Transfer Pricing in a Post -BEPS World · 2018-02-17 · Transfer Pricing in a Post BEPS...

Transfer Pricing in a Post -BEPS World

Intangibles Perspective

Ajit Kumar Jain

Transfer Pricing in a Post BEPS World-Intangibles Perspective | Ajit Kumar Jain

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About the Author

Ajit is a Chartered Accountant and Company Secretary. He has done his graduation from Jai

Narayan Vyas University, Jodhpur. He is also awarded certificates in International Taxation and

Transfer Pricing by the Chartered Institute of Taxation, UK.

Contact Details

Address: 101 Sai Mahal CHS, Nadiyaadwala Colony

Road No.2, S.V. Road, Malad (West)

Mumbai -400064

Phone : Mobile: +91 9619758917

Email [email protected]

Disclaimer: The views expressed in this document are not intended to be used as professional

advice and also, represent only the personal views of the author.

mailto:[email protected]


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Table of Contents

List of abbreviations ……………………………………………………………………. 4

1. Introduction………………………………………………………………………….5

2. OECD’s Pre-BEPS Guidance……………………………………………………….7

3. New Guidance on intangibles………………………………………………………9

4. Indian Perspective……………………………………………………………. ……25

5. Alternative to the Arm’s Length Principle………………………………………. 27

6. Case Study…………………………………………………………………………..29

7. Conclusion………………………………………………………………………… 31


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List of abbreviations

AE Associated Enterprise

ALP Arm’s Length Price

APA Advance Pricing Agreement

BEPS Base Erosion and Profit Shifting

CRO Contract Research Organization

CUP Comparable Uncontrolled Price

DEMPE Development Enhancement, Maintenance,

Protection and Exploitation

EU European Union

FAR Functions Assets and Risk

MNE Multinational Enterprise

TNMM Transactional Net Margin Method

OECD Organization of Economic Corporation and Development

PSM Profit Split Method

R&D Research & Development

RPM Resale Price Method


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1. Introduction

In the past two decades, with the development of information technologies and efficient

communication system, the countries across the globe became interdependent. As a consequence,

the multinational enterprises established integrated supply chain models. This has led to increase

in the cross-border transactions between affiliate entities located in different jurisdictions. Such

transactions give opportunity to the multinational enterprises to shift profits from one jurisdiction

to another jurisdiction, since profit shifting may be favorable for the entity located in the high tax

jurisdiction. Such profit shifting can be achieved by manipulating transfer prices on ‘intra-group

transactions’, strategically concentrating intangible assets (and associated income) in low-tax

countries, concentrating internal & external debt in high-tax countries.

Any shifting of profit leads to loss of tax revenue to the country from where profit is shifted. Tax

authorities across the globe are very much concerned regarding tax avoidance and tax evasion.

As per the OECD, the net tax revenue lost from tax planning is estimated at 4% to 10% of global

corporate tax revenue. The OECD and G20 countries acknowledged this issue and agreed to find

out a unanimous resolution for the same. With the involvement of more than 60 countries, the

OECD published its final report on BEPS. In the final report, fifteen action points have been

developed, each action point has its own specific subject.

Some of the action points that are presented by the OECD are applied immediately, such as the

changes in the Transfer Pricing Guidelines. While some other actions need to be implemented in

treaties, such as for example the multilateral instruments. The OECD and G20 have agreed on

cooperating on the BEPS project until at least 2020, to make sure that efficient monitoring upon

the agreed measures can be done.

In last two decade, transfer pricing has gained a lot of importance and many countries introduced

transfer pricing regulations to avoid shifting of profits and to safeguard the tax base or tax

revenue. For transfer pricing, four specific action points in the OECD’s BEPS report are of

importance. Action point 8 will provide renewed guidance for transfer pricing of intangibles.

Action 9 will explain the arm’s length principle in a post-BEPS world. The third relevant action

point, namely action point 10, explains how low-value-adding transactions should be priced.

Lastly, in action point 13 renewed guidance for transfer pricing documentation has been

provided in order to improve the transparency.

1.1 Motivation for research

In last one decade, there have been significant changes in the way MNEs conducting their

businesses. Intangibles played a key role in the overall value chain of business operations.

Physical assets became less important as compared to intangible assets One cannot imagine

globalization without intangibles. There is no doubt that brand, R&D, IT system, employees and

management skills are crucial to any company’s success.


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In the world of transfer pricing, ‘intangibles’ is a complex area. A lot has been discussed and

debated over the definition of intangibles, identification of intangibles and the arm’s length

nature of intangibles. Amongst the transfer pricing transactions of MNE Groups, transactions

related intangibles are the most significant and susceptible to dispute with tax authorities.

In the post BEPS world, there would be a change in the way we apply the arm’s length principle

to related party transactions. I believe, in the post BEPS world, intangibles would be the heart of

the transfer pricing analysis. Therefore, my interest arose to write a paper on Transfer Pricing in

a post BEPS world – Intangibles perspective.

1.2 Research area

The research matter for this thesis will be:

Analyzing the guidance issued by the OECD under action plant 8 to 10 in relation to

intangibles and discussing the practical implication of the same.

Whether BEPS guidance addresses the issues faced by taxpayers in relation to

intangibles.

Is there any alternative to arm’s length principle


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2. OECD’s Pre-BEPS Guidance

In the last two decades, the global business scenario has changed significantly. The OECD has

made significant efforts time to time in evaluating arm’s length principle. Based on the pre-

BEPS guidance and local transfer pricing laws, taxpayers and tax authorities have spent a

considerable amount of time in reviewing contracts and debating over functions, assets and risk

for justifying the transfer prices. However, a lot has been debated whether the pre-BEPS OECD

guidance was helping MNEs and tax authorities to find out most appropriate arm’s length price

of the related party transactions and whether the substance of the transaction has been considered

while the performing comparability analysis. However, it has been realized globally by countries

and OECD that pre-BEPS guidance lacks clarity in relation to conduct vis-à-vis contract while

allocating the arm’s length return between the related parties.

