Transfer pricing challenges in the automotive industry

Within the automotive sector, the supply chains and requirements of the OEM car- and commercial vehicle manufacturers drive to a large extent the business models of their automotive suppliers. 

Typically, the automotive suppliers face the following challenges:

• A requirement  to be close to the OEM customer geographically with respect to manufacturing sites, in order to keep lead times short and ensure just-in-time-delivery of products following call off from the OEM client, and potential needs to restructure following changes in the manufacturing footprints of the OEM customer.
• Demand fluctuations on the OEM side and other supply chain issues directly translate into fluctuating call-off figures for the supplier.
• Important to always be able to deliver in OEM-quality, on time and also be able to react to demand fluctuations quickly. If requirements cannot be met and the OEM has the option to multisource, the OEM is able to switch to competitors that can meet the demand, carrying the risk for the supplier to lose valuable business.
• Suppliers are exposed to significant investment risks that are linked to OEM demand fluctuations, related to the requirement to provide sufficient production capacity, often outside of their own control sphere.
• Production sites need to be certified by the OEM, which is often a lengthy and elaborate process.
• Manufacturing sites and the local legal entity typically need to sell and deliver directly to the OEM customer, i.e. the operating model is often predefined and relatively rigid for the supplier’s organization.  

Swiss automotive supplier companies often have operational companies acting in central and strategic roles within their global corporation out of Switzerland. Functions performed by the Swiss companies through key resources and roles often include significant R&D substance and strategy leadership functions that drive various value drivers within the group and benefit the entire enterprise and related parties through their central activities. 

While Key Account Management (KAM) functions often operate out of local production units that are close to the OEM clients for operational reasons, there is a growing trend towards a centralized approach to the sales function in line with the engineering and R&D function, with central steerage of these functions from the Swiss headquarters and limited independence of the sales organization towards the local OEM customers. 

At the same time, uncertainties on global supplies for raw material make centralized procurement capabilities ever more important. Further, a centralized supply chain management function is evolving as a value driver that is increasingly important for value creation, given overall margin pressures from the OEM customer side. 

Following the OECD’s Action Plan against Base Erosion and Profit Shifting ("BEPS"), the international tax and transfer pricing landscape put a focus on the arm’s length principle with a view on the overall value chain of a multinational enterprise. Specifically, a group’s overall profit achieved should be allocated to the different legal entities in accordance with the individual contribution to value creation. Tax authorities now have quite comprehensive insights through globally increased transparency brought forward by e.g. transfer pricing documentation requirements including Country-by-Country Reporting (CbCR). 

The "ideal" profit allocation is from a transfer pricing perspective often challenging to achieve and to document for Swiss automotive suppliers. Among others, this is due to the following reasons: 

• Because of specific industry requirements an automotive supplier typically is required to sell directly from manufacturing units to the OEM customer. Therefore, typical operating models with a central principal entity purchasing and reselling products are often not feasible within this industry.  
• Production units very often show a routine functional profile, controlling limited business risks, and are quite dependent on the centrally steered KAM function and its OEM client relationships to generate sales which then can be served by the manufacturing unit locally, showing the associated revenue locally. From a transfer pricing perspective, these entities would often be qualified as a routine contract manufacturer, even though they have direct sales to OEM customers. However, due to the specific constellation, residual profits or losses from the value chain typically remain with the manufacturing units and lead to a fluctuating operating margin. 

The main challenge from a transfer pricing perspective is therefore to achieve an arm’s length profit allocation throughout the organization, as the operational headquarters and (non-production) entrepreneurial companies are often not directly involved in the product flows.

Both current trends in value creation and transfer pricing challenges prompt many Swiss automotive supplier companies to pursue transformation efforts to redefine their target operating models and transfer pricing policies in order to reflect these changes.   

In recent years, a number of approaches have emerged to deal with the challenges outlined above:

Many automotive suppliers operate elaborate license fee schemes, licensing intangibles (marketing-IP and/or centrally owned technology) to production units against royalty fees.

Opportunities:

• Easy to implement and maintain.
• Fixed royalty rates can be benchmarked using standard transfer pricing methods. 

Challenges: 

• Typically, these transactions represent "red flags" in many jurisdictions from a tax perspective, specifically in China, carrying an increased tax audit risk and challenges on the economic ownership of intangibles, questioning the economic value added of such intangibles for the local companies’ business.  
• Further, license fees paid are in many jurisdictions subject to tax deductibility restrictions or carry withholding taxes.
• License fee rates are often charged in ranges that are difficult to benchmark with usual CUP-approaches and existing databases. A "remaining profitability after paying license fees" argumentation is typically challenged by local tax authorities in the light of high royalty rates.
• Fixed royalty rates do not provide opportunities for reacting to fluctuations of profitability on the licensee’s side.  

