The decision in the recent Oilwell case may cause multi-national enterprises (“MNE”) to again consider moving their Intellectual Property (“IP”) offshore.  

As IP generally represents between 40% - 80% of „value-add‟ of MNEs, it is attractive for MNEs to reduce their global effective tax rates by locating IP in a low tax or tax advantaged jurisdiction. This created a race amongst some low-tax jurisdictions with regard to tax rates and substance thresholds in a bid to attract investments and tax revenue. However, the OECD and many tax authorities are now taking significant steps to address this opportunistic behaviour.  

As many of these favourable jurisdictions have put substance requirements in place and have adopted exchange of information rules, in light of transfer pricing risk management, MNEs should carefully consider the following before moving its IP offshore:

  • The key tax issues such as tax residency and Controlled Foreign Corporation (“CFC”) rules (substance requirements in general terms); and
  • The Organisation for Economic Co-operation and Development (“OECD”) transfer pricing principles for assessing the substance thresholds.

Key tax issues

Tax authorities will generally focus firstly on the effective place of management of the IP company. If the facts and circumstances are at odds with the legal set-up, anti-abuse legislation provides for a substance over form approach. In the Laerstate BV court case the UK Tribunal said that "Where a company is managed by its directors in board meetings it will normally be where the board meetings are held. If the management is carried out outside board meetings one needs to ask who is managing the company by making high level decisions and where, even where this is contrary to the company's constitution." The borderline is between directors making the decisions and not making any decision at all.

Another set of anti-abuse rules can be found in CFC laws introduced by major industrial countries whose legislation has outlined the conceptual framework for the imputation of passive income components earned by a CFC into the hands of its shareholder. CFC is generally defined as a company, which is a resident of one country, while being controlled for 50% or more by a company which is a resident of another country. A CFC is generally subject to a lower level of taxation and some exemptions from imputations may exist.

Typically, in order to legitimately transfer IP to a particular jurisdiction certain substance rules, defined by IP hosting locations, must be satisfied in order to demonstrate that the entity is acting as a profit centre as well as an investment centre. An investment centre only would be entitled to a royalty in relation to the IP, whereas a profit centre may be entitled to other residual profit relating to managing open (trade) positions as a matchmaker. Such requirements generally include:

  • Payroll requirements;
  • Minimum capital requirements;
  • Minimum revenue thresholds;
  • Minimum amount of investments/spending;
  • Reporting requirements; and
  • Requirements in relation to activities/number of activities.

OECD reference to substance

The starting point in assessing substance is that the intercompany agreement between the parties is the leading indicator.

Control over risk

In determining an IP holding location it is critical that the entity deemed to be the owner of the IP is also considered to be in control of the management of the IP and that it has the financial capacity to bear the risk of decisions associated with investing in IP. Without these critical elements being established, tax authorities will raise questions over the commercial substance of the arrangement.

It is not necessary that these functions are, in all cases, actually performed by the employees or directors, as long as they are able to assess the performance of the outsourced function on a day-to-day basis. Failure to demonstrate this, may lead to a tax administration challenging the arm‟s length nature of such a risk allocation.  

A related aspect is whether the risk bearer has the financial capacity to bear the risk in question.  

On another note, demonstrating genuine substance in an IP company located in a favourable tax jurisdiction will in most jurisdictions also be a key test for determining „beneficial ownership‟.

Significant People Functions (SPFs)

The concept of SPFs was introduced by the OECD in respect of the attribution of profits between head offices and branches. The premise is that the assets and risks in a value chain are allocated to the person/location performing the activities associated with the management of those assets and decision making on the related risks. It provides a framework for attributing assets and risks between a single legal entity, i.e. head office and branch, but the principle also has broader application in providing a threshold test for measuring substance within a group, that may not necessarily be consistent with legal reality.

Consideration should be given to the premise that the risk allocation between related parties should, as much as possible, correspond to the risk allocation between head office and branch. SPF are the functions which are connected to the active decision making in relation to the assumption and daily management of risks with regards to the activities of the corporation. These are the „day-to-day‟ activities which have decisive influence on the management of the corporation.

In arm‟s length transactions it generally makes sense for parties to be allocated a greater share of those risks over which they have relatively more control. The concept of „control‟ is a very important factor for the risk allocation as generally constituted between unrelated parties.

It should, however, be noted that the activities of parties which exercise control could have a slightly different character than the activities of parties performing the SPF, as the former may be more remote from the „day-to-day‟ activities. Whilst acknowledging that these two concepts may cause a different interpretation in their application, it should be realised that there is a considerable overlap in the application of both concepts and that they are comparable.

Substance requirements

Certain popular IP holding locations have introduced the following substance requirements:

  • Luxembourg - Various requirements to benefit from IP tax regime, including that the IP must have been created or acquired after 31 December 2007.
  • Singapore - Strict requirement for incentives regarding business spending, employment and IP valuation.
  • Madeira - At least one employee/director on payroll and if it employs less than 6 employees, investment of at least EUR 75,000 in Madeira.
  • Switzerland - Some treaty abuse rules in place and an exemption applies if the company employs at least one qualified foreign employee in activities beyond the mere passive administration of the company‟s assets.


Tax authorities have introduced various ways to counteract opportunistic behaviour of IP companies, e.g. by the introduction of strict substance requirements and/or CFC legislation.

Tax authorities, through the publication of the „control over risk‟ and the „significant people function‟ concepts, are now allowed to take a more economic view on „substance requirements‟ rather than purely looking at the relevant intercompany legal agreements. A more economic „risk/reward‟ balance is being introduced, i.e. no functions/no risk attributable to the IP companies can seriously undermine the positioning of „intangibles‟ in the statutory/tax books of IP companies.  

An active management role and responsibility at the level of the IP companies cannot be left out when creating a sustainable and tax defendable set up of IP companies.  

Certain preferred locations for IP companies are putting in place local „substance‟ requirements as required by the OECD and other countries with less favourable tax rates.  

IP companies may require a minimum level of „substance‟ to anchor their IP ownership and corresponding royalty flows in that country. The interpretation of „substance‟ has been moving from a pure „legal interpretation‟ to a more „substance over form‟ interpretation.  

To achieve all of this may be costly and MNE‟s need to undertake a proper cost-benefit analysis before it merely decides to move its IP offshore.