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Kluwer International Tax Blog

Does the Transactional Profit Split Method Apply to

Centralized Business Models?
Vikram Chand (Managing Editor) · Wednesday, July 31st, 2019

1. Purpose of the blog

The purpose of this blog is to address whether the transactional profit split method (TPSM) applies
to centralized business models operated by multinational enterprises (MNEs). The assessment will
be made in light of the post BEPS transfer pricing guidance, that is, the 2017 OECD Transfer
Pricing Guidelines (TPG) and the revised guidance on the TPSM (revised PSM report). Kindly
note that the blog will not discuss the impact of the international corporate tax debate triggered by
digitalization.

2. Centralized business models

A centralized company within an MNE, for example, that is engaged in the business of selling
physical goods usually operates with the help of related entities in the value chain (hereinafter
“assisting” entities) such as i) research and development (R&D) entities that assist in performing
research services ii) procurement service entities that assist in buying raw materials; iii) contract or
toll manufactures that provide manufacturing services and iv) limited risk distributors that assist in
selling the finished product.

In terms of functions, the centralized company usually takes key decisions associated with the
innovation, purchase, manufacture as well as sale of products. In terms of risks, the centralized
entity usually controls key risks pertaining to its value chain, that is, risks relevant to innovation,
purchasing, processing and selling of the products. In many cases, such entities also own the
valuable intellectual property. On the other hand, the other assisting entities usually perform their
activities under the supervision and guidance of the centralized entity. They [may] also bear low
risks. Moreover, in many circumstances, the “assisting” entities do not own valuable intellectual
property.

The current profit allocation principle, that is, the arm’s length principle is based on the philosophy
that an entity is entitled to higher returns (profits or losses) when it controls key risks in its value
chain. Therefore, if the centralized entity controls key risks through its personnel, then it will be [in
principle] entitled to higher returns. This also implies that assisting entities or low risk entities are
entitled to returns that commensurate with the lower functions performed and lower risks assumed.
Typically, service providers are remunerated on a cost related basis and limited risk distributors on
the basis of a certain percentage of their sales. Essentially, one-sided TP methods are used to
remunerate low risk entities. It should be noted that some (but not all) MNEs structure their
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businesses in such a way that “assisting” entities operate in high tax jurisdictions whereas
centralized entities are located in low tax jurisdictions.

3. Application of the TPSM

The revised PSM report describes that the TPSM may be the most appropriate method where one
or more of the following indicators are prevalent: i) each party makes unique and valuable
contributions; ii) the business operations are highly integrated such that the contributions of the
parties cannot be reliably evaluated in isolation from each other; and iii) the parties share the
assumption of economically significant risks or separately assume closely related risks. Taking into
consideration this background, the blog explores whether the TPSM applies to transactions
between the centralized company and other assisting entities. In other words, should the assisting
entities be entitled to higher returns due to the application of the TPSM? We will analyse the issue
from the sales side of the value chain and work backwards.

Sales through a limited functional distributor

The existence of unique and valuable contributions is perhaps the clearest indicator that the TPSM
may be the most appropriate method. Contributions are “unique and valuable” when they (i) are
not comparable to contributions made by uncontrolled parties in comparable circumstances, and
(ii) represent a key source of actual or potential economic benefits in the business operations. This
concept is discussed in Example 3 and Example 4 of the revised PSM report.

In Example 3, Company A is responsible for the design, development and manufacturing of

electronic appliances, whereas related Company B is responsible for the selling of the products.
Essentially, Company B develops and executes cutting-edge global marketing activities relating to
the new line of products and is responsible for designing the marketing strategy, deciding on the
level of marketing expenditure in each country where the products will be released, and validating
the impact of the marketing campaigns on a monthly basis. The marketing activities performed by
Company B result in a valuable trademark and associated goodwill in the market. The facts
indicate that the contributions of both Company A and B are unique and valuable to the potential
success of the new line of products. Under these circumstances, the Example indicates that the
TPSM might be the most appropriate method, but it does not indicate how it should be applied.

On the other hand, in Example 4, Company B undertakes marketing activities that are rather
limited and which do not significantly enhance the goodwill or reputation associated with the
trademark. The functional analysis determines that the risks assumed by Company B are not
economically significant for the business operations and that Company B does not make any
unique and valuable contributions in relation to the controlled transaction. Moreover, its
distribution activities are not a particular source of competitive advantage in its industry. Under
these circumstances, the revised PSM report argues that the TPSM may not be the most appropriate
method as it is likely that the arm’s length compensation for the contribution of Company B can
reliably be benchmarked by applying one-sided transfer pricing methods. For instance, the resale
price method or transactional net margin method (TNMM).

Manufacturing by a contract manufacturer

Example 8 of the revised PSM report discusses the situation of Company A, the parent company of
an MNE group that is engaged in the manufacturing and distribution of electronic devices.
Company A decides to subcontract the manufacturing of the electronic devices to related Company
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B. Under the terms of the contract, Company B will follow the directions of Company A to
produce the devices. Once the devices are manufactured, Company B (which seems like a contract
manufacturer) will then sell the finished products to Company A, which in turn will market and
distribute the products to unrelated customers. The facts state that Company B does not make any
unique and valuable contributions in relation to the controlled transactions and the risks assumed
by Company B are not economically significant for the business operations of the group. While the
operations of Company B are integrated to some degree with those of the parent company and
dependent upon the latter, an arm’s length compensation for the contributions of Company B can
be reliably benchmarked by reference to one-sided transfer pricing methods. For instance, the cost
plus method (CPM) or TNMM. Under these circumstances, the TPSM is unlikely to be the most
appropriate method.

