After rewarding functional contributions (which can continue to be priced using conventional TP methods), the new OECD guidance implies that residual returns (or, equally importantly, losses) should be captured by the entity or entities controlling the important risks associated with DEMPE functions.
This is known as the “control test.” To meet it, an entity must have the capacity and capability to make the relevant decisions — and must actually do so. Neither setting a policy environment for the relevant decisions nor formalizing decisions made in other locations is sufficient to meet it.
Isn’t that easy to address?
That might seem at first glance like a relatively easy task for business to address. But today’s reality is quite different.
As a result of numerous and complex regulatory and business changes, many companies may now have a significant mismatch between the geographic recognition of returns for tax purposes and the locations of contributions to intangibles (as defined by the OECD’s new guidance) in their operating models.
Further adding to this is that business strategies and business models may be subject to (or may need to) change. It has always been the case that the design of an operating model, and more particularly the locations in which key managers are located, drives where profits should be recognized for tax purposes. This also makes sense from the perspective that, while companies work across borders, the corporate tax sovereignty of a country, in principle, stops at the border.
The DEMPE-focused BEPS changes (as well as related nexus changes) mean that all multinationals should now expect far greater scrutiny from tax authorities of the locus of control of the business processes and assets that drive their profits. Moreover, given the pace of business evolution, the value attributed to new kinds of intangibles will become an increasing focus for tax authorities. It should be fully expected that tax authorities will further refine their frameworks for addressing the role of key intangibles within the future value chain and the changing role of existing functions.
In particular, the role of business concepts or ideas and access to capital is expected to intensify as they become key determinants of success. But, while issues related to the DEMPE functions are indeed important, the assumption, management, and control of risk and funding must also be considered when addressing the overall intangibles strategy. Indeed, some jurisdictions, including the US, may argue that these issues are actually more important than DEMPE.
Furthermore, as illustrated in the current debate on how to tax digitalized business activity, access to customer data and the ability to use it efficiently to better serve other customers will become a major driver for operating models, with related permanent establishment, withholding and indirect tax effects all being experienced as a result.
While we would not advocate having “tax drive the business,” having an integrated design that considers all the different layers of the operating model is key to create a robust, sustainable model from the business and tax perspectives.
Understanding whether there is a “mismatch,” as we defined, is essential in deciding whether action is needed and in determining its urgency and direction of change. This requires an understanding of the nature, ownership and importance of intangibles and an analysis of contributions to these intangibles, ultimately mapped to entities or countries.
Once this is achieved, there are essentially three approaches available to address a mismatch, each of which has differing outcomes, goals, challenges and results:
- Transforming the operating model requires a high level of ambition, fundamentally transforming the company operating model from a business and tax perspective. This can include moving from a vertically integrated to a horizontal organization.
- Enhancing the operating model may require less ambition, but still requires substantial change. It may include reallocating IP ownership, amending processes and pricing models, or moving from “brick to click,” with related changes in structure, processes and value drivers.
- Protecting the operating model can be done by protecting existing tax and business framework by improving on substance (i.e., better alignment of intangibles in context of DEMPE), governance or pricing.