Thomas Borstell, Ernst & Young, Düsseldorf
Thomas Borstell is a Director
On June 6, 2012, the OECD published its proposals for revised guidance on the transfer pricing of intangibles.1 The draft, on which comments were sought by September 14, 2012, presents the results of the OECD's work to date on two key issues relating to transfer pricing for intangibles:
• the definition of intangibles for transfer pricing purposes
• the determination of which entity(ies) should be entitled to the returns from an intangible.
In addition, the draft contains a large number of examples - 22 - illustrating the application of the principles it sets out.
Unusually, the document was issued as an interim draft that is identified as not necessarily reflecting OECD consensus.
The existing guidance on the transfer pricing of intangibles was added to the OECD's Guidelines in 1996. Since then tax authorities and taxpayers have gained considerable experience with transfer pricing issues, and transfer pricing for intangibles has raised some of the most complex issues. More particularly, in its work leading up to the publication of the revised Guidelines in July 2010, including the addition of a chapter on transfer pricing issues arising out of business restructurings, it became apparent to the OECD that further work on intangibles was needed.
In a scoping document issued in January 2011, the OECD announced an initiative to review and refine its guidance on issues such as those considered below. A consultation meeting on scoping issues was held in November 2010. A meeting on the valuation of intangibles took place in March 2011, and in November 2011, a further public consultation meeting took place, dealing with definitional and ownership issues.
When the initiative was launched, it was anticipated that a Discussion Draft would be published in 2013. However, the OECD decided to publish a draft for a discussion somewhat earlier than planned in order to gain input from business as the Working Party continues its work. There is no consensus yet on a number of issues.
Set out in this article are a series of key points from the proposals, along with Ernst & Young's viewpoint on each. These viewpoints - along with supporting details - were submitted to the OECD by Ernst & Young on September 13, 2012.
“… the thrust of a transfer pricing analysis in a matter involving intangibles should be the determination of the conditions that would be agreed between independent parties for a comparable transaction.”
The OECD's proposed definition of an intangible is therefore rooted in the fundamentals of Article 9 of the OECD Model Tax Convention. Although the enforceable rights that make up the legal definition of an intangible, such as patents and trademarks, are potentially encompassed by the transfer pricing definition, legal enforceability or separate transferability are not the focus of the OECD's definition of intangibles for transfer pricing purposes. In addition, the draft calls for caution in use of accounting valuations for transfer pricing purposes generally and states specifically that purchase price allocations for accounting purposes are not relevant for transfer pricing.
The other key point in this section of the draft guidance is the distinction between attributes owned or controlled by a single entity and “comparability factors” that cannot be directly ascribed to a specific entity. These include group synergies and market characteristics such as low labour costs. These factors should be taken into account in the pricing (comparability) analysis for the relevant transaction rather than being treated as a separate transaction in intangibles. In this respect, it is indicated that workforce in place is such a comparability factor. However, it should be noted that, at the same time, it is mentioned that the transfer of an assembled workforce may provide a benefit and may affect the compensation required in connection with the transaction.
Overall, it appears that the OECD is striking a balance between the advocates of a narrow definition focusing on enforceability of property rights and attempts by some tax authorities to broaden the notion of an intangible to include almost any driver of profit such as access to low-cost labour.
The Working Party's work on the definition of intangibles is helpful, but we think there is a need:
1. to further sharpen the definition, and in that context, to clarify the distinction between comparability factors and intangibles, and to recognise that there may be factors too ill-defined to be useful for transfer pricing analysis (e.g., “good management”)
2. to recognise that in many countries, a definition that is not sufficiently concrete could be contrary to domestic law prohibitions, including constitutional prohibitions, on laws that are overly vague.
As much as possible, differences in the definition of intangibles, e.g., between Article 9 and Article 12 (royalties); and if a difference is necessary, the distinction should be made clear.
Ernst & Young's view is that an intangible should be capable of being owned or controlled, and be capable of being transferred on a stand-alone basis. Other aspects that do not meet these requirements (e.g., “synergy”, “location savings”) should be factored into the comparability analysis, but should not otherwise be considered a separate intangible.
It is our experience that in some jurisdictions, tax authorities feel they have an almost unlimited mandate to disaggregate common transactions into transfers of more and more discrete intangibles, each with its own, separately discoverable, arm's length return. In other jurisdictions, the opposite tendency is common. We therefore think further attention also should be devoted to the issue of the level of disaggregation.
