RBRT Comments on the PSM Use in the Context of Global Value Chains (BEPS Action 10)

By Robert Robillard - 16 February 2015

This blogpost originally appeared on rbrt.ca.

The OECD recently released the Public comments received on the discussion draft on the use of profit splits in the context of global value chains (BEPS Action 10).

The opinions expressed in this document are those of the author.

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Comments on the Public Discussion Draft BEPS Action 10: Discussion Draft on the Use of Profit Splits in the Context of Global Value Chains

February 5, 2015

Mr. Andrew Hickman, Head of Transfer Pricing Unit,
OECD, Centre for Tax Policy and Administration
By email: TransferPricing@oecd.org

We are pleased to comment on the public discussion draft BEPS Action 10: Discussion Draft on the Use of Profit Splits in the Context of Global Value Chains (the draft) through the consultation taking place from December 16, 2014 to February 6, 2015.

This document may be posted on the OECD website. Full credit goes to Robert Robillard, RBRT Inc. [1]

1. Scenario #1 (alleged value chain)

1.1. The controlled transactions between the OEMs are the less controversial part of this transfer pricing arrangement.

1.2. If some sort of PSM is to be used in this scenario, why would it be solely on a residual basis for the “interdependent” OEMs?

1.3. Pooling of entrepreneurial functions can easily be disposed of with former chapter VII of the guidelines (whether it is with a direct or indirect approach). [2]

1.4. Having worked with these types of settings before, we must say that this scenario misses the original intended use of the residual PSM.

1.5. Unless partial formulary apportionment was in fact envisioned for these “interdependent” OEMs, the suggested PSM is not relevant in this case.

1.6. The PSM may be relevant to the whole MNE group provided that there is some transfer pricing controversy dealing with the IP licensing or the other transactions. That is, the PSM may apply to the global value chain. [3]

2. Scenario #2 (alleged multisided business models)

2.1. This scenario is far from hypothetical. Question #6 raises discomfort for comments in this format and place.

2.2. As for question #5, it indirectly puts forward the key issue of the geographic location of sales for transfer pricing purposes. [4]

2.3. On the one hand, this is a case were Chapter VII of the guidelines may again find application (with an indirect approach) provided that the alleged involvement of the subsidiaries amounts to more than simply incidental contacts between the subsidiaries and Company R.

2.4. In other words, “regular interaction” has its ways of transmuting itself into occasional phone calls or conference calls from our past professional experience.

2.5. Cutting to the chase, we have repeatedly observed, from both sides of the fence (that is, as a public servant and private practitioner), claims of “market customization” which should have given birth to so-call “marketing intangibles” that were indeed lightly documented by facts.

2.6. Based on the fact of the case, the “interaction” between the local subsidiaries and the Company R does not warrant the use of a PSM.

2.7. On the other hand, if the case was about the development of technology (that is, of IP), the PSM might have had some applications.

2.8. But we do not see the relevance of the PSM in this scenario where the subsidiaries are, at best, helping in maintaining/updating the technology through what are likely incidental contacts with the IP owner. More qualitative and quantitative data would be required to warrant an alternative opinion on the case.

2.9. Obviously from a tax administration perspective, the PSM may indeed become relevant to the whole MNE group, provided that there is some transfer pricing controversy dealing with the development of the technology. [5]

2.10. But in that latter case, the PSM would likely act as an indirect form of imposed re-characterization of the transaction by the tax administration.

2.11. That is to say, that a given tax administration would be looking to re-characterize the risk-profiles of some or all the subsidiaries in their relationship with Company R by ultimately allocating returns unwarranted by the FRA profile (functions, risks, assets) of said subsidiaries.

3. Scenario #3 (alleged unique and valuable contributions)

3.1. Scenario #3 highlights one of the traditional transfer pricing cases where the tax administration of country S will vouch for the use of the PSM, at least on a residual basis, to give “access” to its taxpayers (Company S) to a bigger share of the pie (that is, to increase its own national tax base). [6]

3.2. The use of the PSM in this scenario would be an indirect way of imposing re-characterization of the transaction (risk-profile modifications) by the tax administration of country S.

3.3. As a side note, it is noteworthy that even the humble paper clip salesman will cherish his customer relationships. More complex products or services will indeed require more nurturing, but a sales process is still a sales process notwithstanding its ever-increasing complexity (which shall be reflected in the price of the product or the service, as a matter of fact, or in the accompanying service contracts, as applicable).

