1. Centre for Tax Policy and Administration Case Study on Profit Split / Intangibles Workshop on Transfer Pricing and Exchange of Information Guatemala 2 – 5 May 2011 Wolfgang Büttner OECD

2. 2 Facts  Tirco is a company that specializes in developing, manufacturing and selling tires for passenger cars. It has operations in two countries – Home and Foreign.  One of its products is the high speed tire “A” for sports cars.  The Home entity does the R&D for developing the manufacturing process for product “A” and holds the manufacturing patents and know how in its own name.  Tirco (Home) is also the owner of the marketing intangibles, in particular the tradename “Tirco” and the trademark “A “.

3. 3 Facts (continued)  Tirco (Home) manufactures the raw materials used in Product A;  Tirco (Home) sells the raw materials to be used for manufacturing Product A in finished form to its subsidiary Tirco (Foreign);  Tirco (Home) licenses the patent for the manufacturing process of Product A to Tirco (Foreign);  Tirco (Foreign) manufactures Product A in finished form (using raw materials it purchases from Tirco (Home) and the patent / know-how for the manufacturing process);  Tirco (Foreign) markets and sells Product A in the local Foreign market

4. 4 Intangibles  In addition to the price for the raw materials sold to Tirco (Foreign), Tirco (Home) charges a royalty to Tirco (Foreign) for the patent that Tirco (Foreign) uses in the manufacturing process for product A.  The royalty is calculated as a percentage of the sales of product A made by Tirco (Foreign).

5. 5 Transaction and Invoice Flows Functions performed Tirco (Home) Tirco (Foreign) Home Foreign Undertakes process R&D Manufactures raw materials for product A Sells raw materials for A to Tirco (Foreign) Licenses manufacturing patent for A to Tirco (Foreign) Manufactures product A (using raw materials imported from Tirco (Home) and Tirco (Home’s) manufacturing patent) Sells and markets A to customers in Foreign Flow of Goods Payment for Goods/Intangibles Raw Materials for Product A License of manufactu- ring patent Manufacturing Patent Payment

6. 6 The Transfer Pricing Question  Identify the inter-company (related party) transactions between Tirco (Home) and Tirco (Foreign)!  What is the arm’s length transfer pricing for the inter-company transactions between Tirco (Home) and Tirco (Foreign)?

7. 7 List of Intercompany Transactions and Transfer Pricing Issues 1) Arm’ length transfer price for tangible goods transferred by Tirco (Home) to Tirco (Foreign):  Raw materials for Product A 2) Arm’s length transfer price for intangibles:  Manufacturing Patent / Know How licensed by Tirco (Home) to Tirco (Foreign) for manufacturing Product A

8. 8 Key Steps  Comparability analysis (five factors) 1.Characteristics of goods and services 2.Functional analysis (functions performed taking into account assets used and risks assumed) 3.Contractual terms 4.Economic circumstances 5.Business strategies  Identify Functions, Assets, Risks borne (FAR Analysis) by Tirco (Home) and Tirco (Foreign)  Determine arm’s length transfer pricing based on a comparability analysis (using the FAR (functions, assets, risks) analysis)

9. 9 Functional Analysis (1) Functions re. Product A Tirco (Home)Tirco (Foreign) Manufacturing R&D ( ) (?) Manufacturing (raw material) (finished product) Marketing (marketing strategy) Distribution

10. 10 Functional Analysis (2) Assets re. Product A Tirco (Home)Tirco (Foreign) Manufacturing Intangibles ( ) (?) Marketing Intangibles Other Assets (esp. plant, machines and equipment) …

11. 11 Functional Analysis (3) Risks re. Product A Tirco (Home) (raw material) Tirco (Foreign) Risks related to Manufacturing R&D ( ) (?) Market Risks Credit Risks Other Risks …

12. 12 Tax Administration’s Initial Questions  Transfer pricing policy and relevance for the transactions  Specific transfer pricing method(s) applied  Reasons for the selection of the specific transfer pricing method(s)  Intangibles: who, what, why, protection, scope, … royalties paid (or received)  Licensing and sublicensing agreements (both intra- group and with third parties)  Advance Pricing Arrangement (APA)? (if available)

13. 13 Royalties Valuation of Intangibles  Two-sided analysis!  Transferor: minimum that third party would charge  Transferee: maximum that third party would be willing to pay (based on profits expected from use of the intangible)  Market based approach ≈ CUP  Cost based approach: costs   economic value  Net Present Value / Discounted Cash Flow  Modified resale price method (sublicensing to independent third party)  Residual profit split (bases on anticipated profits)

14. 14 Residual Profit Split Method (RPSM) Combined Profit based on contributions made by both parties Residual Profit Residual Profit Share for Tirco (Home) Residual Profit Share for Tirco (Foreign) Residual Profits Split based on each party’s contribution of non-basic, valuable intangibles Challenge lies in determining the relative contribution of each party! RPSM commonly used to determine arm’s length value of intangibles minus basic functional profit to each party based on market benchmarks

15. 15 Example Assume the following figures: Product A (manufactured in Foreign) Tirco (Home) Tirco (Foreign) Sales 60 (?)100 Costs of goods sold(24) (60) (?) Manufacturing costs (6) (25) Gross Profit30 15 R&D(13) 0 Other operating expenses (5)(12) Royalty of 4 % of sales (4) (?) Other income (royalty) 4 (?) Net Profit reported16 (1) Are these arm’s length?

