Recently the Organisation for Economic Co-operation and Development (OECD) and the G20 formally adopted a plan related to transfer pricing that has implications for valuations of intangible and intellectual property (IP). The Action Plan on Base Erosion and Profit Shifting (BEPS) is meant to address multinational enterprises that engage in harmful tax practices such as, treaty shopping, related-party financial transactions, intangible property transactions and other actions.
To ensure that OECD member countries are not subject to “unfair base erosion practices and profit shifting,” the OECD developed the BEPS Action Plan in 2013. With respect to transfer pricing, the OECD’s main objective is to “assure that transfer pricing outcomes are in line with value creation.” The OECD’s goals include:
- Adopt a broad and clearly delineated definition of intangibles
- Ensure that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation
- Develop transfer pricing rules of special measures for transfers of hard to value intangibles
- Update the guidance on cost contributing arrangements
- Adopt transfer pricing rules or special measures to ensure inappropriate returns will not accrue to an entity solely because it contractually assumed risks or provided capital
The OECD’s multilateral “reporting mechanism,” which calls for a transfer pricing documentation information sharing mechanism among tax administrations, was implemented in January 2015. The OECD is moving in a direction similar to the U.S. in tightening controls and making sure that OECD member countries do not assign a low value to IP for purposes of transferring it out of one jurisdiction into a more favorable tax jurisdiction. In recent years, the OECD has expressed concern over practices that artificially segregate taxable income from the activities that generate it. The OECD’s position is that profits should be going to the place where the profit is being generated.
What a Transfer Pricing Policy Entails
The Documentation Report recommends that tax authorities require a “three-tiered approach” to their transfer pricing documentation requirements:
- A master file – an overview of the entire multinational’s operations, its significant intangible assets, its intercompany financial transactions, and its financial and tax positions. This should include information on the company’s organizational structure and a detailed description of its business.
- A local file – detailed information regarding the local entity and its role within the multinational group, the key intercompany transactions which it undertakes, and a summary of its financial data. The local file must include local entity information including a description of the management structures of the local entity, the local organization chart, and details on reporting structure. This file should also provide a description of material controlled transactions and a list of local entity financial accounts.
- A country-by-country report – a schedule of revenue, profit/(loss), income tax paid, employees and assets held by entity and jurisdiction. The country-by-country report provides global level information relating to allocation of income, taxes paid, and indicators of activity such as lists of employees, assets and revenue associated with each jurisdiction within which the entity operates.
Potential Benefits and Costs
One of the benefits of the new policy is that risk assessment guidance may discourage tax authorities from initiating costly disputes over minor issues. The master file may encourage the adoption of a set of globally-consistent and uniform transfer pricing policies and may streamline the compliance process. Further the recommendation that tax authorities accept documentation written in widely-used languages (e.g., English or French) rather than requiring use of the local language in every case may reduce compliance burdens.
Potential costs of the policy are that tax authorities may use the country-by-country report to inappropriately make “formula-based” adjustments, and therefore increase the likelihood of disputes and double taxation. The country-by-country report requires information that could potentially be used as formulary apportionment allocation factors, such as revenue, number of employees, and tangible property by tax jurisdiction. The amount and level of detail required with respect to multinationals’ financial data may require costly and ultimately unnecessary compliance, and confidential information disclosed to tax authorities may be compromised.
Intellectual Property Valuation Matters
The new regulations formalize the use of the income method for determining the value of the IP. Previous requirements called for use of a valuation approach, but didn’t specify a method. To avoid scrutiny, it is important to obtain a supportable valuation of IP. If you do not have a defensible IP structure in place, tax authorities will assert their view.
Common intercompany IP transfer methods include:
- Outright transfer, either by sale or through a non-recognition transfer
- A royalty-bearing license
- Provision of a service using the intangible property, rather than a direct transfer of the property
- Cost sharing arrangements (CSA)
A CSA is a contractual agreement between companies in the same multinational group which allow the companies to share the costs and the risks of developing, producing and obtaining assets. In a CSA, companies decide to share the development of a global IP platform, for example R&D. An often contentious issue is determining the buy-in or platform contribution transaction (PCT) that each party has contributed.
It is important to note the differences between application of the income method for transfer pricing purposes versus financial reporting purposes. In a purchase price allocation, there is a delineation between intangibles and goodwill. For transfer pricing purposes, the distinction between intangibles and goodwill is blurred. The valuation involves consideration of not only what the value is today, but also what the value will be post-acquisition. For example, what will the value of an intangible asset be once the buyer has integrated it into its distribution channels or its product line. In a transfer pricing situation, the value of the intangibles might include all of goodwill. The IRS has referenced in published papers that valuations for allocation of purchase price should only be used as a starting point for transfer pricing purposes.
Other considerations with respect to valuations for transfer pricing purposes include differences in definitions of IP and Goodwill. The IRS believes that some goodwill should be included as part of intangibles. Also, if U.S.-based IP is going to be transferred out of the U.S., the IRS states that discount rates associated with certain IP transactions should be higher than the overall discount rate. The IRS also views technology, such as software, as something that never fully amortizes. The income stream would thus go out forever, affecting valuation.
In late 2015, one of the first significant cases related to the new transfer pricing rules involved Coca-Cola and several of its foreign-based licensees. Coca-Cola received a statutory notice of a $3.3 billion deficiency from the IRS based on transfer pricing adjustments of more than $9 billion. Coca-Cola petitioned the tax court to overturn the ruling in December 2015.
The IRS claims that Coca Cola’s transfer pricing policies with the licensees, who manufactured concentrate and sold it to bottlers outside the U.S., were not appropriate based on a “comparable profits method” (CPM) approach. Coca Cola disputes the claim saying the IRS inappropriately applied the CPM process and the CPM analysis used inappropriate comparables.
Many are watching this case as it is a sign the IRS is seeking to standardize its approach to transfer pricing cases. Some believe the IRS may be demonstrating a willingness to ignore past agreements, long-term risk allocations and informal shared intangible development agreements.