3.4. In this case, the “best method” is clearly a one-sided method to be applied to the distributor.

3.5. It could be the TNMM or the Resale price method, as the case may be (with the arm’s length sales as the obvious base).

3.6. There is little doubt that appropriate external comparables may be found by applying the guidance found in Chapter III of the guideline. We have also seen many cases where internal comparables were readily available.

3.7. The notion of “unique and valuable intangibles” for the respective parties has no practical application in this particular case.

4. Scenario #4 (actual integration and sharing of risks)

4.1. This is a typical case where the PSM may indeed apply to Company A, B and C in which case the arm’s length costs disbursed by each company (contribution analysis) may provide a worthy transfer pricing method to share the arm’s length revenues initially received by Company A.

4.2. However, the alternative course of action where Company A would compensate Company B and Company C for the services rendered would not in any fashion infringe the arm’s length principle.

4.3. In the end, it is about the actual and ultimate FRA profile (functions, risks, assets) of the parties involved. Since Company A is the sole distributor in the front office, it would not intrude with a proper application of the arm’s length principle if it acted as the “principal” in this transfer pricing arrangement.

4.4. The latter sub-scenario would however necessitate external comparables whereas the PSM would not. From that point of view, the application of the PSM to this type of cases is the enactment of pure global formulary apportionment (for the parties involved, that is) in spite of the fact that the OECD claims otherwise.
4.5. From a tax administration perspective, this is a case where the application of both transfer pricing methods should indeed be expected to produce similar results, on condition that the comparability analysis has been properly performed.

5. Fragmentation

5.1. The analysis of transfer pricing cases where there is “fragmentation of functions” has to be distinguished from the analysis of a “global value chain”.

5.2. The above-mentioned scenario #4 represents a global value chain transfer pricing case.

5.3. “Fragmentation of functions” falls within the scope of Chapter VII of the guidelines.

5.4. “Fragmentation of functions” rarely pertains to the analysis of a global value chain: fragmentation is usually about cost centers instead of profit centers in the MNE group.

5.5. Paragraph 27 of the draft is simply without basis with respect to new Chapter VII of the guidelines. [7] See in particular paragraph Part D of the draft which is about cost centers (that is, “low value-adding intra-group services”).

5.6. In this specific context, the PSM has no relevance to transfer pricing cases where there is “fragmentation of functions” (unlike scenario #4 with respect to global value chain).

6. Scenario #5 (alleged lack of comparables)

6.1. For questions #17-19, see our above comments on scenario #3.

6.2. With respect to question #20, the approach described in the last sentence of paragraph 32 is highly debatable, to say the least, as it seems to suggest a formulary approach to arbitrarily select the point in the arm’s length range.
6.3. To select a precise point in the arm’s length range, see paragraph 3.59 of the OECD guidelines as a starting point:

“Where the application of the most appropriate method (or, in relevant circumstances, of more than one method, see paragraph 2.11), produces a range of figures, a substantial deviation among points in that range may indicate that the data used in establishing some of the points may not be as reliable as the data used to establish the other points in the range or that the deviation may result from features of the comparable data that require adjustments. In such cases, further analysis of those points may be necessary to evaluate their suitability for inclusion in any arm’s length range.”

6.4. Or should we infer from the OECD proposal in paragraph 32 of the draft that §1.482-1(e)(2)(iii)(B) of the Code of Federal Regulations of the United States is now the official position of the OECD member countries? [8]

6.5. As for question #21, the PSM has no relevance if the best method rule is indeed applicable. If guidance is developed on that matter, it will clearly indicate that compliance costs for taxpayers are soon to increase, once again.

6.6. An increase of tax disputes and litigations shall also be expected both between taxpayers and tax administrations and among tax administrations.

7. Aligning taxation with value creation

7.1. Contrary to the BEPS flawed assertions, taxation is already properly aligned with value creation.

7.2. It is the geographical location of that value creation that causes tax distress among the OECD member countries.

7.3. BEPS is, and always will be, about a direct attack from the industrialized countries on developing countries and countries where the tax mix is not heavily dependent on corporate taxation.

7.4. If the real intent was to achieve the alignment of taxation with its ultimate value creator, corporate income taxation would be repealed. [9]

7.5. Corporate entities are creatures of the legal and commercial minds. They do not support the burden of taxes. Flesh and blood shareholders do. In taxation theory, this is economics 101.

