In transfer pricing analysis, the determination of the entity or entities within a multinational enterprise that are entitled to share in the returns derived by the group from exploiting intangibles is crucial. A related issue is which entity or entities within the group should bear the costs, investments and other burdens associated with the development, enhancement, maintenance, protection and exploitation of intangibles. The Organization for Economic Cooperation and Development has addressed this topic as part of its 2017 Transfer Pricing Guidelines, and that guidance is the subject of this post. Although the legal owner of an intangible may initially receive the proceeds from exploitation of the intangible, other members of the legal owner's group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible. Members of the group performing such functions, using such assets and assuming such risks must be compensated for their contributions under the arm's length principle.
Legal rights and contractual arrangements form the starting point for any transfer pricing analysis of transactions involving intangibles. The terms of a transaction may be found in written contracts, public records such as patent or trademark registrations, or in other communications between the parties. In identifying the legal owner of intangibles, an intangible and any license relating to that intangible are considered to be different intangibles for transfer pricing purposes, each having a different owner. While determining legal ownership and contractual arrangements is an important first step in the analysis, these determinations are separate from the question of remuneration under the arm's length principle. For transfer pricing purposes, legal ownership of intangibles, by itself, does not necessarily confer any right ultimately to retain returns derived by the group from exploiting the intangible. Identification of legal ownership, combined with the identification and compensation of relevant functions performed, assets used, and risks assumed by all contributing members, provides the analytical framework for identifying arm's length prices and other conditions for transactions involving intangibles.
The arm's length principle requires that all members of the group receive appropriate compensation for any functions they perform, assets they use, and risks they assume in connection with the development, enhancement, maintenance, protection and exploitation of intangibles. An important question is how to determine the appropriate arm's length remuneration to members of a group for their functions, assets and risks within the framework established by the taxpayer's contractual arrangements, the legal ownership of intangibles, and the conduct of the parties. The determination of arm's length compensation for functional contributions should consider the availability of comparable uncontrolled transactions, the importance of the functions performed to the creation of the intangible value, and the realistically available options of the parties. In assessing whether the compensation provided in the controlled transaction is consistent with the arm's length principle, reference should be made to the level and nature of activity of comparable uncontrolled entities performing similar functions, the compensation received by comparable uncontrolled entities and the anticipated creation of intangible value by comparable uncontrolled entities.
Background. In transfer pricing analysis, the determination of the entity or entities within a multinational enterprise (“MNE”) group that are entitled to share in the returns derived by the group from exploiting intangibles is crucial. A related issue is which entity or entities within the group should bear the costs, investments and other burdens associated with the development, enhancement, maintenance, protection and exploitation (“DEMPE”) of intangibles. The Organization for Economic Cooperation and Development (“OECD”) has addressed this topic as part of its 2017 Transfer Pricing Guidelines, and that guidance is the subject of this post. Although the legal owner of an intangible may receive the proceeds from exploitation of the intangible, other members of the legal owner's MNE group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible. Members of the MNE group performing such functions, using such assets and assuming such risks must be compensated for their contributions under the arm's length principle.
According to the OECD, the framework for analyzing transactions involving intangibles between associated enterprises requires taking the following steps: (1) identify the intangibles used or transferred in the transaction and the economically significant risks associated with the development, enhancement, maintenance, protection and exploitation of the intangibles; (2) identify the contractual arrangements, with emphasis on determining legal ownership of intangibles based on the terms and conditions of legal arrangements and other inidicia of legal ownership, and the contractual rights and obligations, including contractual assumption of risks in the relations between the associated enterprises; (3) identify the parties performing functions, using assets, and managing risks related to developing, enhancing, maintaining, protecting and exploiting the intangibles by means of functional analysis, and in particular which parties control any outsourced functions and control economically significant risks; (4) confirm the consistency between the terms of the relevant contractual arrangements and the conduct of the parties, and determine whether the party assuming economically significant risks controls the risks and has the financial capacity to assume the risks relating to the development, enhancement, maintenance, protection, and exploitation of the intangibles; (5) delineate the actual controlled transactions related to the development, enhancement, maintenance, protection, and exploitation of intangibles in light of the legal ownership of the intangibles, other contractual relations under contracts, and the conduct of the parties, including their contributions of functions, assets, and risks; and (6) where possible, determine arm's length prices for these transactions consistent with each party's contributions of functions performed, assets used, and risks assumed.
