Normally, a sales agent and a buy-sell distributor would not be
regarded as comparable owing to the differences in functions,
assets and risks relevant to each party. However, in a recent
French court case, France vs. SAS Sames Kremlin, March
2023, it was determined that the independent agents and
distributors were comparable based on the relevant facts. The court
ruled that the commission paid to independent agents served as a
comparable uncontrolled price (“CUP“),
and therefore, the commission payable to distributors should be
determined in a similar manner as that of independent agents.
As surprising as the court’s decision may at first appear,
upon further consideration, it becomes apparent that the
court’s finding seems to be correct. Taxpayers who do not
adhere to the basic principles and processes of transfer pricing to
arrive at a correct application of the arm’s length principle
do so at their own peril.
Background
The taxpayer marketed its products either through its
subsidiaries or independent agents. In certain countries, it sold
its products through its subsidiaries in those countries under
either a buy-sell distributor agreement or a commissionaire
agreement. In other countries, it sold its products through
independent agents to whom it paid a commission.
The remuneration of the independent sales agents was set at 20%
of turnover, irrespective of the nature of the products and
equipment sold. Subsidiaries, however, were renumerated based on
the amount of the discount they would have received if they had
acted as a buy-reseller, and this remuneration was payable
irrespective of the nature of the products and equipment sold.
The arguments
The Revenue authorities argued that there was no justification
for the remuneration paid to the subsidiaries for the
intermediation commission to be higher than the 20% rate granted to
the independent representatives.
The taxpayer argued that the geographical markets in which the
subsidiaries operated were fundamentally different from those in
which the third-party sales agents operated. This was because they
were highly strategic for the business as key customers were
located there, while the other markets where the agents operated
were of lesser importance.
The subsidiaries responded to major requests to tender, while
the local sales agents were only involved in the supply of spare
parts and small equipment. Additionally, the subsidiaries played a
crucial role by providing:
- Marketing support
- After-sales service
- On-site assembly and equipment testing
- Assistance with debt collection
These activities demanded a substantial workforce dedicated to
the subsidiaries’ operations.
The taxpayer further argued that the commissions paid to
independent sales agents could not constitute a relevant comparable
for assessing the nature of the remuneration paid to foreign
subsidiaries. The commissions paid to the subsidiaries took into
account the margin they would have made on a purchase-sale of the
product.
The court’s finding
The court found that the difference in the remuneration between
the independent agents and the subsidiaries (economic agents
belonging to the group) could not be justified since both were
involved in the same intermediary activity, which must be
distinguished from the purchase-resale activity.
Based on the evidence, it was not clear that the services
provided by the independent intermediaries were significantly less
substantial than the services provided by the subsidiaries in their
intermediation activity alone. When acting as intermediaries, the
subsidiaries should be remunerated as such and not for their
buy-sell activities, which were separate from the intermediation
activities.
The turnover achieved in the countries where the independent
agents operated was generally lower than that achieved by the
subsidiaries, but the turnover of the subsidiaries was not
systematically higher than the turnover achieved by the independent
agents. It was found that the characteristics of these markets did
not justify the differences in the remuneration paid to the
subsidiaries and independent agents. Furthermore, there was no
evidence that services provided by the independent agents were
significantly less substantial than the services provided by the
subsidiaries in their role as intermediaries. The mere fact that
the subsidiaries had greater material and human resources was not
sufficient to presume, in the absence of any evidence to the
contrary, that those resources were used for the intermediation
activity.
Where did things go wrong for the taxpayer?
To ensure that a transaction between related parties is at
arm’s length, a two-step approach is required: a functional
analysis followed by a comparative analysis. The terms and
conditions of the transaction, which is to be tested must be
similar to those that would have been entered into by unrelated
parties in similar circumstances.
To accurately identify or delineate the actual transaction
between related parties, the commercial and financial relations
between them must be carefully examined. Consideration should be
given to the economic sector in which the parties operate and any
factors which would affect the performance of businesses operating
in that sector.
The role which each party plays in the transaction must be
defined, and a number of “economically relevant “or “comparability factors” should be determined. These
include the contractual terms between the parties, a detailed
analysis of important functions, assets employed and the assumption
of risks. A group value chain analysis should be performed. Other
factors to be considered would be the characteristics of the
property transferred or services rendered and whether these are
tangible or intangible, etc. Market-related factors and business
strategies should also be taken into account. If this analysis is
correctly performed, then the relevant transaction between
connected parties will be correctly delineated.
The root cause of the taxpayer’s difficulties lies in the
fact that the two very different roles which the subsidiaries
played in their countries were not adequately analysed, and the
functional analysis relating to each role was not correctly
conducted. By correctly following the steps required to delineate
the actual transaction that the subsidiary was concluding when
acting in its capacity as an intermediary rather than as a
purchaser-reseller, the differences in the two roles would have
been clearly identified. The consequence of not making these
distinctions was that the incorrect transfer pricing method was
applied, and the subsidiaries were inappropriately remunerated when
transacting in their capacity as intermediaries.
After correctly delineating the transaction, the correct
transfer pricing method must be selected. The court confirmed that,
in this case, the CUP method was appropriate for determining the
remuneration to be paid to the subsidiaries. An internal CUP was
available in the form of the commissions paid to independent
agents, and this was then applied to the remuneration paid to the
subsidiaries when acting in their capacity as intermediaries.
Conclusion
This case illustrates the importance of applying the basic rules
and processes correctly to arrive at the appropriate arm ‘s-length arrangements between the parties.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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