Volume 5, Issue 12

20th June, 2012

Tax Alert
OECD Discussion Draft on revised guidelines on transfer pricing of Intangibles

In January 2011, the OECD Committee on Fiscal Affairs approved a new project to focus on revising the transfer pricing guidelines in respect of intangibles. The project is intended to develop revised guidance on issues specific to transfer pricing of intangibles. In the same context, on 6 June 2012 OECD released the ‘Discussion Draft – Revision of the Special Considerations for Intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions’ (the “Discussion Draft”). Following are the key takeaways from the Discussion Draft.

Identification / Definition of intangibles

The Discussion Draft states that the intangibles that are required to be recognized for transfer pricing purposes might not always be considered for accounting or tax or legal purposes. Instead, the Discussion Draft suggests a definition which focuses on what independent parties would have agreed. Also, while the legally enforceable rights such as patents and trademarks are covered in the above definition, legal enforceability or separate transferability is not the focus of OCED’s definition of intangibles for transfer pricing purposes. No attempts have been made to distinguish between trade vs. marketing, soft vs. hard or routine vs. non-routine intangibles. The Discussion Draft notes that group synergies and market specific characteristics are not to be considered as intangibles as they are not owned or controlled by a single enterprise However, these factors should be considered for comparability purposes. Similarly, in most instances, accounting and business valuation measures of goodwill and going concern value are not relevant for transfer pricing purposes, although underlying drivers should be taken into comparability and transfer pricing analysis.

Entitlement to intangible related returns

Legal registrations and contractual arrangements continue to be considered as the starting point for entitlement of intangible related returns. However, it also lays importance on examining whether the conduct of the parties is in alignment with the legal terms. In the case the conduct of the parties is not aligned with the terms of the registrations and contracts, reallocation of returns may be appropriate. The reallocation of returns should be based on functions, risks and costs that relate to the development, enhancement, maintenance and protection of the intangibles. Exercising ‘control’ over the functions and risks is an important concept in this regard. For the guidance on ‘control’ reference has been made to Chapter IX (Business Restructurings). The Discussion Draft remarks that just undertaking costs does not in itself create entitlement to intangible related returns. Regarding marketing activities undertaken by enterprises that do not own the trademarks or the trade names, their compensation analysis should entail comparability of their functions, risks and costs to those of the independent parties.

Transactions involving the use or transfer of intangibles

The Discussion Draft describes two categories of transactions that involve intangibles. In the first category there is no transfer of intangibles or of the rights, rather intangibles are used by one or both parties to a controlled transaction in connection with sales of goods or services. The second type of transaction encompasses transfer of rights in intangibles in controlled transactions. Such a transfer could be that of all the rights (e.g. sale of the intangible) or of limited rights (e.g. license, with underlying restrictions). In a case where the intangibles are transferred in combination, it is important that all the intangibles in the transaction are identified, and also that the nature of legal and economic interactions between the intangibles is recognized.

Determining arm’s length price and conditions

Large part of the draft guidance has been devoted to pricing issues. Some of the interesting points are:

Factors for comparability analysis

Reference is made to Chapter III (Comparability Analysis) regarding the principles and the recommended process for the comparability analysis. Further, the Discussion Draft provides certain features of intangibles that may prove important in a comparability analysis. Such features include among others, exclusivity of the rights in the intangibles, the extent and duration of the legal protection, geographic scope, useful life of the intangibles and the expectation of future benefit.

Two aided approach

Discussion Draft recommends that pricing analysis should be two-sided and consider the realistic alternatives of both parties. In this context, Options Realistically Available (“ORA”) analysis has been emphasized in the Discussion Draft with reference made to Chapter IX (Business Restructurings) for additional guidance on the concept. In performing the ORA analysis, the perspectives of each of the parties to the transaction must be considered rather than just conducting a one sided analysis. For example, a licensor or transferor of intangible would not accept a price less than it could realize by exploiting the intangible itself; and the licensee would not pay a price that leaves it less profitable.

Valuation methods

The Discussion Draft cautions against adopting a transfer pricing methodology that readily assumes that all residual profit from transactions after routine functional returns should necessarily be allocated to the party entitled to intangible related returns. Rather, the transfer pricing method should reflect all factors contributing to creation of value and not merely reflect intangibles and routine functions. Caution also needs to be exercised in accepting valuations performed for accounting purposes as reflecting arm’s length prices without thorough examination of the underlying assumptions. In particular, valuations of intangibles contained in purchase price allocations performed for accounting purposes are not relevant for transfer pricing purposes. Valuation techniques based on cost of intangible development should usually be avoided since there is little reason to believe that there is any correlation between the cost of developing intangibles and their value or transfer price.

The Discussion Draft contains a good discussion on the valuation approaches based on discounted cash flow analysis. The Discussion Draft cautions against the volatility of such techniques, and observes that the reliability of such models is highly dependent on the reliability of the underlying assumptions and estimates. Further, certain concerns have been identified regarding the underlying assumptions. The accuracy of the financial projections is important and depends on the source and purpose of the projections, length of time and the track record of the financial performance. Another key element is the projected growth rate, and care should be taken that revenue and expense growth patterns of the industry and the company are analyzed. Discount rate is another critical factor. The quantum of risk and the volatility of the expected cash flows should be evaluated in determining the appropriate discount rate.

The useful life of intangibles depends on the nature and duration of legal protections and the rate of technological change in the industry. The Discussion Draft recognizes that in most cases intangibles assets have finite lives. Importantly, while some intangibles may have indeterminate useful life does not imply that non-routine returns are attributable to them indefinitely. It has been observed that the discounted cash flow valuations are done on a post-tax basis, whereas for transfer pricing purposes, the discounted cash flow analysis should be on a pre-tax basis. Thus appropriate adjustments need to be made for consistency purposes. Moreover, it is important to take into account the tax situations of both the parties to the transaction for adjustment purposes.

SKP’s Comments

The increasing frequency and complexity of intangible related transactions have put a strain on the traditional principles of transfer pricing. As intangibles play a growing role in the global and local supply chains, the OECD project on intangibles and the guidelines contained in the Discussion Draft are a welcome step. Whether it’s the identification of intangibles or the entitlement to intangible related returns or the discounted cash flow analysis, the subject matter would guide taxpayers and tax administrations alike in dealing with the transfer pricing aspects of intangibles. Since this is a complex area and considering the litigation and lack of guidance on this aspect, it may be useful if additional guidance on valuation techniques, manner of applying profit split method more specific to intangibles, making comparability adjustments etc could be included in the guidance. One would have to wait and watch till a final guidance is issues probably sometime in 2013 after the public consultation meeting later this year.