Intangible ownership and contractual terms. Legal rights and contractual arrangements form the starting point for any transfer pricing analysis of transactions involving intangibles. The terms of a transaction may be found in written contracts, public records such as patent or trademark registrations, or in other communications between the parties. Contracts may describe which entities provide funding, undertake research and development, maintain and protect intangibles, and perform functions necessary to exploit the intangibles, such as manufacturing, marketing and distribution. They may describe how receipts and expenses of the MNE associated with the intangibles are to be allocated and may specify the form and amount of payment to all members of the group for their contributions. According to the OECD, the prices and other conditions contained in such contracts may or may not be consistent with the arm's length principle. Where no written terms exist, or where the facts, including the conduct of the parties, differ from the written terms of any agreement, the actual transaction must be deduced from the facts as established, including the conduct of the parties. It is therefore good practice for associated enterprises to document their decisions and intentions regarding the allocation of significant rights in intangibles. Documentation of such decisions and intentions, including written agreements, should generally be in place at or before the time that associated enterprises enter into transactions leading to the development, enhancement, maintenance, protection or exploitation of intangibles.
The legal owner will be considered to be the owner of the intangible for transfer pricing purposes. In identifying the legal owner of intangibles, an intangible and any license relating to that intangible are considered to be different intangibles for transfer pricing purposes, each having a different owner. According to the OECD, while determining legal ownership and contractual arrangements is an important first step in the analysis, these determinations are separate from the question of remuneration under the arm's length principle. For transfer pricing purposes, legal ownership of intangibles, by itself, does not confer any right ultimately to retain returns derived by the MNE group from exploiting the intangible, even though such returns may initially accrue to the legal owner as a result of its legal or contractual right to exploit the intangible. The return ultimately retained by or attributed to the legal owner depends upon the functions it performs, the assets it uses, and the risks it assumes, and upon the contributions made by other MNE group members through their functions performed, assets used and risks assumed. Identification of legal ownership, combined with the identification and compensation of relevant functions performed, assets used, and risks assumed by all contributing members provides the analytical framework for identifying arm's length prices and other conditions for transactions involving intangibles.
Because the actual outcomes and manner in which risks associated with the development or acquisition of an intangible will play out over time and are not known with certainty at the time members of the MNE group make decisions regarding intangibles, it is important to distinguish between anticipated (or ex ante) remuneration, which refers to the future income expected to be derived by a member of the MNE group at the time of a transaction, and actual (or ex post) remuneration, which refers to the income actually earned by a member of the group through the exploitation of the intangible. The terms of the compensation that must be paid to members of the MNE group that contribute to the development, enhancement, maintenance, protection and exploitation of intangibles is generally determined on an ex ante basis. The form of such compensation may be fixed or contingent. The actual (ex post) profit or loss of the business after compensating other members of the MNE group may differ from the anticipated profits depending on how the risks associated with the intangible or other relevant risks related to the transaction actually play out.
Functions, assets and risks related to intangibles. An important question is how to determine the appropriate arm's length remuneration to members of a group for their functions, assets and risks within the framework established by the taxpayer's contractual arrangements, the legal ownership of intangibles, and the conduct of the parties. In identifying arm's length prices for transactions among associated enterprises, the contributions of members of the group related to the creation of intangible value should be considered and appropriately rewarded. The arm's length principle requires that all members of the group receive appropriate compensation for any functions they perform, assets they use, and risks they assume in connection with the development, enhancement, maintenance, protection and exploitation of intangibles. It is therefore necessary to determine, by means of a functional analysis, which members perform and exercise control over DEMPE functions, which members provide funding and other assets, and which members assume the various risks associated with the intangible. The relative importance of contributions to the creation of intangible value by members of the group in the form of functions performed, assets used and risks assumed will vary depending on the circumstances.
Performance and control of functions. Each member of the MNE group should receive arm's length compensation for the functions it performs. In cases involving intangibles, this includes functions related to the development, enhancement, maintenance, protection and exploitation of intangibles. The identity of the member or members of the group performing DEMPE functions, therefore, is one of the key considerations in determining arm's length conditions for controlled transactions. If the legal owner of intangibles is to be entitled ultimately to retain all of the returns derived from exploitation of the intangibles, it must perform all of the functions, contribute all assets used and assume all risks related to the development, enhancement maintenance, protection and exploitation of the intangible. According to the OECD, it is not essential that the legal owner physically performs all functions related to the development, enhancement, maintenance, protection and exploitation of an intangible through its own personnel in order to be entitled ultimately to retain or be attributed a portion of the return derived by the MNE group from exploitation of the intangibles. A member of an MNE group that is the legal owner of intangibles could outsource functions related to the development, enhancement, maintenance, protection or exploitation of intangibles to either independent enterprises or associated enterprises. Where associated enterprises other than the legal owner perform relevant functions that are anticipated to contribute to the value of the intangibles, they should be compensated on an arm's length basis for the functions they perform.
