Here’s the scenario.
An international company with headquarters in Europe sells its products via local subsidiaries around the world. The US entity provides selling activities to US customers including prospecting, qualifying candidates, and nurturing the sales process through the close of the contract. The final contract is signed by the headquarters entity and the local customer.
The US entity spends around $1 million per year on office expenses, salaries, and other general and selling expenses. They are responsible for closing around $20 million worth of business per year and receive a 10% commission. Some quick math shows they earn $2 million in commission income on $1 million in expenses for a 50% profit margin.
The jurisdiction where the headquarters is located is upset with the $1 million reduction in taxable income in the home country. They want the company to lower its commission rate.
What is a fair “price” for the selling services the US entity provides?
Transfer pricing decisions should be made assuming an “arms-length” transaction occurs. They should be based on what could be comparably earned by doing business with a 3rd party unrelated to the parent or subsidiary. It can be based on a cost-plus arrangement where a percentage is added to the costs incurred which are charged back to the parent company. It can also be based on the market value of the services, or how much you would have to spend to hire another company to do the work for you.
The challenge is that both the parent and subsidiary jurisdictions tax authorities want to maximize their own tax revenue. So the agreement has to be fair to all parties involved or one or both parties will reject it.
Some other factors to take into consideration:
- What are the relative tax rates in each country? You don’t want to avoid taxes and should always pay your fair share. That said there are legitimate strategies to manage the total tax liability across the global business.
- The parent may want to avoid the appearance of being engaged in trade or business in the subsidiary country. This is often referred to as creating a permanent establishment which would necessitate the parent company filing a tax return and paying taxes directly in the subsidiary’s country. In the US, this could mean they would have to pay taxes on their worldwide income in the US, even though only a portion of the income is earned in the US. This may be one reason a local subsidiary is used.
A more fair approach in the above example would be for the US subsidiary to invoice a 15% service charge on its expenses back to the parent company. This would mean they would charge back 115% of the expenses incurred or $1,150,000. They would earn $150,000 in profit which would be taxable in the US. Depending on the industry, a 15% profit margin on an independent selling company may not be so bad.
One other common pitfall to watch out for is the effect the change in income will have on the US entity employees. Their compensation and bonus plans will need to be re-calibrated so there is no negative impact on the employees due to the change in company profitability. Other than that, certain employees whose egos are based on the size of the business they manage will have to face a new reality.
