the profit split method

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Profit Split Methods

Copenhagen and Aarhus, 8 February 2012

Wave of the future?



© 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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© 2012 Deloitte

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



© 2012 Deloitte

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



© 2012 Deloitte

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



20.0

Dist

Mfg

Resid1

Resid2

Resid3



© 2012 Deloitte

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



© 2012 Deloitte

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%



© 2012 Deloitte

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



© 2012 Deloitte

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.



© 2012 Deloitte

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



© 2012 Deloitte

Situation 4: Cyclical Business – Hybrid Profit Split

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© 2012 Deloitte

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



© 2012 Deloitte

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



© 2012 Deloitte

Outlook for profit splitmethods

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© 2012 Deloitte

Outlook for profit split methods

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© 2012 Deloitte

News from Denmark

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© 2012 Deloitte

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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© 2012 Deloitte

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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© 2012 Deloitte

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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© 2012 Deloitte

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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© 2012 Deloitte

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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© 2012 Deloitte

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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© 2012 Deloitte

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



© 2012 Deloitte

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?



© 2012 Deloitte

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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© 2012 Deloitte

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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© 2012 Deloitte

Kontaktdetaljer

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Asger M. Kelstrup

Tlf. +45 3093 4596E-mail: [email protected]

Partner, National Leader Transfer Pricing

Henrik Arhnung


Partner, Transfer Pricing


Dick Clark

Tlf. +31 (0)61 312 1245E-mail: [email protected]


Kasper Toftemark


mailto:[email protected]










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