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CENTRALIZED PROCUREMENT MODELS -
TRANSFER PRICING PERSPECTIVE
NITHYA SRINIVASAN
Founder &CEO
VSTN Consultancy
Private Limited
NITYA JOSEPH
Principal
VSTN Consultancy
Private Limited
1.Introduction
Centralized Procurement
activities usually fall within risk
parameters for transfer pricing
assessment and are widely
scrutinized by tax authorities
globally. On one hand, payments made to procurement entities
located in low-tax jurisdictions often attract attention and may
be viewed adversely with concerns about lack of economic
substance. On the other hand, tax authorities at the procurement
service provider’s location may recharacterize the services as
high value adding services and allocate a higher remuneration.
In this article, we explore the concept of centralized procurement
in the context of transfer pricing, the key aspects to be considered
in determining an arm’s length remuneration for the same, the
various procurement structures generally adopted by
multinational enterprises (‘MNEs’), how the activities are
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remunerated in accordance with the arm’s length principle,
global practices, as well as local and global jurisprudence
covering this transaction.
2.What is centralized procurement?
MNEs often centralize certain business functions of the Group,
for operational efficiencies. One such function which is routinely
centralised is the procurement activity. Procurement is a critical
component in the value chain of any business and it encompasses
all activities relating to sourcing and acquiring goods or services
(core or non-core) required for the business operations.
Centralized procurement refers to procurement activities
undertaken by an entity for one or more entities in the Group.
Procurement may be centralized for various reasons, including
combining the purchasing power across the MNE, reducing the
administrative costs for the MNE, standardizing buying terms
and making use of specialised experience required in handling
such activities. Centralized Procurement often leads to cost
savings for the Group entities, which could be attributed to the
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volume involved, efficient coordination of vendor and buyer
requirements or reduction of administrative costs by
aggregating purchase orders.
3.Transfer pricing considerations
The United Nations Practical Manual on Transfer Pricing for
Developing Countries extensively discusses the transfer pricing
aspects relating to centralized procurement. While evaluating
an appropriate remuneration for these activities from a transfer
pricing viewpoint, three important various factors need to be
taken into consideration: 1) the level of functions performed by
the service provider 2) the nature of products sourced, and 3)
the risks assumed while rendering these services.
a)Level of functions performed
The value added through centralized procurement activities
varies, depending on the nature of activities performed and
therefore, it must be assessed on a case-to-case basis. Broadly
procurement functions can be divided into two main categories.
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Pu
rchasing
This is a relatively simpler role where the procurement company
acts as a facilitator or coordinator. In a purchasing function, all the
specifications regarding the products and required terms are
provided by the associated enterprises and it does not involve
extensive work in evaluating the vendors or scheduling the delivery
of products. The purchasing company acts on the basis of the
instructions provided by the associated enterprises and
predominantly performs an administrative function relating to
raising purchase orders and managing accounts payable.
Sourcing
A sourcing function is complex and broader in terms of role. It is
strategic and requires specialised expertise of the service provider
.
The activities involved would include collaborating with associated
enterprises to determine specifications of products required,
developing sourcing strategies, identifying vendors, understanding
their capabilities, evaluating alternatives, scheduling delivery by
working along with the vendors based on forecasts of goods
required, performing quality control, managing vendor
relationships.
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Considering the higher level of contributions involved in a
sourcing function, it would warrant a higher compensation.
b)Nature of products sourced
An important factor to consider when assessing the value
contributed by procurement activities is the type of goods or
services procured and their significance to the company’s
operations. The goods/services purchased can be broadly
categorised as core spend and non-core spend.
Core spend
, also known as direct spend, are items that are
converted or resold in the course of the business of the recipient
associated enterprises and which are essential for carrying out
the core business of the Group. Examples include raw materials/
semi-finished goods.
Non-core spend
, also known as indirect
spend are goods and services that support the businesses of the
recipient associated enterprises and are not themselves converted
into a finished item or resold. Examples of the same could be
office stationery, communication related expenses etc.
