Discussion draft under BEPS Actions 8-10, profit split guidance

BEPS Actions 8-10, profit split guidance

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.

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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

Background

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. 

Discussion draft released 4 July 2016

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.

Overview of “profit splits” discussion draft

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.  

  • There is a greater sharing of uncertain risk outcomes under a split of actual profits, since risks that impact the combined profits of the business will also impact the actual profits for each respective party. Thus, the activities and associated risks of the parties should be highly integrated, and the parties sharing the actual profits should—either separately or collectively—control the economically significant risks and each have the financial capacity to assume its share of risk.
  • A split of anticipated profits can be used to determine pricing arrangements based on the relative contributions of each party to the anticipated profits of the enterprise, and is typically used in conjunction with a discounted cash flow valuation technique.
  • In either case—i.e., splitting of anticipated or actual profits—the method of calculating profits and the splitting factors must be determined ex ante based on known or foreseeably anticipated information at the outset of the transaction. 

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:  

  • When both parties to a transaction make unique and valuable contributions—i.e., contributions that (1) are not comparable to contributions made by uncontrolled parties in comparable circumstances, and (2) whose use in business operations represents a key source of actual or potential economic benefits. 
  • When a multinational entity’s business operations are highly integrated such that strategic risks are jointly managed and controlled by more than one party.  While “sequential” integration (e.g., when parties perform discrete functions in an integrated supply chain) may have more easily identifiable comparables for each element of the value chain, “parallel” integration (e.g., when multiple parties are involved in the same stage of a value chain) may exhibit more highly integrated operations among the parties that contribute to the determination of the transactional profit split method as the most appropriate method.   
  • The discussion draft notes that a lack of comparables alone is insufficient to warrant the use of a transactional profit split method. In cases when one party to the transaction bears limited risks, but reliable comparable data is scarce, it may still be more reliable to use the inexact comparables with adjustments than to use a profit split method.
  • Difficulties may arise in applying the transactional profit split method when data is difficult to access (e.g., if it must be gathered from foreign affiliates) or difficult to measure (e.g., separately identifying revenues, costs and profits arising from the transaction from the parties’ other activities). 

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:

  • The economically significant functions, assets and risks; which entities perform them; and how they may be interlinked.
  • The economic circumstances that create sustainable opportunities to capture excess profits (e.g., unique intangibles, first mover advantages, etc.); how and where the value is created; and whether the value is sustainable. 

Approaches for splitting profits: The discussion draft discusses two commonly used approaches to the transactional profit split method: 

  • A contribution analysis divides total profits between the parties based on the division of profits that would be expected between independent enterprises, and can be supported either with comparable data when available or based on the relative value of each party’s functions (considering their assets used and risks assumed). 
  • A residual analysis first assigns profits to the routine contributions of each party and then allocates the remaining combined profits between the parties based on the relative value of their contribution to the residual profit.   

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.  

Next steps

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.  

KPMG observation

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. 

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