Transfer Pricing compliance for distribution companies

Introduction

The implementation of integrated business models and the development of national and multinational groups has been a trend for over 30 years. Many MNEs (Multinational Enterprises) reach a high level of vertical integration in order to ensure economies of scale and higher efficiency. In more detail, a group can be structured from companies incorporated in manufacturing, marketing and distribution, assuming all the functions of the supply chain and generating the whole added value within the group. This article focuses on distribution companies which are affiliates of a MNE. Such companies are usually categorized as wholesale or retail traders, purchase goods or services from associated manufacturers and resell them to either independent companies or other associated firms. From a Transfer Pricing aspect, each case requires a different methodology to be applied in order to review the arm’s length principle.

 

Distribution to independent companies

This section refers to companies which purchase goods or services from related parties and use their distribution channels in order to provide the market with the Group’s products. Such companies usually undertake marketing campaigns or/and transportation activities but do not participate in the production and do not add value to the product itself.

Resale price method is the most common method used to satisfy arm’s length principle in such cases. In general, the resale price method begins with the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. This resale price is then reduced by an appropriate gross margin representing the amount out of which the reseller would seek to cover its selling and other operating expenses and make an appropriate profit, taking into account assets used and risks assumed. For example, where the reseller is carrying on a general brokerage business, the resale price margin may be related to a brokerage fee, which is usually calculated as a percentage of the sales price of the product sold.

Given that gross profit margins represent gross compensation, after the cost of sales for specific functions performed, product differences are less significant. For instance, many times the real circumstances may indicate that a distribution company performs the same functions selling printers as selling keybords; therefore, in a market economy there should be a similar level of compensation for the two activities. It shall be noted that broader differences in products are more likely to be reflected in differences in functions performed between the parties involved in controlled and uncontrolled transactions. As a result, the resale price method mainly depends on comparability of functions performed, assets used and risks assumed.

The time between the original purchase and resale of goods, the existence of warranty to the client or exclusive right to resell the goods and the accounting practices adopted for controlled and uncontrolled transactions, are some other factors that affect the accuracy and reliability of the resale price method. Therefore, any necessary adjustments shall be made in order to integrate the aforementioned factors to the methodology and increase comparability.

 

Distribution to related parties

Where a product or service is purchased from an associated company and resold to another company of the same group, the application of the resale price method is biased and unreliable. In such cases other financial indicators (‘Berry ratios’) are more relevant to verify whether gross profit is in accordance with the arm’s length principle.

“Berry ratios” are defined as ratios of gross profit to operating expenses. Interest and extraordinary income are generally excluded from the gross profit determination. As for depreciation and amortization cost, it may or may not be included in the operating expenses, depending on the possible uncertainties they can create in relation to valuation and comparability.

In order for a Berry ratio to be appropriate to test the remuneration of a controlled transaction, it is necessary that the value of the functions performed in the controlled transaction is proportional to the operating expenses and not materially affected by the value of the products distributed. In addition, it is supposed that the company does not perform any other significant function, such as manufacturing, that should be remunerated using another method or financial indicator.

Berry ratios are very sensitive to classification of costs as operating expenses or not. This feature of the ratio can pose comparability issues and lead to difficulties in the application of the method.

 

Concluding remarks

Contrary to the comparable uncontrolled price (CUP) method, the resale price method (RPM) does not require the similarity of the property transferred but the similarity of the functions and risks assumed in controlled and uncontrolled transactions.

If a company purchases goods only from affiliated parties, comparable transactions shall be retrieved by external databases. From the other hand, if the company under review is quite independent and purchases goods from other suppliers too, internal comparable data can be used for the application of the resale price method. However, the Transfer Pricing analyst shall pay attention to the functions performed for the resale of group and third parties’ products.