Transfer pricing aspects of centralized purchasing
In this blog we will illustrate the application of the arm’s length principle in case of the implementation of a central purchasing function. This type of transfer pricing analysis ultimately reflects the central importance of the functional analysis in order to understand the role played by each of the parties in the creation of synergies, costs savings, or other integration effects. Which transfer pricing method is the most appropriate will depend on a determination of to which parties the cost savings or inefficiencies created by the centralization of the purchasing function should be allocated.
12 Dec. '17 4 min. Patrick T.F. Schrievers
In this blog we will illustrate the application of the arm’s length principle in case of the implementation of a central purchasing function. This type of transfer pricing analysis ultimately reflects the central importance of the functional analysis in order to understand the role played by each of the parties in the creation of synergies, costs savings, or other integration effects. Which transfer pricing method is the most appropriate will depend on a determination of to which parties the cost savings or inefficiencies created by the centralization of the purchasing function should be allocated.
Let’s start with a straight forward example. Company X puts in place a central purchasing entity that will negotiate with third party suppliers the purchase of raw materials used by all the manufacturing plants of the X group. The raw materials are traded on a commodity market. For these cases we typically apply the comparable uncontrolled price (“CUP”) method. Interestingly however, the CUP method, may well mean that all the cost savings would be attributed to the central purchasing entity. If a portion of the cost savings should be attributed to the manufacturing entities, then the question would arise whether the CUP should be adjusted accordingly and how.
In the case of Company Y, as in most other cases, the CUP method cannot be used, because the price of the materials fluctuates and the price paid by the manufacturing entities before the setting up of the central purchasing entity cannot serve as a reference. In these cases typically a mark-up on costs or a commission fee can be considered. If the central purchasing entity purchases the materials from third party suppliers and re-sells them to the manufacturing plants the cost plus method could be useful. In such a case, the mark-up rate attributed to the central purchasing entity should be comparable to the mark-up rate earned in comparable uncontrolled trading activities (i.e. based on a benchmark survey).
It could also be that the central purchasing entity acts as an agent (either for the suppliers or for the purchasers) and is remunerated with a commission fee. In such cases the central purchasing entity typically negotiates with the third party suppliers but does not take title to the inventories. Hence, the manufacturing plants continue to acquire the raw materials directly from the suppliers but at a discounted price obtained thanks to the activity of the central purchasing entity and to the participation of the group of manufacturing plants in the arrangement. The commission fee might be proportional to the supplies (especially if paid by the supplier) or to the discounts obtained (especially if paid by the manufacturing plants). It should be comparable to the commission fee that would be charged by independent parties for comparable agency functions (i.e. based on a benchmark survey).
Interestingly and in day-to-day cases it happens that what would be prima facie regarded as an arm’s length mark-up on costs or commission fee from the perspective of the central purchasing entity in effect leads to determining purchase prices for the manufacturing entities that are higher than the prices they could obtain by themselves. The question arises whether independent manufacturers would have agreed to pay such higher prices and what the economic rationale would be, or whether the central purchasing entity should bear part or all of the inefficiencies through a reduction of its sales prices to the manufacturers. The answer will depend on the facts and circumstances of the case. Key to the analysis will be the determination of the benefits that could reasonably be expected by the parties (manufacturing entities and central purchasing entity) from the implementation of the central purchasing function, and of the options realistically available to them at that time, including in appropriate cases the option not to participate in the central purchasing in case the expected benefits were not as attractive as under other options. This is often difficult for companies.
Where positive effects of synergies have been expected and realized by the parties, it will be key to analyze the contractual terms under which the central purchasing entity operates and the functional analysis of the manufacturers and of the central purchasing entity. In particular the roles and responsibilities in the decisions that led to the positive effects of synergies will be interesting. This analysis should make it possible to determine which parties should share the realized benefits and to what extent. Where this analysis indicates that benefits should be allocated to the central purchasing entity, one way of doing so would be to price the sale transactions to the manufacturing entities by reference to the CUP (based on prices that the manufacturing entities could obtain on the free market for comparable supplies in comparable circumstances).
No inference should be drawn however that any realized benefits should be allocated by default to the central purchasing function, or that any inefficiencies should always be shared amongst the members of the group. Finally, there may be cases where the cost savings (or costs) generated by the centralization of the purchasing function would be shared amongst the central purchasing entity and the manufacturing plants through a form of profit split. This typically is seen as a sanity check to define more accurately the arm’s length range and/or to counterbalance the quality of data experienced in any preliminary search using a one-sided approach.
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