BOMBAY CHARTERED...Page 8 TP Implications of Intangibles Presenter : Sanjay Kapadia The Intangibles...

Presenter : Sanjay KapadiaTP Implications of IntangiblesPage 1 Presenter : Sanjay KapadiaPage 1

BOMBAY CHARTERED

ACCOUNTANTS’ SOCIETY

5TH INTENSIVE STUDY COURSE ON

TRANSFER PRICING

TP implications of IntangiblesApril 11, 2015

Sanjay L. Kapadia


Contents

► Background

► Overview of the OECD Intangibles Discussion/Guidance

► Potential impact of the Intangible Discussion/Guidance and BEPS #

► Case studies from the Intangibles Discussion/Guidance

► Recent Developments

#BEPS means Basis Erosion and Profit Shifting

“Intangible Discussion” herein refers to the Guidance On Transfer Pricing Aspects of Intangibles – Action 8 – 2014

Deliverable, unless otherwise stated


Background


Introduction - Transfer Pricing and IP

► The transfer pricing issue is highly publicized

► Tax reassessments can reach astronomical amounts:

► Transfer Pricing reassessments exceeded $ 3 billion in India

► In France, newspapers have claimed that Google incurred a

reassessment of over € 1 billion (not contested by Google)

► Another example: Microsoft Corp. recorded $ 9.1 billion of tax

provisions on its balance sheet

Transfer

of goods

or

services

Financial

transaction

s

Intangible

related

transaction

s

Transfer

duties

Indirect

taxPermanent

establishment

Tax

residence

For the last 3 years For the next 2 years

The main sources of litigation in Transfer Pricing

(Source : EY, 2013 Global Transfer Pricing Survey)


Intangibles – A complex Transfer Pricing Issue

► Intangibles raise complex transfer pricing issues because

► They account for a high proportion of the value/profits of MNEs in

many industries

► They are hard to price - a multi-period perspective is usually necessary

and there are rarely reliable comparables

► Current global controversy trends

► Increased transfer pricing audit activity including substance reviews

(requests for underlying documentation and interviews) and system-

wide profit analyses

► Increased focus on permanent establishment

► Increased sharing of information and best practices among tax authorities

► More coordinated approaches to cross-border issues

► Establish processes to generate country-by-country income and tax

data


Indian Context – Revised law after 2012 budget

► Increased applicability of Indian Transfer Pricing Regulations by inclusion of

following intangibles explicitly in definition of international transactions

► Various judicial pronouncements in India pertaining to marketing, human

capital and supply chain intangibles, giving rise to uncertainty

Intangible Property

Marketing related

Technology related

Artistic related

Data processing Engineering related

Customer related

Contract related Human capital Location related Goodwill related

Methods, prog., survey etc Derives value from intellectual content


Overview of the Intangibles Discussion/Guidance


The Intangibles initiative and BEPS

The OECD has been working to develop revised guidance on

transfer pricing of intangibles since 2010 but this has assumed

greater importance and impetus as a result of the BEPS initiative

Intangibles Initiative

June 2012 – initial draft issued

November 2012 – public consultation

30 July 2013 – revised draft

1 October 2013 – final date for comments

November 2013 – further consultation

meeting

September 2014 – Guidance issued

BEPS

Transfer of intangibles to low tax

countries seen as a source of BEPS and

the Action Plan (item 8) provides

for:

i. Broad definition of intangibles

ii. Profits from intangibles to be allocated

in line with value creation

iii. Development of valuation rules

iv. Updated guidance on cost

contribution agreements (CCAs)


The Intangibles Discussion/Guidance

A. Identifying intangibles

B. Ownership of intangibles

C. Transactions involving use or transfer of intangibles

D. Pricing of intangibles transactions

► The guidance is supported by 33 examples

► The Intangibles Discussion/Guidance also includes proposed

changes to Chapters I – III of the OECD Transfer Pricing Guidelines

on local market, location savings, assembled workforce, and group

synergies

The guidance is closely aligned with the commitment in the BEPS

Action Plan….

