Transfer Pricing Has Changed

A Trend to Carving Out the Financial and Economic Study from the Functional Analysis

AUTHORS: Kelvin King, VRG UK and Raymond Weisner, VRG US

(Estimated reading time: 4 minutes 11 seconds)

The Organisation for Economic Co-operation and Development’s (OECD) Base Economic Profit Sharing (BEPS) project introduced significant changes to the way transfer pricing rules worldwide apply to intangible assets. The BEPS project links transfer pricing outcomes to value creation through an in-depth financial analysis. This shift in methodology has significant implications for entities that utilize transfer pricing—and for practitioners who perform valuations and/or royalty assessments.

This change in landscape for transactions between related parties, especially among subsidiaries of multinational corporations, has made it necessary—for the very concerned tax authorities—to have a recent transfer pricing study to justify the charges (often including royalty rates) for these transactions.

A Greater Role for Financial Valuation Expertise

The OECD Transfer Pricing Guidelines recognize that economic valuation techniques—in addition to, or even opposed to, more traditional transfer pricing methods—may be beneficial for determining the value or transfer price of an intangible asset or business.

These valuation techniques can include a discounted cash flow method (DCF) and other valuation methods. This is a movement away from the historic transfer pricing focus, namely market and comparability, to now also basing arm’s length price determination on well-practiced intangible asset economic reward valuation techniques.

Transfer pricing practice generally requires a Functional Analysis (often also referred to as a functional and risk analysis), an Economic Analysis, and a Financial Valuation Analysis. VRG provides Economic and Financial Analysis. VRG often does not provide the Functional Analysis, which is more commonly offered by a client’s transfer pricing team, legal counsel, tax groups of the Big 4 or other accounting firms, or other economic or tax consultants.

There is a good reason for the carve-out of the Economic and Financial Analysis. Typically it is to avoid the charge that the due diligence in the Functional Analysis may be designed to steer the financial work; akin to developing consumer surveys that can only give the answer you want. Moreover, for the independence which VRG brings to the table: our affiliate network does not provide tax planning, tax consulting, or audit services. We are dedicated to providing professional valuation and value-related advisory services. Therefore, tax authorities view VRG as a genuinely independent third-party with unbiased opinions.

This shift in methodology has significant implications for entities that utilize transfer pricing - and for practitioners who perform valuations and/or royalty assessments.

Risk and Location Assessment in the Functional Analysis

The allocation of functions, assets, and risks will never be standardized. Fundamental due diligence establishes global risk within an organization and an understanding where the subject of transfer pricing valuations sits. Preparation in the Functional Analysis of a value chain analysis may be helpful.

Global value chains can be complex: there are many people and assets involved in producing goods and services, and there are hierarchical structures, market chains, and relationships, with required weightings of risk and value at every stage. Some businesses are highly integrated, and sometimes the same person or business unit does many different things. In this context, it is rare for one intangible asset to drive the profit outcome when assessing the sources and location of value creation.

These need to be peeled away to present, as best able, a comprehensive and straightforward explanation that tax authorities can navigate. This could include a review of the assets used and risks assumed compared to a previous tax year, especially changes following a business restructuring.

It is rare for one intangible asset to drive the profit outcome when assessing the sources and location of value creation.

Determining Economic Value within a Business

With OECD Transfer Pricing Guidelines’ recognition of economic valuation techniques that differ from more traditional transfer pricing methods comes the need for the valuation professional to determine when an economic valuation method may be appropriate.

There is limited commentary on the valuation parameters deemed appropriate for determining an arm’s length price within the updated Chapter VI of the OECD Transfer Pricing Guidelines and no practical examples. This has created something of a guidance vacuum with related and indirect inconsistencies in approaches.

Profit allocation will remain both science and art in this new transfer pricing world, and the need to consider realistic alternative options adds complexity. For example, following the required two-sided approach, various calculations can produce different values. Namely, the minimum values a licensor would accept on each of the positions of licensor and licensee, and the maximum value a licensee would accept from each perspective, measuring its view of contribution by value (not cost), type of ownership, management, location of significant people with capability and authority, and the nature/location of risk itself. It is then necessary to build in the overlap position where it can be hypothesized a fair negotiation would settle.

Selection of the best financial method may involve an analysis of transaction-based and profit-based methods. Some of the comparisons are return on cost, cost plus, return on sales and return on assets. Approaches may include available profit and based on analysis and net margin calculation. The degree of comparability between controlled and uncontrolled transactions or companies discovered assists to choose methods, and the number, magnitude and accuracy of adjustments required to apply methods. What you can achieve will depend on what accurate and reliable data is available.

Profit allocation will remain both science and art in this new transfer pricing world, and the need to consider realistic alternative options adds complexity.

Transaction Profit Split Methods and Transactional Net Margin Method are viewed as a reliable means of establishing arm’s length prices and allocations. Because of complex business situations even within a small group, the process may be difficult to apply in practice, mainly where information available on comparable transactions is not detailed enough to allow for the adjustments necessary to achieve satisfactory comparability and application.

The Profit Split Method can be applied where operations of two or more non-arm’s length parties are highly integrated, making it difficult to evaluate their transactions on an individual basis.  Identification of unrelated party transactions, Comparable Uncontrolled Price and comparable companies for Comparable Profit Method can remain as crucial as ever while acknowledging that unique and valuable services may make it challenging to establish a proper level of comparability with any uncontrolled transactions.

Finally, having more contemporaneous review can be powerful, rather than later reacting to tax authority questions. It is recommended to regularly review for impairment past transfer pricing values in the light of developing internal and external marketplaces—as well as possibly these new economic valuation options.