Contents - AL-Tax

12.3 Analysis Under Existing Regime 167the residual profit split method, in which one allocates the combined income of allgroup members participating in the subject transactions, our application in this caseentails apportioning only FS’ income.)Transfer pricing practitioners generally value the intangible assets contributedby each group member by capitalizing and amortizing their “intangibles-creatingexpenditures,” rather than by application of standard valuation methodologies, suchas the Discounted Cash Flow (DCF) method. 2 Hence, in applying the residual profitsplit method, the first several implementation steps entail: Determining which expenditures give rise to intangible assets; Estimating the “gestation lag” associated with each such category of expenditure(that is, the lag between investment and the realization of benefits in the form ofimproved products or processes); and, Establishing the economically useful life of each type of intangible asset.Each of these steps is highly subjective, and consequential in determining theallocation of consolidated income. In this instance, we temporarily sidestep theseissues by making certain simplifying assumptions, most of which we then sequentiallyrelax. (This is done for expository purposes, and to illustrate the qualitative andquantitative significance of individual assumptions.) Our simplifying assumptionsare listed below:1. All of FS’ marketing expenditures give rise to intangible assets;2. All of USP’s software development expenditures give rise to intangible assets;3. No other expenditures give rise to intangible assets;4. USP’s IT platform and FS’ marketing-related intangible assets have identicalgestation lags and useful lives;5. The scalability of USP’s IT platform benefits FS, despite the fact that FS’ sitesare individually much smaller than the U.S. site;6. FS performs no routine functions; and,7. USP performs no routine functions vis-a-vis international markets.Given these simplifying assumptions, approximately 25% of FS’ adjusted operatingprofits (all of which are residual profits, in view of assumptions #6 and #7above) should accrue to USP. 3 Given our assumption that FS performs no routinefunctions, we also reduce its operating expenses (and thereby increase its operatingprofits) by the costs of such functions.2 It is unclear why these more standard valuation methods are not discussed in any detail in thetransfer pricing regulations.3 For purposes of this analysis, FS’ adjusted operating profits are computed as (a) its reportedoperating profits, plus (b) its marketing expenditures in the current year, less (c) the estimated amortizationof its marketing intangible assets in the current year. These adjustments to FS’ reportedoperating income conform the treatment of investment in intangible assets to investment in tangibleassets for accounting purposes. (As discussed at Chapter 3, one should, in principle, utilize after-taxfree cash flows in lieu of adjusted operating profits, but the regulations are framed in terms ofoperating profits.)