Common themes in TP controversy across industries
Eddie Morris and Markus Kircher of Deloitte consider the common causes of transfer pricing (TP) disputes in the automotive and media sectors.
Transfer prices and policies must follow the commercial reality of the business they support. Where this fails to happen, the disconnect is highly likely to attract the attention of tax administrations, generating disputes between tax administrations and businesses, and often between tax administrations themselves.
Where an industry is changing and reacting to commercial imperatives, this results in TP uncertainty. TP policies need to be monitored to ensure they are fit for purpose. As businesses adapt to underlying commercial changes, decisions need to be made about whether transfer prices are still valid or should be revisited, and whether the underlying TP policy is still appropriate. This article focuses on how changing commercial factors have created TP controversy in two industries that are going, and will continue to go, through change. Supply chain changes, business integration, and new ways of selling all have the potential to generate controversy.
Many controversy themes will apply to most industries. Here, the focus is on the automotive and media sectors. One involves a physical product; the other does not. But the attributes of both industries result in surprisingly similar areas for controversy – and those areas are common to many other industries as well.
Background to TP in the automotive industry
Focusing in particular on original equipment manufacturers (OEMs), the list of challenges facing the automotive industry seems never-ending: the move to electric power and environmental regulations, supply chain disruption and integration, and the increasing importance of software and data are all having a critical impact on the way large automotive companies do business.
Traditionally, automotive TP disputes have concentrated on a small number of issues, such as the importance or otherwise of the brand and the rewards for manufacturing and distribution. After routine rewards for the two latter functions, profits (or losses) have tended to flow back under TP policies to the brand owner and company headquarters (HQ). Most large automotive companies have also managed their TP positions through Advance Pricing Agreements (APAs) between HQ countries and manufacturing and distributing operations elsewhere. These APA methodologies have tended to reward distribution and manufacturing using a transactional net margin methodology (TNMM).
Disputes have tended to be resolved by agreeing the relevant margin by reference to independent comparable data. For the national sales companies (distributors), the main issue may well have been identifying suitable independent companies of a sufficient size to be comparable. Due to the size of the flows involved, disputes are common and, if not prevented by an APA, move into a Mutual Agreement Procedure (MAP) to eliminate double taxation resulting from a tax audit.
Automotive companies, grounded in the physical economy, resident in what would be considered normally taxing jurisdictions, are often easily able to access tax treaties. Operational TP between HQ and national sales companies can be implemented through a combination of actual vehicle pricing plus market support payments to (and occasionally from) the national sales company to satisfy the TNNM range in the TP policy. Those support payments themselves raise customs and duty issues. The HQ pays the manufacturer based on the manufacturer’s costs, and the main opportunities for dispute are the mark-up applied and the inclusion or otherwise of particular costs in the cost base. Only the size of the flows themselves make the TP arrangements of special interest to tax administrations.
A changing world
However, this traditional world of automotive TP was based in many ways on the economy of a different time: the view that there were few value drivers that mattered, while functions were relatively isolated, with each associated enterprise along the value chain carrying out discrete, identifiable functions. That is to say, a manufacturer manufactured, a distributor distributed, and the brand owner made all design and technology decisions from the HQ territory. The value drivers concerned were a mix of brand, design, manufacturing quality, technology, marketing, and distribution channels.
Those value drivers were separately identifiable and each carried out by discrete group companies. None of the necessary characteristics for an OECD profit split methodology were in place: transactions were not integrated, and many activities were, in traditional TP terms, ‘routine’ – easily (or relatively easily) capable of being benchmarked. There was little dispute over what the TP policy itself should be and what the value drivers were.
This traditional picture still carries considerable weight, of course; an industry as large as the automotive one does not change completely overnight. But the new factors mentioned above – the move to electric power and environmental regulation, supply chain disruption and integration, the increasing importance of software and data – all need to be taken on board when TP is being considered.
Automotive TP and the environment
Focusing on environmental concerns, the degree to which these issues are key risks and/or value drivers will be an area of key interest for tax administrations in their own TP risk assessments of the automotive sector. The need for the automotive companies to meet environmental targets is vital given the penalty for not doing so – and from a distribution point of view, it has long been clear that cleaner vehicles are a selling point (consumers are more environmentally aware and consumption tax or road tax duties play a role in changing consumer behaviour). What is of particular interest is how these environmental concerns, the associated risks, and the necessary functions play out along the value chain.