7.6. Paragraphs 33-37 are putting forward the seeds of a global formulary apportionment approach disguised in a PSM format.

7.7. See paragraph 1.32 of the guidelines on that matter. Perhaps an update of that position may now be required.

7.8. There is considerable evidence in the literature that “factor weighting” is a losing proposition in global formulary apportionment methods.

7.9. It will suffer the same faith for the application of the PSM.

7.10. As “guidance” is developed and implemented unilaterally by tax administration, an increase of tax disputes and litigations shall be expected both between taxpayers and tax administrations and among tax administrations.

8. Scenario #6

8.1. Both from a taxpayer and a tax administration perspective, the fact that risks and assets would be overlooked in any given transfer pricing case is simply absurd.

8.2. In the end, scenario #6 can be expressed as follows: headcounts in Company A and Company B drive the allocation of the “total system profit” (that is, the consolidated profit just like in formulary apportionment) between both companies (which is a sham of a thorough contribution analysis).

8.3. This is disconcerting to put it mildly.

8.4. That approach goes against the most basic economic theory available where technology, if nothing else, plays a key-role to explain value.

8.5. Question #24 and #25 both relate to the design of squeaky clean global formulary apportionment methods where headcount is the sole apportioning factor.

8.6. This has nothing to do with the application of the PSM based on the facts and circumstances of a specific case. See Chapters I and II of the OECD Guidelines.

9. Hard-to-value intangibles

9.1. To answer question #26: none.

9.2. These cases are most likely the hardest cases to deal with since they may never give birth to any actual revenue stream.

9.3. It all depends on the facts and circumstances of the case.

9.4. If there is a type of case where one-size-fit-all should be unacceptable, this may just be it, even though the OECD keeps drifting toward the formulary apportionment philosophy.

10. Scenario #7 (Dealing with ex ante / ex post results)

10.1. Scenario #7 seems fairly self-explanatory.

10.2. Unanticipated results are part of the arm’s length picture.

10.3. Again, as “guidance” is developed and implemented unilaterally by tax administrations, an increase of tax disputes and litigations shall be expected both between taxpayers and tax administrations and among tax administrations.

11. Scenario #8 (Dealing with ex ante / ex post results)

11.1. Obviously in scenario #8, the PSM is an appropriate transfer pricing method. [10]

11.2. However, we note that by design in this scenario Company S ends up with 100 % of the risks with respect to “ex post results” (whether it is an increased burden of the royalty on its financial results or in a lower royalty rate in case of higher profits).

11.3. It would seem, smoothly going along with this “scenario”, that Company P should bear 80 % of the “consequence” of the ex post results for consistency of the PSM.

11.4. It is not so much about “unanticipated event” than basic and intelligible implementation of the PSM based on the facts and circumstances of the case.

11.5. After all, if the comparability analysis, mainly the FRA (functions, risks, assets) profile, indicated that Company P was entitled to 80 % of the profit, this is exactly what it should have ended up with. Otherwise the FRA profile would have been tainted by the ex post results.

11.6. From a tax administration perspective, a year-end adjustment may indeed be warranted in this type of scenario. This would not contravene the proper application of the arm’s length principle. Business contracts regularly include various adjustment clauses, ex ante that is.

12. Scenario #9 (dealing with losses)

12.1. We have had the opportunity to examine such models in our practice.

12.2. In our opinion, there is no circumstance where it might it be appropriate under the arm’s length principle to vary the application of splitting factors depending on whether there is a combined profit or a combined loss.

12.3. Question #30 relates to the “risk-return trade-off curse”.

12.4. As stated elsewhere [11], we are of the opinion that this notion has strictly no relevance to the determination of an arm’s length price.

12.5. It is a bottom-line driven notion that has considerably contaminated the transfer pricing comparability analysis in the last 20 years.

12.6. Paragraphs 41-42 of the Public Discussion Draft BEPS Actions 8, 9 and 10: Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines (Including Risk, Recharacterisation, and Special Measures) provide a good framework to analyze risks in transfer pricing.

13. Conclusion

13.1. Profit split methods can and should play a role in modern transfer pricing, that is, based on the arm’s length principle.

13.2. Notwithstanding every introductory remark included in this OECD document, we must nonetheless conclude that the PSM is now getting pushed for what it was not designed to be.

13.3. One of the misconceptions is that two-sided methods shall enable the resolution of the ills and wrongs associated with one-sided methods. Tax administrations may be in for some surprises.

