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How to scope the Intercompany Agreements you need for Transfer Pricing Compliance

Not another rebranding fail

TP Advisers: How long is long enough?

LCN Legal appoints new partner to support growth

New vacancies at LCN Legal: Senior paralegals / junior lawyers

Ugly cousins and Rube Goldberg machines in Transfer Pricing

Coca-Cola: Contractual terms vs economic substance

OECD Guidance on the TP Implications of Covid – A legal perspective

New Collaboration: LCN Legal and EXA Operational Transfer Pricing

TP functions vs legal transactions

Price setting vs outcome testing in Germany and Poland

The two types of profit split arrangements in transfer pricing

Video Interview: Update on HMRC's Profit Diversion Compliance Facility

Winners: Excellence in International Legal Services

Preparing for Transfer Pricing Audits: Bayer’s Battle with the Canadian Revenue Agency

Building something that stands up

Where's your allotment?

China Handbags Case Study 14.2 and the Abuse of the Deductive Value Method

Case study on TP and customs compliance: impact of alternative payment flows and the treatment of advertising costs

Do you have a protocol for handling TP audits?

How to scope the Intercompany Agreements you need for Transfer Pricing Compliance

Accurately scoping out intercompany transactions is the essential first step in creating, reviewing or updating intercompany agreements for TP compliance. Unless this is done correctly, the resulting agreements are likely to be gibberish, and your TP objectives may fail for lack of legal implementation.

The need for alignment between intercompany agreements and TP analysis of risk has been reiterated by recent IRS guidance addressing perceived defects in transfer pricing documentation (See the answer to Q4 of the FAQs, “Risk analysis should be consistent with intercompany agreements”).

Sometimes it’s obvious what the legal nature of the transaction should be, and who the parties are. For example, central support services provided by a parent to its operating subsidiaries.

Sometimes it’s not so obvious. For example, profit split arrangements or procurement hubs.

We’ve created a new 15-minute video to help you cover the basics of scoping.

Not another rebranding fail

Corporate rebranding projects can be tricky. If you want a laugh, have a look at this short article listing 15 rebranding failures, including some shocking ones such as MasterCard and Gap:


So why are we rebranding?
We’ve come a long way since we first started in 2013. We now do more business in 2 weeks than we did in the whole of our first year. (Which sounds more impressive than it actually is – we started slow!)

We’ve also got a lot clearer about where we’re most needed – which is bridging the gap between ‘tax’ and ‘legal’, and helping multinational groups to maintain structures which give them genuine substance for tax and transfer pricing purposes. Obviously, those structures also need work from a legal and practical point of view, which is where our background as commercial lawyers comes in.

Within that space, we’ve helped multinational groups with a total revenue of more than US$ 130 billion. Most of those groups are not headquartered in the UK – they’re in places like the US, Switzerland, Dubai and Australia.

Recent developments such as the US Tax Court decision in Coca-Cola have highlighted what everyone already knew, but many were turning a blind eye to: adopting TP policies but forgetting to implement them was never a good idea, nor were ‘fake’ agreements which made no commercial sense, nor intercompany transactions which had not even been communicated to legal entity directors, let alone approved by them.

This has all meant that our focus has had to change, and our core offering is now providing outsourced maintenance of intercompany agreements and related structures, as opposed to ad hoc advice. (See our flyer here.)

Anyone who has followed us from the beginning will know that our business also serves the property market, including property joint ventures, funds and SPVs. As part of our rebranding, we’ve decided to separate that out into its own website, so that it can run its own course.

How did we come to choose the new logo for our ‘main’ business serving multinational groups?
The dots around the ‘L’ in ‘LCN’ symbolise the different stakeholders for each multinational group which is the heart and central focus of business. Although we are admittedly very smart when it comes to legal matters, we’re not the source of all knowledge. The legal architecture of a multinational group needs to reconcile potentially conflicting needs – including regulatory, tax, customs, asset protection, sales and so on. A cross-functional, collaborative approach is essential for making this work.

You can see our new website in all its glory here.
Finally, we would like to say thank you to everyone who has supported us on our way, and to you in particular, if you’ve bothered to read this far. As you may have gathered, we’re passionate about providing the best possible support for our communities, and to expanding our awareness of whether we need to improve our knowledge. Now, more than ever, we are extremely grateful for your support, and for holding us to account as we continue to improve.

TP Advisers: How long is long enough?

This is a sensitive subject for many TP advisers.
How long is long enough?
Of course, I’m talking about the duration of intercompany agreements.
Only this week, a Big Four TP adviser suggested that a 6 month notice period was ‘impracticably long’.
Maybe that individual hadn’t read the OECD Guidance on the TP aspects of Covid, which references a 5 year agreement, and how an agreement can ‘play out’ in terms of pricing and risk. The guidance also emphasises the need to consider periodically whether the terms of agreements need to be renegotiated.
Imagine you’re setting up an advisory business. You’re hiring staff and leasing premises. You’ve got just one client, which has agreed to pay fees which gives you a modest return on costs. The catch is that the client insists on a one month break clause.
How would you feel about that as a director? As the person on the hook for meeting payroll?
The inconvenient truth is that the length of notice periods does matter. Because it’s a fundamental commercial term.
We’re not saying that groups should overcomplicate things. Or create unnecessary admin.
We are saying that the legal implementation of TP needs to make commercial sense, and needs to respect the duties of legal entity directors.
And sometimes longer is better.

LCN Legal appoints new partner to support growth

LCN Legal, the niche law firm specialising in the legal implementation and maintenance of corporate structures and intercompany agreements for multinational groups, has appointed a new partner from within its ranks.
Ivan Hanna, who joined the firm in 2016 following a legal career including Baker & McKenzie, with posts in London, Moscow and Amsterdam, Accenture and The Phoenix Group (the UK’s largest life insurance consolidator), became a partner as of 1st February 2021.
A fast growing and award-winning boutique law firm headquartered in London, LCN Legal is recognised internationally as pioneers in the legal design of group structures for multinational organisations. The firm was the winner of the Law Society’s 2020 ‘Excellence in International Legal Services’ award.
Ivan’s corporate, M&A, restructuring and related legal experience have proven invaluable to the firm’s clients and colleagues alike. In recent years, he has focused on international corporate structures and, in particular, Intercompany Agreements which multinational corporates need for their legal and Transfer Pricing compliance. Together with Paul Sutton and Leiza Bladd-Symms, Ivan forms part of the senior legal team which spearheads LCN Legal’s practice in creating legal substance for Transfer Pricing compliance.
Xiaofang Sutton, CEO and Co-Founder of LCN Legal, said: “Ivan’s partnership reflects the invaluable contribution he has already made to the growth of LCN, and his dedication to the future expansion of our firm. His positivity and passion are a true asset, and we are excited to embark on the next stage of our firm’s journey together.”
Commenting on his appointment Ivan added: “It is a great honour to be part of the award-winning team and assisting multinational groups with their corporate and supply chain structures.
“It is also a pleasure to be part of an outstanding international community of clients and professional advisers. I cannot thank the key players in this community enough for their support and collaboration over the years in assisting our mutual clients globally in every step of their growth and I look forward to what will undoubtedly be a bright future of continued collaboration and innovation together.”
Since its establishment in 2013, LCN Legal has advised multinational groups, with combined annual revenues of over USD 130 billion, on their Intercompany agreements and group structures. The firm works alongside leading tax and transfer pricing professionals across five continents, helping large corporates to maintain the legal structures they need.

New vacancies at LCN Legal: Senior paralegals / junior lawyers

LCN Legal is seeking two highly experienced paralegals or junior solicitors / lawyers to join our dynamic and ambitious team.
Following a period of training and oversight, the successful applicants will be responsible for, among other things:

Experience with international group structures (and, for one of the vacancies, property investment structures) would be an advantage but is not essential.
More important is the ability to demonstrate a strong work ethic, a proactive sense of initiative including when working remotely, and a genuine interest in working with our team.
Each successful candidate will work primarily with one of our senior lawyers, but will also support the wider team.
About LCN Legal
LCN Legal is a fast growing and award-winning boutique law firm, recognized internationally as leading the way in the legal design of group structures for multinational groups. With a general focus on corporate and investment structures, we concentrate primarily on:

Competencies needed

Remote working and the need to be flexible regarding working hours
All of LCN Legal’s staff work remotely, and this was the case even before Covid-19. Successful candidates must therefore be able to provide a suitable home office environment. Once Covid-19 restrictions allow, we meet as a team at least once per month and we have regular weekly (or, at times, daily) client project and leadership video calls.
Because much of our work is for clients based outside of Europe, we often need to be flexible when arranging the times for calls with clients. The USA and the Americas is our fastest-growing market, and so this flexibility may mean working later in the day. We also provide a significant amount of support for clients and advisers in the APAC region.
What we offer
For the right candidates, we offer a welcoming team environment including:

How to apply
If you would like to apply for either of these positions, please email us at info@lcnlegal.com.
Please make the subject line of your email “Application: senior paralegal / junior solicitor”.
Please briefly explain in your email who you are and why you are interested in a position with us.
And please attach your CV in the form of a PDF document. Your CV should be no more than 2 pages in 11 point text.
We look forward to hearing from you. We’ll do our best to acknowledge all applications within 7 days.
No agencies please.

Ugly cousins and Rube Goldberg machines in Transfer Pricing

Do you have any ‘ugly cousins’ in your group legal structure?
I hasten to say that none of my actual cousins are ugly.
But in the legal world of multinational groups, ‘ugly cousins’ are common.
Coca-Cola is a prime example. The Court said the group’s intercompany agreements were ‘outmoded’ and ‘inconsistent with their actual behavior’. Some agreements contained ‘no discussion of payment whatever’. Other pricing clauses bore no relationship to the charges actually applied. Most significantly, the agreements contradicted the claimed ownership of intangibles.
The court likened the TP analysis claimed by the company to a ‘Rube Goldberg machine’ (pictured).
It’s unfair to judge actions in 2007 according to 2021 standards. It was probably just a matter of ‘we’ll sort it out next year when we have time’. We all procrastinate.
At LCN Legal, we don’t claim to be the answer to all your TP problems.
But we can take one thing off your shoulders: keep your legal structure updated so that it matches your TP.
It’s like maintaining a property. We check alignment and coverage of agreements. We liaise with your team on a periodic basis to identify changes. And we fix issues as needed.
The result: a maintained, tax-audit-ready archive of signed agreements.
With no ugly cousins.

