Distributors put on notice

Distributors of goods sourced from international related parties face renewed regulator scrutiny following the release of a Tax Office transfer pricing booklet, Marketing Intangibles. The booklet deals with marketing activities undertaken by Australian companies that use trademarks or trade names they do not own (typically importers and distributors of branded goods).

Intangibles have long been one of the most complex issues in transfer pricing. In recent years intangibles have been singled out as an area of focus.

In the 2005/06 Compliance Program for example, the Tax Office gave notice that it would target instances where intangibles are used to shift profits. Marketing intangibles, in particular, create unique issues for distribution entities, and the Tax Office has sought to address these through the booklet, which is based on the OECD’s transfer pricing guidelines.

‘The timing of the release and the ATO’s focus coincides with significant action on the international front,’ said Michael Jenkins, leading transfer pricing economist at Deloitte. ‘A key issue in the US$13bn Glaxo transfer pricing case (a dispute before the US Tax Court) is likely to be one involving marketing intangibles – their very existence and whether the distribution entity is entitled to any of the associated profits. The issues likely to be at the heart of this dispute – the existence of marketing intangibles, and whether profit is attributable to the marketing or product-related intangibles – highlight some of the difficulties in this area.’

The booklet uses a series of examples to illustrate the issues the Tax Office is likely to challenge in situations where distributors/marketers promote a product whose brand is owned by an offshore related party. The examples centre around two issues: marketing expenditure, and royalty payments incurred by the Australian taxpayer in respect of brands owned by the overseas related party.

When a distributor incurs marketing and advertising expenditure in excess of that incurred by comparable independent distributors and has only limited opportunity to benefit from the spending, the Tax Office is likely to challenge the arrangement and propose adjustments.

The Tax Office is also likely to challenge situations where a distributor is paying a royalty for the right to distribute branded products in Australia. It is of the view that independent parties don’t pay royalties for the right to simply market and distribute products.

Although not stated in the booklet, the corollary to this view (which has been expressed by the Tax Office on other occasions) is that a distributor paying a royalty for a trade name or brand name has some rights in the marketing intangible, and this should be reflected in a higher level of profits.

Any distributor paying a royalty for a marketing intangible is therefore at risk of either having the royalty payments decreased or disallowed by the Tax Office (where rights are limited to simply distributing branded product), or having to defend ‘normal’ distribution profits as appropriate.

The booklet reaffirms the Tax Office’s approach to any transfer pricing review; it will ultimately look to the level of profits returned in making judgements about the arm’s-length nature of the arrangements. In the case of marketing and royalty costs incurred, the Tax Office will look to the level of profit returned by similar independent distributors.

What will attract Tax Office attention?

• Payment of a royalty by an Australian marketer/distributor.
• Extraordinary expenditure on marketing beyond what comparable independent marketer/distributors incur.
• Renegotiation of agreements to transfer costs and risks of developing the market to the Australian company without an appropriate reward.
• Reimbursement of marketing costs incurred by an Australian company without an appropriate reward.
• Expenditure of significant amounts on brand marketing when the distribution agreement is only short term.

The Tax Office gives an assurance that taxpayers who try to follow the advice given in the booklet but make an honest mistake will not be charged a penalty.

Timing

The examples raise continuing concerns over how long it takes the Tax Office to form an opinion in transfer-pricing matters. For instance, the booklet discusses an example where, ‘in year six we become concerned about B’s profitability in years one to five.’ The example goes on to canvas potential transfer-pricing adjustments in each of years one to five.

The law currently allows the Tax Office an indefinite period of time to make a transfer pricing adjustment. It is important  we head towards a situation where the Tax Office is required to form a view on a taxpayer’s transfer pricing matters within a period of no more than four years.

Access to information

The Tax Office refers to companies incurring ‘marketing costs far beyond those of comparable independent enterprises’ yet makes no mention of how companies might determine what other entities are spending, or the range of spending that would be considered acceptable. This exposes a fundamental difficulty for companies that attempt to follow the advice in the booklet. That is, while companies will often have some degree of information about the operations of their competitors, in most industries competitors will be companies that are themselves dealing with overseas related parties. Therefore, whatever information that is able to be obtained on what competitors spend on marketing activities will often be of no use because the competitors will not be representative of comparable independent enterprises that are dealing at arm’s length with their overseas related parties. In order to obtain information that is both relevant and reliable, companies need to undertake searches for suitable companies, and they are then likely to be confronted with difficulties in getting access to publicly available information.

The Tax Office’s 20/20 hindsight enables the it to use this information in order to flag cases where the it considers marketing expenditure is outside industry norms.

Type of expenditure

The examples assume that all of the marketing costs contribute to the value of the foreign-owned brand name (or other intangible). Much of the expenditure incurred by a distribution entity, however, is ‘tactical’ marketing aimed at either developing distribution channels or is ‘product-specific’. Neither of these can be seen as building the value of the brand, which makes it difficult to see how the Tax Office could build a case for these costs to be recharged to a foreign parent. For example, the costs of co-operative advertising in a retailer’s catalogue builds local sales over a defined time period.

The message

The clear message is that distributors who spend money on marketing and advertising foreign-owned and branded goods, and are paying a royalty for the right to exploit the value of the brand, have been put on notice by the Tax Office. Moreover, the Tax Office’s use of 20/20 hindsight in transfer pricing audits means that the Tax Office can potentially seize the high ground when reviewing a company’s marketing activities. The most effective response is for companies to have sound contemporaneous documentation (prepared on an annual basis) that explains the arm’s-length nature of any royalty payments and that highlights the value that has been derived from the exploitation of brands in Australia.

Reference: August 2006, volume 76:07, p. 56-57

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