The emissions of a particular model will be created and fixed at the design and technology stage – and it is likely to still be the case that this function is carried out under the control of one group company only (highly likely to be at HQ level). The need to have a balanced vehicle model range across the business that fulfils the necessary environmental regulatory standards is also a function highly likely to be carried out at the HQ level. Given the global footprint of most automotive businesses, there will also be a need to consider the various environmental regulations in operation globally as well as nationally, where business is carried out from the point of view of the whole business.
It is easy to see that not only is this area a key risk for the business, but it is also a value driver because environmental concerns increasingly impact sales. However, the issue will be of concern at the individual country level (as well as at a wider political level, for example in the EU). It will be important to consider where these risks are being managed. For instance, is an individual national sales company managing environmental risk in its own territory? How does it do this? How can a company factor in the fact that the national sales company, being a group subsidiary, only has access to a certain range of vehicles? The larger independent dealer groups, often used with appropriate adjustments for benchmarking purposes, can have access to vehicles from more than one manufacturer, which could bring opportunities denied to national sales companies.
All of these factors will need to be taken into account for any analysis of TP, including not only what is a value driver and what is a risk, but also which group entities are carrying out the associated functions. And if, as is increasingly likely, more than one associated enterprise is involved in the same function or managing the same risk, how is the risk and reward to be split between each party?
Managing risks and value drivers
Observers can therefore note that there may be new value drivers and risks affecting the automotive industry, which will need to be identified and factored in to TP. The possibility that more than one group entity is involved in managing a key risk or value driver will also be a complicating factor. In some cases, this possibility may also mean that a move away from the traditional TP TNMM methodology may need to be considered. If the changes extend to functions, with asset and risk management becoming highly integrated, it might be the case that other TP methodologies become appropriate. Perhaps a profit split methodology will need to be carefully analysed.
Such an approach will apply to areas of change other than environmental impact, of course. As supply chain disruption and integration are key areas of risk, the importance of managing those risks becomes more of a value driver and might affect TP policies if group companies other than the HQ are involved. The industry disruption caused by COVID-19, centered initially on the over-availability of stocks and sales-related disruption, quickly swung into supply chain disruption and the non-availability of key components, hence affecting the vehicles themselves. Depending on the facts and circumstances, it seems likely that in some or many cases, managing these risks has become a key value driver for an automotive operation.
Briefly, it is also worth considering the importance of software and data. These areas, which were not a primary concern for the automotive industry in the distant past, have become increasingly important over the past few years. Traditionally, important factors for the consumer were manufacturing/engineering quality, and design, both of which governed traditional performance criteria such as the handling, speed, economy, reliability, and price. Brand image and associated value arose in the main from quality and design (coupled with, to a lesser degree, marketing).
Software and data complicate matters in that quality is no longer a product only of physical manufacturing/engineering and design, and neither is reliability solely a function of these functions. Software and data, by their nature can be developed away from the physical manufacturing process itself. Where this is done directly by the HQ, this raises ‘only’ the issue of how the more traditional manufacturing activity should continue to be rewarded. However, where software is created outside the HQ, the importance of that activity will need to be separately identified as well as, potentially, revenue sources attached to software sold separately. Tax administrations will doubtless be interested in both the level of reward and which group company should own the associated intellectual property (IP).
Finally, automotive distribution has been classically undertaken via national sales companies that are part of the same group, and then onto the independent dealer network in a country – and those independent dealers sell to consumers. However, direct sales models (in which, for example, the manufacturer or HQ sells directly to an independent dealer network, or even directly to the consumer) are becoming common, particularly for intangible offerings; for example. additional apps.
The role, and hence reward, for the national sales company needs to be addressed in this new business model. Automotive groups may also need to consider whether they have permanent establishments – either fixed place of business or deemed agency – as a result of activities under the new business models.
The old and new worlds of media
Now we turn to an industry that has been around for equally as long: media. Traditional TP analysis highlights the similarities (that might not be immediately apparent) between the two sectors: both industries, like many others, create a product, then need to distribute it. Perhaps the greatest commercial changes for the media industry come in the distribution channel area. Media companies traditionally distributed the IP they created to independent owners of cinemas as well as state- and privately-owned television networks, as well as undertaking the physical distribution of recorded media.
That world has changed radically; IP may still be created in much the same way that it always was, but digital downloads (renting or purchasing) have replaced physical media, cinema sales are still recovering from the COVID-19 pandemic, and media companies may now have their own online distribution channels as well as using those of large third-party operations they partner with. This paints a very complex picture for the industry that will need to be factored into any TP analysis.