…..and the TP documentation paper released in September 2014 calls

for transparency so that authorities can assess risk for transfers of IP to

related parties


Identifying Intangibles – Difficulties in defining

intangibles

► No internationally accepted definition of intangibles, however, concept

covered by Revised Chapter VI of OECD Guidelines

► As per Revised Chapter VI of OECD Guidelines, revised definition of

Intangible is – “The term “intangible” is intended to address 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”

► A few key statements in the Revised Chapter VI in relation to the

identification of Intangibles:

► Intangible for TP purpose may not be recognized for accounting purposes

► Transferability as a separate intangible is not a necessary condition

► Accounting treatment ≠ TP treatment

► Purchase Price Allocation are not determinative for TP


Introduction - Transfer Pricing and IP

► For transfer pricing purpose, a company that performs functions, using assets and

bears the risk of developing an intangible should be entitled to a corresponding

profit, even if the company is not legally the owner of the intangible. It is possible to

finance development of IP (e.g. via CCA) and be the economic owner of the IP

► However, the allocation of intangible related returns is now moving towards an

analysis based on the performance and the effective control of key functions

(DEMP), as a barrier to discourage assets centralization in financial companies

without economic substance

Intangible

Develop

Protect Enhance

Maintain


Changing perceptions of entitlement to

profit from intangibles

1980’s 2014 1990’s

Owner

Legal Owner Legal Owner

Economic OwnerInvestor

Controller/Functional Contributor

Developer DeveloperRoutine Developer

Developer/Functional Contributor

User UserPure User

Value Contributor

Non-routine (residual claimant)

Routine


Transfer of intangibles

► Although being neither appropriated nor transferable separately, certain

elements should lead to an arm’s length compensation since they must be

considered in the comparability analysis:

► Group synergies

► Local market features

► Locations savings

► Quality and experience of human capital

► The realistic available options to the related parties must be taken into

account in the valuation of transactions

The OECD proposes a general framework for transactions analysis:

► Transactions between independent parties must be taken into account.

► Active and passive financial contributions must be taken into account

► The allocation of intangible related returns should not be made solely on

the basis of the legal framework as intended by related parties


Identifying Intangibles – Difficulties in defining

intangibles

► Revised Chapter VI proclaims that the usual OECD transfer pricing methods

are still operative, with stated preference for CUP (arguable) and profit split

► Revised Chapter VI greatly risks increasing compliance burden:

► External CUP method appears to be almost impossible to apply: any tax

inspector can always find comparability differences, but tax courts do

tend to consider external CUPs (where available)

► Profit splits risk to become the norm

► Options Realistically Available (ORA) analyses could lead to multiple

valuations for one single transaction

► Important to educate management on the difference between accounting

and tax: Purchase price allocation will not be automatically accepted

► Substance will be key for robustness of any structure (think about CBCR

and automatic exchange of information)

► Hindsight may become the norm for IP valuation issues (potential inclusion

of “commensurate with income” rule in Revised Chapter VI)


Potential impact of the Intangible

Discussion/Guidance and BEPS


What questions should you be thinking about?

► Can you demonstrate that key value drivers are controlled by the

Principal and its IP licensor?

► Do you have entities performing high-value functions being

remunerated as service providers to IP owners?

► Does your definition of intangibles extend beyond legal or

accounting definitions?

► Do you plan the transfer of any (further) intangibles?

► Does your structure leverage a low cost base in new/ emerging

markets?

► Do you derive key benefits from an operating structure that relies on

group synergies – e.g. centralized purchasing?

► Do you plan the transfer or secondment of individuals between

jurisdictions in conjunction with a new operating model/ IP strategy?

► Do you have inter-company transactions where one or both parties

uses intangibles in connection with the sale of goods or provision of

services?


Can you demonstrate that key value drivers are

controlled by the Principal and its IP licensor?

► As their collective title suggests

(“Assure that Transfer Pricing

Outcomes are in Line with Value

Creation”), a unifying theme

underpinning BEPS Actions 8,9 &10

is a likely increase in “substance

requirements”

► The concept of “functional

alignment” is reiterated in the

revised Guidelines on intangibles.

These establish criteria to be used

to test whether legal ownership of

an intangible should be accepted to

allocate (part of) the residual

profit.

Alignment between functional and legal

ownership requires bearing cost and risk

and fulfilment of important functions by

the contractual owner including:

• Performs and controls the important

functions related to the Development,

Enhancement, Maintenance and

Protection (DEMP) of the intangibles;

• Controls other functions outsourced

to independent enterprises or

associated enterprises and

compensates those functions on an

arm’s length basis;

• Provides assets necessary to DEMP of

the intangibles; and

• Bears and controls the risks and costs

related to DEMP of the intangibles.


