Berry Ratio- Transfer Pricing

I History:  
The ratio is named after Professor Charles Berry, the expert hired by the IRS in the 1979 DuPont case

II Basic  

The underlying assumption of  the Berry ratio is that there is a positive relationship between the level of operating expenses and the gross profit. The more operating expenses that a distributor incurs, the higher the level of gross profit that should be derived.

 Barry Ratio= Gross Profit/Operating expenses  

The markup imposed on operating expenses represents the only value added by the distributor’s function, excluding the cost of goods sold.  As spending can merely represent the value added by the distributor, the arm’s length remuneration should not be higher than the markup earned on operating expenses.  

III Function Asset & Risk Analysis  

The unrelated distributor may take more risks than the related entity performing similar functions. This is because the market, inventory and credit risks are, to a major extent, borne by the parent company. The related distributor acts on behalf of the parent company, which assumes the majority of the functions and risks. Having said this, it may also be that, in practice, the unrelated distributor bears more risks than the related distributors performing similar functions.    

IV Application of Barry Ratio  

 In principle, the Berry ratio reflects the low risk profile of a pure distribution function, as compared to that of other independent distributors.    The Berry ratio cannot be applied to an integrated distributor that performs different functions such as assembling or customizing, because the ratio will not be able to reflect the pure return on operating expenses.  

V Non-application  of   Berry Ratio for Manufacturers  

For manufacturing activities, it is often difficult to distinguish which expenses relate to which activities and in what proportions. Moreover, a manufacturer’s cost base normally consists not only of operating expenses but also the cost of goods sold. In this regard, a profitability measure based solely on reduced operating expenses does not seem to be the most reliable one. For manufacturing activities, in addition to a markup on costs, a check of the return on assets should also be performed.

 VI OECD view  

The OECD supports the possible use of the Berry ratio, which, as mentioned, is defined as the ratio of gross profit to operating expenses. Interest and extraneous income are generally excluded from the gross profit determination; depreciation and amortization may or may not be included in the operating expenses.  

Difficulty

One common difficulty in the determination of Berry ratio, according to the OECD, is that the Berry ratio is very sensitive to the classification of costs as operating expenses or not, and therefore can pose comparability issues.

Usefulness

A situation where the Berry ratio can prove useful, according to the OECD, is for intermediary activities where a taxpayer purchases goods from a related party and on-sells them to other related parties. In such cases, the resale price method may not be applicable, given the absence of uncontrolled sales, and a cost-plus method that would provide for a markup on the cost of goods sold might not be applicable either where the cost of goods sold consists of controlled purchases. By contrast, operating expenses in the case of an intermediary may be reasonably independent from transfer pricing considerations, unless they are materially affected by related-party costs such as head office charges, rental fees or royalties paid to a related party, so that a Berry ratio may be an appropriate indicator, subject to the comments above.