In the pre-BEPS world, excessive market returns were allocated to affiliates (‘entrepreneurs’)

who only invested in the capital and did not participate in business related risks. In other words,

legal owners of intangibles were entitled to more than normal routine returns irrespective of their

contribution in the overall value creation of intangibles.

Allocation of return in a pre-BEPS world – E.g. Company A is based in USA and it is the legal

owner if the intangibles developed over the period of years. The role of Company A is only to

protect the legal ownership of intangibles and make the required investment for the development

of intangibles. Company A licenses the use of such intangibles and related technology to

Company B based in India. The role of Company B is to conduct further R&D for the

development of intangibles, develop a customer market in India for the product and also assumes

related risks. Company A reported significant profit on account of legal ownership of intangibles

and funding for the development of intangibles. While Company B reported routine returns in

relation to R&D and market development of the product irrespective of the significant value

creation.

Particular Company A Company B

Legal owner of intangible √ -

Funding for development of

intangibles and assumes

funding related risks

√ -

Further development and

exploitation of intangibles

- R&D

- Market development

Assumes related risks

- √√√

Allocation of return √√√ √

Whether related party Yes Yes


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Particular Company A Company B

transactions are arm’s length

( pre-BEPS world)

In the aforesaid example, one can clearly see that even if the related party transactions are at

arm’s length, the allocation of returns are not as per the value created. Most of the returns are

allocated to Company A which adds little value in the overall development of intangibles. The

fundamental point is that whether countries are getting fair share of revenue on account of cross-

border transactions.

Eventually, the OECD realized that pre-BEPS guidance related to arm’s length computation is

not aligned to the actual conduct of the parties or ‘value creation’. Further, the OECD mentioned

that legal owner cannot be entitled significant returns of the intangible assets unless significant

contribution has been made in creating further value to the said intangibles. Taxation should

place where value is created.

With the 2015 final BEPS reports, the OECD attempted to address the following key challenges

by making significant changes in the arm’s length related guidance.

- The difficulties in adequately assessing the economic value of intangibles

- The fact that intangibles and respective profits can comparatively easily be shifted to low tax

jurisdictions

This paper examines the OECD’s guidance in relation to intangibles and evaluate the practical

application of the same.


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3. New Guidance on intangibles

New guidance on intangibles under Action 8 of the BEPS Action Plan is provided in the

OECD/G20 Final Reports. The guidance in the Actions 8-10 Final Reports taken the form of

revisions to chapters I, II, VI, VII and VIII of the OECD Guidelines 2017. In respect of Action 8,

the provisions of the previous version of chapter VI of the OECD Guidelines are deleted in their

entirety and replaced by the language of the “Intangibles” section of the Actions 8-10 Final

Reports. The key provisions of the new guidance are discussed as under:

3.1 Meaning of intangibles

In the final report of BEPS, first time the OECD has provided a definition of intangibles.

Definition of intangibles has been a contentious issue for taxpayer and tax authorities. Economist

consider the value driver of market as intangibles. According to them, value driver of the market

in which any company trades their product and services, constitute intangibles. Accountants, on

the other hand, tend to think that if the intangible is not reflected on the balance sheet, it does not

exist and value cannot be attributed to it.

The BEPS final report provides a helpful guidance in relation to definition of intangibles. As per

the OECD’s BEPS report on ‘Aligning Transfer Pricing Outcome with Value Creation’, the

definitions1 of intangibles and marketing intangibles as follows:

Intangibles2

‘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.

1 New definitions as compared to the definition provided in the OECD transfer pricing guidelines [2017] 2 Paragraph 6.6 of the OECD’s report on BEPS


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A flow chart depicting identification of intangibles is as under:

No

No No

Yes Yes

Yes

With the new definition of intangibles, the OECD’s focus has now shifted from a more detailed

definition to a more principled-based approach specifically involving the determination of conditions

and pricing that would be agreed upon between independent parties for a comparable transaction.

Marketing Intangibles3

“An intangible (within the meaning of paragraph 6.6) that relates to marketing activities, aids

in the commercial exploitation of a product or service, and/or has an important promotional

value for the product concerned. Depending on the context, marketing intangibles may include,

for example, trademarks, trade names, customer lists, customer relationships, and proprietary

market and customer data that is used or aids in marketing and selling goods or services to

customers.”

The above definition is the new definition of marketing intangibles prescribed by the OECD in

its BEPS report. Here, it would be also important to look at the following earlier definition of the

marketing intangibles as prescribed in the OECD Transfer Pricing Guidelines.

3 Glossary of the OECD’s report on BEPS

A physical assets or financial

assets

Whether capable of being owned or controlled for use in commercial

activities

Would a transfer (of

the item) be

compensated in a

transaction between

independent parties in

comparable

circumstances?

Not an intangible (for transfer pricing purposes)

A relevant intangible (for transfer pricing

purposes)


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An intangible that is concerned with marketing activities, which aids in the commercial

exploitation of a product or service and/or has an important promotional value for the product

concerned

The new definition has widened the scope of ‘marketing intangibles’ and it is most likely to give

rise to increase in transfer pricing scrutiny of such intangibles since it provides illustrative

examples of marketing intangibles such as customer lists, customer relationships, and proprietary

market and customer data as marketing intangibles. The illustrations are critical for ‘MNE’

groups operating in developing markets since these markets have very large consumer bases that

may give rise to significant amounts of consumer-related data, which may be treated by the tax

authorities as marketing intangibles.

