HMRC internal manual

International Manual

INTM440150 - Transfer pricing: Types of transactions: intangibles: branded goods

Marketing of “branded” goods

In general terms, an independent party will only pay to use something if it stands to benefit from using it. How much it will pay will very much depend on its expectation of the extent of such benefit. An independent might be reluctant to strongly promote a trade mark in the first place if someone else owned it.

Carefully consider a situation where a company pays a royalty or a premium through the purchase price, for a consumer brand owned by an affiliate when the brand has value largely because of the efforts of the licensee in the first place. For example a foreign parent company registers a new trade name in a country offering specific tax incentives. The brand is new and therefore the trade name has no value. The UK subsidiary begins to manufacture and sells products under the trade name. There is nothing particularly special about the products - only the trade name and packaging differentiates the product (as opposed to a product that has intrinsic value due to its quality). To promote sales the UK company incurs massive advertising and marketing expenditure. The products are a spectacular sales success. To maintain the sales the marketing expenditure is ongoing.

  • Would a royalty be payable and at what point in time?
  • Why would an independent pay a royalty to use something which initially has no value?
  • What intangibles are actually involved and who owns them? (for example, the goodwill for a product previously unknown in a territory is likely to be legally owned by the party which carries on business in the territory and it is likely to be this, rather than the trade name or trade mark of itself, which is valuable).

The trade name owner might claim that ownership entitled it to a reward because legally the trade name belongs to it and someone else is using it. At arm’s length the UK company would probably have used a trade name of its own and not one owned by someone else. Depending upon the exact facts and circumstances, it may be the case that an option realistically available to the licensee would have been to register and use its own trade name and consequently the maximum it would be prepared to pay the licensor would be the costs of registration and maintenance of the trade name.

Cases may be encountered where despite heavy promotional expenditure, consumers have not taken to the trade name and are not prepared to pay a premium price. If the licence agreement allowed the UK to potentially earn a significant proportion of the expected premium profit, and the business model looked reasonable, then such arrangements might be considered to be arm’s length when they were made. However, an independent would attempt to renegotiate as soon as it became apparent that losses were being made. If the trade name has truly failed they would pull out. If it is clearly going to take longer to establish the name then an independent distributor will expect the terms of his agreement to be modified to ensure he had a reasonable expectation of net profits.

Example involving sale of branded products

Assume a distributor, Company Z, sells expensive trainers from its “Z” branded range, aimed at the teenage market and selling for on average £100 a pair. The product costs much less to produce; this premium pricing can be attributed to what might be termed “brand” value. The product is widely recognised throughout the UK, due to heavy promotion and the connection with the Z name and logo, which is well known throughout the world. The brand has been cleverly promoted by the distributor. The name & logo are owned by the parent company and the trainers are bought from a group company based in a country which offers incentives for manufacturing enterprises. The results for Company Z are shown in the table below.

  2008 \n£’000 2009 \n£’000 2010 \n£’000 2011 \n£’000 2012 \n£’000
Sales 50,000 80,000 110,000 130,000 140,000
Cost of sales 35,000 56,000 76,000 90,000 96,500
Gross profit 15,000 24,000 34,000 40,000 43,500
GPR 30.0% 30.0% 30.9% 30.8% 31.1%
Distribution 750 1,500 2,500 3,000 3,500
Promotion 4,500 6,500 7,500 8,500 9,500
Marketing and selling 7,000 11,500 16,000 19,000 20,000
Administration 2,250 3,500 6,000 7,000 7,500
Operating profit 500 1,000 2,000 2,500 3,000
OPR 1.0% 1.25% 1.8% 1.9% 2.1%

The best way of testing the controlled price - the price and terms by which the company pays for the trainers - is to look for a CUP. The best (and likely only) source will be internal comparables; is the Z group selling the same trainers to any independents in the same quantities, in similar markets, and under the same terms? While there may be cases where the group is selling to independents, the terms may be very different. For example, the trainers may be sold to a distributor which is not expected or contractually required to incur substantial marketing and promotional expenditure. Unless adjustments can be made to account for this, it will not be of much use as a comparable.

An external CUP will involve finding an independent distributor, of approximately the same size, selling a similar volume of very similar trainers, aimed at the same teenage market. Obtaining this information will be extremely difficult: such an independent may not exist. Failing a CUP, for a distributor a potential OECD method is resale price as this looks at the actual transactions that need to be compared. As Company Z are selling branded goods, and are actively promoting those goods then the case team would need to look for independent companies selling and promoting similar numbers of similar branded trainers to the same teenage market. The best information on likely competitors will be Company Z - they will probably have marketing data on their chief competitors. The marketing team may well have information about how competitors’ brands are being promoted (for example, they may attend the same trade fairs, advertise in the same trade journals, etc). Some, if not all of these, will be subsidiaries of other groups, but an independent might be found. One good comparable is better than a number of other independent companies who are markedly different in ways which would affect price (e.g. distributor of other types of branded goods, distributor in another country, significantly different levels of turnover, etc.).

