Application of the Comparable Profit SplitMethod (CPSM) to Business Service

Providers

STUART L HARSHBARGER PHD and NERA ECONOMIC CONSULTING

INC

SYNOPSIS

sect 2901 Overview

sect 2902 US Cross-Border Trade in Business Services

sect 2903 Application of the Comparable Profit Split Method (CPSM)

[1] In General

[2] CPSM According to the US Treasury Regulations

[a] Functional Analysis

[b] Contractual Terms

[c] Risks

[d] Economic Conditions

[e] Property Services

[f] The 2009 US Section 1482-9 Amendment

[3] CPSM According to the OECD Guidelines

[4] CPSM According to the OECD Work on Permanent Establishments (PE)

[a] In General

[b] CPSM According to Significant People Functions (SPF)

sect 2904 Application of CPSM Using Compensation Data

sect 2905 Conclusion

sect 2901 Overview

We limit our efforts to the application of the Comparable Profit Split Method

Reprinted from Chapter 29 of Practical Guide to US Transfer Pricing Third Edition with

permission Copyright 2015 Matthew Bender amp Company Inc a LexisNexis company All rights

reserved Stuart L Harshbarger PhD is an economist in the transfer pricing practice at NERA Economic

Consulting and he is located in White Plains New York The views expressed in this article are those of the author and do not necessarily represent the

views of and should not be attributed to NERA Economic Consulting or Marsh amp McLennan

Companies

29-1 (Rel 9-122015)

(CPSM) to Multi-National Service (MNS) providers which are widely occurring in

the US and continue to grow in importance as a proportion of total US corporate

profits We examine the description of the CPSM in the current 1994 US Transfer

Pricing Regulations (US Section 482 Regulations or US Treas Regulations)1 as

amended pinpointing the relevant sections on profit splitting in the existing US

federal regulations for business services These regulations are then reviewed with the

advice provided by the 1995 OECD Guidelines (OECD Guidelines)2 and more recent

advice on Significant People Functions (SPF) for profit attribution among related

parties (OECD 2010 PEs)3

After reviewing the existing regulations for allocating profits among related entities

we examine compensation data from a recent study to discuss how the CPSM may be

applied in practice Business service companies especially professional scientific and

technical service providers can readily produce compensation data from existing

accounting systems and such data can be a reliable proxy to define economic

ownership of intercompany profits

sect 2902 US Cross-Border Trade in Business Services

For the US intra-firm cross-border trade defines a large and growing sector of

economic activity As shown in Table 29-1 the total amount of services supplied by

US Multi-National Service (MNS) companies through their majority owned foreign

affiliates is approaching $13 trillion and appears to be growing at over 10 percent per

year (at least from 2010 to 2011)4 Finance and Insurance is the largest single service

sector Our analysis is directed towards the non-financial service industries especially

the professional scientific and technical service providers that represented approxi-

mately 14 percent of the total services supplied by overseas affiliates of US

companies in 20115 The principal components of this category of services consist of

architectural engineering computer systems design and related management scien-

tific and technical services These professional service industries rely primarily upon

human capital and knowledge-based expertise to generate profits This business sector

appears to be a particularly good choice to evaluate the relevance and applicability of

the OECD work on Significant People Functions (SPF) to assign armrsquos length

profitability among related parties

1 26 CFR sect 14822 Organization for Economic Co-operation and Development ldquoTransfer Pricing Guidelines for

Multinational Enterprises and Tax Administrationsrdquo (The Guidelines) 19953 OECD ldquo2010 Report on the Attribution of Profits to Permanent Establishmentsrdquo July 22 20104 US International Services US Department of Commerce Bureau of Economic Analysis Table I

Services Supplied to Foreign Persons by US MNCs Through Their Majority-Owned Foreign Affiliates

by Selected Industry5 Calculated as ($181969$1287021) = 1421 percent

sect 2902 US TRANSFER PRICING 29-2

(Rel 9-122015)

Table 29-1

Total Services Supplied by Overseas Affiliates of US Companies

sect 2903 Application of the Comparable Profit Split Method (CPSM)

