RoyaltyStat Blog

Residual Profit Split is an Avoidable Cul-de-Sac

Posted by Ednaldo Silva on Feb 21, 2017 4:20:07 PM

The claim that it is impossible to find comparable royalty rates and that from the start we should use the residual profit split method for high-value intangibles needs revisiting. This claim is made prima facie without regard for the license agreements available in curated databases such as RoyaltyStat, which as of today contains over 17,875 unique and unredacted license agreements. Also, adopting the residual profit split method, when separate tested party methods such as the TNMM could suffice, creates unwarranted costs and audit management challenges for both the taxpayer and the tax administration.

The profit split method is favored by certain tax authorities because it is the only transfer pricing method requiring the audit of the tested party and its related counterparties, including the licensor and licensees. To wit, in the U.S. case, the abandonment of the separate-entity audit under the profit split method was noted by Bittker & Eustice, Federal Income Taxation of Corporations & Shareholders (WG&L), ¶ 13.21[5][b] (Super-Royalty Amendment): “In the case of intangibles transferred by one related party to another after 1986, the final sentence of § 482 (added in 1986), in effect, imposes a profit-sharing, or super-royalty, approach for income derived from intangibles (which amount also will fluctuate throughout the use of that property):

‘In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.’

While the effect of this restriction on (or perhaps abandonment of) the normal separate-entity arm’s-length standard of the regulations remains to be fully worked out (although the regulations strive mightily to do so), the legislative objective was to ensure ‘that the division of income between related parties reasonably reflect[s] the relative economic activity undertaken by each.’ This statement implies that the transferor must report (and that the transferee can deduct) a higher amount (a so-called super-royalty) than the license fee that would result from arm’s-length bargaining between unrelated parties.” Thomson Reuters Checkpoint (paid subscription), retrieved on February 17, 2017.

In addition to the regulatory and audit hurdles, the residual profit split method entails calculations of “routine” returns (for each of the related parties) that are vulnerable to error propagation and become more vulnerable as the number of tested parties in the related party transactions increases. This means that application of the residual profit split method requires that we find company-level comparables to measure the arm’s return for all the relevant “routine” functions (such as manufacturing, IT and R&D services, wholesale distribution), each located in a separate country (or separate income tax jurisdiction).

Let’s suppose that we have a chemical manufacturer in Germany and a related distributor in Italy. For the residual profit split to apply, both the manufacturer and the controlled distributor must own and exploit intangibles in their conduct of trade or business. E.g. In Medtronic, Inc. and Consolidated Subs. v. Comm., TC Memo 2016-112 (issued June 9, 2016), Code § 482, the IRS’s reallocations of the taxpayer's taxable income (based on the comparable profits method, ergo TNMM) were regarded by the US Tax Court as “arbitrary and capricious” because of the failure by the IRS to recognize that both the US parent and its Puerto Rico subsidiary owned intangibles (in other transfer pricing litigation cases, the IRS attempted characterization that the foreign subsidiary of a US parent was a “contract manufacturer” (without its own self-developed or acquired intangibles) was also rejected by the US Tax Court).

In our example, the German manufacturer is able to show on its financials a cumulative history of tax deductible R&D expenses, and the resulting existence of patents and know-how. Likewise, the related Italian distributor is able to show on its financials a cumulative history of tax deductible advertising expenses and the existence of marketing intangibles, including registered or assigned trademarks and customer list. In these conditions, we would need to find:

     (a) Comparable manufacturers in Germany to determine an arm’s length return for its primary function; and

     (b) Comparable distributors in Italy to determine an arm’s length return for its complementary function.

If those two groups of comparable companies can be found, we would determine the residual profit split using two accounting equations:

     (1)     R = Ŝ – (M + D), and

     (2)     Rm = αm × R,

In equation (1), R denotes the residual profit after subtracting the “routine” returns for both the German manufacturing (M) and the Italian distribution (D) functions, starting from the known combined operating profits (Ŝ) of the manufacturer and distributor. The circumflex above S marks that the data are known from the combined financials, and are not estimated from comparables. In this case, the tax administration and taxpayer would benefit from the fact that both Germany and Italy have adopted the IFRS and the same EUR currency; otherwise, the M and D accounts would need to conform to an accepted accounting standard and be translated into the jurisdictional language. Of course, the new OECD country-by-country reporting makes the calculation of the equation system (1) and (2) c’est très facile à faire.