The group has provided data on 16 companies who sell branded goods, which show that between 2008 and 2012, an inter-quartile range of between 1% and 3% net margin. Only reliable data on five companies was available to provide information on gross margins, so a transactional net margin method (‘TNMM’) method was chosen. A detailed examination (including looking at the web-sites of the comparable companies) reveals that:

  • Two of the companies are making continual losses.
  • Thirteen of the companies are in other European countries.
  • Nine of the companies have a turnover of less than £5 million.
  • Only four of the companies just sell footwear.
  • Five of the companies sold other non-branded, or minor league branded goods.
  • One of the companies sells kitchens.
  • Three of the companies sell goods retail.
  • Three companies were not independent during the review years.
  • The case team finds an additional company which did not show up on the search carried out by the group.

The case team concludes that there are two companies which are properly comparable (one of which was a new find). Both are UK independents distributing branded footwear, with turnover of between £30 million and £75 million. Both promote well-known brands in the UK and both are known to Company Z, who agree they are competitors. Financial reviews of both companies reveal sufficient data to be able to compare gross margins.

Although there are only two companies, they are much better than those offered by the business. It is far better to use the two exact comparables as opposed to any number of inexact ones.

Adjustments are proposed as follows, using the average gross margin of the two comparable companies for each year being reviewed:

  2008 \n£’000 2009 \n£’000 2010 \n£’000 2011 \n£’000 2012 \n£’000
Z Sales 50,000 80,000 110,000 130,000 140,000
Z GPR 30.0% 30.0% 30.9% 30.8% 31.1%
Average GPR of comparable companies 34.2% 33.9% 34.7% 34.5% 35.0%
Z gross margin 15,000 24,000 34,000 40,000 43,500
Adjusted gross margin 17,100 27,120 38,170 44,850 49,000
Operating profit 500 1,000 2,000 2,500 3,000
OPR 1.0% 1.25% 1.8% 1.9% 2.1%
Adjusted op. Profit 2,600 4,120 6,170 7,350 8,500
Adjusted OPR 5.2% 5.1% 5.6% 5.7% 6.1%

Assume instead that there was insufficient data on the two comparable companies to produce a resale price model. In this case, then the net margin results of the two comparable companies might be a better comparable to establish the arm’s length margin.

What if comparable companies who sell and promote branded trainers can’t be found? In this situation, one way of establishing the arm’s length price may be to look at independent distributors which sell unbranded trainers. If the difference between the two is only the existence of the brand, it might be possible to make adjustments to the comparable so it can be used to establish the arm’s length price for the controlled provision. Alternatively, companies that are functionally similar even though they sell different products could be considered.

Examine the information from the table below, which is the summary for DEF Ltd, a distributor of shoes (including athletic footwear) throughout the UK, which started trading at around the same time as Company Z. While some branded shoes are sold, these are less successful consumer brands.

  2008 \n£’000 2009 \n£’000 2010 \n£’000 2011 \n£’000 2012 \n£’000
Sales 70,000 75,000 80,000 85,000 90,000
Cost of sales 52,000 55,000 61,000 63,000 67,000
Gross profit 18,000 20,000 19,000 22,000 23,000
GPR 25.7% 26.7% 23.8% 25.9% 25.6%
Distribution 2,500 2,750 2,800 3,200 3,400
Marketing and selling 9,000 10,000 9,500 11,000 11,500
Administration 5,000 5,250 5,200 5,600 6,100
Operating profit 1,500 2,000 1,500 2,200 2,000
OPR 2.1% 2.7% 1.9% 2.6% 2.2%

So DEF Ltd makes on average a gross margin of 25.5% and an average operating margin of 2.3%. By contrast Company Z are making an average gross margin of 30.6% and an average operating margin of 1.6%.

The key issue here is whether adjustments can be made to the results of DEF Ltd to produce a good comparable. Here it is unlikely.

The gross margins for Company Z are higher and so the company may argue that the price charged by the manufacturer is clearly arm’s length - in fact they are paying too much. However there may be a reason why the gross margins would be higher; remember they are selling expensive premium trainers. Gross margins may be different for branded and unbranded goods. The dynamics in a real case will be very complex. Branded goods might be higher in quality or incorporate novel or patented features and so cost more to manufacture. There are promotional costs and brand maintenance costs. Retail costs may be higher (e.g. selling goods from a prestigious high street location). The costs of manufacturing, marketing and selling branded goods might be higher at all points along the chain than for unbranded goods. The profit potential is higher for branded goods, but the premium element of the profit will be shared along the chain. Some will be due more of a share than others, though.

