INSIGHT: Cost-Plus Transfer Pricing for Marketing Support Services Between BEPS 1.0 and BEPS 2.0

KPMG LLP collected feedback from 26 KPMG International Member Firms (KPMG International member firms in Argentina, Australia, Austria, Belgium, Chile, China, Colombia, Croatia, Germany, Greece, India, Indonesia, Italy, Japan, Luxembourg, Mexico, Netherlands, New Zealand, Norway, Peru, Poland, Romania, Taiwan, U.K., Uruguay, Vietnam) to understand the extent to which a cost-plus transfer pricing remuneration for marketing support services would be challenged in today’s environment from a local transfer pricing perspective.

As it relates to local sales and marketing activities, multinational enterprises (MNEs) often structure their transfer pricing arrangements in two ways:

I. Local sales and marketing entities are structured as limited risk distributors (LRDs) that have no ownership of intangible property, do not perform DEMPE (development, enhancement, maintenance, protection, exploitation) functions and do not assume key risks. Accordingly, the transfer pricing policy typically leaves the LRD with a modest profit margin for its local sales and marketing activities.

II. A MNE may record third-party sales from local customers remotely in a foreign principal entity and structure the local affiliate as a routine market support service provider. Under this model the local affiliate often receives a cost-plus service fee from the principal entity.

Of the two transfer pricing arrangements described above, the service fee model (i.e., cost-plus return) is common for highly digitalized companies, including software and technology companies, and is of particular concern to market jurisdiction tax authorities. While the recent emphasis has been on highly digitalized companies, the service fee model for more traditional companies is also under the microscope of local tax authorities. Specifically, some tax authorities are challenging whether the LRD and service fee models (and associated transfer pricing) adequately compensate local affiliates for their local marketing intangibles for digital and non-digital companies alike. This concern is currently being addressed head-on in the “marketing intangibles” proposal described in the February 2019 Organization for Economic Co-operation and Development (OECD) Public Consultation Document (OECD Public Consultation Document, Addressing the Tax Challenges of the Digitalization of the Economy).

On Jan. 29, 2019, the OECD announced that the Inclusive Framework on BEPS would develop a new program of work, which we have labeled “BEPS 2.0,” to introduce further reforms to the framework for international taxation (OECD/G20 Base Erosion and Profit Shifting Project, Addressing the Tax Challenges of the Digitalization of the Economy—Policy Note). BEPS 2.0 follows the OECD/G20 project which set out recommendations in 2015 for countries to adopt in order to counteract Base Erosion and Profit Shifting (BEPS project) by MNEs. The focus of BEPS 2.0 is to proceed on a “without prejudice” basis to create an international consensus on new rules for the framework for international taxation, particularly for businesses with valuable intangible assets. All of the proposals under consideration would go beyond the arm’s-length principle, and the several of the proposals would change the scope of current tax nexus rules, which generally are limited to businesses with a physical presence in a country.

As part of BEPS 2.0, the “marketing intangibles” proposal, which would change the existing profit allocation and nexus rules, illustrates a scenario where an MNE can “reach into” a jurisdiction, either remotely or through an LRD/services provider, to develop user and customer base and other marketing intangibles.

While the OECD discussion paper references the definition of the marketing intangibles in the OECD Transfer Pricing Guidelines, the proposal sees an intrinsic functional link between marketing intangibles and the customer base in a market jurisdiction that could be considered to go beyond that definition and appears to be the basis for proposing an expansion of the taxing rights of market jurisdictions beyond that resulting from application of the arm’s length principle. (The term “marketing intangibles” as used in this article has the same meaning as is set forth in the OECD Transfer Pricing Guidelines: “an intangible . . . that relates to marketing activities, aids in the commercial exploitation of a product or service and/or has an important promotional value for the product concerned. Depending on the context, marketing intangibles may include, for example, trademarks, trade names, customer lists, customer relationships, and proprietary market and customer data that is used or aids in marketing and selling goods or services to customers.” (OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (OECD TPG), p. 27). OECD Public Consultation Document p. 12 fn. 4.)

In May 2019 the OECD/G20 released a programme of work (OECD/G20 Inclusive Framework on BEPS, Programme of Work to Develop a Consensus Solution to the Tax Challenges Arising From the Digitalization of the Economy) outlining potential solutions for determining where tax is to be paid and on what basis “nexus,” as well as what portion of profits could or should be taxed in the jurisdictions where clients or users are located “profit allocation.” The proposals put forth by the OECD/G20 include a modified residual profit split (MRPS) method, fractional apportionment method, and a distribution-based approach. These approaches explore the possibility of specifying a “baseline profit in the market jurisdiction for marketing, distribution and user-related activities.”

While the OECD’s BEPS 2.0 work on marketing intangibles and other proposals related to the digitalization of the economy is still underway, we have observed tax authorities around the world increasing their focus on the compensation of marketing and distribution entities in their jurisdictions. Specifically, in recent months we have noted an uptick in local tax authority challenges to the cost-plus service fee model as adequate remuneration for local sales and marketing activities in connection with the potential development of local marketing intangibles.

