Transfer pricing practitioners fell in love with the concept of a “limited risk distribution” (LRD) on the hope that they could convince tax authorities in high tax jurisdictions to accept the premise that the local distribution affiliate should be happy with a low operating margin. This pandemic, however, has generated a lot of new transfer pricing advice that appears to contradict the original LRD argument.
Before the pandemic, the usual multinational arrangement placed the lion’s share of worldwide income in a principle affiliate in a low tax jurisdiction on the grounds that the principle is the entrepreneur bearing the risk of the multinational. The recent losses from this pandemic would accrue to the principle under LRD logic. Representatives of such multinationals have in the past used applications of the Comparable Profits Method (CPM) to justify low operating margins for both the distribution affiliates and the contract manufacturing affiliates in high tax jurisdictions.
However, with the onset of the pandemic and accompanying sharp economic downturn, some practitioners are now asserting that an LRD should incur losses during this period. As one presentation quipped “limited risk does not mean no risk.” Another suggestion was that that declining sales volumes might allow a multinational to adjust intercompany prices for distribution affiliates for customs valuation purposes (which we address in an addendum).
To bolster the case for this new LRD logic, a recent article also pointed to data showing that publicly traded contract manufacturers (CM) consistently turn low operating profit margins and some experienced losses during the last global recession.
The notion that an LRD deserves a low operating margin during normal periods or even periods of strong economic activity, but should be subject to downside risk during a pandemic may have turned option pricing theory on its head; and the low profit margins of independent CM's may be distorted by factors such as significant pass-through costs and lower asset intensities.
An Illustrative Example and the Turning of Option Pricing Theory on its Head
Economists have long noted that distributors with limited functions and a modest level of tangible assets relative to sales would receive a gross margin that covers their normal operating expense to sales ratio plus a modest operating margin, even if the distributor is not characterized with the LRD tag.
As a simple example, consider a distributor receiving an 18% gross margin and has an average operating expense to sales ratio equal to 15%. If this distributor were a third-party entity, its expected 3% operating margin would be consistent with the usual economic model for distributor gross margins.
If the distributor were a related party entity, the multinational might conduct a transfer pricing report based on an application of CPM using third-party distributors as allegedly comparable companies. If this application of CPM were properly conducted, it might result in some interquartile range from 2% to 4% with a median equal to 3%. This range may be due two factors:
- Comparability differences between the distribution affiliate and the third-party distributors that were not entirely accounted for in the analysis:
- Temporary variations in the operating margins for the third-party distributors over the period being evaluated.
While some transfer pricing advisors would advise the multinational to target the median margin, the LRD crowd might argue for targeting an operating margin closer to 2%.
The operating expense to sales ratio for distribution affiliates vary over time. During periods of strong economic activity, this ratio might decline to something near 13%. While sensible economics would suggest that the gross margin should remain at 18%, the LRD crowd would argue for reducing the gross margin to something closer to 15% in order to source more profits with the principle. A symmetrical approach would have the gross margin rise if weak economic activity increased the operating expense to sales ratio. While we note below that such a variable gross margin policy might create customs valuation issues, this LRD approach has become quite popular for income tax purposes as long as variations in economic activity have been modest.
The discussions of the transfer pricing impact of the pandemic raise the possibility that the distribution affiliate’s operating expense to sales ratio increases more dramatically to something equal to 20% of sales or even more. The usual LRD approach would have the gross margin increased to at least 22%, which could lead to losses for the principle affiliate supplying goods to this distribution affiliate. Under this variable gross margin approach, the LRD would be shielded from any downside risk. We see, however, some of the former proponents of LRD now arguing that a distributor does indeed bear downside risks in such cases, which is inconsistent with prior positions they have taken.
We can think of this less-than-consistent advice in terms of option pricing where the principle is afforded with the following option. When economic activity is strong, the principle is allowed to raise the transfer price such that the distribution affiliate receives the target operating margin even if its operating expenses relative to sales have declined. When economic activity is weak, such as during this pandemic, the related party principle is advised not lower transfer prices dramatically but rather have the distributor to bear the downside risk. In effect, the principle has been afforded an option without having to pay it.
Third-party distributors, however, would not enter an agreement that has it bear the downside risk but not receive any upside potential. In cases where the target margin has been reduced on the basis of LRD thinking, the distribution affiliate has granted the principle with an option and yet the distribution affiliate pays the principle for this arrangement. Of course, such an arrangement makes little economic sense.
Some practitioners have also cautioned against the risks of an such an inconsistent approach For instance, John Warner of Buchanan Ingersoll & Rooney PC told Moses:
The comparable profits method, which calculates a company's income based on the profitability of similar, unrelated companies, is commonly used to set the return for a low-risk entity. If a company has been using that method, "it wouldn't be kosher to switch to some sort of profit split, which would be a loss split," he told Law360. "Your story really ought to be consistent throughout various aspects of the business cycle," Warner said.
