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:

  • the marginal Berry ratio (b), which will generally be less than the average Berry ratio (GP/OE);
  • the return to working capital (r); and
  • profits attributable to intangible assets (a).

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:

  • The cost of production including designer costs are $150 per bag;
  • The operating expenses of the Chinese affiliate including advertising represent $250 per bag; and
  • Consolidated profits equal $100 per bag or 20 percent of sales.

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:

  • Sales = $100 million ;
  • Cost of sales = $58 million; and
  • Operating expenses = $35 million.

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.

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