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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
Presenter : Sanjay KapadiaTP Implications of IntangiblesPage 2 Presenter : Sanjay KapadiaPage 2
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
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Background
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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)
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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
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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
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Overview of the Intangibles Discussion/Guidance
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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)
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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
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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
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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
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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
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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
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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)
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Potential impact of the Intangible
Discussion/Guidance and BEPS
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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?
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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.
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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.
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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
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Case studies from the Intangibles
Discussion/Guidance
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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
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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)
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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
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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
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Recent Developments
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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
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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
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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
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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
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Contact Details
Sanjay Kapadia
Ph No: 022 61920880 /+91 9892400222
E-mail: sanjay1.kapadia@in.ey.com
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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