What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax Impact of the New Revenue Standard on Transfer Pricing In May 2014 the International Accounting Standards Board ( IASB ) and Financial Accounting Standards Board ( FASB ) took a major step forward towards their goal of convergence of international accounting standards with the publication of a new standard on revenue recognition. The new standard will be effective for annual reporting periods beginning after December 15, Although that date may appear far into the future, companies need to start thinking about how to transition to the new standard soon. Companies should also consider how the new standard may affect transfer pricing policies and documentation. This article discusses potential impacts of the new revenue recognition standard on transfer pricing and recommendations for dealing with those effects. Monday, August 18, 2014 by Prita Subramanian, Washington National Tax Prita Subramanian is a managing director in the Economic and Valuation Services-Transfer Pricing group in WNT. What is the New Revenue Standard? 2 On May 28, 2014, the FASB and the IASB issued substantially converged guidance on recognizing revenue in contracts with customers. The new guidance is a major achievement in the Boards joint efforts to improve the financial reporting of revenue. It establishes reporting principles related to the nature, timing, and uncertainty of revenue from contracts with customers. The core principle of the new standard is for companies to recognize revenue to depict the transfer of goods or services to customers in amounts that reflect the consideration (that is, payment) to which the company expects to be entitled in exchange for those goods or services. A reporting organization recognizes revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer, which is when the customer obtains control of that good or service. 1 2 There is a one year deferral for non-public entities. This section is based on and includes excerpts from a summary of the new revenue recognition standard on the FASB website ( accessed on July 2, entity. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

2 Impact of the New Revenue Standard on Transfer Pricing page 2 The new standard will also result in enhanced disclosures about revenue, provide guidance for transactions that were not previously addressed comprehensively (for example, service revenue and contract modifications), and change guidance for multiple-element arrangements. Presently, U.S. generally accepted accounting principles ( GAAP ) has complex, detailed, and disparate revenue recognition requirements for specific transactions and industries including, for example, software and real estate. As a result, different industries use different accounting for economically similar transactions. The new guidance will replace numerous, industry-specific revenue recognition requirements. Currently, goods or services promised in a contract with a customer may not be deemed to be distinct revenue-generating transactions when in fact those promises might represent separate obligations of the entity to the customer. With the new guidance, reporting organizations will identify each of the goods or services promised to a customer, determine whether those goods or services represent a performance obligation, and recognize revenue when (or as) each performance obligation is satisfied. In addition to the updated guidance on revenue recognition, the new standard also specifies the accounting for some costs to obtain or fulfill a contract with a customer, as well as enhanced disclosure requirements. Options Available to Companies for Transitioning to the New Standard 3 The standard offers a range of transition options to companies for adoption of the new standard. Retrospective method: At one end of the spectrum, an entity can choose to apply the new standard to its historical transactions and retrospectively adjust each comparative period presented in its 2017 financial statements. Companies can also elect to use any or all of three practical expedients. Two of these provide relief from applying the new standard to certain types of contracts that are completed under legacy GAAP before the date of the initial application. 4 The other 3 4 This section is based on and includes excerpts from KPMG s white paper: Transition to the New Revenue Standard: What is the Best Option for Your Business? (June 2014). The date of initial application is the start of the reporting period in which an entity first applies the new standard. For a calendar year-end public business entity, this will be January 1, 2017.

3 Impact of the New Revenue Standard on Transfer Pricing page 3 provides a disclosure exemption for the comparative periods presented. Cumulative method: At the other end of the spectrum, an entity can recognize the cumulative effect of applying the new standard at the date of initial application and make no adjustments to its comparative information, i.e., the comparative periods are presented in accordance with legacy GAAP. By contrast with the retrospective method, the new standard is only applied to contracts that are open under legacy GAAP at the date of initial application. The following table provides an example of the differences in application of the two transition approaches. Suppose under legacy GAAP, an entity recognized revenue of 100 for years 2014, 2015, and 2016, and would have recognized revenue of 100 for Under the new standard, the entity determines that its revenue would be 325, 25, 25, and 25 for the same periods. The table below illustrates the revenue numbers presented under each option. Comparatives Current Year Total Legacy GAAP Revenue Retrospective method (no practical expedients) Revenue Adjustment to opening equity 225 a Cumulative effect method Revenue Adjustment to equity b 75 Notes: a. Calculated as , being the difference between revenue recognized in 2014 under legacy GAAP and what would have been recognized under the new standard as of that date. b. Calculated as , being the difference between revenue recognized under legacy GAAP up to the initial date of application and what would have been recognized under the new standard.