Coca-Cola: Contractual terms vs economic substance

In transfer pricing analysis, which prevails: the contractual terms of a related party transaction, or the economic substance?
The general view expressed by many TP professionals is that economic analysis is king.
The Court’s decision in the recent Coca-Cola case shows that this view is at best simplistic – and for practical purposes as a guide to compliance, wrong.
As you’re probably aware, one of the central issues in the case related to the taxpayer’s assertion that valuable intellectual property (including marketing intangibles) was owned by the local ‘supply points’ rather than the ‘HQ’. The ‘supply points’ in question engaged in the manufacture and distribution of concentrate, which was supplied to separate ‘bottlers’. The bottlers produced and distributed the actual beverages.
The intercompany agreements in place during the relevant period (2007 to 2009) were (to put it mildly) unsupportive of the taxpayer’s position regarding the ownership of IP and marketing intangibles. The Court made extensive comments on the legal analysis, including the following:

“The parties often did not spell out the details of their relationships in formal contracts but left these details to be governed by mutual understanding. In some cases, System participants operated under outmoded contracts that included terms inconsistent with their actual behavior.” (p 41)

“Although [The Coca-Cola Co. or ‘TCCC’] used the 10-50-50 method to compute royalties payable by the supply points, it never incorporated any aspect of that formula into its written supply point agreements. Agreements with the Chilean and Costa Rican supply points included no discussion of payment whatever. … It does not appear that TCCC or the supply points paid much if any attention to these remuneration clauses.” (pp 47, 48)

In relation to the taxpayer’s assertion that marketing intangibles were owned by the local ‘supply points’ rather than the ‘HQ’, the Court said this:

“[P]etitioner owned virtually all the intangible assets needed to produce and sell the Company’s beverages. Petitioner was the registered owner of virtually all trademarks covering the Coca-Cola, Fanta, and Sprite brands and of the most valuable trademarks covering the Company’s other products. Petitioner was the registered owner of nearly all of the Company’s patents, including patents covering aesthetic designs, packaging materials, beverage ingredients, and production processes. Petitioner owned all rights to the Company’s secret formulas and proprietary manufacturing protocols. Petitioner owned all intangible property resulting from the Company’s R&D concerning new products, ingredients, and packaging. Petitioner was the counterparty to all bottler agreements, giving it ultimate control over the distribution system for the Company’s beverages. And most ServCo agreements executed after 2003 explicitly provided that “any marketing concepts developed by third party vendors are the property of Export,” thus cementing petitioner’s ownership of marketing intangibles subsequently developed outside the United States.”

“The supply points, by contrast, owned few (if any) valuable intangibles. Their agreements with petitioner explicitly acknowledged that TCCC owned the Company’s trademarks, giving the supply points only a limited right to use petitioner’s IP in connection with manufacturing and distributing concentrate.” (pp 116, 117)

Pausing here for a moment, it is interesting to wonder why one of the largest companies in the world – presumably with well-resourced tax and legal functions – would fail to implement its TP polices through coherent intercompany agreements.
One possible explanation is that Coca-Cola’s tax function considered that agreements were unimportant, based on the belief that the contractual position would always be trumped by economic arguments. And indeed, the taxpayer attempted to argue, amongst other things, that the ‘economic substance’ of the arrangements should determine the ownership of intangibles for TP purposes.
The Court firmly rejected the contention that, in economic substance, the supply points should own valuable marketing intangibles.
However, it went further in saying that as a matter of principle, this argument was not available to the taxpayer to overcome the unfavourable contractual terms, even if the economic analysis had been favourable.
See for example p 160:

“[O]nly the Commission, and not the taxpayer, may set aside contractual terms inconsistent with economic substance.”

When referring to the relevant US income tax regulation, the Court commented as follows:

“Notably absent from this regulation is any provision authorizing the taxpayer to set aside its own contract terms or impute terms where no written agreement exists. That is not surprising: It is recurring principle of tax law that setting aside contract terms is not a two-way street. In a related-party setting such as this, the taxpayer has complete control over how contracts with its affiliates are drafted. There is thus rarely any justification for letting the taxpayer disavow contract terms it has freely chosen.” (p 161)

One of the many valuable lessons from the Coca-Cola case is therefore the necessity for multinational groups to implement their TP policies legally, through coherent intercompany agreements, and to keep those agreements updated.
Based on the number of corporates we’ve helped over the years, including household name groups, we’re no longer surprised when we find intercompany agreements which:

For Coca-Cola, as for every other corporate group, what’s done is done. We can’t go back in time and change the intercompany agreements which existed in historic periods.
But we can fix things going forwards, and help ensure that TP policies for 2021 and later years are legally substantiated.
That’s why we provide an outsourced maintenance service for intercompany agreements, which ensures that the group’s intercompany agreements are aligned with their TP policies, kept up to date, and maintained in a central, tax-audit ready archive.
If you’d like to discuss how this could benefit a group you look after, please email us at info@lcnlegal.com or contact us here.
We also publish a free suite of checklists for reviewing and designing intercompany agreements, covering the most common intercompany transaction types. You can access the checklists here.

OECD Guidance on the TP Implications of Covid – A legal perspective

The OECD’s guidance issued on 18 December 2020 on the Transfer Pricing implications of Covid (the ‘Covid Guidance’) may not have offered up any real surprises. Certainly that seems to have been the intention, and para 5 of the Covid Guidance states that it should be regarded as an application of existing guidance, and not an expansion or extension of the 2017 Transfer Pricing Guidelines.
Nevertheless, this Covid Guidance is to be welcomed as providing helpful commentary. It also contains interesting observations on the role of Intercompany Agreements and other legal considerations in the context of transfer pricing analysis and compliance.
This article examines some of the key points raised in the Covid Guidance from a legal perspective.
1. Keep in mind the key TP and legal objectives
The Covid Guidance states in para 5 that ‘it is important not to lose sight of the objective to find a reasonable estimate of an arm’s length outcome’ and, in para 6, that ‘businesses  should  seek  to  contemporaneously  document  how,  and  to  what  extent,  they  have  been impacted by the pandemic.’
This key TP objective should be seen in parallel with the corresponding fundamental legal objective, which is that intercompany transactions must be consistent with the legal obligations of the participating legal entities and their directors, whether before, during or following the pandemic.
This means that a proper understanding of the legal as well as the operational environment is essential.
The Covid Guidance cites an example of this, when it states that ‘government assistance may be subject to a number of legal conditions that could limit or even prevent the capacity of the party receiving the assistance from modifying the pricing of its transactions with other parties across the value chain’ (see para 75).
2. Pay attention to the timing and duration of Intercompany Agreements
The Covid Guidance reiterates that ‘it is important to emphasise that the allocation of risks between the parties to an arrangement affects how profits or losses resulting from the transaction are allocated at arm’s length through the pricing of the transaction’ (para 35).
As pointed out in the 2017 TP Guidelines, the concept of ‘risk allocation’ is only meaningful when it takes place and is legally implemented in advance, and not when risk outcomes are known.
This means that the timing of the conclusion of intercompany agreements is significant, as is their duration and the contractual notice periods for termination for convenience (i.e., without cause).
The Covid Guidance gives the example of a pre-existing intercompany agreement which was concluded in 2018 for a term of five years, and which therefore covered 2020 and the period of the Covid pandemic. That arrangement may have been accurately delineated at the time, and priced by reference to comparables contemporaneous with the negotiation of the arrangement. In that case, it may be appropriate to allow that allocation of risk to ‘play out’, and it may not be necessary to perform a separate comparability analysis for FY 2020 (see paras 10 and 17).
The position would have been different if, for example, the transactions had been priced on an annual basis (see para 10).
3. Check the risk allocation in your Intercompany Agreements, especially for so-called ‘limited risk’ arrangements
Contractual assumption of risk through Intercompany Agreements is the starting point for the TP analysis of any controlled transaction (see, for example, Section D1 of the 2017 TP Guidelines). However, it is particularly important in so-called ‘limited risk’ arrangements and in considering the question of how losses should be allocated.
The Covid Guidance reminds us that the description ‘limited risk’ has no particular meaning in the OECD TP Guidelines, and that ‘no supposition should be made regarding the most appropriate transfer pricing method … without first undertaking a full and accurate delineation of the transaction.’ (See para 38 of the Covid Guidance).
Contractual terms in agreements between unconnected parties rarely use terms such as ‘credit risk’, ‘inventory risk’, ‘product liability risk’ or ‘marketplace risk’. Instead, the contractual allocation of those risks (if present) is a function of a combination of various contractual terms. Those terms may include warranties, indemnities, exclusion clauses, hurdles for claims and price adjustment mechanisms.
Exactly the same principles apply to Intercompany Agreements between related parties, although the contractual provisions should usually be simplified. In addition, it is often helpful to make explicit reference to the intended effect as regards the allocation of the key risks involved. This helps with contractual interpretation by key stakeholders within the group and, importantly, when the agreements are reviewed by tax authorities.
In situations where business models are under stress, it becomes even more important to be clear about contractual allocation of risks (and rewards). Bald, unsubstantiated statements in TP documentation that certain risks are not assumed by particular entities are unlikely to suffice.
If groups have not already carried out an analysis of their Intercompany Agreements in this level of detail, now is the time for them to do so, and to consider whether their agreements may need to be renegotiated and updated (see item 6 below).
4. Review pricing clauses and price adjustment mechanisms in Intercompany Agreements
The specification of contractual prices goes hand-in-hand with the contractual allocation of risk; one is meaningless without the other. In fact, when it comes to ‘marketplace risk’, the allocation of that risk is often primarily effected through pricing clauses.
The Covid Guidance contains an interesting discussion of the inclusion of ‘price adjustment mechanisms’ in controlled transactions, as a potential approach for allowing flexibility, while also maintaining an arm’s length outcome (see para 30).
The only way to ‘include’ such a mechanism in a controlled transaction is to incorporate legally binding clauses in the relevant Intercompany Agreements. In general, those clauses need to operate with legal certainty in order to be binding. This is not just key for transfer pricing analysis, but is also fundamental in order for the directors of participating entities to comply with their legal duties when considering the terms of intercompany transactions and whether they should be approved or negotiated further.
Again, groups which have not already ensured that the pricing provisions contained in their Intercompany Agreements are aligned with their transfer pricing objectives, should take the opportunity to do so now.
5. Exercise caution before seeking to invoke force majeure clauses
The Covid Guidance rightly reminds us that the application of force majeure clauses and related doctrines is entirely fact-dependent, and that ‘the agreement and underlying legal framework within which force majeure may be invoked should form the starting point of a transfer pricing analysis’ (para 57).
The following example is given in the Covid Guidance:

For example, assume that Company G in jurisdiction G provides manufacturing services to Company H under a long-term manufacturing services agreement that includes a force majeure clause. The government in jurisdiction G mandates the closure of the manufacturing facility for a certain specified short-term period, which may be extended depending on the duration of the pandemic. Given the lack of clarity on the extent of the disruption, it would be important to analyse the contract to see if the disruption qualifies as a force majeure event and consider whether, at arm’s length, Company G or Company H would seek to invoke the clause. Assuming that a clause may be legally invoked under the relevant legal framework, given the long-term nature of the relationship and the short-term nature of the disruption, it may be the case that neither company would invoke the clause, even if it did qualify as a force majeure event. If the disruption was for a longer period, then the circumstances may be different, and force majeure may be more likely invoked.‘ (Para 58).

