Download transfer pricing for far east (china) procurement companies

TRANSFER PRICING
FOR FAR EAST (CHINA)
PROCUREMENT
COMPANIES
J. Harold McClure, Senior Manager, ONESOURCE Transfer Pricing
ONESOURCE TRANSFER PRICING
TAX & ACCOUNTING
TRANSFER PRICING
FOR FAR EAST (CHINA)
PROCUREMENT
COMPANIES
THE SELECTION AND APPLICATION OF EITHER A CUT OR
CPM APPROACH DEPENDS ON THE FACTS SURROUNDING
THE RELATIONSHIP BETWEEN THE U.S. PARENT AND ITS
RELATED-PARTY PROCUREMENT ENTITY
Introduction
Imports from China have grown dramatically over the
past several years. Exhibit 1 shows the growth in
inflation-adjusted or real imports, which were only
$6.5 billion in 1985 (in terms of 2006 dollars) but
grew to $287.8 billion as of 2006. 1 U.S. imports from
China increased from less than 0.1% of U.S. GDP in
1985 to almost 2.2% of GDP as of 2006. The largest
categories in terms of the value of U.S. imports from
China are toys, footwear, apparel, and electronic
equipment. 2 Exhibit 2 shows U.S. imports from
China from 2002 through 2006 for the following
three-digit end-use codes:





Code 213: computers, computer
accessories and peripherals, and
semiconductors.
Code 400: apparel and footwear.
Code 410: furniture, glassware, cookware,
and household and kitchen appliances.
Code 411: toys, motorcycles, pleasure
boats, and musical instruments.
Code 412: radios, various stereo
equipment, and records and tapes.
The growth in imports from China has been
particularly significant in the apparel and footwear
sector. U.S. imports from China grew from $21.9
billion in 2001 to $31.7 billion in 2004, then by almost
30% in 2005 to $40.8 billion, and during 2006 by
another 13.5%, reaching $46.3 billion. This rapid
increase in apparel imports during 2005 and 2006 is
mainly attributed to the elimination of the Multi-Fibre
Agreement (a.k.a. the Agreement on Textile and
Clothing), which placed quota restrictions on imports
of apparel goods from 1974-2004. It expired on
January 1, 2005.
The Census Bureau reported that 25.5% of imports
from China during 2006 represented purchases from
3
related parties, as compared 10.5% in 1992.
However, it is not clear how much of these relatedparty purchases represented U.S. multinationals
sourcing products from related-party Chinese
manufacturers, Chinese parents exporting goods to
the United States through related-party distributors,
or the use of related-party procurement entities.
A related-party procurement structure may take a
couple of different forms. Most of this article
considers the situation where a U.S. parent directly
employs the procurement functions of a Hong Kong
subsidiary. However, a more elaborate tax planning
structure, often known as a Chinese Business Trust
(CBT), is also discussed. A CBT is frequently a
subsidiary of a U.S. importer of goods purchased
from third-party Chinese manufacturers that acts as
the purchasing or procurement agent of its parent
corporation. The CBT hires a wholly owned foreign
entity (WOFE) to perform the actual procurement
functions and compensates the WOFE with a
payment equal to 110% of its operating expenses.
The U.S. parent pays the CBT a commission rate
based on some percentage of the value of the goods
purchased from a third-party manufacturer. The
difference between the CBT's commission income
and this payment to the WOFE represents income,
which is virtually tax free until it is repatriated.
However, if commission income exceeds 110% of
operating expenses by any material amount, the
multinational enterprise may face the risk of a Section
482 challenge from the IRS.
The following example illustrates the transfer pricing
controversy over related-party procurement entities.
Example. A U.S. parent
purchases $1 billion in
products from third-party
Chinese manufacturers
enlisting the assistance
of its related-party
procurement entity.
While the operating
expenses of the
procurement entity are
$40 million, which is 4%
of the volume of goods
sourced, the
intercompany pricing
policy is set such that
the procurement entity
receives commission
income equal to 8% of
the volume of the goods
sourced or $80 million.
In other words, the
operating profits for this
procurement entity are
$40 million.
This article discusses the use of the comparable
uncontrolled transaction (CUT) approach, as
suggested by transfer pricing practitioners at FTI
4
Consulting, and then considers the application of
the comparable profits method (CPM). The
practitioners at FTI Consulting note: 5
It has been the authors' experience
that a standard CPM using generic
service providers generally does
not support a CUT analysis. A
BOC [buying office commission]
rate that can be supported using
reliable CUTs may result in a very
profitable buying agent. A CPM
analysis using generic service
providers generally does not
support the profit margins earned
by apparel buying offices due to
the following factors: there are
virtually no publicly-traded pure
buying office comparables for
which financial information is
available; the few publicly traded
companies that classify
themselves as buying agents
perform a significant number of
activities in addition to those
functions that are typical of a
related-party buying agent. For
example, an independent buying
agent may act as a distributor or
manufacturer as well as a buying
agent; independent buying agents
may report their financials in a
manner that is inconsistent with a
related-party agent. For example,
an independent agent may report
the value of the FOB price plus the
amount of commission earned as
revenue while a related-party
agent generally only reports the
amount of the commission earned
as revenue.
A central theme of this article is that the selection
and application of either a CUT or CPM approach
depends on the facts surrounding the relationship
between the U.S. parent and its related-party
procurement entity. The application of a CPM
approach depends critically on the characterization
of the related-party procurement entity, and a
service-provider characterization may lead to overly
conservative results. The article further addresses
the economic literature on third-party Hong Kong
sourcing companies compared with various fact
patterns relating to related-party procurement
companies, and concludes with an extension of the
findings to the CBT controversy.
Is the CUT Method Reliable?
Many transfer pricing reports rely on a CUT
approach but these reports often fail to sufficiently
develop the facts of the controlled transaction or the
facts with respect to the third-party transactions
offered as comparables to establish that the CUT
approach as presented is a reliable means for
evaluating whether the controlled transaction is
consistent with the arm's-length standard. This
section of the article addresses the key aspects as to
whether a CUT approach does reliably capture an
arm's-length commission rate.
A Digression on Nomenclature
Most transfer pricing reports for related-party
procurement companies describe the activities of
these entities as the provision of services and then
argue for some variation of a comparable
uncontrolled price or CUT approach. Recent transfer
pricing reports have relied on the new services
Regulations, which mention a comparable
uncontrolled services price (CUSP) approach, as well
6
as the gross services margin (GSM) approach. The
GSM approach is equivalent to the commission rate
received by a comparable third-party broker.