4 Impact of the New Revenue Standard on Transfer Pricing page 4 While the chosen transition option can have a significant effect on revenue trends in the financial statements, it can also affect cost trends, because the standard includes specific guidance on costs related to acquiring and fulfilling a contract. Furthermore, a change in the timing of revenue recognition may require a corresponding change in the timing of recognition of related costs. Implications for Transfer Pricing Overview The U.S. transfer pricing regulations and Organisation for Economic Cooperation and Development ( OECD ) guidelines require that prices in transactions among controlled parties should be the same as the prices that would have been charged had the transactions taken place among uncontrolled parties (i.e., the prices should be at arm s length). They provide for the use of either transactional methods or profit-based methods to determine arm s-length pricing. Transactional methods are based upon pricing or margin data from comparable transactions. Profitbased methods make inferences about prices in controlled transactions based upon the profits realized from these controlled transactions relative to the profit earned by uncontrolled parties in comparable transactions. The changes to the revenue recognition standard are most likely to affect transfer pricing when profit-based methods are used to set or test transfer prices. The two specified profit-based methods are: Comparable Profits Method ( CPM ), which evaluates the price in a controlled transaction based upon comparing an objective measure of profitability (known as the profit level indicator) of one of the parties to the controlled transaction (the tested party) to the range of the same profit level indicator calculated from comparable uncontrolled parties Profit Split Method ( PSM ), which determines an arm s-length division of the combined operating profit/loss from one or more controlled transactions based on the relative value of each controlled taxpayer s contribution to that combined operating profit or loss Since the profit-based methods rely on profit measures, which in turn are a function of revenues and costs, a change in the revenue or cost measures might lead to a change in profit measures. We discuss some potential impacts of the new revenue standard on CPM and PSM analyses below.

5 Impact of the New Revenue Standard on Transfer Pricing page 5 In addition to the traditional profit-based methods of CPM and PSM, intangible valuations also use income approaches based on operating profit or cash flow measures. A change in the way revenue and costs are measured may also affect transfer prices of intangibles, which is also discussed further below. In general, we can distinguish between two types of impacts of the new revenue standard on transfer prices: Distortive impacts These are potential effects of the new revenue standard on transfer prices that are distortive in that they move the transfer prices away from arm s-length pricing through purely accounting changes. Such impacts can reduce the reliability of transfer pricing analyses unless controlled for, and erroneously lead to adjustments in the transfer pricing. Non-distortive impacts These are changes to transfer prices resulting from the new standard but there is no reason to believe the changes are distortive. The new revenue standard can lead to different prices because of changes in the financial data of the taxpayer. For instance, suppose a taxpayer sets prices for products purchased from related parties such that it achieves a target profit margin. If its revenues change because of the new standard, its transfer prices will also change, commensurate with its revenue change. However, there is no reason to believe that just because the new transfer prices are different they are erroneous or distorted. We discuss both distortive and non-distortive impacts of the new revenue standard below, but with a greater emphasis on the distortive impacts since those are the ones taxpayers will need to actively counter. While the taxpayer needs to understand and account for non-distortive impacts (such as the one discussed above on the change in cost of related party purchases when the taxpayer targets a profit margin), there may not be much it needs to do to counter or reverse the impacts. We also note that the distortive effects are more likely to arise during the transition period between the new standard and legacy GAAP.

6 Impact of the New Revenue Standard on Transfer Pricing page 6 Impact on CPM Analyses More Reliable Comparisons across Industries One of the enhancements of the new revenue standard is that it will replace numerous industry-specific revenue recognition requirements. Thus, economically similar transactions from different industries that might have used different accounting will now follow the same accounting principles. Since a CPM analysis often considers companies that are functionally similar but from different industries, the effect of the uniform revenue standard across industries should be to enable more reliable comparisons across industries. Comparisons During the Transition Period The greatest impact on the CPM is likely to occur during the transition period, especially since CPM analyses often use multiple years of data. If some or all of the comparables use different transition approaches than the tested party, the results of the comparables and tested party might diverge for purely accounting reasons. Without further evaluation or adjustments, one might draw erroneous conclusions about the transfer prices. The table below provides an illustration. It presents the three-year weighted average operating margin ( OM ) of two companies the controlled entity (tested party) and an uncontrolled comparable that are identical in every respect except that the comparable follows the retrospective method for transitioning to the new revenue standard and the tested party follows the cumulative effect method. At a superficial level, the comparable looks more profitable than the tested party with a 2 percent OM compared to the tested party s 1.3 percent OM. Without further consideration of their accounting policies, one might conclude that the tested party s transfer prices were not arm s length since it had significantly lower OM than the comparable. However, once the differences in accounting approaches are eliminated, both would have identical OM, and one would rightly conclude that the transfer prices were arm s length.