Thus, marketing intangibles may include any kind of intellectual property which indicates the

origin of the product or service, promotes the marketing, sale or advertising, and adds value to

the business itself. Marketing intangibles are a result of extensive marketing campaigns and

efforts made to promote and sell products or services.

As per the OECD’s BEPS related guidance, certain items are not considers as intangibles for

transfer pricing purposes. The discussion in relation to those items are as under:

Item OECD’s Report

Goodwill and going concern

value4

Goodwill and going concern value should be

attributed to intangibles to which they relate i.e.

value driver in the particular market under

consideration.

Goodwill and going concern are not individually

identified and separately recognised.

Goodwill and going concern value, if they exist,

cannot be transferred separately from the intangibles

to which they relate. Accordingly, it is very crucial

that goodwill and going concern should be

appropriately considered while conducting valuation

of intangibles to which such goodwill and going

concern relate.

Group Synergies5 The group synergies that can be attributed to

4 Para 6.27 to Para 6.29 of the OECD TP Guidelines 2017


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Item OECD’s Report

“deliberate concerted group actions” should generally

be shared between the members of the group in

proportion to their contribution to the creation of the

synergy.

Specific market conditions6 Just because any entity is based in low cost market, it

is not to be considered as a separate intangibles. Any

market specific circumstances should be captured in

the analysis of arm’s length compensation.

Company Name7 No payment for a company name is appropriate when

it merely shows that the legal entity is a member of

the MNE group.

Where the name provides a financial benefit,

however, a payment for use of the name may be

appropriate. Whether a payment is needed is,

essentially, related to the amount of financial benefit

that the user of the name receives through use of the

name.

3.2 Key characteristics of intangibles

With regard to comparability of intangibles or rights in intangibles, the specific features listed in the

guidance and to be taken into consideration are:

- Exclusivity;

- Extent and duration of legal protection;

- Geographic scope;

- Useful life;

- Stage of development;

- Rights to enhancements, revisions, and updates; and

- Expectation of future benefit

Further, below is the summary of the OECD’s guidance in relation to definition of intangibles:

Intangibles must not be a tangible asset or financial asset ;

Intangibles must be capable of being used in commercial activities

5 Para 6.30 of the OECD TP Guidelines 2017 6 Para 6.31 of the OECD TP Guidelines 2017 7 Para 6.81 to 6.84 of the OECD TP Guidelines 2017


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Intangibles use or transfer would be compensated in transactions between independent

parties

Intangibles do not have to be legally protected to be valuable ;

Intangibles need not to be separately transferred

Intangibles do not have to be recorded in company’s balance sheet for considering as

intangibles

Value drivers of market can be considered as intangibles regardless of whether they are

legally protected or recorded in balance sheet.

The identification of an item as an intangible is separate and distinct from the process for

determining the price for the use or transfer of the item under the facts and circumstances of

a given case

In certain instances these Guidelines refer to “unique and valuable” intangibles. “Unique

and valuable” intangibles are those intangibles (i) that are not comparable to intangibles

used by or available to parties to potentially comparable transactions, and (ii) whose use in

business operations (e.g. manufacturing, provision of services, marketing, sales or

administration) is expected to yield greater future economic benefits than would be expected

in the absence of the intangible

A thorough functional analysis, including an analysis of the importance of identified

relevant intangibles in the MNE’s global business, should support the determination of

arm’s length conditions

Following items are the illustrative list of items considered in transfer pricing analysis

- Patents ;

- Know-how and trade secretes ;

- Know-how and trade secret ;

- Customer relationship ;

- Rights under government license and concessions ; and

- Rights under contract with suppliers and key customers

Although the OECD has made significant efforts in introducing a broad definition of intangibles,

one need to evaluate the practical difficulties in identifying intangibles. The new guidance

mentions that transfer pricing analysis should carefully consider whether an intangible exist and

whether an intangibles has been used or transferred. For example, not all research and

development expenditure produce or enhance intangibles and not all marketing activities result in

enhancement of intangibles. Overall, the OECD attempted to bring an economic definition of

intangibles. Such intangibles could be identified through a detailed function, assets and risk

analysis.


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3.3 Returns on Intangibles

After identification of intangibles, evaluating the returns on intangibles is the key and complex

exercise. In the pre-BEPS world, FAR analysis has been given due importance for identification

of intangibles and evaluating appropriate returns. As per the OECD’s guidance on BEPS, group

companies performing important functions, controlling economic significant risks and

contributing assets in DEMPE of intangibles shall be entitled to appropriate return in line with

value of their contribution. It is very clear that there is no short-cut for computing the returns on

intangibles, it is a detailed exercise which require significant efforts to understand entire value

chain of group entity from DEMPE perspective. The OECD provided a framework for analysing

transactions involving intangibles and can be summarised as follows8:

3.3.1 Framework for analyzing transaction involving intangibles

(i) Identify the intangibles used or transferred in the transaction with specificity, and the

specific, economically significant risks associated with DEMPE functions

(ii) Identify the full contractual arrangements, with special emphasis on determining legal

ownership of intangibles.

(iii) identify the parties performing functions, using assets and managing risks related to

DEMPE functions by means of a functional analysis

(iv) 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 DEMPE functions.

(v) Delineate the actual controlled transactions related to the DEMPE functions in light of the

legal ownership of the intangibles

(vi) Where possible, determine arm’s length prices for these transactions consistent with each

party’ s contributions of functions performed, assets used and risks assumed.

