Two conflicting TP models in the automotive supplier industry
OEM (Original Equipment Manufacturer) customers typically request to be invoiced by their suppliers from manufacturing sites geographically close to OEM factories. For transfer pricing (TP) from automotive suppliers, this means that the relationship between the HQ entity (HQ) and local manufacturing entities is of paramount importance. However, in practice, different companies have developed two – even contradictory – approaches.
The first approach is a decentralized operating model in which local manufacturers are seen as the entrepreneurial entities. They license the technology at a royalty rate (usually low) and purchase some central support services from headquarters on a cost plus basis (also low). Typically, both transactions will be evaluated through traditional simple database searches. Therefore, most of the upside business opportunities and downside risks lie with the manufacturing entities, which according to this model are also supposed to control the risks involved.
The opposite approach is a centralized operating model in which the local manufacturer is effectively seen as a subcontractor (low risk), while the head office company earns most of the residual profit. This is achieved through flexible royalty payments and service charges so that the manufacturer ends up with low risk contract manufacturing returns, regardless of local market developments and risks such as capacity utilization. . This implies that the head office is presumed to control the entrepreneurial risks which impact the commercial development of the manufacturer.
Growing tax risks due to the DEMPE analytical framework
Tax auditors in countries with strong auto industries often find both approaches in the different groups they control. – even between competing groups with similar business models and similar decision making by the respective headquarters and local manufacturer. Such inconsistencies suggest that the TP must be faulty in one group or the other. – or both.
Tax authorities interested in high local tax revenues may be biased in favor of certain outcomes. Tax inspectors who audit outgoing headquarters companies may view central business models as more appropriate, while tax inspectors who audit incoming manufacturing companies may have a bias towards decentralized licensing manufacturing structures. These conflicting views invite tax authorities to be hand-picked and make dispute resolution difficult, as tax authorities will come up against fundamentally opposing views.
The challenge presented by these conflicting models is heightened by recent developments in PT legislation which give tax authorities more powers to reassess taxpayer methodology (see previous article on the new German PT guidelines). In particular, the concept known as DEMPE implies that TP should be based on the contributions of entities to the development, improvement, maintenance, protection and operation of engines of commercial value. Since these contributions can be interpreted relatively broadly, it becomes easier to challenge either of the opposing approaches that are so prevalent in practice.
A realistic TP framework
The pragmatic solution is to recognize that, in a post-BEPS world where the potential contributions of DEMPE could be legitimately suspected of coming from entities along the value chain, having an arbitrary black and white view of the functions of taking decision making and risk control is not a sustainable or realistic position to achieve dispute resolution and avoid double taxation of multinational corporations (MNEs).
Even for companies where decisions are mostly concentrated at the headquarters level, value creation is, to a large extent, the result of cooperative cross-fertilization of functions across countries. For example, the research and development (R&D) center at headquarters benefits from permanent interfaces, technical know-how and the provision of data from manufacturing operations in different territories.
A new head office technological innovation is useless if it cannot be integrated into efficient mass manufacturing processes; local manufacturing engineers contribute their know-how and experience to this efficient integration of technologies. Risks can be controlled centrally at the headquarters level through appropriate contracts, but ultimately the risks must also be mitigated at the local level. In increasingly globalized virtual functional leadership teams, local managers are often able to influence decisions made at headquarters, and they do more than just execute central controls.
Conversely, local manufacturers often rely critically on centrally delivered technology, which generally cannot simply be relegated to a secondary âroutine intangibleâ role. Moreover, in practice, the central office does not generally provide only routine services, but is deeply involved in the management of central value creation activities and key risk-taking decisions.
Therefore, entrepreneurial value results not only from intangible assets in the traditional narrow sense (i.e. protected rights such as patents or trademarks), but also from synergistic collaboration between functions. The principle of value creation enshrined in the 2017 OECD Transfer Pricing Guidelines suggests that synergistic benefits should be shared in proportion to marginal contributions to the respective contributing parties (i.e. headquarters and local manufacturers). It remains to be seen how these relative marginal contributions can be assessed in practice.
A practical solution approach
Literature on industrial economics and practices applied in a wide range of industries show that the concepts of cooperative game theory provide useful tools for equitable distribution of economic benefits in contexts of synergistic cooperation. On the basis of the individual case, cooperative game theory can help determine royalty payments and service fees that offer consensual common ground over the two extreme solutions usually seen in practice and described at the start of this article. article.
With such solutions, which are firmly aligned with the OECD principles for considering DEMPE contributions, multinationals can occupy common ground that makes it much easier for tax authorities to come to an understanding in tax controversies. An innovative form of applied game theory analysis drastically reduces the costs of a subsequent tax controversy for a multinational.
The authors have successfully adopted the concept of “Shapley’s value” as a theoretical application of cooperative play in several cases to resolve tax controversies in Germany. Although the approach is innovative, the German tax authorities appreciated the good balance of this economic analysis and were willing to settle based on the results of the submitted analysis.
Managing Director, NERA Economic Council
Philippe de Homont
Director, NERA Economic Council
Consultant, NERA Economic Council
Â© 2021 Euromoney Institutional Investor PLC. For help, please see our FAQ.