The release of the final BEPS deliverables on Actions 8-10 on October 5 2015 contains a completely revised Chapter VI of the OECD Transfer Pricing Guidelines (TPG) on intangibles. Section B of Chapter VI of the TPG introduced new concepts on the right to receive intangible income. The right to receive intangible income is based on the functions performed, assets used and risks assumed in the development, enhancement, maintenance, protection, and exploitation (DEMPE) of the intangibles. In accordance with the changes to Section D. 1 of Chapter I of the TPG, the assumption of risk in the DEMPE activities, in particular the management and control of risk with respect to those activities is intended to drive the entitlement to intangible returns. Section D of Chapter VI of the TPG provides guidance on the valuation of the various contributions to intangible income. Par. 6.141 suggests that one-sided methods, such as the transactional net margin method (TNMM), are unlikely to provide a reliable method to value entitlement to intangible returns. Par. 138 suggests that an appropriate comparability analysis will lead to the conclusion that there are no comparable uncontrolled transactions in many cases that can be used to determine the arm's-length price. Therefore, as a practical matter, the guidance heavily relied on the transactional profit split method and valuation techniques described in Section D.2.6.3 to determine rights to intangible returns. Because the transactional profit split method and valuation techniques had many common elements, additional guidance on the transactional profit split method was eagerly anticipated.
The OECD on December 16 2014, released the first non-consensus discussion draft on proposed changes to the transactional profit split method contained in Chapter II of the TPG. The tone of the 2014 discussion draft suggested to many the broad applicability of profit splits to integrated value chains. The OECD received numerous comments that suggested the discussion draft appeared to adopt many strains of a formulary apportionment approach to allocating intangible returns, and did not sufficiently rely on the basic tenets of the arm's-length standard. A public consultation on the topic was held at the OECD in March 2015. The BEPS final reports, published October 5 2015, did not incorporate any proposed changes to Chapter II of the TPG contained in the discussion draft, rather they provided instead that Working Party 6 (WP6) would reconvene in 2016 and 2017 to provide such consensus guidance on the transactional profit split method.
The OECD on July 4 2016, released a Discussion Draft on Revised Guidance on Profit Splits. The discussion draft does not reflect, at this stage, a consensus position of the governments involved, but is designed to provide substantive proposals for public review and comment. The introduction to the discussion draft specifically indicates that insofar as the guidance differs from the guidance contained in the 2010 OECD Transfer Pricing Guidelines For Multinational Enterprises and Tax Administrations (2010 OECD TPG), it is not to be relied upon by taxpayers or tax administrations.
Overview of discussion draft
The discussion draft modifies the 2010 OECD TPG Chapter II guidance on profit splits (rather than withdraw and replace it in its entirety, as was the case with Chapter I, Chapter VI, and Chapter VIII). It clarifies and expands on the 2010 OECD TPG Chapter II guidance to conform to the new 'risk control' framework of Chapter I. Missing from the discussion draft is a clear link to the valuation guidance contained in Section D.2 of Chapter VI on intangibles.
Along with discussing conditions under which transactional profit splits are most appropriate, the discussion draft also articulates the role of a value chain analysis in accurately delineating a transaction (within the meaning of Chapter I), and in determining the most appropriate transfer pricing method. The discussion draft specifically indicates that the existence of an integrated value chain does not necessarily imply the use of transactional profit splits, as many multinational enterprises (MNEs) operate through a global value chain.
If the December 2014 draft could reasonably be interpreted as suggesting formulary apportionment of an MNE's profit as appropriate in certain circumstances, the discussion draft dismisses such an interpretation. The draft contains a number of safeguards and cautions against application of transactional profit splits when it would not be appropriate, including as a default method when comparables are hard to find, other methods are not reliable, or group synergies exist as some interpretations of the intangible valuation methods section of Chapter VI may have implied. The discussion draft also recognises that profit splits are difficult to apply, and are generally not appropriate when a party makes only routine contributions.
Analysis of discussion draft
Value chain analysis: An approach to delineating the transaction
The discussion draft provides four new paragraphs under Section C.3.4 articulating the role of a value chain analysis in a transfer pricing study. Some were concerned that Par. 6.133 of Chapter VI, which emphasised the need for an undefined valuation chain analysis in valuing intangibles, would result in the transactional profit split method being the primary method in valuing intangibles:
"The selection of the most appropriate transfer pricing method should be based on a functional analysis that provides a clear understanding of the MNE's global business processes and how the transferred intangibles interact with other functions, assets and risks that comprise the global business. The functional analysis should identify all factors that contribute to value creation, which may include risks borne, specific market characteristics, location, business strategies, and MNE group synergies among others." [Emphasis added.]
