A Tax Tribunal appeal case (the ‘Appeal’) reported on 28 June 2010 provides a useful ‘mini case study’ in the application of a residual profit split transfer pricing methodology. The Appeal reviewed the identification of key intangible assets, issues in the choice of an appropriate third party comparable and the use of an appropriate allocation factor in the method concerned. This article reports the facts and findings in the case concerned.
The appellant company (below ‘Japan Co’) was a Japanese manufacturer and distributor which owned 70% of the total issued shares of a non-Japanese company (below ‘Foreign Sub’). Hence Japan Co and Foreign Sub were related parties for the purposes of Japanese transfer pricing regulations.
Japan Co had concluded with Foreign Sub a contract for the manufacture and distribution of its products in consideration for a royalty (below, the ‘Subject Transaction’).
The tax office having jurisdiction over Japan Co (below the ‘Tax Authorities’) examined the Subject Transaction and issued a tax assessment levying additional taxes on Japan Co further to the Japanese transfer pricing regulations in article 66 no 4 of the Japanese Special Taxation Measures Law (‘STML’).
The assessment was based on an assertion that differences in the royalty rate paid in the Subject Transaction and the royalty rate that would be paid to an independent third party had resulted in the transfer of Japan Co’s income overseas to Foreign Sub.
Points of contention
The two principal points of contention in the case where, firstly, whether or not it was appropriate for Japan Co to apply a residual profit split method to the Subject Transaction and secondly where a residual profit split method is applied, what are appropriate costs to include as an allocation factor.
Japan Co’s intangible assets, related allocation factors
Japan Co’s transfer pricing methodology identified two key intangible assets: The now-how and quality control contributing to the maintenance and expansion of the network of major customers (the ‘Japan Co Customer Intangible’); pricing evaluation and technical know-how around product development and customization (the ‘Japan Co Product Intangible’).
The allocation factor for the Japan Co Customer Intangible was based on the total of the personnel costs of the management and planning office, the examination office, the manufacturing technology office and the product quality control and management office (to the extent that the costs of these offices related to the products concerned) plus travel costs less amounts treated as attributable to earning basic profits.
The allocation factor for the Japan Co Product Intangible was comprised of the personnel costs related to product research and development together with costs of depreciation and of consumables.
The Tax Authorities’ position
The Tax Authorities had identified three key intangible assets. These were:
- The production know-how developed independently by Foreign Co. (the ‘Tax Authority Product Intangible’)
- Know-how relating to sales promotion and planning (the ‘Tax Authority Sales Intangible’)
- Know-how relating to product improvement and manufacturing equipment for realizing price reduction (the ‘Tax Authority Development Intangible’).
The Tax Authorities’ proposed allocation factor was based on the annual salaries of the persons responsible for the control of the sales and product development departments less an amount attributable to their basic activities based on the average personnel costs of the manufacturing department (calculated based on data provided by the tax payer). Below this amount is referred to as ‘Super Personnel Costs’.
A third party comparable transaction?
The taxpayer presented a third party comparable transaction and asserted that the Subject Transaction and the third party transaction were comparable in terms of underlying product and technology and that, even though there were differences between the transactions in time of commencement, period, conditions for use, existence or otherwise of dispatched staff and geographic region which the contract covered, these differences were not sufficient to influence the amount of the royalty. Accordingly the royalty rate in this third party contract, which if used would not have given rise to a transfer pricing adjustment, was comparable.
The Tribunal found that, in order for the Subject Transaction to be deemed comparable to the third party transaction to the extent required to justify its use as an arm’s length price, the underlying intangible assets of both transactions should be comparable or of the same type, as should the period over which the transactions were effective including the commencement and duration of the period concerned.
The Tribunal noted that, even though the intangible assets relating to the Subject Transaction and the third party transaction were similar, the time the transaction commenced, period of the transaction, the lack of exclusivity in the third party contract, dispatch in staff and areas of effectiveness of the contract were clearly different and that the differences would be excepted to influence the royalty rate paid. Furthermore, the Tribunal found that it was not possible to calculate an appropriate adjustment to the royalty amount to account for these differences.
The Tax Authorities had identified seven senior individuals responsible for both sales and manufacturing operations in the Foreign Sub as contributing to the maintenance of the various key Tax Authority Intangible Assets referred to above. The authorities asserted that the ‘Super Personnel Costs’ of these individuals should be used as an allocation factor in the residual profit split method.
The taxpayer asserted that the Super Personnel Costs of other individuals the nature of whose work contributed to the maintenance of the intangibles assets of the firms should be added to the costs of the seven individuals identified by the tax authorities.
The Tribunal agreed with the fundamental underlying principal that the costs of individuals contributing to the creation and similar of the intangibles assets concerned should be used as an allocation factor.
However, the Tribunal found that only the costs of persons directing the activities of the departments concerned should be included in Super Personnel Costs. More junior staff receiving direction from the heads of the departments concerned should not be so included. In particular the Tribunal noted that:
- From the start, the scale of Foreign Co was not large and the number of individuals in each department was small.
- Know-how was developed through experience of the business activity concerned, [so by implication arose from the knowledge and experience of more senior staff able to give instruction].
While these facts are unique to the case concerned and do not offer any unique or unusual technical insight, they provide a useful review of the issues that are likely to be considered in a transfer pricing review.
A key initial step in applying the residual profit split in this case is the identification of the key intangible assets that underlie the generation of the ‘super profits’ of the business. This is then followed by identifying who is responsible for their formation and maintenance of the intangibles and in which country this contribution takes place.
Regrettably the nature of the underlying product is not identified in the discussion. However, we can infer that the product probably had a degree of specialization (perhaps a high tech product?) and was, for example, not a commoditized or retail product heavily dependent on public advertising given the nature of the intangibles and the relatively small numbers of people who were identified as contributing to its ongoing value.