This example is possibly not the best illustration of the meaningful invocation of force majeure clauses. In many cases in a group context, a provider of manufacturing services such as Company G, will have no revenue other than the fees payable under the relevant manufacturing services agreement. For Company G (as service provider) to rely on a force majeure clause to suspend or terminate that agreement would therefore be equivalent to an employee asking for voluntary redundancy or to take a period of unpaid leave. It is difficult to envisage circumstances in which the directors of Company G could properly approve such course of action.
Force majeure clauses between unconnected parties rarely operate to relieve a party from payment obligations on the grounds of financial hardship. So, from the perspective of a service recipient such as Company H, force majeure may also not be a useful legal tool to realise such an outcome.
It is submitted that in most cases, force majeure clauses should best be regarded as part of the context within which the renegotiation of Intercompany Agreements may take place, rather than a mechanism by which to give effect to price adjustments or to amend other terms agreed between related parties.
6. Establish ongoing processes for periodic review of whether legal entities should renegotiate and update their Intercompany Agreements
This is perhaps the most significant aspect of the Covid Guidance from a legal perspective.
The guidance reminds us that ‘unrelated enterprises may opt to renegotiate a contract to support the financial survival of any of the transactional counterparties given the potential costs or business disruptions of enforcing the contractual obligations, or in view of anticipated increased future business with the counterparty’ (para 43).
The word ‘negotiate’ (or ‘renegotiate’) is significant here – Intercompany Agreements are not fictional contracts which exist merely for the purposes of TP documentation and compliance requirements. They are a legally binding expressions of the arrangements entered into by separate legal entities with separate interests and obligations.
In para 45, the Covid Guidance states that ‘Determining whether a renegotiation of a commercial arrangement (including pricing under the arrangement going forward and any potential compensation for the renegotiation itself) represents the best interests of the parties to a transaction requires careful consideration of their options realistically available and the long-run effects on the profit potential of the parties.’
In the context of the current pandemic or, for that matter, any other material change in the economic or other environmental factors impacting the relevant business, allowing an existing arrangement to continue is just as much a decision as entering into a new arrangement. The reasons for the decision need to be documented in the same way, both for the purposes of transfer pricing compliance and also for the purposes of legal defence files to protect the relevant directors from personal liability in each relevant jurisdiction.
This is therefore an important reminder of the need for periodic reassessment and review of Intercompany Agreements and the corporate governance processes and decisions made by related parties on a contemporaneous and prospective basis, and not merely as part of processes for the preparation of corporation tax returns.

New Collaboration: LCN Legal and EXA Operational Transfer Pricing

We are very excited to announce a new collaboration between LCN Legal and EXA AG, that brings together EXA AG’s unique Operational Transfer Pricing solutions and LCN Legal’s know-how regarding the creation and maintenance of tax-audit ready Intercompany Agreements which multinational groups need for their transfer pricing compliance.
EXA is a leading provider of digital transformation solutions and services with headquarters in Heidelberg, Germany and affiliates in India and the U.S. They have now created a new add-on to their Operational Transfer Pricing software component for “ICA Management” which will allow companies to effectively centrally manage their intercompany agreements.
As part of this new offering, LCN Legal are proud to be supplying a range of Intercompany Agreement templates for various transactions, creating a comprehensive offering where transfer pricing know-how and legal implementation meet, to form the reassurance global companies require to remain tax-audit-ready. LCN Legal also provides a full management service regarding intercompany agreements for groups which want to outsource this critical function.
For further details please read more here (4 minute read) and do get in touch if you would like to know more.

TP functions vs legal transactions

One of the perennial challenges in the legal implementation of transfer pricing policies is reconciling differing perspectives: those of functional analysis on the one hand, and legal rights and obligations on the other.

A classic example is routine returns for distribution and production functions, as in the recent Coca-Cola case. As the US Tax Court stated in that case, ‘understanding the rights and obligations of entities within the Coca-Cola System requires an examination of both written contracts and the parties’ course of dealing.’

However, one of the Court’s key findings was that, although the group used a certain formula to allocate profits between the relevant entities, ‘it never incorporated any aspect of that formula into its written supply point agreements.’ (You can find a link to the case report here.)

From a TP perspective, routine distribution functions are often described as the provision of routine services by the distributors to the principal.

From a legal perspective, the principal supply is in the opposite direction: for example, the sale of goods, license of software, or provision of services for resale to customers. And the payments between the parties may be in either direction, depending on the third party revenue actually achieved by the ‘routine entity’ in the relevant period, and whether that results in an amount which is more or less than the targeted / guaranteed margin.

It may be tempting to create agreements which follow the TP perspective alone, and merely describe the provision of routine services. But ultimately this would be counterproductive, because it would misrepresent the transactions which actually exist, and which need to be documented for non-TP reasons (such as VAT/GST, customs, regulatory compliance, personal duties of directors etc).

Substance can only be based on reality, and not on a convenience or fiction.

It’s perfectly possible (and essential) to create and maintain legal agreements which accurately describe and delineate the actual transactions, but which are also consistent with the TP analysis of functions and value chain.

As always, it requires a cross-functional approach and a global perspective, and accurately describing the basis on which intercompany charges are being made.

N.B. You can find the latest version of our Guide to Maintaining Effective Intercompany Agreements for Transfer Pricing Compliance here.

Price setting vs outcome testing in Germany and Poland

The following article has been kindly contributed by Dr Harold McClure, a New-York based economist who has over 25 years of transfer pricing experience. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983 and began his transfer pricing career at the IRS. He later worked at several Big 4 accounting firms, Law and Economics Consulting Group, and was the lead economist in Thomson Reuters’ transfer pricing practice.
Dr. McClure’s engagements have included the valuation of intangible assets, the interplay between transfer pricing and enterprise valuation, arm’s length royalty rates, intercompany loans, intercompany factoring, intercompany leasing rates, the analysis of a related party distributor’s gross margin under a market share strategy, various aspects with respect to contract manufacturing, and the coordination between customs valuation and transfer pricing.
Dr. Monika Laskowska recently discussed a public consultation launched by Poland’s Ministry of Finance on an explanatory note addressing taxpayers’ ability to make year-end, self-initiated, transfer pricing adjustments. She noted Poland’s proposal for a price-setting approach for transfer pricing, which the German tax authorities considered but did not adopt.[1]
We review the Polish discussion as well as the prior discussions in Germany as detailed by Susann van der Ham and Karin Ruëtz. We also consider the key issues in terms of a German customs valuation case as well as a Polish income tax litigation.
Germany’s flirtation with the price-setting approach
Susann van der Ham and Karin Ruëtz pose the key question:[2]

Should information be used for determining and documenting transfer prices that is available at the time when the intercompany transaction takes place (ex-ante or price setting approach)? Or should the actual outcome of the transaction between related parties be used when demonstrating whether the conditions actually comply with the arm’s-length principle (ex-post or outcome testing approach)?

Consider a German distribution affiliate purchasing goods from its Japanese parent for sale to its customers. The classic transfer pricing debate is whether the intercompany contract should target a gross margin for the distribution affiliate versus specify its operating margin. Susann van der Ham and Karin Ruëtz note the following issues:

Which financial data of the transaction partner(s) should be used in determining and testing transfer pricing? In case of the first approach, budget figures based on information of the economic and market conditions including financial projections at the time of the transaction need to be applied, whereas under the latter, actual figures on revenues and cost structures are already available … German tax authorities argue that unrelated parties would not agree on retroactive adjustments to their profits but instead only accept changes to the pricing and this only based on a forward-looking basis. It is claimed that a guaranteed profit in the form of a fixed net margin, as often agreed on (for example, limited-risk distributors), would not be observed between third parties.

