residual profit split method Archives

The main attraction in the US Tax Court (Tax Court) is just a few weeks away. On March 5, 2018, The Coca-Cola Company (TCCC) and the Internal Revenue Service (IRS) square-off for a much anticipated six-week trial before Judge Lauber. The parties recently filed their Pretrial Memoranda in the case, although the IRS’s memorandum was filed under seal. TCCC’s Pretrial Memorandum gives us deep insight into the issues and how the trial will be conducted. The primary issue in the $3 billion transfer pricing case is the proper amount of the arm’s length royalties payable by six foreign licensees to TCCC for the licenses of TCCC’s trademarks and certain other intangible property for exploitation in international markets. In its Pretrial Memorandum, TCCC contends that the IRS’s application of an approximately 45 percent royalty rate using a bottler-based Comparable Profit Margin (CPM) that allocates to TCCC more than 100 percent of the aggregate operating (after accounting for the amounts paid pursuant to the Royalty Closing Agreement) profits of the six foreign licensees is arbitrary and capricious. (more…)

On March 7, 2016, the Internal Revenue Service (IRS) released a new International Practice Unit (IPU) on a specific transfer pricing method—the residual profit split method (RPSM). The IPU explains to IRS examiners how to determine if the RPSM is the “best method” under Section 482, and if so, how to apply such method between a US parent and its controlled foreign corporation in a transaction where intangible property is employed. As stated in a previous post, IPUs generally identify strategic areas of importance to the IRS but they are not official pronouncements of law or directives and cannot be used, cited or relied upon as such. However, taxpayers should benefit from reviewing IPUs, as they reflect the current thinking of the IRS on pertinent issues, and therefore allow taxpayers to structure and document their transfer pricing arrangements in a manner that is consistent with such thinking, as noted in a prior post available here.

Section 482 was designed to prevent the improper shifting or distorting of the true taxable income of related enterprises. Section 482 accomplishes this by requiring that all transactions between related enterprises must satisfy the arm’s length standard. That is, the terms of intercompany transactions generally must reflect the same pricing that would have occurred if the parties had been uncontrolled taxpayers engaged in the same transaction under the same circumstances. One of several possible transfer pricing methods for determining whether a transaction meets the arm’s length standard is the profit split method. One specific application of the profit split method is the RPSM. This IPU focuses on the application of the RPSM as it applies to outbound transactions involving intangible property.

The IPU outlines four steps for IRS examiners to follow in determining whether the RPSM is the best method to evaluate a controlled transaction and if so, how to apply the RPSM to that particular transaction.

Identify the routine and nonroutine contributions made by the parties. The IPU cautions that if there are no nonroutine contributions, or if only one controlled taxpayer is making nonroutine contributions (most commonly of intangibles), then the RPSM should not be used. The IPU provides three examples of when the RPSM may be used: (a) a tangible goods sale if the seller uses nonroutine manufacturing intangibles to make the goods, and another controlled party purchases and resells the goods using its nonroutine marketing intangibles; (b) a licensing transaction where one controlled party licenses nonroutine manufacturing intangibles to a second controlled party, who then manufactures goods using those manufacturing intangibles and sells the goods using its own nonroutine marketing intangibles; and (c) a commercial sale of software product, if two controlled parties each contribute nonroutine software intangibles to manufacture the product, and the controlled parties share the revenue from the sales.

Determine if the RPSM is the best method. The RPSM is the best method only if it provides the most reliable measure of an arm’s length result. The IPU cautions that the RPSM should [...]

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