Taxing Intangible Assets: A New Global ApproachBy Angela Sadang | April 28, 2016 | Download PDF
Next in our update on the Base Erosion and Profit Shifting (BEPS) initiatives of the Organisation for Economic Co-operation and Development (OECD) is a discussion of Action Plan 8 – Chapter VI of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations
In recent years the OECD has been intent on tightening controls and making sure that OECD member countries don’t assign low values to intangible assets for the purpose of transferring them from one tax jurisdiction to another with more favourable tax rules. Plus, the OECD has become particularly concerned over procedures that artificially segregate taxable income from the activities that actually generate and create value.
The OECD’s main objective is to “assure that transfer pricing outcomes are in line with value creation.” In its action plan, it detailed its goals namely:
• Adopting a broad and clearly delineated definition of intangibles
• Ensuring that profits associated with the transfer and use of intangibles are
allocated in accordance with (rather than divorced from) value creation
• Developing transfer pricing rules or special measures for transfers of
• Updating the guidance on cost contribution arrangements and adopting transfer
pricing rules or special measures to ensure inappropriate returns will not accrue
to an entity solely because it contractually assumed risks or provided capital.
With that in mind, in October, 2015, the OECD issued its final report on all the 15 Action Plans. Its aim was to restore confidence in the international tax framework by addressing weaknesses that create opportunities for Base Erosion and Profit Shifting (BEPS). The focal point of the report’s Chapter VI is ensuring that the profits associated with the transfer and use of intangibles are appropriately allocated in accordance with value creation
A compensable “intangible” is defined by the OECD as something which is not a physical asset or a financial asset capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties. On a case-to-case basis – and taking into consideration the specific legal and regulatory environments that prevail in various countries – the OECD recognises the following as intangibles:
• Know-how and trade secret
• Trademark, trade names and brand
• Rights under contracts and government licenses
• Licenses and similar limited rights in intangibles
• Goodwill and ongoing concern value.
However, it’s worth noting that group synergies and market specific characteristics are not recognised as intangibles since they cannot be controlled by any party or group. It also emphasises that an intangible for accounting or tax purposes may not necessarily be considered as an intangible for transfer pricing purposes.
The first step in identifying intangibles is via a review of the data and the proposed license agreements between the companies involved:
Company G provides a non-exclusive license to Company A for present and future technology relating to the production of rigid PVC film (hereinafter referred to as “PVC Technology”), which includes know-how for production in the United States and marketing in all countries of North and South America in the following fields:
• Selection, coordination, treatment, and maintenance of machinery and auxiliary equipment
• Process technology relating to the speed, temperature and friction in the
production of various types of film
• Control technology
• Formulae and quality standards
• Application technology.
Company S licenses to Company A the technology needed to laminate rigid PVC films with polyethylene (“PE”) film and/or coating with polyvinylidenechloride copolymers emulsions (“PVDC”), hereinafter referred to as “PE/PVDC Technology”, to enhance the water and gas barrier qualities of rigid PVC films. The agreement provides Company A with exclusive rights to the North, Central, and South America geographical regions.
The laminating and coating technology transferred under the agreement includes:
• Selection, layout, drawings, and combination of machinery equipment and auxiliary installations
• Systems engineering
• Chemical formulae and processes
• Raw materials sources
• Raw materials qualification studies and analyses
• All application know-how relating to the manufacturing
• Quality control test results and techniques to monitor quality
• Pollution control devices and techniques
• Customer lists and leads in North, Central, and South America.
Clearly, the license agreement between these companies covered the transfer of patents and technical know-how and technology with several components, as outlined above.
Ownership of intangibles and the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangibles
Determining a) the owner of an intangible and b) the parties responsible for developing, enhancing, maintaining, protecting and exploiting that intangible is important in identifying the proper allocation of profits and costs for transactions that comply with the ‘‘Arm’s Length’’ principle.
