INTM440160 - Transfer pricing: Types of transactions: intangibles: establishing an arm’s length price for valuable intangibles: product line income statements

Overview

One of the difficulties when reviewing a controlled transaction, particularly when considering a profit split method, is isolating the transactions and establishing what functions add value along the product chain.

A useful tool to help overcome these problems is a product line income statement, which is a profit and loss account for a particular product showing how and by whom the profit is made (manufacturers, distributors, intangibles owner). The results of a particular product can be isolated, and the profits made by each link in the chain can be compared. A product line income statement can also be prepared on projected costs and profits.

A product line income statement may be called by other terms: case teams should work with a business to explain the purpose of the statement and help them to provide the details needed. This information will show where profits have accrued to function in the whole trade. Case teams can then consider whether this is in accordance with the arm’s length principle.

Note that a product-line income statement will feature an allocation of business overheads, which will impact on profitability.

Example

Consider the example below, involving the group Good Sounds Plc. The group is recognised worldwide as producing excellent audio equipment, and the brand name ‘Good Sounds’ has global recognition. One of their divisions is involved in the development, manufacture and marketing of recordable DVD players. The figures are illustrative only.

• The technology to make the players and the trade name is owned by the intangible owner, Good Sounds Plc.
• Sub-assembly manufacture is carried out in a low tax territory, by Good Incentives Pte Ltd, which has been granted a licence to manufacture and market the players. They also carry out process R & D, to try to increase quality and reduce manufacturing costs. The low tax country pays a royalty to Good Sounds Plc, calculated at 5% of the sale price of the distributors (the in-market price).
• Finished goods manufacture is carried out in regional markets - for example, Good Packages GmbH carries out finished goods manufacture for the European region. All the regional finished goods manufacturers buy the sub-assembled products from Good Incentives Pte Ltd.
• Distribution is carried out in the local markets, where tailored marketing strategies are developed and implemented. All the DVD players are bought from the regional finished goods manufacturers, such as Good Packages GmbH.
• The results of the regional finished goods manufacturers have been aggregated, as have the results of the local distributors.

-	Product line income
statement	External
sales and costs	Allocation of
profits
-	£’000	£’000	£’000
Good Deals	-	-	-
Distributors	-	-	-
Sales	1,000,000	1,000,000	-
Cost of sales	450,000	-	-
Gross profit	550,000	-	-
Distribution	50,000	(50,000)	-
Marketing	300,000	(300,000)	-
Administration	100,000	(100,000)	-
Net profit	100,000	-	100,000
Good Packages	-	-	-
Finished goods manufacturers	-	-	-
Sales	450,000	-	-
Costs of goods	350,000	-	-
Raw materials	25,000	(25,000)	-
Factory costs	50,000	(50,000)	-
Gross profit	25,000	-	-
Administration	10,000	(10,000)	-
Net profit	15,000	-	15,000
Good Incentives Pte Ltd	-	-	-
Sub-assembly manufacturer	-	-	-
Sales	350,000	-	-
Raw materials	60,000	(60,000)	-
Factory costs	80,000	(80,000)	-
Gross profit	210,000	-	-
Royalties	50,000	-	-
R & D	5,000	(5,000)	-
Administration	10,000	(10,000)	-
Net profit	145,000	-	145,000
Good Sounds Plc	-	-	-
Intangible owner	-	-	-
Royalties	50,000	-	50,000
System profit	-	310,000	310,000

The product line income statement actually shows a mini profit and loss statement for each of the four distinct stages in the product chain, for the DVD players only. Good Sounds Plc does not have any costs as all the extensive, expensive R & D work was carried out in previous years. In practice there may be relatively small ongoing costs relating to protecting its intellectual property such as registering patents and renewing trademarks.

Good Sounds Plc will be incurring lots of other expenditure (e.g. R & D on new products). However this product line income statement is concerned only with expenditure associated with the DVD players.

Profit split method

In cases where the arm’s length price of transactions needs to be established involving highly valuable and sometimes unique intangibles, the profit split method can be used in the absence of any comparable uncontrolled price. This may involve considering the transfer price for the grant of a licence agreement. There are two key steps involved:

1. Calculating the reward the intangible holders should receive.
2. Allocating that reward between the different types of intangibles that are used in manufacturing and marketing the products.

