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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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