The Challenges Of Transfer Pricing

Management In Rapid Growth Markets

François Thomas

Foreword: What is Tax Optimisation?

• It’s all about monitoring profit and tax: maximising profit by/while

minimising tax

• What is profit?

• What is tax?

• Efficient tax planning… must be sustainable!

• Sound tax planning is based on tangible facts and consistent

business realities, not on loopholes!

Challenges of Transfer Pricing Management

in Rapid Growth Markets

• The lack of maturity of tax legislation and government officials

• The uncertainty of business forecasts in rapidly changing economies

• The specific difficulties in monitoring TNMM in rapid growth markets

• The customs issues

• The foreign exchange control issues

Lack of Maturity of Tax Legislation

• Tax legislation is often quite different from that of developed countries

• Some « modern » instruments or concepts are ignored (e.g. cash pooling)

• International bodies such as OECD or WTO may not be recognised

• Tax legislation is changing fast

• «State of Law» concept does not exist or is not understood

• Taxes and duties are commonly created with retroactive effect

• Tax treaties are often based on the UN model rather than the OECD model

• Tax and customs audit procedures leave very little room for defence

• Training of tax and customs officials may be insufficient

• Language is likely to be an issue

Uncertainty of Business Forecasts

in Rapidly Changing Economies

• Depending on business organisation and the relevant transfer

pricing policy, minor changes in currency exchange rates,

selling prices, sales volumes, customs duties, costs, etc. may

lead to actual results significantly different from those targeted

based on the forecasts.

• Some transfer pricing methods are more sensitive to this

phenomenon and may create a deeper gap than others.

• It is therefore essential, when considering the proper business

organisation and transfer pricing policy to be implemented, to

think of mitigation mechanisms, to consider a customized

system rather than duplicating group’s policies without proper

thinking.

Specific Difficulties in Monitoring TNMM

in Rapid Growth Markets

Limited Risk Distributor Supplier

LDR costs 18

Benchmarked profit 2

Transfer price = 70

Net resale price 100

Gross margin 20

Cost of goods sold 80

Duties & landing costs 10

• TNMM : transactional net margin method

• Tested Party: e.g. Limited Risk Distributor

• Profit Level Indicator (PLI): e.g. « net profit / sales »

• Benchmarked arm’s length range: e.g. « 2 < PLI < 5 »

• Target: e.g. « PLI = 2 »

Specific Difficulties in Monitoring TNMM

in Rapid Growth Markets

• TNMM calculations involve a number of variables from which the

final result depends, and TNMM is therefore very sensitive to

changes between forecasts and actual figures.

• Selling prices

• Sales volumes

• Expenses and their allocation (marketing and commercial costs,

management costs, financial costs, …)

• Import duties (depending on sourcing)

• Currency exchange rates (especially when the purchasing

currency is not the selling currency)

Why is it So Difficult? Example 1

Sales and marketing forecast for

year N is that the selling price of

product X will be 100 and that we

will sell 10,000 of them. Total sales

forecast = 1,000,000.

Based on the total sales forecast

and the forecast of the operational

and financial expenses for year N,

we expect these expenses to

represent 18% of the sales.

Net Sales to 1/3 parties

1,000,000

Net profit before tax 20,000

Operational & Financial Costs 180,000

Gross Margin

Cost of goods sold 800,000

Landing Costs 100,000

Purchase Price 700,000

Purchase Price per Unit 70

200,000

Example 1 (continued):

Thanks to favorable market conditions,

we manage to sell 6,000 units in the

1st semester and 6,000 units in the

second semester after increasing the

selling price to 110. Total sales =

600,000 + 660,000 = 1,260,000.

Actual operational and financial costs

where only slightly higher than

forecast, at 200,000.

Net Sales to 1/3 parties

1,260,000

Net profit before tax 260,000

Operational & Financial Costs 200,000

Gross Margin 460,000

Cost of goods sold 800,000

Landing Costs 100,000

Purchase Price 700,000

Net Profit before tax / Net sales > 20% !!!

Transfer price is no longer at arm’s length !

Why is it So Difficult? Example 1

Example 1 (continued):

Determining what the arm’s length

price should have been in order to

achieve a net profit margin over net

sales ratio corresponding to an arm’s

length price for year N:

Net Sales to 1/3 parties

1,260,000

Net profit before tax (2%) 25,200

Operational & Financial Costs 200,000

Gross Margin

Cost of goods sold 1,034,800

Landing Costs * 129,350

Purchase Price 905,450

Purchase Price per Unit 90.54

The company should receive

debit notes from its suppliers for

905,450 – 700,000 = 205,450

* : Additional duties and sales tax

are included in landing costs

225,200

Why is it So Difficult? Example 1

Example 1 (continued):

Determining new transfer price for N+1

based on re-forecasts for N+1:

Sales and marketing forecast for year N+1

is that the selling price of product X will be

110 and that we will sell 14,000 of them.

Total sales forecast = 1,540,000.

Budget for operational and financial

expenses for N+1 is 220,000.

