OVERVIEW
The recent Italian Supreme Court ruling No. 26432 of October 10th, 2024, held that, when sales are made to an affiliated entity acting as a limited-risk distributor, TNMM is preferable to CUP method.
The case
The case concerns the 2008 fiscal year, during which the Italian-based parent company, engaged in the manufacturing of industrial machinery, sold finished products to its foreign affiliates.
The non-resident entities operated as Limited Risk Distributors (LRDs), purchasing the products based on orders.
In compliance with the 1995 OECD Guidelines, which were in effect during the fiscal audit year, the taxpayer adhered to the hierarchy of methods and adopted the CUP method for the transfer pricing analysis.
During the audit, the Italian Revenue Agency revised this analysis, applying TNMM as the more appropriate method for the purpose of the assessment.
The justification lies in the fact that, in this case, the net margin provides a more accurate indicator than the price itself, as the latter, in a low-risk intragroup sale of goods, cannot reliably be compared to the arm’s length price.
The ruling
The Court, stating that the OECD Guidelines do not form part of the hierarchy of legal sources but instead provide technical assistance and a framework, sided with the Tax Office.
According to the Court, it is the interpreter’s responsibility to identify the most appropriate technical standard, in this case, the transfer pricing method, that best fits the specific case at hand.
The Supreme Court therefore considers it correct to apply the most appropriate method rather than strictly follow the hierarchy of methods as set out in the OECD Guidelines in effect during the relevant fiscal period.
In the case of a product sale by a manufacturing entity to an affiliated company operating as an LRD and thus under low-risk conditions, the Court found that the net margin is considered a more suitable indicator than the price.
Hence, the use of TNMM is preferred over CUP method.
Impact on transfer pricing
The Supreme Court ruling is consistent with the guidance provided in the 2010 and following versions of the OECD Guidelines regarding the selection of the most appropriate transfer pricing method for assessing the arm’s length principle.
It is therefore necessary, in cases of product sales to entities operating as limited-risk distributors, to evaluate the appropriateness of the TNMM method and the net margin as a suitable indicator to assess the arm’s length principle. In such cases, even when the CUP method is available, the comparable price method would not be the most appropriate approach.
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