APMA's Functional Cost Diagnostic Model
The Internal Revenue Service’s Advance Pricing and Mutual Agreement Program (APMA) has recently released the Functional Cost Diagnostic (FCD) model, which is an Excel-based financial model designed to facilitate review and due diligence of certain Advanced Pricing Agreement (APA) requests. The FCD model collects and analyzes financial data relevant to an APA request’s proposed covered transactions and focuses on the functional costs incurred by a controlled taxpayer in relation to its covered operations. The primary goal of the FCD model is to assess the economic value of a taxpayer’s functional costs across the relevant related parties to a tested transaction and calculate each related party’s relative contribution to the key value drivers of its business operations. In this alert, we discuss the model’s purpose, review the specific inputs of the model, and discuss our view on its potential application to APMA’s current APA request inventory.
FCD Model Overview
The FCD model’s implementation is conceptually consistent with a value chain analysis of an APA tested transaction(s). The FCD model instructs taxpayers to identify and present functional costs for APMA’s review, as part of the overall profit and loss results of a tested issue or transaction. Consistent with prevailing guidance in the Treasury Regulations under Section 482 and 2017 OECD Transfer Pricing Guidelines, the taxpayer is required to bifurcate its business operations and related costs between routine and non-routine functions.[1]
With regard to routine functions, the economic value of related functional costs is measured according to the taxpayer’s benchmarks and selected profit level indicators (PLIs). The model allows for flexible application of PLI by function (e.g., a distribution function can target a Berry ratio, while the manufacturing function can target an operating margin).
The remaining functional costs that cannot be reliably benchmarked are deemed non-routine, and the taxpayer should separately account for them. The FCD model then accumulates and capitalizes each development cost according to formulas that take into account the taxpayer’s specific facts and assumptions, including the lead time and useful life of each stream of contributions. The FCD model then constructs a pro forma split of residual profits or losses given the taxpayer’s accumulated and capitalized functional costs.
Review of APMA Example
APMA’s example of the FCD model relies on the following fact pattern: a foreign parent that undertakes R&D activities and manufactures products, with a U.S. affiliate that distributes the products.
Inputs
Entity Profit & Loss Statements
The APMA example includes two related parties to the tested transactions: Related Party 1 and Related Party 2. Income statement and balance sheet information are included for both entities using APMA’s financial analysis template (APMA Template).[2] Since the FCD model assumes a combination of routine and non-routine activities for each entity, the APMA Template must be completed for each function within a given entity. In the APMA example, Related Party 1 has two functions, R&D (non-routine) and manufacturing (routine), and Related Party 2 has one function, distribution (with non-routine development costs carved out). The model, thus, requires taxpayers to segment financial data within entities.
The model also includes a “Combined Financials” tab that aggregates the segmented financials provided and captures the revenue, costs, and profits of the taxpayer’s integrated operations.
Functional Costs
The FCD model then segments each party’s cost structure into multiple cost streams, specifically those related to routine costs and those related to non-routine contributions (i.e., development costs). The APMA example includes two streams of development costs, one for each related party. It is worth noting that the years of data required for analysis must be equal to the sum of the intangibles’ gestation period (i.e., lead time or lag) and useful life, a common approach applied in residual profit split analyses.
Benchmarks
The FCD model includes a tab for the benchmarks applicable to each related party. The model allocates profit to routine functions based on the costs and expenses related to such activities, as summarized in the model’s functional cost tab.
Model Outputs
The FCD model’s outputs are generated on the Computations tab. First, the combined profit and loss results for each taxable year covered in the APA request are referenced from the Combined Financial tab. Next, total operating profit is determined by adding back all development costs to the profit and loss results to arrive at a combined operating profit amount before deductions for intangible developments costs. Then, the profit allocable to each routine function is deducted from total operating profit, leaving the total residual profit for each year in the APA term.
Split of Residual Profit
The total residual profit is then split between the two parties according to their respective share of the capitalized intangible stocks calculated. As mentioned above, the APMA example assumes a U.S. taxpayer sourcing inputs from a related foreign manufacturer. The foreign parent’s non-routine function is R&D, while the U.S. affiliate’s non-routine contribution is marketing. The development costs incurred by each party are capitalized in the model, after the specified lead time, and then amortized over the specified useful life. The amortization curve or function for the non-routine intangibles is not specified; nevertheless, the model’s formulae indicate a linear decay function, which is a typical approach.[3],[4]
Calculation of Net Operating Profit
Finally, the FCD model deducts development costs from the residual profit and adds the net intangible profit to the benchmark profit to arrive at each entity’s target operating profit per covered APA year. Any adjustments to each entity’s reported profit are then calculated on a per-year basis.
Commentary on Application of Model
General commentary to date has focused on the model’s construction of a pro forma residual analysis and APMA’s anticipated predisposition towards application of the residual profit split method (RPSM). While the model includes the typical complexities of the RPSM (i.e., through the identification of non-routine value drivers across multiple entities, segmentation of non-routine costs and expenses, assignment of lead time and useful lives to each non-routine expense category, and capitalization of expenses), there has been no indication that APMA intends to use the model to invalidate and eliminate routine analyses performed historically with the comparable profits method (CPM).
Specifically, APMA has neither requested that all taxpayers in its program complete the FCD model nor transitioned all taxpayers who have completed the FCD model from one-sided CPM/TNMM (transactional net margin method) benchmarks to residual profit splits.
APMA has also publicly commented that:
- There are no plans to use the model in mutual agreement procedure (double-tax) cases.
- They will be selective about the advance pricing agreements in which they do request the model.
- They would prefer to discuss the FCD model with a taxpayer before the taxpayer submits an APA application (i.e., at the pre-filing conference) rather than have the taxpayer revise an APA request.
APMA’s actual practice, as indicated in the 2018 APA Annual Report, is consistent with these pronouncements. Specifically, the predominant method used in APAs is not the profit split but rather the CPM, which was applied in over 80 percent of APAs concluded during 2018. This is also consistent with prior years.[5] Thus, we infer from initial public statements and current practice that APMA intends to use the model primarily as a diagnostic tool to initiate discussions and analyses, and not to impose specific transfer pricing methodologies and conclusions.
Conclusion
After review of the FCD model, our preliminary impression is that the model could serve as a useful tool for applying an RPSM transfer pricing methodology, if a taxpayer’s facts and circumstances merit consideration of that approach. There is limited evidence, based on public commentary and long-standing APMA practice, to indicate that APMA’s development of the FCD model will lead to increased application of the RPSM.
For more information, visit our Transfer Pricing page.
Special thanks to Tiffany Wong for her contributions to this article.
[1] For purposes of the model, all non-routine functions are referred to as “development” functions.
[2] Rev. Proc. 2015-41
[3] Some taxpayers may argue that certain intangibles have non-linear decay curves, which would require modifications to the model’s formulae.
[4] As a technical note, it appears that the invested non-routine costs and expenses do not earn a return while in gestation (i.e., from the moment the expense is incurred until the related intangible property asset enters service). If the lead times for the different IP assets are different, as indicated in the APMA example, this would potentially undervalue IP assets with longer lead times, relative to intangible property assets with shorter lead times. The model further assumes the internal development of intangibles. Consequently, taxpayers with one or more entities that have material amounts of acquired intangibles would need to consider if and how the FCD model would incorporate such assets.
[5] We refer to page 10 of the “Announcement and Report concerning Advance Pricing Agreements” issued by APMA on March 22, 2019 pursuant to §521(b) of the Public Law 106-70.
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