By Gary Sprague, Esq.*
Baker & McKenzie LLP, Palo Alto, CA
* The author gratefully acknowledges the assistance of Ivan Morales, partner in the Baker & McKenzie transfer pricing practice, for his contributions to this commentary.
The Organization for Economic Cooperation and Development (OECD) is considering whether to commence a new project to address whether and how the OECD's Transfer Pricing Guidelines (TPG) should be updated to deal with transactions in "intangibles." (The project is described as addressing "intangibles" rather than "intangible property;" this point is discussed below.) If the project goes forward, it is expected that the project will deal principally with issues relating to a category of intangibles being referred to as "soft intangibles," such as profit potential, workforce in place, and goodwill. Given the lack of current guidance in the TPG on these issues, this project has the potential to provide taxpayers and tax administrations with important standards in areas which now give rise to considerable controversy. Correspondingly, the direction and conclusion of this project carry considerable significance for multinational groups, which frequently engage in cross-border related-party transactions in goods, services, property, and rights, the arm's-length price for which could be influenced by whether a party is able to realize the commercial benefits of one of these "intangibles."
The OECD has been quite active on the transfer pricing front of late. Recent amendments to the TPG have supplemented the guidance to taxpayers and tax administrations in the areas of the general application of the arm's-length principle, transfer pricing methods, and comparability. The recently completed work on the Transfer Pricing Aspects of Business Restructurings has resulted in a new Chapter IX of the TPG.
This new project on intangibles, if it goes forward, would proceed through Working Party No. 6 ("WP 6"), which deals with transfer pricing issues. It is expected that WP 6 will discuss the scope of this project in November. As currently described by OECD officials, the category of "soft intangibles" includes: (1) unprotected marketing intangibles; (2) workforce in place; (3) a commitment to undertake research and contribute to the development of future intangibles; (4) goodwill; (5) profit potential; (6) business opportunities; and (7) value drivers. See 19 Tax Management Transfer Pricing Rpt., No. 5 (7/1/10).
Multinational enterprises and their advisers will recognize in this list a number of the usual suspects past and future controversies.
Unprotected marketing intangibles. U.S. transfer pricing principles applicable to transfers of intangible property start with the identification of the owner of the property, under applicable law and contracts. Regs. §1.482-4(f)(3)(i)(A), defining the "owner" of intangible property for purposes of §482, states that, unless inconsistent with the economic substance of the underlying transactions, the sole owner is determined to be the legal owner of the intangible property pursuant to the relevant intellectual property law, or the holder of rights "constituting an intangible property" pursuant to a contract (including a license) or "other legal provision." If no owner can be identified under the relevant intellectual property law, contractual terms, or other legal provision, then the person which has control of the intangible property will be treated as the owner. Once the owner is determined, then traditional transfer pricing principles apply to determine if a separate allocation is necessary to compensate a party that contributes to the value of the intangible property. See Regs. §1.482-4(f)(4). These rules allow a party to earn an entrepreneurial return on marketing expenditure, even if it is not the legal owner of the trademark, trade name, or other similar property, but generally the person must hold contractual or other rights over the use of that property as appropriate to support the investment and return.
By referring to "unprotected" marketing intangibles, the OECD list exits the universe described above of intangible property rights defined by law or contract and enters a new universe of much more subjective and ambiguous space. Tax examiners in many jurisdictions have argued that factors other than traditional marketing intangible properties have played a principal role in producing profit in a local market, such as knowledge of local business customs, local management expertise, successful execution of marketing strategies, and the like. See, e.g., Respondent's Answer to Petitioner's Petition in GlaxoSmithKline Holdings (Americas) Inc. and Subsidiaries v. Comr., Docket No. 5750-04 (stipulated decision entered on Dec. 6, 2006) (where the IRS asserted that a U.S. pharmaceutical distributor, in addition to being the owner for U.S. tax purposes of various trademarks and marketing intangibles licensed from its U.K. affiliate, had also devised and implemented various marketing and promotional strategies for the U.S. market). Presumably, WP6 will debate whether these items really rise to the level of intangible property at all, or whether they should simply be addressed through a normal comparability analysis.