[1] In General

Our key focus is to examine the application of the CPSM to business services

because this method shows how related parties operating at armrsquos length can share

total profits or losses without the expectation of a minimum guaranteed profit for

certain participants6 Taxpayers often select the Residual Profit Split Method (RPSM)

instead of the CPSM for application because it takes advantage of available third party

data for assigning routine returns to a part of the economic activity that is being

evaluated The operational ease of RPSM however comes with two analytical

shortcomings routine members of an RPSM split may under certain circumstances be

guaranteed a minimal amount of profit even if the total combined activity is

unprofitable and practitioners still have to solve the problem of dividing up the

remaining non-routine income among profit share participants after assigning routine

returns without the aid of third party benchmarks In many instances application of the

second step of an RPSM approach relies upon the guidance given for CPSM In other

words even when applying the RPSM there is a de facto requirement for taxpayers

to apply the CPSM

[2] CPSM According to the US Treasury Regulations

The key operational passage of the US Treasury Regulation sect 1482-6 Profit SplitMethod that serves as guidance for determining an appropriate share of profits and lossesis

The relative value of each taxpayerrsquos contribution to the success of the relevant

business activity must be determined in a manner that reflects the functions

performed risks assumed and resources employed by each participant in the

6 26 CFR sect 1482-6(b) The armrsquos-length nature of this outcome is explicitly stated in this section but

it is transitory ie ldquoin a given yearrdquo

29-3 APPLICATION OF CPSM TO BUSINESS SERV PROVIDER sect 2903[2]

(Rel 9-122015)

relevant business activity consistent with the comparability provisions of Section

1482-1(d)(3)7(emphasis added)

Practitioners must first apply the comparability provisions to the unrelated CPSMparticipants before turning their attention to the problem of profit allocation among relatedparties Application of the comparability provisions is necessary to identify and thenweigh economically the different characteristics of each party to the transactionPractitioners are asked to identify and weigh participant comparability factors that ldquocouldaffect prices or profits in armrsquos length dealingsrdquo8 Application of the CPSM from the USTreasury Regulations sect 1482-1(d)(1) requires an analysis of all factors that could affectprices or profits of the related transacting parties in order to demonstrate that they aredealing with each other at armrsquos length At a minimum there are five factors that taxpayersmust address through functional analyses9

(1) Functions

(2) Contractual terms

(3) Risks

(4) Economic conditions

(5) Property or services

[a] Functional Analysis

Completion of a robust functional analysis is the most important task required by the

US Section 482 Regulations in order for taxpayers to assert upon audit that the tested

transactions are sufficiently similar to the comparable independent transactions and

that such transactions can be used to reliably show that their related parties are

reporting taxable income levels that meet the armrsquos length standard The functional

analysis should include an accounting of the ldquotype of assets used such as plant and

equipment or the use of valuable intangiblesrdquo10

As given by the US Section 482 Regulations taxpayers should account for the

following functions in determining the comparability of two transactions

(A) Research amp development

(B) Product design and engineering

(C) Manufacturing production and process engineering

(D) Product fabrication extraction and assembly

(E) Purchasing and materials management

(F) Marketing and distribution functions including inventory management

warranty administration and advertising activities

(G) Transportation and warehousing

7 26 CFR sect 1482-6(b)8 26 CFR sect 1482-1(d)(1)9 26 CFR sect 1482-1(d)(1)10 26 CFR sect 1482-1(d)(3)(i)

sect 2903[2][a] US TRANSFER PRICING 29-4

(Rel 9-122015)

(H) Managerial legal accounting and finance credit and collection training and

personnel management services11

Comparability item (A) can apply to service providers but not in a traditional

patent yielding capacity such as is found in the manufacturing industries Items (B)

(C) and (D) denote predominantly manufacturing functions that are associated with

the production of tangible goods Item (E) has some applicability to service providers

albeit in a supporting or overhead manifestation rather than as a business line Item (G)

is directed towards manufacturing and material handling activities Only items (F) and

(H) mention the influential functions that are performed by a large number of business

service providers The activities mentioned however generally denote support

activities performed during the normal course of business by global manufacturing

companies The majority of comparability factors outlined in this Section of the US

