Reproduced with permission from Tax Management Transfer Pricing Report, Vol. 24 No. 4, 6/25/2015. Copy-right � 2015 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

Sharing Costs at Cost or at Value? The Economics of CostContribution Arrangements

As the Organization for Economic Cooperation and Development prepares to hear from

the public about its discussion draft on cost contribution arrangements in July, the author

examines the non-consensus draft and finds inconsistencies that he says will place taxpay-

ers at risk of adjustments if they are following the OECD’s current guidance.

BY PHILIPPE G. PENELLE, DELOITTE TAX LLP

L ike many of the proposed revisions to the Organi-zation for Economic Cooperation and Develop-ment’s transfer pricing guidelines resulting from

the organization’s Action Plan on Base Erosion andProfit Shifting (BEPS), the 20-page discussion draft on

cost contribution arrangements, issued April 29,1 re-quires greater consistency with simple economic prin-ciples.2

Some of those commenting on the draft asked theOECD to delete a key provision—one that would re-quire all contributions to the arrangements to be as-sessed based on their value rather than cost.3

The discussion draft addresses cost contribution ar-rangements for both services and development. This ar-ticle, which focuses on development rather than servicearrangements, addresses the OECD’s approach to ap-plying the arm’s-length principle. As a result of the dis-cussion draft’s current inconsistencies, the vast major-ity of taxpayers engaged in cost contribution arrange-ments under the current governing guidance of Chapter

1 See 23 Transfer Pricing Report 1621, 4/30/15. The draft isavailable at http://op.bna.com/ITDTR.nsf/id/mmos-9w2hjr/$File/CCABEPSdisc.pdf.

2 The incidence of fixed costs on the cost of capital of inves-tors and businesses was first studied by Prof. Baruch Lev, thePhilip Bardes Professor of Accounting and Finance at NewYork University’s Stern School of Business, in his University ofChicago doctoral dissertation published in 1974.

3 See 24 Transfer Pricing Report 154, 6/11/15.

Philippe Penelle is a principal of Deloitte TaxLLP in Los Angeles, California. The authoris grateful for extensive discussions onthis topic with Alan Shapiro and Joe Tobin,who along with him prepared commentsto the OECD on behalf of Deloitte Tax LLP.He also thanks Carol Doran Klein andArin Mitra for their comments. All errors,omissions, and other shortcomings are theauthor’s. This article does not necessarily rep-resent the views and opinions of Deloitte TaxLLP or any of its affiliated member firms, andshould not be construed as such. The viewsand opinions expressed herein are solelythose of the author.

Copyright � 2015 Deloitte Development LLC

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8 may be vulnerable to non-arm’s-length adjustmentsby their respective tax authorities should the discussiondraft be finalized in its current form.

It should be noted that the draft does not provide forgrandfathering of existing cost contribution arrange-ments, nor does it provide a transition period for tax-payers currently engaged in the arrangements. Practi-tioners are likely to request this additional guidanceshould the OECD continue with the approach outlinedin the draft.

This article describes a cost contribution arrange-ment qualifying under the discussion draft guidanceand highlights the main areas of departure from thecurrent guidance under Chapter 8. Next, it explains theeconomics of cost contribution arrangements in thecontext of uncontrolled transactions of market partici-pants. That discussion sets the stage for examining thearm’s-length nature of the guidance in the discussiondraft—and specifically why requiring cost contributionarrangement participants to share the value of their on-going development activities, as opposed to sharing thecosts thereof, results in arbitrage opportunities underthe draft’s analytical framework.

Arbitrage opportunities are the ultimate proof ofnon-arm’s-length results, because competitive marketsdo not allow arbitrage opportunities to survive. The eco-nomics of cost contribution arrangements are exactlythe same as the economics of a profit split—therefore,an arm’s-length cost contribution arrangement shouldreplicate the results of a transactional or residual profitsplit instead of the results of a series of transactions, asasserted in paragraph 6 of the discussion draft. Currentguidance provided by the OECD’s transfer pricingguidelines under Chapter 2, sections C.3.2.2 andC.3.4.3, sanctions the use of relative contributions mea-sured at cost to split the residual profit.

