Policy Proposals Business Law Comments on the Public Discussion Draft on BEPS Action 10 (Profit Splits)
Head of Transfer Pricing Unit, Centre for Tax Policy and Administration
Organisation for Economic Co-operation and Development
Keidanren hereby submits its comments on the Public Discussion Draft "BEPS Action 10: Discussion Draft on the Use of Profit Splits in the Context of Global Value Chains" published by the OECD on 16 December 2014.
It is true that, in general, the transactional profit split ("PS") method may be applicable to cases in which identifying comparable transactions is difficult and applying one-sided transfer pricing methods does not provide a solution. The PS method is one of the OECD-approved transfer pricing methods, and has been used by Japanese companies to deal with transactions in particular countries, including cases to which they have applied the method according to a mutual agreement obtained through a bilateral advance pricing arrangement. We have no intention of taking a position against the PS method per se, and basically welcome the refinement of the method.
The problem is that, as mentioned in paragraph 2.114 of the existing Guidelines, the PS method is difficult to apply, due partly to difficulty in accessing information on foreign affiliates and in measuring revenue and costs segmented by transaction. As MNEs' value chains are increasingly complex and diverse, it is hard to determine the appropriate profit split factor, too. It should also be noted that, in the case of splitting profits generated in multiple countries, an adjustment by one country may affect other countries.
The Japanese business community is strongly concerned that the outcome of BEPS Action 10 may lead the application of the PS method to be readily expanded. Under the method, the prices of controlled transactions can be set from the perspective of value creation alone, without using comparables. If this approach prevails, the transfer pricing rules underpinned by the arm's length principle will become ambiguous. Additionally, if tax administrations around the world unilaterally determine profit split factors at their discretion, double taxation will increase further. It goes without saying that formulary apportionment is unacceptable.
Accordingly, when considering the PS method, the following three points are of particular importance:
Retain the most appropriate method approach
It is overhasty to conclude, solely on account of the complexity of MNEs' global value chains, that identifying comparable transactions is difficult and thus the PS method is the most appropriate method. For example, although the relationships among suppliers described in Scenario 5 of the public discussion draft appear intricate at first glance, not a few enterprises conduct their business in a similar fashion. In cases where reliable comparable transactions are available, the transactional net margin method ("TNMM") and other one-sided methods still work effectively.
Suppose a clear determination cannot be made as to whether the TNMM should be used. Even in that case, if the taxpayer has taken into account the entire transaction value chain and other facts and thereby adjusted the range to a certain degree on the basis of the TNMM using additional factors, such an approach should be accepted. We believe that the application of the PS method should be considered only when the use of other possible methods has been examined and determined not appropriate.
We consider the following statement in paragraph 3 very important: "The separate discussion of the transactional profit split method in this discussion draft should not be taken to imply any change to this wider framework" (of paragraph 2.2 of the existing Guidelines that refers to the selection of the most appropriate transfer pricing method). This statement needs to be revisited.
It should also be noted that the most appropriate method referred to does not mean the one most appropriate for taxation. Therefore, the inconsistent selection of transfer pricing methods should be strictly refrained from. An example of such practice is, with regard to MNEs' controlled transactions, applying the PS method to a case with combined profits for the purpose of levying taxes, while applying the TNMM to a case with combined losses for the purpose of artificially creating profits.
Place emphasis on "unique and valuable" contributions
Even if the role of the PS method is redefined, what is acceptable to us is the residual profit split method. In other words, core profits from transactions should be split only among the parties who have made unique and valuable contributions to them; the parties who have performed a mere routine function should be compensated only in an amount commensurate with the level of that function. Another important matter here is that the definition of the term "unique and valuable" in the context of profit splits should be deemed the same as that in the context of intangibles, that is, being "not comparable ... and ... expected to yield greater future economic benefits" as laid down in paragraph 6.17 of the Guidance on Transfer Pricing Aspects of Intangibles.
Value intangibles in a right way
This is closely related to the second point. While the public discussion draft refers to transactions involving intangibles as cases to which the PS method applies, we would like to stress that, above all, importance should be attached to the legal ownership of intangibles. In the process of analyzing functions performed for the development, enhancement, maintenance, protection, and exploitation of the intangibles, the assets used, and the risks assumed by the parties to the transactions, and the contributions made in the development phase to the value of the intangibles should be clearly distinguished from those made in the other phases. This is especially important to manufacturers.
Suppose a parent company licenses intangibles it developed and legally owns to its overseas subsidiary engaged in manufacturing end products. In that case, even if the overseas subsidiary has enhanced the intangibles for purposes such as localization, such enhancement constitutes nothing more than a mere ancillary activity, nor does it reduce the original value of the intangibles. Even if new intangibles are created in ancillary phases other than development, such enhancement should be required to satisfy multiple conditions, including a unique and original contribution that can be seen in patents, the possibility to be marketed as an independent product or technology, and the assumption of product liability and other risks.
Due recognition should also be given to a difference in the level of contributions to value creation between the development and marketing functions in the context of operations of manufacturing companies. Basically, marketing is an activity that produces a synergistic effect by building on development work and on the foundation it has laid in the form of the product's or service's specifications, quality, price, and other characteristics. As such, it is often the case that the marketing phase cannot be treated in the same way as the development phase.
In connection with that, Scenario 3 of the public discussion draft warrants some comments. Although Company S may probably be said to make unique and valuable contributions to a certain extent by actively performing the marketing function, we cannot agree on valuing its contributions too highly. It is reasonable to think that a substantial portion of value creation in Group X stems from Company P's extensive research and development activities.
Subcommittee on Taxation