Treas Regulations on functions for practitioners to establish valid comparability are

directed more towards manufacturing companies and tangible goods trading

(distribution) rather than service providers

[b] Contractual Terms

Taxpayers are also explicitly required to consider the nature of significant

contractual terms to establish that the observed unrelated contracts are valid bench-

marks in determining whether or not their affiliates are reporting the correct amount of

taxable income where they operate Significant contractual terms that affect profit-

ability to be evaluated by all taxpayers include

(1) The form of consideration charged or paid

(2) Sales or purchase volume

(3) The scope and terms of warranties provided

(4) Rights to updates revisions or modifications

(5) The duration of relevant license contract or other agreements and termina-

tion or renegotiation rights

(6) Collateral transactions or ongoing business relationships between the buyer

and the seller including arrangements for the provision of ancillary or

subsidiary services

(7) Extension of credit and payment terms12

Item (1) is a source of ongoing attention by global service providers but this

comparability factor is almost universally the same for all professional service

providers clients are charged for the total cost of human capital employed plus a

markup and remuneration is obtained by hourly billings fixed fees or some

combination of the two Item (2) is applicable to global professional service providers

because as engagement size increases economies of scale improve and the profitability

of large projects will typically be higher than the same amount of revenue received

11 26 CFR sect 1482-1(d)(3)(i)12 26 CFR sect 1482-1(d)(3)(ii)(A)

29-5 APPLICATION OF CPSM TO BUSINESS SERV PROVIDER sect 2903[2][b]

(Rel 9-122015)

from completing many small projects Further discounted labor prices are typically

only found on larger projects to pass on some of the economies of scale

With respect to item (3) global professional service providers do not generally

provide warranties outside of the total amount of fees charged or some multiple of the

base fees as a performance warranty The nature of these warranty terms is generally

similar across global service providers without measurable differences that would

differentiate aggregate prices and profits Item (4) is more applicable to goods

transactions than services in general because buyers tend to be continuously provided

with new features and enhancements as they become available rather than the releasing

of discrete updates The applicability of item (5) to global services would generally not

identify much distinctiveness among companies Item (6) identifies an important

comparability factor for professional service providers initial or new client engage-

ments are often ldquoloss leadersrdquo and represent an investment by the service provider to

obtain follow-on projects that are more profitable Comparing the terms embedded in

unrelated party contracts from older deep well established client relationships will

contain pricing that is not generally comparable with related party contracts that are

negotiated with new clients With respect to item (7) professional service firms

typically follow similar if not identical payment terms of billing for services rendered

as the work is completed In summary some of the contractual terms that the taxpayer

is asked to examine in applying the US Section 482 Regulations do describe key

terms that determine the prices and profits for business service providers

[c] Risks

Similarly taxpayers must identify and evaluate for materiality the business risks

born by potentially comparable transactions to determine which risks significantly

affect pricing and profitability Taxpayers are directed by the US Treasury Depart-

ment that explicit attention should be paid to six principal business risks to establish

reliable comparability13

(1) Market risks including fluctuations in cost demand pricing and inventory

levels

(2) Risks associated with the success or failure of research and development

activities

(3) Financial risks including fluctuations in foreign currency rates of exchange

and interest rates

(4) Credit and collection risks

(5) Product liability risks

(6) General business risks related to the ownership of property plant and

equipment

Identifying significant risks outside of these factors is the responsibility of the

taxpayer Service providers in the industries being considered generally only have

13 26 CFR sect 1482-1(d)(3)(iii)(A)

sect 2903[2][c] US TRANSFER PRICING 29-6

(Rel 9-122015)

market risks (item 1) as stated with the possible exception of not having inventory risk

Inventory risks consist of cancellation of previously ordered services that consist of

signed contracts which is especially rare for professional service providers Profes-

sional service providers also face the risk of underutilized employees which should be

considered a market risk

After identifying the salient risks taxpayers must identify who bears those risks

Risk bearers are entities who have economic substance which may or may not be

aligned with legal or contractual arrangements Economic substance is established by

showing that a risk bearer has consistently born the stated risks over a period of time

has ldquoadequate financial capacityrdquo to fund reasonable losses and that the risk bearer has

ldquomanagerialrdquo or ldquooperationalrdquo control of activities or functions that determine the

amount of profits or losses earned Finally control and risk are positively correlated

having relatively more risk implies having relatively more control In other words an

entity dealing at armrsquos length with another entity would be unwilling to accept

relatively more risk unless it also received more control This would seem to rule out

accepting more risk for a higher reward even if an entity has no additional control of

that risk It is worth noting here the near equivalence in some aspects of the authorized

