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Basic Problem. A good and substantiated understanding of value creation in an MNE group is the initial starting point for transfer pricing analysis. This principle is internationally recognized and formulated in Section 1.51 of the TPG as follows:

„In particular, it is important to understand how value is generated by the group as a whole, the interdependencies of the functions performed by the associated enterprises with the rest of the group, and the contribution that the associated enterprises make to that value creation.”

The idea is that the determination of transfer prices is based on economic reality, i. e. the contributions of the individual entities belonging to an MNE group, which is reflected in the added value. The determination of value creation within an MNE group can be based on business methods and concepts, for example by means of an analysis of value chains, business model analysis or the examination of responsibilities within business processes.

Where can it be found. Chapter I of the TPG contains explanations of the function and risk analysis as well as a value-driver approach. See also part A, especially part A.3.5. of the TP-Manual on value chain analysis.

Basic thoughts on the case at hand. In principle, added value can be analysed from different perspectives, with the following four dimensions of added value being particularly emphasised for further considerations:

functional value added,

organizational value added,

value driver-oriented value creation and

geographical value added.

Each of these dimensions provides additional insights and important information regarding the way in which value add is generated within a MNE group.

In transfer pricing practice, the analysis of functional value added (para. 1.51 TPG) usually is the starting point of the analysis. Functional value added describes the exercise of various operational functions based on the Porter value chain (for example research and development, purchasing, production, sales) within an MNE group.

The functional value added dimension must be complemented in further steps by the other dimensions of added value. In a second step, this is done, for example, by examining the responsibilities with regard to the planning and risk management of individual functions or business transactions within the framework of the operational value chain. The organisational value added value, for example, originates from taking suitable measures to reduce risks, but also from making a balanced decision to consciously take risks (para. 1.56 et seq. TPG).

The value driver-oriented value creation refers to the value creation from the use of business model-specific value drivers (in particular intangibles and general economic conditions) within the specific business model.

Finally, a distinction is made between the geographical value added (para. 1.112 et seq., para. 1.139 et seq. TPG), which relates to the geographical origin of added value contributions, e. g. the particularities of the individual companies and the economic framework, such as wage costs, purchasing power in individual countries or regions.

Tab. 8: Dimensions of value creation

The business model specific value drivers (para. 1.36 et seq. TPG) are the linchpin of operational success. In this respect, their proper analysis and classification requires a good understanding of the specific business model. The following questions typically arise in analyzing the business model:

What specific benefits do customers have from the products or services provided by the multinational group?

How does the MNE group create added value and how does the group make it accessible to customers?

How does the MNE group earn money from its business activities?

A clear understanding of the business model (para. 1.114 et seq. TPG) is essential to further analyse internal strengths, weaknesses and be able to describe the external economic environment. As such, the knowledge of the business model (central factors of value creation, exogenous economic and regulatory factors and essential value drivers) is the cornerstone of the transfer pricing analysis.

Economic and regulatory factors (para. 1.110 et seq., para. 1.139 et seq. TPG) are exogenous factors and set important boundaries, within MNE groups implementing and executing their business model. They are a key determinant of entrepreneurial success or failure. Despite the fact that these exogenous factors cannot be influenced by the MNE group, their implications for the respective business model must be taken into account. The aim is to use the positive exogenous factors (such as low wages, little competition, high purchasing power of customers) and at the same time manage the associated risks. On the other hand, negative exogenous factors should be avoided or their adverse effects on the own business model should be minimised.

In addition to the exogenous economic and legal framework, well-founded information about the MNE group itself and the business units (company-specific influencing factors) and its impact on the business models being pursued is an important component of the transfer price analysis. Important information in this respect consists of

general information (e. g. portfolio of products and services, important markets (para 1.107 et seq. TPG),

financial indicators (e. g. profit, profitability) and

individual strengths and weaknesses related to the business model and the value added.

For a combined analysis of the economic and regulatory factors as well as the company-specific factors, various business methods and concepts can be used, such as the SWOT analysis (acronym for Strengths, Weaknesses, Opportunities, Threats). This methodology is simple to use and addresses four basic questions: The first two focus on an analysis of the company’s strengths and weaknesses. The other questions focus on an analysis of the opportunities and risks for the multinational group.