Ryan Dudley of Friedman LLP also noted taxpayers should take into account what tax authorities expect before adopting such an approach:
For a multinational group that suffers an overall loss after the novel coronavirus pandemic, tax authorities in the country where the routine operations are based may well continue to expect some type of positive return
Low Margins: Limited Risk vs. Limited Functions
The idea that limited functions translates to limited risk and therefore low profit margins has a long history in transfer pricing. Proponents of the idea often point to data from alleged comparables as evidence that it reflects real-world business conditions, but the evidence for this assertion also suggests that low margins may be due to other factors.
For instance, in the case of the publicly traded CM's mentioned earlier:
The exhibit shows the operating margin for 16 CMs from 2007 to 2019. The data confirms several tenets of transfer pricing. Most of the firms have operating margins between 1% and 5%, and although there is variability over time, most firms stay within this range. More important, several firms had operating losses, at least for a short period, and those that could not remain viable in the long term discontinued operations. The period around the Great Recession shows much higher variability in operating margin and greater likelihood of loss. While a similar analysis for distributors is not included, similar results can be expected.
However, the roles of pass-through costs versus value-added expenses and asset intensities for the evaluation of gross margins for distribution affiliates has long been recognized. Similar considerations apply for the evaluation of contract manufacturers.
The 16 CM's in this data sample were publicly traded electronic manufacturing services (EMS) companies. EMS companies typically have high expected cost of capital as they bear significant systematic risk. While it is true that their reported operating profits to gross revenues to be tend near 3%, EMS companies also have pass-through costs that represent around 90% of total costs. On a net revenue basis, the profits for EMS companies are quite high as the ratio of fixed assets to value-added expenses is quite high. An EMS that is able to keep inventory levels lean would have overall tangible assets representing less than 30% of gross revenues.
Addendum: Targeting Operating Margins vs. Gross Margins in Customs Valuation
I recently discussed the issue of targeting gross margins versus operating margins in an April 2020 article for the Journal of International Taxation:
The key issue, which we shall return to in other case studies, relates to the difference between targeting gross margins versus targeting operating margins in the face of various potential shocks to a business. An approach that targets operating margins would lead to varying gross margins in the presence of temporary variations in the operating expense to sales ratio. This ruling sensibly notes that third party arrangements rarely award a distributor with a higher gross margin if its operating expenses relative to sales temporarily increased. Consider, however, a relative price shock where the market price of a commodity falls relative to production costs. Both the Deductive Value Method and the usual application of CPM would allow for a reduction in the price charged by the related party manufacturer so as to maintain an appropriate gross margin.
This comment was in reference to a U.S. customs ruling involving the imports of food additives, where the customs authority in HQ H260036 insisted on targeting gross margins. I also note how these considerations may have applied to the December 20, 2017 ruling by the Court of Justice of the European Union (CJEU) with respect to imports of optical devices by Hamamatsu Photonics Deutschland GmbH (HPD) and a transfer pricing adjustment to target the operating margin.
We shall pose three possible reasons and discuss each in turn. Two arise from an increase in the operating expense to sales ratio. If this increase were due to a temporary fall in sales with operating expenses not fully adjusting to the lower level of sales, CJEU was right not to accept this adjustment. In fact, it used to be the practice of the German and Japanese income tax authorities to argue that such variations of the operating expense to sales ratio should not affect the arm's length gross margin as volume risk should be borne by the distributor. So why would any APA pose an operating margin target? One concern with targeting the gross margin in an APA is the concern that the multinational will subsequently increase the functions of the distribution affiliate. An increase in functions naturally should call for an increase in an arm's length gross margin but how would one effect this reasonable expectation in the context of an APA?
My discussion continues with the possibility that the drop in the reported operating margin was due to price or exchange rate risk. Under a gross margin target, a retroactive adjustment in the transfer pricing would be consistent with arm’s length pricing. If the decline in operating margins was due to a permanent increase in the operating expense to sales ratio from an increase in the functions performed by the distribution affiliate, an upward adjustment to the gross margin would be consistent with arm’s length pricing. Note, however, that a temporary increase in the operating expense to sales from a transitory decline in economic activity would not warrant an increase in gross margins under arm’s length pricing.
Harold McClure, “A Renewed Interest in the Modified Resale Price Method for Customs Valuation,” Journal of International Taxation, April 2020.Published on Jul 22, 2020 8:30:19 AM
Harold McClure has over 25 years of transfer pricing and valuation experience. Dr. McClure began his transfer pricing career at the IRS and went on to work at several Big 4 accounting firms before becoming the lead economist in Thomson Reuters’ transfer pricing practice. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983.
He can be contacted at: firstname.lastname@example.org
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