OECD approach of 2010 especially the use of Significant People Functions (SPF) and

ldquoeconomic ownershiprdquo with the original IRS concept of ldquoeconomic substancerdquo and

risk assignment contained in sect 148211(d)(iii)(B) of 1994

[d] Economic Conditions

To assert that uncontrolled transactions are valid for transfer pricing purposes

taxpayers must show that the economic conditions that affect prices or earnings are not

materially dissimilar between controlled and uncontrolled transactions Taxpayers are

required to consider and if necessary adjust for differences in eight key economic

conditions

(1) The similarity of geographic markets

(2) The relative size of each market and the extent of the overall economic

development in each market

(3) The level of the market (eg wholesale retail etc)

(4) The relevant market shares for the products properties or services trans-

ferred or provided

(5) The location-specific costs of the factors of production and distribution

(6) The extent of competition in each market with regard to the property or

services under review

(7) The economic condition of the particular industry including whether the

market is in contraction or expansion

(8) The alternatives realistically available to the buyer and seller14

14 26 CFR sect 1482-1(d)

29-7 APPLICATION OF CPSM TO BUSINESS SERV PROVIDER sect 2903[2][d]

(Rel 9-122015)

Many of the conditions mentioned are interrelated and overlapping and satisfying

one criterion often will touch upon and even satisfy one or more of the other economic

conditions that affect comparability Explicitly absent from this list of comparability

factors is an acknowledgement of variability in regulations and legal practices among

countries that significantly impact the economic returns in various service industries

but especially in the professional services

[e] Property Services

Finally as a last step in establishing comparability according to the US Section 482

Regulations taxpayers must determine if the property or services being compared have

embedded intangibles as part of the goods or services being provided If significant and

measurable embedded intangibles are present then the comparability factors contained

in other regulatory sections dealing predominately with comparable intangible

property have to be applied15

[f] The 2009 US Section 1482-9 Amendment

The US Treasury Department added Section 1482-9 in 2009 to the US Section

482 Regulations in part to further clarify and extend the application of profit split

approaches Section 1482-9 was also added to fix the analytical omissions and biases

summarized above in the existing US Treasury Regulations promulgated in 1994

Departing from a perceived prerequisite that the CPSM is the best method only when

the transactions are viewed as highly integrated or interrelated and of a high value the

2009 amendment asserts that profit split methods are appropriate when controlled

service transactions consist of ldquoa combination of non-routine contributions by multiple

controlled taxpayersrdquo16 A non-routine contribution is one for ldquowhich the return cannot

be determined by reference to market benchmarksrdquo17 which does not necessarily

mean a return is high One main purpose of the new regulatory language is to avoid

giving taxpayers the impression that the profit split method is the default method for

interrelated-controlled services that exhibit market prices substantially in excess of

their costs Instead the CPSM applies if at least one of the material contribution

factors cannot be benchmarked reliably using market-based returns Section 1482-9

puts forth two new RPSM examplesmdashsoftware and hazardous waste service

providersmdashbut does not offer any new examples on how to apply the CPSM to US

global service companies even though this is becoming an increasingly larger part of

the total domestic corporate tax base

[3] CPSM According to the OECD Guidelines

If transactions are ldquovery interrelatedrdquo it may be that they cannot be evaluated

15 26 CFR sect 1482-1(d)16 The actual quote is from the preamble (Profit Split MethodmdashTemp Treas Regs sectsect 1482-9T(g)

and 1482-6T(c)(3)(i)(B)) to the Temporary Regulations of 2006 regarding Section 1482T(g)(1) US

Treasury Department Internal Revenue Bulletin 2006-3417 This observation is also from the preamble (Profit Split MethodmdashTemp Treas Regs sectsect 1482-

9T(g) and 1482-6T(c)(3)(i)(B)) to the Temporary Regulations of 2006 regarding Section 1482T(g)(1)

US Treasury Department Internal Revenue Bulletin 2006-34

sect 2903[2][e] US TRANSFER PRICING 29-8

(Rel 9-122015)

separately18 Taxpayerrsquos first need to identify the profits to be split from the controlled

transactions and then once identified split those profits in an ldquoeconomically validrdquo way

that approximates the division of profits that would have been performed by

independent enterprises

The combined profit may be the total profit from the transactions or a residual

profit intended to represent the profit that cannot readily be assigned to one of the

parties such as the profit arising from high-value sometimes unique intan-

gibles19

The relative value of the contribution of each participant is based upon a functional

analysis that takes into account assets used and risks assumed Application of the

