The EU Joint Transfer Pricing Forum (JTPF) assists and advises the European Commission on transfer pricing tax matters. Recently, it issued a report on the application of the profit-split method (PSM) within the EU. 1 The report clarifies key concepts and elaborates under which conditions the method is to be used and how to split the profit.
Being complementary to, and supportive of, the OECD guidance, the report expands on two important parts: (i) justification in applying PSM; and (ii) the allocation keys that can be used to split the profit ("splitting factors"). The report addresses these issues with the aim of exploring how the application of the PSM can be simplified. A summary of the guidance provided under the report is set out below.
What is the profit-split method?
The PSM is one of the transfer pricing methods used to establish whether the conditions imposed on transactions between associated enterprises are consistent with the arm's length principle. The PSM is typically applied when the level of interrelation between transactions is high (for instance, when the parties are involved in the same stage of the value chain) and thus clearly cannot be assessed separately using a one-sided method. This method also applies when the parties to the transaction are jointly contributing to the core earning power of the group (i.e. both parties make a unique and valuable contribution or there exists a shared assumption of economically significant risks). In such cases, it is frequent that the reliable information on a comparable is insufficient and, therefore, the comparable transactions cannot be identified.
The report provides examples and specifics around the application of PSM in a transfer pricing analysis. One of the main benefits of PSM is that it demonstrates a more holistic assessment of a company's transfer pricing policies. In general, there are two mainly used approaches to splitting the profits: (i) the contribution analysis (remuneration attributable based on relative value of contributions); and (ii) the residual profit split analysis (remuneration attributable based on the relative value of contributions after a contribution for which a benchmark exists has been remunerated).
The report provides a nonexclusive list and an overview of acceptable profit splitting factors that can be employed to split profit in an economically viable way. It also details the advantages and disadvantages of each factor. The factors are summarized below:
- People-based factors: This category is taken into consideration when the value creation is driven by the workforce, personnel knowledge, and skills. Two kinds of splitting factors are identified, namely 'remuneration' and 'head account of key employees'. For application, it is important (i) to map the employees, (ii) to describe the functions carried out by the employees and identify which would be DEMPE-related functions, and (iii) to calculate the remuneration/number of the key employees.
- Sales- and cost-based factors: The report identifies five key allocation factors under cost-based factors, i.e. 'operating expenses', 'cost of goods sold', 'marketing costs', 'brand development expenses', and 'R&D costs', while 'turnover/revenue' and 'volume of trade' are identified as sales-based splitting factors. This category is considered where there is joint performance of value-creating activities.
- Asset-based factors: The report lays down four allocation keys, i.e. 'value of key business assets', 'assets under management', 'royalty rates', and 'franchise agreement', which can be employed in complicated cases involving intangibles. However, there may be difficulties in the application, for instance in finding a comparable or finding the value of the asset.
- Other factors: The key allocation factors cited under this category are (i) weights assigned on the value chain (to break down an integrated business into its distinct, value-creating activities); (ii) external benchmarks that perform different steps of the value chain; and (iii) a hedge fund model (i.e. a business model where one party provides capital and strategic directions and the other party provides valuable investment/trading know-how and day-to-day decisions).
According to the report's survey, PSM has not been used very often so far. Nonetheless, specifically in the context of Luxembourg transfer pricing practice, PSM may turn out to be useful in the application of arm's length principles in the asset management sector.
However, a reliable application of PSM should be assessed by taking into account the contribution of each stakeholder in the asset management intercompany transaction scheme, whereby the stakeholder can be a related party or an independent entity. This means that actual fact pattern should be assessed to establish whether PSM would be the most appropriate method for a given case.
Generally, the application of PSM can be supported by considering various data points that are used as measurement tools to evaluate the relative contribution of stakeholders in the asset management supply chain, including the following:
- contribution analysis based on 'relative weighting (i.e. value-added) of the functions performed' in the context of asset management intra-group transactions
- contribution analysis based on 'operating expenses incurred by stakeholders' in the said context
- contribution analysis based on 'headcount/ remuneration of key employees' in the said context
Given that Luxembourg is a key jurisdiction for asset management and funds (often having intra-group transactions with the presence of unique and valuable contributions by each party involved in the transaction) and with the blessing/guidance of the report on the application of PSM (which is not always a straightforward transfer pricing method to apply), it is indeed critical to assess the application of PSM in the context of each business value chain, and to document the same in a clear and complete manner to avoid follow-up enquiries from tax authorities.
KPMG Luxembourg's dedicated transfer pricing team can assist taxpayers in assessing their intra-group transactions to ensure they meet the arm's length principle and are in compliance with current Luxembourg transfer pricing requirements.
I would like to thank Khyati Joneja who helped me prepare this article.
1 JTPF report; March 2019
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