Although legal rights and contractual arrangements form the starting point for any transfer pricing analysis of transactions involving intangibles, as far as the OECD is concerned, the pure legal owner of an intangible is not necessarily entitled to a substantial share of the returns if their role is merely that of owner. The groups that assume the risks regarding the development, enhancement, maintenance, protection and exploitation of the intangible should be compensated for the contributions they make – even if they don’t actually own the intangible, expect to earn a significant portion of the returns commensurate with the function and risks they have undertaken. The functions performed, assets used and risks borne by the different parties associated with intangibles should always be taken into consideration. Consequently, if the pure legal owner doesn’t perform any key functions related to the intangible then they aren’t entitled to any return derived from the exploitation of that intangible – other than ‘‘Arm’s Length’’ compensation, if any.
The following are regarded as important functions that contribute to the value of the intangibles:
• Design and control of research and marketing programs
• Direction of and establishing priorities for creative undertakings including
determining the course of ‘blue sky’ research
• Control over strategic decisions regarding intangible development programs
• Management and control of budgets
• Defense and protection of intangibles
• Ongoing quality control over functions performed by independent or associated enterprises.
Identifying transactions involving intangibles
In addition to identifying with the intangibles that make up a particular transaction – and identifying the owner of those intangibles – it’s also important at the onset of any transfer pricing analysis to identify and accurately describe the controlled transactions that involve those intangibles. The OEDCD’s guidelines identify two general types of transactions, which are:
• Those involving the transfer of intangibles or the transfer of all, or limited,
Rights, relating to the intangibles; and
• those involving the use of intangibles in connection with sales of goods or
the performance of services where said intangibles are used, but no transfer of
the intangibles themselves – or rights to the intangibles – takes place.
The OECD guidelines also discussed which features of an intangible should be taken into consideration when conducting a comparability analysis, such as the exclusivity and duration of legal protection, geographic scope, useful life, stage of development, rights to enhancements; revisions and updates, as well expectations of future benefits.
The DEMPE functions advocated by the OCED are identified in the next step we performed in this engagement process, i.e., the functional analysis. Functional and risk analysis provides the factual basis for establishing a transfer pricing methodology that’s consistent with the ‘Arm’s Length’ standard set forth in § 482 of the US Treasury Regulations and the OECD Guidelines. It’s a means of organising facts about the companies involved in specific transactions with regards to the functions performed, risks assumed, and the intangible assets used in order to identify how these responsibilities are divided among the companies involved. Functional and risk analysis is crucial to the development of transfer pricing policy because:
• The economic return generated by the functions undertaken by each related
party typically correlates with the risks borne and the intangible assets owned
• The functions, risks, and intangible assets associated with a related party’s
operations usually have a significant effect on its profitability
• The functional analysis provides the information and insight necessary to
(i) determine which transaction (or entity) to evaluate, (ii) establish the best
(or most appropriate) method of evaluating the transaction (or entity), and
(iii) develop comparability characteristics to help identify comparable,
independent transactions (or companies) so as to determine the appropriate
‘Arm’s Length’ pricing level of the controlled transactions.
By providing a description of the functions, risks, assets (both tangible and intangible) and their location within a corporate group, functional analysis provides the first step in evaluating the particular profit-related contributions of the various related companies, and the appropriate pricing of intercompany transactions.
The functional analysis we performed was generally conducted in accordance with the value-chain concept, which begins with R&D and culminates with the final sale to the end-user or intermediary of the MNE’s product.
In terms of risk, Company A bears most of the burden, including general business risk. Company G and Company S shoulder the R&D risk, i.e., the success or failure of R&D undertakings and, accordingly, the development of product and process intangibles. As far as the PVC Technology and PE/PVDC Technology is concerned, the R&D risks are borne by Company G and Company S respectively. Neither Company A nor the other related entities bear this risk. Company G and Company S, respectively, also assume the risks arising from PVC Technology and the PE/PVDC Technology product modifications and development. Company A does not bear this risk.
In summary, in the diagram below we captured the functions relating to the intercompany transactions evaluated in this case.
Transfer pricing methods
Depending on the circumstances, at least one of the five OECD transfer pricing methods would appropriate when transferring intangibles, or rights in intangibles. However, according to the guidelines, the Comparable Uncontrolled Price (CUP) and transactional profit split methods are likely to prove especially useful in case of transfer of intangibles or rights in intangibles. Also, valuation techniques can also be useful.
