In June 2018 the OECD published its final "Revised Guidance on the Application of the Transactional Profit Split Method" (ie Revised Guidance) to provide more clarity around the practical application of the profit split method. Work on the revised guidance was initiated as part of the OECD Base Erosion and Profit Shifting (BEPS) Action Plan, but consensus on the guideline has proven to be difficult to achieve.
Included in the Revised Guidance are 14 examples that cover multiple sectors such as trading, pharmaceuticals, and consumer products, among others. While the examples are helpful in providing further context around the practical application of the method, they leave some key areas open for further interpretation and consideration. In this short insight, we discuss some of the key practical implications that may arise in applying the Revised Guidance to global trading activities as they are areas that likely require further discussions with tax authorities. Businesses in the banking, mining, energy and agricultural sector where trading are core activities in the supply chain need to pay particular attention to these areas.
Employee compensation as a profit split factor
Consistent with the global trading guidance for permanent establishments in the 2010 OECD "Report on the Attribution of Profits to Permanent Establishments", the Revised Guidance points to employee compensation as an appropriate profit splitting factor for trading profits. The basis for this is that the performance of trading personnel, particularly traders, risk managers, specialised marketers, the so-called "front office" high-value functions, is critical to the profitability of global trading and, as a result, compensation of these functions is generally related to performance and value add.
The practical application of compensation as a profit splitting factor raises two immediate issues:
- How to accurately define performance related compensation, and
- What adjustments are appropriate (if any)
Defining performance related compensation
Whether compensation is defined in a narrow or broad way can ultimately impact the relative weight of the profit splitting factors when applying the profit split method. As a result, it must be considered carefully in light of the Revised Guidance.
With no clear definition included in the Revised Guidance, taxpayers (and tax authorities) can take different views on what constitutes performance related compensation in the trading industry. Depending on the specific facts and circumstances, employee compensation for trading functions can include basic salary, performance bonuses, stock options, discretionary spend for travel and entertainment.
While using a broad definition of compensation is likely to provide a more holistic measure of the relative contribution of the trading personnel in relation to profits realised from their activities, any part of the compensation package which is unrelated to performance should be excluded to avoid overstating the relative contribution of certain employees / functions to profit generation.
Considering relevance of adjustments
Given that global trading is a multi-jurisdictional activity by nature, key front office personnel is often located in multiple countries. Depending on location, employee compensation may be impacted by certain market-specific characteristics. In these cases, some adjustments may be appropriate to ensure that the profit splitting factor (ie performance related compensation) uses the same baseline across the board. Potential adjustments that taxpayers may want to consider include accounting for differences in operating costs between various countries (eg labour costs, real estate costs, currency, etc) as well as differences in local market features (eg purchasing power, degree of competition in the market), or other factors that can and have a bearing on employee compensation.
Any adjustments should be properly documented and supported with robust fact-driven analysis, preferably by reference to external market data. The mere fact that trading personnel are located in different jurisdictions should not on its own automatically trigger adjustments of the selected profit splitting factor.
The application of the profit split method remains a challenging exercise for multinationals engaged in global trading. While the Revised Guidance proposes some practical solutions, particularly around the selection of employee compensation as an appropriate profit splitting factor, it does not address some of the nuances which have a bearing on the application of the method, such as the definition of compensation and the applicability of any adjustments (and the extent to which these should be considered).
Despite the references to compensation as an appropriate profit splitting factor for highly integrated trading activities, taxpayers should not automatically assume that employee compensation is the most appropriate profit splitting factor - the selection of the most appropriate transfer pricing method, and the appropriate application of that method, must always be determined on a case by case basis, through analysis of the specific facts and circumstances.
To support their transfer pricing policies, taxpayers engaged in global trading activities should continue to prepare evidence-based documentation that is aligned with internal performance metrics, as this can provide a solid foundation in discussions with tax authorities globally.