8 Para 6.81 to 6.84 of the OECD TP Guidelines 2017


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3.3.2 FAR analysis from DEMPE perspective

In the pre-BEPS world, emphasizes was also given to a detailed FAR analysis. However, the

taxpayers have been conducting FAR analysis from tested party perspective (one side analysis)

without giving special importance to ‘DEMPE’ and ‘value creation’.

In the post BEPS world, if the conduct of the parties is inconsistent with the contract or there is

no written contract or the contract is silent in some respect then the transaction has to be

identified by the conduct. This requires examination of the functions performed by the parties to

the transaction, taking into account assets employed and risks assumed and managed, including

how those functions relate to the wider generation of value by the MNE group to which the

parties belong, the circumstances surrounding the transaction, and industry practices.

As per the OECD’s BEPS guidance, returns on intangibles are allocated to entity that:

Perform intangible activities (DEMPE)

Manage and control risk associated with performance of intangible activities (Operation

Risk)

Manage and control financing the intangibles activities and is able to bear the risk associated

with financing activities (Finance Risk)

The table below identifies companies within the MNE which perform and exercise control over

DEMPE; provide the necessary funding and other assets; and bear and control the various risks

associated with the intangible.

Intangible ‘X’ Functions Funding Risk

Perform Control Control Bear

Development

Enhancement

Maintenance

Protection

Exploitation

DEMPE of intangibles - In the functional analysis from DEMPE perspective it is very

important to focus on the critical functions (e.g. formulate overall strategy for productions) and

the critical risks (e.g. assuming market risk) which contribute in the overall development of the

intangibles. Further, in order to identify the ‘value creation’, it is important to conduct two side

analysis by conducting functional interviews of both the parties involved in affiliated transaction.

Two side analysis of functions and risk will only give true picture regarding economic value


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added by the parties. Following are the key functions which have special significance for the

purpose of functional analysis while arriving at arm’s length compensation:

- Design and control of research and marketing programmes

- Management and control of budgets

- Control over strategic decisions regarding intangible development programmes

- Important decisions regarding defence and protection of intangibles

- Ongoing quality control over functions performed by associated enterprises that may have

a material effect on the value of the intangible

In the whole process of DEMPE analysis, entity has to clarify:

- Which group entities are performing the DEMPE functions or contributing a part of

DEMPE function,

- Using the assets related to the DEMPE functions and

- Controlling the economically significant risks related to the DEMPE functions.

Therefore, MNEs are now required to identify specific activities for each DEMPE function and

ascertain the relative importance of each DEMPE function. Such detailed analysis may be

required not only involving group entities, which are currently involved in DEMPE activities,

but also entities which performed DEMPE activities in the past.

Risks Analysis - With regard to risks, the key factor is the control of the risk in determining

which legal entity is entitled to the return to risk-bearing. The OECD’s report suggests that the

entity that controls over risk of DEMPE functions should bear the risk. As per the OECD’s

report, separate arm’s length test of risk allocation is required. Under this test, actual conduct of

the parties is decisive. The below table provides details regarding risk allocation:

Particular Determining Factor Meaning

Basis of risk

allocation

Control over Risk - Capability to take decision to take loan

- Capability to make decision on whether and how

to respond the risk

- Capability to mitigate the risk

Financial Capacity to

assume the risk

- Take on the risk

- Lay off the risk

- Pay for the risk mitigation functions and to bear


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Particular Determining Factor Meaning

the consequences

Contractual risk allocation is disregarded if inconsistent with the “actual conduct of the parties”

The fundamental principle coming out from the OECD’s guidance is that entity assuming the

risk in relation to DEMPE of intangibles must exercise control over the risk and have the

financial capacity to assume the risk for getting return on intangibles. In author’s view, DEMPE

analysis involves analysis of both functions (performance), control over functions, control &

assumption over risks of DEMPE. Analysis of functions and risks should go hand in hand with

analyzing the DEMPE of intangibles. In author’s view, risk cannot be outsourced while functions

can be, the entity controlling the risk must assume the risk.

E.g. If a parent company (legal owner) also control the operational risk in relation to distribution

of product by subsidiary company. Any losses incurred by subsidiary on account of market

downturn shall be borne by parent company. However, a detailed FAR analysis should be

documented to justify business decision, controlling key decision, assumption of risks etc. for

appropriate allocation of losses.

Conducts prevails over Contract- once the DEMPE analysis for intangibles is performed, it is

important to compare the DEMPE of intangibles (‘conduct’) with contractual arrangements.

Once the contractual arrangements and the conduct of the party/-ies have been reviewed within

the DEMPE analysis context, the MNE has to confirm that there is consistency between legal

and economic reality.

Delineate the actual controlled transactions related to the DEMPE of intangibles is the key

outcome of the analytical framework. In this step, the MNE has, on the basis of the steps

performed so far, access to all the key elements to accurately delineate the actual controlled

transaction(s) related to the DEMPE of intangibles.

The new OECD guidance has moved away from concept of ownership, and has adopted

an approach looking at who is contributing to the value of the intangible, i.e. a clear

focus on ‘substance’ for conducting TP analysis of intangibles. The focus is shifted from

testing stand-alone entities (‘tested parties’) to mapping the relative position of group

entities involved in the process of jointly creating value.


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3.3.3 Returns on intangibles

The Final Report states that legal ownership alone does not entitled to returns on intangibles i.e.

entities that fund but do not perform functions (DEMPE of intangibles)relating to the intangibles

should be allocated a risk-adjusted return on their funding. Entities that provide funding, but do

not control the risks should receive a risk-free return.

The final report distinguishes between controlling functions and performing the functions. If the

legal owner of the intangibles only controls the functions and actual functions are outsourced, the

legal owner shall be entitled for the returns in relation to controlling the functions. If the legal

entity does not control or perform the functions related to the intangibles, it is not entitled to the

benefit attributable to these outsourced functions. The parties who perform DEMPE functions

are entitled for the returns on the relevant contributions (value creation) to the intangibles.

