During COVID-19: Is RPSM The Best Choice For Multinational Companies?
Posted by Dan Peters and Matthew De Felice on June 18, 2020
The OECD’s Base Erosion and Profit Shifting (BEPS) effort has resulted in many changes in the transfer pricing approaches taken by multinational companies. BEPS, and the subsequent and ongoing efforts on Digital Taxation, pushed the decisions of many multinational enterprises (MNEs) on a most appropriate method away from the Transactional Net Margin Method (TNMM) and toward other transfer pricing methods such as the Transactional Profit Split Method using a residual analysis (RPSM). The severity and length of the COVID-19 economic crisis will certainly test both the decision to select the RPSM in certain circumstances, and also how best to apply it for certain 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 initiative challenged the use of “one-sided” transfer pricing methods used by the great majority of taxpayers. It has been estimated that roughly 80 percent of MNEs select a one-sided method such as the TNMM as their best (or most appropriate) method to evaluate their transfer pricing among entities.
In recent years, BEPS and the subsequent and ongoing efforts on digital taxation have pushed MNEs away from the TNMM and towards other transfer pricing methods. An obvious choice for many transactions is the Profit Split Method (PSM), and, specifically, the profit-based RPSM. Some commentators have joked that the acronym BEPS could have represented “Basically Everything a Profit Split.”
The RPSM is intended for use in systems where both parties make non-routine contributions that are expected to result in residual profit. Residual profit is defined as the system profit remaining after routine contributions of the parties are appropriately compensated. A classic example of a transaction for which the RPSM may be the most appropriate method is that of a Licensor who develops and owns technology and provides the use of these intangibles and possibly guidance to a Licensee, who owns certain market intangibles and is responsible for all aspects of the supply chain in its defined market. The Licensor and Licensee would apply the RPSM to determine how to split the resulting residual profit within the Licensee’s system.
It follows that the RPSM would be most likely to be selected as the most appropriate method in a relatively high-profit system—one that has historically and in the future expects to produce positive residual profits and is expected to continue doing so in the future. (Tweet this!) However, positive residual profits are not required, as relevant regulations and guidance by both the U.S. and OECD clearly consider the use of the Profit Split Method in a situation where losses occur.
The Impact Of COVID-19 On The RPSM
The severity and length of the COVID-19 economic crisis will test both the decision to select the RPSM and how best to apply it for certain MNEs. We consider several issues that will likely be faced in each of the three primary steps when applying or updating an existing residual profit split between the typical Licensor and Licensee:
- 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 usual circumstances, this is a straightforward, factual exercise using existing financials. Post-Covid-19, however, a new issue will likely arise: Which period should be evaluated? Taxpayers and tax authorities want to determine how profits are actually split in the current year. In our experience, most RPSM calculations are executed either using current year results or a multi-year period that utilizes prior, current, and possibly one future year of results. If the severe economic impact of the COVID-19 crisis is limited to 2020, the decision regarding which period to evaluate can have a significant impact on the ultimate allocation of income in the current year. This is especially true in cases where the economic impacts of the COVID-19 crisis are severe, or when the relative contributions of the parties are expected to change over time.
Taxpayers will also need to determine how to properly treat one-time events that could have a significant impact on operating profits in the current economic environment. Asset write-downs or impairments may accelerate expenses, while governmental economic relief programs may provide a short-term influx of cash that may or may not ultimately be taxable as income. Taxpayers will need to be aware of how these items are being treated for accounting purposes, and whether they are being considered extraordinary items when determining combined operating profit or loss in the context of the RPSM.
Allocating Income To Routine Contributions
Numerous commentators have written about the impact of the COVID-19 crisis on the expected compensation for limited-risk entities, which generally perform routine functions. Much attention will be focused on the outcomes of the comparable firms used to benchmark routine distributors, manufacturers, and service providers to evaluate how their 2020 results will be impacted by the crisis. One can generally expect that the income earned by these firms will be reduced to some extent. It is not certain, however, that tax authorities will accept large reductions in returns to limited-risk entities. Taxpayers will need to pay close attention to the firms they have historically chosen as comparables, as the economic crisis may expose key differences in the risk profiles of these entities when compared to an MNE’s own routine activities.
An interesting aspect of the operating models for which the RPSM is typically applied is that often the routine functions are performed largely (or even exclusively) by the Licensee and the Licensor. Neither of these entities is, by definition, “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 indicates that routine returns could be significantly reduced (or potentially even negative) for certain firms in 2020.
The practitioner applying an RPSM thus needs to consider how much less risky the routine contributions are to be considered than the non-routine contributions that attract the residual profit (or loss).
Allocating Income To Non-routine Contributions
Generally, residual profits are allocated in an application of the RPSM based on a measure of each party’s investments in intangibles or their specific contributions of value drivers. However, profits in the period of COVID-19 are more likely to reflect specific risk events—both good and bad—rather than historical investments in intangibles.
Practitioners will need to consider how to address the likely situation of a residual loss in 2020. This situation raises numerous questions for the typical Licensor/Licensee example outlined above, the answers to which are open to 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?
An interesting example of the impact the COVID-19 economic crisis might have on an existing RPSM would be that of a clothing retailer. A clothing retailer may be composed of one entity engaged in product design, one entity engaged in online distribution and a third entity engaged in brick and mortar retail. In the current COVID-19 environment, the demand and appeal of clothing designs may be largely unaffected, the online retailer may be selling at higher volumes, while the brick and mortar retailer may experience a significant decline in sales. Should these entities continue to split profits or losses in the same proportion as they did prior to the COVID-19 economic crisis? Or should the profits of the online retailer increase while the brick and mortar retailer bears losses? Whether or not an existing RPSM properly accounts for risk and provides a reasonable result will need to be assessed by taxpayers.
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.
Any opinions expressed in this article are those of the authors, and not necessarily those of Valentiam Group.