Consider a situation where a German distribution affiliate is expected to sell $1 billion in goods and incur $200 million in operating expenses. A 24 percent gross margin would afford this distribution affiliate with an expected operating margin equal to 4 percent as the expected operating expense to sales is 20 percent.
The traditional benchmarking approach is to examine the operating margins of comparable third party distributors under the Transactional Net Margin Method (TNMM). If a TNMM analysis suggested that a 4 percent operating margin was consistent with the arm’s length standard, then this analysis would support this policy as long as the actual operating margin was reasonably close to this 4 percent expected operating margin.
The dilemma is what would be the appropriate remedy if the actual operating expense to sales ratio unexpectedly changed. For example suppose that a period of weak sales led to a temporary increase in the operating expense to sales ratio such that it was 23 percent. A price setting approach might be seen as maintaining the 24 percent gross margin, which would allow the operating margin to fall to 1 percent. An outcomes based approach would maintain the 4 percent operating margin but lowering the intercompany price such that the gross margin would increase to 27 percent. Conversely a period of strong sales could lead to a temporary decrease in the operating expense to sales ratio such that it was 17 percent. A price setting approach might be seen as maintaining the 24 percent gross margin, which would allow the operating margin to rise to 7 percent. An outcomes based approach would maintain the 4 percent operating margin but lowering the intercompany price such that the gross margin would increase to 21 percent.
The Hamamatsu customs valuation case
Hamamatsu Photonics is a Japanese manufacturer of various optical devices, which are sold in Europe by Hamamatsu Photonics Deutschland GmbH (HPD). HPD obtained an Advance Pricing Agreement (APA) with the German and Japanese tax authorities that targeted an operating margin. On December 20, 2017, the Court of Justice of the European Union (CJEU) issued a ruling objecting to this targeting of an operating margin when HPD lowered its transfer pricing, where the actual financial results showed an operating margin below the targeted margin.
Yanan Li and I noted:[3]

While the economic analysis prepared for an APA application may provide useful information, two caveats apply. This first, that not all transfer pricing analyses are informative on what an appropriate pricing policy would be. The second caveat is that the issue of post-importation may involve a different question, which customs officials often allude to by reference to “industry standards”. Much of income tax transfer pricing addresses technical issues with respect to the benchmarking of a distributor’s margin based on its function and assets, while many of the customs issues revolve around implementation issues. Third party distributors negotiate an appropriate gross margin based on its functions and assets involved in carrying out its responsibilities as the distributor of a manufacturer’s products. The deductive value method is fundamentally equivalent to the use of a Transactional Net Margin Method (TNMM) to construct the appropriate gross margin. Customs authorities often insist on a fixed gross margin approach arguing that third party distributors do not target operating margins. Interestingly tax authorities in Germany and Japan have often made similar arguments. Some transfer pricing practitioners, however, insist that distribution affiliates be seen as “limited risk” and argue for targeting operating margins. APA agreements are often written in terms of a band for an acceptable operating margin. Temporary variations in the operating expense to sales ratio would likely not lead to variability in the gross margin under arm’s length pricing.

We also noted two other possibilities for the decline in the operating margin of the German distribution affiliate. One possibility is that a relative price decline from exchange rate variability may have lowered the gross margin for the distribution affiliate. In this case, a gross margin target would have allowed the transfer pricing adjustment requested by the multinational. We also suggested:

Permanent increases in the operating expense to sales ratio may emanate from function creep, that is, the distribution affiliate taking on more responsibilities. If the operating expense to sales ratio increased from function creep, a case can be made for lowering the transfer price to increase the gross margin commensurate with the new functions.

Susann van der Ham and Karin Ruëtz similarly noted:

Looking at the regulations regarding relocation of functions, German tax authorities take quite the opposite view. Under section 1 paragraph 3 of the Foreign Tax Code it is refutably assumed that third parties would have agreed on retroactive price adjustments under such circumstances. Therefore, in cases where the transaction parties have not agreed on a specific price adjustment clause, the regulation stipulates that tax authorities may assume price adjustments within a 10 year period. This shows that retroactive adjustments are not a priori rejected by German tax authorities. However, overall German tax authorities strongly prefer the price setting approach over the outcome testing approach and allow only under specific circumstances that transfer prices are adjusted retroactively.

In our example where the operating expense to sales ratio rose from 20 percent to 23 percent, if the increase in the operating expense to sales ratio was due to an increase in functions and thus could be seen as permanent and not transitory, then a higher gross margin could be warranted.
Polish considerations
Poland’s Ministry of Finance is considering the price setting approach for reasons similar to what the German tax authorities were articulating. Dr. Monika Laskowska noted several arguments but we shall note only a few considerations.

under Polish law, year-end adjustments cannot be made to introduce arm’s length conditions to controlled transactions, but to make “minor” adjustments to prices already set in accordance with arm’s length principle. To make these transfer pricing adjustments, several conditions must be met. First, the controlled transaction must be compliant with the arm’s length principle. Second, there must be a change of relevant circumstances that have an impact on the transactional conditions or a taxpayer must gain new information on actually incurred costs (if the transfer price was set on budgeted costs) or on actually attained revenue in the controlled transaction.

We have noted that a third party supplier and distributor would not adjust an agreed upon arm’s length gross margin from temporary variations in the operating expense to sales ratio but would allow for an increase in the gross margin if increases in functions led to a permanent increase in the operating expense to sales ratio. This portion of Polish law is consistent with these considerations.
Dr. Monika Laskowska also noted:

Another controversial area of interpretation involves the availability of a transfer pricing adjustment in cases where there is no direct transaction to be adjusted. For example, according to the explanatory note, an adjustment is permitted between a limited risk distributor and the principal of a company even there is no suitable and direct transaction between these two. The explanatory note states that a transfer pricing adjustment is permitted to adjust the controlled entity’s profitability, no matter what document is used. When there is no direct transaction, a correcting note is a satisfactory document to adjust the entity’s profitability. Through this explanation, the Ministry of Finance was aiming to address the ongoing debate on transferring residual profit between limited risk entities and principal entities through inadequate forms of intra-group agreements.

While her discussion does not note any of the litigations in Poland, some of these considerations appear in the court decision in Poland vs K. sp. z o.o.[4] TPCases.com describes this litigation:[5]

K.sp. z o.o. is a Polish company belonging to an international group. The main activity of K is local sale of goods purchased from a intra group supplier. K is best characterized as a limited risk distributor and as such should achieve an certain predetermined level of profitability as a result of its activities. In order to achieve the determined level of profitability, the group had established that, if the operating margin actually achieved by the distributor during a given period is less or more than the assumed level of profit, it will be adjusted. The year-end adjustment will not be directly related to the prices of goods purchased from the intra-group supplier and will be made after the end of each financial year.

The court rejected such year-end adjustments.
A litigation involving a Polish distribution affiliate
The court decision noted the following provisions of the intercompany contract:

The European (local) companies in the group, including the applicant, have been integrated into a centralised model and operate as distributors of the supplier’s goods, with limited business risk; the supplier sells its products to its local distributors in each country; the distributors take the goods from the supplier’s warehouse and resell them to final customers; the supplier remains the owner of the goods while they are in stock and the applicant, as a distributor, acquires ownership of the goods from the supplier when the products are delivered to the final recipients; the supplier treats the sale as domestic sales and issues an invoice to the Complainant including VAT at the appropriate rate; the applicant also handles the supplier’s goods in the warehouse, providing him with a comprehensive logistics service, as well as handling the sale and purchase process. The supplier’s services to the distributor also include assisting in the performance of contractual obligations, granting a limited right to use the trade mark, and repurchasing fully sold products sold by the distributor and returned by customers.

This description notes that the distribution affiliates are responsible for both selling and logistics activities. It also suggests that the distribution affiliates hold very modest levels of inventories. The court also noted the following from the intercompany agreement:

The parties agreed in the agreement that the settlement between them will take place on the basis of equalisation of profitability to the established level of net operating margin, which is to ensure that an appropriate level of margins and profits is achieved in relation to costs incurred, resources employed and risks incurred. If the operating margin actually achieved by the distributor over a given period is less or more than his remuneration, the parties to the distribution agreement may align the purchase price in order to achieve the level of the net operating margin … the net operating margin (EBIT) achieved by the applicant after the year-end was generally set at 4.5% for 2016 and 3.5% for 2017 of revenues from external sales of products, after deducting the bonuses and discounts it will itself grant to customers and an additional cost plus 7% of total logistics costs, as remuneration for logistics services.

Consider a situation where a Poland distribution affiliate is expected to sell $1 billion in goods an incur $190 million in selling expenses plus $70 million in logistic expenses. The 7 percent markup for logistics expenses is roughly consistent with expected profits equal to 0.5 percent of sales. Let’s also assume that a TNMM analysis supports expected operating profits for selling activity equal to 3.5 percent of sales. Our example is consistent with expected operating expenses equal to 26 percent of sales and expected operating profits equal to 4 percent of sales. A price setting approach would establish a 30 percent gross margin. The taxpayer’s expressed transfer pricing approach, however, targeted the operating profit margin.
The court made several statements with respect to the issue in the litigation as well as Polish law including:

The legal problem examined in this case relates to the use by the applicant company of a mechanism applied in economic practice, in group settlements, referred to as a ‘compensating adjustment’. Generally speaking, that mechanism consists in an upward (true-up) or downward (true down) adjustment of the price between the supplier and the distributor, depending on whether the latter obtains income from sales to third parties which exceeds or is less than the margin fixed in the agreement between those entities. In the present case, the essence of the dispute concerns the tax consequences, in terms of corporation tax, of offsetting the net operating margin downwards (true down), under an agreement concluded by the applicant with the controlling company (the supplier). That means that the applicant (distributor) transfers funds to the supplier at an amount corresponding to the excess of the margin set in the contract concluded previously by those entities.

If the operating expense to sales ratio for the distribution affiliate fell from 26 percent to 24 percent maintaining a 30 percent gross margin would have the actual operating margin rise to 6 percent. A compensating adjustment under a policy where the operating margin is pegged at 4 percent would lower the gross margin to 28 percent, which would mean the Polish affiliate would pay the related party supplier additional compensation equal to 2 percent of sales.
The Polish tax authority, however, argued that this compensating adjustment is inconsistent with the arm’s length standard. Their argument is the price setting approach where the parties would agree to a 30 percent gross margin. The court was less than explicit on which approach was consistent with Polish law noting:

On the other hand, in the legal status in force before 2019, a typical transfer pricing arrangement concerned settlements between related companies for the direct supply of goods or services. For the sake of order, it should be recalled that until the end of 2018 the legislator, both in the Corporate Income Tax Act, the Personal Income Tax Act and the Value Added Tax Act, did not use the term “transfer prices” but used the term “transaction prices”…The situation has fundamentally changed as of 1 January 2019, due to the amendment of, inter alia, the Corporate Income Tax Act as of that date. In art. 11a sec. 1 point 1, the definition of the transfer price has been established (a broader scope than the concept of a transaction price within the meaning of art. 3 point 10 of the Corporate Income Tax Act). ), and in art. 11e of the C.C.P.I.P. there are certain possibilities and rules of making transfer price adjustments. However, the considerations in this respect go beyond the limits of this case.

