BEPS Action Plan 8: Transfer pricing of intangibles

IN THIS INSTALLMENT of our series on the Base Erosion and Profit Shifting (BEPS) initiatives of the Organization for Economic Co-operation and Development (OECD), we will tackle Action Plan 8 on the revisions to Chapters I, II and VI of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2010) (the “2010 OECD TP Guidelines”), which addressed a number of transfer pricing issues on intangibles, namely:

• Adopting a broad and clearly delineated definition of intangibles;

• Ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation;

• Developing transfer pricing rules or special measures for transfers of hard to value intangibles; and

• Updating the guidance on cost contribution arrangements.

However, the OECD has not yet completely finalized the revisions in Action Plan 8. Some parts of the report are considered interim drafts of guidance that will be finalized this year.

Amendment to Chapter I of the 2010 OECD TP Guidelines discusses the arm’s length principle and how this principle is applied. The 2010 OECD TP Guidelines provide that the application of the arm’s length principle is essentially based on comparing transactions between independent enterprises (uncontrolled transactions) and transactions between related parties (controlled transactions). In amending Chapter 1 of the 2010 OECD TP Guidelines, the OECD discussed additional factors which could affect the comparison between uncontrolled transactions and controlled transactions. These factors are location savings and other local market features, assembled workforce and multinational enterprise (MNE) group synergies.

Location savings refer to the cost savings attributable to operating in a particular location. Other local market features include relevant geographic characteristics, purchasing power and product preferences, size of the market, competition, and the like. Assembled workforce refers to a group of uniquely qualified or experienced employees of an enterprise. Lastly, MNE group synergies refer to the unique interaction among companies belonging to a group which may not be present in similarly situated independent companies. When these factors are present in controlled transactions, it is necessary to identify uncontrolled transactions where these factors are present as well in order for the transactions to be considered as comparable. If no comparables can be found, comparability adjustments may be made for the comparison to be useful.

AMENDMENTS TO CHAPTER II
For Chapter II, the paragraph on the use of “other methods” as the most appropriate transfer pricing method is to be revisited and will be finalized in 2015. The changes will consider the application of valuation techniques as one of the “other methods” to determine the arm’s length price or income. In addition, a new paragraph was added to emphasize that the rule of thumb cannot be used to apply the arm’s length principle.

AMENDMENTS TO CHAPTER VI
Chapter VI of the 2010 OECD TP Guidelines was deleted in its entirety and was replaced by the amendments introduced in the report. Some of the key points in the revised Chapter VI are:

Prior to the amendment, the term “intangible property” was defined as including rights to use industrial assets such as patents, trademarks, trade names, designs or models. It also includes literary and artistic property rights and intellectual property such as know-how and trade secrets.

As amended, the term is now simply “intangible” which is now defined as something which is not a physical asset or a financial asset, which is 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 in comparable circumstances. It also emphasizes that an intangible for accounting or tax purposes may not necessarily be considered as an intangible for transfer pricing purposes.

OECD also held that it is important to identify the relevant intangibles with specificity in conducting transfer pricing analysis involving intangibles. The analysis should specifically identify the relevant intangibles at issue, the manner in which these intangibles contribute to the creation of value in the controlled transactions under review and the manner in which these intangibles interact with other intangibles, with tangibles and with business operations to create value.

The Guidelines also refer to “unique and valuable intangibles,” which are intangibles that are not comparable to the intangibles used by, or available to, parties to potentially comparable transactions, and whose use in business operations is expected to yield greater future economic benefits than would be expected in the absence of the intangible.

Items considered as intangibles on a case-to-case basis, taking into consideration the specific legal and regulatory environments that prevail in each country include: patents, know-how and trade secrets; trademarks, trade names and brands; rights under contracts and government licenses, licenses and similar limited rights in intangibles; goodwill and ongoing concern value; group synergies and market specific characteristics.

DEVELOPMENT, ENHANCEMENT, MAINTENANCE, PROTECTION AND EXPLOITATION OF INTANGIBLES
This section of the report has not yet been finalized and serves as interim guidance. The significant items in this section are (1) determining the owner of the intangible and (2) determining the parties responsible for developing, enhancing, maintaining, protecting and exploiting intangibles.

Determining these parties is relevant in identifying the proper allocation of profits and costs for transactions involving intangibles which comply with the arm’s length principle. Functions performed, assets used and risks borne by the different parties related to intangibles should be taken into consideration. The owner of an intangible is not necessarily entitled to a substantial share of the returns on the intangibles if its function is limited to the ownership of the intangible. A party which significantly contributes to developing, enhancing, maintaining, protecting and exploiting intangibles — even if not the owner of the intangible — is expected to earn a significant portion of the returns considering the function and risks undertaken by such party.

With respect to compensation, the Guidelines provide that the compensation that must be paid to the member of the MNE group that contributes to developing, maintaining, protecting and exploiting intangibles, even if not the owner of the intangible, is generally determined on an ex ante basis or anticipated remuneration which refers to the future income expected to be earned at the time of the transaction.

Next week, we will continue the discussion on BEPS Action Plan 8, specifically the identification of transactions involving intangibles, together with other supplemental guidelines.

Deonah L. Marco-Go is a Tax Senior Director of SGV & Co.