Transfer Pricing Strategy – Limited vs. Full Risk Distributor

We’ve written about TP before –  https://htj.tax/?s=transfer+pricing

Today we get into strategy a bit more as opposed to just policy documents.

General issues to be kept in mind while structuring a global transfer pricing policy:

  • MNCs should prepare a customized pricing policy for key risk jurisdictions. Such policy should be based on the global pricing policy
  • Global Transfer Pricing policy should clearly define and document the global supply chain of the multinational group
  • Terms and conditions of cross-border transactions between related parties should, as far as possible, be substantiated by an agreement: would ensure transparency in inter-company dealings‒ provide comfort during audit proceedings
  • Need to strengthen internal systems and processes to maintain transactional level data and collate contemporaneous documents
  • Transfer Pricing documentation should be robust, updated and monitored on a yearly basis based on the jurisdiction’s requirement

Distribution activity

Limited risk distributors are a relatively common feature of intercompany arrangements within multinational groups. The essence of the arrangement is of course to de-risk the role of the intra-group distributor, resulting in a correspondingly lower return or margin for the distributor. In many ways, the position of the distributor is commercially analogous with that of a commercial agent or commissionaire.

  • Transfer Pricing policy for distribution must take into consideration the positioning of the distributor i.e., low-risk distributor, full-fledged distributor or somewhere in between
  • In the scenario where the distribution entity imports finished goods from parent and sells it in its domestic market
  • Under a low-risk distribution model the transfer pricing method should be such that it results in a consistent margin over a period of time
  • Return for low-risk distributors in developing markets are general higher than corresponding margins in developed economies.
        • In contrast, a full-fledged distributor would
        • take marketing and credit risk
        • perform significant brand building exercises
        • be willing to dynamically change pricing strategies to increase its market share
        • Perform value added services such as packing and labeling, logistics, pre-sales presentation and after sale services
        • Accordingly, a full-fledged distributor must have a policy that compensates for such value-added functions
        • The determination of the “most appropriate method” will depend on the level of value addition also considering any marketing intangibles created
        • Profitability of a distributor also depends on the selling strategy and channel adopted
        • If distributor undertakes to establish its own distribution network it may result in initial year losses due to disproportionate costs incurred
        • However, in later years greater profits are expected on account of improved efficiencies

What to know

Chances are you need to have a lawyer draft an appropriate distribution agreement once you decide on distribution strategy.

  • A Limited Risk Distribution Agreement appoints a distributor to sell products with limited risk. Usually, a distributor selling products bears the risks associated with items like inventory or bad debt. With a Limited Risk Distribution Agreement, risk is shifted from the distributor to the principal.
  • Because the risk has been shifted to the principal, the principal earns more with a Limited Risk Distribution Agreement than it would in a traditional distributor agreement.
  • Often, a Limited Risk Distribution Agreement is used as part of a tax planning or transfer pricing strategy within a group of multinational companies,
  • A Limited Risk Distribution Agreement is also known as a Limited Risk Distributor Agreement.
  • Because of the nature of the risks shifted, a Limited Risk Distribution Agreement is usually entered into for physical, tangible products.

What to do

  • The Limited Risk Distribution Agreement is usually part of a transfer-pricing strategy within a group of companies. If you don't have a transfer pricing strategy, it makes sense to have one in place.
  • If you've got your transfer pricing strategy sorted, you need to roll out the Limited Risk Distribution Agreement.
  • You'll need to know the following to enter into a Limited Risk Distribution Agreement:
        • How and where the products are supplied. Outside the US, Limited Risk Distribution Agreements usually follow Incoterms to define how and where the products are supplied. Incotermsare the International Chamber of Commerce (ICC)'s rules for the facilitation of international trade,
        • The warranties the principal provides to the distributor,
        • The territory your distributor is responsible for, and whether they are the exclusive distributors for that territory,
        • Responsibility for registering products, setting prices and discounts, and marketing and sales,
        • What you expect for reporting,
        • How the intellectual property of your products (including the trademark of the principal) should be treated,
        • Payment terms, and
        • Dispute resolution and the other items that usually frame an agreement.

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