and Development, "Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations," (Discussion Draft) June 1994 (Paris: OECD).
4 Organization for Economic Cooperation and Development "Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations," 1995 (Paris: OECD), hereinafter referred to as the OECD guidelines.
5 OECD guidelines, section B, para. 3.26.
6 U.S. Treas. reg. section 1.482-5.
7 Operating profit is defined as profit from the relevant operating activities before interest, tax, and extraordinary items. Operating assets can be defined in a variety of ways, including but not limited to: capital employed, which is defined as total assets less excess cash and investments in subsidiaries; gross assets; gross assets minus current liabilities; assets minus liabilities; and so forth.
8 APA Study Guide, p. 14, available as of Nov. 4, 2005, at http://www.irs.gov/pub/irs-apa/apa_study_guide.pdf.
9 Id.
10 OECD guidelines, para. 3.27: "The net margins also may be more tolerant to some functional differences between the controlled and uncontrolled transactions than gross profit margins."
11 Operating profit is defined as above.
12 Operating profit is defined as above. Total cost is defined as the cost of sales plus operating expenses.
13 Gross profit is defined as sales less the cost of sales. Operating expenses are defined as expenses related to business operations other than the cost of sales, interest, taxes, and extraordinary items.
14 E.I. DuPont de Nemours & Co. v. United States, 608 F.2d 445 (Ct. Cl. 1979).
15 Id., p. 16.
16 Id., pp. 16-17.
17 Id., p. 17.
18 Contrary to the U.S. Treasury regulations, which define operating expenses as including "a reasonable allowance for amortization and depreciation" (Treas. reg. section 1.482-5(d)), Berry's preference is to exclude depreciation from operating expenses altogether because of the inherent arbitrariness in determining what might constitute this reasonable allowance.
19 Id., p. 18.
20 Charles H. Berry, "Berry Ratios: Their Use and Misuse," Journal of Global Transfer Pricing, April-May 1999, reprinted by CCH Inc.
21 APA Study Guide, p. 16, available as of Nov. 4, 2005, at http://www.irs.gov/pub/irs-apa/apa_study_guide.pdf.
22 An APA is an arrangement between a taxpayer and a tax administration that confirms the appropriate transfer pricing method to establish an arm's-length price for transactions between related parties. The U.S. IRS has been concluding APAs using the Berry ratio for some time now, and the CRA recently completed one APA using the Berry ratio, with two more in progress. See the CRA's 2003-2004 APA Report, released by the Competent Authority Services Division, International Tax Directorate, Compliance Programs Branch, for additional details.
23 APA Study Guide, p. 16, available as of Nov. 4, 2005, at http://www.irs.gov/pub/irs-apa/apa_study_guide.pdf.
24 Charles H. Berry, "Berry Ratios: Their Use and Misuse," supra note 20, p. 23.
