Documenting ‘target margin’ arrangements: you have two choices

When you’re dealing with a controlled transaction which is priced on a ‘target margin’ basis (e.g. so-called limited risk distribution), you have two main options as regards the pricing clause in your intercompany agreement.

Option 1 can be described as a ‘framework agreement’. In this approach, the agreement does not actually specify the price payable by the distributor for the relevant products. The agreement may express the intention that the distributor should achieve a specific margin within the benchmarked range. But it may leave the pricing to each individual purchase order, or otherwise specify that the price will be agreed between the parties from time to time. There’s therefore no legally binding true up or true down mechanism.

Option 2 might be called ‘contractual target margin’. The agreement specifies the target margin with legal certainty (e.g. defining the range by reference to a ceiling and a floor). It may still allow flexibility of pricing individual shipments or orders, but there is a legally binding true up / true down mechanism which relates to the specified target margin (or the ceiling and floor).

Below you’ll see a slide from one of our workshops that summarises the two options.

As always, one has to consider the matter not just from a purely legal perspective but also with an eye on potential practical issues. For example, from a purely legal perspective Option 1 is a valid approach. It’s a kind of arrangement which is not uncommon in commercial arrangements between third parties. However, will the intended TP policies actually be implemented in legal reality? Will statements made regarding the transaction in post-year end TP filings will be true?

With option 1, the TP documents cannot truthfully say that distributor has a guaranteed return: ‘guarantee’ is a strong word, and there would be no such guarantee with this approach. It is therefore doubtful whether market risk has been allocated to the principal (and away from the distributor) from a contractual perspective.

For transactions involving physical products, there are additional considerations regarding customs duties. The lack of a contractual true up / true down mechanism may mean that in some countries (the USA, for example) when a post year-end adjustment is made it’s not possible for the distributor to claim a refund of overpaid customs duties.

As always with such decisions, all perspectives must be considered carefully and all the options fully explored before making a choice. Because once the decision is made, it can be rather difficult to reverse it.