Value-based fee approaches
There is an emerging trend towards value-based-fee approaches, i.e. the definition of target margins based on a TNMM-approach for routine entities within the corporation (which might be complemented by additional remuneration for non-routine activities carried out or IP owned locally), and an additional value-based-fee transaction. This VBF ensures that excess earnings are repatriated, or excess losses are pooled at the entrepreneurial entities. Value-based-fee payments may then go in both directions. 

Opportunities:

• The VBF represents an elegant solution from a conceptual perspective, allowing an arm’s length profitability allocation through a simple mechanism that is easy to implement and maintain.
• Arm’s length profitabilities and target profit margins of routine entities can be benchmarked using standard transfer pricing methods.
• The VBF mechanism allows for an active management of local profitability and flexible response towards changes in the business environment. 

Challenges: 

• The treatment of the VBF transaction from a tax perspective may vary in different countries, triggering indirect tax- and customs issues and WHT-issues locally, as the VBF is remunerating a variety of activities carried out by the principal company (services, intangibles, etc.).
• As such, the VBF may not be implementable without local variations in all jurisdictions. 

License fee transactions with variable rates
Rather than agreeing up-front on a fixed royalty rate for licensing specific intangibles by production units, the parties agree to the effective rate every business year, taking implicitly the local profitability into account. 

Opportunities:

• This approach enables the entrepreneur to provide support to local units in reducing license fees as necessary, with flexibility in raising the rate in case of good financial performance.
• The qualification of the transaction as a licensing transaction is clear from a tax perspective, and as such represents a standard arrangement many tax authorities are familiar with.

Challenges: 

• The defense of variable license rates may still be difficult if rates are reaching double digits.
• WHT and other tax consequences are still relevant. 

In order to mitigate those difficulties for specific jurisdictions, companies also resort to establishing service transactions for headquarter services (e.g. for central business support services and other centralized activities such as central procurement, supply chain management, central marketing), combined with certain profit-trigger elements. With this mechanism, central service fees set at arm’s length are only charged if the local profitability is above the defined target, and reduced or even waived in times of insufficient profitability, linking the remuneration for the service provision to the local benefit achieved from the service reception.  

Opportunities:

• Potentially easier to defend in certain local jurisdictions, where license fee transactions are critical from a tax-/transfer pricing perspective.
• Explicitly remunerating activities performed at headquarter level at arm’s length may support in substance discussions on overall principal. 

Challenges: 

• Headquarter support for local legal entities is capped at the service-fee charges, i.e. only limited support is possible if local entities exhibit financial losses. Further, the approach also limits the amounts of excess earnings that can be repatriated at the level of the service-fee charges.
• Challenges by tax authorities in Switzerland are possible given that services provided are not remunerated, even though they have been rendered.  

Especially in cases where e.g. the global organization of the automotive suppliers is to a certain extent decentralized with significant value creation performed locally, where the taxpayer is set up in a matrix organization, or where significant intangibles are owned and controlled through functions in different legal entities, the abovementioned approaches may not lead to an arm’s length earnings allocation. 

In these cases, there may be various legal entities that need to be qualified as entrepreneurial entities within the organization, and require a remuneration in line with the entrepreneurial functional profile as an appropriate share in the overall profits (or losses) generated through the business. There is an emerging trend towards the application of profit split methods, e.g. through the application of the "Residual Profit Split Method" (RPSM). With the RPSM, routine functions, assets and risks of the organization are remunerated based on a standard transfer pricing method (e.g. the transactional net margin method, TNMM). The residual profits or losses of the value chain are then allocated to the entrepreneurial entities according to allocation mechanisms that reflect the individual share in value creation in the business. 

While the RPSM is an elegant solution from a conceptual point of view given the OECD’s standpoint on the alignment of profit allocation with value creation, the operationalization is however challenging in practice for most automotive suppliers:

• Tax authorities are typically open to sharing profits during the growth cycles of the industry, however splits of losses during downturns (such as in recent years) receive less goodwill from the authorities’ side.
• The operationalization of the residual profit split, i.e. KPI’s and metrics that define the allocation of earnings between entities may be subjective, subject to negotiations and prone to changes in the organization.    
• Tax authorities in certain jurisdictions are not yet familiar with the practical use of the RPSM and have a strong preference for "standard" transactional transfer pricing methods. 

As a result, many automotive suppliers seek security in applying for advance pricing agreements for their business models and transfer pricing arrangements under the RPSM, in order to control and mitigate transfer pricing risks involved.