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Transcript of The Profit Split Method
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Profit Split Methods
Copenhagen and Aarhus, 8 February 2012
Wave of the future?
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© 2012 Deloitte
Agenda
Welcome
Introduction and overview of profit split methods
• Introduction to profit split – OECD and US regs.
• Situations “made” for profit splits
• Dispersed R&D – residual profit split
• Dispersed marketing and brand development – (subjective) contribution profit split
• Highly integrated businesses – (objective) contribution profit split
• Volatile businesses – hybrid profit split
• Outlook for profit split methods
News from Denmark
• Focus areas in audit environment
• Symbion case
International update
• UK draft legislation on patent box compared to other selected countries
• GSK case in Canada
• OECD on Corporate Loss Utilization Through Aggressive Tax Planning
• Vodaphone case in India
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Introduction andoverview of profit splitmethods
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Profit Split Regulations
• OECD Guidelines:
− Residual Profit Split− Contribution Profit Split
• US regulations:
− Residual Profit Split
− Comparable Profit Split
− Other methods
• OECD and US both reject formulary apportionment
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The Profit Split Method
The profit split method identifies the profit to be split between the associated enterprises from thecontrolled transactions in which the associated enterprises are engaged. It then splits those combined
profits between the associated enterprises on an economically valid basis that approximates the divisionof profits that would have been anticipated and reflected in an agreement made at arm‟s length.
Contribution analysis
The profit is split based on the functions and risks that the enterprises assume in relation to the
transaction
Residual analysis
Divides the combined profits in two stages:
In the first stage the enterprises are remunerated for its non-unique contribution in relation to thetransaction. In the second stage any residual profit remaining are allocated to the enterprises based on ananalysis of the facts and circumstances.
The Profit split method is not as dependent of comparable data as the other methods, hence it can beapplicable when comparable data isn‟t accessible. The method analyses both parties of the transaction
which entails a reasonable split between the associated enterprises, though the application of the methodalso depends on the collaboration of all the associated enterprises.
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The residual Profit Split Method - ApplicationEx: The success of an electronic product is linked to the innovative technological design both of itselectronic processes and of its major component. That component is designed and manufactured byassociated company A, is transferred to associated company B which designs and manufactures the restof the product, and is distributed by associated company C.
As B‟s selling price to C is considered arm‟s length, the amount of residual profit accrued by A and B
together from the exploration of their respective intangible property can be determined (an arm‟s length
return on costs of 10% is applied)
A‟s manufacturing costs are 15, so A‟s manufacturing profit = 1.5
B‟s manufacturing costs are 20, so B‟s manufacturing profit = 2.0
The residual profit is therefore 6.5 arrived at by a
deduction from the combined net profit of 10.
Company A‟s R&D expenditure is 15 and Company
B‟s is 10 giving a combined expenditure of 25.
The residual is 6.5 which may be allocated 15/25
to A and 10/25 to B.
A‟s share 6.5 x 15/25 = 3.9
B‟s share 6.5 x 10/25 = 2.6
A‟s new net profit: 1.5 + 3.9 = 5.4
B‟s new net profit: 2.0 + 2.6 = 4.66
Current P&L
Sales 50 100
Purschases -10 -50
Manufacturing costs -15 -20
Gross profit 25 30
R&D 15 10
Operaing expenses 10 -25 10 -20
Net Profit 0 10
Revised P&L
Sales 55.4 100
Purschases -10 -55.4
Manufacturing costs -15 -20
Gross profit 30.4 24.6
R&D 15 10
Operaing expenses 10 -25 10 -20
Net Profit 5.4 4.6
Company A Company B
Company A Company B
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Situations “made” for
profit splits
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Situation 1: Technology Company -- Dispersed R&D
Residual Profit Split
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50%
15%
35%
Location 1
Profit for routine activitiesR&D Location 2
R&D Location 1
R&D Location 3
Combinedprofit
Residual profit
Split residual profit based onR&D cost percentages
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Situation 1: Residual Profit Split
• Profit split is alternative to cost sharing or to single IP owner
• Best for situations in which R&D at varous locations is:
− Complimentary
− Collaborative
• Split residual profit based on current costs or amortized historical R&D
costs
• Key assumption: only R&D contributes to residual profit
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Residual Profit Split – Example of Division of Total
Operating Profit
10
Sales 100
Cost of sales - manufacturing 30
Gross Profit 70
Operating costs 50
SG&A - Manufacturing 10
SG&A - Distribution 20
R&D costs - Location 1 7
R&D costs - Location 2 10R&D costs - Location 3 3
Operating profit 20
Split of profit
Maufacturing (10% x mfg
costs) 4.0
Distribution (4% x sales) 4.0
Residual to Location 1 4.2
Residual to Location 2 6.0
Residual to Location 3 1.8
20.0
Dist
Mfg
Resid1
Resid2
Resid3
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Situation 1: Residual Profit Split
Advantages over cost sharing
• Simpler – no forecasts required• No need to consider true ups, or revisions to cost share percentages
• May be no buy-in payments
• May be a better fit with corporate culture
Disadvantages over cost sharing:
• Joint economic ownership of intellectual property, but single legal owner?
