Supreme Court of Argentina rules on the application of the Transactional Net Margin Method.

The Supreme Court of Argentina decided on two crucial transfer pricing issues concerning the exclusion of extraordinary income while computing the profit level indicator and testing the results for the year under consideration only in the case of Volkswagen Argentina S. A.? (VWA) for 1999 to 2001. The decision was pronounced on 13.08.2024.

Facts of the case

The taxpayer (VWA) had undertaken transactions of purchase and export of vehicles and their components with related companies. VWA used the transactional net margin method (TNMM) and rate of return on capital employed (ROTC) as the profit indicator to demonstrate that its results were at arm's length.

To calculate its ROTC, VWA did not use the profit from the profit and loss account in its balance sheet for 2001 but made certain adjustments to the profit and loss account. Among these adjustments was the 'Financial Loan Forgiveness Adjustment', which included the income from the loan forgiveness in the operating results of the numerator of the ROTC. These adjustments resulted in an ROTC of 23.85%, which was above the market interquartile range based on the average ROTC of the comparables, which was between 4.18% (lower quartile) and 12.86% (upper quartile), with a median of 8.17%.

The VWA had determined the ROTC of the companies selected as comparables (hereinafter:? 'the comparables') based on an average of their last three adjusted operating margins (1998 to 2000) for comparison with its own ROTC, calculated based on an average of the years 1999 to 2001. The taxpayer used the average of three years of its results because the profitability of the 2001 period had been seriously affected by the economic crisis that led to the exit from convertibility in January 2002.

The Federal Administration of Public Revenues (AFIP) did not question the method used or profit indicator. Still, it noted that VWA included extraordinary results obtained from the cancellation of a loan made by its controlling entity in its operating results to calculate the ROTC. Further, it used an average of its ROTC for the financial years 1999 to 2001 instead of the ROTC for the financial year 2001, in which the transfer prices were determined. The ROTC, the profit level indicator, measures the ratio between profits (numerator) and assets employed (denominator). The AFIP adjusted the operating results by not accepting the taxpayer's position on the above two issues.

The National Tax Court revoked both the adjustments.

Regarding the first adjustment, the Court noted that the income generated by the loan forgiveness was applied by VWA to the cancellation of bank and financial loans, with the consequent reduction of the financial burden borne by the company, as well as to obtain funds which, for the most part, were used to finance the construction of a new manufacturing plant in the Province of Córdoba which started operating in 2002. It reasoned that these revenues had been used to expand the company's operating capacity and should, therefore, be considered part of the operating results to calculate the ROTC. Finally, it stated that VWA had not carried out a comparability analysis in its transfer pricing study with similarly situated independent companies and whether those comparables had similar transaction loan forgiveness did not alter its conclusion, as this was a factor unique to VWA.

Regarding the second issue of the use of an average of ROTC for the financial years to justify the operating results for the year 2001, the National Court noted that AFIP had accepted that VWA used the average ROTC for three years (1998 to 2000) only for the companies selected as comparables. It was considered inappropriate to use an average to establish the operating profit of the tested party, VWA, which had to use only the information for the year 2001 under examination. In this respect, the National Court argued that using multi-year data provided consistent and useful information to investigate the comparables' relevant business cycles and life cycles. It pointed out that the economic expert opinion had shown that the use of multi-year data responded to differences in the economic cycle of the automotive industry, with VWA having suffered a recession similar to that of various companies in the sector during that period.

The National Court of Appeal also disagreed with the AFIP and upheld the decision of the National Court.

The AFIP appealed to the Supreme Court.

Transfer Pricing Law and Regulation

Section 14 (3) of the income tax law in force at the time of the facts (t.o. by Decree 649/97, as amended by Law 25.239, B.O. 31 December 1999) provided that transactions between local parties and related entities abroad 'shall be considered, for all purposes, as entered into between independent parties when their terms and conditions conform to normal market practices between independent entities...', providing that '[w]hen such terms and conditions do not conform to market practices between independent entities, they shall be adjusted in accordance with the provisions of section 15.

