The IRS’s Advance Pricing and Mutual Agreement program (APMA) recently introduced the Functional Cost Diagnostic Model (FCD Model or FCD), the latest addition in a steadily growing alphabet soup of transfer pricing acronyms.
The FCD is intended to identify, organize, and analyze “functional” costs in certain advance pricing agreement (APA) cases, presumably with the goal of understanding what each party brings, at least in terms of expenses, to the covered transactions under the APA. Revenue Procedure 2015-41 requires that an APA request provide details on the covered transactions, the tested parties, the proposed transfer pricing methods, financial data for the covered transactions, and a function and risk analysis of the covered entities. After reviewing the request, the APMA team assigned to the APA will generally issue one or more rounds of due diligence questions to further develop the facts about the business, the covered transactions, and the covered entities. Despite these existing requirements and processes, APMA has issued another tool, the FCD Model, to garner additional information.
Although the FCD is an APMA initiative, there is a significant likelihood that its use will leech into exams. Despite initial assurances that the FCD model was “not a tool for exam,” the IRS has announced that the tool “may be used in the exam context, if appropriate.”
At its core, the FCD model is a profit split based on costs. Bucketing costs as either routine or non-routine has an appeal that is easy to grasp, yet costs in themselves do not and cannot answer the real questions that APMA, like other tax authorities, want answered. Ultimately, tax authorities are trying to establish where and how value is created and which entities are exploiting and benefitting from that value, however it’s defined.
Despite the earlier introduction by the Organization for Economic Cooperation and Development (OECD) of its Action Plan on base erosion and profit shifting (BEPS), with its new acronyms such as “development, enhancement, maintenance, protection and exploitation” (DEMPE) and Control of Risk (COR), APMA is not alone in revisiting these questions. For example, the U.K.’s HM Revenue and Customs recently announced the Profit Diversion Compliance Facility (PDCF), and there are also all the Digital Services proposals from the OECD and HM Treasury that are questioning how income is allocated.
The PDCF is a result of HMRC’s apparent view that some taxpayers have provided insufficient, incorrect, and even misleading statements on the nature or value of the functions, assets, and risks relevant to their transfer pricing, and further that many business have undervalued the contributions made by staff in the U.K. To correct these perceived inadequacies, taxpayers are offered an opportunity to enter the facility, which requires registration with HMRC; an acknowledgement that there may be additional tax due, along with interest and penalties; a proposal that settles the tax, interest and penalties; and then payment of the proposed settlement amount.
The written proposal also requires a corrected transfer pricing policy that aligns with the economic activity in the U.K. In describing how taxpayers can remediate their situations, HMRC is adamant that superficial labels simply will no longer suffice when considering risk profiles, asset ownership, and people functions: Evidence is needed to demonstrate where the economic activities that generate profits are carried out. In short, HMRC are saying that in the four years since the BEPS report was published, not enough U.K. taxpayers have properly implemented the revised OECD guidance on transfer pricing.
Likewise, the OECD’s recent proposals on taxing the digital economy are rooted in the questions of where value is created, and where it should be taxed. The user participation proposal posits that “soliciting the sustained engagement and active participation of users is a critical component of value creation for certain highly digitalized businesses”—user participation is seen as critical to the development of brands and market power, and is considered to generate valuable data. Similarly, the marketing intangibles proposal is premised on the notion that marketing activities in a jurisdiction create value, both through the creation of favorable attitudes among local consumers and the generation of customer data.
The significant economic presence proposal, motivated by the same concerns, suggests a more formulary approach to identifying value. Notwithstanding BEPS, these various proposals indicate that tax authorities are still not getting the information they want to clearly identify value drivers, and to ensure that profits align with the correct jurisdictions. More cynically, some might presume that perhaps tax authorities are unsatisfied with the profit outcomes in their jurisdictions; however, best motives are assumed here, and it is important to recognize both the importance of the profit allocation question, as well as the diversity of possible answers.
The FCD Model
The FCD model is APMA’s tool for gathering additional information on value creation. APMA’s approach relies on a residual profit split tool to determine whether there are undiscovered pots of gold stashed among the APA’s covered transactions. It is a different approach from the PDCF facility and the OECD proposals, but one that seemingly shares the same goal—ensuring that profitability in a jurisdiction aligns with the activities performed, risks undertaken, and value created there.
Profits splits have an inherent appeal—perhaps it’s the suggestive nature of the name itself. Under the FCD model’s residual profit split method (RPSM), taxpayers are instructed to bucket the costs of activities that can be readily benchmarked. These are habitually labeled “routine costs” (a term which often fails to describe the complexity of many of the functions lumped into this category). The FCD uses another bucket to describe costs that cannot be reliably benchmarked, and which are deemed to result in unique and valuable contributions. Common transfer pricing parlance would label this the non-routine bucket.
