German transfer pricing methods in the context of digital transformations
In our last article, we described the challenges that the digital transformation poses for transfer pricing (TP). In this article, we want to show how emerging business interdependencies can be translated into new TP models.
The complexities of digital transformation for TP can be illustrated by the case previously discussed from the agrochemical industry. In that situation, the group's headquarters had well-known brands and active ingredients, while the group's local entities had valuable customer relationships with farmers globally.
However, the group then started to expand by building new digital offerings through an in-house start-up (this new entity develops field management software allowing farmers to estimate yields and target the use of herbicides more efficiently).
This complicated the company's value chain by turning it into a value network.
Before its digital initiative, the situation was a comparatively simple two-party set-up with value and products mainly flowing one way: from its company headquarters to the local affiliates. Now, there are intertwined dependencies as the start-up relies on the technical expertise of the headquarters to design the software and on its local affiliates to persuade farmers to use it.
The software enhances the value proposition of the local affiliates towards the farmers, and allows the group to gather data and target future sales campaigns more accurately. Furthermore, the software enables the group's headquarters to further analyse the gathered data and improve its research and development efforts. Much of the value creation happens in this network of effects.
Due to the complexity of the case, standard TP methods with guaranteed fixed margins will lose their usefulness in such situations. It is clear that the chosen TP methods in such an intertwined business, with such unique contributions from many parties, has to be the profit-split method, which applies TP in accordance with the contributions to the profitability of a business.
However, while the profit-split method is a recognised OECD method, a critical factor in its application is the profit-split ratio (the method by which the parties' contributions are measured).
In the given example, we could establish a profit-split ratio by the 'shapley value' method (named after Economics Nobel Prize laureate Lloyd Shapley). The method measures the marginal contribution by each party to the various possible combinations of entities (coalitions). Economically, the method uses a bargaining split method (i.e. it looks at how much value each entity could withhold from the others in various constellations).
The groundwork in this case revolved around the economic analysis of how much profit could be achieved by various entity combinations. Without other entities, the tech company alone would likely not earn more than a third-party IT development firm and could be benchmarked.
However, in combination with local sales companies, it can drive additional revenue through better-targeted sales campaigns, and in conjunction with the headquarters, it can improve the research and development (R&D) process through data analytics.
Importantly, these effects can typically be measured through A/B testing. Typically, new features are only introduced for some clients, and the effect is closely monitored before being rolled out to all clients. This allows for a detailed modelling of the direct improvements due to the software itself.
Likewise, the bargaining power of the headquarters and the local sales entities can be measured through their stand-alone contributions (which can be assessed through benchmarking the activities and intangibles respectively), and their joint value contribution (which can be assessed through reference to the pre-digitalisation profits).
The overall results of this framework imply that between 21% and 34% of the segmented profits are attributable to the group's start-up entity.
This profitability was achieved through a combined license fee from the headquarters and sales companies, with the headquarters contributing a larger part.
Importantly, this method allowed a much higher profit share for the start-up company than a simple cost-based or headcount-based allocation key would allow, which reflects the digitalisation trends and the importance of joint value creation to digital business models.