Non-core spend may not pose any significant risk for the service
recipient since these items may be available from various
sources and the prices would already be competitive. Hence the
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role of the procurement company in this regard would be
limited to coordinating and aggregating the purchases within
the Group. On the other hand, core spend would be specific to
the business of the company and if it is in niche area, there
would be specifications involved and the items would be
available only from a few sources. As a result, the availability
and pricing of core items would be associated with significant
risks for the service recipient. The activities relating to core
spend would therefore require expertise and skill from the
procurement team.
Considering the higher value added and risks involved in
connection with core spend, procurement activities for these items
should generally earn higher returns when compared to non-
core spend.
c.Risks assumed
The procurement company should be compensated in line with
the level of risk it assumes. While the company may
contractually bear various risks, it is important to evaluate
whether it can control the risk and has the financial capacity to
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assume the risk. In case of a procurement company that buys
and sells goods to the associated enterprises, inventory risk
would be assumed. Hence the company needs to determine an
appropriate purchasing strategy to minimise its inventory risk.
However, if the goods are only procured and sold on a back-to-
back basis where the procurement company only takes flash title,
this risk is considerably reduced. Also, it needs to be evaluated
which party is responsible for inventory management,
determining purchase quantity etc. as that party would be the
one controlling the inventory risk.
The Company may also assume price risk or volume risk, if it
undertakes to provide goods at a certain price or of a certain
volume to the associated enterprises. This risk would be
minimised by negotiating similar terms with vendors
4.Procurement structures
Procurement entities are generally structured in either of the
following ways
Purchasing or sourcing entities
– These are service providers
that render procurement related services to associated
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enterprises, but the contract for purchase of goods/services is
entered into directly between the associated enterprises and
vendors. In this case, the procurement company does not take
title to the goods.
Buy-sell companies
- These companies purchase the goods/
services on behalf of the associated enterprises. Often,
procurement companies only take flash title of goods, and
delivery is directly made by the vendors to the associated
enterprises.
5.Compensation structures and TP methods
Some of the commonly used compensation models for
procurement activities are described below:
Cost plus model
– Under this model, all costs incurred in
rendering the services are charged to the service recipient along
with a mark-up. While applying this model, the suitability of a
direct charge or indirect charge method would need to be
evaluated. The Direct charge method can be used when the
specific services and costs relating to a service recipient can be
directly identified. Indirect charge method is more commonly
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used when services are rendered to multiple recipients, wherein
cost allocation and apportionment methods are used as a basis
for calculating an arm’s length charge. Under this method,
selection of reasonable allocation keys for costs allocation is a
key point. While using the indirect charge method, it is important
that similar services (eg: whether sourcing or purchasing) are
identified and categorised together for the purpose of allocating
the relevant costs.
The cost-plus methodology would be more suitable in connection
with purchasing activities or for sourcing activities involving
non-core spend. The Transactional Net Margin Method
(‘TNMM’) would be an appropriate transfer pricing method in
this case and a search for comparable companies undertaking
such functions would need to be performed from public
databases.
Commission based model –
In this model, the procurement
company is remunerated based on a percentage on managed
spend (i.e. the portion of a company’s total spend that is managed
by the procurement company)/total value of goods/services
acquired. This remuneration structure typically translates to a
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higher compensation as against a cost-plus model and is therefore
more suitable for sourcing activities, where greater value
addition is involved. The Comparable Uncontrolled Price
(‘CUP’) method would be ideal in this case and comparable
commission rates would need to be identified from public
domain. In practice, availability of commission rates for
procurement activity may be limited, hence one could consider
evaluating service agreements akin to sourcing as an alternative,
if similar functions are performed.
Gain share –
This structure takes into account the cost reduction
achieved by the procurement company while procuring goods
and services and shares the savings between the procurement
company and associated enterprises receiving the services. A
Profit Split Method (‘PSM’) may be evaluated depending on the
facts and circumstances.