CPSM is done prospectively knowing that taxpayers do not know a priori what the

realized profits will be from the joint exercise Proper application using projected

profits rather than actual profits is correct according to the OECD Guidelines because

independent establishments operating in a similar capacity would base their profit

splits using projected data with knowledge of the functional contributions of the

participants

According to the OECD Guidelines application of the ldquocontribution analysisrdquo or

CPSM is done by determining profits splits on forecasted data according to the

Relative value of the functions performed by each of the associate enterprises

participating in the controlled transactions supplemented as much as possible by

external data that indicate how independent enterprises would have divided profits

in similar circumstances20

As stated by the OECD Guidelines in practice determining the relative value of

related party participant shares to split profits is difficult Three analytical suggestions

are given by the OECD Guidelines determination might be made by weighing each

participantrsquos contribution of services or the relative amount of development expenses

incurred or the amount of capital invested or through various combinations of these

profit split factors These factors might then be used to assign a percentage based on

relative contributions along with any external market benchmarks that can be found

[4] CPSM According to the OECD Work on Permanent Establishments

(PE)

[a] In General

In an effort to identify and clarify how Permanent Establishments (PEs) should be

taxed the OECD issued newly conceived ldquoauthorized approachesrdquo in 2008 and again

in 2010 and further clarified its position that ldquothe same principles should be applied

to attribute losses as to attribute profitsrdquo21 In other words the same factors that assign

18 Organization for Economic Co-operation and Development OECD Guidelines chapter III para 3519 Organization for Economic Co-operation and Development OECD Guidelines chapter III para 31220 Organization for Economic Co-operation and Development OECD Guidelines chapter III para 31621 Organization for Economic Co-operation and Development OECD Guidelines Part I para 3

29-9 APPLICATION OF CPSM TO BUSINESS SERV PROVIDER sect 2903[4][a]

(Rel 9-122015)

economic profits to entities need to be used to determine who bears losses Entities

cannot win under one set of allocation factors and lose with a different set

In order to correctly determine the profits associated with PEs tax authorities need

to hypothesize the existence of a separate unrelated entity that possesses sufficient

assets and attributed capital to conduct its business at armrsquos length as if it were a

standalone entity or subsidiary The assets and capital that would ordinarily be

possessed are instead created economically and then allocated locally by performing

a detailed functional analysis that reveals what assets are being used locally and the

source of those assets ie which foreign affiliates are providing the assets A detailed

functional analysis is necessary to correctly hypothesize

The PE as a functionally separate entity to identify the significant people functions

relevant to determining which part of the enterprise assumes andor subsequently

manages particular risksand economically owns particular assets and to

attribute to the PE as a hypothetically separate entity an appropriate amount of

capital22

The OECD created the term Significant People Functions (SPF) as a determining

factor for the attribution of assets and risks to PEs and consequently the profits to be

taxed by the host country23

[b] CPSM According to Significant People Functions (SPF)

Application of the SPF approach begins by completing a robust functional analysis

to explain how the enterprise works and to identify the SPF activities that are present

ie those activities which directly affect the performance of the company in

measurable ways such as activities that cause it to succeed or fail24 This implies that

they have an economic right to the income attributable to the ownership of the assets25

Depending on the facts and circumstances economic ownership not legal or

contractual arrangements signals where profits and losses should be assigned and

accordingly taxed Identification of SPFs within an organization is necessary to

determine armrsquos length earnings for functional activities Profits or losses follow the

22 Organization for Economic Co-operation and Development OECD Guidelines Part I para 4523 The OECD has also adopted the nomenclature of Key Entrepreneurial Risk Taking (KERT)

functions to distinguish a subset of entities (banks global traders of financial instruments and insurance

companies) where the same significant people functions will be relevant to the assumption of risk and to

the ownership of capital SPF is a broader functional definition and is inclusive of KERT but it is not

immediately synonymous with an ipso facto assumption of the ownership of capital like KERT

Participants in this special sector often have to be sufficiently capitalized to trade or participate and so

attribution of capital commensurate with risks assumed may already be determined by the market for