It would preserve economic consistency for theOECD to reconsider its approach to cost contributionarrangements, and to defer to the economics of thesetransactions when issuing guidance to achieve anarm’s-length result.

Highlights of the Discussion DraftThe two paragraphs of the discussion draft that will

be the subject of this article’s focus are paragraphs 11and 21. To that end, consider the second sentence ofparagraph 11:

Independent enterprises would require that the valueof each participant’s proportionate share of the ac-tual overall contributions to the arrangement is con-sistent with the participant’s proportionate share ofthe overall expected benefits to be received underthe arrangement.

Moreover, consider the third sentence of paragraph21:

For development CCAs, contributions typically in-clude the performance of development activities(e.g., R&D, marketing), and often include additionalcontributions relevant to the development CCA suchas tangible assets or intangibles.

Finally, consider the fourth sentence of paragraph21:

Irrespective of the type of CCA, all contributions ofcurrent or pre-existing value must be identified and

accounted for appropriately in accordance to thearm’s length principle.

The discussion draft, in other words, requires allcontributions by participants—whether of preexistingrights or of development activities—to be accounted forat value rather than at cost, and the proportions of thevalue contributed by all participants must be alignedwith the proportions of expected benefits expected byall participants in the aggregate.4

One may question why the guidance provided underChapter 8 is called guidance on ‘‘cost contribution ar-rangements’’ as opposed to guidance on ‘‘value contri-bution arrangements.’’ To that point, Andrew Hickman,head of the OECD’s transfer pricing unit, was quoted assaying that cost contribution arrangements ‘‘need anew name’’ because ‘‘the discussion draft clarifies thatcontributions should generally be measured based onfull value rather than on cost.’’5

Another notable aspect of the discussion draft is therequirement that a participant in a cost contribution ar-rangement have the capability and authority to controlthe risks associated with the risk-bearing opportunityunder the arrangement, and in accordance with thedefinition of control of risks set out in Chapter 1 of thetransfer pricing guidelines.6

These two requirements—that participants share thevalue of all their various contributions, rather than thecosts of certain of their contributions, and that they as-sess, monitor and direct any outsourced measures af-fecting risk outcomes under the cost contributionarrangement—are new to Chapter 8.

This article focuses exclusively on the requirementto share costs at value rather than at cost; however, thediscussion draft’s assertion that at arm’s length, partici-pants to cost contribution arrangements assess, moni-tor and direct any outsourced measures affecting riskoutcomes is in direct contradiction with observed co-financing arrangements in the movie industry and co-development arrangements in the life sciences indus-try.7

The vast majority of controlled and uncontrolled costcontribution arrangements, including all arrangementsqualifying under the U.S. cost sharing guidance at Regs.§1.482-7, involve taxpayers that share the costs of theirdevelopment activities, not the value thereof.

This limitation of the ability to share developmentactivities at cost is the single most important changeproposed in the non-consensus discussion draft. Be-cause this is such a significant departure from the exist-

4 Although the language of paragraph 11 arguably is broadenough to allow for an ex ante valuation of cost contributionsat cost (when cost is the best measure of value), the languagecreates ambiguity as to what ‘‘value’’ means and when it ismeasured.

5 23 Transfer Pricing Report 1621, 4/30/15.6 See paragraph 13 of the draft. The definition of control of

risks set out in the non-consensus discussion draft revisions toChapter 1, issued Dec. 19, 2014, was the subject of a significantnumber of comments by taxpayers and other interested partiessubmitted to the OECD, as well as to intense debate at the pub-lic consultation held March 19, 2015 at the OECD in Paris. See23 Transfer Pricing Report 1497, 4/2/15.

7 See, for example, Deloitte’s, USCIB’s, and BIAC’s com-ments submitted to the OECD in response to the discussiondraft. See comment letters on the draft at http://www.oecd.org/ctp/transfer-pricing/public-comments-beps-action-8-cost-contribution-arrangements.pdf.

