The transfer pricing of intangible properties has always been a significant issue for multinational enterprises (MNEs). The excellent idea devoted to this matter with the current drive of the OECD to counter tax base erosion is dim long over-due. Indeed, the case with transfer pricing is technically considered a neutral concept but erroneously taken as an offensive action of MNEs that permits them to transfer profits generated by intangibles to so-called tax havens. Although, the arm’s length principle enshrine in the OECD Model has been misidentified as the primary instrument to tackle such abusive behavior of MNEs.
Current globalization has prompted the expansion of numerous organizations in several countries and jurisdictions through subsidiaries. These MNEs therefor create, transfer and offer their tangible and intangible property everywhere throughout the world. These transactions occur between the parent organization and its foreign subsidiary or between various subsidiaries of the multinational company. Transfer pricing would not be an issue if there were very few differences between the nations in regards to tax treatment. These distinctions concern the inquiries which country may tax the incomes on these transfers and what ought to be the ‘fair’ valuation of these transfers.
One of the primary publications of the OECD in connection to tax practices is the “Guidelines for Multinational Enterprises and Tax Administrations on Transfer Pricing”. The OECD Transfer Pricing rules manage the right assurance of an arm’s length compensation for inter-company transfers concerning the taxable income. As indicated by the OECD Transfer Pricing rules the proper valuation of inter-company exchanges relies upon the value an unrelated party would pay for the intangible or tangible property. In other words, the cost of the transaction concerning tangible and intangible property must be at arm’s length. Royalties present stiff but fascinating dispute from a transfer valuation and price perspective. This discussion describes the factors that are relevant to transfer price of trademark-related to intangible properties in a variety of contexts, including case analysis.
The definition of IP for treaty purposes
Article 12 of the OECD Model treaty defines the term royalty as the compensation for the right to use IP:
“Royalties, as used in this article, refers to any payments received for the use of any copyright that is literary, artistic or scientific work including cinematograph films, trademark any patent design, secret formula, or for information in regard to industrial, commercial purpose. A trademark is an economic instrument to help final consumers to determine the quality of goods and services in making a purchase decision based on the reputation of the producer or seller.
Arm Length Principle
Remuneration under the arm’s length principle
The initial step of the transfer pricing analysis is to decide legal possession and binding contractual arrangements, which are isolated from the second step – remuneration under the arm’s length guideline. To determine the appropriate arm’ s length remuneration to members of a group (including the legal owner) for their functions, assets, and risks, the Actions 8-10 Final Reports provide for the analytical framework which is established by three ideas:
- Taxpayer’ s authoritative plan
- The legal ownership of intangibles and
- The conduct of the parties.
Like some other type of transaction, the analysis involving intangibles must take into account all of the significant facts and circumstances present in a particular case, and price determination must reflect the realistic alternatives of the relevant group members.
The reference to arm’s length remuneration generally assumes the anticipated returns and remuneration. The entitlement of any member of the MNE group to profit or loss relating to differences between actual and proper estimation of anticipated (ex-ante) profitability will depend on which entity or entities in the MNE group, in fact, assume the risks as identified when delineating the actual transaction. To the extent that one or more members of the MNE group, other than the legal owner perform functions, use assets or assume risks related to the DEMPE functions, such associated enterprises must be compensated on the arm’s length basis for their contributions.
Marketing activities undertaken by enterprises not owning trademarks or trade names
This section refers to the situation where the legal and beneficial owner of a trademark or trade name licenses this IP to one of her foreign subsidiaries. The subsidiary may attempt exercise to keep up or improve the IP abroad. The question, therefore, is at which level the embraced practices by the licensee could lead to the ownership of the IP abroad. The possession issue may likewise include the transfer of the IP from the parent organization to its foreign subsidiary.