In the second section of the new draft guidance, the OECD maintains and perhaps enhances the focus on economic substance already demonstrated in its commentary on profit attribution to permanent establishments under Article 7 of the Model Tax Convention 5 and, in particular, the first part of Chapter IX (Business Restructurings) of the OECD Guidelines on testing the contractual assignment of economically significant risks between the parties to a transaction.
The new guidance defines three criteria to be taken into account in determining which entity(ies) should have a claim on the returns to an intangible:
1. the terms of the legal agreement
2. the alignment of functional contributions and financial investment with legal rights
3. whether “services rendered in connection with developing, enhancing, maintaining and protecting intangibles” are compensated on an arm's length basis.
“Where the conduct of the parties is not aligned with the terms of legal registrations and contracts, it may be appropriate to allocate all or part of the intangible-related returns to the entity or entities that, as a matter of substance, perform the functions, bear the risks and bear the costs that relate to development, enhancement, maintenance and protection of the intangibles.” (Discussion Draft, paragraph 37)
As already suggested, the discussion of functional alignment explicitly and closely follows the framework set out in Chapter IX (Business Restructurings). Alignment requires that the entity contractually entitled to returns should either:
1. develop, enhance, maintain and protect the intangible itself
2. physically perform the important functions itself and “control” the supporting contribution of any service providers.
We do not see the necessity for the new concept of “intangible-related returns”. If such a new concept is introduced, it should be clarified. In particular, although the Discussion Draft recognises the issue, it needs to be made very clear that the profit attributable to drivers such as market circumstances and entrepreneurial activity should not be routinely allocated to the party entitled to intangible-related returns.Financing and intangible-related returns
It is unclear whether the Discussion Draft's definition of an intangible-related return would include the remuneration for the financing of the development of the intangible. We believe that at arm's length and in line with the current transfer pricing guidelines, a party financing the development of an intangible can be entitled to take part of the “excess profits” in connection with an intangible.Entitlement to the returns
Another major concern with this draft guidance concerns the emphasis placed on an assessment of whether the allocation of functions, assets, risks and costs is “in alignment” with the legal and contractual framework.
We agree that entities within an Multinational Enterprise (MNE) should have an appropriate level of substance to manage and control the development, enhancement, maintenance and/or protection (“DEMP” functions) related to intangibles, in order to claim entitlement to some or all of the intangible-related return. However, in our view, the level of substance and the level of control required should, wherever possible, be tested by reference to comparable transactions between third parties, rather than by a hypothesis about arm's length behaviour. Our view is that the guidance as currently drafted is too prescriptive about the behaviour that is required in order for an entity to be entitled to intangible-related returns.
Such prescriptive guidance could not practically address the whole variety of arrangements that are seen at arm's length, and this likely would lead to implementation problems and a risk of inappropriate deviation from the arm's length standard.
Particular issues that we foresee arising in this regard include the following:
• There are undoubtedly arm's length situations where third parties retain entitlement to intangible-related returns without themselves performing and controlling all the “important” functions to the extent that the guidance appears to require. MNEs should be free to adopt arrangements comparable to those observed between arm's length parties in comparable circumstances without the risk of those arrangements being disregarded.
• Normal practice in many MNE groups is to allocate different DEMP functions to different entities within the group. (For example, group IP protection may be handled centrally, while development and enhancement of IP might be handled by entities in different jurisdictions.) In these cases, the entities that perform the protection functions may not exert control over the development or enhancement functions, or vice versa. The guidance should be able to address this situation without the risk of intangible-related returns being reallocated around the group.
• There are arm's length situations where a party will obtain the right to share in intangible-related returns by investing in the development of intangibles or purchasing intangible rights, but will perform little or no “control” activity other than due diligence at the outset, and will bear only risks associated with the loss of its initial investment and the volatility of intangible-related returns. Although we can see that this type of arrangement can fit in to the guidance (noting the references to paragraph 9.23-9.28), it would be helpful to confirm this.
Almost 20 pages of the draft guidance are devoted to pricing issues. Although for a large part, the guidance confirms what is now familiar practice (e.g., the use of discounted cash flow (DCF) analysis as a “tool” in pricing, particularly for transfers of intangibles), there are a number of points worth noting.Two-sided perspective and application of ORA (options realistically available) concept to intangibles
Pricing analysis should be two-sided and consider the “realistic alternatives of both parties” as part of the comparability analysis. For example, a licensor or transferor of an intangible would not accept a price less than it could realise by exploiting the intangible itself, and the licensee/transferee would not pay a price that leaves it less profitable.