Two associated enterprises embark on a joint intangible development project. One party owns

the intangible and provides the funding for the development. It performs the functions necessary

to control its financing risk. The other party manages the development project, performs all the

relevant research activities, controls the development risks, and is responsible for exploiting the

intangible once the development is complete. Hence, it performs most, if not all, of the DEMPE

functions. Under these circumstances, the largest share of the anticipated returns from exploiting

the intangible are allocated to the “doing” participant, rather than to the “owning” participant.

The key outcome of the OECD’s BEPS final report in relation to the returns of intangibles are as

under:

Contribution Return Details

- Entity funding the intangibles

- Taking control over risk

related to intangibles

Risk

adjusted

return

Legal ownership alone does not

determine entitlement to returns from

the exploitation of intangibles, i.e.

entities that fund but do not perform

functions relating to the intangibles

should be allocated a risk-adjusted

return on their funding.

Only Funding of intangibles Risk free

return

Entities that provide funding but do

not control the risks should receive a

risk free return

Perform DEME functions

related to intangibles

Return from

exploitation

Return attributable to intangibles

based on contribution in DEMPE


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Contribution Return Details

- Development

- Enhancement

- Maintenance

- Protection; and

- Exploitation of

intangibles

of

intangibles

functions

The new BEPS guidance provides that associated enterprises contributing to the value of the

intangibles must be rewarded substantially. Such reward must be aligned with the value addition

or contribution made to the intangibles. Based on the above, the report seeks to reverse a

perception of pre-BEPS world that the owner of a key intangible can claim all of the residual

profit of the business after rewarding certain low-risk or routine functions.

In the whole process of identification of intangibles and evaluating the returns, value chain

analysis plays a very important role. In the pre-BEPS world, we used to refer FAR analysis,

however in the post BEPS scenario, analysis of the whole value chain of group is very important

to (i) understand DEMPE functions & control, operational risk, financing risks (ii) Identifying

intangibles and delineate actual inter-company transactions (iii) To allocate arm’s length returns

3.3.4 Two side Analysis

One of the key messages of the supplemental guidance is that the transfer pricing analysis must

consider the perspectives of each party to a transaction when looking for comparables. In

particular, the options realistically available to each of the parties to the transaction should be

taken into account before arriving at the appropriate comparable for the relevant transaction.

According to the new guidance, a comparability analysis focusing only on one side of a

transaction may not provide a sufficient basis for evaluating a transaction involving intangibles,

including in those situations for which a one- sided method is ultimately determined. At the same

time, the specific business circumstances of one of the parties should not be used to dictate an

outcome contrary to the realistically available options of the other party.

Functions and risk analysis would not determine not only how much profit would be

allocated but also amongst whom


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3.3.5 New Approach- Example 17 of the revised OECD Guidelines

The author refers to example 17 of the OECD Guidelines to explain how the allocation of profits

from IP transfers differ between a pre- and post-BEPS world. In the example, the following facts

are assumed:

Parent is a large Pharma company and conducts operations in country A. Parent regularly retains

independent (unrelated) CRO for R&D activities, including designing and conducting clinical

trials. CROs are not engaged in the blue sky research to identify new compounds. When retained,

Parent actively participates with CRO engaged in clinical research activities. CROs are paid a

negotiated fee for services and do not have an ongoing interest in the profits. Parent transfers

patents related to Product to Subsidiary operating in country B. Product is early stage

pharmaceutical drug (high risk, low probability of commercialisation). Payment based on

anticipated future cash flows – expected cash flow discounted by appropriate discount rate.

Subsidiary has no technical personnel for ongoing research activities. Subsidiary contracts with

Parent to carry out research related to Product. Subsidiary funds all Product research, assumes

risk, and pays Parent based on cost plus margins earned by similar CROs.

Above is a classic example of an early stage pharma company wanting to realise future profit in

a low-tax jurisdiction. In the pre-BEPS world, a significant portion of the profits would have

moved to Country B. Given that subsidiary was legal owner, it was entitled to any excess profit

or loss after paying routine returns for the R&D activities even when the subsidiary is not

playing role for DEMPE of intangibles and control over intangibles. In the per-BEPS world,

parent was entitled to cost plus margin for the R&D services. While Subsidiary legally owns the

patents it lacks the capability to control research risks while Parent performs key decision

making functions and thus should be appropriately compensated.

Key changes to ALP

DEMPE of

intangibles Risk allocation Intangible

profit allocation


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In the post-BEPS world, less emphasis given to legal ownership and more on economic aspect of

substance. In the example above, the parent controls functions and manages patent risks owned

by Subsidiary and is entitled to a healthy compensation. The Amended OECD’s Guidelines,

including the analysis to example 17, will support that Parent's compensation is not appropriately

recognised by the profits earned by a CRO. Parent's transactions with CROs are not comparable

to the Subsidiary/Parent arrangement given that the functional profiles differ, i.e. parent is in

control of function and is the more appropriate party to assume the risks of success or failure.

Clearly there has been a fundamental shift in the way we look at the division of profits due to the

introduction of BEPS. In a pre- BEPS environment, Subsidiary would be better able to keep

profits given it legally owned the intangibles and paid arm's length prices for development

functions. Post-BEPS, it is clear this will change with an emphasis on functions, including

control of those functions and risks.