The supplemental guidance clarifies that a value chain analysis is merely a tool to assist in accurately delineating a transaction, in particular with respect to the functional analysis, and thereby determining the most appropriate method, which may or may not be the profit split. The discussion draft makes clear that there is no causal relationship between a value chain analysis and use of the transactional profit split method.
A value chain analysis should consider where and how value is created in the business operations, including:
- Consideration of the economically significant functions, assets, and risks;
- Which company performs the functions, contributes the assets, and assumes the risks;
- How the functions, assets, and risks are interrelated;
- How the economic circumstances may create opportunities to capture profits in excess of what the market would allow (e.g., unique intangibles or first mover advantages); and
- Whether the value creation is sustainable.
Because the value chain analysis discussion appears to provide additional guidance on identifying the commercial or financial relations between the associated enterprises required under paragraph 1.34, commentators have questioned the placement of such guidance in Chapter II (guidance on profit split), rather than in Chapter I (guidance on accurate delineation) and requested clarity in the next draft as to whether or not a value chain analysis is viewed by WP6 as part of a functional analysis to be performed in the accurate delineation of every transaction, or merely as a tool to be applied in transactions in which the profit split is being considered as the most appropriate method. Providing this guidance under Chapter I would reinforce what appears to be the intent of WP6, namely, to use value chain analyses to inform the selection of the most appropriate method as opposed to cause the transactional profit split to be the most appropriate method in every case of an MNE operating through a global value chain.
The main takeaway from the supplemental guidance on value chain analyses provided in the discussion draft is the casting of a value chain analysis as a delineation tool for a specific transaction, rather than as a justification to apply a profit split on every integrated MNE operating through a global value chain. This is a significant change in direction (likely to be welcomed by taxpayers) from the December 2014 non-consensus draft on profit splits, which suggested the latter rather than the former.
Profit split guidance
The overriding purpose of the use of a transactional profit split should be to approximate as closely as possible the split of profits that would have been realised had the parties been independent enterprises. Consistent with the guidance provided in the October 5, 2015, final report under actions 8-10, identifying the economically significant risks each party to a transaction controls, and accurately delineating such transactions (including the respective contributions of each party and the profits to be split), is the starting point to inform whether or not transactional profit splits are appropriate and reliable.
The discussion draft describes transactional profit split as a method whereby the combined profits are split between associated enterprises on an economically valid basis that approximates the division of profits that would have occurred in comparable circumstances at arm's-length. The discussion draft distinguishes transactional profit splits of anticipated profits from profit splits of actual profits. In many cases, the split of profits using anticipated profits will rely, in part, on the additional guidance in Section D.2.6.3 in Chapter VI of the TPG on valuation techniques. Although most of the guidance provided in the discussion draft addresses splitting actual profits, this distinction, and the provision of separate guidance for these two types of transactional profit splits, expands on Chapter II of the 2010 OECD TPG.
Irrespective of whether anticipated or actual profits are split, the determination of which profits need to be combined (base for the split), and the way combined profits are split (key for the split) must be determined ex-ante on the basis of data that are reasonably available at the time of the initial transaction and are capable of being measured in a reliable and verifiable manner and without the use of hindsight, a key criterion to ensure that profit splits are consistent with the arm's-length standard.
These requirements make profit split keys constructed through subjective weighing of taxpayers' representations or tax authorities' unsubstantiated view of the various value drivers in their business inappropriate, and significantly decrease any perceived authority granted by the guidance to tax administrations to allocate taxable income between parties based on formulary-type apportionments.
When is a profit split most appropriate?
Transactional profit splits are most appropriate in cases of (i) highly integrated operations, and (ii) unique and valuable contributions by multiple parties.
Highly integrated operations
The use of a transactional profit split of actual profits is most appropriate in cases of high integration of activities performed by the parties, with greater sharing of uncertain outcomes resulting from the economically significant risks controlled by the parties. In contrast, the use of a transactional profit split of anticipated profit does not require the level of integration or risk sharing required for a transactional profit split of actual profits. Thus, a taxpayer that wishes to use the transactional profit method ex ante in order to share the risks associated with the use of intangibles may be able to share the risk through the use of the transactional profit split method even though the transaction would not otherwise warrant the sharing of profits because of the lack of high integration.