The FCD instructions indicate that the model is designed to provide a pro forma split of the residual profits or losses based on the relative stocks of accumulated and capitalized functional costs, and that this pro forma residual analysis will provide APMA with a more comprehensive understanding of a taxpayer’s value drivers. The instructions note that APMA’s demand that a taxpayer complete the FCD does not mean that it has concluded the RPSM is the most appropriate method for the APA; rather, it will use the FCD as a diagnostic tool in conjunction with the APA submission and due diligence.
The primary flaw of APMA’s approach is that instead of ascertaining what the value drivers are based on an analysis of the business operations and the value chain, the model prioritizes costs to determine the key value or entrepreneurial drivers of the business. Relying on, or for that matter, starting with a cost analysis to pinpoint value drivers is putting the proverbial cart before the horse, or using the nail as the hammer. While the model requires that taxpayers to include historic costs that may generate income in the years under review, this acknowledgement of lead time and useful life does not translate into a determination of value. A strict quantitative cost analysis in and of itself, without any context or conditional qualification or modification, is at best a poor—and potentially a misleading—indicator of value. While cost may be one objective measure of functions, what are equally—if not more—important in an analysis of relative value are the character, timing, conditions, and associated risk of those functions.
The FCD model as presented makes the implicit assumption that all cost is either routine or non-routine, with non-routine equating to intangible creating. Presumably this strict characterization is a consequence of APMA’s desire to make the tool and its application simple; however, in the area of intangibles and value creation, rarely are there such clear, “bright lines.” As the OECD Guidelines observe, not all R&D expenditures or marketing activities result in the creation or enhancement of an intangible. Then there is the issue of timing, which is particularly relevant for non-routine contributions. The first dollar of cost is inherently and unambiguously much more risky, and potentially more valuable, than the last dollar of cost, but the design of the FCD fails to capture this aspect of spending.
The FCD also fails to address the relative, fundamental risks of the parties’ functions. For example, the risk associated with marketing is inherently different from that of technology development. As the OECD and the BEPS initiative have attempted to make clear through the introduction of DEMPE and other Action 8 – 10 items like COR, the inherent risk of a function, as well as the contractual obligations, managerial capabilities, and financial capacity surrounding the function can have material consequences for the value attributable to such function. Yet neither the FCD instructions nor the model acknowledge or provide a mechanism for addressing these considerations.
Another concern is a taxpayer’s accounting conventions for its cost centers. One taxpayer may organize a cost center that accumulates a multitude of tasks, with a variety of different and oftentimes distinct functions such as marketing planning, brand strategy, advertising, and marketing support; whereas another taxpayer may use cost centers that are more limited in scope. The cost center’s granularity or breadth may or may not reveal the value or conversely expose the risk associated with the function.
Even when properly categorized and capitalized, costs by themselves may not provide a reliable or accurate proxy of value, especially for different categories of contributions. Indeed, the OECD’s updated profit split guidance acknowledges that there may be a variety of metrics by which profits may reliably be split: assets, capital, costs, or a specific subset of one of these categories may provide an appropriate basis for dividing profits, as may the parties’ relative spending on key areas. When appropriate, more specific factors including employee compensation and headcount may be used. The OECD specifically notes that “costs may be a poor measure of the value of intangibles contributed,” and that relative costs incurred may provide a reasonable indication of the relative value of intangible contributions only where “such contributions are similar in nature.” In other words, even in cases where the residual profit split is the best transfer pricing method for a transaction, it does not follow that the cost-based analysis employed by the FCD is a reliable basis for the profit split.
Another fundamental concern is that the FCD model, like any profit split, hinges on the determination of allocable profit to the contributions of the parties. This requires a business to determine not only the profit from its covered transactions in the host country, but also the profits of the source country, which is typically the domicile of the principal or parent company. The company must then segment the system profit allocable to covered transactions. Instructions in the FCD model give scant consideration to these issues and to the practical difficulties faced in trying to determine the combined channel of profit from the covered transactions. As noted in the OECD’s revised guidance on transactional profit split, determining this can be a complex, time-consuming, and costly endeavor.
Varying accounting standards between the parties can give rise to differences in the treatment and recognition of revenues and certain costs, and there is also the need for currency translations to consider. Some of these accounting differences will create only temporary timing differences, whereas others can be permanent or very long-lived. Regardless, there need to be conventions for addressing these differences. Further, it is not uncommon to find differences in accounting systems and firm-specific accounting practices—often borne out of different accounting standards and ERP systems—that may not be so easily identified or reconciled, making the matching of income and expense as well as the consolidation of profit and loss far from a simple or straightforward task.
