Nestle Portugal: Issues with Comparables' Royalty Bases

Portugal’s Southern Administrative Appeals Court decided in favor of the taxpayer on March 15, 2023 in Nestlé Portugal S.A. v. Fazenda Pública (762/09.0BESNT). This litigation raised an oft-seen issue as what is meant by “sales” for transfer pricing approaches that rely on the Comparable Uncontrolled Transaction (CUT) where the royalty rate is set as a certain percentage of sales.

Nestlé Portugal paid its Swiss parent royalties equal to 5% of sales income, calculated as gross sales proceeds minus “rebates (other than periodic allowances, temporary price promotions, consumer price promotions, trade price promotions, and other similar expenses); returns accepted by licensee on account of spoilage, breakage, or other damage rendering the relevant products unmarketable; and sales taxes. The Portuguese tax authority re-defined sales income as gross sales minus all of the deductions from gross sales including periodic allowances, temporary price promotions, consumer price promotions, trade price promotions, and other similar expenses. For the year 2004, this redefinition of the sales base lowered intercompany royalties by €780 thousand.

Table 1 considers a European licensee with gross sales = €265 million per year and net sales = €250 million per year. Its intercompany policy is to for the licensee to pay its related party licensor royalties = 5% of gross sales or €13.25 million. If the tax authority insisted royalties should be only 5% of net sales, the newly calculated royalty payment would fall to only €12 million.

Table 1: Gross sales versus net sales (in Millions)

If we interpreted the appropriate transfer pricing policy as what Table 1's Revised Policy, then the effective royalty rate would be 5.3% of net sales resulting in €13.25 million in intercompany royalty rates. The question is whether there is a reasonable defense for this modest increase in the effective royalty rate. Any analyst that relied on the CUT approach should carefully review the terms of the third-party agreements that were used to justify the original royalty rate. Were they based on gross sales or net sales? If these agreements were also stated in gross sales, what would be their effective royalty rates if the agreement were restated in terms of net sales?

We should also note that the operations of Nestlé are generally very profitable. While we do not know the operating margin for Nestlé Portugal, a profits based approach would likely suggest that setting intercompany royalties equal to 5.3% of net sales is not unreasonable.

Table 2 illustrates a different tendency where intercompany royalty rates are stated in terms of a percentage of the the manufacturing affiliate's income from intercompany sales to distribution affiliates. Consider a U.S. parent that licenses its technology to a Hungarian manufacturing affiliate. The manufacturing affiliate sells finished products to European distribution affiliates. One intercompany policy is to set the intercompany price from the manufacturing affiliate to the distribution affiliates such that the distribution affiliates reasonably receive a 20% gross margin. European sales = €250 million, which implies that the Hungarian affiliate receives €200 million in intercompany manufacturing sales. The formal intercompany policy has the Hungarian affiliate pay intercompany royalties to the U.S. parent = 5% of sales. Since the cost base is manufacturing sales, intercompany royalties = €10 million.

Table 2: Net sales versus manufacturer sales (in Millions)

The IRS could argue that the sales base be customer sales or €250 million. If this sales base is used with a 5% royalty rate, intercompany royalties would be €12,5 million. The multinational could revise it policy such that a 4% royalty rate is applied to the customer sales base, which would result in €4 million in intercompany payments.

The question is whether there is a reasonable defense for this decrease in the effective royalty rate. Any analyst that relied on the CUT approach should carefully review the terms of the third-party agreements that were used to justify the original royalty rate. Were they based on sales to distributors or to end-users? If these agreements were also stated in manufacturer sales, what would be their effective royalty rates if the agreement were restated in terms of net sales?

References

"Nestlé Portugal S.A. v. Fazenda Pública, 762/09.0BESNT (Original Language)

"Nestlé Portugal S.A. v. Fazenda Pública, 762/09.0BESNT, TPcases.com (English Translation)