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1 International Journal TM Reproduced with permission from Tax Management International Journal, 47 TM International Journal 328, 5/11/18. Copyright 2018 by The Bureau of National Affairs, Inc. ( ) Impact of the New Revenue Standard on Transfer Pricing By Prita Subramanian and Kaitlyn Wiatrak * INTRODUCTION With the May 2014 publication of a new standard on revenue recognition, the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) took a major step toward their goal of convergence of international accounting standards. On August 12, 2015, the FASB issued an Accounting Standards Update (ASU) deferring the effective date of the new revenue recognition standard by one year. Based on FASB s decision, public organizations using U.S. generally accepted accounting * Prita Subramanian (psubramanian@kpmg.com) is a principal in the Economic and Valuation Services Transfer Pricing group of the Washington National Tax practice of KPMG LLP. She is based in Boston. Kaitlyn Wiatrak (kwiatrak@kpmg.com) is a manager in the Transfer Pricing group of the Economic and Valuation Services practice of KPMG LLP. She is based in New York. This is an update of an article under the same title, which was previously published in Bloomberg BNA Transfer Pricing International Journal in November These comments represent the views of the authors only, and do not necessarily represent the views or professional advice of KPMG LLP. 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. KPMG LLP, the audit, tax and advisory firm ( us), is the independent U.S. member firm of KPMG International Cooperative ( KPMG International ). KPMG International s independent member firms have 197,000 people in 154 countries. principles (GAAP) should apply the new revenue standard to annual reporting periods beginning after December 15, Nonpublic organizations using U.S. GAAP should apply the new revenue standard to annual reporting periods beginning after December 15, The new standard will also be effective for companies currently using international financial reporting standards (IFRS) starting January 1, As companies transition to the new standard, they 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. WHAT IS THE NEW REVENUE STANDARD? On May 28, 2014, the FASB and the IASB issued substantially converged guidance on recognizing revenue in contracts with customers. Subsequent amendments to the new guidance were made in 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. In order to achieve the core principle, companies should follow a five-step process: 1 Early application is permitted as of the original effective date of December 15, Early adoption is permitted under IFRS. 3 This section is based on and includes excerpts from a summary of the new revenue recognition standard on the FASB website ( accessed on October 24, Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 1

2 Step 1: Identify the contracts with a customer. Step 2: Identify the performance obligations in the contract. Step 3: Determine the transaction price. Step 4: Allocate the transaction price to the performance obligations in the contract. Step 5: Recognize revenue when (or as) the reporting organization 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. 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 multipleelement arrangements. At present, IFRS has limited revenue guidance that is often difficult to apply to complex transactions, 4 and U.S. 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. 4 Revenue Recognition: Finally, a Standard Approach for All, Investor Perspectives, IFRS website (June 2014). 5 This section is based on and includes excerpts from KPMG s OPTIONS AVAILABLE TO COMPANIES FOR TRANSITIONING TO THE NEW STANDARD A range of transition options are offered to companies for adoption of the new standard. 5. At one end of the spectrum, an entity can choose to apply the new standard to its historical transactions at the start of the earliest period presented in its 2018 financial statements. Companies can also elect to use one or more of four practical expedients available under the retrospective approach. The practical expedients help to simplify how contracts are restated or reduce the number of contracts to be restated. Cumulative effect 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). Under the cumulative effect method, a company may elect to apply the new standard only to uncompleted contracts under current U.S. GAAP as of the adoption date or to all contracts. The cumulative effect is the difference between the cumulative revenue recognized under current U.S. GAAP as of the adoption date compared to cumulative revenue that would have been recognized had the requirements of the standard been applied to those contracts. 6 Companies can also elect to apply a practical expedient related to contract modifications prior to the date of initial application of the standard. Table 1 provides an example of the differences in application of the two transition approaches. Suppose that under legacy GAAP, an entity recognized revenue of $100 for years 2015, 2016, and 2017, 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. Table 1, below, illustrates the revenue numbers presented under each option. Table 1 Comparatives Current Year Total Legacy GAAP Revenue $100 $100 $100 $300 (no practical expedients) Adjustment to opening equity 225 a Cumulative effect method white paper: Revenue Transition Options: What Is the Best Option for Your Business? (June 2016). 6 KPMG s Defining Issues: Implementing the Forthcoming Revenue Recognition Standard (Feb. 2014) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