Section 15 (3) provided that, for the purposes of determining the prices of transactions, 'the most appropriate methods shall be used in accordance with the type of transaction carried out', and the fifth paragraph provided that 'the methods of comparable prices between independent parties, of resale prices fixed between independent parties, of cost plus profit, of division of profits and net margin of the transaction, in the form and between the parties, shall be applied, in accordance with section? 15.

To determine the most appropriate transfer pricing method in accordance with the type of transaction carried out, Art. 21.2 of the regulatory Decree of the Income Tax Law then in force (t.o. by Decree 1344/1998, as amended by Decree 1037/2000, hereinafter 'Regulatory Decree') provided that 'the transactions analysed between which there are no differences affecting the price, the profit margin or the amount of the consideration... shall be considered comparable', with the elimination of such differences 'by virtue of adjustments that allow for a substantial degree of comparability', if possible. Specifically, the second paragraph of that article dealt with the aforementioned comparability adjustments by establishing that '[f]or the purposes of adjusting the aforementioned differences, those elements or circumstances that most closely reflect the economic reality of the transaction or transactions shall be taken into account, based on the use of the method best suited to the case', considering, among other elements and circumstances, the characteristics of the transactions, the functions performed and risks assumed, the contractual terms and the economic circumstances. The TNMM takes into consideration the "profit margin applicable to transactions between related parties that are determined for profits obtained by any of them in comparable uncontrolled transactions, or in comparable transactions between independent parties. For the purpose of establishing such margin, profitability factors such as returns on assets, sales, costs, expenses or cash flows may be considered' (cfr. 21.1, sub. e, of the Regulatory Decree).

Decision of the Supreme Court

Two issues for a decision by the Supreme Court were:

Whether the extraordinary result of $177,822,875.85 - obtained by VWA as a result of the loan forgiveness by its controlling company - should be included in the numerator of the ROTC profit indicator for the purpose of determining its transfer prices for the year 2001; and

?(ii) Whether VWA may use an average ROTC for 1999 to 2001 instead of the ROTC for 2001, which was the subject of the AFIP's ex officio determination.

Computation of ROTC

The AFIP argued that if VWA had not included in the numerator of the ROTC the extraordinary result of $177,822,875.85 generated by the loan waiver, its ROTC would have shown a net margin 'well below the lower limit' of the interquartile range established with the information of the comparables. In its view, this implied recognition that VWA's net profit from transactions with related parties abroad was lower than it would have been under arm's length conditions between independent parties. The AFIP determined a negative ROTC of 10.13% for VWA, which was below the interquartile range, located between 7.57% (lower quartile) and 12.40% (upper quartile), with a median of 8.98%. Accordingly, it adjusted VWA's operating profit to the median of the operating profit margins of the comparables minus 5%, i.e. a median of 8.53%

About the first question, the Court noted that, when replying on 4 August 2020 to the extraordinary appeal lodged by the AFIP, VWA reaffirmed that the 'adjustment for loan write-offs' made in its transfer pricing study was a 'comparability adjustment' with the 'purpose of homogenising the sample between the comparables and the sample tested' in order to 'ensure a genuine comparison'.

Comparability adjustments consist of eliminating differences between the transactions entered into by the tested party - in this case, VWA - and the comparables that affect the price, the profit margin or the amount of the consideration (cf. art. 21.1 of the regulatory Decree). The aim is to achieve a 'substantial degree of comparability' between the transactions being compared, and 'those elements or circumstances that most closely reflect the economic reality of the transaction(s)' must be 'taken into account' (cf. art. 21.2 of the Decree).

Based on these premises, the inclusion of an extraordinary result unrelated to the line of business for determining operating profit - such as that derived from the cancellation of a loan - represents an anomalous criterion that distorts the comparability analysis. Indeed, internationally accepted accounting standards provide that financial returns are set out in the income statement after 'gross profit' (sales - cost of goods sold) and 'operating profit' (gross profit - administrative and marketing expenses) to arrive at the final result for the year. This was also the approach which VWA itself adopted in drawing up its profit and loss account for the year ended 31 December 2001, when setting out the item 'Loan waiver - Volkswagen AG' for 177 822 875.85 in a single line item, outside its operating result and below the net loss for the year. This criterion was also corroborated by the experts in the accounting report produced in the proceedings when they pointed out that VWA included the result of the write-off in the last line of its statement of income for 2001 after calculating the net loss for the year and outside the operating result, to arrive at the final result.