* : Additional duties and sales tax

are included in landing costs

Net Sales to 1/3 parties

1,540,000

Net profit before tax (2%) 30,800

Operational & Financial Costs 220,000

Gross Margin

Cost of goods sold 1,289,200

Landing Costs * 161,150

Purchase Price 1,128,050

Purchase Price per Unit 112.80

250,800

This new price must be

implemented ASAP (inventory …)

A price increase begins to produce the intended effect on net profit before tax

over sales only once all inventory purchased at the prior price has been sold.

Why is it So Difficult? Example 1

Why is it So Difficult? Example 2

Example 2 :

We can also be facing unfavorable

market conditions. If actual sales

where only 8,000 at a unit price of 100,

total sales would have been only

800,000.

Net Sales to 1/3 parties

800,000

Net profit before tax <180,000>

Operational & Financial Costs 180,000

Gross Margin 0

Cost of goods sold 800,000

Landing Costs 100,000

Purchase Price 700,000

Net Profit before tax / Net sales <22.5%> !

Transfer price is no longer at arm’s length !

Why is it So Difficult? Example 2

Example 2 (continued) :

Determining what the arm’s length

price should have been in order to

achieve a net profit margin over net

sales ratio corresponding to an arm’s

length price for year N :

Net Sales to 1/3 parties

800,000

Net profit before tax (2%) 16,000

Operational & Financial Costs 180,000

Gross Margin

Cost of goods sold 604,000

Landing Costs * 75.500

Purchase Price 528,500

Purchase Price per Unit 52.85

The company should receive

credit notes from its suppliers for

700,000 – 528,500 = 171,500

* : Assuming the company could obtain duty and sales tax refunds ;

If not, purchase price is 504,000 and credit notes 196,000.

196,000

Specific Difficulties in Monitoring TNMM

in Rapid Growth Markets

• Rotation of inventories may have a major impact on the TP

monitoring: a new purchasing price will produce an impact on the

P&L only after the inventory purchased at previous prices has been

sold out.

• With TNMM people tend to focus on the results of the «Tested

Party» (which can be affected by external events and is determined

after the FY has been closed), where TP is about determining prices

for each transaction of goods or services at the time it is concluded.

• When the Profit Level Indicator deviates from what the benchmarked

arms length range shows as being acceptable, something must be

done to bring the PLI back in line with the target.

Specific difficulties in monitoring TNMM

in rapid growth markets

For the past

there is only one way, the retrospective price adjustment using:

- credit notes (when transfer prices resulted in a PLI below the target,

profit must be transferred back from the suppliers to the LRD Tested

Party – it is a retrospective price reduction) or

- debit notes (when transfer prices resulted in a PLI above the target,

profit must be further transferred from the LRD Tested Party to the

suppliers – it is a retrospective price increase).

However, the use of credit notes and/or debit notes is not always

possible (foreign exchange control …) and always creates a risk from

either tax or customs perspectives (and often both).

Specific Difficulties in Monitoring TNMM

in Rapid Growth Markets

For the future

a price change must be implemented based on the best re-forecasts

available, keeping in mind that the new prices will have an impact only

after a delay that depends on the rotation of inventory for each goods.

It is not advisable at all to try to compensate the past under or over

profitability when setting the new transfer prices or to compensate from

one business line to another because this would result in transfer prices

that would not be arms length.

Customs Issues

• Any price change is suspicious, from a customs authority’s perspective.

• A lower new price often results in a retention of the goods until the importer may

provide an acceptable explanation, … or pays the duties based on the former (higher)

price. Practically, is is often recommended never to reduce any price (even if this

results in a deterioration of the gross margin, result and PLI of the LRD).

• A higher new price creates a suspicion that the former price was too low, that it

should have been risen earlier.

• Credit notes (retrospective price reduction) and debit notes (retrospective price

increase) are tempting. However, even when they are accepted by tax authorities (for

instance within an APA), they may not be accepted from customs perspective. The

customs value must be properly determined at the time the goods cross the border. A

further adjustment may be considered as evidence that the initial price was incorrect,

which may trigger penalties

• NB: “debit notes” may trigger withholding tax exposure!

Foreign Exchange Control Issues

• Foreign exchange regulations are often complex and may be an obstacle to the use of

debit notes (retrospective price increase) and/or credit notes (retrospective price

reduction).

• In order to prevent or mitigate the impact of currency exchange rates variations

troubling the monitoring of the results and the PLI of the LRD Tested Party (when a

“commissionaire” structure is not in place), the transfer prices should be determined in

the local currency.

• However, some currencies are not convertible outside the country, which may lead to

invoicing in foreign currencies, adding complexity to the monitoring of the PLI because

of the impact of exchange rates fluctuations.

• Rather than having to chose between Plague and Cholera, it is therefore worth

considering to set the pricing currency independently from the payment currency. In

cases where the local currency is not convertible outside the country, it may still be

agreed that although the price is set in local currency, payment is in USD or Euro or

any appropriate convertible foreign currency, conversion being made at the time of the

payment through the local bank system.

François THOMAS

fr.linkedin.com/pub/françois-thomas/20/59/902/

francois.philippe.thomas@gmail.com

+33666660446

Conclusion

«L’artifice se dément toujours et ne produit pas

longtemps les mêmes effets que la vérité.»

Louis XIV - Memoires

Fraus omnia corrumpit.