Commitment to undertake research and contribute to the development of future intangibles. The OECD apparently has been observing the further development of U.S. cost-sharing rules, and this concept has piqued the OECD's interest. The idea that this "commitment" is a proprietary asset which can demand compensation is one of the major underpinnings of arguments that "platform contribution transactions" can account for a substantial portion of the future profits of the noncontributing participant entering into a cost-sharing arrangement under the January 5, 2009 cost-sharing regulations. A platform contribution transaction covers "any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity," but does not include so-called "make-or-sell rights," which are rights "to exploit an existing intangible without further development." See Regs. §1.482-7T(c)(1), (c)(4).
An example in the new cost-sharing regulations proposes a justification of why "a commitment to undertake research" may constitute a compensable item. In that example, one party contributes to a project to develop a new vaccine its research team "that has successfully developed a number of other vaccines. The expertise and existing integration of the research team is a unique resource or capability of Company P…." Regs. §1.482-7T(c)(5), Ex. 2. This example at least attempts to justify treating this situation as attracting some buy-in payment on the basis that the R&D team creates an identified competitive advantage, so that the exclusive provision of that team to a project (assuming that the enterprise indeed could be relied upon to keep the team in place) would have some commercial value. See also IRS Coordinated Issue Paper (LMSB-04-0907-62) on Cost-Sharing Arrangement Buy-In Adjustments for All Industries (9/27/07), in which the IRS sets forth the argument that the commitment of an existing research team and the "synergy value" of that research team to the research in progress can require a buy-in payment. In contrast, the proposed item for discussion at the OECD of a mere "commitment" to undertake research appears on the list, at least for now, without a similar suggestion as to why such a commitment would have commercial value independent of the compensation which will need to be paid for the actual performance of the research.
Workforce in place. Disputes over possible compensation for workforce in place also have been common in buy-in cases in the United States. In VERITAS v. Comr., 133 T.C. No. 14 (12/10/09), the IRS argued in support of its buy-in allocation that the workforce in place in the United States was a valuable intangible property which required compensation as part of the alleged transfer of an aggregate business. In the opinion, however, Judge Foley noted that even if there had been evidence that access to the U.S. R&D and marketing teams was transferred to a related party, such workforce in place "would not be taken into account in calculating the requisite buy-in payment because they do not have `substantial value independent of the services of any individual' and thus do not meet the requirements of §936(h)(3)(B) or §1.482-4(b), Income Tax Regs." Id.(slip op. at 43-44, n. 31).
Goodwill. The tax treatment of the transfer of goodwill also is a high profile issue in the United States in the context of cost-sharing buy-ins. Taxpayers have noted that current law allows the tax-free transfer of foreign goodwill and going concern value in the context of the transfer of assets to a foreign corporation for use in the active conduct of a trade or business outside the United States. See Regs. §§1.367(d)-1T(b), 1.367(a)-1T(d)(5)(iii). This issue has created controversy on audit (TAM 200907024 (2/13/09)); the new cost-sharing regulations warn that the "goodwill," which is determined under purchase price allocation analyses for financial statement purposes, may not be regarded as such for tax purposes (Regs. §1.482-7T(g)(2)(vii)), and legislative proposals have been presented to expand the definition of compensable intangible property for purposes of §§367(d) and 482 to include "goodwill" and "going concern value" (as well as workforce in place). See Department of the Treasury, General Explanations of the Administration's Fiscal Year 2011 Revenue Proposals, at 44 (February 2010).
Profit potential. Disputes over compensation for an asserted transfer of "profit potential" have been most recently highlighted in the area of business restructurings. After considerable work on the topic, the OECD released on July 22, 2010, its Report on the Transfer Pricing Aspects of Business Restructurings, which also became a new Chapter IX of the Transfer Pricing Guidelines. The Guidelines define "profit potential" as "expected future profits." Guidelines, Ch. IX, ¶ 9.66. The issue of whether a business restructuring has resulted in the disposition of "profit potential" in a way requiring compensation has given rise to significant controversies, as in some cases tax examiners have argued that the entire anticipated future profits of the unstructured entity could be regarded as the foundation for calculating an exit charge.
The concept has been expressed in different ways in various jurisdictions. The Australian Taxation Office recently issued Draft Taxation Ruling 2010/D2 on business restructurings, noting at paragraph 118:
A "profit-making opportunity," "business opportunity" or a "profit potential" is not of itself a proprietary right that is an intangible asset. Profit potential may be relevant to valuing an asset, but is not of itself an asset.
The TPG are generally consistent with that statement, providing at ¶ 9.67 that "an entity with considerable rights and/or other assets at the time of the restructuring may have considerable profit potential, which must ultimately be appropriately remunerated in order to justify the sacrifice of such profit potential."
