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.
The Impact Of COVID-19 On The RPSM
The severity and duration of the COVID-19 economic crisis will put the RPSM’s selection and application for particular MNEs to the test. When applying or revising an existing residual profit split between the typical Licensor and Licensee, we explore various concerns that will almost certainly be encountered in each of the three basic steps:
- Determine the combined operating profit or loss
- Allocate income to routine contributions
- Allocate income to non-routine contributions
Determining The Combined Operating Profit Or Loss
In most cases, this is a simple, factual exercise that uses existing financials. However, after Covid-19, a new question will almost certainly arise: which era should be evaluated? Taxpayers and tax authorities are interested in learning how profits were shared in the current fiscal year. Most RPSM computations, in our experience, are performed using either current year results or a multi-year period that includes historical, current, and perhaps one future year’s outcomes. If the severe economic impact of the COVID-19 situation is limited to 2020, the choice of which period to analyze can have a big impact on how much money is allocated in the current year. This is especially relevant when the COVID-19 crises’ economic consequences are severe, or when the parties’ respective contributions are likely to alter over time.
In the current economic climate, taxpayers will also need to figure out how to correctly treat one-time events that could have a substantial impact on operating profitability. Asset write-downs or impairments may accelerate expenses, while government economic relief programs may give a quick infusion of cash that may or may not be taxable as income in the long run. Taxpayers must understand how these things are processed for accounting purposes, as well as whether they are deemed extraordinary items when calculating combined operating profit or loss under the RPSM.
Allocating Income To Routine Contributions
The Impact of COVID-19 crisis on projected remuneration for limited risk firms that normally perform regular operations has been discussed by a number of authors.
Much attention will be paid to results of comparable firms used to benchmark ordinary distributors, manufacturers, and service providers in order to assess how the crisis may affect their 2020 performance.
It is reasonable to predict that these companies’ earnings will be impacted to some extent.
However, it is not guaranteed that tax authorities will tolerate significant decreases in returns to low-risk firms.
Taxpayers will have to pay special attention to the companies they’ve used as comparables in the past, as the economic crisis may expose key differences in the risk profiles of these entities when compared to an MNE’s own routine activities.
The routine functions are commonly done substantially (or even solely) by the Licensee and the Licensor in the operating models for which the RPSM is often applied, which is an intriguing element of the operating models for which the RPSM is typically applied. By definition, neither of these entities is, “limited-risk.” Section 1.482-6 of the U.S. transfer pricing regulations specifically indicates that “market returns for the routine contributions should be determined by reference to the returns achieved by uncontrolled taxpayers engaged in similar activities.” This statement implies that in 2020, normal returns for some companies may be drastically decreased (or even negative).
As a result, when using an RPSM, the practitioner must examine how much less risky normal contributions are compared to non-routine contributions that attract the residual profit (or loss).
Allocating Income To Non-routine Contributions
In most cases, residual profits are allocated using the RPSM based on a measure of each party’s intangible investments or particular contributions to value drivers. Profits during COVID-19, on the other hand, are more likely to represent specific risk events—both positive and bad—than past intangible investments.
Practitioners will need to think about how to deal with the possibility of a residual loss in 2020. For the standard Licensor/Licensee scenario stated above, this position poses a number of problems, the answers to which are up for debate:
- How should such a loss be allocated between the Licensor and Licensee?
- Would a Licensor accept a negative royalty in such a situation? Is this situation addressed in the intercompany contracts between the Licensor and Licensee?
- How much of the expected residual profit or loss should the Licensee bear for taking on the market risks inherent with being the Principal in transactions with customers, versus the provider of intangible assets (i.e. the Licensor)?
- Is no royalty the correct answer for the transfer price in a situation where there is a residual loss? If so, can the loss be “carried-forward” so that future royalties will be lower once the economy has recovered?
A clothing business is an interesting example of the influence the COVID-19 economic crisis might have on an existing RPSM. A clothes store could be made up of one business doing product design, another doing internet distribution, and a third doing brick-and-mortar sales. The demand and attraction of apparel designs may be essentially unaffected in the present COVID-19 climate, with internet retailers selling at increasing volumes and brick and mortar retailers seeing considerable sales declines. Should these companies continue to distribute profits and losses in the same way they did before the COVID-19 financial crisis? Should the internet merchant’s earnings rise while the brick and mortar retailer loses money? Taxpayers will have to judge if an existing RPSM effectively accounts for risk and produces a reasonable result.
Taxpayers will need to give serious consideration to the reliability of the selection of the RPSM as the most appropriate method in the COVID-19 economic crisis. While the first sentence in 1.482-6 of the U.S. transfer pricing regulations indicates that the PSM “evaluates whether the allocation of the combined operating profit or loss (emphasis added)” is consistent with an arm’s length outcome, the issues associated with applying the RPSM in a loss situation are such that some taxpayers may choose to temporarily (or permanently) choose an alternative method to govern these intercompany transactions that would provide a more reasonable and reliable outcome.