The change in the criterion for disclosing the loan waiver result in VWA's transfer pricing study to 'operating' profit is clearly a mere accounting reclassification. The effect was to increase the ROTC numerator with a corresponding increase in its net profit margin, putting the company above the interquartile range.

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Since it was not a 'comparability adjustment' - as wrongly held by the Tax Court and the Chamber - such accounting reclassification did not have - and could never have had - the objective of increasing the degree of comparability of the transactions analysed.

As stated above, a comparability adjustment is made to eliminate existing differences with the comparables, not to create them, which is precisely what caused the reclassification of the income generated by the loan forgiveness because none of the comparables made such a reclassification. In this regard, the AFIP is right when it argues in its determination that 'no difference has been detected in the Standards for the disclosure of the results of all the comparable companies (including the one analysed), which would make it necessary to make the reclassification made by Volkswagen since such reclassification undermines the comparability of the determination of the Result of the Transactions analysed'.

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It should be noted that VWA itself acknowledged that the adjustment under examination was not a comparability adjustment. Indeed, to ascertain whether the prices of the transactions entered into by VWA with its related companies had been in line with normal market practice between independent parties, AFIP carried out a comparability analysis which included an examination of the companies selected as comparables, as well as of the 'comparability adjustments' made by VWA to determine its own ROTC. Regarding the latter, AFIP found that VWA had not conducted a comparability study with the independent companies selected as comparables to determine whether they also had any financial loan waivers and included them in their operating results.

When the AFIP asked VWA for a comparability analysis of the adjustments made for financial loans, VWA replied that 'although this concept was mentioned as an adjustment in the Transfer Pricing Study for 2001, it corresponds to a reclassification of the income generated by the forgiveness -of financial loans- received by VWA from its parent company, due to the difficult economic and financial situation of the company, caused by the recession in the local market and the exchange rate disparity with Brazil'. This acknowledgement that it was not a comparability adjustment reaffirms the conclusion that the accounting reclassification made should not have influenced the assessment of whether VWA's operating profit margin was within the market margin.

Use of Average profits for 1999 to 2001

Article 29, paragraph e, last paragraph, of the regulatory Decree of the Income Tax Law (t.o. by decree 862/2019) establishes that '[t]he profit to be compared shall be the net profit before financial expenses and income tax, without considering extraordinary results'. For its part, art. 33 of the regulatory decree establishes in its second and third paragraphs that "[i]n order to carry out comparability, data from comparables covering more than one period may be taken when the type of business or market conditions so justify. The information corresponding to the assessed party must always be that of the tax period under analysis.

According to these rules, VWA had to limit the calculation of its own ROTC to the result and assets of the tax year 2001 - taking them as numerator and denominator, respectively - since the company determined the transfer prices in respect of transactions occurring in that tax period. The examination as to whether the prices and considerations of such transactions are in accordance with normal market practices between independent parties must take as exclusive reference the same tax year to which the tested party is subject to taxation, as the methodology is in line with the procedure to determine the income tax.

Using multi-year information for comparability purposes is very different from allowing the tested party -as the Tax Court and the Chamber did- to use its own information for statistical purposes in order to justify that its average ROTC is within the inter-quartile range and, therefore, exempt from any transfer pricing adjustment.

To conclude, the Court noted that the exclusion of extraordinary results in the application of the TNMM responds to the need for that method to take into account various 'profitability factors' to determine the net profit to be compared (cf. 21.1(e) of the regulatory Decree in force at the time of the facts). Such factors can only relate to the ordinary business activity of the tested party, which is why - for the purposes of comparability - they require the segregation of exceptional and non-recurring results, such as those resulting from the cancellation of a loan. Similarly, in the absence of an express legal provision exempting the tested party from the general rules for the determination and imputation of the net taxable profit, the only possibility to use multi-year information is in relation to comparables and to the extent that this contributes to the purpose of improving the comparability of transactions. This purpose does not apply to the tested party, which knows precisely the extraordinary events that influenced the normal determination of its results and can, therefore, exclude them without resorting to the average results of previous years.

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