16. 16 Example (cont.) Product AConsolidat ed Sales100 Costs of goods sold (24) Manufacturing costs (31) Gross Profit 45 R&D (13) Other operating expenses (17) Operating/Net Profit 15 Combined profit (consolidated) reported

17. 17 Example (cont.) 1. Assign basic profit – Assume that on the basis of a comparability analysis, Tirco (Home) should earn a basic return of 10% net cost plus for the routine (benchmarkable) manufacturing function (excluding R&D) and Tirco (Foreign) a basic return of 6% of the sales for the routine (benchmarkable) manufacturing and distribution functions. – Tirco (Home): (COGS 24 + manuf. costs 6) X 10% = 3 – Tirco (Foreign): sales 100 X 6% = 6 – Total basic (routine) profit = 9 (3+6) 2. Calculate residual: 15 (total net profit) – 9 (basic profit) = residual net profit 6

18. 18 Example (cont.)  Split residual (based on contribution of non-routine functions / intangibles): – Tirco (Home): Manufacturing and marketing intangibles (R&D, tradename, trademark, marketing strategy) – Tirco (Foreign): no non-routine functions, no valuable unique intangibles – Residual  100% Tirco (Home): 6

19. 19 Example (cont.) Adjusted accounts / but how to calculate royalty ? Product ATirco (Home)Tirco (Foreign) Sales [60] 33100 Costs of goods sold(24) [(60)] (33) Manufacturing costs (6)(25) Gross Profit [40] 3 [15] 42 R&D(13) Other operating expenses(5)(12) Royalty expenses (license fees) [(4)] (?) Other income (royalties) [4] ? Operating/Net Profit[19] 9 [(1)] 6

20. 20 Example (cont.) Adjusted accounts / royalty calculated Product ATirco (Home)Tirco (Foreign) Sales [60] 33100 Costs of goods sold(24) [(60)] (33) Manufacturing costs (6)(25) Gross Profit [40] 3 [15] 42 R&D(13) Other operating expenses(5)(12) Royalty expenses (license fees) [(4)] (24) Other income (royalties) [4] 24 Operating/Net Profit[19] 9 [(1)] 6

21. 21 Example (cont.) Remaining Issues  Can we say: royalty embedded in transfer price? 33 (sales product A) + 24 (royalty) = 57 Transfer Price?  Or: 24 + 6 + 13 + royalty of 15 % on sales: 43 + 15 = 58

22. 22 Customs Valuation Considerations #1: Is the transfer price of the raw materials for Product A arm’s length for custom valuation purposes? #2: Is the royalty for the manufacturing patent for Product A included or excluded from the Customs Value?

23. 23 Selection of the TP Method  Is the residual profit split method the most appropriate TP method in this case???  If yes, why?  If no, why not?

24. 24 CCA Variation of the Example Facts re. Product B  Let us assume the following additional facts of the case: – There is an additional associated enterprise in Country CS that has entered into a R&D cost contribution arrangement with Tirco (Home) to develop manufacturing intangibles (patents, know-how) for a new product “B”. – Tirco (CS) holds the rights to the intangibles in all territories outside Home. – Tirco (CS) charges a royalty to Tirco (Foreign) for the manufacturing patent licensed to Tirco (Foreign) to manufacture product B. – Tirco (Foreign)’s undertakes extraordinary marketing efforts (advertising campaigns etc.) that result in non- routine marketing intangibles.

25. 25 Flow of Goods and Functions Tirco (Home) Tirco (Foreign) Home Foreign Manufactures raw materials for B Sells raw materials for B to Tirco (Foreign) Manufactures finished product B (using raw materials from Tirco (Home)) Sells and markets B to customers in Foreign Owns non-basic marketing intangibles Flow of Goods License of know-how Raw Materials for A Tirco (CS) CS CCA for developing manufacturing intangible Payment for Goods and Intangibles Holds right to manufacturing patent for B outside Home Licenses manufacturing patent for B to Tirco (Foreign) Know-how Royalty Payment

26. 26 Facts re. Product B Transfer Pricing Considerations  Related party transactions 1)Sale of raw materials (for product B) from Tirco (Home) to Tirco (Foreign) arm’s length TP? 2)License of manufacturing patent associated with Product B from Tirco (CS) to Tirco (Foreign)arm’s length royalty? Double dip if already embedded in transfer price! 3)Extraordinary marketing efforts of Tirco (Foreign) related to product B (advertising campaign, market penetration, new group of customer etc., substantially adding value to brand name,...)arm’s length remuneration?