KERT enterprises24 Following the OECD Report on PEs we use the following terms interchangeably establishment

business company enterprise to denote a going concern and not to make a distinction in functionality

or organization25 Economic Ownership of assets is equivalent to ownership for income tax purposes by a separate

enterprise with the accompanying or associated benefits (profits) and burdens (losses)

sect 2903[4][b] US TRANSFER PRICING 29-10

(Rel 9-122015)

person responsible for creating them where creation is limited to individuals

performing SPF functions26

Participants have to be ldquoactive decision makersrdquo within the SPF activities and

involved in managing individual risks and portfolios of risks Emphasis is placed on

identifying those employees who actively manage accept and take on risks rather than

simply saying ldquoyesrdquo or ldquonordquo to a proposal Active decision makers are identified by

examining the business decision ldquoratification processrdquo within an organization to

determine who makes the decisions that affect risks and financial performance Use of

active decision makers is meant to suggest subject to the facts in each case that

economic ownership is often determined by functions performed below the strategic

level of senior management27 This asserts that senior executives who make and

approve of general directives policies and procedures and provide the organization

with broad strategic planning and management initiatives do not engage in SPF

activities because they are not ldquoactive decision makersrdquo

The authorized OECD approach is implying that typical head office executives

even those whose strategic duties are clearly defined are not performing functions of

economic significance and consequently they do not have direct economic ownership

of profits or losses being produced by an enterprise This conclusion however does

not align with compensation data senior management is typically the highest paid

level of executives showing that they bear the most risk and maintain the greatest

amount of economic ownership of enterprise activities The tax compliance perspec-

tive of OECD regulators as expressed within their recent PE publications does not

validate competitive market outcomes and does not offer taxpayers a practical ie an

operational approach to profit splitting outside of financial services28

Additional examples and further clarification as to what is meant by ldquoactive decision

makingrdquo from the OECD cannot be readily found It has been suggested however that

this lack of specificity in active decision making and what constitutes a ldquoratification

processrdquo for transfer pricing studies can be met by application of standard industrial

organization theories from the economics literature This approach however also

lacks practicality and comes with high upfront costs and ongoing maintenance

expenses

sect 2904 Application of CPSM Using Compensation Data

Our review of the US Treasury Regulations shows a dearth of attention by US tax

regulators when it comes to CPSM The 2009 service fee amendment did not add many

new requirements or examples for applying CPSM other than stating it can also be

applied to low intangible value services that are integrated across tax jurisdictions The

OECD Guidelines offer refinements to taxpayers current development expenses and

26 OECD 2010 PEs Part I para 4427 OECD 2010 PEs Part I para 7228 Kamphuis Erik ldquoSignificant People Functions and Functional Ownership The New Motto in

Transfer Pricingrdquo 2008 Tax Management Inc The Bureau of National Affairs Inc Vol 17 Number

7 page 309

29-11 APPLICATION OF CPSM TO BUSINESS SERV PROVIDER sect 2904

(Rel 9-122015)

prior capital investments receive additional attention as influential and potentially

acceptable CPSM profit allocation factors However compensation is not mentioned

as determinative29 This omits outcomes determined by wage differentials that come

from competitive labor markets which already signal economic ownership through

pay This includes the activities of global service providers whose profits are primarily

determined by the development of human capital with accompanying business models

based on selling human knowledge and expertise Outside of subject area expertise

these firms typically have few valuable intangible assets with the possible exception of

their IT systems These firms use their human assets of managerial and executive

experience of what works prior templates and procedures to generate routine and

non-routine value

In order to reliably use compensation data as a proxy for economic ownership a

distribution of wages among workers involved in the profits or losses to be split is

obtained The distribution of the total wage and benefit data collected captures the

variance in compensation found between entry level workers middle level managers

and executives The following wage distribution example comes from the pay

distribution and organizational performance literature30 The study here as an example

only shows the disbursement of salary levels among IT business managers who were

members of a large software corporation The data comes from a sample that was used

as part of a large study on decision making

Survey Data Eighty-four business managers (60 male 20 female 4nr) who

were members of a large enterprise software corporation based in the eastern

USmdasha Fortune 200 Corporation31 The managers are stationed across the US

and were at middle levels of their organizations hierarchy Approximately 98

percent hold a BA or equivalent and were 117 years on average in their current

position

29 The authorized OECD approach discounts the assignment of economic ownership of enterprise

profits through compensation levels and does not utilize accounting data that is readily available and

consistently produced during the normal course of business by a MNS company30 Jordan Jennifer M ldquoSalary and Decision Making Relationship Between Pay and Focus on