The correct compensation structure should be carefully determined
based on the functions performed and risks assumed by the
procurement companies, as remuneration can vary significantly
under different models. For example, a cost-plus model may
result in a markup of 5–10% on costs incurred, whereas a
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commission-based model could yield remuneration of 1–3% on
total managed spend, which, depending on the spend volume,
might translate into substantially higher earnings.
In addition to the above pricing models, a return on value added
costs (Berry ratio) could be evaluated in the case of buy-sell
entities, only taking flash title of goods.
6.Discussion in OECD guidelines
The OECD guidelines have discussed procurement activities in
a few areas.
While mentioning about low value adding intra group services,
in Para no.7.47 of the Guidelines, it is stated that “purchasing
activities relating to raw materials or other materials that are
used in the manufacturing or production process” would not
qualify for the simplified approach relating to low value-adding
intra-group services. Hence entities carrying out procurement
activities for core components cannot opt for the simplified
approach, since this activity relates to the core business of the
Group.
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Additionally, the CbC report requires reporting of companies
engaged in procurement activity. As per the OECD Country-by-
Country Reporting: Handbook on Effective Tax Risk Assessment
(2017), one of the potential tax indicators that could be derived
from a CbC report is where a group has procurement entities
located in jurisdictions outside its key manufacturing locations.
While it is acknowledged that there can be good business
reasons for the use of centralised procurement entities, there is
also a risk that this can be used to reduce the level of taxable
income in the jurisdictions where manufacturing occurs. Tax
authorities are advised to understand the business reasons for
use of a procurement entity before deciding that there is a
transfer pricing risk.
7.Global practices
Netherlands
The Dutch TP decree has a section which discusses intra-group
procurement. According to it, the remuneration for procurement-
related activities can range from a routine remuneration (based
on the operational costs incurred, or compensation related to the
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purchase value) for activities of a routine nature to a transactional
profit split-type remuneration if the activities can be considered
a core function of the group. If, by centralising the purchasing
activities, the group manages to realise higher discounts than
before as a result of the increased purchase volume, the extra
benefit should ideally not be allocated to the centralised
purchasing office. Such a benefit must be allocated to the
members of the group that enable the purchasing office to realise
the extra discounts by their joint purchase volumes. Only where
the extra discounts are realised by the specific knowledge and
skills of the purchasing office, allocation of part of this to the
purchasing office will be at arm’s length. This concept has arisen
out of the decision of the Supreme Court (judgment dated 23
April 2004, no. 39 542), which has been described subsequently.
Australia
The Australian Taxation Office (‘ATO’) has laid down specific
guidelines (Practical Compliance Guidelines) in relation to the
TP compliance approach for centralized non-core procurement
activities carried out by procurement ‘hubs’ to address issues
relating to tax avoidance using offshore hubs. The ATO uses a
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hub risk framework, consisting of six risk zones, ranging from
low risk to very high risk depending on the profits earned by
the hub and other factors such as tax impact. This is used to
self-assess a hub’s compliance’s risk. Based on the risk rating
identified for the hub, the compliance approach would vary. The
higher the risk rating, the higher the priority for review and
higher is the level of analysis and supporting evidence required.
Non-core procurement hub arrangements (offshore procurement
hubs that supply ‘indirect’ or ‘non-core’ goods or services to an
Australian entity) are assessed as low risk and in the green zone
where the hub profit is less than or equal to a 25% mark-up of
hub costs. If the hub is rated as being in the green zone, the
company can opt to minimise the transfer pricing documentation
and compliance costs in relation to the hub. If the arrangement
is outside of the green zone, there would be increased disclosure
requirements including provision of additional data in relation
to the hub on a yearly basis.
The ATO also provides guidance to assist with the transfer
pricing analysis if the risk rating is outside the green zone,
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which would help companies understand the enquiries and
potential concerns that may arise from the ATO if the hub is
subject to review.