• Classification of profit split payments
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Situation 2: Consumer Products Co. – dispersed non-
routine functions Contribution Profit Split
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Division of entrepreneurialactivities between HQ(central entrepreneur)and marketing / salesentities
HQ
Strategic functions / planning /procurement / principal for
manufacturing and distribution
Manufacturing
Entities
Manufacturing on atoll or contract basis
Sales Entities
Marketing / branddevelopment / new product
launches / customer development
Divide non-manufacturing profitusing subjectivecontribution analysis
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Situation 2: Contribution Profit Split (subjective version)
Profit split percentages built up by detailed functional analysis
• Identify key value creating functions• Weight the relative contributions of those functions
• Determine the split of those functions between the entities
• From above, construct scores for each entity
• Split profit based on relative scores
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Situation 2: Contribution Profit Split – Example
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Function Category FunctionsHQ relative
contribution Function WeightShare of Profit to
CE
Corporate / Category Strategy & LeadershipSet corporate / category strategy 30% 3.8% 1.1%
Direct & Monitor 30% 1.1% 0.3%
Manage stakeholder expectations 30% 0.7% 0.2%
Brand Development / BuildingGain consumer insight - 8.7% -
Strategy and brand key design - 7.5% -
Innovation & renovation 40% 15.6% 6.2%
Brand equity management and activation - 7.7% -
Customer DevelopmentGain customer insight - 1.0% -
Customer portfolio management (strategy) - 6.7% -
Customer management (day-to-day) - 16.9% -
Trade promotion - 5.1% -
Demand FulfilmentDetermine supply chain strategy 100% 6.5% 6.5%
Demand and supply planning 71% 4.9% 3.5%
Sourcing 97% 4.4% 4.3%
Product manufacture 91% 6.3% 5.7%
Delivery 54% 3.0% 1.6%
TOTAL SHARE OF PROFIT 30%
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Situation 2: Contribution Profit Split
Advantages
• Flexible• Accounts for valuable contributions that may not be directly correlated to costs or other
objective measures
Disadvantages
• Not based on external comparable transactions
• Highly subjective• Could be easily manipulated to move profit around
• Difficult for tax authorities to audit the split
• Weak support in OECD Guidelines
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Situation 3: Highly Integrated Manufacturing Entities
Contribution Profit Split
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ManufacturingEntity 1
ManufacturingEntity 2
Third PartySuppliers
Third PartyCustomers
Example: Commodity chemical manufacturing
• All of Manufacturing Entity 1‟s output is sold to Manufacturing Entity
2 (related party).
Commodity Commodity Commodity
Split the combined profit of the twomanufacturing entities in proportion to their
operating assets
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Global Profit-Split Model Description
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• Profit Split Factors
• Strategic management split – portion of global profit based on percentage of global management costs
divided by global operating costs
• Management profit split with those entities performing management functions based on their relative amounts of
costs
• Manufacturing
• 50 percent of global profit after removing management split
• Further divided between contributions of manufacturing operation and manufacturing IP
• Relative Value of manufacturing tangibleassets vs. manufacturing IP
• Profit attributable to manufacturing operation is based on relative adjusted PP&E balances
• Profit attributable to manufacturing IP is based on relative R&P costs
• Sales and Technical Services
• 50 percent of global profit after removing management split
• Profit split between entities performing STS activities based on relative costs for technical service and supply
chain.
