Outcome based business models: what are they and what do they mean for your TP?

You may not have noticed, but you are living in the world of outcome-based business models (or ‘as-a-service’ models, ‘aaS’).

What is an aaS model? It may be anything that turns a physical or intangible product, or bundle of products, into a service: subscriptions, Software-as-a-Service and other ‘as-a-service’ offerings. These are often enabled via ‘Internet-of-Things’ components which are now routinely being built into the items we buy and use.

Everyone is at it, from industrial goods manufacturers, consumer products to banks and fund managers, all underpinned by the revolution in digital technology. Recent study conducted by Vanson Bourne Research[1] has found that those born from the mid-1990s onwards may be the last generation to see an economy dominated by products alone without any embedded services or outcomes.

Where customers used to purchase the means to their desired outcome (like buying a car in order to get from one place to another), they often now take a shortcut and buy the outcome itself (order access to a car online and get a ride from one place to another). Even doing something as mundane as grocery shopping may be turned into a subscription service that keeps your fridge fully stocked, an outcome that turned out to be particularly desirable in the early stages of the recent lockdown. In recent months we have worked with subscription models as diverse as ‘Robotics as a service’, ‘Connected factory’ and ‘Treasury as a service’.

However, aaS models create new tax and transfer pricing (‘TP’) challenges because they have the potential to change how and where value is created, and they often also demand changes in operating models, supply chains and transactions.

Having helped a number of clients through a shift towards outcome-based models, we have identified the following common transfer pricing issues:

• Assessing transfer pricing with bundled functions, assets and risks: At the heart of the aaS model is a ‘bundle’ of tangible products, intellectual property (‘IP’), and services. These are typically contributed by more than one entity in the value chain and it is then difficult to determine the arm’s length price for each entity’s contribution to the value created. What’s more, in many aaS models the ‘bundle’ includes elements of contributions from third parties as well as intra-group 
• A good starting point is to look to unpick each distinct element of the ‘bundle’ (e.g. warranty, services, IT platform, tangible goods) and locate its owner and all relevant entities involved in the operations. Once the value chain is understood and the ‘bundle’ of contributions has been dissected into manageable units, you may proceed with a classical transfer pricing analysis of functions performed, risks borne, and assets employed to capture and document the allocation of profit that would occur at arm’s length. However, this is made more complicated by the next issue on the list...
• Rewarding synergies and decision-making functions: When we take a closer look at the elements which make up an aaS model, we often see that the value created by the overall ‘bundle’ significantly exceeds the value of its elements viewed in isolation. The OECD guidelines tell us that when dealing with group synergies, we must establish whether they arise by virtue of ‘passive association’ or ‘deliberate concerted action’ by a part of a multinational. In simple terms, where ‘bundling’ has been a result of clever strategic decision-making by a specific group of individuals, the incremental value created by such synergies may be - at least partly - attributed to such individuals. This differs significantly from a situation where putting together a product and service has become a widespread market practice and as such the central service element would not create significant value. Then we need to share the synergy benefit between the various players in a fair way.
• Ownership structure and reward for IP: As ever, the element of reward to be aligned with IP may be the most complex to analyse. Potentially valuable group IP is now being shared with third parties in a different way. We need to identify the IP-related reward through an economic analysis and flow a fair share of reward back to the legal owners, financial contributors and DEMPE functions, which may sit in many different group companies. A commercial shift to aaS business models may bring into question whether centralised ownership of IP is desirable/ necessary, as opposed to decentralised ownership, for example with a Cost Contribution Arrangement (‘CCA’). In fact, it may make any kind of ownership model other than a centralised one difficult to manage.
• Rewarding investment risk and control of risk functions: Going off the well-trodden paths and implementing a novel business model is potentially a risky move which one would expect to be rewarded with an appropriate return over a period of time. There may be significant up-front investment costs incurred, which will need to be borne by a location or multiple locations in the group. Many of these investments may really mean spending in order to stay still for a period of time, the goal being market share protection (or sheer survival) rather than any tangible volume or margin benefit.
• Centralised investment cost with central risk control functions could create a tendency for a single, central, entrepreneur in this new business area. An alternative model, which pushes investment costs out to potential beneficiaries, can be difficult where it is hard to quantify the expected benefit of various participants. New business models such as aaS are a common trigger for businesses to move away from classical cost-plus based remuneration to ‘value-based fees’. Cost-plus recharges struggle to properly account for the higher level of investment risk, centrally provided risk management by key senior individuals and the risky nature of the business. It is, however, vital to determine the arm’s length level of the value-based fee and how it should be calculated (e.g. based on the number of transactions, the number of users, a return on investment) in a way which will hold up to tax authorities’ scrutiny.
• Operational challenges: Everyone who has ever been involved in implementing a TP model will know that getting it to work is as important as designing the right model. The limitations of ERP systems often necessitate cumbersome transaction flows which do not sit well with the preferred TP policy. For instance, multiple entities may contribute to the ‘bundle’ (e.g. delivery of product, onsite servicing), whilst only one entity has been flagged in the ERP system as a sales entity for external customers and therefore records all revenue in its books. We will not go into the details of potential VAT and customs complexities involved in multiple supply, but these also warrant a closer look.

When implemented properly, aaS models help move your business forward and give you a competitive edge. For instance, aaS models can provide a more comprehensive and convenient offering to your consumers, whilst being commercially efficient (e.g. better working capital management and forecast capability). In addition, aaS models have a natural drive for centralisation within the business and, consequently, leaner local operations. This change within the business may in turn unlock tax efficiency opportunities, provided the tax and TP model has been set up and documented in a robust way. As ever, you need to take account of the whole end to end value creation process, with a special focus on how synergies are created, strategic decisions are made, and risks are managed. We would, of course, be delighted to help you on the journey.

[1] ServiceMax GE / Vanson Bourne Research, The Rise of Asset and Service Data Gravity, 2018.