A summary of the new guidance in dealing with intangibles is as under:

Legal ownership of intangibles alone does not determine entitlement to returns from the

exploitation of intangibles;

Associated enterprises performing important value-creating functions related to the DEMPE

can expect appropriate remuneration;

An associated enterprise assuming risk in relation to the DEMPE of the intangibles must

exercise control over the risks and have the financial capacity to assume the risks

An associated enterprise providing funding and assuming the related financial risks, but not

performing any functions relating to the intangible, could generally only expect a risk

adjusted return on its funding; and

If the associated enterprise providing funding does not exercise control over the financial

risks associated with the funding, then it is entitled to no more than a risk-free return.

3.3.6 Debatable issues

There are certain points in the OECD’s guidance on which more clarity is required from a

practical implication perspective. These are discussed as under:

Particular Debatable Issues

Value creation The fundamental principle of the revised OECD guidance is that the

transfer pricing outcome should be aligned to the value creation.

However the value creation is not defined by the OECD.

In the pre-BEPS scenario, the arm’s length price of the related party


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transactions were computed without evaluating DEMPE and value

creation.

As per the new guidance, the value creation will be performance of

functions (DEMPE) and controlling the functions. However, from an

arm’s length perspective and also from the perspective of economics, it

is not clear that why capital contribution and assuming related risks not

considered as a value creation.

In the Post BEPS scenario, it would be important to see changes in the

margin of the taxpayer after allocating returns based on DEMPE and

control of risk (based on value creation) and whether it will have any

impact on the overall arm’s length results vis-à-vis the arm’s length

results in pre-BEPS scenario.

Pursuant to the intention of the new OECD’s guidance, the author

believes in conducting a detailed value chain analysis of a MNE for

identifying the intangibles and finding out actual value creation of the

group entities in inter-company dealings. However, value chain analysis

is not discussed by OECD.

DEMPE OECD has not discussed DEMPE in detail. Further, if part of DEMPE

function performed by one entity and part of DEMPE function is

performed by another entity of same group, whether PSM would be

appropriate for allocation of return. It is not clarified in the OECD

report.

Further, as per the OECD guidance, if a legal owner outsource the

DEMPE functions to another entity of the group, legal owner shall be

compensated for controlling the functions and the entity performing the

outsourced functions shall be entitled to the return on overall value

creation. However, it is not clarified to what extent a legal owner can

outsource.

Risk The arm’s length principle refers to commercial and financial

relationships between entities within a group. Such relations must be

assessed through a detailed value chain analysis, which comprises of

functions (including people) as well as risks and assets.

OECD’s BEPS related guidance recommends to review risk allocation

from a purely controlling perspective, ignoring the fact that an arm’s


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length negotiation between entities would take into account their

bargaining positions that are being extensively influenced by their

history, their legal rights, and the intangibles they have built over time.

As per the OECD guidance, risk bearing entities have a superior claim

to residual profit vis-à-vis the entities which is funding the capital. As

per the new guidance, investor should earn only risk adjusted return if it

has not contributed in the overall development of intangible through

DEMPE. But in an independent economy, investor gets maximum

returns irrespective of his contribution whether he is skilled investor or

not.

Article 9 of

OECD Model

Convention

As per the article 9 of the OECD Model Tax Convention on Income and

Capital, the arm’ s length principle is a bilateral concept and is aimed at

the appropriate allocation of profits between source and residence

countries. By its nature, it is not anti-avoidance rule.

It is not clear whether the OECD’s BEPS related guidance is aligned

with the arm’s length principle embedded in Article 9. The new

guidance is focusing on labor and not capital. It is focusing on DEMPE,

value creation, control and risk based approached for computing the

arm’s length price. With all these development, it is not discussed

whether the interpretation of the arm’s length principle will remain

same and whether it enforce conditions that independent parties would

have agreed upon.

The OECD BEPS report is a guide to help taxpayer and tax authorities

and cannot substitute commentaries of the OECD Model Convention.

It can be stated that the subjectivity of the new arm’s length principle will lead to more legal

uncertainty for taxpayers. Besides, it leads to more compliance burdens and the increase of cross-

border tax disputes.

3.3.7 Transfer Pricing Method and Valuation of Intangibles

Which method shall be the future of transfer pricing methods? Given that we perform one side

transfer pricing analysis with TNMM, RPM and Cost Plus Method, the appropriateness of the

same may not be continue with OECDs BEPS related guidance which focuses on two side


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analysis and value creation. The OECD’s BEPS related guidance urging taxpayer to consider

CUP or PSM while performing benchmarking analysis, wherever they seems appropriate.

Considering the changing business scenarios and the overall objectives of G20 nations, the

authors agree that PSM could be the future of transfer pricing method. However, appropriateness

of the said method require a detailed analysis and evaluation of entire value chain. There are

certain open issues related to applicability of PSM, those issues are debatable and guidance on

the same is required from OECD.

With regard to valuation of intangibles for transfer pricing purposes, the Actions 8-10 Final

Reports state that it is not the intention to set out a comprehensive summary of the valuation

techniques utilized by valuation professionals, nor to endorse or reject one or more sets of

valuation standards. Rather, valuation techniques can be seen as useful tools in a transfer pricing

analysis where reliable comparable uncontrolled transactions are not available. In particular, the

application of income-based valuation techniques (i.e. discounted value of projected future

income streams or cash flows methods) are considered to be particularly useful when properly

applied.

According OECD’s BEPS related guidance, depending on the facts and circumstances, valuation

techniques may be used by taxpayers and tax administrations as a part of one of the five OECD

transfer pricing methods described in chapter II, or as a tool that can be usefully applied in

identifying an arm’s length price. However, where valuation techniques are utilized in a transfer

pricing analysis involving the transfer of intangibles or rights in intangibles, it is necessary to

apply such techniques in a manner that is consistent with the arm’s length principle and the

principles of the OECD Guidelines.

