Are we approaching a next wave of TP documentation?

Pre-BEPS compliance with arm’s length principle was considered as transaction-based, or at most entity-based. With changing perspective, requirements evolved from this singular approach towards mapping the relative position of the group entities and reconciling the profit allocated according to “arm’s length” with economic value creation. Having said so, we can immediately spot the source of the above questions. While OECD Masterfile and C-b-C reporting already requires an overview of group value creation, there is not yet a bridge which enables a taxpayer to create that “360 degree” assessment using the methodological transfer pricing tools given by OECD guidelines. And without clarity how to build such a bridge, in majority of cases, sustainability of transfer pricing policy will require an additional analysis - like value chain analysis which complements current BEPS driven documentation on one side, and standard application of transfer pricing methods on the other. Now one may challenge me on that statement and say: if the arm’s length principle as well as reporting of the profits are implemented correctly, should we not ultimately come to the same results, with or without additional analysis?  Once the intercompany transaction is priced at arm’s length, the profit generated should basically match the transfer price, and even more optimistically add-up in value chain. It is difficult not to agree with that statement but if that “test of truth” would be indeed passed so easily, it is not yet clear by looking at current documentation and reporting (and let me add even less clear from practical approach of tax authorities). Let’s take one step back, and have a look at currently recommended “state of the art” process of setting the transfer prices, and see again where it leads us. Following recommended standard OECD approach, in order to select and apply appropriate transfer pricing method, tax payer as a first step should accurately delineate the transaction under review, by performing analysis of functions, risk and assets. Furthermore, revised OECD guidance underlines the significance of evaluation and identification of the intangibles, and the allocation of risks. Such “new” functions/ risk/assets analysis might result, for many companies, in the identification of additional intangibles or risks which consequently should be considered when assessing the appropriateness of existing TP methods (choosing between one-sided methods, or basically a profit split method). Having all that done, the tax payer, although formally compliant with the arm’s length principle, is still far away from an assessment if transfer price drives the entitlement to profit of the individual entity, and corresponds with the results achieved through the whole value chain. The trouble is still that OECD did not yet “land” the final guideline to help navigate from transaction-based outcome of transfer pricing analysis (even if got closer to it by more in depth considering important economical drivers such as risks diversification) to allocation of profit in the value chain. The latest Profit Split Discussion Draft sheds more light into that aspect by stating that the splitting of the profits should be done on the basis of the relative contributions to the creation of those profits. It refers to a multinational enterprise BEPS Master File as a potential useful source of information to determine such splitting factors (e.g., the sections on important drivers of business profit, principal contributions to value creation, and key group intangibles). However, let’s be clear that even in the case of application of the profit split method, the original conclusion seems to remain valid, as a two-sided type of method limits itself to transaction-based fragment of the value chain, similarly as one-sided ones. PSM sets the price for certain, selected segment of the “puzzle” whereas the analysis is required for the full picture of value chain, and consequently all different value driver, contributions or risks ought to be brought to consideration. So, circling back to the opening question, it is perhaps a good time to re-phrase it: is my “arm’s length” price sustainable as “BEPS arm’s length” price (or profit allocation) even without value chain analysis? Most likely the simple answer is: no. Looking at the current state of play of BEPS project, it looks like sooner or later, OECD will introduce some type of value chain analysis as obligatory element of transfer pricing documentation package. By sustaining the arm’s length principle as a core of transfer pricing regulation (and particularly regulating further application of PSM and consequently keeping” on board” one-sided methods), OECD is naturally forced to bridge economical type of profit allocation in the group with traditional TP methods. And if so, it needs to provide with defendable tools for such purpose. In the meantime, while this kind of corroborative analysis are not (yet) regulated, it is also worth contemplating what kind of additional analysis would suit best in individual cases. Although there is more and more pressure on having a value chain analysis, in my opinion it may be also advisable to also look into a slightly alternative direction, as for instance quantitative “benefit test” type of check-up. Compared to full-blown value chain analysis, a benefit test supports only partial profit allocation in the value chain, i.e. regarding the transaction at hand, however practically could be a useful tool, specifically for transfer prices set via one-sided methods. In whatever direction OECD will finally drive, will it be value chain analysis or benefit tests, we should probably be prepared for the next wave of transfer pricing documentation.

Joanna Gniadecka