3 Revenue Adjustment to equity b 75 a. Notes: Calculated as , being the amount of revenue that would have been recognized under the new standard in 2015 less the actual amount of revenue recognized in 2015 under current GAAP. b. Calculated as , being the amount of revenue that would have been recognized under the new standard in 2015, 2016, and 2017 less the amount of revenue recognized in 2015, 2016, and 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 Organization for Economic Cooperation and Development (OECD) transfer pricing guidelines and U.S. transfer pricing regulations 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. A taxpayer s ability to meet the applicable transfer pricing regulations entails the taxpayer spending a substantial amount of time and effort developing and supporting their transfer pricing policies. The implementation of these transfer pricing policies requires cross-functional collaboration across many departments within the multinational group. In this article, we discuss the impact of the new revenue standard on the implementation of transfer pricing policies. Further, we note that 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: Transactional Net Margin Method (TNMM) or 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; and 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. Because 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 also discuss some potential impacts of the new revenue standard on assessing the transfer pricing results under TNMM/CPM and PSM analyses. In addition to the traditional profit-based methods of TNMM/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 or volume of payments/receipts 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 that they are erroneous or distorted Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 3

4 We discuss both distortive and non-distortive impacts of the new revenue standard at the transfer pricing implementation and assessment stages 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 relatedparty 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 legacy GAAP and the new standard. IMPACT ON TRANSFER PRICING IMPLEMENTATION Multinational companies spend significant time and effort developing and supporting their transfer pricing policies in order to meet the applicable tax regulations. Implementing these carefully designed transfer pricing policies is an extensive process that requires cross-functional collaboration among operations, information technology (IT), finance and accounting, and tax departments. This implementation process is commonly referred to as operational transfer pricing. A failure by a company to effectively carry out its operational transfer pricing activities can lead to significant risks, such as financial reporting issues, increased tax liabilities, misstated financial statements, and higher costs in terms of intercompany accounting and tax compliance. Each company faces distinct operational transfer pricing challenges, such as technology enablement, data management, and crossfunctional process integration. Given anticipated changes from the new revenue recognition standards, companies would benefit from a comprehensive review of their transfer pricing processes in order to determine the impact of the revenue recognition standards on their transfer prices. The first step in this review is to identify all intercompany arrangements and the associated transfer pricing policies. A suggested process map is presented in Figure 1. Table 2 Figure 1 Identify the accounting items in the IT systems that are impacted by new revenue standards Identify all of the transfer pricing inputs in the IT systems Map the gross set of impacted accounting items in the IT systems to transfer pricing inputs used in the transfer pricing calculations Assess the outcomes of the transfer pricing calculations given changes to the revenue recognition standards Items to Impacted U.S. GAAP Inputs to transfer be and IFRS line items pricing calculations assessed Planning ahead through a process similar to the one presented above is critical to effective operational transfer pricing. For example, if a taxpayer has an intercompany transfer pricing policy targeting an operating profit margin within a range of 5% to 15%, which it implements by setting the price for its intercompany purchases at a 40% discount over the final sales price to its third-party customers, changes to revenue may result in an operating margin that is greater or less than what was earned in prior years even when using the same operational transfer pricing approach (Table 2). Results Prior to Implementation of New Standards Results After Implementation of New Standards (Cumulative Effect Method) Revenue COGS Gross Profit Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

