In 2016, the OECD released its final guidance on transfer pricing issues as they relate to the development, enhancement, maintenance, protection and exploitation of intangibles; including patents, trademarks and know how.
This new guidance material has been developed because most tax authorities and the OECD believe that the transfer pricing of intangibles has long been used as a mechanism for multinational groups to move profits (and therefore tax) from high tax jurisdictions to low/no tax jurisdictions. In its new guidance material, the OECD is seeking to establish a transfer pricing framework for intangibles that will ensure profits associated with the transfer or use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation.
What is transfer pricing?
From a taxation perspective, transfer pricing refers to the pricing of international dealings between associated enterprises or entities within a multinational group. As a result of the unique relationship between related parties, it is possible for one member of a multinational group to influence another member with respect to the pricing of goods, services and intellectual property. The result of this unique relationship is that the parties could agree to a price that is different to the price that would have been agreed between unrelated parties.
Transfer pricing requires international related parties to price transactions between themselves based on the ‘arm’s length principle’. This is the price that independent entities would have agreed in comparable circumstances, if they were acting to maximise their economic return from the transaction.
How do the new OECD Guidelines impact how multinationals price intangibles?
Many multinational groups employ a strategy whereby any intellectual property developed within the group is transferred into a ‘title holding’ entity or a centralised IP holding company, which is responsible to ensure the legal ownership of the IP is maintained in one centralised entity within the group. Under this structure, the legal owner of the IP charges royalties or licensing fees to other group members for the use of the IP. This is regardless of the fact that the legal owner of the IP may have had limited involvement in the development of the IP.
Under the new OECD Guidelines, where an entity within a multinational group is involved in the development of IP, and that IP is transferred or assigned to a centralised IP holding company, the economic rights associated with the IP do not automatically follow legal ownership. In accordance with the new OECD Guidelines, unless the centralised IP holding entity (the legal owner of the IP) has been economically responsible and exercised control over the development, enhancement, maintenance, protection and exploitation of the IP, the centralised IP holding entity is not the economic owner of the IP. This is despite the fact that it may be the legal owner.
In such circumstances, the OECD Guidelines sets out a scenario whereby the legal owner of the IP may have no rights to income associated with the exploitation of the IP (despite owning the IP), which is a significant divergence from how many multinational groups have currently structured their IP dealings.
How does the legal owner of IP guard against loss of rights to income?
According to Chapter VI of the OECD’s revised transfer pricing guidelines, if the legal owner of intangibles or intellectual property has an expectation to retain all profits derived from the exploitation of the intangible, the legal owner must:
- perform all functions;
- contribute all assets; and
- assume all risks
related to the:
- protection; and
- exploitation of the IP.
If the legal owner of the intangible is economically responsible for all functions, assets and risks with respect to the five above mentioned areas of the intangible lifecycle, the OECD Guidelines indicate the legal owner of the intangible is likely to have the right to expect full rights to any profits derived from the use of that intangible.
Glasshouse Advisory – Growing the power of potential | OECD changes to the transfer pricing of intangibles
What if another group member contributes to the value of the intangible?
According to the revised OECD Guidelines on intangibles, where a related party other than the legal owner of the intangible performs activities that could contribute to the value of the intangible, either:
- the legal owner of the intangible needs to fully compensate the related party, on an arm’s length basis, for the functions performed, assets contributes and risks assumed in order for the legal owner of the intangible to retain all rights to the profits associated with the exploitation of the intangible; or
- if the legal owner does not compensate the related party for its contribution to the value of the intangible, the related party who contributed that value (i.e. not the legal owner of the intangible) would have rights to some of the profits associated with the exploitation of the intangible. This is by virtue of the fact that, despite not being the legal owner of the intangible, the related party that has contributed to the value of the intangible has become an economic owner of the intangible, with rights to some of the profits generated from its use.
Can a legal owner outsource functions to a related party and still retain economic ownership of the intangible?
In the development, enhancement, maintenance, protection and exploitation of intangibles, it is very common for the legal owner of an intangible to outsource various functions to third parties. For example, many legal owners of intangibles seek to protect their assets via the use of a patent or trademark attorney. In dealings between independent parties, the provider of outsourced functions will operate under the direction or control of the legal owner of the intangible.
Where the legal owner of IP outsources the conduct of what the OECD terms ‘important functions’ to a related party, consideration must be given as to the contributions of those functions to the value of the resulting intangible. The OECD guidance material suggests that some important functions create so much value, they cannot be remunerated on a ‘cost plus’ basis. Instead, the OECD indicates that the payment for performance of ‘important functions’ should be via an appropriate share of the returns derived by the group from the exploitation of the intangible, which the OECD advocates should be calculated via the use of the profit split methodology.
