An essential step prior to benchmarking. Ready... steady...
In real life, the contractual structure of remuneration can make an enormous difference to price and willingness to transact.
For example, in the field of professional advisory services, the options as regards contractual structure of remuneration include:
- Hourly rates
- Fixed fees*
- Monthly retainers
- Value billing (% of transaction value)
- Success billing (contingent on a specified outcome)
If you’re involved in the business of advisory services, whether as buyer or seller or both, you’ll immediately understand what a difference the selection of these options can make to the absolute amount of fees which may be payable. And to whether or not you think it's a suitable arrangement in any given situation.
The OECD Transfer Pricing Guidelines recognise this: the contractual structure of remuneration is an essential part of the delineation of a transaction, because it can constitutes an implicit risk allocation – which therefore needs to be taken into account in assessing an arm’s length price. Here’s the key section, also shown in the slide above:
“A written contract typically sets out an intended assumption of risk by the parties. Some risks may be explicitly assumed in the contractual arrangements. For example, a distributor might contractually assume accounts receivable risk, inventory risk, and credit risks associated with the distributor’s sales to unrelated customers. Other risks might be implicitly assumed. For example, contractual arrangements that provide non-contingent remuneration for one of the parties implicitly allocate the outcome of some risks, including unanticipated profits or losses, to the other party.”
(OECD TPG 2022 Edition, Para 1.77)
What does this mean in practice?
Some TP methods (such as cost plus) imply a particular structure of remuneration.
Others, such as TNMM / CPM, don’t.
So, for example, a transaction in which a distributor is guaranteed a particular margin is a completely different economic proposition to a transaction in which a distributor buys at a specified discount to list prices, with the intention (or hope, or expectation, or possibility) that this might produce an outcome within a specific range.
Either way, you can’t begin to look at comparables (benchmarking) for that transaction until you’ve established the intended contractual structure of remuneration.
Otherwise, you’re pricing something which has not yet been identified. You’ve jumped the gun.
*PS: In case you're wondering, at LCN Legal, most of our work designing intercompany agreements is on a fixed fee basis.
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