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ing guidance and from past and current practices, andfor the reasons outlined in this article, it seems unlikelythat the U.S. representatives to Working Party No. 6will agree with that departure—or that they agreed withthe first sentence of paragraph 10:

For the conditions of a CCA to satisfy the arm’slength principle, the value of participants’ contribu-tions must be consistent with what independent en-terprises would have agreed to contribute undercomparable circumstances given their proportionateshare of the total anticipated benefits they reason-ably expect to derive from the arrangement.

The next section outlines a simple explanation of theeconomics of cost contribution arrangements. This ex-planation provides a useful prism for analyzing the pro-posed changes in the discussion draft and the appropri-ateness of the first sentence of paragraph 10 above.

Economics of Cost ContributionArrangements

A cost contribution arrangement is an arrangementbetween two or more parties to take ownership stakesin the same investment opportunity, under the sameeconomic terms, by contract rather than by the creationof a separate and distinct legal or taxable entity (suchas a joint venture or a partnership) whereby sharehold-ers provide capital (cash) and receive a proportionalclaim to the earnings of the business.8

Such arrangements are observed in the open market,where uncontrolled taxpayers contractually agree to co-develop or co-finance risky projects without creating ajoint venture or partnership, or without giving rise toany claim from any participant over any resources,rights or capabilities of any participants other thanthose specifically committed to in the contracted proj-ect.

Although some cost contribution arrangements mayrequire the contribution of certain preexisting rights,resources or capabilities, a valid arrangement alwaysrequires the existence of a funding obligation that isreasonably expected to result in the creation of futurevalue.9 The funding obligation takes the form of intan-gible development costs (IDC); the value created takesthe form of gross intangibles income.10

IDCs are fixed costs—they do not co-vary with thebusiness’ current level of revenue.11 Fundamental tothe understanding of the economics of cost contributionarrangements is the concept that fixed costs affect thecost of capital of the business—the greater the fundingobligation of an investment per dollar of expected grossintangibles income, the greater the increase in the costof capital of the business.

To illustrate that concept, consider the consolidatedinvestment of the figure below.

The light-gray shaded area marked 1 represents thepresent value of the expected gross intangibles incomeassociated with the investment; that quantum will bedenoted PV(R,rL).

The expected gross intangibles income R is dis-counted at the rate rL reflecting the market-correlatedrisk of that stream of expected income.

The medium-gray shaded area marked 2 representsthe present value of the expected funding commitmentrequired to capture the expected stream R; that quan-tum will be denoted PV(IDC,rIDC).

The expected intangible development costs IDC arediscounted at the rate rIDC reflecting the market-correlated risk of that stream of expected costs.

Subtracting the medium-gray shaded area marked 2from the light-gray shaded area marked 1 results in thedark-gray shaded area marked 3, which represents thepresent value of the expected net intangibles incomePV(R-IDC,rCCA).

The discount rate rCCA reflects the market-correlatedrisk of the stream of expected net intangibles income.

It should be clear from the figure above that

This equation simply states that the present value ofthe expected net intangibles income discounted at itsappropriate rate should be equal to the present value ofthe expected gross intangibles income discounted at itsappropriate rate minus the present value of the intan-gible development costs discounted at their appropriaterate.

This is just an accounting equality requirement;therefore, it always holds true.

The importance of this relationship may not be di-rectly apparent until one notices that it implies the ex-istence of a deterministic relationship between the cost

8 A cost contribution arrangement is not defined herein asan arrangement to share intangible development costs in pro-portion to expected benefits. Instead, in order to share in agiven investment opportunity under the same economic terms,it is necessary to share those costs in proportion to the ex-pected gross intangibles income resulting from the develop-ment activity.

9 Preexisting rights contributed to a cost contribution ar-rangement involve costs that are sunk, within the meaningeconomists attribute to that term—they are thus irrelevant tothe participant’s investment decisions and are contributed atvalue at arm’s length.

