Taxpayers should take action now to address the increased pressure on the transactional net margin method (TNMM), while the tax community awaits new OECD guidance on the application of the transactional profit split method

Rise of the profit split

Tax authorities are increasingly suggesting that the profit split method be applied to transactions that have historically been tested using one-sided methods. Although additional guidance by the OECD is expected next year, companies will need to analyze their global value chain and prepare robust transfer pricing documentation to mitigate possible audit risk.

State of play on the development of profit split guidance

One of the mandates of BEPS Action 10 is to clarify the application of transfer pricing methods, in particular profit splits, in the context of global value chains. Additionally, the final report on Action 1: Tax Challenges of the Digital Economy prescribes that additional work must be done to improve the guidance issued on the use of profit splits, taking into account the greater integration of business models as a result of an increasingly digitized economy.

On December 16, 2014, the OECD released a discussion draft on the use of profit splits in the context of global value chains. Following on from the subsequent public consultation, it emerged that additional guidance is needed on the application of the transactional profit split method and when it is appropriate to use this method.

On October 5, 2015, the OECD, as part of its final reports on Actions 8-10: Aligning Transfer Pricing Outcomes with Value Creation, issued a scoping note on the profit split guidance that is currently being developed. A discussion draft is expected to be released by the OECD at some point in 2016, with final guidance to be issued in the first half of 2017 although this timeline may be impacted by the discussions on some of the other key transfer pricing issues, including the discussion on intangibles. The key elements of the in-progress guidance concern the following:

  1. the selection of the most appropriate method;
  2. highly integrated business operations;
  3. unique and valuable contributions;
  4. synergistic benefits;
  5. profit splitting factors; and
  6. the use of the profit split method to determine the TNMM range, royalty rates and other payments.

Factors 2 through 4 mainly focus on the impact these factors may have on the selection of the most appropriate method, with factor 3 anticipated to have a more elevated role. In addition, factor 3 is expected to include further guidance on unique and valuable contributions, other than those in the form of intangibles. Moreover, such guidance is expected to focus on the element of risk and, in particular, the control over and the capacity to absorb risks, and the subsequent impact of integration on sharing these risks.

Implication for multinational companies

The OECD acknowledges that the profit split method should not become the default transfer pricing method. If profit sharing would be unlikely to represent an arm's length outcome, it states that imperfect comparables should be used rather than applying the profit split. Moreover, OECD representatives have stated that a lack of comparables should not necessarily lead to a profit split, while good comparables may support that the profit split method is not the most appropriate method.

Tax authorities, however, are increasingly scrutinizing the transfer prices applied by companies, especially those of companies with complex business models. Tax authorities may argue that the profit split method be applied to transactions for which taxpayers historically have relied on one-sided methods, such as the TNMM. This goes as far as suggesting that activities considered by the company as routine are, in fact, unique and valuable contributions. Especially when the routine nature of the activities of a subsidiary, when compared to activities performed by other entities in the group, has not been sufficiently documented, tax authorities may develop their own interpretation of how value is created in the group and propose the use of a profit split for transactions that the business internally considers routine.

Further, in an era of increased tax transparency, with more and more jurisdictions implementing country-by-country reporting requirements, the risk is that tax authorities are more inclined to apply the profit split method in part due to conclusions drawn from the limited overview of the value chain provided in the country-by-country file.

There are many practical issues in applying the profit split method, including the risk of double taxation if tax authorities do not apply the profit split method consistently. The current guidance on the use of profit splits is relatively limited and does not provide practical examples. This leaves taxpayers in uncertainty with respect to their transfer price policies and makes it difficult for tax authorities to evaluate the appropriateness thereof. Additional guidance on the application of the profit split is welcome and should provide more clarity on when it is appropriate to apply the transactional profit split method (and when it is not) and how to apply the method.

Actions to consider

For those multinationals where a significant part of their transfer pricing policy relies on the TNMM, in order to mitigate possible audit risk, companies should assess their value chain now to determine if the transfer pricing method applied is still considered the most appropriate method. This will require:

  • early assessment of the country-by-country report and potential patterns raised by the report;
  • a two-sided functional analysis (or multi-sided in the case of complex and integrated business models) to document the functions performed, assets used and risks assumed by all entities involved;
  • a thorough value chain analysis that takes into account the contributions of all group companies to the value creation;
  • a review of intercompany agreements to assess if the contractual allocation of risks is in line with the actual functions performed (and to ensure that the relevant business stakeholders are informed of the terms and conditions of the intercompany agreements);
  • considering a more granular approach on intercompany transactions that may be at risk of creating local intangibles, separating out certain functions from the more routine functions subject to the TNMM;
  • a detailed economic analysis to ensure that sufficient and adequate comparable companies are used to establish an arm's length range of results;
  • the preparation of robust transfer pricing documentation that provides a detailed functional analysis, value chain analysis and economic analysis, and which substantiates the appropriateness of the transfer pricing method applied;
  • canvassing industry or in-house information on commercial contracts akin to the intercompany relationship subject to review to further support the choice of method; and
  • tracking of local transfer pricing developments that may diverge or introduce guidance on methods and method selection ahead of the OECD guidance.