BEPS discussion draft: revised guidance on profit splits

Business World (09/12/2016; p. S1/4)

By Norman Paul A. Turingan

In 2015, the Organization for Economic Co-operation and Development (OECD) released its final reports on base erosion and profit shifting (BEPS). The reports addressed 15 focus areas, including “Aligning Transfer Pricing Outcome with Value Creation, Actions 8-10 — 2015 Final Reports,” issued on Oct. 5, 2015. BEPS Action Plans 8-10 provided discussions regarding, among others, the “Guidance on Applying Arm’s Length Principle” and “Scope of Work for Guidance on the Transactional Profit Split Method.” The discussions mentioned additional work to be conducted by the OECD to produce new guidance on the application of the transactional profit split method.

In this column, we will take a look at the discussion draft on the “Revised Guidance on Profit Splits” recently issued by the OECD pursuant to the report mentioned above.

There are five transfer pricing methods to apply the arm’s length principle: (1) the Comparable Uncontrolled Price (CUP) Method; (2) the Cost Plus Method; (3) the Resale Price Method: (4) the Profit Split Method (PSM); and (5) the Transactional Net Margin Method. Unlike the other four methods, the PSM is where the arm’s length standard is directly established for all the associated participants in the controlled transaction.

The PSM is applied by initially identifying the total combined profits earned by the affiliated parties engaging in the controlled transaction. The combined profits are then split among the affiliated parties on an economically valid basis that approximates how the division would be, had the parties been independent of each other.

The combining and splitting of profits may apply to either the anticipated profits or actual profits. In the case of anticipated profits, the projected earnings over an appropriate period by each associated enterprise for their participation in the controlled transactions are determined and combined. The specific contributions by each enterprise are then used to determine a pricing arrangement at the time of the implementation of the transaction that would appropriately reward each participant to the transaction.

On the other hand, for actual profits, the profits earned by each associated enterprise for each taxable period are combined and split based on their respective contributions. In both cases, the economically valid basis for splitting the profits, including the profit split factors and the manner of calculating the combined profits, must be determined ex ante on the basis of information known or reasonably foreseeable by the parties at the time the transactions were entered into.

A significant difference between the two approaches to the application of the PSM is that combining the actual profits of each associated enterprise requires a high level of integration of activities. A high degree of integration means that the way in which one party to the transaction performs functions, uses assets and assumes risks is interlinked with, and cannot reliably be evaluated in isolation from, the way in which another party to the transaction performs functions, uses assets and assumes risks.

Further, there is a greater sharing of uncertain outcomes resulting from risks associated with the transaction under the splitting of actual profits than in the case of anticipated profits. In the PSM of actual profits, since the profit (or loss) that will be split is the actual result of operations, this already reflects the effects of the various risks of the business operations. The risks shared would vary depending on which actual profit, whether gross or net, is split by the associated enterprises. In contrast, the use of the PSM involving anticipated profits could, as an example, produce an arrangement where the reward for the contribution of an enterprise is a specific percentage of the sales. The amount of payment will then adjust depending on whether the actual sales is higher or lower than what was anticipated.

Applying the PSM offers flexibility since it takes into account facts and circumstances that are specific to the associated enterprises in relation to controlled transactions that may even be absent had they been independent parties. Nevertheless, it would still operate as an arm’s length approach to the extent that it would reflect what independent parties would reasonably have done had they been in similar circumstances. Further, using the actual profits makes it less likely that either party to the controlled transaction will have an improbable profit result that does not appropriately reflect the value of its contribution. Such improbable results could happen when the contributions of only one party to the controlled transaction are evaluated and its profit is benchmarked.

On the flip side, the application of the PSM may prove difficult. Depending on the circumstances, relevant information necessary to properly apply the PSM may not be readily available. The way in which profits are split may require detailed analysis of revenues and expenditure. An example would be when a party to the transaction earns revenues from sources other than the controlled transaction. The revenues and expenses relating to the controlled transaction have to be isolated and used in applying the PSM.

Applying the PSM of actual profits reflects a relationship where the associated enterprises should share in the profits or losses resulting from the transaction as they undertake the same economically significant risks or separately assume risks that are closely related. The accurate delineation of the actual transaction will be important in determining whether the PSM of actual profits is potentially applicable. The lack of comparables alone is not enough reason to warrant the use of the PSM. If the accurate delineation of the transaction shows that one of the associated parties assumes only limited risk but there is no sufficient reliable comparable data, it is likely a better approach to make adjustments to inexact comparable data in order to arrive at an arm’s length outcome.

The OECD intends to hold a public consultation on the proposed guidance and aims to produce a final guidance in 2017. On the other hand, the Bureau of Internal Revenue has begun to include transfer pricing among the issues that it raises in tax investigations and, with expanding knowledge and experience in transfer pricing, could continue to do so moving forward.

This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.

Norman Paul A. Turingan is a Senior Director in SGV & Co.’s International Tax Services-Transfer Pricing Practice