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International profit splits: rewarding value drivers

18 October 2016

A key objective of the OECD’s work on Base Erosion and Profit Shifting (BEPS) has been to increase consistency between the income and profit in a territory and its substance – the activities performed there and their role in the business’ value chain.

Where these value drivers are spread between entities and territories it becomes more likely that a ‘profit split’ will be the most appropriate method to use for transfer pricing purposes. There will not be a ‘simpler’ party to an intercompany transaction which can be tested and supported for transfer pricing purposes. With this in mind, the OECD is updating its guidance on profit split and in summer 2016 ran its second consultation on the subject. Aspects of BDO’s response to the consultation are summarised below.

The new consultation document provides draft guidance and raises associated questions on the application of profit splits. The guidance covers key areas such as the need to structure a profit split and associated allocation keys based on a robust analysis of the business’ value chain and substance, how a residual profit split might be applied once reward for more routine functions have been allocated, and the circumstances when a profit split might appropriately be used. These circumstances include where both parties have control over a business activity and share in its outcomes, as well as the possession of valuable or unique intangible property by both parties that is used in the business.

While consistent with the principles of the OECD’s Transfer Pricing Guidelines, this broadens the range of triggers that make the use of profit split appropriate, although it is clear that profit split is not an answer or last resort simply because comparable data may not available. BDO suggests that the OECD could go further and be more specific in this area, for example by extending the guidance to cover shared management activity, to provide clarity for businesses setting policy and tax authorities reviewing it.

The OECD discussion draft gives significant attention to two different types of profit split:

  1. Profit split based wholly on anticipated profits (ie forecasts) of a business stream or venture
  2. Profit split drawn from the actual profits of the business (by calculating the respective shares of reward based on the outturn).

The draft acknowledges that both of these types of profit split policy would be set at the time of the transaction based upon financial and other information available at that time. However, the practical application of the transactional profit split raises questions over  whether a distinction between a split of anticipated profits and actual profits is in fact helpful.

Our comments also raise other points which the OECD may wish to consider addressing to increase the effectiveness of the guidance including:

  • The types of activities whose functions, assets and risks might fall within the transactional profit split parameters
  • Whether the OECD’s use of royalties is a helpful illustration of a transactional profit split given that, amongst other things, royalties are typically set as a percentage of relevant sales, rather than a profit level which is affected by a cost base that the licensor cannot easily influence
  • The importance of residual profit split in practice and whether this may be emphasised more strongly
  • The level of guidance provided around the mechanism for splitting profit, including the most appropriate profit level at which a split may be made, for example, gross profit compared to operating profit
  • Numerical examples to illustrate the application of the profit split in various scenarios.

We expect there to be more developments as the guidance is finalised but the consultation document provides some important messages:

  • Profit split is expected to be used more frequently as a transfer pricing policy in future; the OECD is working to demystify its use as far as possible, and so businesses need to be open to its use
  • The OECD expects that policies will be set and supported at the time the related business model is put in place, with review and implementation in subsequent periods; information will need to be identified and retained at the same point to support this
  • A clear understanding of the value chain and where substance falls within the business is critical to a robust application of profit split and an effective transfer pricing policy.

If your business uses the profit split method as part of its transfer pricing policy, or if key value drivers to your business model include intangible property or a management team employed across group entities (which may necessitate the use of profit split as an appropriate transfer pricing methodology), then a review of your transfer pricing policy is recommended. This is a good opportunity to ensure that your policy is consistent with the developing approach to the use of profit split which is emerging from the OECD consultation, and that sufficient and effective support is in place as part of your transfer pricing documentation.

If you would like to discuss this or any transfer pricing issue please contact Anton Hume.

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