The OECD provides guidance as to what it considers important functions, noting such functions related to, for example:
- 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 the strategic decisions regarding intangible development programs;
- management and control of budgets; and
- important decisions regarding defense and protection of intangibles.
Circumstances where the legal owner of an intangible is not entitled to any income
In the new guidelines on intangibles, the OECD makes the following comment (paragraph 6.57):
“where the legal owner (of an intangible) outsources most or all of such important functions to other group members, the entitlement of the legal owner to be attributed any material portion of the return derived from the exploitation of the intangible after compensating other group members for their functions is highly doubtful. In some circumstances it may also be determined that the outsourcing of such important functions would not have been undertaken by independent enterprises behaving in a commercially rational manner and that the actual structure adopted impedes the determination of an appropriate transfer price.”
It is clear that one of the objectives of the OECD Guidelines is to match returns generated via the use of intangibles with the functions/assets/risks (and therefore entities) involved in the development of the value within the intangible. In this regard, the OECD encourages multinational groups to look at the economic substance associated with the development, enhancement, maintenance, protection and exploitation of the intangible, rather than the legal structures/ownership associated with the intangible.
The OECD cautions against the use of structures that involve the location of a few key personnel in a low/no tax jurisdiction to evidence economic substance, noting that such structures are unlikely to be able to evidence the required decision making, control or assumption of risk to prove economic substance. Nor are they likely to have the development, enhancement, maintenance, protection and enhancement functions/assets/risks associated with the intangible to prove economic substance.
Specific examples of where the OECD Guidelines challenge the rights of the legal owner of an intangible to all profits derived from the use of the intangible are in the area of ‘risks’ adopted within the multinational group regarding the development, enhancement, maintenance, protection and exploitation of the intangible.
In order for a legal entity to assert all rights over the profits associated with the use of an intangible, the OECD notes it should be able to evidence it has assumed all the risks associated with the development, enhancement, maintenance, protection and exploitation associated with an intangible.
In assessing the arm’s length nature of such arrangements, the OECD Guidelines note that the legal owner of the intangible must have the financial capacity to assume the risks associated with the development, enhancement, maintenance, protection and exploitation of the intangible. The OECD Guidelines also identify four key forms of risk that need to be identified in any functional analysis, being:
- risks related to the development of intangibles, including the risk that costly research and developed marketing activities will prove to be unsuccessful;
- the risk of product obsolescence, including the possibility that technology advances of competitors will adversely affect the value of the intangible;
- infringement risk, including the risk that defence of intangible rights or defence of other persons’ claims of infringement may prove to be time consuming and costly and/or unavailing; and
- product liability and similar risks related to products and services based on the intangibles.
For the legal owner to assert claim to all profit associated with the use of an intangible, the OECD Guidelines note that the legal owner must also actually bear responsibility for the costs incurred, if the relevant risk materialises. At paragraph 6.65 of the revised guidelines, the OECD notes:
“where one part to a transaction is both contractually allocated risk and performs the functions controlling those risks, while the other party bears the costs that arise from the risks, then a transfer pricing adjustment may be necessary to reflect the actual sharing of risks and the appropriate attribution of relevant costs.”
This financial capacity to bear the risks extends to evidencing which entity, within a multinational group, bears the risk associated with unanticipated events where anticipated (ex ante) profitability varies from actual (ex post) profitability.
For example, if a breakthrough technology developed by a competitor renders products produced via the use of the intangible obsolete which entity within the multinational group bears the risk of such unanticipated events? Where the contractual allocation of such risk does not align with the conduct of the parties (i.e. the legal owner does not actually assume all ex post unanticipated risk), the OECD believes the arm’s length nature of the dealings should be called into question.
Do you need help navigating the new OECD Guidelines?
Australia’s new transfer pricing provisions now provide the Commissioner of Taxation with powers to disregard the form and type of any international related party dealings and replace the actual transaction with a transaction the Commissioner believes is in accordance with the ‘arm’s length principle’, a concept that is reinforced in the new OECD Guidelines. This could result in a significant variation between the tax jurisdiction in which profits (and expenses) are initially recognised and where revenue authorities assess where the profits and expenses should reside, which could result in either tax payable in a jurisdiction it was not intended to be paid or, at worse, double taxation.
This article first appeared on Glasshouse Advisory’s website on 5 June 2017