Valuation Of Intangibles In The World Of BEPS
Flick Gocke Schaumburg
Flick Gocke Schaumburg
1. The Role of Intangibles in Transfer Pricing and the BEPS-Project of the OECD
Intangibles play a significant and dual role in the determination of arm’s length transfer prices for cross-border transactions between related parties. On the one hand, the ownership of intangibles is one of the key determinants for the distribution of the total profit of the multinational group. If a related party owns intangibles that significantly contribute to the value creation of the group, this entity is generally entitled to receive (part of) the residual profits of the group, i.e. the remaining profits after compensating all routine activities. Otherwise, if a company does not hold any right in any intangibles, it would in general only be entitled to a low routine return for the functions performed and risks assumed. The ownership in an intangible is thus a crucial element when setting up an arm’s length transfer pricing system. This connection between ownership in intangibles and the entitlement to the residual profits of the group, however, has led to transfer pricing systems where a great share of the group’s total profit is allocated to a group company in a low-tax country which does not perform any functions except that it holds the legal ownership in the intangible.
On the other hand, the cross-border intercompany sale or licensing of an intangible itself has to be in line with the arm’s length principle. For both sales and licensing transactions, the arm’s length transfer price is determined through one of the transfer pricing methods as outlined in the OECD-Guidelines and in many national transfer pricing regulations. These methods are based on comparable transactions between unrelated parties. In certain cases, however, no comparable transactions can be found in order to determine an arm’s length transfer price. This is particularly the case for unique intangibles. As a consequence, the general transfer pricing methods cannot always reliably be applied to determine arm’s length transfer prices for intangibles. In addition, the application of a cost-based transfer pricing method for the valuation of intangibles, which does not necessarily lead to arm’s length results, has sometimes been used to transfer an intangible for less than the full value to a related party.
These two issues relating to the intercompany transfer and use of intangibles—the role of intangibles in the overall transfer pricing system and the valuation of the intangibles in case of an intercompany transaction— can thus create profit shifting opportunities for multinational companies, leading to low or non-taxation of the respective profits. The OECD has therefore elaborated an Action Plan on Base Erosion and Profit Shifting (“BEPS Action Plan”), published in July 2013, in order to address these issues as well as other areas leading to profit shifting and base erosion of multinationals. The BEPS Action Plan identifies transfer pricing and intangibles as one of the key pressure items in the BEPS-project. In actions 8, 9 and 10 of the 15-actions plan, the OECD therefore aims at aligning transfer pricing outcomes with value creation, especially with respect to intangibles and other mobile assets. Since the beginning of the BEPS-project, the OECD has published several discussion drafts relating to transfer pricing aspects of intangibles. The Guidance on Transfer Pricing Aspects of Intangibles of 2014 already contains the final outcomes for the large part of the changes to the OECD-Guidelines with respect to intangibles, with some further changes still to come. By September 2015, all drafts should be finalized and incorporated into the OECD-Guidelines.
2. Definition of Intangibles by the OECD
The current version of the OECD-Guidelines of 2010 includes a chapter on transfer pricing issues of IP.1 According to the OECD, the term “intangible property” should include rights to use industrial assets such as patents, trademarks, trade names, designs or models as well as literary and artistic property rights, and intellectual property such as know-how and trade secrets.2 The focus on IP, however, was considered too narrow by the OECD to capture all types of transfer of economic value between related parties. One of the objectives of the BEPS-project is therefore to adopt a broad and clearly delineated definition of intangibles. The new Guidance on Transfer Pricing Aspects of Intangibles, as one of the deliverables of the BEPS project, now refers to the term “intangibles,” instead of IP, which is 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.”3
The existence of legal, contractual, or other forms of protection is not considered a necessary condition for an item to be characterized as an intangible for transfer pricing purposes, neither is separate transferability.4 Examples for intangibles are patents, know-how and trade secrets, trademarks, trade names and brands, rights under contracts and government licenses, as well as licenses and similar rights in intangibles. Group synergies and market-specific characteristics are not considered intangibles for transfer pricing purposes. Whether goodwill and ongoing concern value should be treated as intangible is not clearly stated in the new guidelines and should depend on the specific case. Accounting and business valuation measures of goodwill and ongoing concern value, however, do not correspond to the arm’s length price in case of a transfer, according to the OECD.