5 Targeted Gross 40% 40% 40% 40% 40% 40% Profit Margin % (per transfer pricing policy) Op. Expenses Op. Margin Op. Margin % 10.0% 10.0% 10.0% 10.0% 10.0% 0.0% 7 We assume that operating expenses will decrease as sales decrease, while it is not clear the operating expenses would change in exactly the same proportion as revenues. As shown in Table 2, above, the company s operating margin after implementing the new revenue recognition standards decreased from 10% to 0%, while an operational approach of targeting a gross profit margin of 40% is maintained. Therefore, the transfer pricing implementation method, which has remained unchanged, may lead to the transfer pricing policy not being achieved due to differences in revenue as a result of the new accounting method. The company may consider revising its target gross profit margin for this particular intercompany transaction. In order to manage results such as the above, companies need to start (i) gathering the relevant financial data from their IT systems, (ii) understanding the impact that the new data has on transfer pricing, (iii) assessing the outcomes on the transfer pricing calculations and how these outcomes align with the ability to substantiate the arm s-length nature of the transaction, and then (iv) plan ahead with respect to updating the transfer pricing policies and calculations, as necessary. IMPACT ON ASSESSING TRANSFER PRICING RESULTS The following sections discuss the impact on assessing the transfer pricing results using several prescribed methods under the OECD and U.S. transfer pricing regulations. Impact on TNMM/ 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 TNMM/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 TNMM/CPM is likely to occur during the transition period, especially since TNMM/CPM analyses often use multiple years of data. If some or all of the comparables use different transition approaches than the controlled entity whose profits are being evaluated (i.e., 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 (Table 3) 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% OM compared to the tested party s 1.3% OM. Without further consideration of their accounting policies, one might conclude that the tested party s transfer prices were not arm slength because 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. Table 3 Current Comparatives Year Total (comparable) OM 1% 1% 4% 2.0% Cumulative effect method (tested party) 2018 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 5

6 Revenue OM 1% 1% 4% 1.3% Note that in Table 3, 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 4 below) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

7 Table 4 Current Comparatives Year Total (comparable) OM - Alternative scenario 1 2.0% 2.0% 4% 2.7% OM - Alternative scenario 2-0.2% -0.1% 4% 1.2% Cumulative effect method (tested party) Revenue OM 1% 1% 4% 1.3% 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 TNMM/CPM analysis to determine if different accounting approaches are causing distortions in the results. Some possible ways of correcting for distortions in the TNMM/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 adopting it under the cumulative effect method 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. 8 Thus, it should be possible for companies that adopt the standard using the cumulative effect method 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 then for subsequent years include data from no farther back than the year the new standard takes effect. 8 For example, under U.S. GAAP, entities adopting the new standard under the cumulative effect method 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 Impact on PSM Analyses There are two types of PSM described in the OECD guidelines and in the U.S. transfer pricing regulations the U.S. transfer pricing regulations call them the comparable profit-split method (CPSM) and the residual profit-split method (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 thirdparty transactions. In the RPSM, residual profit derived after allocating profit to routine contributions is split between parties making non-routine contributions based on one or more allocation keys. As with the TNMM/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. Table 5, below, shows the split of profits between a third-party licensee and licensor of 33% and 67%. Table 5 Current Comparatives Year Total Split of Profits (comparable licensee) Operating profit % Cumulative effect method (comparable licensor) Revenue Operating profit % Table 6, 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 retrospective 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 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 7

8 Table 6 Comparatives Current Year Total Split of Profits (related licensee) Operating profit % (related licensor) 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 also be used for the PSM, 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 An income approach values an intangible by discounting a stream of cash flows attributable to the intangible to the present using an appropriate discount rate. 9 For transfer pricing purposes, companies often transfer intangibles that are unique and without good market comparables to related parties. In such cases, an income or discounted cash flow 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 9 This discussion relates to valuations for intangibles for transfer pricing purposes only, and not to other tax valuations or financial reporting valuations. 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 Internal Revenue Service 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 downward 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 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 Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

9 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. CONCLUSION With the new revenue recognition standard now in place, companies are transitioning to the new standard. From a transfer pricing perspective, it will be useful to understand the company s approach to adoption of the new standard and how this approach will impact the company s transfer pricing policies and results. 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 companies in the fields of services, telecommunications, software, and real estate, as well as companies with significant longterm 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 part of their evaluation of IT and other system needs in adopting the new revenue standard Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 9

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