INSIGHT: Searching for Comparables in the Changing Global Garment Import Industry

Tax authorites and importers need a directory of what independent agents charge in order to determine the fair commission that should be paid to a buying office for transfer pricing purposes.

We are told that under tax authority regulations a commission paid to a buying office (defined as an agent wholly-owned by an importer) is considered to be fair if that same commission is paid to an independent agent for the same work. This is a very reasonable, sensible and practical rule.

Unfortunately, what appears to be reasonable, sensible and practical on paper becomes virtually impossible to implement in real life.

Consider the challenges of defining the work, inadequate comparables, including value added services, under-the-table trading companies and the lack of first-hand industry knowledge.

Defining the Work

First and obvious, to have a comparable you need to define the work. For decades past and up to very recently, there was at least a tacitly agreed list of six basic services performed by all agents (and, of course, buying offices):

1. Select the pool of factory suppliers;
2. Allocate each order to a specific factory;
3. Negotiate FOB prices (based on customer’s target);
4. Carry out quality control to ensure that each order meets the customer’s quality standard and level;
5. Notify the customer on a timely basis of any problems, particularly those that may result in delayed shipment; and
6. Act as a nexus of communication between the customer and the factory supplier.

However, recent cases brought by tax authorities appear to have omitted this or any other list defining the work of the agent. If we cannot define the work performed by both the independent agent and the buying office, the entire issue of comparables becomes moot.

Inadequate Comparables

The basis of fair commission is the ability to find and present a comparable.

Furthermore, assuming the list of six services is still considered to be relevant, you would think that locating independent agents competent to carry out the work of your buying office and deciding commission for that work would be fairly easy. And it is. The Canton Fair features 25,000 factories and agents dealing in every conceivable product. The Hong Kong Trade Development Council (HKTDC) has a database listing 130,000 products, factories and agents also dealing in every conceivable product, and with 47 offices worldwide you do not even have to travel to Hong Kong—you can access your data online. In fact, every exporting country is more than happy to provide a list of agents for every product.

The problem is that for the purpose of transfer pricing, with very few exceptions, the importer cannot use this information because under current regulations, you can use only information which is in the public domain. This drastically limits the number of comparables.

Currently there is only one reasonably complete list of agents and their commissions—Birnbaum’s Directory of Garment Factories & Agents. Hong Kong & South China 1994, Hong Kong 1995—and that is 25 years out of date. This is but one reason why almost all comparables declared by either side in transfer pricing disputes go back decades and are therefore irrelevant to the current state of the industry.

Relevant Comparables

The comparable must be relevant: The services provided by both the independent agent and the buying office must relate to the current needs of the customer. The list of six services may fill some needs but during the past 25 years, the nature of the customer, the needs of the customer and the tools available to the agent to meet those needs have changed.

The nature of the customer: 25 years ago, we assumed that all customers were equal. Today agents look at 12 factors differentiating one customer from another (Birnbaum’s Global Guide to Agents and Buying Offices, New York 2015, pp 27-32).

The needs of the customer: 25 years ago, we assumed that customers had the same six needs. Today agents look at 20+ factors (ibid pp 33-82).

Agents’ tools: 25 years ago, agents met those needs with only merchandisers to communicate with the customer and quality control inspectors to ensure the goods were correct and shipped on time. Today these same agents require engineers, chemists, IT specialists, management specialists, just to name a few. Each specialist has their own tools.

Value Added Services

The comparable must include more than the traditional services: Today, all independent agents are required to provide two types of services:

The old basic six services: In the very early days, when the supplier side was still in its infancy, these basic services were indispensable to ensure that the factory shipped a decent product, on time, and at a reasonable price. However, as the factory suppliers developed, the importance of these services has been reduced, with the result that an agent providing only these basic services is entitled to a much reduced commission.

The new value-added services: The importance of this second group has increased rapidly over time, with the result that agents able to provide these new services are entitled to ever-increasing rates of commission. We are fast reaching a tipping point whereby value-added services will constitute the lion’s share of the commission.

The problem is that tax authorities as yet do not recognize the existence of value-added services much less their growing importance.

Under-the-table Trading Companies

To be a valid comparable, the independent agent must truly be an agent.

Many so-called independent agents are in fact under-the-table trading companies which greatly enhances their income.

An agent works directly for the customer. While the agent may transfer money from the customer to the supplier, it does not play a direct financial role and therefore receives no money other than the agreed commission based on the factory FOB price.

