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By Philip Morrison, Esq.
McDermott Will & Emery, Washington, DC
At 186 pages of mostly mind-numbing discussion, the BEPS Actions 8-10 2015 final report ("the Report")1 is neither an enjoyable read nor much of a reference document. Even a tax nerd like me suffers a serious case of MEGO (my eyes glaze over) trying to plow through it. Like so many OECD tomes, one must read large sections of often-repetitive and often-obvious blather to get the gist of the subject one might be examining. Despite the length and detail, however, there is little in the way of specific guidance with respect to some of the hardest transfer pricing questions. And there is no way to quickly find anything resembling an answer. But if one persists, one can pick up the general direction the Report intends tax authorities to go. Unfortunately, with respect to the transfer pricing of intangibles, that direction is a disturbing one for taxpayers.
This commentator read the general and intangibles portions of the Report with an eye to guidance for drafting contract R&D agreements that would entitle the contractor to the lion's share of profits from the exploitation of intangible property (IP) developed under such agreements. Since the revisions to the cost-sharing regulations under §482, such agreements have been one of the more popular approaches used by U.S. multinational enterprises (MNEs) to assure the location of IP-related profits outside the United States, provided adequate risk-taking and decision-making also resides outside the United States. The message this commentator received from this exercise is that the OECD has a very different view of contract R&D arrangements than most U.S. tax practitioners.
The Report takes an almost anti-capitalism tone. It indirectly addresses the age-old question as to whether capital or labor is the predominant factor in creating value by taking the view that labor is all-important. While ownership of IP and the provision of money to develop it are not entirely ignored, they take a distant backseat to "people functions" — camouflaged somewhat under the rubric of "control." Fundamentally, the Report fails to recognize that not everyone works for an equity-like return; that some important persons, even those who may make important decisions, might provide their services at arm's length for an essentially risk-free or low-risk return (like a salary) in exchange for the comfort of knowing that they are very likely to obtain that return.
Like all transfer pricing discussions, the Report notes that the arm's-length principle requires that all members of a controlled group receive appropriate compensation for the functions they perform, the assets they use, and the risks they assume in connection with the development, enhancement, maintenance, protection, and exploitation of IP.2 But never is there any recognition that "appropriate compensation" for functions performed by one entity might be very low where another entity assumes virtually all the risks. Indeed, the Report explicitly declares that:[t]he need to ensure that all members of the MNE group are appropriately compensated…implies that if the legal owner of intangibles is to be entitled ultimately to retain all of the returns derived from the exploitation of the intangibles it must perform all of the functions, contribute all assets used and assume all risks related to the development [etc.] of the intangible.3
While it is later explained that such an owner of IP need not physically perform all such functions through its own personnel, it is nevertheless made clear that the IP owner must "control" all such functions when they are performed by others.
What "control" of a function means is not crystal clear but what guidance one can divine is troubling. Paragraph 6.53 sends the reader back to section D.1.2.1 of Chapter 1 of the OECD Transfer Pricing Guidelines to apply the principles outlined there. That section deals with assuming, managing, and controlling risk. Paragraph 1.65 provides that control over risk involves the capability to make, and actually making, decisions about taking on (or not) risks. While day-to-day management of risk can be outsourced, to retain control of risk the outsourcer must determine the objectives of the outsourced activities, hire (and fire) the provider, and assess whether the objectives are being met. Paragraph 1.66 explains that a risk controller must have an "understanding of the risk based on a relevant analysis of the information required for assessing the foreseeable downside and upside risk outcomes" of its decisions. Such a person must also possess competence and experience in the area of the particular risk for which the decision is being made, and possess an understanding of the impact of their decision on the business. It also must gather and analyze all relevant information necessary to make such decision.
Tellingly, ¶6.55 declares that a company that "merely funds research and development should have a lower anticipated return than if it both funds and controls research and development." In turn, the funder and controller will have a return lower than the person funding, controlling, and performing the R&D. This bias against the funder and in favor of the controller/performer is woven throughout. It appears that a person who provides all the R&D funding, assumes all the risk of the R&D being a failure, and hires a group of competent researchers to perform the R&D can only expect a financial sort of return as opposed to the major return on any successfully developed IP. So perhaps such an investor can earn a junk bond rate of return but anything more is denied him.
This is unfortunate because it does not comport with the real world. There are and have long been examples of situations where the provider of capital assumes all the risks of an endeavor while only knowing the general outline and goals of the endeavor. Such an investor likely assures himself the best he can that those performing the functions of the endeavor are the best available to perform such functions, but many times he knows little about the actual performance of those functions. He hires a firm or a group of scientists to find a cure for cancer; he doesn't tell them how to do their jobs or involve himself in the actual scientific direction of their research. And the scientists are happy to earn a healthy salary and compensation for their expenses; they don't always or even often demand an equity return for their services. But the provider of funds does, in such cases, expect to enjoy the vast majority of the returns on his investment should the research prove successful. After all, he is taking on all the risk that the research is a failure.
Under the Report, however, it appears that such a provider of capital will earn only a small return unless he "controls" all of the research. To control the research, it appears that he must have competence and experience in the area of scientific inquiry the research involves. Further, he must apparently be able to evaluate scientifically relevant information and demonstrate that he bears responsibility for the actions the scientists take, or don't take. Nowhere is there an endorsement of a risk-taking entrepreneur receiving the lion's share of the return on research if the entrepreneur does not have technical research experience and knowledge himself. As Examples 14, 15, and 16 make clear, the major return on R&D will go only to those with the experience, knowledge, and capacity to develop and design a research program, establish research budgets, determine levels of research staffing, make decisions regarding whether to pursue or terminate particular research projects, and actually supervise research. If one cannot and/or does not control the important decisions regarding each of the management, design, budgeting, and funding of research, one cannot enjoy the returns from success of research.
This seems to be overkill for preventing the so-called "cash-box" arrangement for locating IP profit in a low-tax jurisdiction. Even if an MNE's true decision-makers with respect to the general direction of research and the amount of its budget are located in an entity, if such persons have little technical background or technical supervisory functions, the Report appears to deny such an entity any major return from successful research. This seems wrong if such entity contractually and actually bears the risk that the research is unsuccessful.
Though the Report clearly rejects the idea that a non-technical risk-taker can earn the major return from successful research, it does not offer much guidance as to how much technical experience and supervision is adequate. In Example 14, the participant performs extensive and regular supervision of research. In Examples 15 and 16, it performs virtually no supervision. What about something in-between? The Report doesn't venture far into that realm. Even in Example 14, however, where the contractor provides extensive and regular supervision over the entity performing the contracted-for research, the compensation paid to the research-performing entity must take into account "the relative skill and efficiency" of that company's research personnel. To this commentator, that suggests that a cost-plus contract research arrangement would be very hard to create unless most of the supervisory scientific personnel were employed by the contractor, rather than the research-performing entity. This, of course, could prove quite impractical.
While the status of the Report, even when formally incorporated into the OECD Transfer Pricing Guidelines, is typically "soft law,"4 it can be anticipated that the problems recited above will be real ones asserted by real tax authorities around the world. One can only expect a greater volume of double taxation cases as a result.
This commentary also appears in the April 2016 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Maruca and Warner, 886 T.M., Transfer Pricing: The Code, the Regulations, and Selected Case Law, Chip, Culbertson, and Maruca, 6936 T.M., Transfer Pricing: OECD Transfer Pricing Guidelines, and in Tax Practice Series, see ¶3600, Section 482 — Allocations of Income and Deductions Between Related Taxpayers, ¶7160, U.S. Income Tax Treaties.
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