The Ministry of Finance’s proposal for an explicit endorsement of the price setting approach may have been motivated by the ambiguous statement in this court decision.
Concluding comments
The debate between price setting approaches versus outcomes based approaches is relevant for intercompany transactions other than the compensation for distribution affiliates. We have focused on distribution affiliates in Germany and Poland as the distinction between gross margins versus operating margins have been debated internationally for over 25 years. The German and Polish tax authorities have recently proposed the price setting approach, which in our context equates to targeting gross margins.
Some tax authorities, however, insist on targeting operating margins. The IRS is particularly stubborn on this viewpoint. Targeting operating margins is a popular approach for practitioners who establish operational transfer pricing systems. Making operational transfer pricing easier, however, may lead to problems elsewhere especially when customs valuations often require targeting gross margins. The concern of double taxation is also present if the tax authority for the supplying affiliate takes a different approach from the approach adopted by the tax authority for the distribution affiliate.
[1] “Poland tax guidance confirms controversial position on year-end transfer pricing adjustments”, November 5, 2020 – mnetax.com/poland-tax-guidance-confirms-controversial-position-on-year-end-transfer-pricing-adjustments-41255
[2] “Arm’s length price setting versus outcome testing approach”, June 22, 2014 – www.internationaltaxreview.com/article/b1f9k18pwgvklg/german-insights-on-price-setting-versus-outcome-testing-approach
[3] “CJEU denies the Hamamatsu Photonics Retroactive Transfer Pricing Adjustment”, August 24, 2018, tax.thomsonreuters.com/blog/cjeu-denies-the-hamamatsu-photonics-retroactive-transfer-pricing-adjustment
[4] January 2020, Supreme Administrative Court, Case No II FSK 191/19 – Wyrok
[5] tpcases.com/poland-vs-k-sp-z-o-o-january-2020-supreme-administrative-court-case-no-ii-fsk-191-19-wyrok

The two types of profit split arrangements in transfer pricing

In commercial relationships as in intra-group structures, there are two types of profit split arrangements.
In both types, the participants to the arrangement may make (a) an up front contribution of cash or assets, and/or (b) ongoing contributions of services.
The distinction is in the nature of the interest which each participant receives.
A Type 1 profit split involves a sharing in the growth of the enterprise value of the underlying venture. An example from the commercial world would be a property development joint venture. One party may contribute land. Another may contribute expertise in managing the development. The parties’ respective contributions would often be reflected in their percentage shareholdings in a special purpose vehicle which holds the legal title to the development. The parties will continue to benefit from their proportionate interests, even after their respective contributions have ceased (for example, after the development has been completed).
An example of a Type 2 profit split would be an equity partner joining a large professional partnership. The new joiner would often be required to make a capital contribution, and would participate in the ongoing income profits of the partnership for so long as she remains a partner. However, when that partner leaves the partnership, she would usually just get her capital contribution back – there would be no valuation of partnership assets at that point, and the outgoing partner would not usually receive an additional buy-out payment reflecting any growth in enterprise value.
In the context of intra group arrangements, both types of profit split are possible. However, in general, Type 1 profit splits are less likely to be appropriate, because they imply a split beneficial ownership in the underlying assets (including intangible assets). Such arrangements are more complex to manage, and would have a significant impact on arrangements for the enforcement of intellectual property rights against third parties. For the same reasons, split shareholdings within group structures are usually a recipe for confusion and mistakes later on down the line.
All other things being equal, Type 2 profit splits are more likely to be appropriate within group structures for multinational enterprises, as they make it easier for the group to maintain alignment as between legal / beneficial ownership of intangibles, and the ‘economic’ ownership for transfer pricing purposes.
Whichever approach is chosen, it is clearly fundamental for all parties (including economists who are valuing the respective contributions, as well as the directors of the participating entities) to be clear as to the risks and rewards of the relevant arrangements, including what type of profit split the arrangements represent.
LCN Legal have recently added a template profit split agreement to our toolkit of template intercompany agreements for transfer pricing compliance. The toolkit is available here.

Video Interview: Update on HMRC's Profit Diversion Compliance Facility

Many thanks to Ken Almand for sharing his insights and updates on HMRC’s Profit Diversion Compliance Facility (PDCF), including his commentary on HMRC’s webinar last week.
Questions we discussed included:
* Did HMRC’s webinar on 6th October tell us anything new?
* What have we learned from our experiences with the PDCF so far? In which situations is it helping?
* How can or should corporates change their approach to transfer pricing compliance, to respond to the current environment?
* What other key takeaways should corporates consider in relation to their TP compliance?
You can access the interview through the following link: https://lcnlegal.com/interview-with-ken-almand/

Winners: Excellence in International Legal Services

My colleagues and I were humbled that our firm was shortlisted for the Law Society’s 2020 Excellence Awards, alongside firms like Baker McKenzie, Dentons, King & Spalding, Reed Smith, Societe Generale and Travers Smith.

We were even more humbled that we actually won last week, in the category of ‘Excellence in International Services’.

A result like this would have been impossible without the help of the hundreds of people who have supported us along the way.

These include the clients who have entrusted us with the legal maintenance of their corporate structures: since its establishment in 2013, LCN Legal has advised multinational groups with combined annual revenues of over USD 130 billion.

It also includes people who have received our newsletters and shared them with others, and contributed their own thoughts and comments, so that the information and resources we provide can be improved and expanded.

Thank you.

Preparing for Transfer Pricing Audits: Bayer’s Battle with the Canadian Revenue Agency

The following article is part of a series of case studies and articles which have been kindly contributed by Dr Harold McClure, a New-York based economist who has advised in the area of transfer pricing for many years.
Action 13 of the Base Erosion and Profit Shifting project requires large multinationals to prepare a Master File along with Country-by-Country (CbC) reporting in addition to local documentation. Before the adoption of these requirements, many multinationals prepared separate documentation reports for each of their key local affiliates. One concern has always been whether such local documentation represented sufficient information of the transfer pricing for the local affiliate
The audit of Bayer’s Canadian affiliate by the Canada Revenue Agency (CRA) is a cautionary tale of what multinationals should consider as additional information beyond the typical local documentation report if they face scrutiny of their transfer pricing by a foreign local tax authority.
Bayer is not a client of mine so any information noted in this discussion comes from its Annual Reports or the July 20, 2020 court ruling in Bayer Inc. v. the Attorney General, which considered the scope of information that Bayer must provide to CRA. The court decision noted that the CRA began a transfer pricing audit of Bayer Canada for the 2013 to 2015 period, which focused on the transfer prices paid by Bayer Canada for pharmaceutical products.
A Simple Application of the Transactional Net Margin Method (TNMM)
Transfer pricing audits often begin with a request of the taxpayer’s documentation report. While Bayer may have produced an informative and detailed transfer pricing analysis for the relevant issues involving its Canadian affiliate, many multinationals simply produce a very high level TNMM analysis with the local affiliate as the tested party. Bayer’s sales are approximately $50 billion per year and if the Canadian market represents 4 percent of these sales, Canadian sales represent $4 billion per year.
Bayer’s 2015 Annual Report also notes that the consolidated operating margin was nearly 13 percent for the audit period. Let’s further assume the following:

Consolidated profits on sales to Canadian customers are $260 million per year, which are allocated between the parent and the Canadian affiliate depending on the transfer pricing policy. The following table presents the income statement for the Canadian affiliate and the parent corporation on sales to Canadian customers under the assumption that the Canadian affiliate receives a 35 percent gross margin.
Hypothetical Income Statement for Bayer Canada

Millions Affiliate Parent
Sales $2000 $0
Intercompany payment $1300 $1300
Production and R&D costs $0 $1140
Distribution costs $600 $0
Profits $100 $160

The standard TNMM analysis asserts that the parent corporation owns all intangible assets including product, process, and marketing intangibles. This assertion is the justification for arguing that if the distribution affiliate receives a routine return for selling activities, then the intercompany pricing must be arm’s length. A 5 percent operating margin should be seen as a reasonable estimate of this routine return even if transfer pricing practitioners struggle with finding third party distributors in the life science sector that are functionally comparable to a high function distributor of branded pharmaceuticals. Wholesale distributors of generic pharmaceuticals tend to have gross margins near 5 percent as their operating expenses are near 3 percent of sales. While their operating margins are low, their return on operating expenses are very high.
The Data Requests from the CRA
Selecting appropriate comparable companies and the choice of the profit level indicator for a TNMM analysis, however, might not be the most serious problem with the transfer pricing documentation we suggested. The court decision noted a very broad information request from the CRA. After a series of requests issued in 2018, the August 21, 2018 query number 17 requested:

Pursuant to our discussion on July 18, 2018, we would like to audit agreements made between any member of the Bayer Group with third party(s) in force during the 2013 and 2014 taxation years that perform some or all of the following activities in regards to pharmaceutical products:

Please provide a matrix of no less than 50 contracts that meet some or all of the criterion [sic] listed above, and make sure activities contemplated in the agreements are highlighted, so that CRA can select contracts for further review.

On November 14, 2018 the CRA issued requests for foreign based information. The representatives objected to these data requests. While the court decision noted that the CRA was entitled to request relevant information, the court order limited the scope of these requests to the agreements with the 21 named pharmaceutical and life sciences companies that operate at arm’s length from Bayer. The tone of these data requests appear to be inquiries as to whether Bayer Canada was engaged in more than distribution activities, which could raise issues with respect to the ownership of intangible assets.
Master File Requirements
A well prepared Master File could address many of the concerns of the local tax authority. The broad categories of the information to be provided in a Master File include:

The detailed information includes a listing of the top markets, a description of the main geographic markets for those products, and a functional analysis describing the principle contributions to value creation by each affiliate. The detailed information also includes a list of the key intangible assets, listing of the key R&D facilities and how R&D is managed, and agreements with respect to cost sharing and contract R&D arrangement as well as license agreements.
The information in the CbC report indicates how worldwide profits are allocated across the various affiliates but does not directly provide guidance as the intercompany policies that led to the actual allocation of worldwide profits. The head count and functional headcount information required in the CbC report, however, could prove useful.
Note that the CRA initially wanted to know what R&D activities were conducted by Bayer Canada. If this head count information showed that all of its employees were only involved in either selling or marketing activities, then this issue becomes moot. Of course, it is possible that phase III trials on some of Bayer’s branded products were conducted by Canadian employees then a question with respect to the ownership of product intangibles could be raised. If the parent compensated the Canadian affiliate at fully loaded costs plus a reasonable markup in a contract R&D arrangement, the assertion that the parent owns the product intangibles is warranted.
The Annual Reports for Bayer provide segmented financial information for its four business lines:

