OECD Releases Discussion Draft on Transfer Pricing of Intangibles
19 July 2012
The OECD recently released a discussion draft on transfer pricing considerations for intangibles, including proposed revisions to Chapter VI of its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (“the OECD Guidelines”). The guidance was not originally expected until late 2013, but has been released earlier as an “interim” document to accelerate obtaining input from the business community.
OECD projects such as this now have greater significance for Australia than ever before, given the current process of reforming its transfer pricing rules, which includes legislating a requirement to interpret those rules consistently with the OECD Guidelines.
The discussion draft reflects some major changes to the current Chapter VI. The highlights are:
- “Intangibles” are defined for transfer pricing purposes more broadly than under traditional legal or accounting definitions
- A tax administration can use the transfer pricing rules to disregard a multinational company’s legal arrangements in respect of its intangibles and allocate their profits to group members who functionally control the intangible-related activity
- Qualified endorsement of using valuation techniques, and in particular discounted cash flow approaches, where currently recognised arm’s length pricing methods cannot reliably be used.
Below we discuss some key sections of the draft.
1. Identifying intangibles
The OECD rejects traditional legal, accounting, tax, and treaty definitions of intellectual property or intangible assets in defining what constitutes an intangible for transfer pricing purposes. Instead, it adopts a broad, two-pronged definition of intangibles: (1) it includes items that are not physical or financial assets; and, (2) items that are capable of being owned or controlled for use in commercial activities.
The draft provides some illustrations of items that would be considered intangibles under its definition, including patents, know-how and trade secrets, trademarks and trade names, licences, and similar rights in intangibles.
The draft states that goodwill and going concern value are intangibles. However, it rather unhelpfully refutes the need to precisely define them for transfer pricing purposes, while nevertheless observing that accounting and business valuation measures of them are not relevant for purposes of transfer pricing analysis. The draft’s cursory discussion of goodwill is at odds with it being, in our experience, one of the biggest practical issues in relation to identification and valuation of intangibles.
The draft is unclear on whether an assembled workforce (so-called “workforce in place”) is an intangible, apparently because there is currently no consensus OECD view on this.
The draft states that group synergies and market-specific characteristics (e.g. location savings) are not intangibles, but may need to be taken into account for transfer pricing purposes as factors in a comparability analysis.
Importantly, the OECD position is clearly that if there is something of value that would be expected to be taken into account in compensating dealings between independent parties, then it must be taken into account in a transfer pricing analysis, whether it is defined as an “intangible” or not.
2. Identification of parties entitled to intangible-related returns
In addressing the issue of which members of a multinational group are entitled to its intangible-related returns, the OECD’s views are based on two general propositions:
- The intangible related returns should follow the contributions made to the value of the intangible and
- Funding or bearing the costs of intangible-related activity does not of itself give entitlement to intangible-related returns.
The draft states that legal registrations and contractual arrangements (for example, transfers and licences) are the starting point for determining entitlement to intangible-related returns. However, the multinational group member(s) legally entitled to those returns must also be “economically entitled” by performing or controlling the important functions related to development, enhancement, maintenance and protection of the intangible and bearing and controlling the associated risks. The OECD indicates that for product-related intangibles, R&D functions are important, whilset for trademarks and brand names, marketing functions are important.
The draft prescribes a “control” test where an entity hires a related or unrelated party to perform such functions. This essentially requires operational control over the intangible-creating activity, so that the entity must have the necessary functional (i.e. decision-making) capability if it is to be treated as being entitled to the returns from the relevant intangible.
If a strict control standard is adopted, assessing who actually controlled the individual decisions and documenting the decision-making is likely to increase taxpayers’ compliance burden, and to lead to increased controversy.
We also find it concerning that funding intangible-related activity (or contractually being responsible for it) does not of itself entitle the funder to any intangible returns. There are numerous real-life examples in which individuals and companies agree to make equity investments in intangible-creating activity conducted by unrelated parties, though the funder may have very limited control over the actual conduct of the intangible-creating activity. The draft indicates that the party seeking to claim intangible-related returns should exercise a degree of oversight (i.e. demonstrate requisite control) over any outsourced intangible-creating activities.
3. Determining Arm’s Length Pricing for Intangibles
Importantly, the draft recognises that the application of any of the five arm’s length pricing methods currently recognised in the OECD Guidelines is likely to be problematic in practice for intangibles. This is because the five recognised methods generally rely on comparability analysis, using data for comparable uncontrolled transactions. For intangibles, that data is likely to be unavailable, largely because of the relative uniqueness of most intangibles, and the fact that a multinational company rarely transfers or licences its intangibles outside the group.
Of the five recognised arm’s length pricing methods, the draft endorses the comparable uncontrolled price (CUP) method and the transactional profit split method as likely to be the most appropriate in practice for intangibles. However, the draft emphasises the importance of conducting a reliable comparability analysis in applying a CUP method, and the difficulty in doing so using publicly available data drawn from commercial databases. The OECD indicates that where the specific features or circumstances of an intangible cannot reliably be taken into account in a comparability analysis, then a method other than the CUP method may be more reliable.
Where reliable data as to comparable uncontrolled transactions is not available, the draft gives qualified endorsement to using valuation techniques, in particular discounted cash flow, to price intangibles transfers. This is a significant change to the current Chapter VI. However, the draft emphasises the potential reliability issues in using such techniques, particularly focusing on the validity of the assumptions underlying the valuation model and the accuracy of any projections made.
As regards other methods, the draft: generally “discourages” the use of cost-based methods to value intangibles; cautions that valuations of intangibles contained in purchase price allocations for accounting purposes “are not relevant for transfer pricing purposes”; and, interestingly, makes no mention of the transactional net margin method (TNMM).
This OECD project is in many ways a follow-up to its recently completed project on business restructuring that resulted in Chapter IX of the OECD Guidelines. It is apparent from the draft document that some similar concerns underlie the two projects. The transfer of ownership of a multinational company’s valuable intangibles to a shell company in a tax-advantaged location was a major focus of the work and ultimate guidance on business restructuring, and it is apparent that giving tax administrations the ammunition to deal with this scenario by applying transfer pricing rules remains a key objective of this current project.
However, the OECD’s work should not simply be about defending the revenue base of OECD countries from the tax planning of some multinational companies. In practice, tax administrations are increasingly adopting aggressive positions based upon identifying “intangibles” created and owned in their jurisdiction as a means of justifying the allocation of significant taxable profits to it. This could lead to serious potential double taxation problems that the draft is likely to do little to alleviate.
In several areas, the discussion draft is likely to increase compliance costs, controversy, and uncertainty regarding the allocation of intangible returns of multinational enterprises. It is important that the business community take this opportunity to influence OECD thinking. Written comments on the draft are due by September 14, 2012. Deloitte will be making a submission and we would welcome the opportunity to receive any comments you may have or to discuss any aspect of the discussion draft with you.