10 In some cases, the value created takes the form of a re-duction in some production costs. Although most productioncosts are likely to be variable costs, it is conceivable that insome cases the value created takes the form of a reduction infixed production costs. This analysis and discussion is generaland does not depend on whether that value is in the form ofincremental income or reduction in costs. If the cost contribu-tion arrangement results in a reduction of specific fixed pro-duction costs, the expected resulting reduction in the cost of

capital of the investor alleviates the increase in the cost of capi-tal that results from the funding commitment itself.

11 The term ‘‘fixed costs’’ should not be construed to mean‘‘perfectly fixed costs’’—that is, costs that do not co-vary what-soever with the business’ current level of revenue. They arejust more fixed (co-varying less) than production costs.

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of capital of a business not bound by the funding obli-gation of the IDC, and one bound by it.

This relationship was demonstrated by the author in2012.12

Economists call the term L, defined below, the oper-ating leverage of the investment—it drives its cost ofcapital. In the figure above, it is the ratio of the medium-gray shaded area marked 2 to the dark-gray shadedarea marked 3.

Notice that any and all investments that have thesame operating leverage L will result in the same incre-mental cost of capital, for any given rL and rIDC.13

Stated differently, any and all investments that requirethe same level of fixed costs funding obligation per dol-lar of expected net intangibles income (or gross ex-pected intangibles income) will result in the same in-crease in cost of capital.14

Recall that a cost contribution arrangement is an ar-rangement between two or more parties to take owner-ship stakes in the same investment opportunity, underthe same economic terms. That means that however thetotal funding commitment IDC is split up between theparticipants to the cost contribution arrangement, theyeach must face the same cost of capital on their result-ing shares of the total investment. That is the sense inwhich a cost contribution arrangement is about sharingrisks. More precisely, it is about sharing in the market-correlated risk of the investment.

Using Penelle (2012), it is clear that if each partici-pant to a cost contribution arrangement has the same rL

and rIDC, to ensure that each participant ends up facingthe same cost of capital rCCA, it has to be the case thateach participant is allocated a portion of the total fund-ing commitment IDC, such that the resulting operatingleverage of each share of the total investment is thesame as the operating leverage of the total investmentL.

Therefore, the only way to share the total fundingcommitment IDC among participants such that the par-ticipants’ share in the overall market-correlated risk ofthe total investment equally (face cost of capital rCCA)is in proportion to each participant’s share of the pres-

ent value of expected gross intangibles incomePV(R,rL).

Any other way to share the IDCs will result in a dif-ferent increment in the participants’ cost of capital.Moreover, as demonstrated in the next section, eachparticipant will receive a share of the total investmentthat is outside the efficient risk-expected return fron-tier, resulting in arbitrage opportunities. Arbitrage op-portunities do not survive the open markets and there-fore cannot be arm’s-length outcomes.

Arbitrage OpportunitiesParagraph 11 of the discussion draft requires partici-

pants to share the value of their respective contribu-tions in proportion to their relative expected benefitshares. Based on the discussion above, unless the totalfunding commitment of the investment is shared in ex-act proportion to the expected gross intangibles incomeshares of each participant, the resulting cost of capitalof each participant will be different, and different fromthe cost of capital of the total investment.

Consider a simple cost contribution arrangement be-tween two participants that does not involve the contri-bution of preexisting rights. Assume that the partici-pants agree to share the total ongoing funding commit-ment of the investment based on a ratio that differsfrom the ratio of reasonably expected gross intangiblesincome.

Because this agreement violates the requirement thatboth participants face the same cost of capital, it be-comes certain that they each will face a different cost ofcapital. It then follows that the participant being allo-cated relatively more of the total funding commitmentthan when costs are contributed at cost is not only re-ceiving less expected cash flows, it also faces a highercost of capital on those lower expected cash flows.15

No rational investor would agree to take a position inan investment that provides less expected cash flows,exposed to greater market-correlated risks than alter-native investments available in the open market.

These alternative investments available in the openmarket include the total investment subject to the costcontribution arrangement, and all realistically availableinvestments on the efficient risk-expected return fron-tier. The resulting arbitrage opportunity would not sur-vive the competitive forces of the open market.