Related-party brokers may take a couple of different
forms. If the parent entity is the manufacturer
exporting its goods to foreign customers with the
assistance of a sales subsidiary, the related-party
entity is a commission agent. In this instance, the
customer pays the parent company and then the
parent company issues commission income to the
subsidiary based on the amount that the customer
pays times the commission rate.
Temp. Reg. 1.482-9T(d) describes the GSM as
follows:
The gross services margin method
evaluates whether the amount
charged in a controlled services
transaction is arm's length by
reference to the gross profit margin
realized in comparable uncontrolled
transactions. This method ordinarily
is used in cases where a controlled
taxpayer performs services or
functions in connection with an
uncontrolled transaction between a
member of the controlled group
and an uncontrolled taxpayer. This
method may be used where a
controlled taxpayer renders
services (agent services) to
another member of the controlled
group in connection with a
transaction between that other
member and an uncontrolled
taxpayer. This method also may be
used in cases where a controlled
taxpayer contracts to provide
services to an uncontrolled
taxpayer (intermediary function)
and another member of the
controlled group actually performs
a portion of the services provided.
The new service Regulations note that the GSM is
equivalent to the resale price method under Reg.
1.482-3(c), with similar comparability requirements:
Example. If sales are
$100 and the
commission rate is
7.5%, commission
income is $7.50 and the
parent manufacturer
nets $92.50. For relatedparty procurement
entities, the parent is the
buyer, while the
manufacturer is the third
party. If the buyer pays
$100 in total fees, which
includes a $92.50
payment to the
manufacturer and a
commission payment to
the related-party
procurement entity, the
ratio of commission
income to the payment
to the manufacturer is
just over 8%.
A gross services profit provides
compensation for services or
functions that bear a relationship to
the relevant uncontrolled
transaction, including an operating
profit in return for the investment of
capital and the assumption of risks
by the controlled taxpayer
performing the services or
functions under review. Therefore,
although all of the factors
described in §1.482-1(d)(3) must
be considered, comparability under
this method is particularly
dependent on similarity of services
or functions performed, risks
borne, intangibles (if any) used in
providing the services or functions,
and contractual terms, or
adjustments to account for the
effects of any such differences. If
possible, the appropriate gross
services profit margin should be
derived from comparable
uncontrolled transactions by the
controlled taxpayer under review,
because similar characteristics are
more likely found among different
transactions by the same
controlled taxpayer than among
transactions by other parties. In
the absence of comparable
uncontrolled transactions involving
the same controlled taxpayer, an
appropriate gross services profit
margin may be derived from
transactions of uncontrolled
taxpayers involving comparable
services or functions with respect
to similarly related transactions.
As discussed in more detail below, the third-party
sourcing companies that are often used in transfer
pricing reports that rely on this approach tend to take
certain risks and own certain intangible assets. If the
related-party procurement company does not take
risks and does not own similar intangible assets, the
comparability requirements for the reliable
application of this approach may not be satisfied.
While a CUT approach has the advantage of
attempting to measure the arm's-length price directly,
as opposed to inferring a market price from
profitability data, transactional approaches tend to
have high comparability requirements. Possible
reasons why these approaches might not lead to
reliable measures of an arm's-length commission
rate are discussed below.
Is the Transaction Truly Uncontrolled?
Some procurement companies that have been used
as potential comparables may not even represent
uncontrolled transactions. For example, consider the
1997 agency agreement between Toymax
International and Tai Nam, which has been proposed
as a CUT by transfer pricing practitioners where U.S.
toy companies rely on related-party procurement
entities for sourcing goods from third-party Chinese
manufacturers. The Form 14A (proxy statement) that
Toymax filed with the SEC on July 20, 1999,
discloses the details of this agreement:
Since the Company's founding, Tai
Nam and its affiliate, Concentric,
have served as the Company's
purchasing agent. Tai Nam and
Concentric are owned by David
Chu, the Chairman and a principal
stockholder of the Company. As
the Company's purchasing agent,
Tai Nam arranges for the
manufacturing of the Company's
products based on purchase orders
placed with Tai Nam by the
Company. In addition, Tai Nam
handles all shipping documents,
letters of credit, bills and payment,
serves as liaison with other
vendors and performs quality
control functions. Pursuant to the
Agency Agreement, Tai Nam
receives an agency fee equal to
seven percent (7%) of the gross
invoiced value of products
purchased by Toymax, Inc. (based
on the factory purchase price of the
merchandise).... In fiscal 1999, the
Company's purchases from Tai
Nam totaled $52.8 million. The
majority of the Company's products
are manufactured by Jauntiway,
which is also owned by Mr. Chu.
Even if Mr. Chu did not have a controlling interest
with respect to the agreement between Toymax and
Tai Nam, his ownership of both Tai Nam and
Jauntiway implied that the split of the $52.8 million
paid by Toymax to Tai Nam and Jauntiway was
arbitrary. 8 While the 7% commission rate implied that
Jauntiway received $49.35 million and Tai Nam
received $3.45 million in payments, Toymax would
have incurred the same overall costs had the split
been $50.3 million to Jauntiway and $2.5 million to
Tai Nam. Had the split allowed Tai Nam to receive
only $2.5 million of the $52.8 million, the implied
commission rate would have been only 5%.
Internal CUTs
The practitioners at FTI Consulting note various
means for using the CUT approach to evaluate BOC
rates:
It is first important to identify any
transactions or agreements that
can serve as internal CUTs. There
are generally two types of
transactions that should be
considered as potential CUTs:
BOCs received by the buying agent
from unrelated parties; and/or
BOCs paid by the buying agent to
unrelated sub-agents. The first type
of transaction (the BOCs received
by the buying agent) are generally
paid by a licensee of the parent
company responsible for
distributing products bearing the
parent company's tradename.
These can be viable CUTs, since
the functions performed by the
agent for the parent company, or
the related party under review, as
well as the unrelated licensees are
probably very similar. It is
important to note, however, that
differences in volume and the
existence of collateral transactions
may impact the comparability of
these transactions... The second
type of transaction (the BOCs paid
by the agent to unrelated subagents) can also serve as useful
CUTs. These also tend to be more
prevalent in the marketplace.
