Sourcing (Procurement) in Transfer Pricing in Action

Depending on a company’s business model, sourcing can be a significant value driver. For many retailers, access to competitively priced merchandise makes the difference between going out of and staying in business. After all, sourcing is just another form of the ancient art of buying cheap and selling high, and Karen Wu is the most consummate practitioner of that art! 

As far as the corporate world is concerned, she worked her magic for more than a decade on behalf of MSell, Inc., as its employee.  When she moved her sourcing operations China and became an employee of MSell-China, we walked into one of the most controversial areas of international taxation – business restructurings.

What is it that Karen Wu took with her to MSell-China that rightfully belonged to MSell, Inc.? After some back and forth with Corrine Rogers, Jay concluded their sourcing structure as follows:

Never the one to complicate his life unnecessarily, Jay opted for a sourcing agent structure, but decided to use the MSell-PRC structure. MSell-PRC concluded a sourcing agent agreement with MSell-US under which MSell-PRC would develop or select and maintain an assortment of merchandise, effectively a catalog. MSell-US orders products from this catalog. MSell-PRC, through the WFOE, liaises and works with vendors to get these orders fulfilled. The vendors invoice MSell-US (through a third party logistics service provider that consolidates and ships the products and also converts hard currency payments to Rimimbi and pay the vendors). MSell-US pays MSell-PRC a separate sourcing fee specified as a percentage of the value of merchandise they purchase from the vendors.

As for the sourcing fee percentage, Jay picked 5 percent. His advisors identified a number of uncontrolled sourcing agent agreements carrying sourcing agent fees from 5 percent of the value of purchases to 10 percent. They also advised him that he may select a rate at the top of the range because his sourcing operation also designs or selects the products whereas sourcing agents get their product specifications from their customers. Jay felt more comfortable with the lower rate, thinking about increasing the rate at a later time.

Considering that many products and the vendors for them were already developed prior to the establishment of the new structure, Jay and his advisors decided to put in place a buy-in payment from MSell-PRC to Msell-US. As they could only track the pre-existing SKUs numbers, the buy-in payment would be a portion of the sourcing fees earned on the purchases of them. They decided that Msell-PRC would pay a sourcing fee of only 2 percent of the value of merchandise on the pre-existing SKUs. Theoretically, the sourcing fee would have two components: a pure service component that covers liaising and follow-up with the vendor to get the order placed and delivered, and an intangible component related to the identification of the product, selection of the vendor, and the pricing arrangement with the vendor. The buy-in payment should cover only the intangible component.

Jay had to explain his choices on the witness stand as the IRS litigator questioned him on whether the definition of a new product was appropriate.

“Mr. Patel, your procurement agreement recognizes the fact that MSell-US had already established relationships to source its current merchandise portfolio from the same vendors with whom MSell-PRC has begun to work. Your procurement agreement specifies a 2 percent fee for existing SKUs and 5 percent for new ones. Is that correct?”

“Yes.”

“Mr. Patel, is it true that you change SKU number as soon as a product has the slightest modification, or even a new color is introduced. Can this be the reason that within a year of the start of the agreement, close to 50 percent of the purchase volume of MSell-US was new SKUs, and subject to the full rate?”

“Well, two points.”

“Please, yes or no.”

“Hmm, then no.”

“I have the exhibit here from your own files, showing how the purchasing agent fee for

the first year averaged at 3.4 percent.”

“No. Our agreement specifies new SKUs as being new in the first 15 digits. The last 3 digits are used to differentiate size, color, and geographic destination. On an existing product, if new sizes or colors are introduced, it would not count as a new product. Yes, close to 50 percent of the products were new SKUs by the end of our first year, but not because we changed the colors, but with Karen Wu down there we had a good turnover in products.”

“Let us stick to the facts. You confirmed that in the first year alone close to half of the SKUs were new. Do you know whether they were all sourced from new vendors?”

“No. I am not the most knowledgeable person on this matter, but Karen Wu’s strategy was to reduce the number of vendors, and get more volume from them. She …”

“Mr. Patel, is it possible that in her first year there, Ms. Wu may have relied on her established relationships with these vendors.”

“Certainly. She has all the knowledge. We have checked and documented that we …”

“Thanks, Mr. Patel. Sorry to cut you off, but we have to keep moving.

I personally like procurement projects as they bring almost all aspects of transfer pricing to bear, services, products, and intangibles, and there is usually a business restructuring as well. In the book, the sourcing strategy is implemented with the use of a hybrid entity known as the China Business Trust. However, the transfer pricing approach would be the same even if the sourcing strategy was done without it.