Does your definition of intangibles extend beyond

legal or accounting definitions?

► BEPS Action 8 includes: “Develop

rules to prevent BEPS by moving

intangibles among group members”

► Adopting a broad, clear

definition of intangibles

► Ensuring that profits associated

with the transfer and use of

intangibles are appropriately

allocated in line with value

creation

► Developing rules for transfers of

hard-to-value intangibles

► Updating guidance on cost

contribution arrangements

In the Intangibles Guidance, legal and

accounting definitions of intangibles are

rejected in favor of one focusing on what

unrelated parties would have agreed:

• Legal enforceability or separate

transferability is not the focus.

• Accounting concepts such as goodwill

and going concern value are not

relevant for transfer pricing purposes

(although they are included in the

OECD definition of intangibles).

• Group synergies and market

characteristics such as low labor costs

should be taken into account when

pricing

• Assembled workforce may provide a

benefit and may affect the price.


Does your operating structure benefit from:

- local market features, location savings, group synergies,

assembled workforce?

► These comparability factors should be taken into account

► They are not by themselves intangible assets

► In certain situations, they can involve intangible assets, as discussed in the

Intangibles Discussion/Guidance

► Examples

► Regulatory license required to operate in a specific market may

constitute an intangible

► Transfer or secondment of employees may result in the transfer of

valuable know-how

► Group synergies

• Focus on how these would be shared at arm’s length

• Group synergy benefits simply from being part of the MNE should

not be shared with other group members (credit enhancement due

to parent’s balance sheet)

• Where MNE takes active steps to activate synergy (central

purchasing organization), benefits and charges should be shared

according to contribution


Case studies from the Intangibles

Discussion/Guidance


Impact of functions, assets and risks on Intangible

returns - Example: Who performs & control

functions; and assumes risksFacts

► Co.A, a pharmaceutical company hires third

party CROs to perform R&D activities

► Co.A controls and manages the CRO activities

(e.g., actively participates in designing the

studies, establishes budgets and timelines and

conducts quality control) and pays the CRO a

negotiated fee for services

► Co.A transfers Product M intangibles to Co. S.

► Co.S agrees to fund all of the ongoing Product

M research, assume the financial risk of

potential failure of such research, and to pay

for Co.A’s services a fee comparable to that

which the CROs receive

Third Party Contract

Research Organizations

(“CROs”)

Co. A

Co. SCountry Y

R&D

activities

Transfer

patents and

related

intangibles

with

respect to

Product M

in

exchange

for arm’s

length

payment

Research

program

related to

Product M

(status quo

from before

the transfer of

intangibles) in

exchange for

cost plus fee

1

2

3Country X

No technical personnel capable of

designing, conducting or

supervising ongoing research

activities related to Product M


Impact of functions, assets and risks on Intangible

returns - Example: Who performs & control

functions; and assumes risks

Intangibles Discussion/Guidance Conclusion

► Co.S is the legal owner of Product M intangibles. However, Co.A continues to perform

and control functions and to manage risks related to the intangibles owned by Co.S,

including the important functions that may have a material effect on intangible value

(e.g., design and control of research and marketing program, management and control

of budgets, control over strategic decisions regarding intangible development program,

important decisions regarding defense and protection of intangibles, and ongoing

quality control over functions performed by third parties)

► Therefore, Co.S should not be entitled to all of the returns attributable to the

intangibles

► In determining appropriate compensation of Co.A, Co.A’s relationship with the CROs

may not be used as a benchmark (Co.S’s activity vis-a-vis Co.A does not reach the

level of Co.A’s activity vis-a-vis the CROs)


Marketing and Distribution: Examples – 9-11

Examples (Intangibles Discussion/Guidance

conclusions)

In Ex. 9, Co. S purchases watches with the R

trademark and trade name from Primair

(manufacturer and owner of the R name), takes

title to, and distributes, the watches in Country Y

and acts as a marketing agent, to execute

Primair’s marketing plan under Primair’s

direction

The compensation to Co. S from reselling the

watches and service fee for marketing activities is

at arm’s length. Primair retains all other income

Primair

Co. S

Third party

customers

Sale

5 yr royalty-

free,

exclusive

marketing

and

distribution

with option

to renew

Country X

Country Y

Country Y


Marketing and Distribution: Examples – 9-11

In Ex. 10, Co. S develops and executes the marketing plan at its own

expense and without extensive design and budget review by Primair

• As a result of the greater risk to Co. S, the price of watches is lowered and Co.