These transactions have
limitations, as sub-agents
generally perform only a limited
number of functions compared to
the “principal” agent... In addition
to internal CUTs, potential external
CUTs may be available. However,
the activities specified in unrelated
agreements may be somewhat
generic in nature, making it difficult
to determine functional
comparability. Due to the fact that
the type of functions and the
degree of value-added activities
performed by various buying
agents may differ significantly and
the fact that a relatively wide range
of BOC rates can be found, this
approach is generally not as robust
as an internal CUT analysis.
This article initially addresses internal CUT
approaches, and then discusses external CUT
approaches. While transfer pricing practitioners tend
to argue that the CUT approach is reliable if it is
based on internal comparable transactions, GAC
Produce, TC Memo 1999-134, RIA TC Memo
¶99134, 77 CCH TCM 1890 GAC Produce , gives
reasons to scrutinize any such proposed
comparables carefully. The litigation involved
commission rates received by GAC Produce for
tomatoes purchased from GAC's affiliate growers
(Canelos).
The taxpayer's expert witness argued that the
commission rate for the controlled transaction should
be based on the commission rates between (1)
Apache as distributor of Canelos products; (2) Bud
Antle as a distributor of Canelos products; and (3)
GAC as distributor of Van Dyke products. Based on
the testimony of the IRS expert, the court rejected
what would have appeared to be three internal
CUTs. The Bud Antle transaction was deemed to be
a controlled transaction, while the other two
transactions offered by the taxpayer's expert were
deemed to have material comparability differences
with the controlled transaction. Although the IRS
expert used another potential internal comparable in
his application of the resale price method, this case
highlights the importance of scrutinizing the
transactions put forth as potential comparables both
in terms of whether they are comparable to the
controlled transaction and whether the proposed
comparable itself is an uncontrolled transaction.
Comparability differences may exist between the
controlled transaction and any uncontrolled
transactions that may be offered as potential
comparables, and may include not only risks incurred
and intangible assets, but also functions performed
by the procurement entity and collateral aspects of
the transactions. As an example of collateral aspects,
one taxpayer that designed and distributed products
sourced from various third-party suppliers noted the
9
following:
The unrelated buying agents may
provide original designs to parent,
which procurement subsidiary does
not provide to parent....We found
no evidence that buying agents
earn a higher commission when
providing original designs, as these
designs are not proprietary. In fact,
it is often the case that the same
unrelated buying agents can
provide original designs for one line
of products for parent and not
provide original designs for another
line of products, while earning the
same commission rate. Also, the
agreements make no mention of
providing original designs.In this
particular situation, each of the
unrelated entities described as
buying agents were designers in
the taxpayer's sector. The
payments from the taxpayer to
these unrelated entities were,
therefore, a combination of the
value of the procurement services
and the value of these designs.
Absent clear evidence that the
designs had no value, the internal
CUT approach would not be a
reliable method without
adjustments for the value of these
designs.
Other comparability differences may exist between
the uncontrolled transactions put forth as potential
comparables and the controlled transaction being
evaluated. Comparability is as important for internal
CUTs as it is for external CUTs, and is considered in
more detail in the discussion of external CUTs. The
only advantage of using internal CUTs is that the
taxpayer may have more detailed information on
these transactions than on external CUTs.
External CUTs
Exhibit 3 summarizes 13 agreements between
buyers and third-party sourcing companies in the
apparel and footwear sector. These agreements are
often put forth as potential external CUTs. The
summary provides only limited information, such as
the commission rate and the date that the
agreements were signed. Some of these agreements
were signed during the 1980s and only one was
signed after the elimination of the Multi-Fibre
Agreement. The commission rates range from as low
as 3% to as high as 10%. Reports that often rely on
these agreements provide only a qualitative
statement of what functions are performed by the
sourcing companies, which may include identifying
vendors, quality control, arranging shipments, and
invoicing. No additional information is provided, such
as the intensity of the services rendered or financial
data as to the operating expenses or operating
profits received by the third-party sourcing
companies. As the practitioners at FTI Consulting
note, it is “difficult to determine functional
comparability” when external CUTs are used.
In E.I. DuPont De Nemours, 44 AFTR 2d 79-5906,
221 Ct Cl 333, 608 F2d 445, 79-2 USTC ¶9633 E.I.
DuPont De Nemours , the court found that gross
margins can differ substantially when the functions of
sales entities differ:
Taxpayer tells us that a group of
21 distributors, whose general
functions were similar to DISA's,
provides the proper base of
comparison. Beyond the most
general showing that this group,
like DISA, distributed
manufactured goods, there is
nothing in the record showing the
degree of similarity called for by
the regulation. No data exist to
establish similarity of products
(with associated marketing costs),
comparability of functions, or
parallel geographic (and
economic) market conditions.
Rather, the record suggests
significant differences. Defendant
has introduced evidence that the
six companies plaintiff identifies
most closely with DISA all had
average selling costs much higher
than DISA. Because we agree with
the trial judge and defendant's
expert that, in general, what a
business spends to provide
services is a reasonable indication
of the magnitude of those services,
and because plaintiff has not
rebutted that normal presumption
in this case, we cannot view these
six companies as having made
resales similar to DISA's. They
may have made gross profits
comparable to DISA's but their
selling costs, reflecting the greater
scale of their services or efforts,
were much higher in each
instance.... The lack of any
significantly comparable resale (or
group of resales) in this record is
underscored by taxpayer's failure
to suggest any means for adjusting
for differences between DISA and
the uncontrolled resellers.
Charles Berry, testifying for the IRS, argued
that gross profits were the compensation for
the operating expenses incurred by the
sales entity plus a reasonable level of
operating profits, which he measured as a
markup over operating expenses. The use
10
of Berry ratios and other means for
evaluating appropriate operating profits are
discussed below. The reliable use of a CUT
approach requires that the analysis either
chose entities that are functionally
comparable to the related-party sourcing
entity or that adjustments be made for
functional differences. The wide range of
commission rates within this set of 15 thirdparty entities suggests that they may not be
comparable to each other. Without more
specificity as to the nature of the relatedparty entity compared with the nature of the
third-party entities, it is difficult to tell
whether the arm's-length commission rate
for the controlled transaction should fall
nearer the bottom or the top of this range.