In the case of transactions involving intangibles for which valuation is highly uncertain at the

time of the transaction, the Actions 8-10 Final Reports provide a number of mechanisms that

independent enterprises might adopt to address the high level of uncertainty at the time of the

transaction. The OECD specifically defines so-called “hard-to-value intangibles” as those for

which, at the time the transaction was entered into by related parties, no reliable comparable

exists and projections of future cash flows or income expected to be derived from the

transferred intangible, or the assumptions used in valuing the intangible, are highly uncertain.

This also includes intangibles used in connection with or developed under a cost contribution

arrangement.


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4. Indian Perspective

MNEs have positioned their brand in India for further development. Indian tax authorities have

been raising various issues in relation to the arm’s length price of intangibles with the objective

getting fair share of taxes. The concept of value creation will change the way transfer pricing is

dealt across the globe including India. Author is discussing impact of BEPS guidance in relation

to certain India related issues.

4.1 Issue of marketing Intangibles

The OECD’s BEPS report stipulates guidance related to the issue of marketing intangibles. The

guidance addresses issue of marketing activities undertaken by an enterprise not owning the

trademark by responding the following question:

“Whether a marketer/distributor should be compensated only for providing promotional

and distribution services or the marketer/distributor should also be compensated for

enhancing the value of the trademarks and other marketing intangibles by virtue of its

functions performed, assets used and risk assumed”

The OECD’s BEPS report prescribes that the analysis of the marketing issue requires assessment

of following:

- The obligations and rights implied by the legal registrations and agreements between the

parties; The functions performed, the assets used, and the risks assumed by the parties;

- The intangible value anticipated to be created through the marketer/distributor’s activities;

and

- The compensation provided for the functions performed by the marketer/distributor

(taking into account of the assets used and risks assumed.

Based on the above guidance, obligation, conduct and the characterization of the party are the

key elements which determine whether a separate compensation for AMP expenses shall be

required or not. If the distributor merely acting as an independent agent there may not be any

issue pertaining to the marketing intangibles, since the distributor is entitled to a compensation

for all the AMP expenditure it has incurred from the owner of the brand.


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On the other hand, when the distributor actually bears the cost of marketing activities (i.e., there

is no arrangement for the owner to reimburse the marketing expenditure), the issue is to find out

to what extent the distributor is contributing in the brand owned by its parent entity by functions

performed, assets used and risk assumed currently or in future. In general, the party that is not

the legal owner of the trademark or marketing intangible, to obtain any benefit (compensation for

marketing efforts) of marketing intangibles will depend upon the substance of the rights and

obligation of that party. An independent comparable analysis should also be required to find out

whether the distributor is entitled for any compensation for its marketing efforts.

The OECD’s guidance brings clarity on various aspects (i.e. need for compensation,

methodology for compensating distributor for the marketing efforts, etc.) for dealing with

the issue of marketing intangibles. The key question that needs to be raised and answered

in the context of marketing intangibles is whether the licensee of the brand had incurred

the AMP expenses in the capacity of a service provider or on its own account as an

entrepreneur. For analyzing the whole issue, the OECD has given emphasis on assessing

the rights, obligations and conduct of parties by performing a detailed FAR analysis.

4.2 Contract R&D

The OECD BEPS related guidance, emphasizes supplementing the contractual arrangement

through examination of the actual conduct of the parties based on DEMPE and control over risks.

This approach finds support in the Indian context as the CBDT Circular No. 6/ 2013 (‘Circular’)

issued to classify the contract R&D centres of overseas MNEs as R&D centres bearing

insignificant risk, does emphasize on the conduct of the parties rather than the contractual

arrangement. The alignment of functional contributions and funding with legal ownership is seen

in the circular as well. Contribution for the important functions by the foreign principal and

control over service providers are factors that are in line with the OECD Guidelines.

4.3 Assembled Workforce

In the OECD’s guidance, assembled workforce has been considered as a comparability factor

and not an intangible, likely because work force cannot be owned or controlled by a single

enterprise as per the definition of intangibles in the revised guidance on intangibles. However,

the Indian TP regulations consider trained and organized work force as an intangible property

requiring compensation for any related transaction.


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5. Alternative to the Arm’s Length Principle

The revised guidance by OECD on BEPS is hard to comply with and lead to increased

controversy. This could be reason to evaluate alternative to the arm’s length principle. The

contentious nature of arms-length pricing regime post-BEPs should be compared to other

alternative methods of allocating multinational income among taxing jurisdictions.

The alternative to the Arm’s Length approach is a unitary method or a global formulary

apportionment system. In this system, affiliate entities within an MNE are taxed as if they were a

single corporation. The worldwide income of the MNE is attributed by a predetermined formula

among all of the countries where the MNE engages in meaningful economic activity. By using a

formula to distribute total profits across locations, the company does not need to calculate the

profits earned by each member of the group in each location

If all countries could agree on the use of this system and could also agree on a reasonably

uniform definition of taxable income, the global taxable earnings/ profits of the MNEs would be

taxable only once. Formulary apportionment method is used by provinces of Canada,

Switzerland and the states within the USA. It has been proposed for internal use within the

North-America Free Trade Agreement and the EU.

The Arm’s Length Principle, is based on the idea of national economies and independent

enterprises and not on that of integrated organizations and global trade. Objections against Arm’s

length pricing, such as the search for comparables and the difficulty in applying the Principle to

global financial trading, are largely absent with formulatory apportionment. The administrative

burden for the MNEs and also the task of the tax authorities would be much lighter under

formulatory apportionment because the apportionment takes place on the basis of internal,

available data.

Some of the problems with the use of this alternative method are: 1. The arbitrariness of

predetermined formulas; 2. Reliance on foreign based information; 3. It almost guarantees that

the amount of profits attributed to each member of a MNE will differ, from the income shown on

its books of accounts, even if those books are kept in good faith and in accordance to accounting

standards.