The discussion draft includes a paragraph discussing the concept of 'integration of activities' within an MNE, distinguishing between 'sequential' and 'parallel' integration. In the former case, parties sequentially perform discrete functions in the integrated value chain. The discussion draft suggests that it often will be the case that reliable comparables exist for each stage or element in the value chain. An example of sequential valuation is a distributor's use of a trademark or trade name or a manufacturer's use of design and process technology developed by the licensor. The suggestion that in sequential integration of a value chain it is often possible to reliably benchmark the sequential activities would suggest in a DEMPE analysis, in which the exploitation functions sequentially follows development functions that a profit split of actual profits may not be reliable as long as the exploitation function can be benchmarked. This interpretation would leave valuation methods as the only suggested method to price intangible returns if no reliable comparable uncontrolled price (CUP) exists. It is unclear whether Chapter VI, as currently drafted, concurs with that view.
In parallel integration, multiple parties to the transaction are involved at the same stage of the value chain in contributing assets or sharing functions; it is therefore more likely that an accurate delineation of the transaction will determine that each party shares economically important risks, and a transactional profit split may thus be appropriate. An example of parallel integration is when two parties separately develop an important component or share the development, enhancement, or maintenance of the intangibles.
Although the distinction between sequential and parallel integration may be valid as a theoretical matter, it is unclear how useful the current guidance is as a practical matter. For example, taxpayers and tax administrations seeking to apply the guidance and determine in a specific transaction whether there is sufficient 'parallel' integration of activities to justify the use of a transactional profit split may end up at both ends of the spectrum – resulting in taxpayers benchmarking activities and tax administrations applying a transactional profit split, or vice versa. Additional examples may help to illustrate when the 'sufficient integration' bar is crossed to justify the use of transactional profit splits.
Unique and valuable contributions
Another situation in which a transactional profit split may be the most appropriate method is when multiple parties make unique and valuable contributions. 'Unique and valuable' is defined as cases in which (i) the contributions are not comparable to contributions made by uncontrolled parties in comparable circumstances, and (ii) the use of the contributions in business operations represents a key source of actual or potential economic benefits. As a practical matter, such situations are likely to involve intangibles in which each party controls the development risks of their unique and valuable contributions and share in the combined profits resulting from their contributions per Chapter I. An example of such a situation may be where one entity has developed the technology platform and the other entity has developed the trademark, trade name, and other marketing intangibles. In such a case, even though the activities may be sequential, the transactional profit split method may be the most appropriate method because of the inability to benchmark each party's contribution.
Profit to split, profit split key, and delineation of transaction
The discussion draft does not provide many details as to how a transactional profit split of actual or anticipated profits should be performed. However, some general principles are laid out, most of which highlight how the accurate delineation of the transaction that reflects the functions performed, assets used, and risks assumed is essential to applying an arm's-length transactional profit split.
The discussion draft suggests that profits can be split by using a contribution analysis or a variation, the residual profit split analysis. The contribution analysis splits the combined profits on the basis of comparable data or the relative value of functions performed by each of the parties, taking into account the assets used and risks assumed. The residual profit split analysis is similar to the contribution analysis, except that in the residual profit split analysis the combined profits are first reduced by the functional routine returns of the parties.
The discussion draft provides guidance on the determination of the profits to be split. The first step is to determine the combined profits to be split for the transaction under review. For companies with multiple product lines and products, this step is likely to require significant segmentation of financial data. The financial data to be used will need to be expressed under a common accounting method and currency. The guidance cautions that: "Experience suggests that that this initial stage in performing the profit split can in some circumstances be extremely complex." Some may view this statement as an understatement for companies with complex or multitier value chains.
The guidance notes that the measure of profits used as the basis for the profit split will depend on the nature of the integrated operations and the sharing of risks they share, as determined by the accurate delineation of the transaction. Sharing of gross profit margins would be appropriate when the parties share market risks, which affects volume and prices, as well as risks associated with producing or acquiring goods and services, including intangible development. Sharing operating margin would be appropriate if the parties share the risks of the entire value chain, including level of operating expenses. Thus, sharing gross margins would be expected to involve less integration and risk sharing by the parties than splitting operating margins.
The guidance notes that the determination of an appropriate profit-splitting factor should be based on objective data, such as sales to third parties, verifiable and supported by comparable data, internal data, or both. The profit split factors should reflect the key value drivers in relation to the transaction. Depending on the key value drivers, asset-based factors or cost-based factors may be appropriate. If cost-based factors are used, it may be necessary to risk-weight the cost factors and adjust the factors for a time value of money component. Importantly, the guidance suggests that if costs are used, costs may have to be adjusted for cost of living differentials and location savings. Although the discussion draft seems to suggest that multiple factors could be weighed into one profit-splitting key, such weighing cannot be subjective and must be verifiable by tax administrations. This requirement is likely to make it difficult to use multiple weighed factors as a practical matter, because finding objective and verifiable data to derive the weights will be challenging in most cases.