The OECD recognised that database comparables involving intangibles may be difficult – or in some case impossible – to assess. In such cases they suggest that the profit split method and/or valuation techniques might be the best method to set the ‘Arm’s Length’ prices the transactions involving intangibles. The application of the transactional profit split method should be in line with a comprehensive analysis that considers the functions performed, risks assumed and assets used by each of the parties in the MNE.
The use of other approaches – such as valuation techniques based on the calculation of the discounted value of projected future income streams or cash flows derived from the exploitation of the intangible – should consider such things as the accuracy of financial projections, assumptions regarding growth rates, discount rates, the useful life of intangibles and terminal values, assumptions regarding taxes and the form of payment.
Hard to value intangibles (HTVI)
HTVI are those for which no comparables exist and profit projections are highly uncertain at the time of the transfer. However, the updated report does allow tax authorities to consider ex post evidence about ex ante ‘Arm’s Length’ pricing arrangements. This also includes any contingent pricing arrangements made when a taxpayer is unable to show that ambiguous items were factored into the pricing methodology.
We illustrate the means employed to evaluate the ‘Arm’s Length’ nature of the intangible property transactions between (i) Company A and Company G and (ii) Company A and Company S. To determine the extent to which these transactions were conducted at ‘Arm’s Length’ between the affiliated parties entails:
• Selecting the best (or most appropriate) method and determining the
appropriate transaction (or entity) to evaluate the ‘Arm’s Length’
nature of intercompany charges
• Identifying truly comparable independent transactions (or companies) that
can be used in applying the best (or most appropriate) method
• Analysing the financial and economic outcomes of the controlled transactions
against comparable third-party price (or profit) benchmarks that make
appropriate adjustments for differences between the tested transaction (or
entity) and the comparable transactions (or companies).
Selection of the Best (or Most Appropriate) Method
The selection of the best (or most appropriate) method depends on a number of factors, such as (i) the availability of complete and reliable data, (ii) the degree of comparability between controlled and uncontrolled transactions (or companies), and (iii) the number, magnitude, and accuracy of the adjustments necessary to apply the method.
Identifying comparable transactions (or companies) requires an evaluation of the functions performed, the risks assumed, as well as contractual terms, economic conditions and the types of intangible property exchanged between the affiliated entities engaged in the intercompany transaction. Each factor should be evaluated in order to determine its potential impact on the pricing method and, depending on the approach chosen, one factor may be more important than another in establishing comparability. The documentation of these analyses (i.e., functional analysis, risk analysis, and an assessment of contractual agreements) is required to support the best (or most appropriate) pricing method.
• In determining the best (or most appropriate) method to analyse the
intangible property provided to Company A by Company G, we evaluated
the functions performed and risks undertaken by each entity in accordance
with § 482 of the Treasury Regulations and the OECD Guidelines. Based on
this assessment, we determined that the best (or most appropriate)
method for analysing the transfer prices between Company A and Company
G for the licensing of the PVC Technology is the external CUT (or CUP)
The CUT method compares the price charged in a controlled transaction with that charged in an uncontrolled transaction. Under this method, the ‘Arm’s Length’ nature of an intercompany price is determined by reference to either: (i) the price charged by a member of the group for the provision of the same or highly comparable intangible property to an unrelated party (i.e., an internal CUT), or (ii) the price charged by an independent company for the provision of comparable intangible property to a third party (i.e., an external CUT).
We selected the external CUT as the best method, based on a comparison of the ‘know-how’ and technology licensed in the uncontrolled agreements, over that licensed in the agreement between Company A and Company G. We considered other methods, such as the profit split approach but decided that it was an unsuitable way of evaluating the ‘Arm’s Length’ nature of the transactions between Company G and Company A.
Our research identified several possible licensing agreements, which were then evaluated to determine (i) the profit potential of the intangible asset, (ii) the stage of development of the intangible asset, (iii) the expected economic life of the property, (iv) what rights were granted, and (v) the type and extent of the technical assistance provided. Plus, we examined the financial data present in the third-party agreements to eliminate those that either (i) did not disclose royalty rates or (ii) provided for a flat fee in lieu of a percentage of revenue.