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Situation 3: Objective Contribution Profit Split
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• Profit split percentages determined using an objective allocation key
• Advantages:
− Objective
− Economically rational
• Disadvantages:
− Limited applicability
− Wider application might be construed as formularly apportionment
− A number of allocation keys increase complexity
− May be difficult to establish a good cooperability test
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Situation 4: Cyclical Business – Hybrid Profit Split
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Situation 4: Hybrid Profit Split
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CPM upper bound
CPM lower limit
Combined profits
Hybrid PSLine
TestedPartyCountry.Profits
CPM lower bound
Formulary Profit Split Line – divides total profit based onfactors (e.g. assets, sales)
Hybrid PSLine
• “Splits the difference” between
the CPM range and the formularyprofit split 50/50
• Shares impact of market cycles
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Situation 4: Hybrid Profit Split
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• Combines an objective contribution analysis profit split with TNMM / CPM
• Reduces the likelihood of a TNMM / CPM resulting in taxable income inoverall loss situations
• Popular (in various guises) with the Japanese tax authorities (NTA)
• Advantages:
− Recognizes the interrelatedness of the businesses
− Preserves some elements of CPM / TNMM for remuneration of the least
complex entity
• Disadvantages:
− The overall contribution profit split is effectively a formulary apportionmentmethod
− Contribution profit split is not a specified method under US regulations
− Lack of third party evidence to support upsided and downside sharing
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Outlook for profit splitmethods
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Outlook for profit split methods
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News from Denmark
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Focus areas in audit environment
Indsats- og indrivelsesplan 2012
• SKAT will continue to focus on ”abusive tax structures”.
• SKAT‟s Large Enterprises Division are in the process of recruiting 40 additional employees
to audit large companies. 20 of these specialists will be fully dedicated to transfer pricing.
• SKAT have 27 projects about large enterprises including 7 projects that are fully focusedon transfer pricing.
Audits of Danish based MNEs (150 largest):
• Approx. 15 groups each year
• Will most likely be full audits of both general corporate tax and transfer pricing
• SKAT possibly looking to make clear that:
• Audits are not a thing of the past
• SKAT still has resources to audit very large companies
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Focus areas in audit environment
Transactions in focus
• Loss-making DK companies part of MNE group
• Transfers and use of intangible assets
• Transactions with group companies located in tax havens
• Management fee allocations from DK based MNEs
• Financial transactions
• Captive/reinsurance companies located in tax havens
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Draft tax bill out for comments
Highligths of the bill
• Limitation in losses carry forward
• Audit opinion on specific companies (loss makers and for transactions with tax havens)
• Penialties for lack of TP documentation wil be DKK 250,000 + 10% of a resulting upwardadjustment
• Publically available information about taxation
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Symbion case
Background
• Venture company and management company• Deduction for management fee paid by a venture company to a non-affiliated managementcompany
• Asset management costs are tax-deductible operating cost
• SKAT did not agree on deductibility because Symbion‟s income would mostly be taxexempt income (sale of shares)
The ruling
• The costs from the management fee are deductible:• Since Symbion has carried on their business with (although modest) returns from interests and dividends as well as
taxable and tax-free profits from sale of shares
• And despite the majority of the profit was tax-free capital gains because of the time of realization (3 year statute of limitations)
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Symbion case
Possible consequences
•Deduction of expenses despite the majority of the income is tax-exempt• In The Supreme Court's ruling, it is acknowledged that Symbion had the possibility of income from interests and dividends and thus a taxable income. Not enough for SKAT todeny deduction of the management costs to the taxable income
• A tax-free income does not challenge a deduction of the management fees as operatingcosts
• Tax losses do not preclude deductions• No implicit requirement of an allocation of expenses between tax-free and taxable income
Holding companies
• There is “a limit” on how much they can deduct if they have no taxable income – to bedefined
• Holding companies should however consider their structure in order to earn a positive(taxable) income by reviewing their cost allocations
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International updates
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UK patent box
• Patent box works as a reduced rate of corporation tax of 10% for profits attributed topatents from 1 April 2013 (60% of the benefit of the regime can be obtained in the first year
rising in 10% increments to 100% in 2017.)
• Significant cost to UK exchequer - expected to cost the UK government £0.9-1bn per annum at steady state
• The combination of the Patent Box regime and a potentially improved „above the line‟ R&Dtax incentive makes the UK a competitive jurisdiction for the whole innovation lifecycle
• Qualifying company” either holds ”qualifying IP rights” or exclusive license OR receives
taxable income in respect of ”qualifying IP rights” or an exclusive license sold in the
previous period
• A company will fall within the Patent Box if it has the rights to use, sell or license theinvention and to receive the profits related to that IP under a group agreement
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Comparison of four Patent Box regimes
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Tax factors Belgium Netherlands Luxembourg UK
ETR 0-6.8% 0-5% 0-5.76% 10%IP Patents, extended
patent certificatesPatented IP or R&DIP
Patents, trademarks,design, domainnames, models,software copyrights
Patents
Acquired IP? No, unless further developed
No, unless further developed
No Yes
Cap No No No No
Income Gross patent Net income and netcapital gains fromqualifying IP
Royalties and capitalgains
Net patent incomeafter associatedexpenses
Can work beperformed abroad?
