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Cost Sharing or Profit Distribution?

Hello there, In a case where we have: - Parent Company, with tasks such as research and development, finance, strategy and management, (which costs are non clearly allocable to subisidaries and shared with all of them). - Subsidiaries, with tasks such as marketing and sales. If sales are booked in the Parent and Subsidiaries costs are paid by the Parent as fees for serivces, the Income Statement would look something like this: + Revenues - Subsidiaries fees (Subisidiaries costs) = Total Subsdiaries Margin - Parent costs - Taxes = Total Profit To reach the fair profit share for each subsidiary, would it be better to share Parent costs across subsidiaries using some more or less fair method (like = Subsidiary cost / Total Subsisdiary costs * Parent costs), or instead by dividing the total profit across subisidiaries based on each subsidiary contrbuiton to the Subsidiaries Margin (Total profit * Subsidiary margin / Total subsidiaries margin)? Hope I exposed it understandable.Thanks in advance!

Answers

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

My humble opinion....

Instead of figuring out who gets what and how much, I think it is best for you to reevaluate your corp structure. You have made your corporate structure (revenue and expense paths) too convoluted for what....for tax purposes?

While I understand the need for tax strategies and operational efficiencies, there is a point where we take them too far. Your subsidiaries have become basically shell/paper companies and subsidiary revenues are completelly dependent on parent. When how to avoid or lessen taxes BECOMES your business instead of focusing on your REAL business, you have taken it too far.

I recognize that you are the Financial Manager and may have little to do with the design (CFO/Legal/CEO/Board) of your structure/business model.

Anonymous
(Financial Manager) |

Hello Emerson and thank you for your reply,

The reason for this structure is to centralize costs and financial control in just one place, as we can't afford to split these areas. Moreover, each subsidiary will operate independently with the resources provided by the parent.

Centralizing revenue will give the parent the funds necessary to operate as its cost structure will be much greater than the subsidiaries, plus it will have a greater control over capital allocation as the interest in the subsidiaries will be of 51%.

PD. It's a startup company so we are looking for the most efficient way to operate.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Anon,

The more I make my point if you are a startup, I dont get the multiple entities (other than for tax purposes). Growing companies SHED companies. If you really want control and operational efficiencies, you corral them in one entity. Then if one aspect of the company can grow and operate on it's own,,,,you shed them and watch them grow.

Don't get me wrong....I understand what you are doing and why you are doing it. I just think it is a misguided strategy. Moreso for being a startup, you are taking away the focus from the real business.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Anon,

I apologize if this ended up as a critique of what you are doing instead of answering your question.

As a way of atonement (lol), here is my answer/response...

First of, I am a fan of arms length transactions. It provides real information whether that subsidiary really needs to exist or if it can exist on it's own.

Second, there is NO standard way of revenue and cost allocation. What I subscribe to is finding out a way to FAIRLY distribute revenue and costs. What "fairly" means is up to management to decide. Bear in mind that one entity's "fair" can be another's "unfair" allocation.

Topic Expert
Wayne Spivak
Title: President & CFO
Company: SBAConsulting.com
LinkedIn Profile
(President & CFO, SBAConsulting.com) |

A long-long time ago I once wrote a paper (I think it was published in an accounting journal) that clearly elicited the notion that allocation was a political decision, not an accounting decision.

Emerson's line about fair/unfair is dead-on.

Anonymous
(Financial Manager) |

Sorry, I didn't provided enough information.

The subsidiaries will be located in different countries, and the will be doing the same task (marketing and sales) of the services developed and provided by the parent Co.

These entities will be owned 51% by the parent and 49% by local partners.

Splitting it's just a function of cost efficiency and responsibilities/power sharing.

Regards.

Len Green
Title: Performance Improvement Consultant and E..
Company: Haygarth Consulting LLC
LinkedIn Profile
(Performance Improvement Consultant and ERP Strategist, Haygarth Consulting LLC) |

Anon
You may need to look at setting up interco transfer pricing agreements soon, in case the basis you establish for cost sharing etc gets investigated by both US and overseas country tax authorities. Please consider getting advice in this becomes a risk exposure for you.

