Splitting the Unsplittable: Toward a Formulary Approach to Allocating Residuals Under Profit Split
Reuven S. Avi-Yonah
University of Michigan Law School
December 19, 2013
U of Michigan Public Law Research Paper No. 378
It has been recognized at least since the publication of the US Treasury White Paper in 1988 that the key problem in applying the Arm’s Length Standard (ALS) to multinational enterprises (MNEs) is what to do in the absence of comparables. The White Paper proposed to apply a functional analysis to the various components of the MNE, and to allocate profits based on the comparables that can be found for each function. This led to the development of the profit split method, which was incorporated in the US regulations in 1994 and into the OECD Guidelines soon thereafter. The OECD paper on intangibles has recently recognized that profit split is the most likely candidate of the five ALS compliant methods to be applied to modern MNEs that derive the bulk of their profit from intangibles.
But the problem with the profit split method is that it frequently results in a residual that cannot be allocated under the functional analysis because it results from cost savings that inhere in the relationship of the group members to each other. The OECD Transfer Pricing Guidelines do not say what should be done with residuals under the profit split method. The OECDs preferred method of applying the profit split method is to analyze the functions, assets and risk of each member of the affiliated group. However, in the context of residuals this method also proves to be illusory. A functional analysis can only be applied to those functions that can be assigned to the group members, such as production or distribution, but it does not help with residuals that result from the relationship among the group members. Assets can include intangibles, which are usually the most valuable assets of a modern MNE, but intangibles also get their value from the relationship among the group members,and they cannot be allocated to either where they were developed or where they are exploited.
Risk is the most tricky concept of all. Recent case studies by the US Joint Committee on Taxation reveal a model in which the entrepreneurial risk for a product is assigned to an affiliate in a low tax jurisdiction and the manufacturing and distribution of the product in high tax jurisdictions are done on a contract manufacturing and commissionaire basis. But it is not clear what the allocation of entrepreneurial risk means among related parties. If a product fails because of technological change or defects in manufacturing or environmental hazards, the risk is effectively borne by the entire MNE.
I would therefore propose that the OECD accept the use of formulas to allocate the residual in the profit split method. Specifically, I would suggest using a formula based entirely on the destination to which the goods and services that the MNE provides are sold.
Number of Pages in PDF File: 6
Keywords: Transfer pricing, formulary apportionment, profit split
JEL Classification: H26
Date posted: December 20, 2013 ; Last revised: February 6, 2014
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