The foundation for the first step will often be a product line income statement. This should be based as far as possible on projected figures for sales and costs that were available at the time. Hindsight should be avoided as the purpose of the exercise is to replicate what the negotiation process would be between two independent parties. This can potentially involve trying to estimate how a product is going to perform over a number of years.

In cases involving valuable and perhaps unique intangibles, independent parties are likely to be very wary of committing themselves to long term agreements, without some way of redressing any imbalances. A break clause (i.e. a review after a set period of time, with the option for the royalty to be increased or decreased, depending on performance so far), or stepped royalty agreement may be a realistic alternative to a ten or fifteen year agreement.

While hindsight should be avoided when trying to set the price, the actual results should be compared against the projections to see if there are major differences. If there are, this may highlight inadequacies in the forecast figures that potentially can be adjusted for. For example it may be found that sales forecasts have been downgraded, expenditure has been overstated, the forecast sale price is significantly lower, etc. As much information as possible should be gathered about the original estimates, including:

• The source of the estimated figures.
• Details of assumptions made.
• Details of adjustments made.
• Details of how the projections have evolved (there may be a series of projections).
• Whether any other projections (not just limited to the products being considered) were prepared at around the same time for other purposes - perhaps for a presentation to business analysts.
• Copies of all reports dealing with the viability or go ahead for any project involving the intangibles.
• Copies of any reports comparing locations and costings for the project.
• Copies of any reports to the board of directors or finance director.

Evidence to support the credibility of contemporaneous projections should be sought from the business. The guidance on ‘hard to value intangibles’ (see INTM440175 may also be in point.

Having agreed the forecast figures, the product line income statement can be constructed along the lines of the example in the previous section. When examining the returns for the individual companies, the aim is to reward each company in the chain for the basic functions carried out; at this stage the companies are not rewarded for intangibles they may own. This means a functional analysis covering each company is needed, together with details of the intangibles owned by each that are relevant to the transactions in question. If say two products are being considered out of a possible thirty a company owns, the case team will only be interested in the intangible rights that relate either solely to the two products under review, or relate to the company’s operations as a whole.

In the case detailed in the previous section the following intangibles or possible source of intangibles have been identified:

• The patents and manufacturing know-how relating to the manufacture of the DVD players belongs to Good Sounds Plc.
• The trade name, ‘Good Sounds’, is owned by Good Sounds Plc.
• Good Incentives Pte Ltd carries out R & D, which might potentially result in valuable intangibles.
• The distribution companies all develop their own marketing strategies, which might result in marketing intangibles such as goodwill. (Always consider carefully whether marketing activity has actually created a valuable intangible. See INTM440110).

The case team confirms that the companies carrying out the finished goods own no intangibles of any significant value. It’s also established that the Good Packages companies act under a tightly drawn contract, whereby they are guaranteed to sell the products they finish, subject to acceptable quality control. Good Incentives Pte Ltd will buy any surplus that the distributors have not contracted to buy. As such the risks are limited.

For final assembly of sub-assembled goods, a cost plus method is probably most appropriate. In this case the group have provided evidence for a number of manufacturers around the world. The comparable range of results show that external costs of manufacture are marked up by between 15% and 20%. The group has taken the top end of the range, 20%, when setting the transfer prices for this group of companies. The evidence shows that in this case this is an arm’s length margin.

Good Incentives Pte Ltd holds a licence from Good Sounds Plc and under that licence manufactures the sub-assemblies. The case team establishes that the R & D it carries out is geared towards improving the quality of the products, and reducing manufacturing costs. This expenditure could potentially create valuable intangibles. Any reduction in the manufacturing costs would not affect the royalties payable under the licence. Good Incentives Pte Ltd will in theory receive its reward for any successful R & D on this front by being able to reduce its manufacturing costs, but still charging the same sale price to the regional finished goods manufacturers.

