The EU joint transfer pricing forum (JTPF), has released a report on the application of the profit-split method. The report is intended as the first part of a two-stage process, beginning with the clarification of certain concepts, while the second stage will explore simplification.
Under the first stage, the EU report aims to complement the OECD guidelines by clarifying situations when to use profit-split as the most appropriate transfer pricing method and how to split the profit, based on the revised OECD guidelines, as well as providing an inventory of potential splitting factors.
According to the JTPF report, each of the three conditions may by itself be sufficient to justify a profit split. To be unique and valuable, contributions must independently be unique — in that, no comparables are available — and potentially valuable. A unique and valuable contribution should represent a key source of actual or potential economic benefit in business operations. Within this concept the important factor is not whether a (potential) economic benefit is realized or not, but if the success of the contribution is key for the success of the business operations.
The report also emphasizes that a high level of integration entails more than the integration that multinational groups typically have. Use of a cross-border or cross-entity business unit structure does not, by itself, warrant use of a profit split. Further, JTPF reiterated that the lack of comparables alone is insufficient for determining that the PSM should be selected as the most appropriate method; in such cases a pragmatic approach needs to be taken such as broadening the search criteria, without compromising the quality of the comparables, by looking at independent enterprises.
With regard to the method of splitting the profit when using PSM, the report provides a nonexclusive list and brief overview of common allocation factors, with further detail on the advantages and disadvantages of each factor:
- People-based factors.
There are two kinds of split factors under this category, remuneration and head account of key employees. These splitting factors may be taken into consideration when the value creation is driven by the workforce and personnel knowledge and skills. In order to apply the factor, it is important: A: to map the employees; B: to describe the functions carried out by the employees and identify those related to DEMPE functions; C: calculate the remuneration/number of the key employees. These splitting factors tie in with the Significant People Functions concept of the OECD guidance on the attribution of profits to permanent establishments and link to functions performed and risk assumption. However, people-based factors are subjective and may be hard to verify in terms of selection of key employees.
- Sales/volume-based factors.
Turnover/revenue and volume of trades can be used to allocate the profit under these factors. The report mentions that these factors are objective if determined on the basis of uncontrolled transactions. On the other hand, these factors may not be a good indicator of value creation, as turnover and volume of trades are not necessarily aligned with DEMPE functions.
- Asset-based factors.
Under its report, the EU JTPF lays down four allocation keys, the value of key business assets, assets under management, royalty rates, and franchise agreement. All key allocations can be a solution to complicated cases involving intangibles, however, it may be difficult to find comparables or to find the value of the asset.
- Cost-based factors.
There are five key allocation factors under the cost-based factors – operating expenses, cost of goods sold, marketing costs, brand development expenses, and R&D costs. The cost-based splitting factors are often used in the joint performance of the value-creating activities. Nevertheless, the report emphasizes that these factors may not be a good indicator of value creation.
The report notes that although the PSM is not used very often currently, there is the possibility that the PSM may be applied more often in the future due to the emergence of new business models. In particular, the PSM may be used as a method for allocating profits in the digital economy where users make unique and valuable contributions to the creation of value in the business and the degree of integration is assumed to be high. In this respect, the paper suggests further collection of data and monitoring of the practical application of the PSM in order to evaluate whether the mechanism could be further clarified and to move onto the second stage of simplification.
The report was based on a survey of JTPF members, receiving 17 replies from member states and 11 from non-government members. The survey found no direct correlation between the method and any specific industry. It is applied in several sectors, albeit only to a limited extent, including financial, industrial equipment, automotive, IT, trade in consumer goods, pharmaceutical, chemical and food.
The JTPF report on PSM provides specific hallmarks to consider for selecting the PSM, and through number of examples, its application. Unlike the OECD guideline, the report also caters the clarification on to what extent the activity is highly integrated and the unique and valuable of contribution.
The examples on splitting the profits may seem simple in theory, but are complex in practice, and ultimately leave a lot of space open for interpretation. In line with the current experiences, the identification and measurement of appropriate profit split factors are likely to create the bigger headaches and be the most significant contentious point/audit risk for those deciding to adopt the PSM.
The drivers of value used to split the profits should reflect the contributions of the parties and are consistent with the value drivers reported elsewhere by the business, e.g., in the master file and local files. Further, it is advisable to check for consistency with any other public resource such as the annual report and accounts, and the company website.
As in future the use of PSM might increase, it is necessary to make thorough value chain analysis to streamline the value drivers across the value chain. Thus, it would be easier to decide which splitting factor could be used to split the profit.
** TPA Global serves international businesses with integrated and value-added solutions. To ensure the highest quality and seamless service provision, thereby meeting international standards and regulations, a global network of dedicated professionals and specialists is a key and determining factor.