OECD recently finalized "Revised Guidance on the Application of the Transactional Profit Split Method - BEPS Action 10" in response to the mandate in the 2015 BEPS Action 10 report of the BEPS Action Plan. The Guidance has been formally incorporated into OECD Transfer Pricing Guidelines as a revised Section C of Part III, Chapter II.
This is the fourth paper the OECD has issued on the profit split method (PSM) in the past four years, highlighting the inherent difficulties in generating guidelines for this complex method. PSMs have been of particular interest to the OECD BEPS initiative. OECD is of the general opinion that one-sided methods such as the transactional net margin method are employed too frequently, and shield a tax authority from visibility of the financial results of counterparty, hampering their ability to combat perceived tax avoidance by way of transfer pricing.
Taxpayer comments on the earlier OECD drafts have focused on fear of tax authority over-reaching in their application of PSM, the administrative complexity associated with PSM, and the concern that overuse of PSM will lead to a quasi-formulary apportionment standard, weakening the arm's length standard that underlies OECD transfer pricing principles. The Guidance will likely continue the uncertainty for taxpayers as they develop and maintain their transfer pricing policies.
HIGHLIGHTS OF THE GUIDANCE
The Guidance maintains the basic premise that PSM should be applied where it is deemed the most appropriate method for analyzing the transaction. The Guidance clarifies and, significantly, expands the guidance available to help determine when that may be the case and how to apply the method. While the Guidance is not prescriptive, it includes sixteen examples to illustrate the principles. The Guidance describes that the transactional profit split method may be the most appropriate method in the presence of one or more of the following business indicators:
- 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 key strength of the transactional profit split method is that it offers a solution for situations where both parties make unique and valuable contributions. Contributions are considered unique if they are not comparable to contributions made by uncontrolled parties in comparable circumstances. Thus, no reliable comparables exist for the application of another method. If the contributions represent a key source of actual or potential economic benefits in the business operations, the allocation of profits based on the respective relative value of parties' contributions may be appropriate.
The Guidance lists several weaknesses of the PSM that affect the appropriateness of the method. Primarily that the method requires complex data analysis to create the integrated profit pool from all related parties in the transaction, including expense allocation, foreign exchange, accounting differences and data access. Additionally, since the PSM is generally less reliant on benchmarks, greater subjectivity on the many parameters that comprise a PSM is required. Interestingly, the Guidance acknowledges that the PSM is rarely used among independent parties operating at arm's length, but argues that the results, if not the method itself, are in fact arm's length.
Where reliable comparables are available, it is unlikely that the transactional profit split method will be the most appropriate method. Importantly, the lack of comparables, by itself, is insufficient to warrant the use of PSM. When applying the transactional split method pursuant to the Guidance, the reference to profits generally applies equally to losses.
The Guidance provides some insights on two critical issues in implementing a PSM: determining the profits to be split and the split factors. While transfer pricing is a transaction-specific analysis, the appropriate level of profit should include all bundled transactions. The combined level of profit of all entities participating in this broadly-defined transaction should be computed, requiring significant cost accounting analysis.
The profit split factors should be based on objective data, verifiable and supported by comparables or internal data. As guidance rather than regulation, the Guidance does not endorse specific profit split factors, but rather lists potential candidates as assets or capital invested, costs, especially costs in intangible-creating activities, and less frequently incremental sales, payroll or headcount.
The Guidance mentions that generally the relevant profits to be split are measured by operating profits, but a different measure of profits such as gross profits may also be appropriate. While the appropriate profit measurement may be different case by case, it should be selected in advance of applying the method and applied consistently over the life time of the arrangement.
The Guidance includes sixteen examples to demonstrate how the method might be applied in practice, six of which are new from the ones included in the 2017 discussion draft. These examples illustrates –
- how the provision of unique and valuable contributions can lead to the conclusion that the profit split method is the most appropriate
- when the profit split method may be the most appropriate in analyzing intercompany transactions for highly integrated business operations
- the considerations for splitting revenue or gross profits when parties assuming highly interdependent risks and bear the consequences of playing out of risks relating to their own operating costs
- numerical examples of the application of the residual profit approach including principles connected to choosing a profit measurement
- the importance of accurately delineating the transactions to be covered by the profit split, including the identification of any separate transactions for which a one-sided transfer pricing method would likely be more appropriate than a profit split
- when to perform the profit split based on anticipated profits or actual profits
- how one may apply the principles related to profit splitting factors such as asset-based factors or cost-based factors
Tax authorities have shown an increasing interest in using PSM in their attempt to align transfer pricing outcomes with value creation. This Guidance, along with other components of the BEPS initiative such as country by country reporting, will likely increase the use of PSMs in tax audits and APAs. While we recognize the difficulty in developing generally acceptable guidelines for PSM, the Guidance suffers from many of the drawbacks in the previous drafts. The PSM is less reliant on external data and comparables, and requires a greater focus on subjective characterizations and internal data. Transfer pricing method selection, the determination of the relevant profits to be split and the appropriate split factors are highly dependent on facts and circumstances. This makes the application of PSM both difficult and risky, and will likely put tax authorities at odds with taxpayers current transfer pricing methodology.
Learn more about this development by contacting any of the following:
Sirathorn B.J. Dechsakulthorn
Jessica W. Tien