S earns greater profit

• Since Co. S performs functions and bears risks under a long-term contract of

exclusive distribution rights, it has the opportunity to benefit (or suffer a loss)

from the activities it undertakes. Therefore, no additional compensation is due,

assuming third party comparables support the level of functions and expenses

incurred, and the return is at arm’s length

In Ex. 11, Co. S undertakes/ incurs increased functions/ expenses but

realizes profits significantly lower than those of potential comparables.

Therefore, its margins on resale of R watches need to be supplemented

A transfer pricing adjustment is appropriate in the form of higher distribution

profits (i.e., decrease of product price of watches); a share of profits based on

relative contributions; or direct compensation for the excess market expenditure,

including a profit element


Recent Developments

Presenter : Sanjay KapadiaTP Implications of IntangiblesPage 26

TP Audit Proceedings:

► During the TP Audit proceedings for FY 2006-07, the TPO

proposed to make an adjustment, contesting that LG India

incurred excessive/ non routine AMP expenses

► Reliance placed by TPO on the “bright-line test” as laid

out by the US Tax Court in the case of DHL Inc and

Subsidiaries

► TPO alleged that LG India incurred higher AMP expenses

when compared to the comparable uncontrolled

companies and disallowed the excess of the average AMP

expenses incurred

► Further, TPO alleged that these expenses enhanced the

value of trademark/marketing intangibles

► In the order, the TPO held that the excess AMP expenses

ought to have been reimbursed by the AE under arm’s

length conditions

DRP:

► Aggrieved by TPO’s order, LG India appealed before the

DRP

► DRP upheld the TPO’s order and also held that LG India

should be receiving a mark up on the expenditure

incurred and suggested a mark up of 13% on the

adjustment made by the TPO

LG Korea (LGK)

Customers

- Engaged in the business of

manufacture, sale and

distribution of electronic

products and appliances

India

Outside India

-Licensee of LG

trademark/ brand name.

-Enjoys the right to use

marketing intangibles

on royalty free basisManufacture, sale and

distribution of LGK

products

LG India

Transactions:

► Manufacture, sale and distribution of LGK

products in India.

Wholly owned

subsidiary of LGK

M/s LG Electronics India Private Ltd vs ACIT

Payment for supply

goods


M/s LG Electronics India Private Ltd vs ACIT

► A Special Bench (SB) was constituted to look into the matter

► Issues before the SB:

► whether a transfer pricing adjustment in relation to the AMP expenses

incurred by the Taxpayer was justified; and

► whether the Taxpayer should have earned a mark up from the AE with respect

to the AMP expenses alleged to have been incurred for the benefit of the AE

► Majority decision largely upholds the positions of the TPO


Recent Delhi High Court Ruling on Intangibles (M/s Sony

Ericsson Mobile Communications India Pvt. Ltd vs CIT)

Issues considered

Favourable

to the

Assessee

Adverse

to the

Assessee

AMP is an international transaction 4

Bundling of transactions is permitted for

benchmarking purpose and hence it is

improper to treat AMP expenses as a separate

transaction from the distribution transaction

4

AMP expenses may be included or subsumed

in the low purchase price or lower/no charge

of royalty

4

AMP expenses are not to be segregated from

the main transaction while applying TNMM

without providing an appropriate set-off of the

composite profits earned

4


Recent Delhi High Court Ruling on Intangibles (M/s Sony

Ericsson Mobile Communications India Pvt. Ltd vs CIT)

Issues considered

Favourable

to the

Assessee

Adverse to

the Assessee

Rejected the use of Bright Line Test4

Brand value depends on many factors

including quality of the product. Thus,

incurring AMP expenses not always

equivalent brand building. Expenses like

trade discounts, volume discounts, etc are

not in the nature of brand promotion

4

Prime Lending Rate (PLR) cannot be used to

determine the ALP mark up on the AMP

expenses

4

Gross profit margin could remunerate an AE

for performing marketing and selling function4


Contact Details

Sanjay Kapadia

Ph No: 022 61920880 /+91 9892400222

E-mail: [email protected]

All the views expressed during the presentation are personal opinions of the presenter

and the presenter is not liable for any consequences arising out of reliance on the same


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