Limited risk distributors (sometimes referred to as ‘LRDs’) are a common feature of intercompany transactions within multinational groups. The essence of the arrangement is of course to de-risk the role of the intra-group distributor, resulting in a correspondingly lower return or margin for the distributor. In many ways, the position of the distributor is commercially analogous with that of a commercial agent, commissionaire or ‘glorified employee’.
By contrast, the term ‘fully-fledged distributor’ is often used to describe a distribution entity that undertakes all significant functions, bears and controls substantial risks, and engages in activities such as marketing, inventory management, and assuming market risks.
The role of agreements in transfer pricing analysis
Alignment between the legal design of intra-group transactions and the tax/transfer pricing analysis, including ongoing transfer pricing documentation, is essential to ensure the arrangement is robust and defensible.
The reason for this is simple: contractual terms can change the commercial nature of a controlled transaction, which in turn can affect the economic analysis.
Put another way: contractual allocation of risk can have independent value, irrespective of functions performed.
As for any intra-group relationship, the legal design of the arrangement should therefore go hand-in-hand with the tax and transfer pricing analysis (including functional analysis, comparables, VAT and customs duties). This requires careful identification of the legal fact pattern, the relevant functional elements of the distribution arrangements, and the selection of the appropriate tested party for transfer pricing purposes.
The following is a non-exhaustive list of considerations as regards the legal aspects of limited risk distribution arrangements, to reflect the allocation of risk and reward between the parties.
Wider stakeholders in the design of intercompany transactions
Although transfer pricing is often regarded as the most significant category of tax risk affecting multinational groups, it is not the only stakeholder in the design of intercompany transactions and agreements.
Other relevant stakeholders include the corporation tax deductibility of payments (which often requires contemporaneous agreement which contain legal binding payment obligations), the VAT / GST treatment of payments, customs and tariffs considerations, regulatory obligations, the accounting treatment of the relevant transactions and the need for legal entity directors to demonstrate that they are complying with their fiduciary obligations.
Risks and obligations
At the outset, it is important to identify with specificity the economically significant risks which are relevant to the appointment of the distributor. Then design and document a set of transactions which reflects an appropriate allocation of each risk, aligning the contractual terms with the control over risk, financial capacity to bear risk and the actual conduct of the parties in practice.
Relevant risks affecting distributors selling products, and their contractual treatment, may include the following:
- Buying risk / inventory risk – this may be reflected by the absence of any minimum purchase obligations imposed on the distributor, together with an obligation on the supplier to repurchase any unsold stock (akin to a ‘sale or return’ arrangement). Alternatively, the relationship may be structured as a consignment stock arrangement, so that the stock remains the property and risk of the supplier until the point of sale to the distributor’s customer. Inventory risk is thus effectively controlled by the principal, limiting the distributor’s exposure.
- Credit risks – may be addressed through deferred payment terms for purchase of stock by the distributor or, alternatively, by a supplier’s duty to purchase any outstanding book debts of the distributor at face value. In some cases, the principal may reimburse or control for bad debts, ensuring that the distributor does not bear the financial impact of uncollectible receivables.
- Product liability and intellectual property infringement risks – the distributor may be entitled to an indemnity against any product liability-type claims, whether arising in contract or tort, including the costs of dealing with any warranty claims and infringement of intellectual property claims.
- Market investment risks – the cost of entering a new market or maintaining and developing a market position may be borne by the supplier, either by allocating the relevant obligations to the supplier, or by entitling the distributor to reimbursement of all relevant costs. Market risk and market risks associated with fluctuations in demand or competitive conditions may also be assumed by the supplier.
- Currency risk – this is primarily a function of the distributor’s exposure to different currencies for buying and selling the supplier’s products, but may also be addressed by guaranteeing the distributor a minimum operating margin on the terms of the intercompany agreement.
If risks are not properly analysed and reflected in an appropriate intercompany agreement, the group concerned will be exposed to unnecessary risks of double taxation, fines and penalties. The costs of benchmarking and TP compliance may have been wasted, as the benchmarking may not relate to the ‘actual transaction’ between the associated entities.
Ability to derive ongoing benefit
Limited risk will typically be associated with a limited ability on the part of the distributor to derive an ongoing benefit from the arrangements. The distributor’s functions may be restricted to routine activities such as basic marketing, promotion, and distribution, and may not include activities that would develop significant marketing intangibles. This may be reflected in the contractual terms dealing with the following matters:
- Ownership of customer lists;
- Ownership of reputation and goodwill created through the distributor’s activities, with the distributor’s functions not entitling them to ongoing benefits from any intangibles developed;
- Exclusion of any right on the part of the distributor to receive any payment by way of compensation or indemnity on termination of the intercompany agreement (subject to any mandatory provisions of local law).