The discussion draft’s proposed cost contribution ar-rangement method of requiring costs to be shared atvalue therefore generally violates the arm’s-length prin-ciple, despite numerous claims in the discussion draft tothe contrary.16

12 ‘‘The Mathematics of Cost Sharing Under the IncomeMethod,’’ 21 Transfer Pricing Report 665, 11/1/12. Thatarticle—which will be referred to as Penelle (2012)—alsoproves that rIDC<rL<rCCA.

13 The discount rates rL and rIDC are those of market partici-pants. This is the sense in which the cost of capital is a func-tion of the investment, not the investors. Because all partici-pants to a cost contribution arrangement, whether controlledor uncontrolled, are by definition or by application of thearm’s-length principle market participants, they face the samediscount rates rL and rIDC for a given investment opportunity.

14 The equivalence between expected gross intangibles in-come and expected net intangibles income in the context ofreasonably anticipated benefit shares will be addressed in a fu-ture article.

15 The expected gross intangibles income of that participanthas not changed, despite being allocated a greater share of thetotal funding commitment. The resulting increase in operatingleverage increases the cost of capital of that participant. SeePenelle (2012) and the figure above. Because the expected to-tal funding commitment is fixed and the share allocated to oneparticipant has increased, it necessarily is the case that theshare allocated to the other participant has decreased, result-ing in a decrease in operating leverage (it is a zero-sum game).

16 The only case when it does not violate the arm’s-lengthprinciple is in the rare instances when the value of the ongoingcost contributions of each participant is equal, so that the ratioof values is equal to the ratio of costs.

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Numerical ExampleFor readers who prefer a numerical example to a for-

mula, consider an upcoming movie that may be ex-pected to require:

s net present value of $100 million to make themovie; and

s net present value of $100 million of print and ad-vertisement (P&A) costs.Assume that the appropriate rate used to discount thestreams of IDCs is rIDC = 5 percent. Assume that thepresent value of the expected gross intangibles incomeis $500 million. Assume that the appropriate rate usedto discount the stream of gross intangibles income is rL

= 10 percent.Use Penelle (2012) to calculate the cost of capital of

this investment as

Note that there are plenty other investment opportu-nities in the open market with cost of capital of 13.33percent and operating leverage L = 0.67.

Assume that the movie is expected to generate $300million of gross intangibles income in Europe, and $200million in North America. For simplicity, assume thatno gross intangibles income is reasonably expectedanywhere else in the world.

Assume that Canal Minus, a European studio inter-ested in producing this movie, approaches RealityFilms, an uncontrolled U.S.-based studio interested incompeting in this particular movie genre. Reality Filmswill co-finance the production of the movie and exploitthe resulting distribution rights in North America. Ca-nal Minus will be responsible for the actual productionof the movie, including the development of the P&A,and will exploit the resulting distribution rights in Eu-rope.17

The first question to consider is the cost of capitalfaced by each party when sharing costs at cost.

Because the reasonably anticipated benefit share ofCanal Minus is 60 percent, versus 40 percent for RealityFilms, the participants agree to share the total IDCfunding commitment accordingly. Canal Minus thuswill fund $120 million, and Reality Films will fund $80million of the total IDC commitment of $200 million.

To prove that each participant, when sharing costs atcost, faces the same cost of capital—equal to the 13.33percent cost of capital of the entire investment—applyPenelle (2012) to each participant.

Canal Minus’ Cost of Capital:

Reality Films’ Cost of Capital:

By allocating the total IDC funding commitment sothat each participant faces the same operating leverageas the total investment, the participants are sharing in

the same investment opportunity, with the same eco-nomics as the overall investment. This is an arm’s-length outcome; it leaves no arbitrage opportunitiesopen.

Now assume that Canal Minus argues that its contri-bution is more valuable than Reality Films’, and there-fore the appropriate cost split ratio is 50 percent each.Canal Minus and Reality Films thus will fund $100 mil-lion each of the total IDC commitment of $200 million.

