Market support payments
Where market support payments are made by New Zealand parents to offshore subsidiaries (usually distributors), we look at their economic material to determine their exact nature and deductibility. It’s essential that the primary question as to why a party would pay such subsidies at arm’s-length (taking into account other options realistically available) is answered fully in supporting documentation, ideally at the same time as the strategy’s implementation.
In normal economic circumstances it may be appropriate for a parent to reward a distributor in another country on a consistent rate of return basis, while assuming most business risk itself. However, the distributor must exercise its good business judgement to manage its own business activities in the context of the local economic environment. A failure to set up that as a basis for the separate nature of the two businesses raises issues of moral hazard. In other words, without some boundaries, the limited risk distributor has no reason to run its business efficiently, to the ultimate cost of the parent.
Overseas markets
Some overseas markets have experienced severe recessionary conditions recently, far worse than those in Australia and New Zealand. There have also been considerable variations between and within industries, some sectors having been hit far worse than others. From a practical transfer pricing perspective, it can be assumed that it would be reasonable to expect a force majeure provision in a contract, and that it would be invoked in the event of a major economic meltdown. This means that it is necessary to differentiate between the effects attributable to normal trading and those attributable to the significant recession.
While it may be normal to use the TNMM or comparable profits methodology in normal economic circumstances, it may well be more appropriate to look at the gross margin that has been achieved during the regular market conditions and apply that to the severe recessionary period. Losses that are the result of an excess of costs over the gross profit achieved would prima facie be the result of the recession and would sit in the country in which the distributor was resident.
Identifying costs
It may be possible to identify particular costs arising from the economic circumstances; for instance, the cost of redundancy, branch closure or compensation for breach of contract. A further alternative is to identify the ratio of SG&A to sales in the normal trading period and apply it to identify excess costs in the severe recessionary period. Such excess would fall outside the expected reimbursement and mark-up base. Whatever method is used, it’s important to determine a reliable way to differentiate between the normal trading costs and those costs resulting directly from the recession.
It is possible to determine with some accuracy adjustments that would be appropriate under normal contractual terms in normal economic circumstances. Such adjustments to the cost of goods sold would be acceptable for transfer pricing purposes.
What to do with the remaining losses?
The remaining losses lie in the country in which they were created. It has been suggested that market support payments could be made to ensure the viability of the limited risk distributor
Why would the parent do that?
Market support payments are not a catch-all or an open cheque book. They are a targeted response to a need to establish a market or brand or to promote a product. As such they need documented authorisation and a goal with periodic checks to see what progress is being made. They also need a reviewable termination date.
Under some circumstances a parent may consider a market so important that the distributor must be supported through the abnormal period. The payments made in this context will need to be evaluated using normal deductibility rules. This includes consideration that a payment may be made for the enduring benefit of the business and may therefore be capital in nature and not deductible.
Date published: 02 Dec 2010
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