The creation of the IP
We start at the first part of the value chain: the creation of the IP itself – the all-important content that customers pay to see. Following the OECD Base Erosion and Profit Shifting (BEPS) project, tax administrations are increasingly considering the decision-making process around the creation of content, rather than just the funding and legal ownership of the resulting IP. With some tax administrations taking the view that the reward for bare legal ownership can be zero, it is more important than ever to align the development, enhancement, maintenance, protection and exploitation (DEMPE) functions with the underlying TP policies. Any disconnect is likely to generate controversy. Likewise, an entity merely funding the creation of IP is likely to attract challenges from tax administrations where it receives anything more than a financing reward arising from that IP. However, financing remains a vital function in the media industry, and decisions around what will be financed, the level of that financing, and what will not be financed, are all value drivers.
Decisions and risk around financing, though complex, may actually be easier to analyse than some subject areas that arise from the nature of the media industry, particularly artistic quality. The proof of the pudding is, of course, in most cases in the eating, and artistic quality in TP terms could perhaps be considered as commercial success. However, many would consider it unwise to restrict the TP analysis to only successful ventures. Opportunity cost should be considered alongside the decision over whether to proceed with a production or not.
Of course, TP complexities arise from the nature of business where, in some cases, decisions are taken and the control of risk is exercised across different group entities rather than within a particular group company. In reality, the facts will not always support an analysis that all DEMPE is done in one company, and indeed the business reality is often that individual DEMPE functions are split across different group companies. This dynamic can be difficult to price using a traditional TP method.
A media company’s product can be global, regional or national. But the first two may need localisation in various countries and even a national product may be exported. The reward for localisation attracts the attention of local tax administrations for obvious reasons: a localisation function tends to be one carried out within a national boundary, not outside of it.
Distribution in the marketplace
Once the IP itself exists, it needs to be distributed in what is clearly a changing marketplace. A fundamental consideration for TP in this industry has been how to isolate the ‘purer’ distribution return from the value of the IP itself. It is striking that the automotive industry also grapples with the age-old question: is it the nature of the product itself that sells, or is it the distribution activity that sells the product?
The existence or otherwise of third party media distribution companies is obviously key to the success of benchmarking a distribution return – but those third parties are unlikely to be distributing the actual products owned by the media company. And, in an industry where the localisation referred to above is likely to be carried out by the same group company acting as national distributor, identifying the proper distribution return with empirical evidence is not always easy.
Larger businesses will have global, regional, and local organisations, not only because of global, regional and product development and distribution but in order to manage and control, for shareholder due diligence purposes, a widespread number of group companies. In short, an oversight structure is necessary. It is perhaps the nature of media distribution, where the customers/partners (not the consumer) tend to be large national or international organisations, that an interaction is required with those customers at a regional and even global level. Put another way, the fewer customers you have, the more important each customer is, and the more the relationship with that customer needs to be appropriately managed from the perspective of the overall business rather than the perspective of an individual local company.
In the commercial reality, this may lead to the blurring of the line between (a) the traditional management/oversight of group companies, rewarded traditionally with a service fee based on the cost of providing the service, and (b) a more value-driving activity that might be more appropriately rewarded with a value-based (not cost-based) fee. Tax administrations that collect tax from a group company which has a global or regional management function are keen to explore this possibility, particularly where customer relationships are managed or assisted at a level above the solely national.
Finally, perhaps the greatest industry change has been the creation of direct internet-based channels of distribution, owned and operated by the business that created the content. This has generated new sales channels directly to the consumer, and income is no longer restricted to that generated by a particular product, but includes recurring subscriptions and ad-sales.
How those revenues, profits, or losses should be shared between the group companies involved is a particularly complicated area. Since it may be the case that a revenue stream from a direct-to-consumer subscription channel removes functional activity and its associated income from other channels and also perhaps from a local group company that acts as national distributor, this market development is clearly of interest to tax administrations. It will be interesting to monitor the impact of the implementation of OECD pillars one and two (and any other digital or online-related tax initiatives) in this area to see what they mean for the TP-related uncertainties inherent in these evolving commercial models.
The underlying nature of a successful trade has never changed: obtain or create something that is wanted or needed, and enable those who want it or need to it to pay for it. Viewed in these simple terms, it is easy to understand why areas of TP uncertainty are similar across many industries. The features of a particular industry can only result in even more TP considerations coming to the forefront. Industry changes will need to be reflected in TP analyses and may give rise to TP changes. And TP changes almost always generate controversy.