The Dolce & Gabbana Litigation and Type C Service Provider Arrangements

This is a guest post by Harold McClure, a New York City-based independent economist with 26 years of transfer pricing and valuation experience. (One of several that he has written for us.) Here he discusses the issues raised by a 2022 Italian tax case: Italy vs Dolce & Gabbana.

Paul Sutton’s recent discussion of cost plus compensation in intercompany agreements noted:

Although cost plus service recharges are commonplace in transfer pricing, it’s actually quite an extreme position when looked at from a commercial perspective. Would you hire out your team at cost plus 5%? Or even cost plus 10%? Probably not. And if you did, you would probably want the security of a long-term arrangement. (Just one reason why contractual notice periods can be important.)

His type C structure addressed situations where multiple affiliates provide services to the parent corporation, as in “local sales and marketing services provided to the principal”. Italy vs Dolce & Gabbana (S.R.L., November 2022, Supreme Court, Case no 02599/2023) may represent a recent litigation that allows us to explore these considerations. TPCases.com notes:

DG s.r.l., in order to carry out promotion and marketing activities in the U.S.A., made use of the company Dolce&Gabbana Usa Inc. (hereinafter DG Usa) with contracts in force since 2002; in particular, on March 16, 2005, it entered into a service agreement whereby DG Usa undertook to provide the aforesaid services in return for an annual fee payable by DG s.r.l.; this consideration is determined on the basis of the costs analytically attributable to the provision of the agreed services in addition to a markup, i.e. a markup determined in a variable percentage based on the amount of the cost. In order to verify the fairness of the consideration, the parties have provided for the obligation of analytical reporting as well as an amicable settlement procedure through an auditing company. Lastly, DG s.r.l., DG Usa and DG Industria entered into another agreement, supply agreement, whereby DG Industria appointed DG Usa as its distributor for the USA in mono-brand shops, DG Usa committed to DG s.r.l. to adapt the shops to its high-quality standards functional to increasing brand awareness, and DG s.r.l. committed to pay a service fee. The service contribution was recognised in relation to the costs exceeding a percentage of the turnover realised through the mono-brand sales outlets.

The court decision provides no financial information with respect to this transfer pricing issue and Dolce & Gabbana is a privately held multinational. We shall, however, present a reasonable illustrative numerical example of what the transfer pricing dispute may have been about.

Dolce & Gabbana is a luxury Italian fashion house founded in 1985 by the two Italian designers, Domenico Dolce and Stefano Gabbana. Its annual sales have hovered around $800 million per year, with record operating profits near $100 million per year. Its marketing budget has also been near $100 million per year. Our illustration also assumes that the Italian parent incurs $400 million in production and design costs per year, with the worldwide distributors incurring $200 million per year in selling costs. Consolidated operating profits = $100 million per year or an operating margin of 12.5%.

If the Italian parent bore not only the design costs but also the marketing costs, then the standard transfer pricing approach under the Comparable Profits Method (CPM) or Transactional Net Margin Method (TNMM) would determine the appropriate gross margin for the distribution affiliates as the sum of the selling costs/sales ratio plus a reasonable operating profit margin. The selling cost/sales ratio in our example = 25%, and a 5% operating margin would afford the distribution affiliates with a 20% return to selling costs. As such a 30% gross margin would be reasonable, which would allocate $60 million per year in profits to the Italian parent and $40 million per year to the distribution affiliates.

Local distribution affiliates, however, are required to incur the marketing costs as well as the selling costs. The facts in the Dolce & Gabbana litigation suggest that its distribution affiliates were bearing marketing costs. These situations are commonplace but pose difficult transfer pricing issues.

The primary question is whether the marketing intangibles are owned by the parent corporation or the local distribution affiliates. If the beneficiary of the marketing efforts is the local distribution affiliate, then tax authorities such as the IRS could reject the premises behind CPM with the U.S. distribution affiliate as the tested party. The argument would essentially be that the U.S. distribution affiliate deserves not only the 5% routine return for selling but also a share of residual profits.

