Splitting profits between group companies: prerequisites for the application of a profit split method

Published on July 4, 2017

For years now, companies operating in the automotive supplier industry have structured their business models in an internationally oriented manner, and this trend has been on an increase. In this process, value chains of corporate groups become globalised, as a result of which essential functions become highly integrated and foreign subsidiaries directly contribute to value creation within the corporate group. For example, development, production or sales activities are often carried out not only from the head office in Germany alone but also by employees scattered across locations abroad. In practice, it is often difficult to delineate individual contributions made by associated enterprises to value creation. This basically leads to the question in what cases and how profits should be split among associated enterprises.

In publishing the public discussion draft of the Base Erosion and Profit Shifting (BEPS), the OECD has for the first time put forward for discussion a guidance document offering specific information on how to apply the transactional profit split method. In particular, the published guidelines describe cases in which a profit split can be seen as the most appropriate method for splitting profits between associated enterprises.

Highly integrated business models with unique and valuable contributions

Indicators or prerequisites for the application of the profit split method can include, among others, highly integrated business models and the fact that associated enterprises participating in a transaction make unique and valuable contributions. Decisive here is that operations of each enterprise in terms of functions performed, risks assumed, and assets used, are closely related to transactions with associated enterprises and cannot be evaluated only in isolation or separately from those transactions. Such a close relationship can be normally assumed in the case of transactions between entities operating in the same link of the value chain, where the enterprises participating in the transaction share the economically significant risks or make unique and valuable contributions. The uniqueness and the valuable nature of contributions made by enterprises in an intra-group transaction arises especially from the fact that they are not comparable to contributions that independent third parties would make under similar circumstances and are an important starting point for generating a profit or for the prospect of generating a profit. In consequence, enterprises will have to more intensively identify and analyse value-creating contributions of individual group enterprises in the future. Especially in the case of transactions where intangibles constitute an essential success factor, it is advisable to conduct a detailed analysis of the so-called DEMPE functions. This mainly arises from the effort of the OECD under BEPS Actions 8-10 to ensure consistency between the outcomes of controlled transactions and the value creation.

Stronger focus on the value chain analysis

The allocation of risks and the performance of specific functions as part of intra-group transactions will continue to increase in importance also in the automotive supplier sector. Here, a value chain analysis can be a useful tool. It can be helpful in identifying potential profit shares or factors relevant to the splitting of profits. The value chain analysis should map the economically significant functions, risks and assets and show which party performs which functions, assumes which risks, and uses which assets. In this context, crucial is which party can control/influence the significant risks and is financially able to effectively assume those risks if they materialise. Especially as regards developing or deploying intangibles, enterprises which perform significant functions (the so-called DEMPE functions) and assume relevant risks, e.g. in the area of development, enhancement, maintenance, protection and exploitation of intangibles, should receive an adequate fee that will be appropriate for the contributions they made.

In addition, the value chain analysis provides information as to which party contributes the most value to the transaction and gives an insight into the overall economic activity within the corporate group. Thus, it is an appropriate basis for presenting arguments to tax authorities to substantiate the way in which profits are split between associated enterprises as part of a specific transaction.

Conclusion

Because global corporate groups are increasingly structuring the individual links of their value chains in an internationally oriented manner, the issue of appropriate profit splitting between associated enterprises will continue to increase in importance also in the automotive supplier industry. This alone arises from the fact that it is sometimes difficult to accurately delineate which party made what contribution to value creation – a process that should be examined on a case-by-case basis. Therefore, in the case of transactions where several associated enterprises assume significant risks or contribute unique intangibles, companies should conduct a detailed value chain analysis. The regulations on the transactional profit split method provided by the OECD offer enterprises useful guidance. The OECD is expected to publish a further public discussion draft relating to the application of the profit split method yet this year. For practical considerations, it is thus desirable to concretise further cases in which the so-called profit split method should be applied.