8.Local jurisprudence
An important judgement concerning procurement activities in
the Indian context was that of GAP International Sourcing (India)
(P.) Ltd. ([2012] 25 taxmann.com 414 (Delhi)), where several key
aspects were discussed.
Gap India was engaged in facilitating sourcing of apparel
merchandise from India for its Group, with a pricing policy of
cost plus 15%. The TPO, looking at the company’s functional
profile and other factors, rejected the said Arm’s Length Price
(‘ALP’) and held that commission at the rate of 5 per cent on
FOB value of goods sourced by AE through Indian vendors was
the appropriate PLI for determining ALP, which was also
accepted by DRP. The ITAT held that:
The assessee was only a low-risk procurement support service
provider and no major business risks was borne by assessee.
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Assessee’s role, functions/activities etc. were limited to
scrupulously following prescribed handbook/instructions and
assessee had no authority to deviate from set policies of its
parent group
In case of non-risk bearing procurement facilitating functions
which were preordained by contract and handbook/instructions,
appropriate PLI would be net profit/total cost and not certain
percentage of FOB value of goods sourced by AE.
The arm’s length principle requires benchmarking to be done
with comparables in the jurisdiction of tested party and location
savings, if any, would be reflected in the profitability earned
by comparables. No separate/additional allocation is called for
on account of location savings.
Tribunal accepted the remuneration model of assessee (i.e., Cost
Plus mark-up) but the mark-up was revised to 32 per cent on
cost.
For another assessment year, the said issue had reached the High
Court as well as Supreme Court where the Revenue appeals were
dismissed.
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This judgement emphasises the significance of the functional
profile of the procurement company in determining the arm’s
length remuneration.
9.Global jurisprudence
The Dutch Supreme Court in its judgment dated 23 April 2004,
no. 39 542 had adjudicated on allocation of profits resulting from
centralizing procurement functions within a Group. A Belgian
entity had been appointed by the Group to centralise the
purchasing of raw materials. Its role involved negotiating the
discounts on the basis of the estimated joint raw material
requirements of the Group companies. The Group companies
would conclude and actually sign the agreements with suppliers.
For its services, the Belgian entity was remunerated with a part
of the additional discount, which resulted from the stronger
negotiation position obtained by centralising the demand for
raw materials.
The tax authorities took the position that the profit claimed by
a centralized purchasing office was not aligned with the
functions performed and the risks assumed by the office.
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According to the tax authorities, profits derived from the
realized discounts should be distributed to the members of the
group (including a Dutch member) in proportion to their
contribution of purchasing volume. The Supreme Court ruled
in favor of the tax authorities. It was held that profits in excess
of the operating costs of the centralized purchase office with a
markup of 5%, should at arm’s length be distributed to the
members of the group in proportion to their contribution of
purchasing volume.
10.Key takeaways
A proactive approach that compensates procurement activities
in accordance with the arm’s length principle, supported by
strong documentation, is crucial for effectively justifying these
transactions before tax authorities. Key documentation to
maintain includes:
Detailed Functions, Assets and Risks (‘FAR’) profile, outlining
the activities undertaken by the procurement company
Description of nature of products sourced and their importance
to the business
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The commercial rationale for appointing a procurement service
company
Intercompany agreements specifying the roles, responsibilities,
and risks of the procurement company and associated
enterprises. Moreover, the conduct of the entities should
correspond with the contracts
A robust benchmarking analysis to support the transfer pricing
position.
From an Indian perspective, one may also need to evaluate the
impact of Deemed International Transaction provisions,
considering pricing and other terms are negotiated between the
procurement company and third party vendors on behalf of the
Associated Enterprise.
(The authors are part of VSTN Consultancy Private Limited, Transfer
Pricing boutique firm and can be reached at snithya@vstnconsultancy.com
and nityajoseph@vstnconsultancy.com
)