7 Impact of the New Revenue Standard on Transfer Pricing page 7 Comparatives Current Year Retrospective method (comparable) Total Revenue OM 1% 1% 4% 2.0% Cumulative effect method (tested party) Revenue OM 1% 1% 4% 1.3% Note that in the table above we assumed that the OM for the company under the new revenue standard would be the same as the OM under the legacy GAAP. It remains to be seen whether the revenue standard would introduce any systematic upward or downward trends in the profit margins of companies during the transition period. In the example above, if the retrospective method yielded higher OM than under the legacy GAAP, then the gap between the weighted average OM of the comparable and the tested party would be compounded while if it yielded a lower OM the gap presented above would be reduced (see table below). Current Comparatives Year Total Retrospective method (comparable) Revenue OM - Alternative scenario 1-0.2% -0.1% 4% 1.2% OM - Alternative scenario 2 2.0% 2.0% 4% 2.7% Cumulative effect method (tested party) Revenue OM 1% 1% 4% 1.3%

8 Impact of the New Revenue Standard on Transfer Pricing page 8 While the exact impact of the new revenue standard on profit measures is likely to vary by company, what the example above illustrates is the need for a careful examination of the financial data of the comparables and tested party used in the CPM analysis to determine if different accounting approaches are causing distortions in the results. Some possible ways of correcting for distortions in the CPM results produced by the use of different accounting methods are as follows: One way would be to adjust the financial data of the comparables and/or the tested party such that all are presented using the same accounting principle. The new revenue standard requires that entities disclose the quantitative effect and an explanation of the significant changes between the reported results under the new standard and those that would have been reported under legacy GAAP. 5 Thus, it should be possible to consistently adjust the financial data of the comparables and tested party to legacy GAAP to allow for a more reliable comparison. Once the transition period is over and all data for the comparables and tested party are presented under the new revenue standard, such an adjustment may not be needed any longer. Another possibility for making the comparison more reliable could be to use single year data only in the year the new standard becomes effective and for subsequent years include data from no further back than the year the new standard takes effect. Impact on PSM Analyses There are two types of PSM specified in the U.S. transfer pricing regulations the comparable profit split ( CPSM ) and the residual profit split ( RPSM ). Both depend on being able to derive reliable profit measures. In the CPSM, total profit is split between the parties making non-routine contributions to the intercompany transaction based on the split seen in comparable third-party transactions. In the RPSM, residual profit derived after allocating profit to routine contributions is split 5 Entities are required to disclose the nature of and justification for the change as well as the effects of the change on net income for the period in which the change is made under FASB ASC paragraph

9 Impact of the New Revenue Standard on Transfer Pricing page 9 between parties making non-routine contributions based on one or more allocation keys. As with the CPM, the impact of the new revenue standard on the PSM is likely to be most distortive during the transition period when multiple years of data are used. For instance, in the CPSM, the split of profits between a comparable uncontrolled licensee and licensor might form the basis of splitting profits between the controlled licensee and licensor for a particular intangible. If the CPSM comparables and the related parties in the intercompany transaction adopt different transition approaches to the new revenue standard, the reliability of the comparables might be reduced without further adjustments. The following tables illustrate this point. The first table shows the split of profits between a third party licensee and licensor of 33 percent and 67 percent. Retrospective method (comparable licensee) Comparatives Current Year Total Split of Profits Revenue Operating profit % Cumulative effect method (comparable licensor) Revenue Operating profit %

10 Impact of the New Revenue Standard on Transfer Pricing page 10 The next table below shows the split in profits between the related licensee and licensor, which are identical to the comparable licensee and licensor, respectively, in all respects except that both the related licensee and licensor follow the cumulative effect method for transitioning to the new revenue standard. Even though the licensee and licensor are identical in the related and third-party transactions, their split in profits looks different because of their different accounting approaches. Retrospective method (related licensee) Comparatives Current Year Total Split of Profits Revenue Operating profit % Cumulative effect method (related licensor) Revenue Operating profit % An RPSM analysis using multiple years of data could similarly be distorted by differential adoption of the new revenue standard by the parties to the transaction (although it is less likely with controlled entities within the same multinational group). The same approaches as were suggested for dealing with the distortions introduced by the transition to the new revenue standard could be used for the PSM also, i.e., to use data from the effective date of the new standard only or to adjust the financial data of the parties to the comparable and/or the controlled transaction to the same accounting standard. Impact on Intangibles Valuations Using Income Approaches 6 An income approach values an intangible by discounting a stream of cash flows attributable to the intangible to the present using an appropriate 6 This discussion relates to intangibles valuations for transfer pricing purposes only, and not to other tax valuations or financial reporting valuations.

