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Governing the Transfer Pricing of a Stripped Sales Organisation
During the last decade, many multinational corporations (MNCs) have optimised their sales organisations by converting fully-fledged sales organisations into a principal/agency model. As a result, the local sales organisations are transformed ('stripped') into mere agents or commissionaires acting for a principal in a low tax jurisdiction. Apart from the evident commercial benefits, such as stock optimisation, many such conversions lead to tax reductions as high sales margins are shifted to low tax jurisdictions.
As tax authorities have seen the taxable profit of the local sales organisations drop to levels which are sometimes even below one-tenth of the original sales profit, they have a great interest in challenging the stripped sales organisation.
Below Taxand Netherlands discusses:
- which weapons the tax authorities use to challenge the tax benefits of the new sales organisation
- what MNCs can do to maintain the benefits of the commissionaire's model whilst better governing it, and so manage and reduce the model's tax risks.
Managing the tax risks is critical for an MNC as the contemplated tax reduction may turn into a cash bleeder if tax authorities succeed in their attack of the model, which will normally not only result in reversal of the original benefits but also in substantial interest charges and penalties.
Weapons used by tax authorities to challenge the stripped sales organisation
The first evident weapon used by the tax authorities is transfer pricing. They challenge the arm's length level of the sales commission left in the local agent or commissionaire.
MNCs often believe that they have little to fear from such an attack if they have performed a benchmark study. The truth, however, might be different. Where benchmark studies build on comparable third party transactions, tax authorities can (and do) challenge the reports with the argument that the third party situations used as comparables in the report are not appropriate for the situation at hand. Moreover, as more than 70% of all international transactions are inter-related, comparable third party transactions become harder to find thus strengthening the tax authorities' case.
The second weapon used by tax authorities is the claim that the sales office has transferred goodwill or profit potential to the principal company. Taxpayers often defend themselves against this weapon by claiming that the low commission rates are justified as the sales margins decline commensurate with the sales risks that are shifted from the sales office to the principal company. They claim that no profit potential is transferred if there is a reasonable relationship between the reduction of margin and the reduced risk profile. This allegation is, however, often poorly documented and we have seen many cases in which historical data provide weak evidence that the MNC actually ran the risks that they claim were transferred.
Preparing a risk analysis
To optimise the tax advantages that a stripped sales organisation provides, MNCs should take carefully planned decisions on the tax risks of a conversion. The risk analysis should not be limited to performing the obvious benchmark studies. It should also review the economic boldness of the new sales organisation.
MNCs undertaking risk analysis could use a simulation model developed by Taxand Netherlands to evaluate the sales organisation's economic risk profile before and after the conversion.
The model simulates the key value drivers of the sales organisation based on the organisation's historical risk data. The model also shows the risk-reward relationship of both the old and the new sales organisation and evaluates this relationship.
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