The following figure illustrates the schematic approach:

Fig. 3: SWOT Analysis

The SWOT analysis initially offers the possibility of a clear separation in the analysis of internal and external factors, whereby the findings of the analysis of the economic and regulatory framework can be used for the external factors (opportunities and risks). In a second step, the interactions between internal and external factors must be analysed and their effects and consequences for the business model (e. g. with the help of the business model canvas) can be discussed.

Based on a general analysis of the environmental factors for the business models and the associated opportunities and risks, but also internal strengths and weaknesses, a characterisation of the business model and the underlying value drivers can be carried out. Classic approaches such as the Business Model Canvas are suitable for this. Using the nine so-called key factors, this approach schematizes a large number of possible business model types and identifies the drivers of operational success. These nine key factors are:

Tab. 9: Nine key factors of Zeitgaist group

The following business model canvas with the nine fields (key factors) summarises the business model across the three segments Fossa, Molexx and SmartGaist.

Fig. 4: Business Model Canvas and Business Model Analysis

Although the individual segments differ, it is clear that Zeitgaist’s business model is based on the following two main aspects:

The most important activities are located in the area of product design and marketing and from this the key resources (product design and brand) are derived.

The definition of clear disjunct customer segments (low-budget mass market, luxury segment, technology-savvy mass market) is of great importance for Zeitgaist, so that clearly definable value propositions correspond to this.

Overall, Zeitgaist has a business model whose value drivers generate operational success from the middle of the canvas business model. In this regard, we will speak of a customer-centered business model based on the value proposition.

The various value drivers for transfer pricing purposes are further classified below. A distinction is made as follows:

Tab. 10: Value drivers of Zeitgaist

Types of value drivers. The differentiation into intangibles, other competitive factors and tangible economic goods enables the first schematization of the value drivers. Depending on the type of the business model, these can be broken down further, for example in relation to the key factors of the business model or the functional value chain.

Scoring models, for example, can be used to quantify value contributions, which enable a further analysis of the characteristics of value drivers in one’s own business model. A differentiation is, for example, a subdivision into the following three forms:

Weak: The value driver is rather weak compared to the industry average.

Average: The value driver contributes in line with the industry’s average.

Strong: The value driver is particularly strong.

For further differentiation, the types of value drivers can be subdivided into a further dimension with regard to their intrinsic value within a specific industry in addition to their relevance in their own business model:

Tab. 11: Value Driver and Relevance in the Business Model

By combining the two dimensions (the important value drivers in the own business model and the relevance of the value drivers within the industry), the relevant value drivers can be categorized and analysed in a structured manner. In practice, classic scoring models are often used for this. A possible characterisation could be as follows:

Lowperformer: Value drivers that are a necessary part of business models, but only make small contributions to value creation.

Market performer: Value drivers that shape a business model but are usually used in the bandwidth in the industry.

Outperformer: Value drivers with a unique selling proposition for the business model that enable a clear differentiation from competitors.

In this case, the systematic is illustrated using three exemplary value drivers.

The production facilities are supportive in the dimension relevance, but do not represent a differentiating factor from the competitors. In this respect they correspond to the industry average. This tangible asset could therefore be classified as a low performer based on a simple scoring model.

The Fossa brand has been established for years and is known as a lifestyle watch or fashion item. In this respect, it represents a unique demarcation feature from competitors and the brand is far above average compared to the industry’s average. The combination of both dimensions of the value driver analysis leads to a classification of the value driver as an outperformer.

The marking technology at Molexx ultimately ensures the authenticity of the watch and is therefore a technical quality feature that represents a differentiating feature in the industry. However, the marking technology is not a central component of the watch, so that the competitors are not in competition with this value driver. Albeit the marking technique is necessary and strongly developed for the business model so that this intangible value can be classified as a market performer.

The following figure illustrates the three cases

Fig. 5: Classification of value drivers

Conclusion. The foregoing has provided an overview of how to gain a good and substantiated understanding of how value is generated within an MNE group. This understanding should be at the beginning of any transfer pricing analysis. Only when a good and substantiated understanding of the business model and the value-adding factors has been gained a transfer price analysis can be carried out properly. This understanding also serves to introduce tax administrations to the multinational group and establish a common understanding of the value generation for the specific case at hand.

What else is to consider. In transfer pricing tax audits, it is advisable to develop a common understanding of the business models pursued in the company together with the tax administration right from the start. These business models are mostly company-specific and it is worth clearing up any questions or ambiguities right at the beginning. A good common understanding of the value drivers in the company radiates into all transfer pricing issues.