11 Impact of the New Revenue Standard on Transfer Pricing page 11 discount rate. For transfer pricing purposes, companies often transfer intangibles that are unique and without good market comparables to related parties. In such cases, the income method as specified in the U.S. cost sharing regulations or any of the many different variants of the general income approach may be used for valuing the intangible. An income approach using data based on the new revenue standard may lead to different values for an intangible than when using the legacy GAAP. This in itself need not be distortive. The value under the new approach may well be a better representation of intangible value than the value obtained using the legacy GAAP. One important way in which the new revenue standard can be distortive is in the application of the commensurate with income ( CWI ) standard of the U.S. transfer pricing regulations (which states that the income with respect to transfers or licenses of intangible property must be commensurate with the income attributable to the intangible). Taxpayers often obtain a lump sum value of an intangible using an income approach and then convert that lump sum amount into an ongoing royalty based on sales or fixed installment payments. The royalty rate or fixed installment is set such that the present value ( PV ) of the expected stream of royalty payments or fixed installments is equal to the lump sum intangible value. With the adoption of the new revenue standard, the realized financial data can be significantly different from the projections created under legacy GAAP due primarily to the change in accounting standard. The IRS could potentially make an adjustment under the CWI standard and impose penalties if the revenues under the new standard are higher than under the older standard. On the other hand, if the revenues are lower due to the change in accounting standard, then the taxpayer may not be able to make downwards adjustments and may be stuck with inflated payments for the intangibles. Taxpayers would be advised to understand the impact of the new revenue standard on their financials and to anticipate potential challenges to their transfer prices. It would also be worthwhile to consider adding flexibility into intercompany contracts for intangible transfers to be able to deal with changes arising from the new revenue standard. Finally, cash flow measures might be less affected by the change in the revenue standard than operating profit measures. Hence, taxpayers could consider using

12 Impact of the New Revenue Standard on Transfer Pricing page 12 cash flow measures for determining intangible values instead of operating profit measures, if possible. Other Impacts on Transfer Pricing Jumps in Transfer Prices As noted earlier, there could be changes in transfer prices due to the change in underlying financial statements of the company but these need not be distortive just different. The changes could still pose some issues for companies if there are discrete jumps in the transfer prices. Companies may want to consider ways of smoothing out the impact. Cost Allocation Keys Transfer pricing often involves allocating costs to different entities using allocation keys. A frequently used allocation key is entity revenue. If different entities are affected differently by the new revenue standard, it would be advisable for taxpayers to evaluate whether revenue is still a good allocation key or if other allocation keys might work better. Definition of Intercompany or Comparable Uncontrolled Transactions The new revenue standard might result in accounting for a different number of units of account for financial reporting purposes. For example, the sale of a product with installation services may be accounted for as a single unit of account under legacy GAAP. Under the new standard, the sale of the product and the installation services may be accounted for as two separate units of account. Alternatively, if an entity accounts for the product and installation services as two units of account under legacy GAAP, under the new standard, they may account for the arrangement as a single unit of account. The determination of the unit of account requires the use of judgment under the new standard. Taxpayers should evaluate whether the change in unit of account would have any impact on their definition of the intercompany transaction or selection of comparable uncontrolled transactions in a transactional approach. Transfer Pricing Implementation The new revenue standard is likely to cause some strains on companies financial reporting and IT systems, which is a broader issue than just

13 Impact of the New Revenue Standard on Transfer Pricing page 13 transfer pricing. Nevertheless, if there are changes to transfer prices due to the new revenue standard, companies will also need to figure out how to implement those changes. So transfer pricing needs to be one element of the broader discussion on implementing the new revenue standard. Conclusion While the new revenue standard will not come into effect till 2017, companies are likely to start thinking about how they will transition to the new standard before then. From a transfer pricing perspective, it will be useful to understand the company s approach to adoption of the new standard. Companies should also start trying to understand if there will be significant differences in financial statements due to the new standards. Some industries are more likely to be affected than others. The ones most likely to be affected are services companies, telecommunications companies, software companies, real estate companies, and other companies with significant long term contracts, upfront fees, or retainers. As companies start to develop their approaches for transitioning to the new revenue standard, they should also evaluate their transfer pricing practices and determine if policies and documentation need to be revised; undertake analyses and adjustments to ensure that transfer prices are not distorted by the new standard; and document their approaches. Companies should also include transfer pricing as a component of their evaluation of IT and other system needs to adopt the new revenue standard. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. While 2017 might seem far away, it is not too early to start understanding how the new revenue standard might affect a company s transfer pricing and to start planning for the change. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.