This new definition of an intangible by the OECD should ensure that all types of transactions that convey economic value from one associated company to another is taken into account for transfer pricing purposes. The problem with this definition is that it abstracts from accounting rules and regulations on intangibles and that it leads to increasing uncertainty whether a business transaction involved the transfer of an intangible which should be compensated.
3. Ownership in Intangibles and Value Creation
When performing a transfer pricing analysis, the ownership in significant, value-creating intangibles is a key aspect to be considered. The associated company owning these intangibles is generally entitled to (a share of) the residual profits. For transfer pricing purposes, ownership does not depend on any legal definition or concept. In fact, legal rights and contractual arrangements only form the starting point for any transfer pricing analysis of transactions involving intangibles and serve as a reference point for identifying and analyzing the transactions.5 Legal ownership of intangibles, by itself, does not confer any right ultimately to retain returns of the group from exploiting the intangible, even though such returns may initially accrue to the legal owner of the intangible.6
What matters for transfer pricing purposes is the notion of economic ownership. A company is only entitled to receive the return from the exploitation of an intangible if it is the economic owner of this intangible. Economic ownership, as applied for transfer pricing purposes, depends upon the functions performed, risks assumed, and assets used by the group companies. Based on the new guidance of the OECD on intangibles, the identification of the group entity that performs functions relating to the development, enhancement, maintenance, protection, and exploitation of the intangible and that assumes the corresponding risks is therefore a key aspect for the determination of arm’s length transfer prices.7
According to the new guidelines of the OECD developed for the BEPS-project, the pure funding of an intangible is, just like legal ownership, not considered relevant for transfer pricing purposes anymore.8 As a consequence, an associated company that is the legal owner of the group’s intangibles and also funded the development of these intangibles should not be entitled to receive the residual return from the exploitation of these intangibles if it does not perform the relevant functions and assumes significant risks with respect to the intangibles. In such a case, the company should only receive a return on its capital invested. Based on the allocation of the returns resulting from the exploitation of an intangible according to the functions and risks of the group companies, the OECD wants to make sure that transfer pricing outcomes are in line with value creation. This mainly aims at companies located in tax havens (e.g. Cayman Islands, British Virgin Islands) that do not perform any significant functions and do not contribute to the value creation of the group.
4. Valuation Techniques
In order to determine the arm’s length transfer price in transactions between associated companies, the following five transfer pricing methods can be applied:
- The comparable uncontrolled price method,
- The resale price method,
- The cost plus method,
- The transactional net margin method, and
- The profit split method.
The comparable uncontrolled price method compares the price charged for goods or services transferred between related parties to the price charged for goods or services transferred in a comparable transaction between unrelated parties in comparable circumstances.
The resale price method begins with the price at which a product that has been purchased from an associated enterprise is resold to an independent company. This price is then reduced by an arm’s length gross margin on this price.
The cost plus method begins with the costs incurred by the supplier of goods or services for the goods transferred or the services provided to an associated purchaser. An arm’s length cost plus mark-up is then added to this cost.
The transactional net margin method compares the net profit relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from a transaction with a related party to the net profit of an unrelated party in a comparable transaction.
The profit split method divides the combined profits of the associated companies in an intercompany transaction on an economically valid basis that reflects the division of profits between independent parties in comparable circumstances.
