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Post-BEPS issues with cost sharing arrangements in transfer pricing

Post-BEPS issues with cost sharing arrangements in TP

With the OECD updating the rules on cost sharing arrangements through its BEPS project, what are the changes that many organisations may need to make in order to remain compliant?

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Cost sharing arrangements – or cost contribution arrangements (CCA) as the OECD terms them – are a well-established mechanism used by many different multi-national enterprises (MNE) to manage their transfer pricing. A CCA will typically be used for services or IP development, where associated entities enter into a bespoke financial (and often legal) agreement to share the funding of economic activity.

There is usually an expectation of mutual benefit for the participants in the CCA. By sharing development activity and cost, it is usually cheaper and more efficient overall. 

We see these arrangements used both in third party situations and also between members of an MNE group. They are used across many sectors, commonly where there is a need for significant development spend, such as in oil & gas, extractive industries, telecommunications and financial services. For IP development, they will frequently cover the development of patents, proprietary technology and software.

The OECD's BEPS project has updated the rules

The OECD’s transfer pricing principles make it clear that under a CCA the contributions made by each party should be proportional to the benefits expected to be received. However, in the post-BEPS environment, the way we think about and evaluate a party’s contributions has changed. This means the economics underpinning the CCA need to be reviewed and potentially updated or replaced. 

Focusing on IP development as an example, in broad terms an MNE’s contributions can be in one of three categories: ownership of IP, development functions or investment capital. Post-BEPS, the OECD guidance tells us that ownership of IP is of limited importance, while capital without function should get a limited return - leaving a focus on development functions, which should now receive the bulk of IP-related returns. 

In this example, a pre-existing CCA may have determined that all of the participants part-own the IP in proportion so that their contribution of funding matches their expected benefit from the developed IP. But, importantly, this structure may not reflect a proper post-BEPS reward to the party contributing value-adding functions. 

The OECD requires that an MNE is in the same position whether they are inside or outside a CCA. In short, this all means some CCAs simply don’t work anymore. 

What should you do?

This issue is something that tax authorities are taking notice of. With the first wave of Action 13 documentation compliance including country-by-country reporting now in, more evidence and data is at their fingertips and we can expect increasing numbers of tax authorities to be auditing past years’ returns. CCA arrangements, in particular relating to intangibles, are likely to be on their radar.

At the same time, MNEs themselves are identifying CCAs under BEPS as an issue they need to address. We have already helped a number of large organisations review and adjust their cost sharing structures.

The good news is that unwinding or reconfiguring a CCA need not mean a complete overhaul of the whole arrangement. Often, smaller incremental changes can produce a practical and workable solution.

It helps to approach the issue in a number of simple steps:

  1. Evaluate the contribution of the IP subject to the CCA relative to other drivers in the value chain
  2. Understand DEMPE and other functional contributions and evaluate a portion of the overall IP reward that would go to each activity
  3. Compare that to CCA rewards per entity (as reflected in the transfer pricing underpinning the CCA contributions) 
  4. Decide on one of the following courses of action: 

a) Retain the CCA as is and defend in your documentation

b) Tweak the CCA to reflect the post-BEPS guidance. Typically this means either adding or changing mark-ups relating to costs and/or exiting certain participants from the pool

c) Terminate and replace with a different structure

From KPMG professionals' experience, a strategy to terminate and replace the CCA is more likely where the developed IP is high value in the context of the value chain and/or the functions included are high value. Another important factor is whether or not key functions are centralised in one place or widely dispersed across the MNE. This impacts the risk as viewed across different countries and also the complexity for the group of managing and implementing the CCA. 

Managing the practical challenges

Depending on the remedy required, there are a number of potentially difficult practical issues that are likely to be encountered. Firstly, CCAs are often legal structures as we have noted, and if any changes are made then updating the legal arrangements will be required. There are a range of options available here, which could include replacing a CCA with licence, cross licence or services agreements. Secondly, to facilitate the transition it may be that complex buy in or buy out payments will need to be calculated and new transfer pricing arrangements put in place. As ever, changing the transfer pricing in one year from previous years may bring a historical TP risk that needs to be carefully managed. 

There is a further important practical challenge in terms of managing change to finance systems and implementing the transfer pricing. 

Reviewing your CCA should not only be about managing risks though. IP development activities are often subject to tax incentives in different countries, such as patent boxes or R&D credits. Reviewing your IP arrangements would give an opportunity to consider whether full value is being gained from the available incentives. 

CCAs in their old form are becoming a tax risk for many MNEs. Ignoring this is likely to have onerous consequences eventually. But for those organisations that proactively tackle the issue, solutions can be found that put cost sharing on a solid footing for the future. 

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