Another obstacle is determining the profit attributable to the specific covered transactions, which may be influenced by contributions from related entities outside the source and host countries. While it may not be too difficult to identify the revenues associated with intercompany transactions, most companies do not have specific product-line accounting, making it daunting—if not cost-prohibitive—to identify, segregate, and then allocate the associated costs to the specific product and country transaction. The lack of reliable, easily extractible segmented cost data has been and continues to be the primary detriment of the RPSM. This is unaddressed by the FCD model, which speaks to these complexities by simply instructing taxpayers to simply upload entity financial statements.
Phew—Costs are Covered But Where’s the Value?
All that is not to say that the FCD model is somehow broken—the model correctly does what it sets out to do. The issue is rather with its scope. APMA, in its attempt to create a workable model that would provide insight into value creation without being overly burdensome, has created a tool that generates data rather than meaning.
Even if taxpayer can get to an accurate, reliable determination of combined profit, the quantitative bucketing analysis of the FCD will not provide the answer as to what factors are actually responsible for the creation of the value, or even where the value was created, given that the functions and costs can span jurisdictions. A qualitative analysis of the functions, risks, and assets that translate into profit will need to be done. Such an analysis is required by the U.S. regulations and the OECD, yet often transfer pricing documentation, APA submissions, and MAP applications resort to short-handed terms such as “back-office,” “support services,” “limited risk,” “risk stripped,” “contract R&D,” or simply “routine.” Clearly, based on the introduction of the FCD by APMA and the PDCF by HMRC, such terms are not providing sufficient visibility into the actual value drivers of multinational enterprises.
Identifying value drivers requires understanding a business’s essential activities that, coupled with risk and asset management, drive success and profitability. The mapping of the components of activities, risks, and assets along the operational chain is a necessary exercise to identify and understand the various elements that are the business’s value drivers, each of which may have a different weight and make a different contribution to value creation. The mapping of these activities is not a superficial exercise; a full value chain analysis requires comprehensive interviews and analysis of available data and evidence to break down the components of the activities, including where the COR and DEMPE functions occur; a review of relevant contracts; and an analysis of asset ownership. The functions are mapped with asset ownership locations, risk management activities and locations, and the organizational matrix.
When done correctly, a clear narrative emerges that articulates value creation for the multinational and reflects the relative value of contributions made by the different parties in the value chain. Value chain analysis illuminates both a business’s primary value drivers and the secondary drivers of operational success. Understanding this hierarchy is critical for both businesses and tax authorities. Once the value drivers are identified and understood, the relationship of the value drivers to the covered transactions and the covered entities should be clear, allowing a tax authority to determine what amount of value was generated from its jurisdiction, and therefore what should potentially be subject to tax.
Engaging in a value chain analysis brings taxpayer’s closer to its business operations and provides the critical foundation that underpins the commercial realities and principles of a taxpayer’s transfer pricing model. Taxpayers should carefully consider the benefits of such an analysis. Those who lack in-depth insight into their value chains may expend the time and cost required to complete the APA request, the FCD model, and extensive due diligence, and still be unable to explain to tax authorities what drives the value of their business.
Conclusion—Modeling for the Future
If required to complete the FCD model, a taxpayer should proactively provide a more in-depth analysis to both highlight what the model accurately captures and to explain what eludes the functional cost lens. Taxpayers may also want to proactively run the FCD model prior to a request from APMA or IRS Exam to know whether the model will produce aberrant, incomplete, or nonsensical results, indicating in advance the need for a more robust supplementary analysis and discussion. Understanding where the FCD model falls short based on one’s own facts is critical to successfully shaping a narrative that accurately and persuasively explains both the taxpayer’s value chain and the proper basis for profit allocation.
The introduction of the FCD model brings new challenges, as taxpayers will have to work not only to complete the model, but to supplement and build on it. This is likely not the last such burden to be imposed. In light of the OECD and unilateral taxing proposals currently under discussion, taxpayers should brace themselves for the introduction of more tax authority models and more information requests.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Theresa Kolish is a managing director in the Transfer Pricing Dispute Resolution Services practice within KPMG LLP’s Economic and Valuation Services group (EVS). Mark Martin is the National Leader of the Transfer Pricing Dispute Resolution Services, and a principal in KPMG LLP’s Washington National Tax practice. Tracy Gomes, managing director, and Thomas Bettge, senior associate, also practice in Transfer Pricing Dispute Resolution Services in the EVS group.
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.