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Discussing Intangibles

Tuesday, November 13, 2012

By James J. Tobin, Esq.  

Ernst & Young LLP, New York, NY


Having practiced in the international tax area for over 35 years now (yikes!), I have always viewed the type of projects we work on with clients in two buckets - capital and finance structure and business alignment. The former obviously deals with holding companies, tax consolidation, finance flows, debt or equity, etc., and has traditionally been the majority of our focus. The latter involves product flows, supply chain cycles, and R&D/intangible property ownership and fundamentally comes down to transfer pricing.  In the old days CFOs would tell their tax directors and us outside advisors "you can do whatever tax planning you want with holding and finance companies and the like as long as you do not touch the business." These days tax planning is fully integrated with business planning and, with the pace of change in global and regional business models, a tax director or tax advisor could not possibly do his job without an intimate understanding of the business and a strong working relationship with the operational management of the company as well as the financial management.

All of this means that, more and more, it's all about transfer pricing - how to appropriately allocate the profit pie from a global business among legal entities bounded by national borders that are generally ignored by corporate management whose focus is solely on global or regional or functional results.  In doing that allocation, the hardest aspect likely is appropriately taking into account risk and intangible value. It is the hardest area for corporate tax executives and advisors to figure out. And it is the area that tax authorities are most paranoid may be rampant with tax planning because risk and intangible value have the potential to be more mobile than the tangibles of factories, employees, and customers. So controversy abounds around the world, particularly as changing business models effect geographic shifts in a company's value drivers.

This area has been one of much focus in the Organisation for Economic Co-operation and Development (OECD) as government representatives tackle some of the tough issues and try to agree on guidance. In 2010 the OECD released a report on Tax Aspects of Business Restructurings on which I commented. See 39 Tax Mgmt. Int'l J.  783 (12/10/10). In June of this year, the OECD released a discussion draft on an even more ambitious topic, with a rather daunting title: "Revisions to the Special Considerations for Intangibles in Chapter 6 of the OECD Transfer Pricing Guidelines and Related Provisions." I would like to start by commending the OECD for their efforts in this area - these are important topics which would benefit from thoughtful consideration aimed at achieving informed global consensus (or something close to it). The Discussion Draft indicates it is an interim draft and is not to the point of being a consensus document yet. Comments were requested and were numerous. There are a number of things to like about the Draft, including important areas where the OECD is more reasonable and practical in their approach than positions being taken by some tax authorities.  The objective of establishing some consistent principles for how intangibles should be evaluated in a transfer pricing context is certainly laudable. Greater consistency can lead to greater certainty, which is extremely important for tax directors who need certainty with respect to their transfer pricing policies. But there are some aspects of the OECD paper that are, at least to me, somewhat confusing and quite concerning - which makes me glad it is an interim draft, with further consultation planned.

In this brief commentary I will focus on two aspects - the definition of intangible property and the concept of when a party is entitled to a return from intangible property.

Section A of the Discussion Draft focuses on "Identifying Intangibles." Always good to start at the very beginning. But I have to admit I found this section a bit confusing and in my view unnecessarily so. The Draft starts from the position that the definition of intangibles for transfer pricing purposes would not be limited to intangibles that can be legally protected and separately transferred. So the "definition" of an intangible is much broader than lawyers or accountants would normally think and the Draft does not really delineate what the limits of this broader definition are. It does give some examples of non-intangibles, including market conditions, group synergies, and assembled workforce (as to the latter, the paranoid part of me would note that the particular paragraph on assembled workforce does not explicitly state that it is not an intangible, although the hopeful part of me would view it as implicit in the discussion in that paragraph). The Draft does go on to say that those types of non-intangibles still should be considered in a transfer pricing comparability analysis. So far so good, I think, though more examples of non-intangibles would be a nice addition in the next draft.