The determination of arm's length compensation for functional contributions should consider the availability of comparable uncontrolled transactions, the importance of the functions performed to the creation of the intangible value, and the realistically available options of the parties. According to the OECD, it may be the case that outsourced functions performed by associated enterprises will be controlled by an entity other than the legal owner of the intangibles. In such cases, the legal owner of the intangible should also compensate the entity performing control functions related to the development, enhancement, maintenance, protection and exploitation of intangibles on an arm's length basis. According to the OECD, if the legal owner neither controls nor performs the DEMPE functions, the legal owner would not be entitled to any ongoing benefit attributable to the outsourced functions. The relative value of contributions to development, enhancement, maintenance, protection, and exploitation of intangibles varies depending on the particular facts.
According to the OECD, in considering the arm's length compensation for functional contributions of various members of the MNE group, certain important functions will have special significance. For self-developed intangibles, or for self-developed or acquired intangibles that serve as a platform for further development activities, these more important functions may include, among others, design and control of research and marketing programs, and management and control of budgets. For any intangible, whether self-developed or acquired, other important functions may also include decisions regarding defense and protection of intangibles, and ongoing quality control over functions performed by independent or associated enterprises that may have a material effect on the value of the intangible. According to the OECD, because it may be difficult to find comparable transactions involving the outsourcing of important functions, it may be necessary to utilize transfer pricing methods not directly based on comparables, including transactional profit split methods and ex ante valuation techniques to appropriately reward the performance of those important functions. Again according to the OECD, the reliability of a one-sided transfer pricing method will be substantially reduced if the party or parties performing significant portions of the important functions are treated as the tested party or parties.
Use of assets. Group members that use assets in the development, enhancement, maintenance, protection and exploitation of an intangible should receive appropriate compensation for doing so. Such assets may include intangibles used in research, development or marketing (such as know-how and customer relationships) physical assets or funding. One member of an MNE group may fund some or all of the DEMPE functions related to an intangible, while one or more other members perform all of the relevant functions. According to the OECD, when assessing the appropriate anticipated return to funding in such circumstances, it should be recognized that in arm's length transactions, a party that provides funding, but does not control the risks or perform other functions associated with the funded activity or asset, generally does not receive anticipated returns equivalent to those received by an otherwise similarly situated entity that also performs and controls important functions and controls important risks associated with the funded activity. Funding and risk taking are integrally related in the sense that funding often coincides with the taking of certain risks, such as the risk of loss of the funding party's funds. According to the OECD, where a party providing funding exercises control over the financial risk associated with the provision of funding, without the assumption of, or control over, any other specific risk, it could generally only expect a risk-adjusted return on its funding. Again according to the OECD, exercising control over a specific financial risk requires the capability to make the relevant decisions related to the provision of the funding, and the actual performance of the decision making functions. For example, decisions may have to be made on whether to take the project to the next stage or to allow the investment in costly assets.
Assumption of risks. Particular types of risks that may be important in a functional analysis include (i) risks related to development of intangibles, including the risk that costly research and development or marketing activities will prove to be unsuccessful; (ii) the risk of product obsolescence; (iii) infringement risk; (iv) product liability risks related to the intangibles; and (v) exploitation risks, including the uncertainties related to the returns to be generated by the intangible. The identity of the member or members of the group assuming risks related to the development, enhancement, maintenance, protection and exploitation of the intangibles is an important consideration in determining prices for controlled transactions. According to the OECD, it is especially important to ensure that the group members asserting entitlement to returns from assuming risk actually bear responsibility for the actions that need to be taken and the costs that may be incurred if the relevant risk materializes.
Actual, ex-post returns. It is quite common that actual (ex post) profitability is different than anticipated (ex ante) profitability. This may result from risks materializing in a different way to what was anticipated through the occurrence of unforeseen developments. The question arises in such circumstances whether and, if so, how the profits or losses should be shared among members of an MNE group that have contributed to the development, enhancement, maintenance, protection and exploitation of the intangible in question. Resolution of this question requires a careful analysis of which entity or entities in the MNE group in fact assumes the economically significant risks. According to the OECD, the party actually assuming the economically significant risks may or may not be the associated enterprise contractually assuming these risks, such as the legal owner of the intangible, or may or may not be the funder of the investment.
