Intangibles...of intangible assets is difficult enough. Add to this a merger or acquisi-tion and you...

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TAX REFERENCE LIBRARY NO 120 Intangibles 4th edition Published in association with:

Transcript of Intangibles...of intangible assets is difficult enough. Add to this a merger or acquisi-tion and you...

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T A X R E F E R E N C E L I B R A R Y N O 1 2 0

Intangibles 4th edition

Published in association with:

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3 Acquisitions – are you ready for transfer pricing complexity?We have seen a strong start to 2018 in terms of M&A activity, write Jon Vine and Greg Smithof Deloitte. Mergers and acquisitions invariably involve a range of complex tax issues. Whilethese continue to include matters such as acquisition structuring, financing and structurally inte-grating the acquired business, the complexity and range of transfer pricing (TP) issues whicharise in the M&A context should not be underestimated.

7 Revisiting intangibles in the financial services sectorThere is a lot of discussion about the future of the financial services sector, write Ralf Heussnerand Enrique Marchesi-Herce of Deloitte. New technologies and automation, a changing regula-tory landscape, and the entry of new market players are reshaping the industry. On top of this,the industry is undergoing further consolidation while having to respond to shifting customerdemands and new distribution models.

11 The hypothetical arm’s-length test: Germany’s way of calculating the ALP for IPThe German approach to determining the arm’s-length price for intangibles/intellectual proper-ty (IP) is based on the relevant German tax code and related administrative guidance, explainRichard Schmidtke, Bjorn Heidecke and Oskar Glaser of Deloitte. If other methods are used todetermine the arm’s-length price for IP, this may result in non-compliance in Germany.

17 Outright sale of IP: practical considerations post-BEPSTransfer pricing (TP) for intangible property is an increasingly relevant and complex area of tax-ation for multinational enterprises (MNEs) and taxing authorities, writes Bruno A de Camargoof Deloitte. The main policy driver for the existing and evolving state of intangible property tax-ation globally is the OECD’s BEPS initiative, and its ensuing adoption by local governments.

21 Moving away from traditional methods: lessons from recent Japanese TP casesThe Tokyo District Court recently issued two judgments regarding transfer pricing (TP) cases,both in relation to the treatment of intangibles. These decisions provide insights into how theJapanese tax authorities will evaluate intangibles when dealing with TP issues in audits going for-ward, explain Yutaka Kitamura and Jun Sawada of Deloitte.

25 Embedded IPAndre Schaffers and Filip Vanluydt of Deloitte explain the concept of embedded intellectualproperty (IP), providing detailed guidelines for readers on how to identify and quantify it.

29 Brand value, brand equity, and brand IPBrands are complex intangible assets. As explained by Tim Heberden and Cam Smith ofDeloitte, robust valuations and royalty opinions should incorporate analysis of the legal rightsunderpinning the brand, together with the associated reputational stock that drives purchasebehaviour.

Intangibles

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W elcome to International Tax Review’s guide to intangible assets,published in association with Deloitte. In today’s digital revolution, intangible assets are as central to

the business function as steam-powered machines were during IndustrialRevolution. Despite the evolution of businesses since the 18th century, modern

business is still governed by historic tax laws. With the onset of the BEPS project, no sector or business is immune from

the tax burdens of intangibles. New technologies and automation, a chang-ing regulatory landscape, and the entry of new market players are reshapingthe way we work. Businesses need to be strategic in the way they manage theirintangibles and perform DEMPE functions in line with the BEPS Action Planand the way governments are implementing and interpreting these measures. It is unlikely that the BEPS project will clear up all the confusion over

how to tax intangibles, but substantive guidelines and practical examplesare offering some clarity.However, analysing the most effective approach to dealing with the

international taxation of intangibles remains a particularly challenging area.In the case of transfer pricing, identifying and determining the value

of intangible assets is difficult enough. Add to this a merger or acquisi-tion and you have a host of additional matters to consider – the owner-ship structure of the intangible asset must be reconsidered, for example. Brands are another complex area. One author in our guide writes that

robust valuations and royalty opinions should incorporate analysis of thelegal rights underpinning the brand, together with the associated reputa-tional stock that drives purchase behaviour. Despite increasingly harmonised international tax rules, complying

with the tax rules for intangibles in one country will not guarantee yoursafety from audit in another. Already we are seeing judgments emergingon how tax authorities and the courts are determining the appropriatetransfer pricing method for such assets.Wading through the numerous laws and OECD guidance can be

tough. It is through guides such as this one, that tax directors and taxpractitioners can understand the wider issues of the debate, learn fromcase studies and examples and apply these arguments to their situations.We hope you enjoy the guide and find the articles useful and informative.

Anjana HainesManaging editor, International Tax Review

Editorial

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Acquisitions – are you readyfor transfer pricing complexity?

We have seen a strongstart to 2018 in termsof M&A activity, writeJon Vine andGreg Smith of Deloitte.Mergers and acquisitionsinvariably involve a rangeof complex tax issues.While these continue toinclude matters such asacquisition structuring,financing andstructurally integratingthe acquired business,the complexity and rangeof transfer pricing (TP)issues which arise in theM&A context shouldnot be underestimated.

W ith revised OECD TP guidelines (including the application ofthe accurate delineation of the transaction as it relates to intan-gibles), greater TP documentation requirements, increasing

transparency, and particular attention paid to TP by almost all tax author-ities, it is increasingly important that sufficient focus and time is antici-pated and ultimately given to TP in the M&A context. This article explores a range of intangible and TP-related issues, which

may need careful thought when a group makes an acquisition.

