The transfer pricing implications of Armani’s US advertising payments

By Dr. Harold McClure, New York City

The role of locally incurred advertising expenses is a vexing issue for transfer pricing analysis, especially when applied to common business structures used by multinational apparel and shoe manufacturers where a foreign parent formally owns the trademarks.

A case involving Italian fashion company, Armani, and its US importer and distributor, Trimil S.A. v. United States (No. 16-00025 Court of International Trade 2019), addressed whether advertising fees should be included in the dutiable base for customs valuation purposes.

The court’s decision focused on legal aspects of customs law. Left unexplored, though, were the transfer pricing implications the advertising fees paid by Trimil.

US imports of Armani products

Trimil imported and distributed apparel products such as Armani jeans. Some of these products were manufactured by third-party vendors on behalf of Armani and affiliates of Armani. Other products were manufactured by members of the Armani group.

Armani and the Zegna Group formed Trimil in 2000 as a joint venture to distribute Armani products globally. From a transfer pricing standpoint, any payments between Trimil and Armani and its foreign affiliates were intercompany transactions even if the products were manufactured by third-party vendors.

Armani was responsible for the design costs as well as the sourcing of products from third-party vendors; Trimil was responsible for both selling costs and the payment of advertising fees and trademark royalties.

This business structure is common among multinational apparel and shoe manufacturers. The US imports a substantial amount of apparel and shoe products from China and other Far East third-party vendors.

The parent corporation incurs design costs, while a Hong Kong affiliate is responsible for qualifying third-party vendors. The US importer is responsible for selling functions and often incurs significant third- party marketing costs. These structures pose interesting transfer pricing and customs valuation issues.

 Trimil/Armaini’s customs valuation issues

Under various agreements, Trimil paid Armani both design fees and advertising fees, both calculated as a percent of Trimil’s revenues.

US customs authorities asserted that the customs valuation must include the third-party payment for apparel, the design and advertising fees, and trademark royalties. Trimil’s position was the customs valuation should be based on the cost of the apparel plus the design fees but not the advertising fees and trademark royalties.

Customs rulings going back to 1985 have held that trademark royalties paid to parties related to the sellers of the goods would be dutiable, but trademark royalties paid to parties unrelated to the sellers are not dutiable. Trimil convinced the court to exclude trademark royalties and advertising fees paid to Armani regardless of whether the manufacturer was a related party entity or a third party vendor. The argument was that post-importation advertising benefits either the distributor or the trademark owner but does not benefit the manufacturer.

The court agreed with Trimil, asserting that the advertising fees are not dutiable because they are neither part of the price paid or payable, nor do they fit within a statutory addition to price.

The court concluded that advertising fees were post-importation fees that benefited Trimil and not the third party manufacturer.

Trimil/Armaini’s transfer pricing issues

While the ruling resolved the customs issue, holding that design costs and product royalties remain dutiable, but advertising fees and trademark royalties are not, left unresolved are transfer pricing issues arising from these transactions.

Under these facts, Trimil and Armaini have two transfer pricing issues.

The first is whether the overall payments for design costs, advertising expenses, and royalties are arm’s length. The other issue is how much should be allocated to dutiable product intangible fees versus non-dutiable marketing intangible fees.

While the court decision provides no financial information, the following table poses a hypothetical income statement based on the following assumptions about Armani’s per-unit pricing:

• each piece of apparel sells for $100;
• the payment to the third party manufacturer = $50;
• foreign-based design and procurement costs = $5;
• advertising costs = $10; and
• selling costs = $25.

Consolidated profits = $10 per unit, which is allocated between the foreign affiliates and the US distribution affiliate depending on the intercompany pricing policies.

Our table considers two transfer pricing policies.

Hypothetical Income Statements for Trimil and Armani

Per unit	Trimil	Armani	Trimil	Armani
Sales	$100	$0	$100	$0
Intercompany price	$5	$5	$10	$10
Payment to third party	$50	$0	$50	$0
Design costs	$0	$5	$0	$5
Gross profits	$45	$0	$40	$0
Advertising expenses	$10	$0	$10	$0
Selling costs	$25	$0	$25	$0
Operating profits	$10	$0	$5	$5

In both cases, Trimil, as the US distribution affiliate, pays the third-party vendors and incurs an intercompany expense, paying Armani for the design and procurement services. If this intercompany payment is only $5 per unit, these payments barely compensate the parent for its expenses. As such, the US affiliate retains all of the consolidated profits.

The Italian income tax authorities would certainly object to such an extreme transfer pricing position. Our table also considers an intercompany pricing policy where the US affiliate pays the parent $10 per unit. Under this scenario, consolidated profits are split evenly between the US affiliate and the parent.

If the value of design and procurement activities is $10 per unit, then the cost-based customs valuation of only $5 per unit understates the arm’s length price. Whether the appropriate valuation is $10 per unit depends on a more detailed transfer pricing evaluation that considers the role of each affiliate’s contribution to consolidated profits.

The 10 percent consolidated operating margin is attributable to the routine return for selling activities plus residual profits attributable to design intangibles, procurement intangibles, and marketing intangibles. If the parent owned all the intangible assets, the Italian tax authorities would likely assert that a 5 percent operating margin for the US affiliate was too high. In this case, even a customs valuation equal to $60 per unit might be deemed as too low.

If the US affiliate bears the advertising expenses, however, then the IRS would likely assert that the US affiliate deserves not only a routine return for selling activities but also a portion of the residual profits as the owner of marketing intangibles.

This situation where a foreign parent formally owns the trademark, but the local distribution affiliate incurs significant advertising expenses, is a vexing issue for transfer pricing.

This situation where a foreign parent formally owns the trademark, but the local distribution affiliate incurs significant advertising expenses, is a vexing issue for transfer pricing.

Marketing intangibles ownership

One question is which entity owns the marketing intangibles in such situations.

In our example, the US affiliate incurs selling and marketing expenses equal to 35 percent of sales. The second scenario of our table assumes an intercompany policy where this affiliate receives a 40 percent gross margin.

An application of the comparable profits method that assumes all intangible assets are owned by the Italian parent might conclude that this 40 percent gross margin was overly generous.

A residual profits split approach that considered the US affiliate to be the owner of marketing intangible assets, on the other hand, might conclude that this 40 percent gross margin was too low.

The difficulty of such an approach would be that it would not only have to evaluate the appropriate routine return for selling functions but also the relative values of marketing intangibles owned by the US affiliate versus the intangible assets owned by the parent.

The customs valuation analysis must consider not only whether advertising expenses are dutiable but also the appropriate contributions of each of the activities of the apparel multinational, including not only the selling and marketing activities of the importing affiliate, but also the design and sourcing activities of the foreign affiliates.

Value attributable to product versus marketing intangibles.

Even if the IRS and the Italian tax authorities agreed on the allocation of consolidated profits between the US affiliate and Armani, the customs valuation requires an understanding of the value attributable to product intangibles versus marketing intangibles.

Using our numerical example, let’s assume that the routine return for selling activities is 3 percent of sales, so residual profits represent seven percent of sales. Since the design and advertising expenses collectively represent 15 percent of sales, the overall payment for design and marketing activities represents 22 percent of sales.

If the payment for marketing activities were 15 percent of sales, then the dutiable payment for design activities would be only 7 percent.

This allocation assumes that the profits attributable to the marketing activities should be 5 percent of sales, while the profits attributable to the design activities should be only 2 percent of sales.

The US customs authorities could reasonably question this allocation unless the multinational provided evidence to justify this allocation of residual profits.