This kind of situation seems to be coming to light more and more frequently – perhaps as the reality of transfer pricing compliance kicks in. I would be very interested to hear what you would do about it.
A typical scenario is as follows: A multinational group’s business activities include the sale of products, and the supply chain is described in the Transfer Pricing Master File and Local Files for historic accounting periods. A handful of group companies are described as acting as regional manufacturers and ‘entrepreneurs’ in relation to the sale of the products. Additional local entitles are referred to as ‘limited risk distributors’ or ‘LRDs’, and they act as principals in the sale of products to third parties.
The LRDs may achieve operating margins of around 2% or 2.5%, and the Master File / Local Files usually include words to the effect that the LRDs:
1. Do not assume product liability risk
2. Do not assume inventory risk
3. Earn a guaranteed routine return
Based on the situations we typically come across:
- Statement 1 above is often incorrect. Since the LRDs act as principal, the default position is that they do assume product liability risk, unless the relevant intercompany distribution agreements contain counter-indemnities or other provisions which would move that risk onto the regional entrepreneurs.
- Statement 2 is also typically not supported by the legal allocation of risk in the intercompany distribution agreements.
- Statement 3 is incorrect unless there is a contractual guarantee that a specified return will be earned – and this is often absent.
From a legal perspective, the action is obvious – fix the intercompany agreements as soon as possible. We can’t re-write history, but we can get things on track going forward.
My question to you relates to the Master File itself, the Local Files for the same period, and the associated tax filings which will have been made. What should the group do? Should it:
A. Do nothing, and hope that no-one notices.
B. Attempt to put in place limited risk distribution agreements with a retrospective effective date (knowing that the OECD’s Transfer Pricing Guidelines are clear in saying that risk cannot be allocated after the event).
C. Pro-actively raise the issue with the relevant tax authorities?
What would you do?
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