The trading company is different. The trading company, after accepting an order from the customer, will buy the goods from the factory and will then resell the goods to the customer. Unlike the agent that is limited to a single source of income—commission on the factory FOB—the trading company has multiple sources, including but not limited to:

• Kickback from the factory most often between 2%-3% of the FOB;
• Mark-up on the factory FOB; and
• Commission based on the FOB after the mark-up.

The existence of these under-the-table trading companies is an open secret known to industry professionals and others.

Industry Knowledge

The greatest problem is the almost total lack of first-hand industry knowledge.

In the commercial world, fair-payment is determined by what your customer needs; what you do to meet those needs; and how well you do it. The more you do, the more you should be paid. The better you do it, the better you should be paid. This is true if you are a law firm, a corporation, a baseball player or an orthopedic surgeon and is equally true of factories and agents.

The exception seems to be in transfer pricing where neither side has knowledge nor first-hand experience of the industry. And rather than making an effort to understand what is going on by retaining industry specialists, tax authorities (as well as many on the other side) rely on outside specialists with little or no industry knowledge who produce obscurantist and meaningless arguments based on their skill sets, which are then used as the basis of transfer pricing litigation.

Imagine a government department decides that the Earth is the center of the universe.

Imagine, to prove their contention, the government department employs highly qualified IT specialists to create sophisticated algorithms explaining the apparent movement of the planets based on the Ptolemean theory.

Imagine, because neither side has any real knowledge of astronomy, both sides bring in qualified IT specialists to argue the validity of the algorithms to prove (or otherwise) that the Earth is indeed the center of the universe.

This is the way tax authorities (and in many cases specialists retained by the importers) argue in transfer pricing cases.

The Solution

Bring in the astronomers.

It is past time that we return to the original concept: A Commission paid to a buying office is considered to be fair if that same Commission is paid to an independent agent for the same work. This is still the most reasonable, sensible and practical method.

Twenty-five years ago, we published Birnbaum’s Directory of Garment Factories & Agents. Hong Kong & South China 1994. The directory did not list services provided by agents because 25 years ago most agents did in fact provide the same basic services.

The time has come for us to publish a new directory, one which will place in the public domain a reasonably large number of independent agents; who they are; what they do and what they charge.

Once and for all, we will match concept with implementation.

If we do our job correctly, the new directory will benefit everyone—importers, agents and tax authorities.

The importer: Many importers should work through independent agents rather than through wholly-owned buying offices. There are two major factors to consider here:

1. Export volume: Below a certain volume, the buying office costs are higher than those charged by an independent agent. The math is simple. If you open a buying office, the commission paid must cover all the expenses. Somewhere below annual exports of $100mn, the commission necessary to cover those expenses exceed the commission charged by an independent agent.
2. Services required: If all you need are the six basic services, the independent agent can always provide the same services at a lower commission because while the importer must create a buying office with all the related expenses to do that work, the agent has a fully operational office already carrying out that work and therefore must add only the marginal costs of satisfying the importer’s needs.

In some instances, this is also true of importers with existing buying offices. For, example, if the importer wants to buy goods in some less important exporting country such as Ethiopia or is interested in buying some esoteric product such as equestrian wear, the agent is a much more cost-effective solution than sourcing in-house.

The Agent: In today’s market there are some first-class agents able to provide many of the latest services. While all the major independent agents have first-class websites, they have a problem attracting importers to their sites. The directory is the way in.

Participating agents will not pay fees or other expenses to be included in the directory.

The Tax Authorities: Many buying offices are indeed entitled to a relatively high fair commission because they have the services and they perform them well. Equally true, many buying offices are not entitled to the commissions they receive because they do not provide the services necessary to support their current commission rate or do not perform to the standard required.

The directory will provide a list of comparables from which it will be possible to decide just who is entitled to how much and who is not.

Currently a transfer pricing case takes three to four years to litigate with costs on both sides running in the millions of dollars. A directory providing real verifiable comparables reduces both time and costs to much more manageable levels.

Creating a workable and credible directory will not be easy. To be of any benefit, the information must be seen to be accurate and the listings unbiased.

Most important, to be of value, the data and listings must be open to change as the needs of the customers change and the services provided change to meet those needs.

This is something that both the industry and the tax authorities need.

Author Information

David Birnbaum, co-founder of Birnbaum & Father Ltd. in Hong Kong, is a garment industry specialist who has been retained as an expert in transfer pricing cases for more than 20 years. He is the author of Birnbaum’s Global Guide: Agents and Buying Offices, Fashiondex, N.Y., 2015; India Benchmark Study, New Delhi Government of India, 2013; and The Birnbaum Report, a monthly newsletter for international garment industry professionals.