The German 2008 Transfer Pricing Rules (updated in 2010) define profit potential as "profit expectations" (International Transactions Tax Act, Sec. 1.3, sixth sentence). Profit potential is seen as governing the determination of a hypothetical range of prices that could be agreed between two transacting parties. In the context of transfers of functions (business restructurings), profit potential serves to determine the value of the "transfer package" (id., ninth sentence), i.e., the aggregate of a function, its risks, opportunities, assets leased or transferred, and other benefits.
The Austrian Draft Transfer Pricing Guidelines (¶ 136 et seq. of the 2009 draft version) state that a transfer of profit potential should be remunerated, on the basis that an unrelated party would not waive the right to exercise a business activity without compensation for agreeing to such a waiver. Accordingly, the Austrian tax authorities appear not to consider "profit potential" as an asset which can be transferred or even as an element of value embedded in the taxpayer's rights or other assets, but rather considers that a waiver to pursue an activity is a separate service that requires compensation.
Business opportunity. The question of whether a "business opportunity" constitutes property that if taken up by an affiliate, requires compensation has been settled under U.S. law for some time. In Hospital Corp. of America v. Comr., 81 T.C. 520 (1983), the IRS argued that the transfer of the opportunity to enter into a contract to manage a hospital was the transfer of property under §§351 and 367. The Tax Court concluded that, while the U.S. parent must be compensated for services it performed to negotiate the contract and for the provision of its management expertise and system (which the court did regard as intangible property), the business opportunity itself was not property. The court distinguished this case from other potentially analogous cases involving rights to receive income on the basis that the other cases involved the transfer of "a legally enforceable right in specific property." 81 T.C. 520, 590.
Value drivers. As for "value drivers," this author is at a loss as to what to say about the notion that "value drivers" constitute property or rights which might be transferred commercially at arm's-length.
What do these items have in common? There are two themes running through this list, which are the elements which lead to disputes, and which the OECD hopefully will acknowledge as WP6 wades into this project.
First, the subject matter of this project, at least so far, has been described as simply "intangibles" – not intangible property. The difference is significant. An item of property is an asset which can be exploited by its owner, and its use can be controlled by its owner, either directly or through contract. Because an item of property can be protected by law, it can be transferred, and those who wish to acquire it are willing to compensate the owner for its transfer. None of the items on the list of "soft intangibles" constitutes property. That point was the precise holding in the Hospital Corp. of America case. At best, these terms are descriptive of attributes which may exist due to the historic development of a business (workforce in place, goodwill), or may constitute an attribute of an asset without being a distinct asset itself (profit potential). In one case (value drivers), the term is too amorphous to be of any use in transfer pricing analysis.
A danger resides in discussing these concepts without clearly distinguishing them from intangible property. These items are different in nature from true property, and casual references to "intangibles" coupled with assertions that such items may allow an entrepreneur to enhance its income-making potential should not be allowed to analogize these items to true property rights.
Second, the business benefit and the opportunity to earn income through the exploitation of many of the items can be fleeting. While the income method of Regs. §1.482-7T(g)(4) is premised in its purest form on the concept that some intangibles (i.e., those underlying the PCT) can generate profit in perpetuity, all of the "soft intangibles" listed above may provide a business advantage for only a limited period of time. Goodwill must be maintained continuously and in many cases can be destroyed in transactions, business opportunities do not cause income to arise unless the entrepreneur realizes the business opportunity through the application of other assets and resources, a workforce may dissipate as a result of poor management in the enterprise or simply due to individuals seeing better opportunities elsewhere, and profit potential can remain unrealized unless the entrepreneur is able to successfully compete in the particular market segment. Because none of these "soft intangibles" is legally protected property, they all are particularly susceptible to losing whatever value they may have in the face of competitive forces in the market. At arm's-length, persons contemplating acquiring such "soft intangibles" certainly would have that fact in mind.
This project is important. These issues have created controversy, and the OECD plays an important role in developing and expressing consensus on important international tax issues. It is to be hoped that consensus can be reached in this area as well.
This commentary also will appear in the November 2010 issue of BNA's Tax Management International Journal . For more information, in BNA's Tax Management Portfolios, see Warner and McCawley, 887 T.M., Transfer Pricing: The Code and Regulations, and in Tax Practice Series, see ¶3600, Section 482—Allocations of Income and Deductions Between Related Taxpayers.
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