The branded pharmaceutical segment is more profitable than the other three lines of business and represents approximately 30 percent of sales.
The focus of CRA’s transfer pricing audit is this branded pharmaceutical segment. An aggregate TNMM approach would not necessarily address the transfer pricing issues without segmentation of the financials for the Canadian affiliate.
Roche Australia and Speculation Where This Audit May Be Heading
What information is needed to evaluate any particular transfer pricing issue in part depends on the transfer pricing approach. This CRA audit of Bayer Canada reminds me of the issues in Roche Products Pty Ltd v. Federal Commissioner of Taxation.[1] Roche is a Swiss parent that sold various products to Australian customers via its Australian sales and marketing affiliate, Roche Products Pty Limited. These products included branded pharmaceuticals, reagents and other diagnostic products. An expert witness for the Australian Tax Office (ATO) segmented the Australian affiliate’s financials by line of business and used separate TNMM analyzes for each line of business.
Over the 1993 to 2002 period, the operating expenses for the pharmaceutical division of the Australian affiliate totaled 39 percent of sales but gross profits represented only 37 percent of sales. The TNMM analysis proposed separate markups for selling expenses and for marketing expenses, which suggested operating profits should be 5.4 percent of sales. This analysis suggested that the overall gross margin for the pharmaceutical division should be 44.4 percent.
The expert witness for Roche argued that the Resale Price Method was the preferred approach. This expert also argued actual sales fell short of expected sales as an explanation why the TNMM approach would overstate the arm’s length gross margin.
Even though Roche sold several branded pharmaceuticals, this expert focused on one third party agreement where the third party distributor received a 37 percent gross margin. Another expert witness for the ATO, however, noted that the gross margins for other third party agreements for Roche products exceeded 40 percent. While the Resale Price Method is a viable approach for the Bayer Canada branded pharmaceutical transfer pricing, the question remains which if any of the 21 third party agreements requested by the CRA represents a comparable third party agreement.
A dynamic profits based approach may be considered if no truly comparable transaction can be found for the application of the Resale Price Method. TNMM ignores the dynamics of what is essentially a market share strategy, which is described by section 1.482-1(d)(4) of the US transfer pricing regulations.
In certain circumstances, taxpayers may adopt strategies to enter new markets or to increase a product’s share of an existing market (market share strategy). Such a strategy would be reflected by temporarily increased market development expenses or resale prices that are temporarily lower than the prices charged for comparable products in the same market. Whether or not the strategy is reflected in the transfer price depends on which party to the controlled transaction bears the costs of the pricing strategy.
Market share strategies under arm’s length pricing often witness periods where the upfront market expenses are very high relative to early sales such that overall operating expenses exceed gross profits. As sales grow, the operating expense to sales ratio declines below the gross profit margin, so the local affiliate enjoys sufficient long-run profits to compensate it for both its routine return as well as a reasonable return on its initial investment by incurring the upfront marketing. A reliable application of this approach requires understanding what expected sales over the life of the market share agreement, which may differ from what actual sales turned out to be.
This transfer pricing audit is ongoing so it is unclear what the CRA might argue. The public record also does not inform us as to the various facts that have been gathered by the CRA. Their information requests suggest the focus of the transfer pricing audit comes down to what is the appropriate gross margin for the Canadian affiliate on its selling and marketing activities with respect to branded pharmaceuticals. If the CRA proposes a transfer pricing adjustment based on an application of the Resale Price Method using the 21 third party agreements obtained in this litigation, the taxpayer might consider an alternative approach such as an application of the market share strategy.
[1] 2008 ATC 10-036.

Building something that stands up

Apparently, the IRS believes that the quality of transfer pricing documentation may have declined. (See its FAQ guidance issued in April this year.) They believed it necessary to remind practitioners that TP documentation needs to be consistent with risk allocation in intercompany agreements.

Isn’t that like having to remind a glazier that the glass has to fit the windows?

HMRC seems to have a similarly low opinion of TP documentation it has come across, if its webinar last week on the Profit Diversion Compliance Facility (PDCF) is anything to go by. Apparently they felt they had to remind people that risk cannot be allocated to an entity unless it has the capacity to control that risk.

Isn’t that like reminding a builder that a load-bearing wall can’t be made out of tissue paper?

What theories could account for this kind of transfer pricing incompetence?

Is it a case of cowboy TP advisers who are grossly negligent?

Are the lawyers involved careless about what they are doing, when they create intercompany agreements?

Are in-house finance and tax professionals deliberately cutting corners?

Personally I think none of these theories are a fair reflection of what’s happening. It’s probably more a case of overwhelm, and tasks remaining on the wrong desk for too long.

Here’s an example from my own life. On Thursday afternoon last week, things were not looking too good at Chateau Sutton. We’d just taken delivery of a playhouse for the garden, in self-assembly kit form. Once we had unpacked the crate, our garden was covered by what appeared to be approximately 200 pieces of wood, one of which had already broken.

At best I would describe myself as ‘not completely incompetent’ at do-it-yourself handiwork. It would literally have taken me a week of solid work to assemble the playhouse. Which meant in practice that it would never happen – when do you ever get an undisturbed and uninterrupted week for this kind of thing, in a busy household?

Things were also not looking great in our garage. A chest of drawers had lain there for a few months now, partially sanded. At the time, it seemed like a good idea to remove the old paint and show the original wood, then varnish it. But when would this ever get done?

Luckily my wife Xiaofang had arranged a handyman, who duly arrived the following day. It took him less than 4 hours to assemble the playhouse which you can see in the picture. It then took him less than one hour to complete the sanding of the chest of drawers.

How could he do that so quickly and efficiently?

I think there were three main reasons:

1. He was there to do a job, so he was not tempted to procrastinate.

2. He had all the tools he needed, immediately to hand.

3. He had done very similar jobs, so he knew where to start and how to finish.

Yes, he charged more than minimum wages for his time. But it was worth it many times over.

The moral of the story: if you know any multinational groups which don’t have solid TP policies in place, and which don’t have a comprehensive, tax-audit-ready, up-to-date central archive of intercompany agreements, then do that group a favour: help them overcome their procrastination, give them some decent TP advice, and send them to us to get their agreements under control.

Where's your allotment?

Allotment (noun) a plot of land rented by an individual for growing vegetables or flowers.

In my ignorance, I thought that allotments were something quintessentially British. But it turns out that it’s a phenomenon that exists all over the world. The one pictured above is in the village of Lindfield, West Sussex, where we live.

I’m not an allotment gardener myself, but there’s something very wholesome about people doing their gardening work in public. Maybe because it’s not just about people providing for themselves. It’s also about being part of a community.

Some of the ‘virtual allotments’ in the corporate world that I admire include Keith Brockman’s blog Strategizing Multinational Tax Risks, the prolific output of articles written by Dr Harold McClure (including for our own blog), as well as the TP newsletters of a number of tax and accounting firms.

LCN Legal’s humble allotment includes our Guide to Maintaining Effective Intercompany Agreements for TP Compliance. It originated in an article which was written for Tax Journal back in 2013, and has now grown to 29 pages, including FAQs and a case study. An offshoot of it turned into our book on intercompany agreements, and our online course. We’ve also recently created a series of free checklists for intercompany agreements for the most common transaction times. You can download the latest version of the guide here, and the checklists are available here.

Personally, I think transfer pricing is still in the Stone Age when it comes to cultivating value, because (with some exceptions) it’s still very disjointed from other disciplines. Not so long ago, my colleagues and I facilitated a workshop for one of the major multinational investment banks, including their ‘head of subsidiary governance’. It had not even occurred to that person that transfer pricing was a relevant issue to address.

Until we do a better job in raising awareness of how different processes need to connect with each other, TP concepts such as ‘control of risk’ will be condemned to remain as theoretic concepts which are applied in the abstract, with little substance.

I certainly need all the help I can get in expanding my knowledge. Whose work do you admire, which should be shared more? What initiatives have you contributed to, which should be known more widely? Please drop me a line at info@lcnlegal.com and let me know.

China Handbags Case Study 14.2 and the Abuse of the Deductive Value Method

The following article is part of a series of case studies and articles which have been kindly contributed by Dr Harold McClure, a New-York based economist who has advised in the area of transfer pricing for many years.
In our previous discussion of customs valuations in China, we presented a hypothetical example to capture the two case studies noted by Harvey Lee’s webinar. This example considered a highly profitable biopharmaceutical multinational based in France that sells its treatments to Chinese patients. The Chinese distribution affiliate incurs substantial advertising with the transfer pricing issue being what should be the appropriate gross margin for the Chinese affiliate. We also briefly noted customs case study 14.2.
Customs case study 14.2 involved the imports of designer handbags into China. The WCO document notes:[1]

XCO of country X sells luxury bags to ICO, a distributor of country I. Both XCO and ICO are wholly-owned subsidiaries of ACO, the headquarters of a multinational enterprise and the brand-owner of the luxury bags. Neither XCO nor other companies related to ACO sell the identical or similar luxury bags to unrelated buyers in country I. ICO is the only importer of the luxury bags sold by XCO to country I. Thus, all luxury bags imported into country I by ICO are purchased from XCO… .ICO is a simple or routine distributor. The marketing strategy for the sales of bags in country I is in fact established by XCO. XCO also advises on the levels of inventory to be maintained, and establishes the recommended sales price of the bags sold by ICO, including the discounting policy to be used by ICO. XCO has also invested heavily in developing valuable intangible assets associated with the bags. As a result, XCO assumes the market risk and price risk in relation to the sales of the bags in country I … .The luxury bag market of country I where the imported goods were resold has been very competitive. However, in 2012, the actual sales income of ICO far exceeded the estimated income since more bags were sold at full price, and fewer at a discounted price, than anticipated. Consequently, ICO’s gross margin in 2012 was 64 % which was higher than the targeted gross margin stated in ICO’s transfer pricing policy … .ICO submitted a transfer pricing report, which used the Resale Price Method that compared ICO’s gross margin with the gross margins earned by comparable companies in their transactions with unrelated parties (i.e. comparable uncontrolled transactions). The transfer pricing report was prepared by an independent firm following the process set out in accordance with the OECD Transfer Pricing Guidelines. According to the transfer pricing report, ICO does not employ any valuable, unique intangible assets or assumed any significant risk. The transfer pricing report submitted by ICO selected eight comparable companies located in country I. The functional analysis indicated that the eight selected comparable companies imported comparable products from country X, performed similar functions, assumed similar risks and did not employ any valuable intangible assets, just as ICO. The transfer pricing report indicated that the arm’s length (inter-quartile) range of gross margins earned by the selected comparable companies in 2012 was between 35 %-46 %, with a median of 43 %. Therefore, the 64 % gross margin earned by ICO did not fall within the arm’s length inter-quartile range.