Multinationals often finesse this situation by carefully noting that the local distribution affiliate has been compensated by the parent corporation for any historical or ongoing marketing efforts. This would typically require a clear long-term intercompany contract noting the intent for the beneficiary of marketing efforts to be the parent corporation with the local affiliate receiving appropriate compensation for its marketing efforts. The Dolce & Gabbana litigation appears to suggest that the Italian tax authorities viewed the situation in this way. Whether the IRS would agree with this view is unknown.

A second question is whether the marketing efforts should be separately invoiced from the pricing of goods or whether a policy of setting a sufficiently high distributor gross margin would suffice. The Italian tax authorities appeared to insist on simply setting an appropriate gross margin rather than having separate invoicing for marketing efforts. The following table presents the issue in this fashion under two alternative transfer pricing positions.

An Illustration of the Dolce & Gabbana Transfer Pricing Issue

The Italian tax authority also appears to have asserted that any marketing efforts by the distribution affiliate should receive no additional profit element. As such, the gross margin should reflect the sum of the 25% selling cost/sales ratio, the 12.5% marketing costs/sales ratio, and a 5% operating margin. In other words, the gross margin would be 42.5% implying a payment to the Italian parent of $460 million per year to cover the cost of production, any design costs, and $60 million in profits for the Italian parent.

Before turning to the taxpayer position, let’s consider how segmenting various payments might result in the same overall allocation of income. One issue is how the $460 million in intercompany payments to the Italian parent might be structured. The litigation noted that intercompany royalties were paid but made no mention of what the royalty rate might have been. Let’s suppose that Dolce & Gabbana paid third party vendors $380 million per year for goods and incurred $20 million per year in design costs. If the distributors paid for the goods at third party costs then they would also be paying intercompany royalties equal to 10% of sales. While the CPM/TNMM benchmarking would be the same, the intercompany contracts would likely have to note this alternative payment method. One could also imagine that the tax authorities for the distribution affiliates might challenge 10% royalty rates as being high.

The compensation for the distributor’s efforts might also be bifurcated. We noted that the appropriate gross margin for the selling efforts would put its gross margin at only 30%, which would mean that a separate intercompany payment from the parent to the distribution affiliates would be required. This alternative payment structure appears to be the situation in this litigation. The position of the Italian tax authority appears to be such that this payment should have been made at cost with no markup.

The litigation did not specify the markup over marketing costs afforded to the distribution affiliates. However, our characterization of the taxpayer’s position is that the distributor not only received a 20% markup over selling costs but also a 10% markup over marketing costs, which would result in an operating margin of 6.25%. If the distributor alternatively received a 43.75% gross margin to cover selling and marketing costs, then the resulting operating margin would be 6.25%.

If the gross margin were raised to 45%, then the distributor’s operating margin would have been 7.5%, affording the distribution affiliate not only a 20% markup over selling costs, but also a 20% markup over marketing costs. The appropriate markup over marketing costs has been an issue under India’s “bright line” approach.

The Indian tax authorities have often raised this “bright-line” test, which asserts a certain amount of the sales and marketing expenses for Indian distribution affiliates represent non-routine advertising, marketing and promotional expenses incurred on behalf of the parent corporation. The authorities will impute a marketing agreement where the compensation from the parent to the Indian affiliate should be these non-routine expenses plus a markup, which has ranged from 8% to 13% depending on the litigation.

The Benchmarking Controversy

Benchmarking for the appropriate markup for a marketing services affiliate should carefully distinguish between value-added expenses versus pass-through costs. I previously reviewed an interesting Indian litigation involving the Indian affiliate of Cheil Worldwide where this issue was central:[1]

Cheil Communications India Pvt. Ltd. is a subsidiary of Cheil Communications, a Korean-based advertising agency. Agencies often facilitate the placement of ads with print and electronic media and in doing so make payments to third parties on behalf of their customers. Thus, a portion of their costs represents pass-through expenses that are recovered from their customers in the form of gross billings. The accounting for companies such as Cheil Communications can be performed in terms of either (1) gross billing with costs that include not only value-added expenses but also pass-through costs, or (2) net billings with costs that include only value-added expenses. … Under U.S. GAAP accounting, EITF (Emerging Issue Task Force) 99-19 addresses “Reporting Revenue Gross as a Principal Versus Net as an Agent,” that is, whether the expenses related to pass-through costs and associated billings should be included in the income statement.

