What is a circular sale?

With increasingly different supply changes and procurement models I thought I would do a quick post about circular sales. A circular sale is when a buyer purchase an item from one supplier and sells that item to a supplier and the supplier then sells the item back to the buyer either in its original state or a part of value added they provide. There are a number of ways and reasons why a circular sale can occur. A buyer may purchase items from Supplier B and sell them to the Supplier A because:
1. Supplier B will supplier will not sell to Supplier A for a variety of reasons (past history, credit, etc.)
2. The Buyer may have competitive pricing with Supplier B that it wants to mask from Supplier A.
3. The Buyer may have excess inventory on hand that it wants to liquidate by sale to free up the cash.

There is nothing wrong with circular sales as long as those circular sales are not being used to avoid the payment of income taxes. For it to not be an illegal circular sale, the cost the Buyer sells it for needs to be without overhead and profit, or the cost of the purchase of the item by Buyer from Supplier needs to be adjusted to reflect any overhead and profit the Buyer made on that initial sale.

Here’s an example of how an illegal circular sale would work.
The Buyer makes a purchase of a product from Supplier B in a tax free location.
The buyer sells that product to Supplier A at a rate that includes both overhead and profit.
Supplier A sells a higher level product back to the Buyer.
The cost of Supplier’s product includes their value added plus the cost of their purchase from the Buyer. If the Buyer treats that purchase cost from Supplier A as their cost of good in their sale of that product to a customer, that cost reduces the taxes the Buyer will pay on those sales.

The tax authorities look upon that as an illegal circular sale with the purpose of avoidance of taxes. The profits and overhead they added to the selling price in the sale from Buyer to Supplier A cannot be used to reduce the taxes. For example if the Buyer added a $100 profit to the sale of the product in its sale to Supplier A and that was allowed to flow through as a cost in its purchase back from Supplier A, at the U.S. Corporate Tax rate of 35% for corporations, that profit on which they paid no tax would generate a reduction of $35.00 on their U.S. income tax on that product. Tax authorities don’t want un-taxed profits to be used to reduce their U.S. taxes when it comes time to pay income tax on the customer sales profit. If the sale occurred in the
U.S., the company would have to pay taxes on the profit they made in the sale to Supplier A so it wouldn't be considered a circular sale to avoid taxes as the taxes would need to have been paid.