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United States: “Functional cost diagnostic model” for review of APA requests

Functional cost diagnostic model, review APA requests

The IRS Advance Pricing and Mutual Agreement (APMA) program announced that it has developed a “functional cost diagnostic model” (an Excel program) to facilitate its review of advance pricing agreement (APA) requests.


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As noted in an APMA release [PDF 136 KB], the model organizes the collection of financial data relevant to the proposed covered transactions—in particular, data on costs incurred by "controlled taxpayers" in the covered group.

Taxpayers are being requested to complete the model so that the APMA can better understand the controlled taxpayers’ contributions to the proposed subject transactions—including the contributions of each controlled taxpayer to the exercise of control over the economically significant risks of the transactions. The position of the APMA is that it is necessary to consider whether the arm’s length values of these contributions to the transactions might be more reliably measured by comparing them to one another than by benchmarking returns for the functions performed by a single taxpayer, the assets it employs, and the risks it assumes. 

APMA’s use of model

The model focuses on the identification, organization, and analysis of “functional” costs—i.e., costs incurred by a controlled taxpayer in the group that relate to one or more business operations within the scope of the transactions. These business operations would typically be presented in the covered issue diagram in the APA request.

  • The taxpayer is instructed to identify functional costs and present them in the model for APMA’s review.
  • The taxpayer is asked to analyze the economic value of the contribution associated with the activity for which the functional costs are incurred. It is anticipated that many of the functional costs that will be entered will be incurred by the controlled taxpayers in performing “routine” functions. As such, the economic value of these contributions is measurable by reference to benchmarks obtained from comparable uncontrolled transactions. One feature of the model is that it automatically computes arm’s length compensation for these activities based on the user’s benchmarks and selected profit level indicators.
  • The taxpayer is requested to consider which controlled taxpayer(s) in the proposed covered group incur functional costs having an economic value that would not be measured reliably by referring to benchmarks obtained from comparable uncontrolled transactions and that are expected to last beyond a single accounting period. The model does not specify what functional costs incurred by the controlled taxpayers in the group may meet this description, and the APMA notes these costs will necessarily be specific to the business operations of the group and the scope of the transactions. Taxpayers are directed to refer to the OECD Transfer Pricing Guidelines.

The model handles functional costs differently from how it handles benchmarkable functional costs. The model accumulates these costs and capitalizes them according to standard formulas and techniques and based upon assumptions entered by the taxpayer into the model (such as about the useful life of a “unique and valuable” contribution).

Another functionality of the model, according to the APMA, is that it produces a pro forma split of residual profits (losses) based upon the relative stocks of accumulated and capitalized functional costs that the taxpayer has identified.

In conjunction with the granular financial data entered into the model for each of the controlled taxpayers in the group and, among other items from the APA request and the taxpayer’s covered issue diagram, the APMA believes that this analysis will provide a more comprehensive understanding of the taxpayer’s views of the "value drivers" of its business operations and how these views compare with the distribution of capitalized functional costs incurred throughout the group, which in entering its data into the model, the taxpayer might have identified as being concentrated solely in one controlled taxpayer.

According to the AMPA description, the fact that the model computes a pro forma residual profit (loss) split does not imply that the APMA has already concluded that the transactional profit split method—or, more specifically, the residual profit split method—is the “most appropriate method” for the taxpayer’s transactions under the OECD Transfer Pricing Guidelines. APMA will make that determination based upon its review of the facts obtained through due diligence, including discussions with the taxpayer about the application of this diagnostic model, and the standards set forth in the OECD guidelines.

The APMA’s report included instructions on completing the diagnostic model. Refer to an image of the APMA’s diagnostic model (PDF 133 KB). 

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