Equation (1) reflects a postulate that the combined (MNE group) operating profits consist of two accounting elements: (i) an estimated from company-level comparables "routine" return to basic functions, such as manufacturing, business services, wholesale distribution, retail; (ii) plus an unknown to be determined as a residual intangible profit. In equation (2), Rm denotes the fraction of the residual profit attributed to the manufacturing intangibles, which we can measure, for example, by the proportion of the manufacturing R&D payroll over the combined R&D manufacturing plus the distribution advertising payroll. In fact, equation (1) can be positive, zero, or negative, depending on the facts and circumstances of the case. Thus, a major benefit is that the profit split method can be used to share combined losses.

By considering these two equations, we have identified several major problems with application of the profit split method. First, the nonexistence of comparable royalty rates must be established as a factual matter, and cannot be presumed a priori. Second, finding manufacturing and distribution comparables may not be simple in certain countries. Third, there is a major problem lurking behind the profit split equations (1) and (2), namely the propagation of errors because under the profit split method we need to make at least two estimates, M and D, instead of one when we use a separate-entity method based on comparable royalty rates.

In fact, transfer pricing analysts often do not recognize that the estimates of multiple “routine” returns are each subject to errors. Thus, we have:

     (3)     M = mBest ± Δm and

     (4)     D = dBest ± Δd,

where the subscript “best” denotes the most reliable estimator of the “routine” arm’s length M and D profits. “It is reasonable to expect that the most reliable results we can calculate from a given set of data will be those for which the estimated errors are the smallest.” See Philip Bevington & Keith Robinson, Data Reduction and Error Analysis (2nd edition), McGraw-Hill, 1992, p. 6. The magnitude Δx is called the uncertainty, or error, in the measurement of the variable x (representing M or D). See John Taylor, Introduction to Error Analysis (2nd edition), University Science Books, 1997, p. 13, equation 2.3.

We know that the two magnitudes M and D (e.g., the arm’s length company-level operating profit margin of the controlled manufacturer and distributor) are measured with errors, Δm and Δd, and the sum or difference M ± D affecting R becomes:

     (5)     ΔR ≈ Δm + Δd.

Equation (5) means that the measurement error of the residual profit (ΔR) depends on two separate component errors reflecting "double trouble," i.e., the independent measurement errors of calculating M and D. We know also that these error components are significant in transfer pricing analysis because cross-section company-level data are not clean or harmonized respecting relevant data fields, such as revenue and operating profits. In equation (5), we have the propagation of errors because we need to measure how the errors in estimating M and D “propagate” (add-up) to cause errors in R (see Taylor, op. cit., chapter 3 for a detailed discussion of error propagation).

In RoyaltyStat, we provide data to determine comparable royalty rates. In addititon, we provide listed company-level financials to determine M and D in most countries for those who wish to utilize the TNMM for separate-entity analysis or the residual profit split method. However, as we’ve laid out in this post, we discourage the promiscuous use of the profit split method because of the method’s inherent vulnerability to error propagation (disregard of error analysis is inadmissible in science). We encourage the consideration of facts and circumstances relevant to the audit case, which means that transfer pricing analysts must challenge the untested hypothesis that it is not possible to find royalty rates for high-value intangibles. In two important respects, high-value intangibles are less affected by the royalty rate per se, which we consider as a matter of fact easy to find, than by the existence of additional factors -- primarily if the intangible licensing contractual terms provide for fixed or tiered royalty rates and if otherwise comparable license agreements incorporate additional monetary consideration, such as upfront fees or event-driven milestone payments.  

Ednaldo Silva (Ph.D.) is founder and managing director at RoyaltyStat. He helped draft the US transfer pricing regulations and developed the comparable profits method called TNNM by the OECD. He can be contacted at: [email protected]

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Topics: Royalty Rates