IRS abuse of external CUTs and the MANA survey
evidence
In two cases, the IRS was especially egregious in the
application of a particular form of an external CUT
analysis. The Service challenged the 9% commission
rate that The Limited, Inc., paid to Mast Industries
(Far East), Ltd., its related-party sourcing company. 11
The IRS presented commission rates received by
other third-party sourcing companies, which ranged
from 3% to 7%. The Service's evidence failed to
account for the “speed sourcing” intangible, as well
as the ability of the related-party sourcing company to
provide guarantees that shipments of products to The
Limited would receive favorable treatment under the
quota regime of the Multi-Fibre Agreement. In other
words, the taxpayer was arguing that Mast Industries
(Far East), Ltd., owned certain valuable intangibles
making the controlled transaction not comparable to
the third-party arrangements that the IRS had used
as comparables.
ASAT, Inc., 108 TC 147 ASAT, Inc. , is an odd but
perhaps interesting case if the IRS position, which the
court considered, is compared with the taxpayer's
ultimate position, which the court did not consider
because of ASAT's failure to comply with a Section
6038A request (information with respect to certain
foreign-owned corporations). ASAT, Inc., acted as the
U.S. commission agent for ASAT, Ltd., receiving
commission income equal to 6% of sales. The IRS
argued that this commission rate should be increased
to 15% based in part on evidence drawn from the
1990 and 1992 Manufacturers' Agents National
Association (MANA) Research Bulletin Survey of
Sales Commissions, which noted that commission
rates for brokers of electronic and technical products
ranged from 7% to 12%. Even though the MANA
provided no details on the functions or expense-tosales ratios for the entities surveyed, the IRS argued
that ASAT, Inc., performed more functions than any
of the entities in the survey. The facts suggest that
the operating expense-to-sales ratio of ASAT was
only 5.4%, which would imply that the functions that
it performed were quite modest. With a 6%
commission rate, the ratio of operating profits to
operating expenses was approximately 10%. The
IRS position in this litigation suggested a return to
operating expenses in excess of 175%.
While the 2003 MANA Survey of Sales Commissions
stated that apparel sourcing companies received
commission rates between 4% and 5%, it also
provided several caveats as to why their survey
averages should not be viewed as reliable
comparable data. For example, the survey noted that
some agents provide more services than others and
that lower commission rates are often observed
when the agent and the manufacturer negotiate on
large orders.
The MANA survey data is not particularly useful for
identifying the arm's-length commission rate for a
specific related-party transaction. Whether the use of
external CUTs, or even internal CUTs, provides
reliable measures of the arm's-length commission
rate depends on whether these transactions are
sufficiently similar to the controlled transaction. If the
facts surrounding the controlled transaction are
poorly developed, it is difficult to argue that the
uncontrolled transactions often found in a CUT
analysis are comparable to a controlled transaction
that is not very well defined.
Applications of the CPM
The CPM is an alternative approach that can be
applied to the related-party sourcing company as the
tested party. However, before selecting either the
financial ratio (also known as the profit-level
indicator) or the third-party entities that will be
chosen as comparables, the nature of the sourcing
company must be understood. Three alternative
characterizations of the related-party sourcing entity
were discussed in a recent article on the new
Chinese enterprise income tax law by Thomas Zollo
12
and his co-authors. One business model involves a
subsidiary that provides services, such as vendor
identification, contract negotiation assistance, quality
assurance, and logistics, in exchange for a fee
(service-provider model). Another model is similar,
except that the subsidiary purchases goods from
third-party manufacturers and then sells the goods to
the U.S. parent (trading company model). In the last
model, the responsibility for manufacturing rests with
the subsidiary, which in turn may outsource the
actual responsibility of production to third-party
Chinese manufacturers (general contractor model).
The subsidiary is responsible for most of the risks
associated with manufacturing, as the third-party
entities are contract manufacturers and the U.S.
parent does not bear risks, such as for defective
products.
Service-provider model
Transfer pricing reports for related-party sourcing
companies often describe the tested party as
providing certain services to the principal. One
application of the CPM, therefore, might evaluate the
appropriate markup over the costs incurred by the
tested party. The issue of the appropriate cost base
must be considered carefully in the evaluation of this
markup. A paper by transfer pricing practitioners
formerly at FTI Consulting presented an example
where the volume of goods sourced was $100,000
and the operating expenses of the sourcing company
were $3,250. The example assumed an 8%
commission rate, so commission income was $8,000
and operating profits were $4,750. Operating profits
relative to operating expenses were, therefore, 146%.
The authors also noted EITF 99-19, which addresses
whether the revenues of a trading company should
be reported in terms of gross revenues or net
13
revenues. If revenues were reported in gross
terms, which would be the sum of the payment to the
manufacturer and commission income, the financial
accounting would show $108,000 in revenues and
$100,000 in cost of goods sold. If the markup were
defined as operating profits relative to the sum of the
cost of goods sold and operating expenses, it would
be only 4.6%.
To compare the 4.6% with the markups often
observed for service companies would be an absurd
means of evaluating whether the 8% commission rate
was at arm's length, as service providers do not have
cost of purchases in the same way that distributors or
trading companies do. A recent Dutch tax court case
recognized the logical flaw in this approach and
rejected the taxpayer's use of a CUT. The court
reasoned that the arm's-length commission rate
should be 110% of operating expenses, with
operating profits being only 10% of operating
14
expenses.
Some transfer pricing reports take the more
conservative approach of using the ratio of operating
profits to total costs (cost of goods sold and operating
expenses) to evaluate the appropriate markup over
operating expenses for the related-party sourcing
company, but this approach may be too conservative
unless all of the costs of goods sold for the
comparables represent value-added costs. In some
instances, however, a significant portion of the total
costs for a service company may be pass-through
costs. Exhibit 4 presents certain financial data for
nine logistics companies, including Expeditors
International. Their financials report revenues that
include a charge for transportation expenses even
though this represents a pass-through cost. The most
recent 10-K filing for Expeditors International states:
Management believes that net
revenues are a better measure
than total revenues of the relative
importance of the Company's
principal services since total
revenues earned by the Company
as a freight consolidator include
the carriers' charges to the
Company for carrying the
shipment, whereas revenues
earned by the Company in its other
capacities include only the
commissions and fees actually
earned by the Company.
Exhibit 5 shows two financial ratios based on the
2002-2006 average annual financials for nine logistic
companies. While total costs include both
transportation expenses and other operating costs,
operating expenses exclude transportation costs. For
Expeditors International, operating profits relative to
total costs were 7.8% and operating profits relative to
operating expenses were over 35%. While entities
such as EGL had very low operating profits relative
to total costs, the ratio of operating profits to
operating expense were closer to 10%. The markups
for EGL and Uti Worldwide were consistent with the
view of the Dutch tax court, and with a statement by
Zollo et al.:
A procurement CFC under this
model should be entitled to an
arm's-length return for its services.