Similarly, with respect to valuation, the calculation of the discounted present value of the streams of cash flows attributable to the intangible from the perspectives of both parties to the transaction will generally be necessary. In these cases, the arm's length price will fall somewhere within the range of both present values, after taking into account taxes required to be paid with respect to the transaction.
We believe more guidance on the general notion of “options realistically available” would be very welcome, especially given the importance that is being put on this concept in the context of intangibles. For example, we think there should be more attention devoted to the issue of determining what options might be considered realistically available. Such discussion should consider such issues as, if a company has a certain risk appetite, is it a realistic option to invest in projects with a totally different risk profile?
In our view:
• The “next best alternative” cannot always be assessed by a simple NPV analysis. A wide variety of other factors need to be considered, such as the allocation of capital among different projects (e.g., although the NPV derived from project X might go down if project X is out-licensed, such an out-license might free up capital to exploit project Y in addition to royalties from project X).
• A tax authority's view of what options are realistically available may be quite different from management's view. Our opinion is that the way the guidance and example are currently drafted, with the reference to recharacterisation, may encourage tax authorities to second-guess management decisions.
The draft guidance calls for caution to be exercised in accepting valuations performed for accounting or other purposes when determining arm's length prices. It explicitly dismisses the use of valuations made for purchase price allocation purposes:
“ … valuations of intangibles contained in purchase price allocations performed for accounting purposes are not relevant for transfer purposes.”
Use of cost-based valuations and rules of thumb
Similarly, the OECD sees a limited role in transfer pricing for cost-based valuations except sometimes for non-unique intangibles used for internal business operations (e.g., internal software systems).
The use of rules of thumb (like the “25 percent rule of thumb,” a formulaic apportionment of the profit attributable to an intangible between its owner and the user) is “discouraged.”Pricing of transfers of intangibles
This section of the Discussion Draft also contains guidance for determining arm's length prices in a controlled transaction involving the transfer of intangibles or rights in intangibles. This is of particular importance in the context of business restructuring. It does not set out a prescriptive framework but makes a number of points on the details of pricing these transactions.
We disagree with the suggestion that there is inherent conservatism in valuation assumptions adopted for accounting purposes. This is not consistent with fair value measurement requirements under IFRS, which are intended to reflect the fair value of an intangibles asset in an arm's length sale between a willing buyer and seller, not a conservative estimate of value.
We also rebut the statement that “valuations of intangibles contained in purchase price allocations performed for accounting purposes are not relevant for transfer pricing purposes”. We believe this statement is drafted too broadly.
However, the asset to be valued for transfer pricing purposes is often different when looked at closely to the asset valued for purchase price allocation purposes. In this respect, broad definitions of assets or combinations of assets can be misleading.
We also think that that the acquisition price may not be a good comparable because it can be expected to reflect the value to the group as a whole, not just the value to the acquiring entity, which would typically be lower.
We welcome the OECD's application of discounted cash flow approaches in its examples and also the clear and consistent application of post-tax discount rates to post-tax cash flows. We suggest that further guidance and clarification be included with respect to the use of discounted cash flow techniques and the use of post-tax rather than pre-tax cash flows as the appropriate basis for value measurement.
However, we have concerns over the level of length and depth of discussion of the issues and concerns around valuation techniques. The articulation of the assumptions may add to the burden of documentation that is necessary for MNEs using valuation techniques in pricing intangibles, creating expectations of a level of detail that we feel is not appropriate.Highly uncertain valuation
The Discussion Draft includes language on the pricing in case of highly uncertain situations. In our experience, renegotiation is seldom observed in practice, in particular in the situation of an outright sale of an intangible. We suggest making this explicit in the document. Hence, applying a renegotiation mechanism, by either the taxpayer or the tax administration, should be thoroughly documented and not be done lightly.
A public consultation meeting was held in Paris in November 2012, and it is hoped that another draft will be released for further discussion, likely at some point in 2013.
1 Revision of the Special Considerations for Intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions, 6 June to 14 September 2012 (Discussion Draft). Available at: www.oecd.org/document/41/0,3746,en_2649_33753_50509929_1_1_1_1,00.html
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