The compensation for providing excessive marketing activities
Most legally binding agreements involves trade names or trademarks from one related party to another for a specific period. The OECD Transfer Pricing rules clearly state that the licensee could be repaid as a service provider or share in any extra return attributable to the marketing activities performed by the subsidiary. For a subsidiary to qualify for the income attributable to the trade name would be determined by the following factors:
- The privileges of the licensee;
- Does the agreement comprise a long-term or a short-term license agreement?
- Does the trademark agreement grant the licensee exclusive rights to utilize the trademark or trade name in the region it operates?
- The size of the promoting activities performed by the licensee;
- Does the agreement grant the licensee the privilege to sub-permit the authorized trademark or exchange name to third parties?
This factor concerns the bright line test, which implies that the marketing activities performed by the licensee ought to surpass the marketing activities of an independent third party under similar conditions would undertake. If the marketing activities do not exceed the bright line test, compensation would not be required, because the undertaking of the marketing activities by the licensee is ordinary inside a license structure.
- Reimbursement by the owner of the trademark or trade name.
This factor refers to the circumstance where the licensee is re-paid for every cost incurs concerning the licensed trademark or tradename. For this situation, the licensee can only be regarded as an agent, and may along these lines never be an owner of the IP rights.
Further, the excessive marketing functions undertaken by the licensee may include the advancement of own IP, different from the trademark or trade name or the activities may lead to the progress of the trademark or trade name in the licensee territory. Both cases prompt the advancement and improvement of the trade name in the region of the licensee, however from another point of view.
Conclusively, if the permit agreement comprises of a long-term contract, it gives the licensee exclusive rights to utilize and sub-permit the IP in her nation. The licensee bears every expenses and risk identified with the exercises performed to make the IP profitable and if these expenses and risk surpass the sum a third party would incur under a similar license agreement, the licensee must be compensated through an offer in any extra returns attributable to the marketing activities performed.
Case Analysis of Marketing Activities – Glaxo Case
This case concerned the conveyance of a licensed pharmaceutical medication in the US. The parent organization in the UK developed the drugs and was the legal owner of the patented drugs. Its US subsidiary carried out excessive marketing activities to upgrade the value of the IP in the US because the licensed medication was relatively worthless in the US. The subsidiary created a different IP amid the improvement procedure in the US, which include customer records and the extension of the business network. The UK parent organization repaid the US subsidiary for all the costs made by the subsidiary.
Who is the owner of the licensed medication in the US?
Both parties can be viewed as the economic proprietors of the patented medication in the US since they both satisfy the conditions under the practical and factual analysis:
- The UK parent organization is the lawful owner of the IP;
- The UK parent played out the most critical exercises identified with the IP, in particular, the R&D activities to build up the medication. These R&D activities are exceptionally hazardous and expensive, and consequently, the UK parent organization ought to -on a fundamental level- be qualified for the entire income attributable to the IP. However, the US subsidiary built up marketing activities to promote the IP separate from the medication.
- These different marketing activities on the IP are of fundamental significance for the advancement and improvement of the value of the patented medication in the US and in this way, these exercises prompt qualification to the pay stream attributable from the medication also;
Both the parent and subsidiary organization performed activities regarding the drugs. The manufacturing processes are in particular conducted by the UK parent organization, where the US subsidiary performs the marketing activities. The two organizations controlled there, and it appears that the US subsidiary had the exclusive right to utilize the drugs in the US;
- The asset used originated from both organizations;
- Both organizations bear the expenses and risk. The R&D risk and costs are incurred by the UK parent organization, and the advertising endeavors are taken by the US subsidiary, which surpasses the bright line test.
Further, a third party would never develop marketing activities of IP different from the patented drug if no benefits arising from this marketing IP shall receive.
In conclusion, both the parent and the affiliated company can be considered the owners of the IP in the US. An essential difference between the case of performing marketing activities towards trade IP or marketing IP is that only if the subsidiary develops own marketing IP’s. This must be separate from the trade IP, and these marketing IP’s are of foremost importance in the exploitation process of the trade IP, this subsidiary may be deemed as a “partial” economic owner of the trade IP. When the subsidiary merely performs marketing activities to enhance the existing valuable trade IP, the subsidiary must be considered a contractual manufacturer and therefore only be compensated by the UK parent company for the incurred functions, risks, and costs.