If the procurement CFC does not
perform any non-routine services,
own any valuable intangible
property, or assume any significant
risks, this income may be limited.
This set of nine logistic companies appears to
15
represent a bimodal distribution. While five of the
companies had modest operating profit-to-operating
expense ratios, the markups for the other four
companies (C.H. Robinson Worldwide, Hub Group,
Pacer International, and Expeditors International)
exceeded 20%. The higher markup for these five
companies may be due to their ownership of
valuable intangible property. The difference in the
results obtained in a CUT analysis vs. the standard
CPM analysis using service-provider sets begs the
question as to whether the related-party sourcing
company owns intangible assets and whether this
entity bears significant risks.
Trading company model
Another approach to benchmarking the profitability of
procurement companies is to use trading companies
or even distributors as comparables with a capitaladjusted Berry ratio approach as the profit-level
indicator. Exhibit 5 presents certain financial
information for two trading companies. One is the
Japanese sogo shosha Mitsubishi and the other is
the Hong Kong sourcing company Li & Fung. Exhibit
5 shows the average annual turnover (gross sales),
cost of goods sold, gross profits, operating
expenses, and operating profits for each. For
Mitsubishi, the data is averaged over the 13-year
period starting with the fiscal year ended March 31,
1995, and ending with the fiscal year ended March
31, 2007. For Li & Fun, the data is averaged over the
nine-year period starting with fiscal year ended
December 31, 1998, and ending with fiscal year
ended December 31, 2006.
The financials of Mitsubishi are close to the earlier
example where the operating expenses of the
related-party procurement entity were 4% of the
volume of goods sourced. The operating expense-toturnover ratio for Mitsubishi averaged 3.79% over this
period and operating expense-to-cost of goods sold
averaged 3.97%. Its ratio of gross profits to sales
over this period was 4.61%, which translated into a
gross profit-to-cost of goods sold ratio of 4.84%.
Gross profits as a percent of operating expenses
averaged 121.8%.
Exhibit 5 also represents the ratio of working capital
to turnover. For Mitsubishi, this ratio averaged 3.79%.
The Berry ratio for this entity was due, in part, to the
ratio of working capital to operating expenses being
approximately 100%. If the related-party sourcing
company does not take title to the goods, a capitaladjusted to zero working capital Berry ratio would
tend to be less than the unadjusted Berry ratio.
Buy-sell procurement companies, however, do take
title, so they deserve a return for holding working
capital in the same fashion that distributors and
trading companies bear such risks. If the ratio of
working capital to operating expenses for the tested
party is similar to that of the trading companies
chosen as comparables, the unadjusted Berry ratio of
the comparables may be a suitable means for
evaluating the profitability of the tested party. Where
the tested party has more significant working capital
relative to its operating expenses, the capitaladjusted Berry ratio may exceed the unadjusted
Berry ratios of the third-party trading companies used
as comparables.
Li & Fung has often been used as a CPM comparable
for related-party sourcing companies. From 19982006, the ratio of its gross profits to turnover was
10.05%, while the ratio of its operating expenses to
sales was 6.91%. Li & Fung's operating profits were
3.14% of turnover and its Berry ratio for this period
was 145.5%. This seemingly high return to operating
expenses was due only in small part to its working
capital, which was 1.6% of turnover. As discussed
below, Li & Fung may also have owned certain
intangible assets.
There is a caveat about measuring profitability as
operating profits relative to operating expenses. The
Berry ratio was designed to capture profits relative to
the value-added expenses of either distributors or
service companies. Unless operating expenses
capture all of the value-added expenses, the ratio of
operating profits to operating expenses will exceed
the ratio of operating profits to value-added
expenses. Berry ratios should not be used blindly
when measuring the relative profits of service
companies because the cost of goods sold for
service companies often includes significant amounts
of cost of services. As noted above, some
practitioners use operating profits relative to the total
costs for service providers on the implicit assumption
that all of the costs of goods sold represent the costs
of services. This approach will lead to unreliable
results if some of the costs of goods sold represent
pass-through expenses. Where a distributor's costs
of goods sold include costs of services, the ratio of
operating profits to operating expenses will also be
misleading unless these costs of services are
16
reclassified as operating expenses.
General contractor model
In the general contractor model, the responsibility for
manufacturing rests with the related-party
procurement entity, which in turn may outsource the
actual responsibility of production to third-party
Chinese manufacturers. Zollo et al. describe a
situation where the U.S. parent hires a related-party
entity (denoted as “CFC”)
to act as the principal in a contract
manufacturing arrangement with
one or more unrelated Chinese
manufacturers.... The unrelated
contract manufacturer usually
provides a Chinese processing
facility and production employees.
The CFC principal usually provides
production know-how, quality
control and logistics oversight. In
the contract manufacturing
arrangement, the CFC principal
has an unconditional obligation to
purchase the goods and the
unrelated manufacturer holds legal
title to the raw material and workin-process inventory throughout
the manufacturing process solely
for the purposes of securing
payment of the manufacturing
services fee. Upon payment of the
services fee, the unrelated
manufacturer must surrender legal
title to the goods to the CFC
principal. The manufacturing
services fee in this model is
typically equal to the cost of
materials plus a processing fee.
The contract manufacturer's risk is
limited to the costs associated with
a failure to perform the processing
obligations in accordance with the
principal's specifications and
directions. Subject to this, the
contract manufacturer is generally
not at risk for any other costs
associated with production or sale
of the product.
The construction industry often features similar
arrangements where a homeowner hires a general
contractor to construct or remodel a building. The
general contractor does not actually do the work but
subcontracts it to specialty contractors. The
homeowner pays the general contractor for the
overall project, and the general contractor pays the
specialty contractors. The general contractor is
responsible for ensuring that the homeowner's design
for the work is properly executed and for all quality
control. Similarly, the Asian procurement company in
this model is responsible for design communication
and quality control. The procurement entity—like a
general contractor—bears most of the manufacturing
risks, including responsibility for defective products.
The importance of quality control and the possibility
of defective product risks was highlighted by the
recall of several Mattel products, which were
manufactured by third-party Chinese manufacturers.
