BEPS Action 10 – discussion draft on profit splits in global value chains

Introduction

The Organisation for Economic Cooperation and Development (OECD) recently issued a discussion draft on the use of profit split methods in relation to transfer pricing and in the context of global value chains as part of the Base Erosion and Profit Shifting (BEPS) project.(1) This update provides an overview of and comments on the topics discussed in the discussion draft, as well as giving recommendations on further guidance expected and needed from the OECD.

The profit split method is generally used when transactions are so interrelated or unique that they cannot be evaluated on a stand alone basis using one-sided methods. The profit split method relies on the characterisation of functions, risks and assets according to which routine activities are distinguished from non-routine functions.

Due to the heterogeneous nature of multinational enterprises and the lack of comparability, the problem of allocating profits based on the arm’s-length principle has become more relevant. The objective of the discussion draft is to obtain views on how existing guidance may be amended so that transactional profit split methods can assure that transfer pricing outcomes are in line with value creation.

The main topics covered in the discussion draft are:
• the global value chain;
• the scope for the application of profit split methods; and
• aligning taxation with value creation.

Global value chain

In relation to the global value chain, the discussion draft acknowledges that the profit split method may be a better method for assessing such complex structures than one-sided transfer pricing methods. Scenario 1 of the discussion draft discusses a situation in which several manufacturing companies are involved in the production of durable goods. They are deemed to be interrelated due to the activities performed as well as the leadership board, which consists of managers from different legal entities who take decisions that ultimately drive the business forward.

The application of the profit split method in this scenario would involve identifying:
• the key intangible assets that generate the main profits;
• the senior management responsible for taking important decisions in relation to business activities; and
• the location where these decisions are taken.

In this respect, the costs incurred by the leadership board that takes strategic decisions would represent the relevant allocation factors to consider, together with the costs of the management involved in planning activities. Other allocation factors that may be considered are research and development costs and the production capacity, which reflects the capital invested by each manufacturing company.

In this context, further guidance should be provided to situations where, notwithstanding the differences between controlled and uncontrolled transactions, comparability may still be established. Further, a reasonable allocation formula may be beneficial to address situations where it is not possible to allocate costs, income and assets directly based on factual relationships and due to a lack of comparability.

Scenario 2 of the discussion draft examines the case of an internet service provider with subsidiaries located abroad. Considering the facts and circumstances of the case, a profit split method may not be needed at first. However, if the functions performed locally were unique and if a permanent establishment were found to exist, a profit split method may be more appropriate. Further guidance should be provided on how profits are to be split when subsidiaries are deemed digital permanent establishments.

Scope of application

The other area discussed in the discussion draft relates to the scope for the application of the profit split method. In this context, as per the 2014 report “Guidance on the transfer pricing aspects of intangibles”, contributions that constitute a “key source of competitive advantage for the business, and create difficulties in terms of finding reliable comparables” can be defined as unique and valuable.

In this respect, Scenario 3 analyses a situation in which a distributor is not seen as a low-risk legal entity, but rather a source of competitive advantage mainly derived from customer services and after sales activities, which entail developing close and long lasting relationships with customers. These are considered key functions of the business.

In general, high value-added activities/services incorporate know-how intangibles, which are reflected in the compensation of the individuals performing those functions. Therefore, in order to assess whether there is scope for the application of the profit split method, the level of interdependence/uniqueness of functions between group profitability and sales force know-how should be examined.

Aligning taxation

Aligning taxation with value creation is the ultimate focus of the BEPS project and in this regard the discussion draft illustrates considerations to develop profit allocation keys such that transfer pricing outcomes are aligned with value creation. The problem arises when the allocation factors used are not objectively perceived and therefore do not reflect what third parties would have agreed on.

In this context, any possible guidance should identify a (non-exhaustive) list of key factors divided per industry. This list should expressly be of a non-exhaustive nature so that the taxpayer can select allocation keys not listed therein if properly justified and that better fit the purpose.

Further, the discussion draft asks commentators to consider scenarios within the banking sector in which there are losses to be split instead of profits. A typical example of such a scenario is found in proprietary trading transactions where 75% of the total positive return is attributed to the risk taker (ie, the capital provider) and 25% to the human capital (ie, the trader).

In case of losses the split usually agreed is 100%/0% of the total negative return where 100% is allocated to the capital provider legal entity and no losses are allocated to the trader. This means that the latter will only suffer from not having been remunerated for the activity performed.

Further guidance should be provided on the weight given to the use of internal data (ie, information taken from a company’s management information system) in order to assess the contribution made by each party to the transaction.

Following the discussion draft, a public consultation was held in Paris between OECD delegates and business commentators to discuss the practical effects of the proposed revisions to the Transfer Pricing Guidelines together with the impact on documentation requirements. A final version that acknowledges the issues identified is now expected to be issued.