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Profit Split May Help Cos. In Crisis, But Comes With Risks

By Molly Moses · August 7, 2020, 2:32 PM EDT

Multinationals suffering the economic effects of the coronavirus pandemic may decide a profit split is the method that will best help them share losses across the organization, but adopting it abruptly — or abandoning it in better times — can be risky.

Both the OECD and the IRS have set forth clear guidelines for when the profit split method is appropriate, a practitioner told Law360. (Getty)

For companies that have historically used much more common transfer pricing methods that attribute profit to one side of a transaction, switching to an approach that shares profits and losses among several group members may raise tax authorities' eyebrows, according to tax specialists. This is especially true if the new method wasn't prompted by changes to the business, they said.

Typically, a profit split is used when a company in each participating jurisdiction contributes something "nonroutine," or unique and valuable, to the enterprise. From a tax authority's perspective, that contribution, usually in the form of an intangible asset, "didn't just arrive there overnight," said Elizabeth Stevens, a member of Caplin & Drysdale Chtd.

"Suddenly, in a loss year, we have something nonroutine, so we share in the losses. What about last year?" she said. To convince a tax authority that a company's switch to profit split is warranted, "you would ideally have some functional change that you can point to, some facts on the ground that support your change" in method, Stevens said.

Another practitioner pointed out that both the Organization for Economic Cooperation and Development and the Internal Revenue Service set forth clear guidelines for when the profit split method is appropriate. Under both sets of guidance, companies must be able to demonstrate that each party is making unique and valuable contributions, that the business operations are highly integrated or that the parties are sharing the assumption of economically significant risks, said Tansy Jefferies, a principal for international tax services with RSM US LLP.

"If you've not documented or demonstrated that in the past through your transfer pricing documentation and, of course, your actions in practice, then I think it would be challenging to try to argue that that is now the fact pattern under COVID," Jefferies said.

Nevertheless, she said, some companies may be able to show a tax authority that their operations are well suited to a profit split after a thorough review of the business.

"To the extent that you can revisit your supply chain, revisit your departmental structure, the decision-making process within the organization — if you can align it to be more consistent with that analysis that you have nonroutine contributions, then you have a strong argument to move towards a profit split," Jefferies said. "You can't just paper a change; you actually have to live that change and substance has to follow form."

Recent events have made it likely that use of profit split will increase, she said, pointing to the OECD's current project to rewrite tax rules for the digital economy and the IRS "functional cost diagnostic" issued in 2019 that described how to value assets contributed by more than one affiliate in an advance pricing agreement.

The OECD's digital economy project seeks to distribute profits more equitably among multinational group members by giving taxing rights to countries where companies have customers but lack a physical presence. In addition, many practitioners viewed guidance developed under the organization's project to combat base erosion and profit shifting in 2015 as encouraging the use of profit splits.

While a profit split may align well with a company's needs during a pandemic, businesses contemplating a switch to the method should consider whether it is likely to serve them well over the long term, Stevens said.

Companies "should be wary of adopting [methods] that suit their interests in dire economic conditions but that would be inconsistent with those interests in 'normal' conditions," she said.

"Profit splits may not be the Hotel California, but once implemented, they may be difficult to walk back," she said, alluding to the Eagles song lyrics that say "you can check out any time you like, but you can never leave."

One technique that gives companies the flexibility to switch between methods is an "escape hatch," according to Matthew Frank of KPMG LLP.

Most transfer pricing methods are built for ordinary times, meaning they can accommodate good and bad years but not necessarily extraordinary events, Frank said. A company's normal transfer pricing method may allow one party to earn a return of 3% to 7%, but the company could include a provision in its intercompany agreement, saying it will earn only a break-even return in the event of a system loss or some other defined trigger, he said.

Profit split backups have been a routine part of transfer pricing analysis for years, Frank said. While a company could try to accomplish the switch on an ad hoc basis, he said, "it's an easier discussion if you've thought about it in advance and baked it into the agreement."

Any company seeking to add a profit split trigger now would have a difficult case to make at this stage of the pandemic, according to Barbara Mantegani of Mantegani Tax PLLC.

In essence, the argument would be, "We were always going to do that, we just hadn't gotten around to it," she said. "I don't see how you would do that with a straight face in 2020."

Companies that lived through the financial crisis of 2008 and 2009 ought to have prepared for future economic downturns, Mantegani added.

"We act like these economic crashes are so rare," she said. "There have been two in the last 11 years."

According to Frank, some companies are currently discussing the profit split escape hatch with personnel in the IRS Advance Pricing and Mutual Agreement Program.

An IRS spokesperson pointed to the agency's announcement in May that APMA is open to "discussing various substantive and procedural issues with treaty partners, including such technical issues as the application of transfer pricing methods in periods of economic distress." The May announcement explains the time and manner in which taxpayers may request a consultation with APMA about these issues, the spokesperson added.

While Stevens said she hadn't seen the profit split escape hatch Frank described, she recalled working on an advance pricing agreement with a somewhat similar provision. The APA, which involved a license of intangible property, specified that no royalty was due if paying the royalty would put the licensee into a loss position, she said.

Jefferies said it might be possible for a company to achieve the desired results within a traditional profit-based approach, such as the transactional net margin method — the comparable profits method in U.S. parlance. For example, the interquartile range determined by the comparables will shift downward as other companies in the industry feel the impact of the pandemic, and economic adjustments may apply, she said.

"There are things you can still do within the parameters of a traditional CPM approach to assist in effectively sharing the pain of COVID throughout the group, but without straying away from what you have historically argued to be your fact pattern and the characterization of your entities," Jefferies said.

--Editing by Robert Rudinger and Neil Cohen.

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