Approaches to Valuation of Intangible Asset
Under this section we shall focus on two key valuation approaches of intangible property.
The Market Approach
This approach regularly focuses on the fair market value of the subject of the valuation. It utilizes market transaction to deliver or substantiate qualities or costs in equivalent to non-market transactions. This is essentially what the act of transfer pricing is about: taxpayers are required to build up transfer costs for their related party in similar transaction. Under this approach, prices are not “ascertained” but rather observed, depending on the “invisible hand” in the market.
The key step in the process of valuation, in light of the market approach, is to establish legitimate similar transactions. Current advance markets do not normally create perfect comparables. So, the focal point of the market-based valuation is on finding the best accessible similar transactions to begin with, i.e. the proper market for comparable transaction should be recognized and characterized. At that point it is confirmed that the corresponding market has enough arm’s length transactions, among which practically identical exchanges could be recognized. Lastly, the information about these exchanges is gathered and the value of the similar transaction is then adjusted to reflect the contrasts between the similar transaction and the tested transaction under review. The points of interest of the similar transaction are investigated to decide the level of equivalence and areas where amendments ought to be made
The Cost Approach
This approach utilizes the input into the valued intangibles to develop their esteem appraisal. It is extraordinary and is mainly based on known fiscal qualities that are specifically identified with the evaluated asset. Information accessibility is a major quality of this approach, since we know the expenses of the valuated resource’s improvement, testing, generation, and so on. The major supposition behind this approach is the costs venture value. If the (anticipated) value exceed the costs significantly, then others would enter the market to compete for such unprecedented profits. On the chance the value does not surpass costs; a rational financial expert would not take part in such investment.
How much it will cost to repeat or supplant the tried resource is the fundamental questions asked in cost based valuation. Note that supplanting may mean supplanting with an advantage that is not indistinguishable to the valuated asset, but instead a benefit that will be “of proportional utility,” which may mean a less expensive resource than the one being tested. One variant of the cost approach thusly takes the historic expenses credited to the intangible asset and depreciate them over the useful life of the asset, to create current value. Different depreciation strategies might be used, which may or may not be adjusted for inflation.
Effect of Valuation on Transfer Pricing
To better comprehend this dynamic, we shall center around two key methodological contrasts between the income method used for financial reporting purposes and the income method utilized for transfer pricing purposes.
Post-Tax Analysis vs. Pre-Tax Analysis
Valuations executed for financial reporting reasons are prepared applying after-tax cash flows. Valuations done for transfer pricing purposes often use a post-tax discount rate to pre-tax operating income. This action is under the stipulated regulations, meant to furnish a shortcut that ensures both buyer and seller are willing to enter into the transaction in question after tax benefit and tax cost are taken into consideration. While the shortcut is necessary only under certain situation, its use by experts is fairly pervasive. The insertion of a tax amortization benefit in financial reporting may work to reduce the contrasting handling of tax under transfer pricing and financial reporting frameworks, but may not totally eliminate the distinction
The Premise of Value is Different
The premise of value is the arm’s length standard for transfer pricing. It may appear that both aim to capture the price that would be paid for an intangible property between parties that are unrelated and in their nature be identical concepts. Nevertheless, the main contrast between the two is that reasonable value looks to evaluate the value that an asset could be sold for, in an exit transaction with a buyer, while the arm’s length principle seems to assess the value that would be paid by a particular buyer to a specific and willing dealer. However, any valuation meant for financial reporting reasons always shut out buyer certain synergies from reasonable value of an intangible property, these synergies are added to the intangible asset price for transfer pricing purposes.
The authors are senior tax advisors and partners of Transfer Pricing Experts’ hub in Cyprus. To contact the authors, please visit www.transferpricing.com.cy or dial +30 210 7245724-5.