The transfer pricing industry has seen major changes in recent years, from new standards regarding base erosion and profit shifting (BEPS) to revised transfer pricing guidelines. One of the latest industry initiatives is the Functional Cost Diagnostic Model put forth by the Advance Pricing and Mutual Agreement (APMA) program. In this article, we’ll provide an overview of the model and what it means for taxpayers involved in advance pricing agreements (APAs) with tax authorities.
What is the APMA Functional Cost Diagnostic Model?
The APMA program was initiated by the Internal Revenue Service (IRS) to resolve transfer pricing disputes in a timely and ethical manner. Recently, the APMA released the Functional Cost Diagnostic Model (FCDM), an Excel-based tool for collecting taxpayer financial data and applying the profit split method.
While the comparable profits method (CPM) has been a default application for the vast majority of the APAs made between taxpayers and tax authorities, APMA has become increasingly concerned that the CPM is overused. This has been inspired in part by the OECD BEPS initiative, which suggested that one-sided transfer pricing methods like the CPM may not be reliable for more complex cases where two or more parties are making significant value-added contributions to relevant business operations. In these situations, APMA has indicated that the residual profit split method may be a more reliable way of arriving at arm’s length values of respective contributions.
Given this, APMA is requesting that taxpayers involved in the APA process complete the FCDM so tax authorities can gain a better understanding of the contributions and risks incurred by all parties. (Tweet this!) APMA expects that, by completing the model, taxpayers will provide insight into the value drivers of the business, including which parties are making non-routine contributions toward generation of profits or losses.
How The FCDM Model Is Used
The model requires the input of functional costs, which are costs related to specific functions carried out by the parties involved in an APA. Manufacturing, advertising, research and development, distribution, and marketing are all examples of functional costs. The FCDM breaks functional costs into two categories:
- Routine functions, for which the economic value can be measured with benchmarks obtained from comparable uncontrolled transactions. The FCDM uses these benchmarks to determine the profits related to these functions.
- Non-routine functions, for which the economic value cannot be benchmarked. These are treated differently from routine costs, as they’re capitalized and amortized based on assumptions regarding their useful life—also provided by the taxpayer.
Using this data, the model builds a capitalization and amortization schedule based on assumed useful lives, then calculates and subtracts the profits from benchmarkable functions. This generates a pro forma split of residual profits based on capitalized functional costs.
The APMA has emphasized that the profit split calculations do not imply that the profit split method is always the most appropriate for APAs. Rather, the FCDM is meant to be a data collection diagnostic tool that’s used as a starting point for identifying functional costs, and determining which are providing a unique and valuable contribution. Because cost is not always indicative of the value of non-routine functions, the APMA has also asked for taxpayers to comment on whether costs are in fact a reliable measure of value for certain functions.
Do you have questions about the APMA Functional Cost Diagnostic Model and how it applies to your organization? Schedule a discovery call today.
What are the implications for taxpayers?
At the very least, the FCDM represents an additional data requirement. While at the moment APMA is simply requesting these data, it’s unclear as to whether or not it will eventually be required for all APA proposals. One consideration is whether the FCDM will be used differently for renewal APAs (those that were already agreed upon in the past) than for new APAs. Both taxpayers and tax authorities generally expect that the same transfer pricing method used in the past—most likely the CPM—will be used for the renewal; however, APMA may take a different view, depending on how discussions around the new model play out.
While APMA has stated that it will not use the FCDM data to automatically conclude that the profit split method is the most appropriate method, the provision of these data is likely to imply that more discussion around the profit split is needed. Multinational taxpayers—particularly those who have historically applied the CPM for APA proposals—should review the FCDM and evaluate the potential impact on their transfer pricing compliance processes. At the moment, taxpayers who would like to use the model should contact the IRS to request access to the FCDM workbook.
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