Target margin arrangements: looking back is easier than looking forward

Some considerations in the legal implementation of target margin arrangements

Intercompany agreements for implementing ‘target margin’ arrangements in TP can be challenging, for a number of reasons. One is that there may be a lack of clarity as to whether TNMM / CPM is being used on a price setting (ex ante) basis, or on an outcome testing (ex post) basis.

If it’s purely for outcome testing, then the intercompany agreement for the relevant transaction will need to specify pricing in a way which is ‘clear and unambigous’, but it may not be not essential to refer to a margin at all.

If TNMM / CPM is being used for forward-looking price setting, then of course the pricing provisions need to be looked at carefully. This is even more important when the arrangements involve the supply of physical goods, such as for a limited function distributor, because individual shipments generally need to be priced in real time. And the overall margin achieved in the course of any given year will depend on total volumes, which may be unpredictable.

So what should the agreement look like, as regards pricing? The slide above uses an example of shipments to a related party distributor that are priced and invoiced in real time, and shows two separate aspects which need to be adressed in the intercompany agreement.

A. How individual shipments should be priced. The options are to specify this (the principal has discretion to set appropriate prices) or to leave it open (an 'agreement to agree').

B. The means by which the distributor achieves an arm's length margin. Is this a legally binding mechanism, and if so does it specify a 'ceiling' for the distributor's profits, as well as a 'floor'? Or does the agreement merely state an intention that this should happen, subject to both parties' agreement?

Of course, other factors will be relevant too, such as allocation of specific risks (inventory risk, credit risk, product liability risk and others), because each of those factors may be economically significant.

As always, if you have any comments about the slide, or suggestions for improving it, we'd be delighted to hear them.

Finally, a quick reminder that target margin arrangements were the subject of the first episode of our podcast. It's a brief (twenty minute) but detailed discussion, and people have told us that they liked the content and the format. You'll find it here.