The Organisation for Economic Cooperation and Development (OECD) earlier this week released a discussion draft concerning the use of “profit splits” in the context of global value chains as follow-up work in relation to Actions 8-10 of the base erosion and profit shifting (BEPS) project.
Read the discussion draft [PDF 330 KB] on profit splits concerning work in relation to BEPS Actions 8-10, Assure that transfer pricing outcomes are in line with value creation
In October 2014, the OECD released a discussion draft* under BEPS Action 10 that considered several key issues related to the application of the transactions profit split method, focusing on illustrative scenarios, and requested public comment.
*Discussion draft on the use of profit splits in the context of global value chains
The OECD then released the BEPS final reports in October 2015, including a report under BEPS Actions 8-10, Aligning transfer pricing outcomes with value creation, outlining follow-up work to be carried out on the transactional profits split method.
The discussion draft released this week addresses this follow-up work and proposes revised guidance on the application of the transactional profit split method as well as addresses several of the comments gathered on the prior discussion draft.
The July 2016 discussion draft considers revisions to be included in Chapter II of the OECD Transfer Pricing Guidelines and does not imply changes to the broader framework of accurately delineating the actual transaction discussed in revised Chapter I or evaluating intangibles discussed in revised Chapter VI.
The July 2016 discussion draft considers several key issues related to the application of transactional profit split methods; addresses certain comments provided on the prior discussion draft; and poses some questions for public discussion related to the issues and scenarios. Appropriate uses of the transactional profit splits are reiterated and the requirement to accurately delineate the actual transaction, through a functional analysis, is emphasized to determine if circumstances exist to support a profit splits as the most appropriate method.
The transactional profit split method can be applied by splitting actual profits or anticipated profits, and discussion about “profits” should be taken as applying equally to losses. The key issues considered in the 2016 discussion draft are as follows:
Splitting of actual versus anticipated profits: While the discussion draft focuses on the application of the transactional split of actual profits, it outlines considerations for the splitting of anticipated and actual profits.
Appropriate scope for the application of transactional profit split methods: The discussion draft provides strengths and weaknesses of the transactional profit split method and discusses circumstances when profit split methods are likely to be the most appropriate for determining arm’s length pricing:
Application of a value chain analysis to accurately delineate the transaction: It is not enough for a value chain analysis to show value creation in multiple places to warrant, in itself, application of the transactional profit split method. However, the value chain analysis may indicate features of the transaction that indicate the transactional profit split method may be the most appropriate method. A value chain analysis should consider:
Approaches for splitting profits: The discussion draft discusses two commonly used approaches to the transactional profit split method:
Measures of profits: The specific measure of profits (e.g., gross profits or operating profits) depends on the accurate delineation of the transaction. The discussion draft provides examples when the split of operating profits may be appropriate (e.g., when the parties have integrated or joint functions and share risks relating to the entire value chain), and when the split of gross profits may be appropriate (e.g., when the parties share market risks and production intangibles to create an integrated product but whose selling and marketing are largely unrelated).
Profit splitting factors: Asset/capital-based factors (e.g., operating assets, intangibles, capital employed, etc.), cost-based factors (e.g., R&D spend, marketing spend, etc.), or other factors (e.g., incremental sales, headcount, etc.) may be used to capture the relative contributions of the parties. The discussion draft notes that cost-based factors need to consider several issues—such as differences in timing of the expenditures by each party, differences in accounting classification of costs, differences in riskiness of the costs, and allocations required to segment costs related only to the specific transaction and location savings.
The discussion draft includes questions intended to elicit responses from the public on each of the issues discussed.
The OECD invites public comments on the discussion draft, to be submitted by 5 September 2016. A public consultation on the discussion draft and other matters will be held in Paris on 11-12 October 2016.
The discussion draft provides guidance on when a profit split method might be most appropriate and on its application. The discussion draft discusses both strengths and weaknesses of the profit split method, and also adds some discussion of situations when a profit split approach might not be most appropriate. The OECD, thus, has tried to address concerns expressed by commentators on the first discussion draft on potential overuse of profit splits.
The structure of the discussion draft follows fairly closely the scope of the guidance on profit splits as set out in the final report under BEPS Actions 8-10. The first discussion draft relied heavily on examples or scenarios to make its points, whereas this week’s discussion draft contains almost no examples. There is also a new discussion on two broad ways of splitting profits—splitting actual profits or splitting anticipated profits. The discussion draft emphasizes the role of risk-sharing or the integration of risks between related parties as an important factor in the determination of whether a profit split is appropriate, thus tying the discussion back to the guidance on risk in Chapter I.