While Mattel insisted that it had rigorous quality
control standards and the Chinese government
promised to enhance its enforcement of quality
control, Mattel suffered both substantial financial
costs and the possibility that some of its customers
17
may have lost confidence in the safety of its toys.
Defective products sourced from Chinese
manufacturers have been discovered in other
sectors, such as the recall of tires purchased by
Foreign Tire Sales Inc. from Hangzhou Zhongce.
While Foreign Tire Sales has sued this Chinese
manufacturer, it is questionable whether it can
18
recover its losses. Foreign Tire Sales does not
appear to have relied on either a third-party or
related-party procurement entity, but multinationals
that source goods from China often rely on a relatedparty procurement entity. Whether this procurement
entity bears the defective product risk is a key factual
element in evaluating the characterization of the
entity.
General contractors and manufacturers incur similar
costs. The general contractor bears its operating
expenses, as well as payments to subcontractors,
which include cost of material and labor and return to
capital owned by the subcontractor.
The accounting costs of a manufacturer would
include its operating expenses and cost of material
and labor. While a manufacturer's opportunity cost of
capital would not be part of its accounting cost, as
this opportunity cost is reflected in operating profits, a
general contractor's expenses would include this
element. The profits that would accrue to the general
contractor, therefore, represent the difference in
profits that a manufacturer would have received and
the profits that accrue to the general contractor's
subcontractor. These profits, however, may be quite
significant relative to the modest operating expenses
that the general contractor incurs and would include
not only compensation for the risks that the general
contractor incurs, but also a return for any intangible
assets that the general contractor might possess.
Using the CPM to evaluate what level of profits
should be earned by a procurement entity that acts
like a general contractor is difficult. We are not aware
of any publicly traded companies that would be highly
comparable to these entities. One approach,
however, might be to use manufacturers as
comparables with the caveat that the profits of the
manufacturer overstate the profits of the general
contractor to the degree that the subcontractor
retained a modest return to its capital. In other
words, the return to total costs for manufacturers can
be used as a starting point for the return to total
costs for the procurement entity that acts a general
contractor. This markup over total costs, however,
overstates the arm's-length compensation to the
degree that some of the system profits to
manufacturing would be captured by the
subcontractor. An adjustment for the difference in the
fixed assets owned by the comparable would have to
be performed, since the general contractor would
own few fixed assets. While general contractors for
residential construction are not likely the most
suitable comparables for Chinese procurement
entities that act as general contractors, these entities
often have operating profits that represent about 5%
19
of their total costs.
Economic Literature on Hong Kong Sourcing
Companies
Raymond Fisman, Peter Moustakerski, and ShangJin Wei recently noted that a substantial amount of
Chinese exports to the United States involve indirect
20
or entrepot trade. The authors state that entrepot
economies include Hong Kong and Singapore. While
they credit another recent paper by Robert C.
Feenstra and Gordon H. Hanson for emphasizing the
role of specialized agents in processing and
distribution, Fisman et al. explore the possibility that
entrepots may facilitate tariff evasion. 21 Their
explanation harkens back to a 1991 World Bank
paper by Refik Erzan, Kala Krishna, and Ling Hui
Tan that noted the role of quota rights in the apparel
sector under the Multi-Fibre Agreement. 22 This
section discusses this literature and its implications
for procurement transfer pricing.
Feenstra and Hanson document the spreads
between the price that Hong Kong entrepots pay
Chinese manufacturers and the price that they
charge U.S. buyers. These spreads are equivalent to
the commission rates in the third-party contracts
often used in CUT analyses for related-party
procurement entities. Feenstra and Hanson note that
these spreads are frequently substantial and offer
several explanations for these high spreads. One of
these explanations can be seen as sourcing
intangibles:
One compelling hypothesis is that
Hong Kong traders have an
informational advantage in trade
between China and the rest of the
world. This advantage may be due
to Hong Kong's proximity to
mainland China, especially the
southern coastal provinces where
export production is
concentrated.... Building on these
links, Hong Kong traders may
specialize in identifying Chinese
producers who can meet foreign
quality standards and in finding
markets for Chinese goods. In their
role as middlemen, traders may
earn informational rents, which
could account for the markups they
charge. This quality-sorting view of
entrepot activities relates closely to
recent theories of search and
intermediation ... and to general
equilibrium models of international
trade with information costs.
Feenstra and Hanson also note that these Hong
Kong entrepots often perform the role of a general
contractor:
Traders are often more than
middlemen. Many firms that import
goods from China for re-export
engage in outward processing....
Before importing goods from China,
they may purchase raw materials
on the world market, process these
materials in Hong Kong or
elsewhere, and export the
unfinished goods to China for yet
further processing.... Quality sorting
and outward processing are often
complementary activities.
In other words, these third-party entrepots are much
more than a mere service provider or trading
company. Feenstra and Hanson also consider the
roles of tariff evasion, later discussed by Fisman,
Moustakerski, and Wei, and transfer pricing designed
“to shift income from high-tax countries to Hong
Kong.”
Given that Li & Fung is often cited as a comparable in
transfer pricing analyses for procurement entities,
Feenstra and Hanson's discussion of this entrepot is
of interest:
One well-known Hong Kong trading house is
Li & Fung, which specializes in trading,
distribution, and retailing. In 1998 it had
global sales of $2 billion and offices in over
20 countries. The typical arrangement is for
a foreign manufacturer or retailer to
approach Li & Fung with a product they
would like to purchase or have produced. In
simple transactions, Li & Fung is purely a
matchmaker: “The idea is that maybe
foreigners don't know which factory to go to,
so you perform an introductory role, maybe
a quality-control role and there it stops,”
says its managing director.... In more
complex transactions, Li & Fung oversee the
entire fabrication of a good, from purchasing
raw materials and planning production to
monitoring manufacturing among the 7,500
independent plants to which it subcontracts
orders. In return for its trading services, Li &
Fung is reported to earn commissions of
7%-12% on each order it fills.
In other words, Li & Fung play different roles
depending on the transaction. It sometimes acts as a
broker with sourcing intangibles and other times as
the general contractor. Li & Fung earns different
commission rates depending on the functions that it
performs and the risks that it takes. As noted, Li &
Fung's average gross profit margin was around 10%
and its operating margin was just over 3%. That Li &
Fung receives an average 45% markup over its
operating expenses is likely a function of its sourcing
intangibles and the risks that it incurs when it acts as
a general contractor.
