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:

  • Chinese sales = $1 billion per year;
  • Distribution costs borne by the Chinese affiliate = 25 percent of sales or $250 million per year;
  • Production costs = 25 percent of sales or $250 million per year; and
  • Third party advertising expenses in China = $100 million per year.

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)”.

How to create effective Intercompany Agreements

Download our free guide to implementing intercompany agreements for a multinational group.

Free Download