Intercompany Management Fees: CUP v. CPM (TNMM)

Transfer pricing practitioners in the US, as well as in other nations, often face the dilemma that clients wish to establish intercompany management fees as a percentage of revenues while tax authorities may test the implied cost plus from any intercompany management policy. US Treasury Regulations, Sec. 1.482-9 lists several possible approaches for evaluating whether an intercompany policy is arm’s length including the comparable uncontrolled services price (CUSP) method and the cost-of-services-plus method. While these regulations also list the Comparable Profits Method (CPM), if CPM is applied to the management services affiliate as the tested party, it is equivalent to the cost-of-services-plus method.

We illustrate the potential issues with certain US domestic pricing issues for two companies – Columbia Sportswear and Extra Space Storage. The former faced a challenge from the Indiana Department of State Revenue, which I address in a 2016 article. The latter is a Real Estate Investment Trust (REIT) with a management affiliate as its primary Taxable REIT subsidiary (TRS). The Columbia Sportswear issue involves a US multinational that designs, markets, and sells apparel sourced from East Asian contract manufacturers. As we will note, certain state transfer pricing structures are established in ways where a high management fee would be in the taxpayer’s interest. The REIT structure in the Extra Space Storage issue is such that the taxpayer would have incentives to charge less than an arm’s length management fee.

Columbia Sportswear

Columbia Sportswear's 10-K filing for fiscal year ended December 31, 2014 stated that the company is “a global leader in designing, sourcing, marketing and distributing outdoor and active lifestyle apparel, footwear, accessories and equipment.” During this fiscal year, global sales were $2.1 billion with almost $1.2 billion of those sales being to US customers. Its cost of goods sold was 54.5% of sales, while its operating expenses were 36.3% of sales. Columbia Sportswear sources its products from third-party vendors in China and Vietnam.

Columbia Sportswear USA Corp. v. Indiana Department of State Revenue involved the transfer pricing between a domestic sales affiliate and the other affiliates of Columbia Sportswear. The relevant passages in the Columbia Sportswear decision can be found in the following extracts:

Columbia Sportswear, in response, presented three Transfer Pricing Studies as evidence that its Intercompany Transactions were conducted at arm's-length rates . . . . Columbia Sportswear also maintains that its Indiana source income was fairly reflected because ‘[m]ost of the value inherent in the Products [was] derived from [CSC and Mountain Hardwear's out-of-state] research, design, sourcing, manufacturing, and advertising activities[,]' and not derived from Columbia Sportswear's in-state distribution and sale activities as evidenced by, among other things, the Transfer Pricing Studies... In this case, the Department's Trial Rule 30(B)(6) witness testified that the Department did ‘not take exception to' the comparable profits method that was utilized in the Transfer Pricing Studies... [T]he Department merely alleged that the Standard Sourcing Rules must have distorted Columbia Sportswear's Indiana source income because of the ‘big variance' between the percentages of gross profit for the consolidated group in comparison to Columbia Sportswear.

The Indiana Department of State Revenue failed to present any substantive argument that the transfer pricing policies were abusive. My discussion of this litigation was based on the model noted in table 1. The US distribution affiliate sales = $1.2 billion, its cost of goods = 50% of sales, and its third-party logistics costs = 4% of sales. While consolidated gross profits represent 46% of sales, the distribution affiliate’s gross margin has been reduced to 23% of sales as it pays various intercompany (I/C) fees = 23% of sales. The distribution affiliate also bears selling costs = 20% of sales, so its operating profits = 3% of sales. The CPM report noted by the tax court decision presented evidence that the overall intercompany payments were consistent with arm’s length pricing for a distribution affiliate with modest functions, very modest tangible assets relative to sales, and no intangible assets. This report, however, does not address the specific intercompany charges including the intercompany commission paid to the Hong Kong sourcing affiliate, the intercompany fees paid the parent for design and marketing, and the intercompany management fee paid to the parent.