Given the prominence of external CUTs drawn from
the apparel sector during the period when the MultiFibre Agreement was still in effect, the discussion of
quota rents by Erzan, Krishna, and Tan is also
significant. The authors note that as tariffs on apparel
products were being lowered by the United States
and other developed nations, non-tariff barriers, such
as quotas, were imposed. The authors drew on
Jagdish Bhagwati's equivalence of tariffs and quotas
to conclude that a quota can grant to the owner of
quota rights an economic rent equivalent to the price
paid by the importer and the price received by the
23
manufacturer. The authors state that these quota
rights were actively traded as if they were a valuable
intangible asset. While they observe that some
estimates of the spreads between the price paid by
the importer and the price received by the
manufacturer exceed 20%, they argue for a rentsharing model where U.S. buyers of apparel possess
certain “buyer power” and are able to extract about
half of the quota rents. In other words, the
commissions received by Hong Kong entrepots may
have been competed downward by sizeable U.S.
buyers. 24
The role of quota rights was raised in The Limited,
Inc., which involved the commission that the Limited
25
paid to Mast Industries (Far East), Ltd. The
taxpayer argued that Mast Industries owned quota
rights that allowed it to export garments to the United
States during periods when trade restrictions limited
trade of these products between exporters such as
China and importers such as the United States.
The termination of the Multi-Fibre Agreement may
have dissipated the value of these quota rents, as
free trade lowered the price paid by the U.S. buyers
of apparel but drove up the payments to the Chinese
manufacturers. The simultaneous decrease in the
price paid by a buyer and the increase in the price to
manufacturers was possible because the
commission rates paid to the Hong Kong entrepots
were competed downward by the opening of free
trade. The Wall Street Journal recently noted that
Hong Kong sourcing agents make significant income
by assisting buyers of Chinese products with the
quota system. The Journal also suggested that the
expiration of the Multi-Fibre Agreement would lead to
lower profits for these sourcing agents unless they
found a way to create more value, such as by
increasing their role as general contractors or
26
creating apparel designs. While there is no direct
evidence that commission rates have declined in the
apparel procurement sector, the only third-party
contract offered by competitors as a CUT in this
sector that was signed after the termination of the
Multi-Fibre Agreement had Li & Fung receiving a
commission rate of just 5%.
While intangible profits from quota rents have
dissipated as trade barriers have been lowered,
intangible profits from sourcing intangibles should still
exist. Profits beyond what would be predicted using
the traditional CPM approach may be justified if the
related-party procurement entity undertakes the risks
that Freeman and Hanson noted for entrepots that
act as general contractors. If the related-party
procurement entity takes these risks and owns
sourcing intangibles, the commission rates in the
CUT approaches often seen in transfer pricing
analyses may be justified.
CBTs and Acquired Sourcing Entities
As noted, this discussion emphasizes the role of the
facts surrounding the related-party procurement
relationship as a prerequisite for deciding on whether
a CUT or CPM approach leads to the more reliable
result. In many transfer pricing reports, the
development of the relevant facts is too weak to
ascertain which approach is the best method. One
particular problem that a poor development of facts
may create can be illustrated by extending the
discussion of CBTs noted by Zollo et al.
Example. A U.S. parent company creates a CBT to
act as its procurement entity. On creation, the CBT
owns no intangible asset has no employees. All of its
functions are performed by a Chinese subsidiary.
Consistent with the earlier example, the Chinese
subsidiary incurs $40 million in expenses as it assists
in the procurement of $1 billion worth of goods. While
the CBT receives an 8% commission rate resulting in
$80 million in commission income, it pays the
Chinese subsidiary its operating expenses plus a
10% markup for a total of $44 million. In other words,
the CBT receives $36 million in operating profits. Its
transfer pricing representatives write a report for the
Chinese tax authorities arguing that the Chinese
subsidiary is simply a service provider, and another
report for the IRS contending that the 8% commission
rate is supported by a CUT analysis. The problem is
that these two very divergent methodologies are
evaluating what appears to be the same transaction.
If the Chinese subsidiary is nothing more than a
service provider that takes no risks and owns no
intangible assets, the IRS could reasonably argue
that a CPM approach should result in a commission
rate near 4.4%. But what if the Chinese subsidiary
had created a sourcing intangible that would justify
the 8% commission rate under the CUT approach? In
either instance, the justification for significant profits
27
in the CBT is weak.
Under a somewhat different fact pattern, procurement
activity had historically been performed by a thirdparty Hong Kong procurement entity. The U.S. parent
establishes a CBT to purchase the third-party Hong
Kong procurement entity, including any sourcing
intangibles that the third party may have possessed.
If the functions and risks of the newly created CBT
and any service subsidiaries that it may rely on to
carry out its functions are not changed as the result
of the acquisition, the commission rate that the U.S
parent had paid to the third-party procurement entity
should be a reliable measure of the arm's-length
commission rate for the related-party procurement
transaction.
Conclusion
Transfer pricing for procurement entities is becoming
an increasingly important issue as U.S. companies
source more goods from third-party Chinese
manufacturers via related-party procurement
subsidiaries. While many transfer pricing
practitioners view this issue as a battle between the
use of transitional or CUT approaches vs. the use of
profits-based or CPM approaches, the attention to
the particular facts surrounding the intercompany
transaction is generally quite weak in the transfer
pricing reports prepared on behalf of the taxpayer. It
is our contention that the particular facts are crucial
to determining whether the arm's-length commission
rate should be the relative high ones that many
taxpayers use vs. a lower one that affords the
procurement subsidiary only very little profit.
We surveyed academic literature on thirdparty Hong Kong sourcing entities that were
able to historically capture significant profits.
The literature observed several possible
explanations for these profits. One
explanation had to do with quota rents,
which have been dissipated with the
relaxation of trade barriers with China. The
literature also notes, however, that some
souring entities take on significant
responsibilities and risks and may own
sourcing intangibles. We also characterized
different possible fact patterns for the
relationship between the procurement
subsidiary and its related-party buyer—for
example, a service provider model where
the procurement subsidiary has few
responsibilities, takes virtually no risk, and
owns no intangible assets. Under this
model, the high profits often captured by the
procurement entity under the existing
intercompany pricing policy are not
warranted and the attempts to justify them
using a CUT approach appear to be
suspect. We also noted a general contractor
model where the procurement subsidiary
has significant responsibilities and risks. If
this subsidiary also owns valuable sourcing
intangibles, this entity would deserve
significant profits under arm's length pricing.