Before we critique this case study, let’s note that Deloitte, Ernst & Young, and KPMG all cited this case with very little to contribute as to what may have been the real issues here. We shall only note the Deloitte discussion:[2]
Case Study 14.2 is the first formal WCO instrument that is based on a submission by China, which demonstrates Chinese Customs’ contribution to, and participation in, the development of international standards for customs valuation practice. Case Study 14.2 provides an important reference and guidance for importers and exporters conducting cross-border trading businesses in China.
The transactional net margin method (TNMM) is the most commonly used method in transfer pricing reports. However, Chinese Customs favors the RPM when using transfer pricing reports to examine related party transactions because Customs normally focuses more on an importer’s gross margin rather than its net profit. According to Chinese Customs, many transfer pricing reports that use the TNMM generally lack sufficient information for Customs to evaluate the reasonableness of an importer’s gross margin.
When selecting comparable companies, a transfer pricing analysis on imports of tangible goods often focuses on the similarities between the functions and risks assumed by the tested party with those of the comparable companies, and the analysis may be less focused on the differences between the tangible goods imported by the tested party and those imported by comparable companies. However, Customs valuation is much stricter on the comparability of goods, with the result that a company with similar functions and risks but that imports goods that are different from the goods imported by the tested party may not be considered a comparable by Customs. Furthermore, the Customs administration in Case Study 14.2 attributes the higher gross profit earned by the importer to the lower import price as a result of the influence of the special relationship. In practice, however, a higher gross profit of a limited risk distributor can result from a number of factors (such as the local market environment). Limited-risk importers with higher gross profits may wish to conduct a comprehensive analysis to identify whether these factors exist and to quantify their contributions to manage the potential risk from a Customs valuation perspective.
As we shall note below, both types of issues involve high function distribution affiliates so one would reasonably expect high gross margins under the arm’s length standard. Practitioners have been known to use naïve applications of the Resale Price Method. MRPM on the other hand would evaluate the appropriate gross margin as the sum of the value-added expenses for the distribution affiliate and its appropriate operating margin. Transfer pricing practitioners typically evaluate the appropriate operating margin using an application of TNMM.
Appropriate applications of TNMM would consider both the functions and the assets of the distribution affiliate. My paper on the appropriate gross margin for distribution affiliates posed the following model:[3]
GP/S = a + b(OE/S) + r(WC/S), where S = sales, GP = gross profits, OE = operating expenses (or more correctly value-added expenses), and WC = working capital (inventory + trade receivables – trade payables). This equation has three key parameters:

This model can be stated alternatively in terms of the operating margin:
OP/S = a + m(OE/S) + r(WC/S)
where OP = operating profits and m = b – 1.
We apply this model to this particular issue below. The report prepared for the multinational alas neither applies our model nor justifies the 64 percent gross margin, which effectively gave the Chinese customs officials an easy argument for their adjustment. We note below that while a 64 percent gross margin may have been too high, the 42 percent gross margin would be too low if the distribution affiliate’s functions exceeded those of the alleged comparables. At least the Deloitte discussion noted that there may be factors that might explain a higher gross margin under arm’s length pricing even as they failed to identify specific. The Deloitte discussion also made the odd claim that the Chinese affiliate was “limited risk”, which would tend to support the premise that the gross margin should be more modest.
Two of the leading designer hand bags labels are Coach – which is owned by Tapestry – and Louis Vuitton – which is part of LVMH. Both multinationals sell other products as well and both have operating margins just shy of 20 percent with operating expenses near 50 percent of sales. While one can purchase a Coach bag for less than $500, Louis Vuitton bags often sell for much more. Louis Vuitton produces its products through manufacturing affiliates in Europe and North America. The 10-K filing for Tapestry shows that its Chinese sales are around $650 million per year. Let’s consider a hypothetical example of a designer hand bag multinational where it sells 1 million bags per year in China at $500 per bag where:

Table 1 presents the consolidated financials as well as how profits are allocated if the intercompany pricing policy affords the Chinese affiliate with a 64 percent gross margin. While the Chinese distribution affiliate captures a 14 percent operating margin or $70 million in profits, the manufacturer and designer affiliates capture only $30 million in profits or 6 percent of sales. The transfer pricing policy is also consistent with the manufacturer affiliate receiving cost plus 20 percent if the Chinese affiliate is assumed to capture all remaining profits. One could reasonably wonder how such a policy might be arm’s length since all of the value of designs and marketing intangibles would be captured by the distribution affiliate. Of course one could also imagine that the transfer pricing policy for customs purposes was originally based on an application of the Computed Value Method with the manufacturing affiliate as the tested party. If so, the Chinese customs authorities could challenge this methodology on the grounds that it ignores the value of the design intangibles with the alternative being an application of the Deductive Value Method, which focuses on the gross margin of the distribution affiliate.
Table 1: Our Hypothetical Designer Handbag Multinational

Millions Millions Chinese affiliate Manufacturer
Sales $500 $500 $180
Cost of goods $150 $180 $150
Gross profits $350 $320 $30
Operating exp. $250 $250 $0
Operating profit $100 $70 $30

While the case study does not specify the financials for the eight allegedly “comparable” distributors, let’s assume the following for the typical alleged comparable:

Table 2 compares our hypothetical alleged comparable and our Chinese affiliate. The gross margin for the comparable may be only 42 percent but its operating expense to sales ratio is only 35 percent as compared to the 50 percent operating expense to sales ratio for the affiliate. When the Chinese customs authority asserts that the transfer price should be raised from $180 per bag to $290 per bag so as to lower the affiliate’s gross margin to 42 percent, the implication is that the affiliate’s operating losses should be $40 million per year. Assuredly, the China’s State Tax Administration (STA) would not agree with this position for income tax purposes. 
Table 2: A Naïve Application of RPM for the Handbag Distribution Affiliate

Millions Chinese affiliate Adjustment Comparable
Sales $500 $500 $100
Cost of goods $180 $290 $58
Gross profits $320 $210 $42
Operating exp. $250 $250 $35
Operating profit $70 -$40 $7
GPM 64% 42% 42%
OE/Sales 50% 50% 35%
OPM 14% -8% 7%
Berry ratio 1.28 0.84 1.2

Note with the 64 percent gross margin, the affiliate’s 14 percent operating margin is twice that of the third party distributor. Of course, its operating expenses relative to sales are higher suggesting greater functional responsibilities than those of the alleged comparable. But how would one explain its 1.28 Berry ratio as opposed to the 1.2 Berry ratio for the comparable? We shall in fact argue that the affiliate’s Berry ratio might be lower than 1.2 unless the Chinese affiliate owned valuable intangible assets.
A key issue in terms of the application of a Berry ratio approach is what would represent appropriate adjustments for items such as differences in the asset intensity of the controlled transaction versus that of the allegedly comparable distributors. In order to do this, let’s specify an underlying set of assumptions for the return to working capital and the ratio of working capital to sales for the comparable and for the Chinese affiliate. Let’s assume that the ratio of working capital to sales for both entities equals 15 percent with the return to working capital being 5 percent. Assume that the return to operating expenses (m) is 15 percent, which would suggest a 6 percent operating margin for the comparable in the absence of any intangible assets and a 8.25 percent operating margin for the Chinese affiliate. If the Chinese affiliate does not own any valuable intangible assets, then our TNMM analysis would suggest a 58.25 percent gross margin as the arm’s length standard. Table 3 presents this scenario in column A.
Table 3: Alternative Transfer Pricing Policy for Our Handbag Distribution Affiliate

Millions A B C D
Sales $500.00 $500.00 $500.00 $500.00
Cost of goods $208.75 $203.75 $200.00 $180.00
Gross profits $291.25 $296.25 $300.00 $320.00
Operating exp. $250.00 $250.00 $250.00 $250.00
Operating profit $41.25 $46.25 $50.00 $70.00
GPM 58.25% 59.25% 60% 64%
OE/Sales 50% 50% 50% 50%
OPM 8.25% 9.25% 10% 14%
Berry ratio 1.165 1.185 1.2 1.28
Routine return $41.25 $41.25 $41.25 $41.25
Intangible profits $0.00 $5.00 $8.75 $28.75