The Hong Kong sourcing affiliate bears sourcing costs, which table 1 assumes represents 4% of the cost of products (2% of sales). While some apparel multinationals set the commission rate for sourcing quite high, table 1 assumes that this multinational choose a 6% commission rate (3% of sales) because the IRS would challenge any commission rate above 6%. Under this intercompany policy, the Hong Kong affiliate’s profits = $12 million per year or 1% of sales.

Table 1 notes that the US parent bears all R&D costs, which represent 10% of sales. The US parent also bears all general and administrative (G&A) costs, which represent 5% of sales. The parent also receives total intercompany fees = 20% of sales thus retaining profits = $60 million per year or 5% of sales. This fee is structured in part as compensation for design and marketing and in part as intercompany management fee. We shall consider two means for structuring this overall intercompany fee = 20% of sales.

Table 1: Columbia Laboratory Allocation of Income Under its Transfer Pricing Policies

Some apparel multinationals prefer to structure these fees such that the design and marketing divisions of the multinational only receive the cost of providing R&D costs. In this case, the intercompany management fee would be 10% of sales, which represent a 100% markup over G&A expenses. If the allocation of this 20% fee between management services versus R&D services matters for domestic tax purposes, tax authorities could challenge this allocation.

A more conservative approach would be to set the intercompany management fee at 6% of sales, while the compensation for design and marketing efforts would be 14% of sales. Under this allocation, the provider of management services would receive profits = 1% of sales, which represents a 20% markup over G&A costs. This intercompany pricing policy could be more readily be defended by an application of CPM with the provider of management services at the tested party. The intercompany payments to the providers of design and marketing functions could be evaluated with applications of the Comparable Uncontrolled Transaction approach.

Extra Space Storage

Extra Space Storage receives third-party revenues from three sources. Its primary business is leasing storage space. The REIT received $1.34 billion during fiscal year ended December 31, 2021. Its expenses include property operations and depreciation plus any intercompany fees to its tax REIT subsidiaries (TRS). Extra Space Storage also generate $170 million in tenant insurance revenue and incurred $29 million in tenant insurance expenses. Our focus will be on the management fees received by Extra Space Management, which is a TRS affiliate.

Table 2: Extra Space Management Income Statement for 2021

Table 2 presents the income statement for this TRS affiliate. Its overall expenses were $102 million, while its third-party managements fees were $66 million. This revenue was generated by charging a 6% management fee on the $1.1 billion in rent revenue collected by its third-party clients. If this same 6% management fee was charged to its REIT’s $1.34 billion in rent revenue, its intercompany management fees would be $80.4 million. Under this intercompany policy, its overall taxable profits would be $44.4 billion.

This income represents a 43.53% markup over costs. Table 2 also provides a segmentation of its costs based on the fact that third-party rent revenue represented 45.08% of the total rent revenue from properties managed by Extra Space Management. While this markup may appear to be high, the suggested transfer pricing policy is consistent with an application of the CUSP approach.

Concluding Remarks

Intercompany management fees take a variety of flavors. If the provider of management services faces a lower effective tax rate than the affiliates paying for management services, the taxpayer may be tempted to charge an intercompany fee that represents a very high markup over the cost of providing these services. If this taxpayer, however, cannot provide a convincing application of CUSP, the tax authorities could challenge the high markup implied by the intercompany fee using an application of CPM with the service provider as the tested party.

We also presented a storage REIT structure where the provider of management services was the taxable entity. While the taxpayer might prefer to use an application of CPM to assert that the appropriate intercompany fee should be set at the cost of providing services plus a modest markup, CUSP may be the best method if the management service affiliate performs management services for third parties or sufficient external comparables can be found. We noted one example where the arm’s length fee was 6% of rental revenue, which afforded the management affiliate with a markup over cost in excess of 40%.

References

Rent-A-Center East, Inc. v. Indiana Dept. of State Revenue, No. 49T10-0612-TA-00106 (Ind. Tax Court 2015).

Harold McClure, “Rent-A-Center v. Indiana: ColorTyme as a CUT?” Journal of Multistate Taxation and Incentives, May 2016.

Harold McClure, “REIT Transfer Pricing: Is the Rent Too High?” Journal of Taxation, October 2015.