People (and the OECD) say transfer pricing is all about substance … but how easy is this to understand substance in practice?

Let me give a few examples based on the following case study.

Picture yourself an international bicycle company with global revenues in 2021 of € 1 billion, with an operating margin (EBIT) of € 150 million (or 15%). It has its headquarters and principal company in Germany and with distributors in 10 countries. The principal company is full-fledged, i.e., a company with all key value chain functions present, being R&D, production, distribution, and sales. The ten distributors have only distribution and sales related functions.

Example 1 – what are the facts telling us?

If we would add that out of the ten distributors, three are operating at a loss, six at different operating margins between 3% and 7%, and one company at 15%. What does this simple fact pattern tell us?

The above facts may tell us that the value chain of this company is probably based on a decentralized operating model. Why? First of all, decentralized means that the local distributions run their local operations independently with their own P&L responsibility, which sometimes may result in a loss, e.g., due to a poor sales performance or a higher than budgeted cost structure, and sometimes to an excessive profit, e.g., due to sales outperformance and/or lower costs.

Example 2 – what are the facts not telling us?

As a tax professional, you should always validate your assumption(s). Let‘s assume you are in a meeting with the CFO to discuss your first finding. You ask him: “Is our assumption that your group is highly decentralized, correct?” If the CFO tells you that the organization is centralized, i.e., that your assumption is incorrect, what should be your reply to the CFO? “In that case, your transfer pricing is incorrect.”

 That statement may come as a shock, and if the CFO asks you why, your answer is: “Because a centralized business model means that the local organizations are dependent on the center (i.e., your German principal company), and a dependent organization cannot operate at a loss or an excessive profit.

And suppose the CFO objects and asks why that isn‘t possible. In that case, you can answer: “Because a dependent organization does not have enough capabilities and resources to survive without the support of the principal company. It simply has not enough profit potential. No 3rd party in similar circumstances would accept compensation that would leave a net loss.”

In case the CFO is not convinced and argues that the losses of some of the distributors are, in fact, start-up losses because they only exist for a few years, you can state: “The decision to enter a specific market has been made at headquarter level, i.e., by the German principal company, and the set-up of the new distributor is then a business development effort coordinated, managed and decided by the German principal. This business risk should not be at the expense of the new distributor.” You can also add that excessive profits for a dependent distributor are unrealistic for the same reasons. Suppose someone else (i.e., the German principal company) takes most of the risks and contributes the most resources. In that case, it is not fair if the other (i.e., the distributor) gets the larger share of the operating margin on a transaction.

As a “cherry on the cake”, you can also add that a good transfer pricing policy would not only avoid unnecessary transfer pricing risks but also improve the consolidated (cash) tax position of the multinational. Why? Because all start-up losses are effectively pushed back where they belong (i.e., to Germany) and can be offset against the taxable profits at the German principal company level.

Now the CFO will be happier that he understands the logic (and because there is an actual tax benefit for his group with fewer risks than before). Now he will see you as a tax professional with real added value.

I hope you see easy it is to find the “substance” in the above examples.

In upcoming articles, I intend to write about how to do a high-level (but, in my view, solid) value chain analysis and how to implement or assess implemented transfer prices.

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