In the case of transactions involving intangibles, the OECD recommends to apply either the comparable uncontrolled price method or the profit split method.9 The application of one of the remaining three methods is discouraged as they would not lead to arm’s length prices for intangibles. Since all transfer pricing methods are based on a comparison with transactions between unrelated parties, the OECD now also allows to use valuation techniques to determine the arm’s length transfer price if comparable transactions cannot be identified. In particular, the application of income based valuation techniques, especially valuation techniques premised on the calculation of the discounted value of projected future income streams or cash flows derived from the exploitation of the intangible being valued, are considered as appropriate methods.10 These valuation techniques should be applied in a manner that is consistent with the arm’s length principle. Valuations performed for accounting purposes that do not necessarily reflect the arm’s length principle should therefore only be utilized with caution and under careful consideration of the underlying assumptions. This is particularly the case with purchase price allocations performed for accounting purposes.11 However, inconsistencies in the assumptions made in a valuation of an intangible undertaken for transfer pricing purposes and valuations undertaken for other purposes should be explained to the tax authorities.12
When applying valuation techniques for transfer pricing purposes based on the discounted value of projected cash flows, the calculation should generally be made from the perspectives of both parties of the transaction.13 This should ensure that synergies, location specific advantages, and other cost savings and advantages are taken into account when determining the arm’s length remuneration. The arm’s length price will then fall somewhere within the range of present values evaluated from the perspectives of the transferor of the intangible and the transferee.
Even though the valuation should in principle be based on general valuation standards, taking into account the arm’s length principle, the OECD has identified several specific areas of concern that should be taken into account when performing the valuation.
- accuracy of financial projections,
- assumptions regarding growth rates,
- discount rates,
- the useful life of intangibles and terminal value, and
- assumptions regarding taxes.
With respect to the accuracy of financial projections, the OECD considers projections prepared for nontax business planning purposes more reliable than projections prepared exclusively for tax or transfer pricing purposes.14 When determining the projected growth rate, it is expected that industry and company experience with similar products is taken into account, instead of readily accepting linear growth rates which are not further justified.15 The selection of an appropriate discount rate should be based on the specific circumstances of the case, as there is no single measure for a discount rate that is appropriate for transfer pricing purposes in all instances. Thus, the Weighted Average Cost of Capital approach should not automatically be used to determine the discount rate for the valuation of an intangible.16 Similarly, the projected useful life should be determined on the basis of all of the relevant facts and circumstances of the specific case, e.g. the nature and duration of legal protection, the rate of technological change in the industry, and other factors affecting competition in the relevant economic environment.17 Finally, the tax effects that should be taken into consideration include (i) taxes projected to be imposed on future cash flows, (ii) tax amortization benefits projected to be available to the transferee, if any, and (iii) taxes projected to be imposed on the transferor as a result of the transfer, if any.18
The guidelines on these issues make clear that— despite the recognition that the transfer pricing methods often cannot be applied and valuation techniques have to be used to determine arm’s length transfer prices—the OECD’s main concern when using valuation techniques is the asymmetric information between multinationals and tax authorities. This asymmetric information could lead to a (presumed) undervaluation of an intangible and hence profit shifting opportunities. Specific care should therefore be taken to provide sufficient explanation regarding the determination of the specific assumptions of the valuation, especially if these assumptions deviate from those used for the valuation of the intangible for other purposes.
The objective of the OECD to provide guidelines that prevent any potential profit shifting to low tax countries is also apparent in the current discussion regarding so-called hard-to-value intangibles. In case the financial outcomes deviate from the forecasted figures that were used for the valuation of these intangibles, the OECD is currently considering using the ex post results to perform price adjustments under specific circumstances. The focus of the OECD is thus to hamper profit shifting instead of providing clear, consistent, and transparent guidance on the valuation of intangibles that would not lead to potential double taxation.
With the new guidance of the OECD on intangibles being incorporated into the OECD-Guidelines, the determination of arm’s length transfer prices for intangibles will more and more frequently be based on valuation techniques. Although the valuation of an intangible for other purposes should not directly be applied for transfer pricing purposes without a closer review of the underlying assumptions, the new guidelines will lead to a closer connection between accounting and transfer pricing valuations of intangibles.
- OECD-Guidelines, Chapter VI: Special Considerations for Intangible Property.
- OECD-Guidelines, note 6.2.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.6.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.8.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.35 and 6.43; OECD-Guidelines, note 9.11.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.42.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.50.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.59.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.142.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.150.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.152.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.158.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.154.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.161.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.166.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.168.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.172.
- Guidance on Transfer Pricing Aspects of Intangibles, note 6.175.