Yes, if qualifying R&Dcenter
Yes for patented IP;For R&D IP strictconditions
Yes Potentially
Year of enactment 2007 2007/2010 2008 Proposed 2013
Applicable to existingIP?
Qualifying patentgranted or commercialized after 01/01/2007
Qualifying IP>12/31/2006
Developed or acquiredIP>12/31/2007
CommercializedPatent>11/29/2010
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UK patent box – why could this be relevant?
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Why 2012?
• Incorporate patent box in payments on account calculations
• Agree methodology and key parameters with UK tax authority
Review of breakdown of current or potential income streams to confirmwhich are derived from qualifying IPrights. Make recommendations toinclude more income, revise patenting
policy or where HMRC agreementshould be sought
Assessment
Consider potential impact for partiesto an IP related transaction
Hold a workshop for wider team/board
to highlight the application of the PatentBox to ensure greater awareness andaid decision making
Calculation StructuringLook at a typical year in isolation andcalculate the value/benefit of electinginto the Patent Box
Areas to consider will include:
• Inappropriate allocation of routineExpenses
• Assessment for whether streamingmay give a better outcome or may bemandatory
• Estimation of notional royalties• Consideration of impact/sensitivity of
NMR rates• Recommendation for improved data
capture
Consider the impact of the patent boxon the company/group‟s long termeffective tax rate to support forecasting,valuation and decision making
Consider whether the IP in the group isheld in such a way to maximise thebenefit of the patent box?
Would alternative structures create
greater value?
Consider the IP ownership location – onshore/offshore options may need tobe revisited
Agree calculations and methodologywith HMRC (inc notional royalty andNMR rates)
Consider the Patenting Policies – Doesthe company have patentableknowledge that could lead to benefits?
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GlaxoSmithKline Canada
Background
• On 13 January 2012, The Canadian Supreme Court met to hear CRA appeal and GSK‟s
response in the case concerning whether the taxpayer paid too much for activepharmaceutical ingredients (API) from a Swiss associated enterprise
• Price for API $1,500 a kilogram versus market price $194 – 304
Arguments
• CRA: Challenges the deductibility of the prices paid, saying it was not reasonable under the circumstances.
• GSK: Purchase of products part of a License agreement that allowed GSK to use theparent‟s trademarks and brand – deemed to have a significant value.
Decision
• The trial judge ignored this and ruled in favor of the CRA that the price GSK from an arm‟slength perspective should have paid was the highest of the prices paid by genericcompanies. Overruled by Federal Court in July 2010.
• The Supreme Court ruling is expected due within the next 6 months. Uncertainty over whether the ALP or reasonable purpose prevails. The decision will illustrate what thecourts finds are comparable transactions under comparable circumstances
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Other news
OECD
• New publication “Corporate Loss Utilization Through Aggressive Tax Planning”
• Large loss carry forwards – Up to 25% of GDP
• Losses used in aggressive tax planning via financial instruments, reorganisations and transfer pricing
• Recommendations to tax authorities are:
‒ Comprehensive approach and increased quality and quantity of data analysis
‒ Consider specific anti-avoidance legislation, revision of disclosure initiatives and restrictions on use of losses
‒ Use of mass media
‒ Increase use of compliance programs – early engagement of taxpayer
Vodafone India
• Vodafone bought telecom business from Hutchison for $ 11 billion in 2007 in a share deal and theIndian tax authorities demanded 2.2 billion in capital gains tax from Vodafone India, even though thedeal was agreed between to foreign independent parties
• Vodafone claimed that the tax administration had no right to tax the transaction and that if thetransaction should be taxed, the tax should be paid by Hutchison as seller
• The Indian authorities argued that under Indian law it was required that buyers have to withhold capitalgains tax and pay these to the government
• The Indian supreme court found that a transfer of shares between two foreign parties can not be subjectto Indian capital gains tax;
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Kontaktdetaljer
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Asger M. Kelstrup
Tlf. +45 3093 4596E-mail: [email protected]
Partner, National Leader Transfer Pricing
Henrik Arhnung
Tlf. +45 3093 5585E-mail: [email protected]
Partner, Transfer Pricing
Partner, Transfer Pricing
Dick Clark
Tlf. +31 (0)61 312 1245E-mail: [email protected]
Partner, Transfer Pricing
Kasper Toftemark
Tlf. +45 3016 2177E-mail: [email protected]
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