Understanding the distribution of profits among different entities within a company is crucial. This is particularly important when entities are conducting routine sales but maintain a group margin below 4%. Limited risk distributors, often remunerated with a net operating profit margin of 2-3%, play a key role in this dynamic. However, does this allocation make sense, especially when almost all of your results are attributed to the sales entity? Let’s delve into this issue and explore why a thorough sanity-check is essential for logical profit distribution.
The role of limited risk distributors in routine sales
Limited risk distributors (LRDs) are entities within a company that undertake routine sales activities. They operate under a low-risk model, meaning they are shielded from most operational risks and receive a more or less fixed profit margin. Typically, the net operating profit margin for LRDs hovers around 2-3%. This remuneration structure is designed to reflect the limited risk they bear compared to other entities within the organization.
However, this raises an important question: does this structure make sense when it means that nearly all of your results are attributed to the sales entity? The answer can vary depending on the industry and the specific functions being performed by different entities within the group.
Evaluating the group margin below 4%
When a company’s overall group margin is below 4%, it is vital to assess whether the distribution of profits among its entities is reasonable. Industries with long-term results not expected to exceed 4% require careful inspection. The key functions and contributions of each entity must be evaluated to ensure a logical and fair division of profits.
For instance, if an LRD is receiving a 3% margin while the group margin is 4%, this implies that the LRD is capturing almost all of the group’s profit. This scenario is questionable, especially if other key functions are being performed by different entities that are not receiving adequate compensation.
The importance of a sanity-check
A sanity-check is a crucial step in assessing the distribution of group profits. This involves a thorough review of how profits are allocated among different entities and whether this allocation feels logical given the roles and risks undertaken by each entity. If the division of profits does not make sense internally, it is unlikely to pass inspection from tax authorities.
Tax authorities are increasingly cautious about profit allocation within multinational companies. They aim to ensure that profits are fairly distributed and reflect the economic reality of the functions, assets, and risks of each entity. Therefore, if your internal profit distribution does not align with these principles, it could trigger tax audits and adjustments.
Steps for conducting a sanity-check
1.Analyze the Functions, Assets, and Risks (FAR) of each entity: Assess the roles and responsibilities of each entity within the group. Consider the assets they manage and the risks they bear. Entities with significant functions and higher risks should receive a proportionate share of the profits.
2.Compare profit margins across the industry: Benchmark your profit margins against industry standards. If your LRDs are receiving higher margins than similar entities in the industry, this could raise red flags.
3.Review transfer pricing policies: Ensure that your transfer pricing policies align with the OECD guidelines and accurately reflect the economic contributions of each entity.
4.Conduct scenario analysis: Perform what-if scenarios to understand the impact of different profit allocations on your overall group margin. This helps identify any imbalances in the current profit distribution.
5.Seek external validation: Engage external experts to review your profit allocation model. Independent validation can provide a fresh perspective and help identify potential issues.
Potential consequences of imbalanced profit distribution
If your profit distribution model is not logical and fails a sanity-check, several consequences could arise:
- Tax audits and adjustments: Tax authorities may challenge your profit allocation, leading to audits and potential tax adjustments. This can result in additional tax liabilities and penalties.
- Reputational damage: Non-compliance with tax regulations can damage your company’s reputation, affecting stakeholder trust and investor confidence.
- Operational inefficiencies: Imbalanced profit distribution can lead to operational inefficiencies and conflicts among entities within the group. Ensuring a fair allocation promotes harmony and efficiency.
- Tax inefficiencies: If a disproportionate portion of the profit goes to an LRD, chances are that another entity is loss-making. This mean that tax is paid over a larger tax base than the group profit and has a negative impact on (at least) cash tax.
Potential solutions
The potential solution for this problem heavily depends on the facts and circumstances that you find yourself in. Overall, some examples could be:
- Use the Berry ratio, which focuses on a high margin on operating expenses (OPEX) rather than a margin on revenue. This approach can be useful if the contribution to sales is limited. For instance, in Pillar 1 amount B, you’re excluded from baseline distribution if OPEX over sales is below 3%.
- Perform a secondary test using a contribution analysis. Although unconventional, this method can help set an additional cap on how much profit is attributed to an LRD. With support of the right storyline and ensuring at least a break-even point, this could be a viable solution.
- Look for comparables that match best in terms of economics and the position in the value chain. For example, a high turnover per Full-Time Equivalent (FTE) might be a more important metric than having the same product.
- If there is no entity that is clearly leading or holding intellectual property (IP), you may consider applying a contribution analysis.
- If products are also sold to third-party distributors, you may leverage the pricing / conditions applied to those distributors for your internal pricing.
Conclusion
When dealing with entities conducting routine sales and maintaining a group margin below 4%, it is essential to evaluate the logic behind profit distribution. Limited risk distributors often receive a fixed net operating profit margin, but this must be justified within the broader context of the group’s overall performance. Conducting a thorough sanity-check ensures that the division of profits is logical, fair, and compliant with tax regulations, ultimately safeguarding your company from potential risks and fostering long-term stability.
FAQs
What are limited risk distributors? Limited risk distributors (LRDs) are entities within a company that perform routine sales activities with limited exposure to operational risks. They typically receive a fixed profit margin.
Why is a group margin below 4% significant? A group margin below 4% requires careful scrutiny because it indicates that the overall profitability of the company is low. This necessitates a logical and fair distribution of profits among different entities to ensure compliance with tax regulations.
How can a sanity-check help in profit distribution? A sanity-check involves reviewing the profit allocation among entities to ensure it is logical and fair. It helps identify imbalances and aligns the distribution with the economic reality of each entity’s functions, assets, and risks.
What are the consequences of imbalanced profit distribution? Imbalanced profit distribution can lead to tax audits, adjustments, reputational damage, and operational and tax inefficiencies. Ensuring a fair allocation promotes compliance, trust, and efficiency within the company.
How do tax authorities assess profit distribution? Tax authorities assess profit distribution based on the functions, assets, and risks of each entity within a group. They ensure that profits are fairly allocated and reflect the economic contributions of each entity.
What steps can companies take to ensure fair profit distribution? Companies can ensure fair profit distribution by analyzing the functions, assets, and risks of each entity, comparing profit margins across the industry, reviewing transfer pricing policies, conducting scenario analysis, and seeking external validation.