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Follow the Money

Four companies, one product. Watch goods, cash and services move between them, and see which company keeps the profit, and why.

8 minutes, five short steps

  1. Guess
  2. Play
  3. Explain
  4. Check
  5. Try it

First, a bet

We start where the Price Dial left off. The US Entrepreneur designs a product and makes it in the US. A subsidiary in Canada, the Canada Distributor, resells it to Canadian customers. Later the story moves the factory to Mexico. Together the group earns $100 of profit.

$30

Follow the money

EntrepreneurUnited Stateskeeps $100EntrepreneurUnited Stateskeeps $100
  • Goods
  • Cash
  • Services
  • Entrepreneur $100

Of $100: routine returns $0, residual $100

Step 1 of 6. US Entrepreneur keeps $100.

  1. 1 of 6

    Meet the US Entrepreneur

    The US Entrepreneur designs the product and makes it in its own US factory. It owns and controls the IP (patents, brand and know-how), sets the prices and carries the big risks. It is the PrincipalThe group company that makes the key decisions, owns or controls the valuable assets such as IP, and bears and controls the main business risks. It keeps the residual profit or loss.Open in the Glossary. If it did everything alone, all $100 of group profit would be its own.

  2. 2 of 6

    A distributor in Canada

    Just like in the Price Dial, the Entrepreneur ships its US-made goods to the Canada Distributor, which resells them to Canadian customers and pays the Entrepreneur. The Entrepreneur sets the prices and takes back unsold stock, so the Distributor carries little risk.

    So how much does it keep? Keep scrolling.

  3. 3 of 6

    Now move the factory to Mexico

    Let's suppose the Entrepreneur wanted to move its manufacturing to Mexico. What happens now to the flows? The US factory closes. From now on, all manufacturing happens in Mexico. A subsidiary there builds the product to the Entrepreneur's design and schedule, and sells everything it makes to the Entrepreneur. The Entrepreneur buys it all, so the manufacturer takes little risk. It earns a steady Routine returnA modest, steady profit for low-risk activities such as contract manufacturing, distribution, or support services, set by reference to comparable companies.Open in the Glossary: its costs plus 8%. In this story that markup works out to $8 of the group's $100 of profit. To save time and freight, the goods ship straight from Mexico to Canada. On paper, the Entrepreneur buys them from the factory and sells them on to the Distributor, so ownership passes through the Entrepreneur for a moment, even though the boxes never visit the US (people call this flash title). So the Distributor still pays the Entrepreneur, and the Entrepreneur pays the manufacturer.

  4. 4 of 6

    And one in Germany

    A Germany distributor does the same job for German customers, on the same terms. It buys from the Entrepreneur and pays the Entrepreneur, while its goods ship straight from Mexico. It earns a small routine return too: $3 of the $100.

  5. 5 of 6

    Services from the US

    The Entrepreneur also runs head-office support for all three companies: accounting, payroll, IT and management support. Each one pays it a service fee. Under the US Services cost methodA US option to charge certain routine support services at cost with no mark-up. It covers services on the IRS list (Rev. Proc. 2007-13) and services whose usual mark-up is 7% or less, but not excluded work such as R&D or manufacturing, and not services that are key to the business's success (Treas. Reg. § 1.482-9(b)).Open in the Glossary, routine support services like these can be charged at cost, with no markup, where they qualify. As the group's parent, the Entrepreneur cannot charge for shareholder activities: work it does only as an owner, such as its own board meetings and stock listing. Every other company still earns its fixed routine return, so the fee does not change the $100 split. (Mexico, Canada and Germany apply their own rules, so the group must check the fee works there too.)

  6. 6 of 6

    The whole picture

    The routine companies earn small, steady returns: $8 + $3 + $3 = $14. What is left, the residual profit, goes to the US Entrepreneur, which owns and controls the IP and carries the big risks: $86. Tap any company to see why. Then try moving work to Canada below.

Now you: move work and risk to Canada

About $24 of the residual is earned on sales in Canada. Today the US Entrepreneur does the key work for that market. Tap an item to move it to the Canada Distributor, and see who should earn what.

US EntrepreneurUnited States
  • Designs the product and runs R&D
  • Owns and controls the patents and know-how

keeps $86

Canada DistributorCanada
  • Local sales, orders and delivery

    keeps $3

    • Manufacturer $8
    • Canada $3
    • Germany $3
    • Entrepreneur $86

    Of $100: routine returns $14, residual $86

    The Canada Distributor is a limited-risk distributor, so it keeps its routine $3. The Entrepreneur does the key work and keeps the residual: $86.

    Paper alone moves nothing. Real work and real risk do. Under section 482 the legal owner is the starting point, but each company that adds to the IP must be paid arm's length, and the IRS follows what the companies actually do, not just the contract (§ 1.482-4(f)(3) and (f)(4)). A risk counts where the company really controls it and can afford the loss (§ 1.482-1(d)(3)(iii)(B)). Simplified: here each real job or risk moves $6 (a quarter of the $24 Canadian residual), and the title alone moves nothing.

    Try this

    1. Move only the legal title to Canada. How much moves?
    2. Move one real job or risk. Watch the Distributor's return grow.
    3. Move both. Does the Entrepreneur still keep the biggest share?

    Profit follows what you do, not what you sign

    Every company in the chain gets paid for its FAR (functions, assets, risks)The analysis of what each company does, what it owns, and what risks it bears. It decides which entity is routine and which is the principal, and drives method selection.Open in the Glossary. The manufacturer and the two distributors do useful work but take little risk. So they earn a Routine returnA modest, steady profit for low-risk activities such as contract manufacturing, distribution, or support services, set by reference to comparable companies.Open in the Glossary: small and steady, set by looking at independent companies that do the same work.

    What is left is the Residual profitThe profit left after every routine function has been paid its routine return. It usually goes to the principal.Open in the Glossary. It goes to the PrincipalThe group company that makes the key decisions, owns or controls the valuable assets such as IP, and bears and controls the main business risks. It keeps the residual profit or loss.Open in the Glossary, the company that makes the key decisions and carries the big risks. Here that is the US Entrepreneur: it keeps $86 of every $100.

    Registering IP to another company on paper does not move that profit by itself. Under section 482 the legal owner is the starting point, but every group company must be paid arm's length for what it adds to the IP, and the IRS can look past a contract that does not match what the companies really do. A company earns more than a routine return only when it really does, and controls, more of the work and risk.

    Sources: Treas. Reg. § 1.482-4, intangibles, including (f)(3) and (f)(4) on ownership and contributions; § 1.482-9(b), the services cost method, and (l)(3)(iv), shareholder activities

    Check yourself

    Three quick questions. Each answer explains itself, right or wrong.

    Question 1 of 3The Canada Distributor buys from the US Entrepreneur and resells to Canadian customers. The Entrepreneur sets the prices and takes back any stock that does not sell. What should the Distributor earn?
    Question 2 of 3The group registers its Canadian brand to the Canada Distributor on paper. Everyone who develops, markets and manages the brand stays at the US Entrepreneur. Under section 482, who should earn most of the brand's profit?
    Question 3 of 3Say the group earns $100 of profit. The Mexico manufacturer earns $8 and the two distributors earn $3 each. The US Entrepreneur also charges all three a service fee. How much residual profit is left for the US Entrepreneur?

    0 of 3 answered.

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