Transfer pricing is all about substance … how it should align with the value chain!
Let‘s first start with the definition of “value chain”
“The value chain describes the full range of activities companies and workers do to bring a product from its conception to its end use and beyond. This includes design, production, marketing, distribution, and support to the final consumer. The activities that comprise a value chain can be contained within a single company or divided among different companies. Value chain activities can produce goods or services and can be contained within a single geographical location or spread over wider areas.”
Source: https://globalvaluechains.org, with some minor alterations
Let’s try to shorten the value chain definition above:
“The most value-adding activities of a company in terms of contribution to profitability.”
Instead of asking a CFO to explain their company’s value chain, it may be more down-to-earth to ask:
“What are the key activities that make your beautiful company successful?”
Remember the case study in my last article:
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. 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%.
Suppose you are invited (together with a few of your peers) by the CFO of the bicycle company because he feels something is wrong with the group‘s transfer pricing and is unhappy with the company’s current tax rate, which is higher than 30%. He only provided you with the above facts of the case study, and you have exactly 1 hour to do an elevator pitch to convince the CFO that he should select you as the preferred advisor.
After a short (5-10min) introduction of ourselves and the company (on a few slides), we typically try to interact with the CFO to assess the extent to which the group‘s transfer pricing is aligned with its value chain.
You start with the above-mentioned question: “What are the key activities that make your beautiful company so successful?”
To give a bit more guidance, you ask him to consider a maximum of 4-5 activities, e.g., innovation/R&D, production, distribution, sales, services, etc.
Let‘s assume he selects five activities:
- Innovation/R&D
- Production
- Distribution
- Sales
- Customer service
The next question to ask the CFO is: “What again is the consolidated operating margin of your group as a percentage of sales?”
The CFO confirms that the consolidated operating margin (EBIT) is 15% of sales.
Then you ask the CFO the following: “Now imagine your company as a perfectly baked pie, and you have to slice the pie into five pieces, with every piece representing the contribution of each activity to that 15% profitability.”
You give the CFO a moment to think and then ask: “May I have your votes please?”
The CFO states as follows:
- Innovation/R&D: 5%
- Production: 2%
- Distribution: 2%
- Sales: 2%
- Customer service: 4%
Now you have an indication that – as a ballpark percentage – a distributor, in this bicycle company, performing distribution, sales, and customer service activities should achieve an operating margin of 8% against sales. Please be aware that this percentage is indicative of a full-fledged distributor with a low dependency on a principal company when it comes to distribution, sales, and customer service and normal exposure to risks such as market, credit, inventory, etc. To the extent the dependency on the principal company is higher, and the risks are lower, you can bring down the percentage a few notches.
In discussion with the CFO, you can stick with the 8% to present the disconnect between his perception of the company‘s value chain and the distributors’ actual performance. You at least have a good starting point for a discussion on what is happening with the distributor that operates at 15% and what is wrong with distributors operating at a loss. Also, explain to him that these questions can also be asked during tax audits and/or due diligence situations, so even when there is a logical explanation, it is better to anticipate these questions.
The more likely cause of the disconnect is an incorrect transfer pricing policy or a poorly implemented transfer pricing, which is also causing the pain he is feeling regarding his current tax position.
The good news is that you can already tell him that you probably will be able to reduce his current taxes for the current year and mitigate his transfer pricing risks simultaneously. Now the CFO is all ears and wonders how you will be able to achieve all this?
.. this I will discuss my next article. Stay tuned!
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