27. 27 Functional Analysis (1) Functions Product A Tirco (Home) Tirco (CS) Tirco (Foreign) Manufacturing R&D ( ) (?) Manufacturing (raw material) (finished product) Marketing (marketing strategy) Distribution

28. 28 Functional Analysis (2) Assets Product A Tirco (Home)Tirco (CS) Tirco (Foreign) Manufacturing Intangibles ( ) (?) Marketing intangibles (tradename/ trademark Other assets …

29. 29 Functional Analysis (3) Risks Product A Tirco (Home) (raw material) Tirco (CS) Tirco (Foreign) Risks related to Manufacturing R&D ( ) (?) Market risk Credit risk Other risks … ( ) (?)

30. 30 Tax Administration’s Initial Questions (1)  Transfer pricing policy and relevancy for the transactions  Specific transfer pricing method applied  Reasons to select the specific transfer pricing method  CCA (where relevant)  Expected benefits from CCA  Legal and economic ownership of result of CCA

31. 31 Tax Administration’s Initial Questions (2)  Buy-in payments (buy-out payments)  Intangibles : who, what, why, protection, scope, … royalties paid (or received)  Licensing and sublicensing agreements (both intra- group and with third parties)  Expected (direct or indirect) returns from additional marketing efforts  Advance Pricing Arrangement (APA)? (if available)

32. 32 Example Assume the following figures: Product B (manufactured in Foreign) Tirco (Home) Tirco (CS) Tirco (Foreign) Sales 60 (?)100 Costs of goods sold(13) (60) (?) Manufacturing costs (2) (25) Gross Profit45 15 R&D(12)(13) Extraordinary marketing costs (5) Other operating expenses (5)(12) Royalty expense (4) (?) Other income (royalty) 4 Operating/Net Profit28 (9) (6) Are these arm’s length?

33. 33 Example (cont.)  Transfer pricing issues:  Sales / costs of goods sold of 60  CCA (joint development of manufacturing know-how)  Royalty  Extraordinary marketing efforts and remuneration thereof  Examine functions:  Routine – Sales / manufacturing function of Tirco (Foreign) and – Manufacturing function of Tirco (Home)  Non-routine – R&D Tirco (Home) and Tirco (CS) – Extraordinary marketing efforts of Tirco (Foreign)

34. 34 Example (cont.) Combined profit (consolidated) Product BConsolidated Sales100 Costs of goods sold(13) Manufacturing costs(27) Gross Profit60 R&D(25) Extraordinary marketing costs (5) Other operating expenses(17) Net Profit13

35. 35 Example (cont.)  Assign basic profit Assume that on the basis of a comparability analysis, Tirco (Home) should earn a basic net return of 20% net cost plus for the routine (benchmarkable) manufacturing function (excluding R&D) and Tirco (Foreign) a basic net return of 5 % of the sales for the routine (benchmarkable) distribution function (TNMM). Calculation: – Tirco (Home): costs 20 X 20% = 4 – Tirco (Foreign): sales 100 X 5% = 5 – Total basic (routine) profit = 9  Calculate residual : 13 (total profit) – 9 (basic profit) = 4

36. 36 Example (cont.)  Split residual of 4: Assume that R&D and extraordinary marketing efforts are equally important for the success / failure of the product and that the costs incurred are an appropriate allocation key. Costs: 12 (R&D) + 13 (R&D) + 5 (extraordinary marketing) = 30 – Tirco (Home): 12/30 X 4 = 1.60 – Tirco (CS): 13/30 X 4 = 1.73 – Tirco (Foreign): 5/30 X 4 = 0.67 4.00

37. 37 Example (cont.)  Calculate Total Profits: Tirco (Home) Tirco (CS) Tirco (Foreign) Total Basic return4.00--5.00 9.00 Residual return1.601.730.67 4.00 Total Profit5.601.735.6713.00

38. 38 Example (cont.) Adjusted accounts (2) Product A – manufactured in Foreign Tirco (Home) Tirco (CS) Tirco (Foreign) Sales [60] 24100 Costs of goods sold-20 [- 60] – 24 Manufacturing costs 25 Gross Profit [40] 4 [15] 51 R&D-12(13) Extraordinary marketing costs - 5 Other operating expenses-12 Royalty expense [-4] - 28.33 Other income (royalty)[0] 13.60[4] 14.73 Net Profit[28] 5.60[-9] 1.73[-6] 5.67

39. 39 Example (cont.) Remaining Issues  Tirco (CS) is legal owner of intangible and licensor  So all royalties (and profits from joint R&D) to Tirco (CS)?  Tirco (CS) performs R&D partly for other market (Home), but is not remunerated for that. Tirco (Home) also performs partly R&D for markets it does not cover, but is not remunerated for that either.  Separate remuneration?  Adjustment of allocation of royalties (profits from R&D)?