The latest discussion draft on the transactional profit split method is a significant improvement on the prior discussion draft. The latest discussion draft makes it clear that the transactional profit split method is not a default method in valuing intangibles, and that the arm's-length standard will be the guiding principle in the application of the method rather than what appeared to be a formulary apportionment approach in the prior discussion draft. In the next release, which is not expected before the second half of 2017, it is hoped the WP6 will provide additional clarification in a number of areas, including better coordination with Chapter VI's valuation guidance on intangibles. However, fundamentally the guidance in the discussion draft provides a reasonable foundation on which the OECD member states can build upon in the next release to apply the transactional profit split method in accordance with the arm's-length standard.
Chicago, United States
Alan Shapiro is a senior adviser to Deloitte Tohmatsu Tax Co. He works with the organisation's largest multinational companies. For the past two years he has worked with the global Deloitte team following the OECD/G20 BEPS process and in that role has assisted multinational companies responding to the changing tax environment. Alan's industry experience includes the hi-tech, software, automotive, pharmaceuticals, electronic components, and consumer products sectors.
Alan was selected for inclusion in the 2002-2013 editions of the Guide to the World's Leading Transfer Pricing Advisers and in the 2003-2012 editions of the Guide to the World's Leading Tax Advisers. He is widely quoted on transfer pricing topics in BNA's Daily Tax Report and Transfer Pricing Report, he has spoken at numerous forums, including the American Bar Association and International Fiscal Association.
Alan has co-authored the soon to be released update of the Cost Sharing Chapter of BNA Portfolio #890 and has authored or co-authored numerous articles on transfer pricing subjects including: OECD Discussion Draft on Intangibles, 66 Tax Notes International 13 (June 25, 2012), among many others.
Alan holds an LLM in tax and a juris doctorate from Georgetown University Law School, a masters in economics and a bachelors of science in business administration from Boston University. He is a member of the legal bar in the US states of Pennsylvania and Georgia and is a US Certified Public Accountant.
Tax managing partner
Eunice Kuo, a tax partner of Deloitte China, is the tax managing partner of eastern region and the national leader for cross-border tax and transfer pricing services.
Eunice has 30 years' experience of providing business structuring and transfer pricing services, having worked on the preparation of transfer pricing reports, planning for cross-border transfer pricing risks on the association between enterprises, assisting enterprises to negotiate transfer pricing agreements and tax adjustments, and providing tax planning for process architecture of cross-border transactions.
Eunice has actively participated in business model optimisation projects in China. The advisory services she has been involved in include the selection of principal company location, restructuring of transactional flow in China and across Asia-Pacific to eliminate tax inefficiency and to mitigate China tax risks, doing financial models to have detailed analysis of the pros and cons with business restructuring and assistance in implementation. Her clients in this area are mainly large MNCs and also include China-based companies.
Eunice is Taiwanese CPA as well as Chinese CPA. Eunice has been named the leading TP adviser every year by Euromoney. She was also named the best female TP adviser by the Legal Media Group for the Asia-Pacific region. Eunice recently has been named as the Best of the Best 2013-2015 & 2016-2018 in transfer pricing by International Tax Review.
Partner and lead economist
Anis Chakravarty is a partner and lead economist of Deloitte India. He brings significant experience in advising companies in the European Union, India and the United States on a number of issues related to economics, finance and transfer pricing.
He is currently recognised by Euromoney/Legal Media Group headquartered in London, as one of the world's leading transfer pricing advisers.
Anis specialises in financial services, intellectual property planning and tax-aligned supply chain implementation of cross-border structures. He has assisted with large cross-border due diligences and post-merger integration projects.
He advises on transfer pricing litigation and dispute resolution for both inbound and outbound companies and has assisted in negotiating APAs and MAP settlements involving complex transfer pricing issues including one of the largest cases in the country.
Anis has been the co-leader of Deloitte's Global Economists Network leading the intellectual property transfer pricing group in the Asia Pacific region. Anis is also a guest faculty at IBFD Asia Pacific lecturing on transfer pricing for business restructuring and supply chain issues.
He is a regularly contributor to the print and electronic media on various macroeconomic issues and trade policies. His technical views have been published in BNA's Transfer Pricing Report, Euromoney's annual Transfer Pricing Review, Bloomberg, and the Wall Street Journal amongst others.
In India, Anis is regularly quoted in The Economic Times, The Hindu, Mint, Business Standard and media channels on economic matters. He is a speaker at seminars on topics related to economics, transfer pricing and business and has appeared in various publications.
Before joining Deloitte India, Anis was based in Brussels, Belgium, advising European inbound as well as outbound clients tax and business matters.
He is a member of the governing Board of the Indo-Belgian-Luxembourg Chamber of Commerce and Industry.
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