Dr. Charles Berry used advertising agencies as an example of the distinction between value-added versus pass-through expenses in his 1999 discussion on the use and misuse of the Berry ratio – the ratio of gross profit to operating expenses).[2] The Cheil litigation was also discussed by Gaurav Garg.[3]

The Indian affiliate also incurred both value-added expenses and pass-through costs in the form of cost of placement. While the Indian tax authority tried to include the Indian affiliate’s pass-through costs in the cost base to be marked up, the tax court agreed with the taxpayer that a return to value-added expense approach should be used.

Some transfer pricing practitioners argue that the appropriate markup should be 10% or less by an appeal to the return to total costs for advertising agencies. If these total costs include pass-through costs, this appeal is misleading. Table 1 presents the income statement for Cheil Worldwide over the 2018 to 2021 period. Profits relative to total costs (cost of placement plus value-added expenses) were only 6.92%. Over this five-year period, profits relative to value-added expenses, however, represented a 22.87% markup. For this multinational, pass-through costs represented 69.73% of total costs. The return to value-added expenses of other major advertising agencies such as Publics and Dentsu tend to be near 20% when the analysis properly excludes pass-through costs.

Table 1: Cheil Worldwide Income Statement (Millions Kwons)

The benchmarking must also consider the nature of the marketing expenses incurred by the local affiliate. If these expenses represent pass-through costs to third party advertising agencies, then no markup is required. If the affiliate’s expenses are solely value-added expenses, however, the markup should be 20% and not merely 10%. Table 2 considers intermediate situations where both pass-through costs and value-added expenses are incurred. In each case, total expenses represent $100 million and profits are defined as a 20% markup over value-added expenses.

Table 2: Three Illustrations of the Markup for a Marketing Affiliate (Millions of dollars).

If half of the expenses represent value-added expenses, then the appropriate markup over total costs is 10%. If value-added expenses represented three-fourths of total costs, then the appropriate markup over total costs is 15%. If value-added expenses represented only one-fourth of total costs, then the appropriate markup over total costs is 5%. Of course, an appropriately drafted intercompany contract will be required to evidence the approach taken.

Concluding Comments

Multinationals often establish local distribution affiliates that incur not only selling costs but also marketing expenses. A substantial number of transfer pricing controversies center on this fact pattern. Clear intercompany contracts could mitigate the extent of such disputes. The primary issue is whether the local affiliate or the parent should reap the benefits of any successful marketing efforts. The Dolce & Gabbana arrangements appeared to have the distribution affiliate compensated for its marketing efforts by the Italian parent, which would assure that the presumption in any CPM /TNMM analysis that the parent owns the marketing intangibles be respected.

The Dolce & Gabbana litigation turned on other factors including whether the marketing efforts should be separately invoiced, or whether a gross margin to cover all sales and marketing expenses plus a reasonable profit margin should have been structured. Another issue appears to be whether the distribution affiliate should receive any profit element from its marketing efforts and what that markup should be. We noted that the distinction between pass-through costs versus value-added expenses is important in evaluating the markups observed by allegedly comparable companies, and should also be reflected in the structuring of the intercompany service contract required to implement the proposed arrangements.

[1] “Indian Transfer Pricing Cases: Good News for Well-Articulated TNMM Approaches”, Journal of International Taxation, March 2013.

[2]  “Berry Ratios: Their Use and Misuse,” Journal of Global Transfer Pricing, June 1999.

[3] “Delhi ITAT: Pass through costs should not be considered while computing net cost plus margin”, Transfer Pricing News, December 24, 2010.