Franchises and transfer pricing regulation

Franchises and transfer pricing regulation

The Albanian regulations reserve the profit split method for situations in which both parties to an intercompany transaction own valuable intangible asset. However, in many respects, a simple profit split is better suited to circumstances in which individual group members engage in an activity that is intrinsically multi-jurisdictional, act in concert, and employ the same types of tangible assets.

The global trading of certain physical commodities (e.g., fuel oils) and the provision of content delivery network (CDN) services are examples of activities for which a simple profit split may produce reasonable results. Global trading firms have traditionally employed financial capital primarily (although such capital is generally invested in physical commodities in some form at any given point).

Given the prevalence of mark-to-market accounting and the need to monitor and manage risk in global trading, the market value of assets is often readily ascertainable. CDN services providers invest predominantly in high-end servers, which are stationed in proximity to the end-users of digital content in numerous geographic locations.

While the book value of these servers will differ from their market value after a comparatively short period of time, the proportional divergence between book and market values will be similar across entities if all group members employ the same types of assets and utilize the same depreciation schedules. In such instances (where individual group members perform the same functions, act in concert and employ the same types of assets), a division of after-tax free cash flows based on the book or market value of assets employed makes intuitive and economic sense.

However, if intangible assets are an important element in the activity at issue, and they are not jointly developed and employed, a simple profit split method will clearly not produce reliable results.

In Internet-based businesses, multinational groups are often formed sequentially: A start-up firm with operations in only one country will develop a business model, intellectual property and vendor and customer relationships in the first instance. Geographic expansion takes the form of replicating the same nationally-based business in individual countries. The founding firm transfers rights to its business model, its intellectual property and, if feasible, its vendor and customer relationships, and provides assistance both in the start-up phase and, in some cases, on an ongoing basis.

One observes this fact pattern in traditional businesses as well, when physical proximity to customers is important and the economic activity does not require significant investment in fixed assets, so that decentralization is not excessively costly.

Under a conservative interpretation of existing transfer pricing regulations, it may be necessary to establish arm’s length charges for each individual transaction (the transfer of a business model, software, trademarks, other intellectual property and services). However, this approach misses the forest for the trees, and is unnecessarily laborious. An alternative approach would entail using franchise arrangements to determine arm’s length fees for the bundle of tangible and intangible assets transferred and services rendered.

The method described above reflect certain basic points of reference.

First, arm’s length pricing data should be used significantly more extensively, and more flexibly, than the Albanian regulations currently provide for.

Second, where individual group members perform distinct functions, and a single entity owns and utilizes all of the group’s intellectual property, transfer pricing issues lend themselves to the use of simple numerical standards. While obviously imperfect from a theoretical perspective, this approach would greatly reduce compliance costs and the potential for double-taxation, a seemingly worthwhile trade-off. Many traditional transfer pricing issues are of this ilk.

Simplified profit splits may be feasible when the activity at issue is intrinsically multi-jurisdictional and individual group members employ similar assets. In such cases, controlled group members often perform undifferentiated functions, and have jointly developed intangible property in the ordinary course of business.

Conversely, in circumstances where the same activity is carried out in multiple, discrete jurisdictions, and there is limited interaction among group members on a day-to-day basis, the franchise model may yield reasonable results. In such cases, a single entity often develops the business model and other intellectual property used by all group members.

Lastly, for complex cases involving atypical divisions of functions and risks, and/or where ownership of intellectual property is not concentrated in a single group member and has not been developed jointly, a required return approach may be warranted.

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