For example, the manufacturing costs are reduced by £10 million per year. The system profit increases to £320 million because the external costs have been reduced by £10 million. Super Sounds Plc will still receive the same royalty as this is calculated as a proportion of the in-market sales (sales to the third party customers).

If the R & D increases the quality of the DVD players, this could create a valuable intangible if patented or otherwise protected from unauthorised use by other parties. While it might not allow the end price to be increased, it may well allow profit margins to be maintained, together with market share, once competitors enter the market.

There is of course the chance that the R & D undertaken in Singapore will not be successful. An independent manufacturer might view this work in a number of ways:

• It might refuse to do it altogether
• It might agree to do the R & D on a contract basis, where it is guaranteed to receive a set fee (perhaps with some linked incentive for reward)
• It might be prepared to take a risk, but would expect to reap a reward by way of the reduced manufacturing costs, and perhaps some other incentive, in case the R & D is fruitless.

The potential for Good Incentives Pte Ltd to produce any valuable intangibles has to be considered very carefully, along with risks of the R & D producing nothing. Case teams could review whether there are any staff in the low tax country working on specific projects. Are those projects designed to measurably increase either volume of sales or the profit margin, or to maintain market share and current margins? If there is significant work of this nature then it might be appropriate to allocate a small proportion of the residual profit to Good Incentives Pte Ltd. Depending on the nature of the work, it may be more proper to treat the R & D as contract R & D, with the arm’s length price being set by a traditional method.

The basic function of the company is that of manufacturer. It also bears the risk of having to buy the excess production not required by the distributors. The case team establishes that the distributors submit their expected purchases three months before the start of each financial year. They must buy the DVD players contracted for, and can submit increases on a quarterly basis. They cannot decrease the amount they contract to buy however. Good Incentives Pte Ltd bases its manufacturing output for any one year on the agreed contracts plus an additional 5% to cover returns etc.

The reward for the manufacture in this case could be calculated using a cost plus method. After searching for suitable comparables the case team concludes that the direct costs of manufacture should be marked up by 20%. It’s also agreed that Good Incentives Pte Ltd should receive a reward for the risk of having to buy back any over-capacity. This could be calculated in number of ways, but the team agrees with the group that this will be covered by a margin of 5% on turnover. This is a purely illustrative figure, but a margin linked to turnover is probably appropriate to cover this aspect of the business.

So the reward for Good Incentives Pte Ltd for its basic functions are as follows:

• Manufacturing costs (60+80) x 20% = £28 million
• Turnover 350 x 5% = £17.5 million
• Adjusted net profit for basic functions = £45.5 million

The case team agrees that the company will be entitled to share in a small proportion of the residual profit in respect of the R & D it undertakes.

Good Sounds Plc carries out no routine functions. Its reward will come wholly from its share of the residual profit.

Having established the reward for each of the companies carrying out routine functions, the residual profit can be established. Remember the overall system profit hasn’t changed, all the external costs remain the same.

-	-	Good Deals	Good Packages	Good Incentives Pte Ltd	Good Sounds Plc
Activity	System profit	Distributor	Finished goods manufacture	Sub-assembly manufacture	Intangibles owner
-	-	£’000	£’000	£’000	£’000
Original net profit	310,000	100,000	15,000	145,000	50,000
Adjusted net profit for basic functions	125,500	65,000	15,000	45,500	Nil
Residual profit	184,500	-	-	-	-

The residual profit is £184.5 million. The companies that hold intangibles are Good Sounds Plc, and potentially Good Incentives Pte Ltd in respect of any improvements to the quality of the DVD players.

A practical solution for the low tax territory might be to allocate a small basic incentive element, along with an increased share in the event that the R & D produces tangible outcomes. This would reflect arrangements that might be found between independents in similar circumstances.

In this case the evidence shows that 5% of the anticipated residual profit should be allocated to the low tax country, and 95% to the UK company, with the option for a review if the R & D produces some tangible outcomes.

Good Sounds Plc receives £175.275 million from the profit split model. A royalty of 17.5% from the low tax country based on the in-market price, instead of the existing royalty of 5%, results in £175 million.

In this example the evidence presented is for one year only. In a real case, data from a number of years can be examined and an average royalty taken over that period.