A final review of the comparable transactions identified a number of agreements that were judged to be appropriate for use in the external CUT analysis.
The royalties charged in the set of comparable third-party agreements are provided below. As indicated, the range of third-party royalty rates is 20.0 percent to 22.0 percent of net sales. If Company G charged Company A a royalty fee of 5.0 percent of net sales, then relative to the range of third-party royalties, Company G will not be charging a price above ‘Arm’s Length’ to Company A for its use of the PVC Technology.
Application of the CPM/TNMM
We also considered a CPM/TNMM analysis as a corroborative method to the external CUT evaluation of the ‘Arm’s Length’ nature of royalties charged by Company G to Company A for the license of the PVC Technology. The CPM/TNMM relies on the general principle that similarly situated taxpayers will tend to earn similar returns over a reasonable period of time, and that charges may not be justified if they reduce a company’s economic returns below the level generated by comparable companies.
It follows, then, that prices that garner returns comparable to similarly situated taxpayers may be viewed as appropriate ‘Arm’s Length’ prices. In essence, if the application of the CPM/TNMM approach produces an ‘Arm’s Length’ result for a company, the price charged thus meets the ‘Arm’s Length’ standard under Treas. Regs. § 1.482-1 and the OECD Guidelines.
The initial step of the intangible property analysis applied § 482 of the Treasury Regulations and the OECD Guidelines to the intercompany licensing transaction between (i) Company A and Company G and (ii) Company A and Company S in order to determine the “best” (or “most appropriate”) method for assessing the royalty rates
In the illustrative case, we decided that the CUT/CUP was the best method to use vis a vis technology and validated the choice with a CPM/TNMM analysis. We established a royalty range for the use of the technology developed by Company G and S. Our recommendation was to move forward with a license arrangement between the two companies, with the royalty rate updated annually.
The importance of intellectual property management for tax planning purposes is clear. When an MNE is looking at its intellectual property portfolio, the interplay of many factors must be considered, along with guidance from the OECD and the local country tax jurisdictions where affiliates are located.
MNEs should also ensure their transfer pricing policies reflect the guidance provided by the OECD, namely that DEMPE functions should be clearly defined and the contributions of each party evaluated in order to determine entity within the group controls the economically significant risks. What’s more, when it comes to the valuation and pricing of transactions, MNEs should carefully consider which valuation techniques they employ and whether or not the substitute methodology they are applying is being done so correctly. As we said earlier, the OECD’s objective is to ensure that profits arising from the transfer and use of intangibles are distributed so that they are aligned with value-creating functions and the control of risks.
About the Author
Angela Sadang, MBA, CFA, ASA, is a Director in the Financial Advisory Services Group at Marks Paneth LLP. She specializes in business valuation and has more than 15 years of experience providing corporate financial consulting services. Angela serves both publicly traded and closely held companies in a wide range of industries that also involves various asset classes.
Before joining the consulting industry, Angela worked in the financial services industry at JP Morgan Securities and Schroders PLC, focusing on institutional equity research covering the Asian equity markets.
Angela is a Chartered Financial Analyst (CFA) as designated by the CFA Institute. She is also an Accredited Senior Appraiser (ASA) with specialty in business valuation as designated by the American Society of Appraisers. Angela holds a Master’s Degree in Business Administration with a concentration in Finance from The Wharton School of the University of Pennsylvania. She is based in Marks Paneth's midtown Manhattan headquarters. She can be reached at firstname.lastname@example.org or 212.201.3012
About Angela Sadang
Angela Sadang is a Principal in the Advisory Services group at Marks Paneth LLP. Ms. Sadang specializes in business valuations and the valuation of intangible assets and has over 20 years' experience providing corporate financial consulting services and performing valuations. She serves both publicly traded and closely held companies in a wide range of industries that also involves various asset classes. Ms. Sadang is a Chartered Financial Analyst (CFA) as designated by the CFA Institute and is... READ MORE +