We must note, however, that the third party distributor’s 7 percent operating margin would imply its return to intangible assets was 1 percent of sales. If the Chinese affiliate owned marketing intangibles that also had a value equal to 1 percent of sales, the analysis would imply a 59.25 percent gross margin as arm’s length. Table 3 presents this scenario in column B. Note that the naïve use of the 1.2 Berry ratio for the alleged comparable to suggest a 60 percent gross margin would imply that the value of intangible assets owned by the Chinese affiliate represented 1.75 percent of sales. Table 3 presents this scenario in column C. Finally, the actual gross margin of 64 percent would be arm’s length only if the value of the intangible assets owned by the Chinese affiliate represented 5.75 percent of sales as in column D of table 3. We noted earlier that the 64 percent gross margin was consistent with the premise that the Chinese affiliate owning all of the valuable intangible assets including the design intangibles. This assumption, however, would not be plausible if the foreign parent owned the design intangibles. The precise gross margin would likely be less than 64 percent but greater than 58.25 percent depending on the relative value of the design intangibles owned abroad versus any marketing intangibles owned by the Chinese affiliate. In other words, the appropriate analysis would likely be some form of residual profit split approach.
Given our discussion of the possible issues in this case, how did a representative of the multinational prepare an analysis that purported to show that the gross margin should be closer to 42 percent? One could imagine that the practitioner was not properly informed of the facts we have suggested here or one could imagine a different set of facts. Case 14.2 does note that there were three related parties. Could the contract manufacturing affiliate been paid $180 per bag while the distribution affiliate was charged $290 per bag with the parent affiliate retaining $110 per bag to cover the cost of advertising and as compensation for its ownership of design and marketing intangibles. The report arguing for a 42 percent gross margin would then likely have been prepared for Chinese income tax purposes while a report based on the Computed Value Method was prepared for customs purposes. We noted earlier that the Chinese customs authority might rightfully reject the Computed Value Method approach in favor of Deductive Method approach. If the Chinese affiliate only incurred operating expenses equal to 35 percent of sales and did not own the marketing intangibles, then the 42 percent gross margin would be a reasonable estimate of what would have occurred under arm’s length pricing. We should note, however, a position being taken by the Chinese SAT. Liao Tizhong of the Chinese SAT used Louis Vuitton handbags as example of where a Chinese affiliate would own valuable marketing intangibles as he noted the high price of these bags in China. [4]  As such, he is arguing for a lower transfer pricing because his scenario assumes the marketing intangibles are owned by the Chinese distribution affiliate.
The issues noted in this discussion as well as our previous discussion are present in other sectors, which exhibit both extensive advertising and high consolidated profit margins. In an upcoming article, we note a U.S. customs ruling involving medical devices as well as Asian imports of alcoholic beverages.
[1] http://www.wcoomd.org/-/media/wco/public/global/pdf/media/press-release/2017/case-study-14_2_en-release-version.pdf?la=en
[2] See “TCCV Issues New Case 14.2 on Transfer Pricing and Customs Valuation”, November 7, 2017 – https://www.taxathand.com/article/7717/China/2017/TCCV-issues-new-case-study-14-2-on-transfer-pricing-and-customs-valuation. Also see http://www.ey.com/Publication/vwLUAssets/ey-customs-valuation-case-study-transfer-pricing/$FILE/ey-customs-valuation-case-study-transfer-pricing.pdf and https://home.kpmg.com/cn/en/home/insights/2017/11/china-tax-alert-29.html.
[3] “Profitability of Limited-Function Distributors: Cases Show Confusion by IRS, CRA Over Profit-Level Indicators”, BNA Transfer Pricing Report, June 26, 2014.
[4] “Chinese Tax Auditors Remunerating Local Affiliates For Location Savings—‘Like it or Not,’ SAT Official Says”, BNA Transfer Pricing Report, March 21, 2013.

Case study on TP and customs compliance: impact of alternative payment flows and the treatment of advertising costs

The following article is part of a series of case studies which have been kindly contributed by Dr Harold McClure, a New-York based economist who has advised in the area of transfer pricing for many years.
In an earlier paper on the application of the modified Resale Price Method (MRPM) for customs valuation purposes, I note:[1]

Transfer pricing practitioners generally focus on technical benchmarking issues, while many of the concerns of customs authorities represent implementation issues. We shall note the distinction in a series of case studies, which are based on actual controversies where a general agreement is that the benchmarking should focus on the appropriate margin for a local distribution affiliate importing a product from its parent corporation. A key question is whether the benchmarking exercise is designed to determine an appropriate gross margin versus operating margin.

The case studies generally involved importing affiliates that performed only a modest level of functions so that a proper application of MRPM would conclude that the gross margin for the importer should also be modest. MRPM is equivalent to the Deductive Value Method for customs valuation as both evaluate the gross margin of the distribution affiliate in terms of its functions and assets.
KPMG’s September 2018 China Tax Alert noted a disturbing development:[2]

In October 2017, WCO TCCV issued Case Study 14.2 regarding “Use of transfer pricing documentation when examining Related Party Transactions under Article 1.2(a) of WTO Valuation Agreement”. Since the issuance of Case Study 14.2, China Customs has increasingly reviewed import prices of related party transactions based on the gross profit level of comparable companies. In current practice, if the gross margin of imported products is higher than the upper quartile of comparable companies, the customs valuation risk would be relatively high.

The discussion below notes the two case studies presented by Harvey Lee of the Shanghai Kingfaith Consulting firm in a webinar hosted by LCN Legal. We shall use the case studies to argue that a naive comparison of gross margins may understate the appropriate gross margin thereby overstating the appropriate customs valuation under the arm’s length standard.
The first case study put forward by Harvey Lee focused on intercompany royalties. Consider a French parent that owns all intangible assets and uses an affiliate in Czech Republic to manufacture goods exported to a Chinese distribution affiliate. The Chinese distribution affiliate pays the Czech Republic an intercompany price equal to production costs plus a reasonable markup. Under arm’s length pricing, the Chinese affiliate would also pay the French parent intercompany royalties for the use of the intangible assets. No such royalties were included in the customs valuation.
The second case study involved simply the transfer price for goods produced in one nation for distribution in China. A French parent designed and manufactured goods that it sold to a third party Chinese distributor where the distributor received a 30 percent gross margin. French parent acquired the Chinese distributor and lowered the prices of goods such that the distribution affiliate received a 60 percent gross margin. Chinese customs found other third party distributors of similar products were their gross margins were near 30 percent.
Both of these case studies consider a multinational that generates high profits. The positions of the Chinese custom authorities are likely to be accepted by the French Tax Authority (FTA) as high goods prices or considerable royalty payments would lead to more French taxable income. The Chinese State Administration of Taxation (SAT) may argue for lower royalty payments in the first case study and for a lower transfer price in the second case study in order to increase Chinese taxable income.
The essence of both case studies can be captured by a hypothetical example where a biopharmaceutical developed a treatment for certain viruses in France, produced the treatment using a Czech manufacturing affiliate, and sold the treatment to Chinese patients using a Chinese distribution affiliate. Our example assumes the following:

A key issue is which entity bears these third party advertising expenses and which entity owns the marketing intangibles. Initially the French parent bore all intangible development costs including these marketing expenses. Consolidated profits are $400 million per year, which are allocated to the three affiliates according to the transfer pricing policies.
We shall describe two payments flows, which lead to the same allocation of consolidated profits among the three affiliates. In both scenarios, the Czech affiliate is paid $300 million representing a 25 percent markup over production costs. The transfer pricing advisers for this multinational justified this markup as being arm’s length using a Transaction Net Margin Method (TNMM) approach with the production affiliate as the tested party. A separate application of TNMM with the distribution affiliate noted that the distribution affiliate should also receive a 25 percent markup over its distribution expenses. This second application would suggest that the distribution affiliate receive a 30 percent gross margin.
One payment flow would have the Chinese distribution affiliate pay the Czech affiliate directly and also pay royalties equal to 40 percent of sales to the French parent for the use of product and marketing intangibles. Another payment flow would have the French parent pay the Czech affiliate $300 million for the treatments and then charge the Chinese affiliate $700 million. Both payment flows grant the Czech affiliate with its routine return equal to $50 million and grant the Chinese affiliate with its routine return equal to $50 million. The French affiliate retains $300 million in profits as owner of all intangible assets.
The first payment flow is an example of Lee’s first scenario. Customs duties would include not only the $300 million payment to the Czech affiliate for the treatments but also the $400 million in intercompany royalties. The second payment flow corresponds to Lee’s second scenario where the Chinese distributor initially received a 30 percent gross margin.
Lee’s second case states that the gross margin for the Chinese distribution affiliates was increased from 30 percent to 60 percent, which lowered the intercompany price for the treatments from $700 million to only $400 million. If this change was not accompanied by any increase in the functions or expenses incurred by the Chinese affiliate, all of the profits attributable to the intangible assets would be diverted away from the French parent to the Chinese affiliate. The FTA would certainly object to this change in the intercompany pricing structure. Lee’s discussion noted two reasonable arguments made by the Chinese customs officials for asserting that the appropriate gross margin is still only 30 percent. One is simply that the Chinese distributor received a 30 percent gross margin before it was acquired. The second argument was based on the identification of other third party distributors that also received a 30 percent gross margin. The underlying premise of this second argument is that the functions of these third party distributors were the same as the functions performed by the distribution affiliate. Customs authorities recognized these approaches as applications of the Deductive Value Method. The FTA could use the same evidence as applications of the Resale Price Method.
Let’s consider, however, another possible change in the intercompany structure where the Chinese affiliate is required to pay the $100 million in advertising expenses. In this case, a 30 percent gross margin is not sufficient compensation for the Chinese distribution affiliate as its operating expenses have increased from 25 percent of sales to 35 percent of sales. Note that the Chinese affiliate would be incurring more functions than either the former independent distributor or the third party distributors used by the customs authorities. A naïve application of the Deductive Value Method or the Resale Price Method that did not incorporate the implications of the additional expenses incurred by the distribution affiliate would lead to absurd results.
The FTA would likely accept letting the gross margin rise from 30 percent to 40 percent, which would retain the original allocation of consolidated profits that granted the French parent with the entirety of residual profits. If the mere payment of the invoices from the third party advertising agency did not alter the assumption that the French parent owns all of the intangibles, then a 40 percent gross margin would be reasonable. If the SAT, however, asserted that the new structure meant that the Chinese affiliate owned a portion of the marketing intangibles, then it could argue for a gross margin higher than 40 percent.
Case Study 14.2 involves the importation of luxury handbags in China. Our next case study explores the issues in this case, which have similarities with the two cases we have discussed in this contribution.
[1] “A Renewed Interest in the Modified Resale Price Method for Customs Valuation”, Journal of International Taxation, April 2020.
[2]  “Release of Guide to Customs Valuation and Transfer Pricing (2018 Edition)”.

Do you have a protocol for handling TP audits?

One of the things I love about attending conferences like TP Minds International last week, is that (as an adviser) you get insights into the real-life practicalities of managing TP risks, as opposed to just high level theory and crystal ball-gazing.
One of the polling questions we asked on the panel session I hosted on TP audits was ‘Do you have a protocol for handling TP audits?’
Interestingly, around 42% of respondents said ‘No’.
The scenario we’re talking about here is very simple. One of your local subsidiaries – maybe in a far flung country – receives a TP related enquiry (or is even subject to a dawn raid from the ‘tax police’).
Who should the local representatives contact internally about this?
Which local or international advisers should they call?
What approach should the local team adopt generally, when dealing with the tax inspectors?
Where are the TP files kept?
Where are the intercompany agreements kept?
If you have a written protocol for handling TP audits, please drop us a quick email at info@lcnlegal.com and let us know what other items your protocol covers. We’ll be very happy to produce a consolidated checklist (anonymised, of course), and share it so that it is available to others for free.

Free Guide: Effective Intercompany Agreements for TP Compliance