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A Tale of Two Business Models: Local Transfer Pricing Treatments of Digital Platform-Based Businesses

 

Digital Platforms

 

Imagine an entrepreneur establishing a digital platform.  The platform may be one which provides a service to users for a fee, such as a music service, or may be free of charge to general users and sustained by advertising revenues from certain users, such as a search engine, or any other platform with a broadly similar business model.  Once the platform is established, it has the potential to reach almost anywhere in the world.  Therefore, while the platform itself is located in a certain geography (“HQ”) it is supported by local service providers (“LSPs”) in other geographies which assist the HQ in winning local business.  There exist digital platform-based business models that do not involve LSPs, but these will not be addressed in the current article.To read more about the tax consequences of such models please click here.

 

The integrated operations of the HQ and LSPs yield a joint income which must be disaggregated and attributed to different geographies for local taxation (and so, transfer pricing) purposes.  As is widely known, the intercompany transaction fees between the HQ and LSP affect the income attributable to a certain geography and therefore, will be the focus of our discussion here.  We will consider the transfer pricing treatment of two different business models; the first one is widely-used by most digital platform-based businesses at the moment, and the second one is a model that is most likely to be suggested by local tax authorities.  Therefore, a comparison of these two models is more than just a theoretical exercise that is likely to have practical applications in the near future.

A Typical Division of Functions & Risks

Without going into much technical detail, we will observe that a profit-based transfer pricing methodology will most likely be applied in this case.  It is a well-known fact that the way functions and risks are divided between the transacting parties is especially important in applications of profit-based transfer pricing methods and is instrumental in determining the final outcome of such applications.  In this article, we will assume a certain distribution of functions and risks between the HQ and the LSP in order to keep the discussion simple and focused.  Obviously, many different divisions of functions and risks exist and/or are imaginable.  For purposes of this article, we will assume the following typical distribution of the primary functions and risks between the HQ and LSP:

 

Table 1: Division of Key Functions & Risks

 

Primary Functions

HQ

LSP

Establishing and maintaining the platform

P

 

Platform R&D

P

 

Brand management

P

 

Establishing/Leasing payment channels

P

 

Invoicing/Payment processing

P

 

Customer support

P

 

Other administrative

P

P

Content management

 

 

Local advisory

 

P

Content financing

P

 

Content purchasing

P

P

Marketing

 

 

Central design and financing

P

 

Local execution

 

P

Legal

 

 

Central planning and execution

P

 

Local execution

 

P

Main Risks

HQ

LSPs

Brand equity risk

P

 

Market risk

P

 

R&D risk

P

 

Collections/Credit risk

P

 

Legal risk

P

 

 

The table above indicates that the HQ is the owner of the platform itself and all associated technology, as well as all brand equity associated with the platform.  Moreover, the HQ makes almost all of the key management decisions with respect to the day-to-day operations of the platform as well as taking all of the main business risks.  The LSP undertakes fairly limited support activities in the local geography and takes no risk.  Now consider two distinct business models given the above setup.

Business Model I: HQ as Primary Contractor

In this business model, the HQ is the counterparty to the business contract with the final customer.  The revenue is collected by the HQ from customers and the LSP charges a service fee to HQ in return for services rendered.  This is illustrated in Figure 1 below.  The transfer pricing question with respect to this business model is: how should the intercompany service fee be calculated?

Figure 1: Business Model I

An important transfer pricing concept in most transfer pricing applications is the concept of the tested party.  The tested party will usually be the participant in the controlled transactions, whose operating profit attributable to the controlled transactions can be verified using the most reliable data and requiring the fewest and most reliable adjustments, and for which reliable data regarding uncontrolled comparable companies can be located. Generally, the tested party is the party with the least complex functions & risks and which does not own valuable intangibles. 

Profit-based transfer pricing methods are usually applied via allocating a certain guaranteed return to the tested party.  The other party’s remuneration is then simply computed as the residual income from the integrated operations in excess of the aforementioned guaranteed return.  This methodology aims to side-step computational complications such as the independently computed remunerations to both sides of the transaction not adding up to the actual income from the integrated operations.  This is a short cut that is fairly generally applied in practice. 

In this case, a classic application of the above mentioned transfer pricing methodology would select the LSP as the tested party and allocate a certain guaranteed return to it based on comparable independent service providers that are functionally and risk-wise broadly similar to it.  These would most probably be independent service providers providing marketing support and back-office type services to the market.  Usually a variant of the cost plus method is used (a markup applied to gross or total costs) in order to compute the arm’s length service fee charged by the LSP to the HQ.  The remuneration to the HQ can then be computed residually. 

Business Model II: LSP as Primary Contractor

In this business model, the LCP is the counterparty to the business contract with the customer.  The revenue is collected by the LCP from customers and the LSP pays a platform usage & associated services fee to the HQ.  This is illustrated in Figure 2 below.  The transfer pricing question with respect to this business model is: how should the intercompany platform usage & associated services fee be calculated? 

Figure 2: Business Model II

Given the functions and risks profile provided in Table 1, benchmarking the platform usage & associated services fee directly would prove to be highly difficult and inaccurate, if not impossible.  That is because, the HQ undertakes a number of integral functions such as brand management, R&D, content management, and establishing/leasing payment channels, and bears central business risks such as brand, R&D, market, and credit risks.  The return to be allocated to the HQ can be viewed as a union of all remunerations to the individual functions undertaken and risks borne as listed above, some which would prove to be extremely difficult to compute on their own and in isolation. 

For example, how would the returns to the brand management function and the associated risks be computed?  In order to do this, one needs to identify two independent entities of which one manages and takes the associated risks of a comparable brand and charges a brand management fee to the other, namely, the owner of the brand.  From a practical perspective, it would be quite difficult, if not impossible, to identify a potentially comparable transaction in this case because third parties do not enter into such arrangements in the marketplace.  A brand is almost always managed by the owner itself, or by an affiliate belonging to the same group.  In practice, a successful brand built from ground up through many challenges is almost never entrusted to a third party manager who manages the brand for a fixed fee.

To compute the remuneration for undertaking R&D success risk would involve similar overwhelming challenges.  For example, it would be practically impossible to identify a firm taking on R&D success risk on behalf of an independent entity in return for some fixed fee.  While there are plenty of contract R&D arrangements between third parties, the service provider does not take the R&D success risk in these cases.  Therefore, R&D success risk is almost never transferred to a third party in return for some fixed fee in practice under normal market conditions.

Therefore it would be infeasible to benchmark the platform usage & associated services fee directly as a whole, or by benchmarking its constituent parts.  In order to solve this tough problem one would be forced to take an indirect approach: compute the remuneration to the LSP – being the least complex side – and then figure out the platform usage & associated services fee to the HQ residually.  In effect, this is would be equivalent to applying the transfer pricing methodology of the first business model.

Summary and Discussion

In this article, we have considered two business models: the first one is widely-used by most digital platform-based businesses, and the second one is a model that will probably be suggested by local tax authorities as an alternative.   

Due to the practical difficulties in computing the arm’s length remuneration to the more complex entity (the HQ) for transfer pricing purposes in the above scenario, the practical solution is always to conduct the transfer pricing analysis from the LSP side.  Thus, for transfer pricing purposes the two business models would yield identical outcomes.  That is, both business models would yield the same division of income between the HQ and LSP given the initial division of functions and risks as summarized in Table 1 stays the same.

The outcome will not be business-model neutral, however, when viewed from a non-corporate income tax perspective, such as a VAT perspective.  You can find out more about the consequences of indirect tax applications by clicking here.