13.4. As the PSM is pushed and “guidance” is developed and implemented, unilaterally by tax administration, an increase of tax disputes and litigations shall be expected both between taxpayers and tax administrations and among tax administrations.

13.5. In the end, the PSM is only relevant where the comparability analysis demonstrates that the FRA (functions, risks, assets) profile of the parties is indeed highly integrated. See paragraph 2.109 of the guidelines.

13.6. It is disconcerting to see that the PSM may now be loosely considered for basically any transfer pricing type of case.

13.7. This philosophical approach with respect to the use, misuse and likely abuse of the PSM is indeed what global formulary apportionment is about.

13.8. Global formulary apportionment eliminates the relevance of a thorough comparability analysis from which follows the proper application of a transfer pricing method.

13.9. Instead, global formulary apportionment requires the inclusion of headcounts (as explicitly seen above) and other variables in a formula to allocate the consolidated profit. It is a cheap imitation of the detailed and systematic contribution analysis as envisioned for the proper application of the PSM.

13.10. Surprisingly, this OECD document has significantly drifted toward that approach.

13.11. This will not make the arm’s length principle “work harder”, quite the contrary. We clearly are at the gates of global formulary apportionment.

Robert Robillard, CPA, CGA, MBA, M.Sc. Economics
514-742-8086
robertrobillard@rbrt.ca

February 5, 2015

[1] Robert Robillard, CPA, CGA, MBA, M.Sc. Economics, is Senior Partner at RBRT Inc. He also teaches tax at Université du Québec à Montréal; 514-742-8086; robertrobillard@rbrt.ca. Robert is the former Transfer Pricing Chief Economist at RBRT Transfer Pricing (RBRT Inc.) and a former Competent Authority Economist and Audit Case Manager at the Canada Revenue Agency. The opinions expressed in this document are those of the author.

[2] We will however assume that they are not meant to be low value-adding intra-group services as would probably be suggested by some tax administrations…

[3] Both a straightforward PSM and a residual PSM could find application to the global value chain.

[4] The apparent intricacies of this case do not make it much more different than other numerous cases that we have had the opportunity to work on in the past in various industries. None of these cases were resolved through a PSM.

[5] Again, both a straightforward PSM and a residual PSM may hence find application. This is a BEPS public consultation draft after all, so we shall play along…

[6] Having seen this typical case numerous times, only in one instance did it ended up with a PSM. The taxpayer was afflicted by “transfer pricing audit fatigue”, having been the constant interest of the tax administration for over ten years. For the record, it should be duly noted that the facts of the case did not warrant the use of the PSM.

[7] See the OECD Public Discussion Draft BEPS Action 10: BEPS Action 10: Proposed Modifications To Chapter VII of The Transfer Pricing Guidelines Relating To Low Value-Adding Intra-Group Services, November 3, 2014 to January 14, 2015.

[8] §1.482-1(e)(2)(iii)(B) states : “[…] The reliability of the analysis is increased when statistical methods are used to establish a range of results in which the limits of the range will be determined such that there is a 75 percent probability of a result falling above the lower end of the range and a 75 percent probability of a result falling below the upper end of the range. The interquartile range ordinarily provides an acceptable measure of this range; however a different statistical method may be applied if it provides a more reliable measure.” [we underline] [9] To be clear, we suggest that corporate entities should be transparent for taxation purposes. The tax burden would ultimately fall on the individual shareholders of any corporate group or structure, that is, the “flesh and blood” individuals, a highly desirable result to start with for tax efficiency purposes.

[10] We have seen and applied the PSM for royalty purpose in the past.

[11] Robert Robillard, Comments on the Public Discussion Draft BEPS Actions 8, 9 and 10: Discussion Draft on Revisions to Chapter I of the Transfer Pricing Guidelines (Including Risk, Recharacterisation, and Special Measures), February 3, 2015.

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Robert Robillard, Ph.D., CPA, CGA, Adm.A., MBA, M.Sc. Econ., M.A.P.
Senior Partner, RBRT Inc.
514-742-8086; robertrobillard “at” rbrt.ca
www.rbrt.ca

The convergence of RBRT’s tax, accounting and economics expertise makes a difference. The information in this blog post is general information only. Data and information come from sources believed to be reliable but complete accuracy cannot be guaranteed. RBRT Inc. or the author are not responsible or liable for any error, omission or inaccuracy in such information. The opinions expressed in this blogpost are those of the author. Readers should seek advice and counsel from RBRT Inc. as required.