To prove that each participant, when sharing costs atvalue, faces different costs of capital—both differentfrom the 13.33 percent cost of capital of the entireinvestment—apply Penelle (2012) to each participant.

Canal Minus’ Cost of Capital:

Reality Films’ Cost of Capital:

The operating leverage of the overall investment is0.67. Sharing the contributions at value results in an op-erating leverage of 0.5 for Canal Minus and 1 for Real-ity Films.

Can this possibly be an arm’s-length outcome?The risk-adjusted value of this investment opportu-

nity to Reality Films is $100 million (15 percent cost ofcapital). There are numerous investment opportunitiesin the open market that have risk-adjusted values of$300 million (13.33 percent cost of capital). Thus, Real-ity Films can take a 40 percent stake in these realisti-cally available investment opportunities. The risk-adjusted value of that share is $120 million (13.33 per-cent cost of capital).

Therefore, no rational investor, including RealityFilms, will agree to an investment worth $100 million(risk-adjusted) when all the realistically available alter-native investments in the open market are worth $120million (risk-adjusted). This difference in value will bearbitraged away until the proposed cost contribution ar-rangement position receives an additional $50 millionof risk-adjusted expected cash inflows such that

Thus, at arm’s length, to induce Reality Films toagree to share IDCs at value, Canal Minus must give up$50 million of its expected gross intangibles income sothat it receives $250 million (that is, $300 million − $50million) of expected gross intangibles income, and Re-ality Films receives $250 million ($200 million + $50million) as well.

Notice that this realigns the total IDC funding com-mitment (at cost) shares with the expected shares ofgross intangibles income.

As discussed earlier, this is the only arm’s-lengthoutcome—share costs at cost in proportion to expectedgross intangibles income shares.

Economics of Profit SplitsConsider the second sentence of paragraph 6 of the

discussion draft:17 This is the typical arrangement seen in the movie indus-

try between uncontrolled studios.

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In a situation where associated enterprises both per-form activities for other group members and simul-taneously benefit from activities performed by othergroup members, a CCA can provide a mechanism forreplacing a web of separate intra-group arm’s lengthpayments with a more streamlined system of nettedpayments, based on aggregated benefits and aggre-gated contributions associated with all the coveredactivities.

Further consider the following language found inChapter 2 of the transfer pricing guidelines under sec-tion C.2, paragraph 2.109:

A transactional profit split method may also be foundto be the most appropriate method in cases whereboth parties to a transaction make unique and valu-able contributions (e.g. contribute unique intan-gibles) to the transaction, because in such a case in-dependent parties might wish to share the profits ofthe transaction in proportion to their respective con-tributions and a two-sided method might be more ap-propriate in these circumstances than a one-sidedmethod.

Chapter 2 proceeds with a discussion of residualprofit splits and provides the following guidance undersection C.3.4.3, paragraph 2.135 to split profits:

In practice, allocation keys based on assets/capital(operating assets, fixed assets, intangible assets,capital employed) or costs (relative spending and/orinvestment in key areas such as research and devel-opment, engineering, marketing) are often used.

Section C.2 of Chapter 2 suggests that, for develop-ment cost contribution arrangements, where associatedenterprises perform intangibles development activitiesthat are simultaneously beneficial to all, a transactionalprofit split (rather than a series of single-sided methodsas paragraph 6 of the discussion draft suggests) is themost appropriate method.

The Dec. 16, 2015, discussion draft on the use ofprofit splits in the context of global value chains ap-pears to reinforce the notion that the OECD believesprofit splits to be more appropriate than single-sidedmethods when dealing with multinational enterprises’integrated value chains.18

Therefore, it appears inconsistent with both the guid-ance provided in Chapter 2 of the transfer pricingguidelines and the profit splits discussion draft to denythe sharing of contributions at cost in the discussiondraft, and to require a cost contribution arrangement toreplicate the results of the application of a series of one-sided methods instead of requiring a cost contributionarrangement to replicate the results of a profit split ap-plication.