Transfer pricing methods
The selection of an appropriate transfer pricing method is the cornerstone of any effective transfer pricing strategy, especially when it comes to structuring limited risk distribution agreements. The primary objective is to ensure that the transfer price set for transactions between related parties—such as a principal and its limited risk distributor—reflects the arm’s length principle and is defensible to tax authorities.
The limited functions performed by LRDs are general expected to generate stable profits and rarely incur losses. Loss making transactions are evaluated carefully for transfer pricing purposes, considering whether such losses reflect normal business risks and economic circumstances.
The Transactional Net Margin Method (TNMM) / Comparable Profits Method (CPM) is probably the most widely used transfer pricing method in connection with limited risk distributors. The TNMM works by comparing the net profit margin earned by the limited risk distributor to those earned by comparable companies operating under similar market conditions. This approach is particularly suitable for limited risk distributors because it takes into account the limited functions performed, the routine nature of their activities, and the minimal risks undertaken—such as limited exposure to bad debt, inventory management, and market fluctuations.
The OECD Transfer Pricing Guidelines specifically endorse the TNMM for limited risk distributors, highlighting the importance of a thorough functional analysis. This analysis should identify the significant functions performed, assets used, and risks assumed by the distributor, ensuring that the transfer pricing method selected accurately reflects the distributor’s risk profile and does not attribute profits for activities or intangibles—such as significant marketing intangibles—that the distributor does not develop.
While the TNMM / CPM is often the preferred method, other transfer pricing methods like the Resale Price Method (RPM) may also be considered, depending on the availability of reliable comparable data and the specific facts of the controlled transactions. The choice of method should always be based on a comprehensive analysis of the distributor’s business operations, the value chain, and the comparability of tested parties.
It is important to recognise that limited risk distributors are typically routine entities within the multinational group, earning a limited and predictable profit that is commensurate with their low risk profile. They do not develop unique and valuable intangibles, nor do they bear the more significant functions or business risks that would justify a higher return. As such, the design of the transaction should ensure that the distributor’s remuneration is consistent with its limited risk and does not expose the group to unnecessary transfer pricing disputes or compliance costs.
In practice, a robust transfer pricing strategy for limited risk distributors involves not only selecting the most appropriate transfer pricing method but also documenting the rationale for that choice, supported by a comprehensive comparability analysis. This approach helps multinational companies demonstrate to tax authorities that their transfer pricing arrangements are in line with the arm’s length principle and the requirements of local transfer pricing regulations.
Contractual structure of remuneration
In traditional third-party distribution arrangements, the primary pricing mechanism relates to the price for goods supplied and the level of discount offered against list prices. In addition, the distributor may be required to pay a one-off or annual fee for the privilege of acting as a distributor, similar to a franchise fee.
For an intra-group distribution arrangements, the price payable for goods supplied may still be the primary payment mechanism. However, there would typically be a price adjustment clause to allow the distributor an appropriate fixed or minimum operating profit, consistent with the group’s transfer pricing compliance strategy.
The OECD Transfer Pricing Guidelines recognise that the contractual structure of remuneration (i.e. the mechanism for calculating payments between the parties), can of itself constitute an allocation of risk. This means that payment clauses in intercompany agreements are an input into the transfer pricing analysis, rather than merely an output from the benchmarking performed.
A common contractual approach is to specify in the limited risk distribution agreement a range of possible outcomes for the distributor. In this approach, the agreement might specify a ‘ceiling’ as regards the relevant Profit Level Indicator which achieved by the distributor in each financial period, with any excess ‘repatriated’ to the principal. The agreement may similarly specify a ‘floor’, so that the principal may be required to make a support payment to the distributor if that floor is not otherwise achieved.
This approach is one way of documenting the allocation of market risk, since the commercial arrangement between principal and distributor is that the distributor is ‘guaranteed’ to achieve a financial result within a specified range, irrespective of fluctuations in market demand for the relevant products.
Corporate governance
As with any intra-group arrangements, written intercompany agreements are essential from a corporate governance perspective. Without such an agreement, the directors or officers of the participating entities (particularly the distributor) have no clear point of focus for determining whether the arrangement is one which they can properly approve.
Linked with this is the need to brief legal entity directors on the arrangements they are being asked to approve, and the implications of the approach reflected in the proposed agreements. This serves two purposes: firstly, it protects those directors from unnecessary risks of personal liability arising for breach of personal fiduciary duties. Secondly, it explains and documents the commercial rationale for the arrangements, which is essential from a tax and transfer pricing compliance perspective.