Where it starts to get murky for me is that the Discussion Draft seems to be proposing that there are three types of intangible-like factors - intangible property which can be owned, legally protected, and transferred; intangible non-property which can be owned but not legally protected or separately transferred; and intangibles which cannot be owned. The Draft explains why all three categories need to be taken into account in determining an arm's-length price for a transaction involving one or more of these factors. That generally seems reasonable to me. I guess my concern is why do we need three categories, when two categories seem more natural and quite sufficient? The concept of intangible non-property to me is very confusing.  While the Draft fortunately limits its scope to transfer pricing, this unnatural concept could add to confusion regarding the character of a transaction and could have other collateral consequences if tax authorities try to assess which member of a group owns or has owned an "intangible" that does not exist for legal or regulatory purposes. Better to focus on the two more natural categories - intangible property with appropriate legal definition, including ownership, protection, and transferability, and other intangible value which could impact comparability in third-party transactions but which lacks the legal definition associated with the first category. Adding what I would consider an unnecessary and ill-defined third category of "intangibles" solely for transfer pricing purposes seems either irrelevant or dangerous.  Given the ferocity of tax authorities in their focus on the transfer pricing and business restructuring area, I am in the "dangerous" camp and thus would urge consideration of a more straightforward (and less dangerous) definition of intangible as the starting point for this work.

My second area of concern is around respect for contractual arrangements and the criteria for an associated entity to be eligible to earn a return from intangibles (and I am thinking here in terms of real intellectual property (IP), not intangible value/non-property).  Section B of the Discussion Draft takes the position that bearing development costs for IP would not be alone sufficient to entitle a party to intangible related returns. Rather, the party incurring the costs must also be in a position to exercise control over the performance of functions and associated risks through its own employees and expertise. I can appreciate a valid concern about the potential for mere paper companies in tax havens claiming full IP ownership.  However, I fear that establishing a standard under which entitlement to IP returns requires a particular legal entity to satisfy a vaguely worded standard of management control involving employment of certain senior level personnel would ignore the reality of today's complex business world where there are business drivers dictating diverse locations for corporate management, liability protection reasons for separation of legal rights from certain corporate activities, and HR, payroll tax, employee benefit, and other reasons for selection of certain legal entities as employment vehicles, all of which could potentially run afoul of such a requirement.

It is not at all clear what the Discussion Draft contemplates in terms of what types of "management" would be needed for the company claiming IP ownership to satisfy this control/supervision standard - would it be technical/scientific management, financial management, and/or overall business unit management and would it be regional and/or global management? The language in the Draft at paragraph 40 could be read to require a whole lot of these different categories of management: "It is expected, however, that where functions are in alignment to intangible related returns in contracts and registrations, the entity claiming entitlement to intangible-related returns will physically perform through its own employees the important functions related to the development, enhancement, maintenance and protection of the intangibles. Depending on the facts and circumstances, these functions would generally include, among others, design and control of research and marketing programmes, management and control of budgets, control over strategic decisions regarding intangible development programmes, important decisions regarding defense and protection of intangibles, and ongoing quality control over functions performed by independent or associated enterprises that may have a material effect on the value of the intangible." Seems to me that it is an awful lot of management to expect to find in a single entity in an integrated global business.

So what happens if the entity that owns the IP does not do all that management? And what happens if the litany of management functions is dispersed among several related entities, as will often be the case? If tax authorities are empowered to reallocate intangible related returns claimed by IP owners, it is not clear how the OECD drafters would allocate value to other related parties.  Indeed, in some cases it seems to me that they would have to create transactions or ignore contractual relationships in order to achieve their desired allocation of intangible income. All of which brings me back to the dangerous point I raised earlier.

I found Example 11 of the Discussion Draft illuminating as to what the OECD Working Group presumably had in mind in this area.  In that example, Parent in country X transferred patents and other valuable IP for arm's-length consideration to a manufacturing subsidiary, T, in country Z. T Sub then entered into a contract R&D arrangement with Parent and with a sister subsidiary, S, in country Y, for further development of its IP. The example concludes that because T Sub does not directly employ "technical personnel" capable of conducting or supervising the R&D activities and because the senior R&D personnel reside in Parent rather than in S Sub, Parent would be entitled to the intangible related returns from the ongoing R&D. Neither T Sub nor S Sub would be entitled to any of such returns. Some practical concerns that I am worrying about in light of this example include:

  •   Why just focus on the location of "technical personnel?" Presumably T Sub would have management supervising its manufacturing process which uses the IP, would have financial management agreeing to and supervising its funding of costs pursuant to the contract R&D arrangement, and could well have brand management, supply chain management, and other senior personnel who would have capability of making informed investment and business risk decisions relating to the capture of the IP value. Presumably the costs and contributions of management personnel in all of these categories would need to be taken into account in establishing an arm's-length price in any event. Carving out this value as if the management service element of the pricing analysis were separable from intangible value would produce a lower intangible value to allocate to Parent in the example. But it certainly would make the analysis more complex and seems unnecessary. And in any event, in my view the notion that technical personnel are the sole drivers and controllers of intangible value is a flawed notion, a view which is well proven in the marketplace by the ghosts of innovative companies that no longer exist.
  •   What if the appropriate risk-controlling management were employed by a separate management company in country Z, T2 Sub, or by a regional management company in another jurisdiction, R Sub.  Assume also that this separate management company did not itself conduct any R&D. The example and the thinking behind it seem to assume a simple organizational structure with a single entity in each of countries X, Y, and Z that employs all of the relevant individuals in each country. However, in fact, multinational groups typically have numerous entities in most jurisdictions (often too many as we are seeing from increasing work in the area of corporate simplification and legal entity reduction). For liability protection, social insurance purposes, pension qualification, or other reasons, management may be in a separate employment company. Expatriate personnel may be employed by a global employment company while on foreign assignment.  And while most companies establish regional management hubs in which, subject to the above caveats, most regional management are employed, in the virtual world in which we live today some management personnel may reside outside the hub because of family constraints on moving, etc., and their activities will be cross-charged to the headquarters company. Filling these real world facts into the example, one wonders whether, if those employment entities neither conduct nor fund the R&D, would they still be allocated the ongoing intangible related returns? And what if the R&D is unsuccessful - would the management entities be allocated a loss from T Sub?
  •   In the example, presumably the mechanism for allocating the intangible related returns to Parent would be to adjust the contract R&D agreement pricing between T Sub and Parent to include intangible related returns, whether gain or loss. In a more complex real world example like that described above, one wonders how mechanically to achieve an adjustment allocating intangible related returns. If group management controlling the intangible risks and development are considered to reside in multiple entities, presumably the IP return or loss should be allocated among those entities. Some of those entities may not even have a direct transactional relationship with T Sub as the group employment or regional management companies may be charging their costs to other central entities that also may or may not be directly dealing with T Sub. Assuming intangible related returns were allocated from T Sub to Parent and certain other affiliates that employ management personnel, what impact should that have on the intercompany pricing between T Sub and its related distribution affiliates? If pricing were based on profit split, would it be necessary to cascade the adjustment of profit to all distribution affiliates? No doubt not all countries would agree to the country X tax authority's conclusion that the intangible related returns should reside in country X - so double tax risk would be high, dangerously high.

I guess overall my concern is that in the real world it is not practical to identify the individual management human beings who control and supervise each type of risk and intangible investment made by a complex multinational group. And even if it were reasonably possible, allocating intangible profit or loss on each element of intangible property to the legal entity in a group that employs such human being or beings would be an impractical exercise, certain to produce an unreasonable outcome in many situations. I believe a more appropriate standard would be that an entity funding intangible costs and bearing risk should have direct or indirect management expertise that would allow it to make informed investment decisions, which expertise could be technical, financial, operational, or some combination thereof.

Despite these concerns, I think the Discussion Draft is a step in the right direction. But it is just one step in what might be a long journey. With the intense focus by many tax authorities on intangibles, I would prefer that discussion and debate be open and participative, with the hope of producing what is overall a consensus approach. Business and the tax profession now have ample opportunity to voice the full range of practical concerns similar to those I note in this commentary. I am hopeful that those comments will be heard and that the process will result in a reasonable approach to this important area that takes into account the complexity of today's business environment. I am anxious to see the next draft.

This commentary also will appear in the November 2012 issue of the  Tax Management International Journal. For more information, in the Tax Management Portfolios, see Culbertson, Durst, and Bailey, 894 T.M., Transfer Pricing: OECD Transfer Pricing Rules and Guidelines,  and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers.

  1 The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.

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