The OECD mentions that the formulary apportionment method has often been proposed of the

administrative convenience it should deliver and stated that the methodology is more in

accordance to economic reality than the arm’s length principle. The OECD points out that it will

be very difficult to create an international accepted formula that satisfies all countries. Each


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individual country will have the incentive to devise the formula in a way that is most profitable.

To conclude, the implementation of a formulary apportionment method will be a heavy political

and administrative process.

I do not think Formulary Apportionment is a feasible solution for the issues that are currently

arising under the arm’s length principle. Formulary apportionment has problems on its own. To

me it seems that if we would adapt Formulary Apportionment on a global basis (which is highly

unlikeable), many other problems will arise. Despite the criticisms, the Arm’s Length Principle is

likely to continue to be the internationally accepted approach for resolving transfer pricing

disputes.


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6. Case Study

The case study aims at illustrating how a detailed value chain analysis of a group may help

MNEs in the design and documentation of transfer pricing policies in the post-BEPS world. It

focuses on understanding value creation and risks within the entire enterprise.

6.1 Background

Company A operates within an industrial sector and exclusively as a B2B business. Within the

sector where the Company operates (industrial with B2B distribution), brands may or may not be

valuable intangible assets. Functions involved in the development and maintenance of the

Company’s brand are centrally controlled and performed but fully funded by the local

operational entities through a management fee recharge. The case study aims at:

- Determining whether the Brand is actually a valuable intangible asset for this Company in this

sector;

- If so, identifying which entities are involved in the DEMPE of the Brand;

- Assessing whether the existing transfer pricing system is arm’s length, BEPS proof, and

compliant with the new OECD risk process; and

- If a change in transfer pricing system is needed, designing the new transfer pricing system for

the Brand

6.2 Value Chain analysis

The application of the value chain analysis to this case is described below.

Step 1: Analyzing Value Creation- The analysis established that the Brand acts as a guarantee

of highest quality and reliability and increases cross-selling opportunities due to a uniform

appearance

Step 2: Linking the Enterprise’s FAR with Value Creation- Functions related to the Brand

(and related intangibles) are not only:

- Central marketing Functions

- Local marketing functions

- Operational management functions

Step 3: Risk related to brand - Risks related to the Brand range from strategic risks to financial

risk


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Step 4: Aligning Roles, Responsibilities, and Control of the Individual Group Entities

This step determines the group entities that can be held responsible for the major risks related to

a certain value driver. This evaluation is made relying on an understanding of the entities’

functional capabilities. This analysis is accorded to the OECD new risk process involving the

identification of ‘control.

Below Table illustrates that the central group entity virtually controls all of the key functions

with respect to the Brand while the funding of related costs is provided by local group entities

which are recharged as brand building costs as well as the costs of central functions involved in

the Brand development:

Particular Functions

(Perform/Control)

Funding Risk

Development C L ?

Enhancement C L ?

Maintenance C L ?

Protection C L ?

Exploitation L L L

C= Central group entity, L= Local group entity

Following the OECD guidance on DEMPE, it is not clear whether the entities performs/control

DEMPE functions also assuming risks related intangibles. In terms of transfer pricing policy in

Post BEPS scenario, following should be considered:

- Central entity, should not charge any cost to local entities for brand development

- Local entities could be willing to pay a trademark fee if local entities substantiate benefit

test

- Local entities may possibly claim at arm’s length that they had been funding brand

building costs for years and that this would be taken into account in an arm’s length

negotiation with the Brand owner

- For trademark royalty, in absence of reliable comparable uncontrolled transactions, PSM

could be applied to determine the arm’s length royalty.


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7. Conclusion

The author believe that the emphasis of the OECD’s BEPS report on aligning transfer pricing

outcome with the value creation is excellent. In practice, it is observed that tax authorities have

started to require the taxpayer in tax audits, in litigation, APA and MAP to substantiate their

position using the approaches laid down in BEPS Actions 8-10. Consequentially, MNEs can

expect having to demonstrate through the prescribed frameworks, leading to a more detailed

functional, risk and DEMPE analysis, that the intercompany transactions are delineated

accurately and priced correctly.

With the new guidance, MNEs are required to ascertain the relative importance of each DEMPE

function in their respective industry and value chain and identify specific activities for each

DEMPE function in order to be able to undertake the detailed analysis, as required. This includes

a detailed description of the group supply and value chain in the context of the intangibles-

related transactions. This is key to support the taxpayer in performing a satisfactory DEMPE

analysis. Pricing intercompany transactions in light of a DEMPE analysis in some industries will

favour the use of a profit split methodology, however guidance on profit split is still under

review within the BEPS project.

In the post BEPS world, focus would be DEMPE functions with a view to determining the

control over these functions. However, the new OECD guidance fails to clearly explain the

DEMPE functions. The lack of definition of key terms of the new guidance will undoubtedly

lead to increased uncertainty as the interpretation of a) which activities constitute which DEMPE

function and b) what relative importance should be attributed to each function will likely lead to

an increasing number of disputes between MNEs and tax authorities.

Another area is the interpretation of arm’s length principle after the new guidance. The current

arm’s length principle is based upon the conditions that independent enterprises would have

agreed upon. The new guidance is not very clear in term of alignment with the arm’s length

principle as prescribed in Article 9 of the OECD Model. In the new guidance labor now taking

precedence over capital.

In spite of several debatable issues, the OECD’s new guidance has provided a comprehensive

guidance in relation to importance of substance in controlled transactions. This will certainly

change the way MNEs are doing inter-company dealing and also the way we compute the arm’s

length price.

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