Anonymous
(Financial Manager) |

Thanks Len,

This is an idea, we are still looking for the best solution that suits our needs. When it's time to establish it, it will be made with lawyers and always looking to comply with all the existing regulations.

Anonymous
(Financial Manager) |

Pd. Now I'm seeing the question post format on PC and looks a mess. In mobile is much more clear.

Elizabeth Sahnas
Title: Finance Director
Company: Workable
(Finance Director, Workable) |

I second the need to have transfer pricing agreements in place. As the subsidiaries are stand along legal entities, and so that you don't establish taxable presence of the parent co in other countries, I imagine you should book the expenses of each subsidiary directly to its respective accounts. At the end of the year, each subsidiary can charge the parent for their expenses plus a mark-up. This mark-up is often determined by transfer pricing specialists by comparing the service they provide to competitors. Now, as for how the subsidiary will get money to start paying its expenses by itself: prepayment from parent company for services or loan from parent company.

Anonymous
(Financial Manager) |

Thank you for your insights, Elizabeth.

Topic Expert
Jake Feldman
Title: Managing Director
Company: Global TaxFin Advisory Group LLC
(Managing Director, Global TaxFin Advisory Group LLC) |

Hi Anonymous,

I'll answer the question you put forward first and then join in the chorus to criticize the approach your company is taking. If I understand the situation correctly, the proposed structure entails subsidiaries providing services to Parent HQ. In that case, the subs should charge their own costs plus a markup to the Parent company. The markup would be determined based on a transfer pricing economic analysis. If the Parent is providing some back office type support to the subs that cannot be directly identified to each sub, then the Parent could first allocate those costs to the subs, typically on the basis of sales, i.e., Sub cost allocation = Total HQ Cost * Market Sales/Global Sales. These allocated costs are of course just being round-tripped back to the parent when the sub charges its cost plus markup to the parent.

As a transfer pricing expert, I will opine that the structure your company intends to pursue may be acceptable and could pass muster with assorted tax authorities but it will likely encounter tax controversy for the simple reason that tax authorities like to see the product or service revenue generated in their country and not invoiced from another country. Search for recent news about Facebook changing its revenue and tax approach in Europe. I should point out that contrary to many of these news stories, changing its structure does not necessarily mean that FB will pay more taxes.

Further to the allocation approach, there are nitpicking details about which costs exactly should be allocated out. For example, so called management stewardship costs (e.g., internal auditing, consolidation reporting, etc.) should not be allocated.

An alternative more common structure would entail the parent appointing the subs as distributors where the parent first sells the product to the sub and the sub resells to the local customers, thereby making a margin on its distribution role. Analogous approaches apply to sales of services rather than merchandise products.

There may be longer term advantages to the alternate structure in the sense that it will be more conducive to the type of sophisticated tax planning structures that larger multinational companies utilize.

In all cases, inter-company agreements should be executed and transfer pricing studies prepared to document the relationships. It certainly sounds like your company will need the advice of both tax attorneys and transfer pricing experts like myself.

Yes, there is a sales pitch in there but everyone else has already told you that. :)

Best Regards,

Jake

Anonymous
(Financial Manager) |

Hi Jake,

Thank you for your views, I'll have them in consideration.

Just to clarify, the parent is who provides services to the subsidiaries. And the intention of this structure is not tax purposes, but operational efficiency and power/responsabilities distribution.

Regards.

EMERSON GALFO
Title: CFO
Company: C-Suite Services
LinkedIn Profile
(CFO, C-Suite Services) |

Anon, out of curiosity, why a 51/49 split and not wholly owned subs?

Anonymous
(Financial Manager) |

Hello Emerson,

Because we don't have enough resources to hire managers for each country we want to operate in, we want to bring in and motivate local partners this way.

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