Some implications. If the legal owner of an intangible in substance (i) performs and controls all of the functions; (ii) provides all assets, including funding; and (iii) assumes all of the risks related to the development, enhancement, maintenance, protection and exploitation of the intangible, then it will be entitled to all of the anticipated, ex ante, returns derived from the MNE group's exploitation of the intangible. To the extent that one or more members of the MNE group other than the legal owner performs functions, uses assets, or assumes risks related to the development, enhancement, maintenance, protection and exploitation of the intangible, such associated enterprises must be compensated on an arm's length basis for their contributions. The entitlement of any member of the MNE group to profit or loss relating to differences between actual (ex post) and a proper estimation of anticipated (ex ante) profitability will depend on which entity or entities in the MNE group assumes the risks identified when delineating the actual transaction.
Determining prices for controlled transactions. In general, the transactions identified by the MNE group in the relevant registrations and contracts are those whose prices and other conditions are to be determined under the arm's length principle. According to the OECD, however, the analysis may reveal that transactions in addition to, or different from, the transactions described in the registrations and contracts actually occurred. The transactions to be analyzed are those determined to have occurred consistent with the actual conduct of the parties and other relevant facts. In assessing whether the compensation provided in the controlled transaction is consistent with the arm's length principle, reference should be made to the level and nature of activity of comparable uncontrolled entities performing similar functions, the compensation received by comparable uncontrolled entities and the anticipated creation of intangible value by comparable uncontrolled entities.
Development and enhancement of marketing intangibles. A common situation where these principles must be applied arises when an enterprise associated with the legal owner of trademarks performs marketing or sales functions that benefit the legal owner of the trademark, for example through a marketing or distribution arrangement. In such cases, it is important to determine how the marketer or distributor should be compensated for its activities. One important issue is whether the marketer or distributor should be compensated only for providing promotion and distribution services, or should also be compensated for enhancing the value of the trademark and other marketing intangibles. The analysis of this issue requires an assessment of several factors: (i) the obligations and rights implied by the legal registrations and agreements between the parties; (ii) the functions performed, assets used, and risks assumed by the parties; (iii) the intangible value anticipated to be created through the activities of the marketer or distributor; and (iv) the compensation provided for the functions performed by the marketer or distributor. According to the OECD, one relatively clear case is where a distributor acts merely as an agent, being reimbursed for its promotional expenditures and being directed and controlled in its activities by the owner of the trademarks and other marketing intangibles. In that case, the distributor ordinarily would be entitled to compensation appropriate to its agency functions alone. When the distributor actually bears the cost of its marketing activities, the analysis should focus on the extent to which the distributor is able to share in the potential benefits deriving from its functions performed, assets used and risks assumed currently or in the future.
Research, development and process improvement arrangements. Appropriate compensation for research and development services performed by a member of an MNE group under a contractual arrangement with an associated enterprise that is the legal owner of any resulting intangibles will depend on all the facts and circumstances, such as whether the research team possesses unique skills and experience relevant to the research, assumes risks, uses its own intangibles or is controlled and managed by another party. According to the OECD, compensation based upon a reimbursement of costs plus a modest mark-up will not reflect the anticipated value of, the arm's length prices for, or the contribution of the research team in all cases. These principles similarly apply in situations where a member of an MNE group provides manufacturing services that may lead to process or product improvements on behalf of an associated enterprise that will assume legal ownership of the product or process improvements.
Payments for use of company name. Questions often arise regarding the arm's length compensation for the use of group names, trade names, and similar intangibles. According to the OECD, generally no payment should be recognized for transfer pricing purposes for the use of group names merely to reflect the fact of group membership. Where one member of the group is the owner of a trademark or other intangible for the group name, and where use of the name provides a financial benefit to members of the group other than the member legally owning such intangible, it is reasonable to conclude that a payment for use would have been made in arm's length transactions. In determining the amount of payment with respect to a group name, it is important to consider the amount of the financial benefit to the user of that name, the costs and benefits associated with other alternatives, and the relative contributions to the value of the name made by the legal owner and the entity using the name in the form of functions performed, assets used and risks assumed. According to the OECD, careful consideration should be given to the functions performed, assets used and risks assumed by the user of the name in creating or enhancing the value of the name in its jurisdiction.
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