During COVID19

The OECD’s Base Erosion and Profit Shifting (BEPS) initiative has led in several modifications in multinational firms’ transfer pricing strategies. Many multinational corporations (MNEs) have been pushed away from the Transactional Net Margin Method (TNMM) and toward other transfer pricing methods such as the Transactional Profit Split Method employing a residual analysis as a result of BEPS and subsequent and ongoing initiatives on Digital Taxation (RPSM). The severity and duration of the COVID-19 economic crisis will undoubtedly put to the test both the decision to use the RPSM in certain situations and the best way to apply it to specific MNEs. In this article, we consider the issues that will likely be faced by taxpayers in their application of the RPSM.

BEPS & The Selection Of The RPSM As The Best Method

The OECD’s BEPs project challenged the vast majority of taxpayers’ usage of “one-sided” transfer pricing schemes. According to estimates, almost 80% of MNEs choose a one-sided method like the TNMM to analyze their transfer pricing among entities as their best (or most appropriate) method.

MNEs have been driven away from the TNMM and toward various transfer pricing schemes in recent years as a result of BEPS and subsequent and ongoing work on digital taxation. The Profit Split Method (PSM), and specifically the profit-based RPSM, is an obvious choice for many transactions. Some have speculated that the abbreviation BEPS could have stood for “Basically Everything a Profit Split.”

The RPSM is designed for systems in which both partners make non-routine contributions with the expectation of residual benefit. The system profit that remains after the parties’ normal contributions have been suitably rewarded is referred to as residual profit. The Licensor who develops and owns technology and provides the use of these intangibles as well as possibly guidance to a Licensee who owns certain market intangibles and is responsible for all aspects of the supply chain in its defined market is a classic example of a transaction for which the RPSM may be the most appropriate method. The Licensor and Licensee would apply the RPSM to determine how to split the resulting residual profit within the Licensee’s system.

As a result, in a reasonably high-profit system—one that has historically and in the future expects to earn positive residual profits and is expected to do so in the future—the RPSM is most likely to be chosen as the most appropriate method. Positive residual earnings are not required, as relevant legislation and guidance from both the US and the OECD explicitly allow for the employment of the Profit Split Method in the event of a loss.

How are deferred tax asset valuation allowances calculated?

The process for identifying deferred tax assets and determining whether a valuation allowance is required has five steps:

• Identify basis differences between GAAP (Generally Accepted Accounting Practices) and tax balance sheets with future tax implications.
• Categorize differences into future taxable and future deductible amounts to determine whether the difference is a deferred tax liability or a deferred tax asset.
• Determine the correct tax rate. The rate to use is the enacted rate applicable when the difference is anticipated to reverse.
• Calculate the deferred tax assets, using the rate from step 3.
• Consider whether a valuation allowance is required. If it is more likely than not (a greater than 50% chance) that the assets will not be fully recoverable, ASC 740 requires a valuation allowance. The assets should be reduced to the amount that more likely than not can be recovered—meaning there is a greater than 50% chance that the remaining assets are recoverable.

Obviously, assessing whether or not a valuation allowance is required, as well as the amount of such adjustment, necessitates considerable judgment. Accurate future forecasts are dependent on making the necessary assumptions; if any of those assumptions are erroneous, the forecast may differ dramatically from reality in terms of how the future unfolds.

Ultimately, ASC 740 valuation allowance guidance has the same intent as goodwill impairment testing: to bring the assets on the balance sheet into alignment with fair market value. ASC 740’s “more likely than not” standard for determining whether a valuation allowance is required is intended to offset wishful thinking that otherwise might keep deferred tax assets on the balance sheet indefinitely, creating a widening gap between the value reflected in the balance sheet and the actual fair market value of the business.

Need help determining the fair market value of your business assets?

Our valuation and transfer pricing experts at Taqeem have decades of combined experience in providing accurate, defensible values and services. Please contact us to learn more about how we can assist your organization with all of its valuation and transfer pricing requirements.