Exhibit 1. U.S. Imports from China (2007$Millions)
Exhibit 2. Imports by 2-digit End Use Code
Exhibit 3. 13 Agreements in Apparel/Footwear
Sector
Exhibit 4. Financial Ratios for Nine Logistic
Companies
Exhibit 5. Key Financial Data for Two Trading
Companies
1
While nominal imports have increased by a factor of
74.52 over this 21-year period, the GDP deflator in
2006 was 1.67 times the GDP deflator in 1985. In
real terms, imports from China in 2006 were 44.57
times real imports from China in 1985.
2
Collectively, these imports represented over 67% of
the goods sourced from China during the 2002 to
2006 period.
3
Census Bureau, “U.S. Goods Trade: Imports &
Exports by Related Parties: 2006.” From 1992-2006,
the share of total U.S. imports from related-party
trade ranged between 45% and 48%.
4
FTI Consulting, Inc., is a global business advisory
firm with more than 2,400 professionals located in
most major business centers in the world.
5
Norton, Burns, and Graham, “Transfer Pricing for
Global Sourcing in the Apparel Industry,” 14 BNA
Tax Mgmt. Transfer Pricing Rep't 873 (February 15,
2006).
6
“Treatment of Services Under Section 482:
Allocation of Income and Deductions from
Intangibles, Stewardship Expense,” IRS, August 1,
2006; Baker & McKenzie, "Intercompany Service and
Intangible Transactions: Temporary Regulations
Respond to Taxpayer Criticisms," 17 JOIT 15
(November 2006).
7
See Reg. 1.482-3(c)(3)(ii)(D) on sales agents and
Reg. 1.482-3(d)(3)(ii)(D) on purchasing agents.
8
1992).
12
Zollo, Kvalseth, Zuvich, and Tao, “Chinese
Procurement Under the New Chinese Enterprise
Income Tax Law,” Int'l Tax J. (Sept.-Oct. 2007). The
alternative characterizations discussed in this article
correspond to the second, third, and fourth business
models discussed in the Zollo article. The first model
involved a U.S. parent purchasing goods from a thirdparty Chinese manufacturer with no assistance from
a related-party entity. The fifth model involved a U.S.
parent with a related-party Chinese manufacturer.
13
EITF stands for “Emerging Issues Task Force” and
EITF 99-19 is entitled “Reporting Revenues Gross as
a Principal versus Net as an Agent.” EITF 99-19 often
requires that trading companies report gross profits
only as revenues and exclude the portion of the
payment to the manufacturer. On the argument to
include this payment in the definition of sales for
transfer pricing purposes, see McClure, “The IRS
APA Program's Approach to Commission Income,”
10 BNA Tax Mgmt. Transfer Pricing Rep't 275
(August 8, 2001).
14
Oosterhoff and de Haan, “Dutch Court Ruling Offer
Insights Into Arm's-Length Pricing for Sourcing,
Procurement,” 15 BNA Tax Mgmt. Transfer Pricing
Rep't 865 (April 4, 2007), which stated that the
commission rate averaged about 12%. The ratio of
commission income to operating expenses also
appears to have been about 200%. In other words,
operating expenses were around 6% of goods
sourced. The court decision would, therefore, suggest
a 6.6% commission rate. The authors also noted the
court's argument that inclusion of the purchase price
of products in the cost base for the application of the
markup was not justified.
15
A bimodal distribution is a probability distribution
with two distinct modes or peaks. Bimodal
distributions can rise when the sample consists of
observations from two distinct populations, each of
which has different central tendencies.
16
For more details, see McClure, supra note 13.
17
See “Mattel CEO: 'Rigorous Standards' After
Massive Toy Recall,”
www.cnn.com/2007/US/08/14/recall/index.html#cnnS
TCText
When Toymax issued its initial public offering in
1997, David Chu owned 45% of its stock. Over time,
he sold some of his shares.
18
The text of the transfer pricing report has been
altered so as not to identify the taxpayer or its sector.
19
9
10
The Berry ratio is used in determining the
appropriateness of economic profits earned relative
to functions performed, and is calculated based on
the ratio of gross profit to operating expenses for
companies in the service or distribution industries.
11
The Limited, Inc., No. 15066-90 (stipulated
decision). See also “The Limited Agrees to Pay
$540,539 in $6 Million Section 482 Dispute,” 1 BNA
Tax Mgmt. Transfer Pricing Rep't 187 (July 22,
See “Recalled: 255,000 Chinese Tires,”
www.cnn.com/2007/US/08/09/tire.problems.ap/index.
html
Financial information for the typical company in
Standard Industrial Classifications 1521 (single-family
homes) and 1522 (other residential construction) is
presented in the Annual Statement Studies from
Robert Morris Associates.
20
Fisman, Moustakerski, and Wei, “Outsourcing Tariff
Evasion: A New Explanation for entrepot Trade,”
NBER Working Paper No. 12818 and IMF Working
Paper No. 05/102 (May 2005). An entrepot is an
intermediary center of trade and transshipment.
21
Feenstra and Hanson, “Intermediaries in Entrepot
Trade: Hong Kong Re-Exports of Chinese Goods,”
13 J. of Economics & Mgmt. Strategy 3 (March
2004).
22
Erzan, Krishna, and Tan, “Rent Sharing in the MultiFibre Arrangement: Theory and Evidence from U.S.
Apparel Imports from Hong Kong” (World Bank,
February 1991).
23
Bhagwati, “On the Equivalence of Tariffs and
Quotas," in Baldwin, et al. Trade. Growth and the
Balance of Payments (Rand McNally, 1965).
24
The authors also note that these quota rights were
not always owned by procurement entities. In some
situations, manufacturers owned the quota rights or
shared these rights with the procurement entity.
25
Note 11, supra.
26
Fong, “Garment Traders Seek New Roles as
Quotas End,” Wall St. J., November 26, 2004.
27
If the IRS argued for the CPM approach and the
Chinese tax authorities argued for the CUT approach
at the same time, one might reasonably expect this
multinational to be spared the double tax implications
from such a whipsaw. If the transaction were
between the U.S. parent and the Chinese subsidiary,
the tax treaty between the two governments should
prove useful in avoiding double taxation. The
complexity of having the CBT in the middle poses an
international tax law question beyond the scope of
this article.
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