OECD clarifies global profit splits

The OECD has issued revised draft guidance on profit splits within multinational groups for transfer pricing purposes (BEPS Actions 8-10, Revised Guidance on Profit Splits July 4 – September 5, 2016). Israel joined the OECD in 2010.

Why is this important?

We live in a global village, but customers in each country usually prefer to buy goods and services from local companies, which buy those goods and services from other companies in the group. Transfer pricing rules in Israel and other countries require those supplies to be on arm’s length terms. But in hi-tech and other sectors, it can be hard to obtain data on “comparable uncontrolled prices” of similar transactions by third parties.

It is often easier to take the total world profit and carve it up between different countries. To stop most profits ending up offshore, the OECD has now published the profit split rules as part of its campaign against so-called Base Erosion Profit Shifting.

What does the OECD say?

The draft OECD guidance says that transactional profit splits are only appropriate in two situations: (1) highly integrated operations, or (2) unique and valuable contributions by the parties. Typically multiple parties may be involved. A value chain analysis is needed – see below.

The OECD says a lack of comparable price data (“comparables”) is insufficient cause to warrant the use of transactional profit splits – it says inexact comparables may be taken and adjusted. As for profits, it is possible to split anticipated profits or actual profits. Anticipated profits may use discounted cash flow estimates. Actual profits should reflect the contribution of each company in the group to functions, assets and risks.

The OECD says actual profits should only be used if each party has the capacity to assume their share of risks and there is a high level of integration of activities.

A high level of integration means high commonality of functions and risks. This is more likely where there is parallel integration than sequential integration. The OECD says there are usually more comparables in the case of sequential integration so actual profits are more appropriate for parallel integration.

It also says the split should not involve hindsight, a key weapon of tax authorities. Instead the parties should use known information or foreseeable (within reason) by them when the transactions were entered into.

All profits may be split, or just residual profits after allocating a portion to specific parties whose contribution can be reliably valued. Profits should be determined using common accounting standards in a common currency. Financial statements may be used. Alternatively, cost accounting data may be used if it is reliable, can be audited and transactional – e.g. using product line statements or divisional accounts.

The OECD recommends splitting gross profit, then allocating the specific operational expenses of each enterprise.

Profit splitting factors may include: assets or capital employed; costs incurred (e.g, R&D, advertising); headcount; time spent. If employee compensation is used, adjustment should be made for different costs of living.

Value Chain Analysis

The OECD says value chain analysis should be conducted to see if a transactional profit split should be applied. The analysis should consider economically significant functions, assets, risks and “opportunities to capture profits in excess of what the market would otherwise allow”– for example: unique intangible assets, first mover advantage and barriers to entry by competitors.

The value chain analysis might usefully provide information about the following aspects of business activity: key value drivers; contributions of functions, assets and risks to the value drivers by the parties; protection and retention of valuable intangible assets – development, enhancement maintenance, protection and exploitation (“DEMPE”); the assumption and control of risks relating to value creation; how (and whether) parties operate in parallel integration.

Comments:

They say a camel is a horse designed by a committee. The draft OECD rules are disjointed and must have been designed by the same committee. Let’s hope the final version will be less jumbled.

Hi-tech operations will find it harder to use profit split formulae to park profits offshore. Instead, hi-tech operations with engineers in Israel would do well to leave the profits here and enjoy “privileged enterprise” tax breaks. These pay company tax 9-16 percent and dividend withholding tax 20%; even lower tax rates are under discussion.

Global financial trading operations may meet the parallel integration criterion for actual profit splitting – for example, currency trading in New York, London and Singapore over a period of 24 hours.

The OECD draft contains no guidance as to whether a profit-splitting group has a taxable permanent establishment in each country concerned – this would be a bureaucratic nightmare. For example, the Tax Authority has been known to tax foreign partners in profit sharing joint ventures with Israeli companies.

As for using inexact comparables where no exact ones exist, the OECD clearly has not heard of “disruptive” technology which is too new for anything remotely comparable to exist.

The OECD draft also does not provide any guidance on how to allocate failed R&D costs. It is not uncommon to use two or more R&D teams in competition to see which can find develop something first or best. What happens to the cost of the other teams?

As always, consult experienced tax advisers in each country at an early stage in specific cases.