Multinational taxpayers often find themselves in a situation where multiple related parties in different taxing jurisdictions make meaningful contributions to the creation of intellectual property or perform valuable functions that are interrelated with each other. A common example of this is where one party is primarily responsible for the creation of technology intangibles, while another entity is responsible for creating marketing-based intangibles, e.g., expansion into a new geographic territory. In such cases, traditional one-sided profit-based methods, such as the transactional net margin method or the comparable profits method under the U.S. transfer pricing regulations, are not appropriate methods for pricing the intercompany transactions. Moreover, comparable benchmark data to analyze these complex transactions rarely exists. As a result, profit split methods (PSM) often are the most appropriate methods to evaluate the arm’s-length nature of these transactions, as they are intended to reward the parties based on their respective value contributions.
While the U.S. transfer pricing regulations contain a great deal of guidance regarding the PSM, there still existed a fair amount of ambiguity regarding the application of the profit split method in non-U.S. tax jurisdictions. On June 21, 2018, the Organisation for Economic Co-Operation and Development (OECD) strived to provide additional clarity regarding the PSM with its release of the final Revised Guidance on the Application of the Transactional Profit Split Method. This guidance builds on and clarifies information contained in the discussion drafts issued on the subject in July 2016 and June 2017. The OECD document provides guidance in the following areas: i) the selection of the PSM as the most appropriate method; ii) general application of the PSM; iii) the profit to be split; and iv) splitting the profits.
Guidance Regarding the Selection of the PSM as the Most Appropriate Method
The revised guidance suggests the PSM may be the most appropriate method under the following circumstances:
- Each party makes unique and valuable contributions
- The business operations are highly integrated such that the contributions of the parties cannot be reliably evaluated in isolation from each other
- The parties share the assumption of economically significant risks, or separately assume closely related risks
The revised guidance also clarifies that a lack of comparables in itself is not reason enough to warrant the use of the PSM. Furthermore, if reliable comparables can be located, it is likely the PSM would be the most appropriate method.
Guidance Regarding the General Application of the PSM
The revised guidance indicates the taxpayer’s Masterfile may provide a meaningful source of information for the determination of appropriate profit splitting factors. The Masterfile is one of three elements of the OECD’s recommendations for transfer pricing documentation. The Masterfile contains global information about the multinational corporate group, including specific information on intangibles, financial activities and key value-driving activities.
Guidance Regarding the Profit to Be Split
The profits to be split should result from the intercompany transactions under review. As a result, a critical first step in the process is ascertaining the relevant income and expenses for each party to the transaction and specific to that transaction. In many cases, this first step may be extremely challenging, as the parties may have diverse activities that require their financial results to be bifurcated by business segment. Depending on the economic risk profile of the parties to the transaction, actual or anticipated profits may be more appropriate.
Guidance Regarding Splitting the Profits
The revised guidance recommends two commonly used methods for splitting profits:
- The use of a contribution analysis that divides the total profits based on the division of profits that would occur between unrelated parties
- A residual analysis that first assigns profits to the routine activities of each related party then allocates the residual combined profits based on the relative value of each party’s contribution to the residual profit
A number of different factors may be used to split profits between related parties. In all cases, the allocation of the profits should be based on a factor that approximates the division of value contribution by the parties to the transaction. Further, the profit split factor should be easily measurable, i.e., not subjective, and consistently employed during the period of the intercompany transaction. Commonly used factors include asset- or capital-based factors, such as operating assets, intangible assets and capital employed; cost-based factors, such as research and development and marketing spending; and other factors, such as incremental sales or employee compensation related to value-creating activities.
The revised guidance provides 16 examples regarding the application of the PSM.
While it may be challenging to implement, the PSM may provide an economically supportable method for pricing intercompany transactions involving complex value-creating parties. Contact Jason or your trusted BKD advisor for additional insight into the PSM or other transfer pricing matters.