In this case Company Z are earning lower net margins than DEF Ltd, yet undertake additional promotional activities. The trainers are manufactured by a group company in a low tax country and it is possible that the manufacturer, whilst likely paying royalties to the parent, is also making in excess of an arm’s length profit.

The case team establishes that the group manufacturer is making average operating profits of 10% and the parent receives royalties from the manufacturer which roughly equates to 6% of the sale price charged by Company Z. For example in 2006, Company Z makes a profit of £2 million, the manufacturer makes a profit of £7.6 million (£76 million sales of goods to the UK, at 10% operating margin) and the parent receives a royalty of £6.6 million. This shows that while everyone in the Z group is making a profit on the trainers, Company Z is not doing as well as others.

The parent owns the trade name, but Company Z has clearly been building up and maintaining the brand. It has incurred significant promotional expenditure and may have built up an efficient, well-motivated marketing organisation.

What should the UK business expect in the way of reward? Between independents, brand support may take a number of forms such as

  • A number of products will be provided free, to help break into the market.
  • Products may be discounted.
  • Particular promotional expenditure might be reimbursed, or contributed to.
  • Marketing material may be provided.
  • Royalties (where payable) may be reduced.

There may be a mix of incentives. Some are designed to provide reimbursement or contribution. Some are designed to allow additional profits to reflect the risks incurred in promoting the products. Replicating these commercial terms is not an easy task. Depending on the complexity of the case and the type of industry the additional reward may be reflected by discounting the purchases, or imputing a recharge for some of the promotional expenditure. The case team may want to try to replicate a number of different commercial terms.

Examine critically any claims that the distributor is a service provider, that it should recharge all of the promotional expenditure and earn a basic reward for the other activities it undertakes. If the company were merely an agent outsourcing all the promotional activity then this might be appropriate. Frequently however, independent distributors who have to promote their products are more than just agents, and their licensing agreements will reflect this, although such agreements may oblige the licensor to contribute towards brand promotion and maintenance.

Establishing what reward an independent manufacturer of branded trainers would expect to earn, could help demonstrate that within the Z group, the manufacturer is making excessive profits. After some more work on searching for independent comparable manufacturing companies, the case team concludes that on average, they earn a net margin of 5%. This suggests that in this case, the Z manufacturer should reduce the prices it charges Company Z by one half (as it currently makes an average operating margin of 10%). This would produce the following results:

  2008 \n£’000 2009 \n£’000 2010 \n£’000 2011 \n£’000 2012 \n£’000
Sales 50,000 80,000 110,000 130,000 140,000
Cost of sales 35,000 56,000 76,000 90,000 96,500
Reduction in price (1,750) (2,800) (3,800) (4,500) (4,825)
Gross profit 16,750 26,800 37,800 44,500 48,325
Operating profit 2,250 3,800 5,800 7,000 7,825
OPR 4.5% 4.8% 5.3% 5.4% 5.6%

In this case the facts suggest that the manufacturer appears to be making excessive non-arm’s length profit.

The other method of increasing the profits of Company Z to the arm’s length amount would be to consider contributions to marketing and promotional expenditure from the owner of the trade name. This might be in addition to discounts from the manufacturer. At this point, the chances of finding comparable transactions will probably have been exhausted, unless there are internal CUPs for this type of expenditure. Case teams will have to agree with the business what form of evidence might help determine the level of contributions an independent party would expect to receive. This will need to be informed by the benefits both parties would expect to receive at arm’s length, bearing in mind their respective risks and functions.

The following table of results shows a possible (illustrative) outcome whereby, as well as the discount on purchases, it is agreed that the owner of the trade name, the parent, will meet one third of the promotional expenditure.

  2008 \n£’000 2009 \n£’000 2010 \n£’000 2011 \n£’000 2012 \n£’000
Sales 50,000 80,000 110,000 130,000 140,000
Cost of sales 35,000 56,000 76,000 90,000 96,500
Reduction in price (1,750) (2,800) (3,800) (4,500) (4,825)
Gross profit 16,750 26,800 37,800 44,500 48,325
Contribution of 1/3 of promotional costs 1,500 2,167 2,500 2,833 3,167
Operating profit 3,750 5,967 8,300 9,833 10,992
OPR 7.5% 7.5% 7.5% 7.6% 7.9%

In this case Company Z returned results showing profits in all years. Other cases involving the marketing and promotion of branded goods will have different features. There may be a royalty payable by the distributor, rather than the manufacturer. The business may be making significant losses, which outstrip the expenditure on brand promotion and maintenance. The business may be manufacturing and marketing/promoting the products. Whatever the situation, consider how the distributor would have profited at arm’s length.