Vertically integrated MNEs often segregate their functions and business operations into several functional elements in combination, forming an end-to-end supply and value chain. Typical entities in the multinational enterprise (MNE) structure are manufacturers, distributors, and service providers (or a combination of the three). Distribution is an essential part of almost every consumer-facing and b2b MNE, and we often see distributor models being used in FMCG, electronics, automotive, and many other industries.
Limited risk distributor is, perhaps, one of the most popular models in the transfer pricing world. In this guide, we will explain how limited risk distributors (usually referred to as LRDs) operate, discuss their key features, list standard functions, assets and risks to consider and present several transfer pricing methodologies for LRDs.
A Limited-Risk Distributor (LRD) is an entity that buys goods and markets them to customers. The arrangement between the distributor and principal significantly limits LRD risks. Risks relating to inventory and debtors will be effectively controlled and covered by the principal. For example, the principal will buy back the obsolete stock, reimburse bad debts, etc. The market risk will also be limited for the LRD. Such a distributor typically does not develop or contribute to significant marketing intangibles. The material difference between an agent and the LRD is that the LRD takes the product’s title, which leads to more significant functions and risks. However, these functions and risks are still limited. The LRD would usually earn limited profit measured as a return on sales (margin).
Imagine Star Group, the global MNE that manufactures and sells smartphones.
Star Germany is a principal manufacturing entity in the Star Group’s structure. Star Germany designs smartphones, purchases components, assembles, and sells them to Star Polska. Star Germany has manufacturing know-how and owns relevant technologies and trademarks.
Star Polska’s role is to resell smartphones in the local market. Star Polska holds a limited inventory of smartphones, hires sales personnel, and has an ongoing relationship with local wholesale and retail consumer electronics businesses.
The arrangement between Star Germany and Star Polska assumes that Star Germany will reimburse Star Polska’s marketing expenses and will cover the bad debt if it arises. Star Polska is guaranteed to earn a 3% fixed resale margin.
LRDs are routine entities that:
There is no standard, universal LRD model, and each case is unique. However, there are some common functions, assets, and risks that MNEs should analyze and document while doing functional analysis for LRDs.
The functions typically performed by LRDs in respect of the intra-group purchases from principal and sales to customers may include:
LRDs bear relatively minimal risk in respect of the intra-group purchases from principal and sales to customers. The typical risks borne by the LRDs may include:
The typical assets held by LRDs may include:
In practice, the most often used transfer pricing method for LRDs is a transactional net margin method (TNMM), using operating margin as a profit level indicator (PLI). However, it’s always worth checking the following information before selecting TNMM:
It is often the case that transactions with distributors involve unique and valuable intangibles (discussed above) – in this case, the application of TNMM can lead to wrong results. Also, it’s worth considering other PLIs, even when the operating margin seems to be the best one. For example, that is what New Zealand’s Inland Revenue suggests: (include) a cross-check using at least a second profit level indicator (for example, if an EBIT : sales yardstick has been applied, then a Berry ratio cross-check should be carried out for a distributor or a return on assets calculated for a manufacturer) – if one methodology produces a result that is significantly different to another it is not sufficient to simply assert that one method is preferable without exploring why those results are different.
Comparability analysis (aka benchmarking studies) is a big topic when testing LRDs, and we do not intend to cover it in full here, but here are the key facts:
We hope this guide help with your transfer pricing arrangements, and please reach out to us for a short demo to see how Aibidia’s solution can help document LRD models!
About the author:
Borys Ulanenko is a Digital Transfer Pricing Category Lead at Aibidia. Borys has more than 9 years of experience in transfer pricing with a background in industry and consulting. In addition, Borys is the founder of the educational platform StarTax Education. At Aibidia, he focuses on developing new transfer pricing applications and contributes to marketing and business development.