Consider paragraph 5 of the profit splits discussiondraft:

BEPS Action 10 invites clarification of how transferpricing methods, including transactional profit splitmethods, apply to global value chains.

In response to that invitation, the following discus-sion will demonstrate that, in the context of a develop-ment cost contribution arrangement, the guidance pro-vided in Chapter 8 should result in an outcome consis-

tent with the results obtained by the application of aresidual profit split where the residual is split using theratio of the funding commitment of each party in the to-tal funding commitment of the intangibles developmentactivities.

A cost contribution arrangement takes the allocationof the expected gross intangibles income between par-ticipants as given, and seeks to allocate the total contri-butions required between the participants so that eachof them faces the same cost of capital on their respec-tive slices of the overall investment, equal to the cost ofcapital of the overall investment.

A residual profit split that takes the allocation of to-tal cost contributions between participants as given,and seeks to allocate the total expected gross intan-gibles income between the participants proportionallyto that allocation, results in each participant facing thesame cost of capital on their respective slices of theoverall investment, equal to the cost of capital of theoverall investment.

Thus, it should be clear that a cost contribution ar-rangement and a residual profit split are two sides ofthe same coin. Furthermore, according to both Chapter2 and the profit split discussion draft, the results of a de-velopment cost contribution arrangement transactionwould be tested most appropriately using the residualprofit split when dealing with a multinational compa-ny’s integrated value chain.

But if that is the case, then the only way applying theresidual profit split will validate the results of applyingthe guidance of Chapter 8 is if, and only if, Chapter 8 al-lows the sharing of costs at cost.

The alternative is for the guidance on profit splits ofChapter 2 under section C.3.4.3 paragraph 2.135 to bemodified to disallow the use of contributions measuredat cost as a residual profit split allocation key, and to re-quire the use of contributions measured at value.

That alternative would move the guidance providedby the transfer pricing guidelines further away from thearm’s-length principle. Indeed, it is the costs of invest-ments measured at cost that are economically relevantbecause they determine the operating leverage andhence the systemic risks of the investment.

ConclusionThe OECD repeatedly has affirmed that the arm’s-

length principle is the guiding principle of transfer pric-ing outcomes. As such, guidance issued under thetransfer pricing guidelines strives to produce arm’s-length results when followed by taxpayers and tax au-thorities. However, the discussion draft repeatedly as-serts that arm’s-length participants in a cost contribu-tion arrangement would share contributions at value,not at cost.

These assertions contradict the overwhelming evi-dence available in the open market that arm’s-lengthparticipants in a cost contribution arrangement sharecontributions at cost and not at value, and also fail tofollow settled economic principles.

This article established clearly that sharing total con-tributions at value in proportion to reasonably antici-pated benefit shares measured by expected gross intan-gibles income generally leads to a non-arm’s-length re-sult, unless the value-based allocation ratio preservesthe operating leverage of the overall investment. This isthe exception rather than the rule.18 Draft available at 23 Transfer Pricing Report 1170, 1/8/15.

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The OECD should defer to economics when issuingguidance aimed at implementing the arm’s-length prin-ciple. Moving costs from one participant to another mayseem innocuous in that it appears to result only in amovement of cash from one participant to another.

Appearances, however, can be deceiving.

Moving costs from one participant to another in thecontext of a cost contribution arrangement requiringfixed costs commitments also results in an increase inthe cost of capital of one participant, and a decrease inthe cost of capital of the other participant. That move-ment of value is not triggered by a movement of cash; itis triggered by a movement of an obligation to fundfixed costs.

Because this movement of value does not appear inaccounting statements, many accountants and lawyersmay not be aware of its existence, but economists are.

The application of this important economic principleshould be reflected in the OECD guidance.

This article contains general information only andDeloitte is not, by means of this publication, renderingaccounting, business, financial, investment, legal, tax,or other professional advice or services. This article isnot a substitute for such professional advice or services,nor should it be used as a basis for any decision or ac-tion that may affect your business. Before making anydecision or taking any action that may affect your busi-ness, you should consult a qualified professional ad-viser.

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