React | Profit splits and cost sharing: what about losses?

In this Insight, we turn our attention to profit split methodologies and cost sharing arrangements⁽¹⁾, and discuss how they can be affected by the economic disruptions caused by COVID-19. Profit splits are typically implemented when the participating parties to an intercompany transaction both (or all) own significant intangibles that are put to use as part of the transaction. In a crisis like the current one brought on by COVID-19, the intangibles may not generate a profit, but rather a loss, e.g. due to reduced sales volumes of branded products and fixed costs, turning the profit split into a loss split.

A similar effect could apply regarding cost arrangements. Under such arrangements, two or more related parties contribute to the development of an intangible, with their cost shares based on a measure of relative value or benefit of the intangible to each party. While such an intangible might have qualified as worthwhile to invest in before the crisis, things might look different now.

Separately, profit split methodologies and cost sharing arrangements both depend on forecasts of future costs and benefits. Forecasts developed before the COVID-19 pandemic will likely bear little resemblance to actual financial results for the next year or longer. If forecasts are not updated, post-year-end adjustments might be required.

Intangibles

Intangible assets, for example brand names, are relevant from a transfer pricing point of view in the context of the 2017 OECD Transfer Pricing Guidelines. The OECD defines an intangible asset as a neither material nor financial value that can be owned or controlled for use in business activities and whose use or transfer in a business transaction between independent companies is remunerated under comparable circumstances. Thus, for example, the mere use of a company name can result in economic benefits that must be adequately remunerated according to the arm's length principle.

According to the OECD and most tax authorities, a discussion of the data and facts relevant to intangible assets must be included in transfer pricing documentation. This requires a precise identification of the intangible assets used or transferred and the related contractual agreements. OECD guidelines state that it is no longer just the legal ownership of an intangible that is decisive for the allocation of income, but also the actual exercise of functions for the creation and maintenance of value. Therefore, a detailed functional analysis, documenting the Development, Enhancement, Modification, Protection and Exploitation (“DEMPE”) functions, assets and risks must be carried out. The aim of this analysis is to confirm the alignment between (ex-ante) contractual agreements and the actual operational behavior of the parties. In addition, the DEMPE analysis forms the basis of the allocation of profit to each of the parties to the controlled transactions.

Profit split

The OECD’s “Revised Guidance on the Application of the Transactional Profit Split Method” published in June 2018, recommends the distribution of intragroup remuneration for the transfer of intangible assets based on the DEMPE functions. The Transactional Profit Split Method (‘TPSM’) will often be the most suitable method when, for example, multiple related parties perform the functions of an entrepreneur, including the development and/or exploitation of brands.

The TPSM is ‘special’ among the OECD transfer pricing methods, since it is the only two-sided method. In the first step, the profits from routine activities are separated from the other profits and allocated to the entities performing those routine activities. In the second step, the remaining or residual profit is divided among the participating companies. This is done using a distribution key that is supposed to realistically reflect the share of the respective companies in the generation of profits. While one-sided methods only analyze the results of one company in an intercompany transaction, the use of a two-sided method requires detailed information on all companies involved in the transaction. This makes the TPSM one of the more complex transfer pricing methods.

Loss split?

In case of a loss, for example, as might be caused by COVID-19, the applied TPSM and the underlying agreements require a thorough review from a tax and transfer pricing perspective. Questions to be addressed include:

Do the agreements and formulas allow for the application of a loss split?
Do any of the entities have a guaranteed minimum profit that could limit loss sharing?
Can the agreements be updated to reflect current economic conditions?

All of these issues should be carefully considered when profit split methodologies are in place.

Cost sharing

In cost sharing arrangements, similar issues arise. If one of the parties to a cost sharing arrangement is in a critical economic situation, it may be possible for its contributions to be postponed, or even cancelled. If this is the case, the cost sharing agreement and any ancillary agreements (such as licensing agreements) may need to be adjusted accordingly. Moreover, the whole cost sharing arrangement could be in jeopardy, and the company may need to consider “unwinding” it. For example, if the outcome of the joint intangible property development efforts could be considered worthless due to the crisis, it might be necessary to terminate the transaction completely.

Forecasts

The transfer pricing of cost sharing arrangements and the implementation of the profit split methodology both depend on financial forecasts. Developing the transfer pricing model for cost sharing arrangements requires the use of forecasts to calculate the relative benefit to each party of the intangible property being developed by the arrangement. This calculation is part of the determination of both the “buy-in” payment for pre-existing intangible property and annual cost sharing payments to fund ongoing development. For existing cost sharing arrangements, reliance on pre-pandemic forecasts may yield inaccurate forecasts of revenues and costs, which in turn can distort relative benefits and cause miscalculations of cost-sharing-related payments. If large enough, retroactive adjustments would then be required to remedy these miscalculations. Timely updated forecasts can mitigate the risk of retroactive adjustments.

In profit split calculations, certain keys through which residual profits are allocated also depend on forecasts of revenues, costs, and benefits. In this case, transfer pricing policies based on pre-pandemic forecasts can lead to under- or overpayments of transfer prices and the potential for year-end adjustments.

Conclusion

Profit split methodologies and cost sharing arrangements are among the more complex transfer pricing structures, even in stable economic environments. Under current conditions, when many companies are experiencing losses and pre-pandemic forecasts are likely not reflective of our current economic realities, these structures require extra attention. Agreements should be reviewed and economic realities should be incorporated into forecasts and calculations⁽²⁾.

⁽¹⁾ The OECD guidelines refer to “development cost contribution” agreements; the U.S. regulations employ the term “cost sharing” agreements. Functionally, both are quite similar. Here, “cost sharing” is used to refer to both types of arrangements.

⁽²⁾ Government support measures related to Covid-19 need to be considered and whether changes with respect to transfer pricing policies would have an impact on subsidies received.