Financial Profitability and Prosociality in an Organizational Contextrdquo Journal of Applied Social

Psychology 2010 40 2 pp 402ndash42031 Six participants were excluded from the study due to incomplete responses and for other reasons

sect 2904 US TRANSFER PRICING 29-12

(Rel 9-122015)

Table 29-2

Example of Wage Distribution Data From IT Group Within MNS Company

Inspection of Table 29-2 shows the distribution of wages among the business

managers Compensation ranges from approximately $50000 to $300000 per year

The largest group of employees (n=25) is clustered at the median salary level of

$80000 to $100000 as expected At the upper end of the distribution is a smaller

number of highly compensated business managers (n=13 est) that report salary levels

from $200000 to $300000 per annum

In the referenced sample survey data further distinctions or information that would

enable greater gradation in salary levels or geographic location are not to be found to

protect the privacy of survey participants This information would be needed to apply

the CPSM to the sample data using an SPF type of an approach and is available to

transfer pricing study practitioners under appropriate confidentiality agreements For

purposes of an illustration we imagine that sample data for completion of a transfer

pricing study could be rearranged to look something like Table 29-2

Example Eighty-four business managers belong to an international IP generat-

ing information technology (IP) group that jointly develops high-margin software

products that are sold globally The group does not do the actual selling but

functionally is the product development and RampD part of the value chain The

group often writes custom software applications for clients as special projects and

these projects are highly profitable because of the unique intangibles that are

involved

29-13 APPLICATION OF CPSM TO BUSINESS SERV PROVIDER sect 2904

(Rel 9-122015)

Table 29-3

Example of Applying CPSM to Wage Distribution Data

A review of Table 29-3 shows that the two groups of programmers in countries A

and B are relatively similar in size however there are nine SPF employees in country

A versus four SPF employees in country B Applying CPSM to this survey data

consists of calculating profit (loss) split allocation factors for each country using the

given compensation data Country A has $18 million in SPF salary costs (nine

employees x $200000 in salary) versus Country B which has $12 million in salary

costs (four employees x $300000 in salary) This yields a split in total profit (losses)

between countries A and B of 60 percent for A ($1800000 $3000000 = 60 percent)

and 40 percent for B ($1200000 $3000000 = 40 percent)

The key innovation of this application of CPSM is that compensation levels (defined

by market forces) identify SPF employees The identification is made using data that

is readily available and known with certainty providing practitioners with immediate

results Completion of a functional analysis comes as a second step to challenge and

confirm the results of the compensation-based profit-split allocation factors We note

that the comparability factors of Section 482 also would not necessarily apply since all

of the compensation data is internal to the firm and outside benchmarks are not

germane to the analysis

sect 2905 Conclusion

The global service industry continues to grow and is characterized by large MNS

companies which operate simultaneously across many different countries with large

senior management hubs that are responsible for operations in a number of different

sect 2905 US TRANSFER PRICING 29-14

(Rel 9-122015)

tax jurisdictions Application of the CPSM approach to this sector is desirable because

of readily available internal financial data on costs especially those costs associated

with human capital We note that such an approach as discussed in our examples does

not capitalize the companyrsquos investment in human capital over time One could argue

that capitalizing SPF costs may be appropriate however capitalizing non-SPF costs

would be inappropriatemdashSPF entrepreneurs in both countries bear these costs and all

these costs are subtracted from total group revenues to calculate group profits or losses

Finally we note from our review of the current US Section 482 Regulations that

application of the CPSM method using compensation data is not specifically

contemplated by way of an example so it is up to US business service providers to

apply this approach in a responsible manner as a powerful ldquoother methodrdquo32 that

should have a detailed functional analysis and complete wage data

32 26 CFR sect 1482-9(h) Unspecified methods

29-15 APPLICATION OF CPSM TO BUSINESS SERV PROVIDER sect 2905

(Rel 9-122015)

(Rel 9-122015)