KPMG gathered feedback for the period Jan. 1, 2019, through March 31, 2019, from KPMG International member firms on the acceptability of cost-plus remuneration for marketing support services in today’s environment. As noted above, there is currently a global debate underway at the OECD level that may significantly alter the nexus and profit allocation rules; hence, any related changes may impact the KPMG International member firm responses in the future. Therefore, the feedback results below represent a snapshot view for the period under consideration.

Key insights include:

— So far, cost-plus remuneration for marketing support services remains sustainable in the majority of jurisdictions, however MNEs should be prepared to defend the nature of the services as “low risk / low value,” which in most jurisdictions is not clearly defined; and,

— Cost-plus remuneration for marketing support services, especially those that are considered “value-adding” (“value-adding” is not clearly defined in most of these jurisdictions) or include selling activities, is increasingly being challenged in local market jurisdictions, including:

• Australia—The Australia Tax Office (ATO) is putting pressure on such cost-plus models and has had success in converting such models to a return on sale methodology through laws such as Australia’s Multinational Anti-Avoidance Law (MAAL), released in November 2015. MAAL is part of the ATO’s efforts to combat tax avoidance by multinational companies operating in Australia, which has been established to ensure that multinationals pay their fair share of tax on the profits earned in Australia. As a general proposition, the ATO appears to challenge a cost-plus model when the activities performed by the Australian entity involve customer touch points.
• Belgium—A net cost-plus method is only applicable if there are no negotiations or sales type activities at all in Belgium.
• India—When an overseas entity undertakes the sale of products/services directly to customers in India, and the host country entity (India) undertakes local marketing support services, the local India entity can be compensated with a cost-plus remuneration provided the local India entity does not play a role in negotiation of contracts. This fact should be proved beyond doubt using documentation such as communications, mail correspondences, etc.
• Italy—Italy’s Finance Act for 2014 introduced a new measure into Italian Transfer Pricing Regulations in relation to multinational enterprises operating in Italy in the online advertising industry. The new measure stipulates that such companies are prohibited from being remunerated on a cost-plus basis, unless agreed in an APA with the Italian Tax Authority.
• New Zealand—Section GB54 of the Income Tax Act 2007 has recently come into effect (applying to income years commencing on or after July 1, 2018) which can “deem” a permanent establishment for non-residents selling into New Zealand in certain circumstances. In particular, where a non-resident seller makes supplies to a New Zealand customer and operates through an associated New Zealand party who carries out activity which “brings about” the sale in question then there is a risk that the New Zealand tax authority will deem a permanent establishment for the non-resident in New Zealand. Regardless of section GB54, the tax authorities have sought to challenge the level of cost-plus remuneration, as well as the cost-plus method.
• U.K.—HM Revenue & Customs (HMRC) is increasingly expecting sales-based returns over cost-based returns for marketing support services provided by a U.K. enterprise to a foreign affiliate. This expectation applies to “digital” and “non-digital” companies alike. In addition, a punitive 25% diverted profits tax (DPT) applies to U.K. sales booked by a foreign company where such sales avoid the creation of a permanent establishment in the U.K. HMRC is particularly focused on situations in which substantial sales and marketing activity takes place in the U.K. (e.g., by a cost-plus marketing support services provider) but structured in such a way so as to ensure that the foreign company is not carrying on a trade in the U.K. (e.g., no conclusion of contracts). The conversion of the marketing support services provider into a buy/sell entity remunerated on the basis of sales is a practical measure to reduce the risk of DPT.

— A common practice for tax authorities that reject cost-plus remuneration for marketing support services is to convert local affiliates to be compensated as a return on sales, akin to remunerating the local affiliate as a distributor of the digital service or the virtual distributor of the physical goods.

Digitization has created a new dynamic when considering the taxation of remote sales. While the OECD considers proposals to address the challenges of taxation of the digital economy through BEPS 2.0, local tax authorities, who may be dissatisfied with the status quo, are actively starting to challenge the LRD and cost-plus transfer pricing models. These local tax authorities are searching for ways to ensure their slice of global profit, or their “piece of the pie.” This is increasing pressure on transfer pricing models and the remuneration of local sales and marketing activities. These challenges of course exist alongside those related to the introduction and implementation of local digital services taxes which are being proposed as an avenue outside of transfer pricing for tax authorities to assert claim to a bigger piece of the pie—specifically as it relates to the most highly digitized businesses.

As we wait for BEPS 2.0, taxpayers will continue to face uncertainty on a country-by-country basis as to whether their transfer pricing models will come under attack by local tax authorities, all with the added transparency pressures of the OECD guidance on country-by-country reporting and revised standards for transfer pricing documentation (i.e., master file and local file requirements in accordance with Annex I and Annex II of Chapter V of the OECD Guidelines ) that were intended to force taxpayers towards global consistency in their transfer pricing models.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

The information in this article is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP.
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Authors

• Doreen Liu (doreenliu@kpmg.com) is a principal in the transfer pricing group of the Economic and Valuation Services practice of KPMG LLP. She is based in New Jersey.
• Prita Subramanian (psubramanian@kpmg.com) is a principal in the Economic and Valuation Services — transfer pricing group of the Washington National Tax practice of KPMG LLP. She is based in Boston.
• Nicholas Stavrakis (nstavrakis@kpmg.com) is a senior manager in the transfer pricing group of the Economic and Valuation Services practice of KPMG LLP. He is based in New York.

Thank you to KPMG International Member Firms for their contributions.