Purchasing by a procurement entity

In the context of discussing MNE Group synergies that arise from deliberate concerted actions, the
TPG in Chapter 1 puts forward several examples that deal with purchasing entities in the MNE
Group. Essentially, Example 3 in Section D.8 discusses a situation wherein Company A purchases
goods for resale to other group members. The facts state that if Company A only coordinates the
purchasing activity and negotiates volume discounts then that entity should only receive a cost plus
return. Example 4 in Section D.8 also discusses a similar situation wherein, instead of taking title
to the goods, Company A only provides a procurement service. In this case, the TPG also states
that Company A should only be entitled to receive a cost plus return. In light of these examples, it
can be argued that the TPSM is unlikely to be the most appropriate method with respect to the
transactions that take place between the centralized entity and the purchasing entity of the MNE
Group. The CPM or TNMM could be used to benchmark the arm’s length nature of the service fee.

Research by contract research and development entities

At several occasions, the TPG discusses examples wherein an entity in an MNE provides research
services to another related entity, in particular, in situations where the latter entity controls the key
risks associated with the research activities. For instance, in its annex on intangibles, Example 14
deals with a situation wherein Company S provides research services to its parent entity under the
latter entity’s supervision. In that example, Company S is entitled to a service fee for its activities
whereas the parent entity is entitled to the returns that would arise from the exploitation of the
intangibles. In this situation, it can be argued that the TPSM is unlikely to be the most appropriate
method when transactions take place between a centralized entity and a research and development
service provider. On the other hand, the CPM or TNMM could be used to determine the arm’s
compensation of the service provider.

4. The open issue: Highly integrated transactions

In the aforementioned examples, the TPSM seems inapplicable to transactions between a high-risk
centralized entity and low-risk assisting entities. Arguably, we arrive at this conclusion by seeing
each transaction in isolation, that is, one transaction each between the centralized company with
the low risk distributor, contract manufacturer, procurement and research and development service
provider. However, the question raised here is whether such transactions can be clubbed together
and be seen as “highly integrated transactions” which would then warrant the application of the
TPSM?

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A highly integrated business transaction is one that features a high degree of inter-connectedness in
a way that the functions performed, assets deployed and risks assumed by the parties to the
transaction are extremely interlinked that they cannot be reliably evaluated in isolation (Para
2.133). A high degree of integration is typically assumed if the parties perform functions jointly,
use assets jointly and/or share assumption of risks to such an extent that it is impossible to evaluate
their respective contributions in isolation from those of others. It is also assumed when the
integration between the parties takes the form of a high level of inter-dependency (Paras 2.134
-2.135).

A typical example of a highly integrated business transaction may be one in which two related
companies jointly perform the same key value-adding functions (for instance, producing and
assembling high-quality key-components for an excavator used in the earthmoving business) and
jointly use and contribute to the MNE group’s most important assets. Additionally, they transact in
a highly integrated manner and operate interdependently (for instance, several process steps are
required to be undertaken between the two fully-fledged entities to successfully complete the
cutting-edge key-components for an excavator and both manufacturers are highly dependent on
each other).

In relation to the question of whether centralized business models can be seen as highly integrated
is indeed debatable. The centralisation could involve elements of integration of the activities, such
as through the dependency of the assisting entities on the decision-making of the centralized entity
(e.g. the assisting entities execute core activities under the control and supervision of the
centralized entity which has the capability to bear and control the key strategic risks). However, it
could be argued that as long as the functions, risks and assets of the centralized entity are separate
and could reliably be evaluated/benchmarked in isolation from the functions, risks and assets from
the assisting entities, the TPSM is not likely to be the most appropriate method, even though there
is a certain degree of integration and interdependence. As the TPG recognise, most MNEs are
integrated to some extent (Para 2.133).

Even if it is argued that the TPSM should apply, the taxpayer could argue that the returns that
should be allocated to each assisting entity should be in line with the value that the entity
generates. In other words, returns should be allocated on the basis of a proper functional analysis.
So, for example, if the tax administration of the State in which the limited functional distributor is
set up claims for a profit split (residual or contribution), the distributor should not get more than
what the distributor was already being remunerated under a one-sided method.

5. Conclusion

In our view, transactions between the centralized entity and assisting entities should not
[automatically] be considered unique or valuable. Moreover, they do not generally seem to share
the assumption of economically significant risks or separately assume closely related risks.
However, the definition of highly integrated transactions is still relatively broad and openly
formulated with no clear threshold. Thus, some concern still remains that transactions could
inadvertently be classified as “highly integrated”, and, consequently, could lead to arbitrary use of
the TPSM by tax authorities. This is because the definition of what exactly highly integrated
business transactions are as well as the application of the concept is still, to a certain degree, a
subjective one, which leaves space for interpretation. Thus, at this stage, an absolutely conclusive
answer cannot be provided to the question of whether the TPSM applies to centralized business
models that operate in a highly integrated manner. The answer may indeed be found in the accurate

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delineation of the actual transaction but this still creates tax uncertainty or compliance costs for
businesses. Accordingly, it is recommended that policymakers provide further guidance in this
area.

The authors would like to thank Mr Johann Muller and Mr Stefaan De Baets for commenting on
draft versions of this blog.

This entry was posted on Wednesday, July 31st, 2019 at 9:07 am and is filed under Transfer Pricing
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