Value-based management feesManagement of the acquiring group may get heavily involved in settingstrategies for, or controlling economically substantial risks of, theacquired group (or vice versa). These situations may arise, in particular,where the acquiring business has a centralised management structure orwhere management brings a unique set of skills in relation to theacquired business. Such involvement may be relatively short-term duringan integration phase, or provide a benefit on a longer-term basis.Where this is the case, the charging of a value-based management fee

is becoming increasingly common, with the fee reflecting the substantialvalue delivered by management. For example, a fee based on a percent-age of revenue or incremental revenue may be more appropriate than,perhaps, what is more typically seen for management charges (where areturn on costs is commonly charged for more routine services such asback office functions including finance, IT, HR and so on).The knowledge and services of management may be combined with

the provision of certain intangible assets such as rights to use a trademark(for example, if the acquired group undertakes a rebranding exercise) ordocumented processes and know-how.The pricing of such services (or bundle of services and provision of

intangible assets) requires a detailed understanding of the value chain ofthe business and the extent to which the services play an important rolewithin this value chain. Given the unique nature of such services, a suffi-ciently reliable comparable transaction may be difficult to identify andtherefore other TP methods may be more reliably applied. That said,identifying similar third-party transactions can be helpful for supportingthe overall arrangement (and potentially providing a corroborative pric-ing methodology). It is also necessary to consider any existing arrangements within the

group for such services to ensure that a consistent approach is taken.

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Integration of intangible assetsIn any integration of a business, it is necessary to considerhow the functions (including control thereof) relating to thedevelopment, enhancement, maintenance, protection orexploitation (DEMPE) of intangible assets may be affected.This may happen in a number of different ways. For exam-ple, a business may: • Use intangible assets within the acquired group in com-bination with its own to create a new product (e.g. takingthe best of both);

• Combine the development groups to create a single cen-tre of excellence;

• Consolidate its sales structure to create a single go-to-market structure; or

• Allow the respective parts of the group to sell the prod-ucts of the other (i.e. upselling to existing customers).Any such changes will require careful consideration from

both a legal and a TP perspective and can result in a complexweb of inter-company agreements and TP flows in order toappropriately reward both the DEMPE functions and thecontrol of such activities. This is particularly importantwhere, as a result of the acquisition, the DEMPE functionsand/or the ownership of intangible assets are located inmultiple jurisdictions. Changes in the way groups operate often result in a

mismatch between those entities that legally own intangi-ble assets and those entities that, under TP principles, areentitled to profits (including residual profits after all othercontributions have received an arm’s-length considera-tion) associated with the assets. While this may not initself be of immediate concern, aligning legal and ‘tax’

ownership can help simplify transaction flows and futurebusiness restructurings. There may inevitably be a period of time until these chal-

lenges can be resolved through an appropriate reorganisa-tion to simplify the intangible ownership structure. Theextent of work undertaken to support the TP in this interimperiod needs to be carefully managed so as to appropriatelymitigate the risk, while not incurring excessive costs for arelatively short-term benefit.

Simplifying the intangible ownership structure There are a variety of commercial, tax and legal factors totake into account when considering the long-term structureof intangibles within a group. The tax issues commonlyinclude:• Identification of the intangible assets – It is important toremember that the intangible assets of a business are like-ly to include more than what is already recognised on thebalance sheet or what is legally protected (e.g. patents,copyrights, and trademarks) because of the expansive def-inition of an intangible asset for TP purposes;

• Valuation of the intangible assets – It will be necessary tovalue any assets being transferred. This can often be acomplex exercise, with a number of valuation techniquesavailable. The acquisition will have resulted in a third-party price being paid for the acquired business; it can beuseful to reconcile the value of the intangible assets tothis value to ensure that any ‘gap’ in value can beexplained to tax authorities. A valuation exercise is likelyto have been undertaken for the purposes of a purchaseprice allocation (PPA) for the financial statements.Purchase price allocations are performed under fair mar-ket value concepts, which can be different in some casesfrom arm’s-length value concepts. Therefore, valuationtechniques used in such a PPA can differ from valuationsperformed for TP purposes;

• Exit charges – The transfer of intangible assets can oftenresult in substantial tax costs for the business. Carefulconsideration may be needed to manage these exposuresfrom both a cash tax and accounting effective tax rate(ETR) perspective. Both the form of the transaction (e.g.sale vs licence) and the tax treatment of the intangibles inthe purchaser’s jurisdiction (e.g. amortisable tax basis),will impact the overall cash tax and ETR. Tax attributesmay also be available to shelter any gains; and

• To the extent that a centralised intangible ownershipmodel is sought, determination of the appropriate juris-diction for centralisation – Aside from the various com-mercial factors which may influence this decision, thereare also a number of tax considerations, including (butcertainly not limited to):

• Location of teams contributing to the control ofDEMPE functions in relation to the intangible assets;

Jon VineDirector, taxDeloitte LLP

Abbots House, Abbey Street, Reading,RG1 3BDTel: +44 118 322 2356Mobile: +44 7971 [email protected]

Jon Vine is a transfer pricing director, based in the UK. Jon hasmore than 17 years’ of experience in advising on a wide rangeof international tax and transfer pricing issues. Jon now whollyfocuses on the area of the taxation of intangibles and theassociated transfer pricing in the post-BEPS environment, help-ing international groups implement sustainable transfer pricingmodels as they go through extensive changes within theirbusiness, whether this be as a result of M&A activity, IP central-isation or other business change.

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• The local tax rate and impact on group ETR; • Ease of profit repatriation, including withholding tax

(WHT) cost; • Availability of tax attributes; • Local intangible tax regimes, including incentives; • Treaty network; • Other rules such as ‘controlled foreign company’ or

diverted profits or similar measures; and • Tax authority interaction and availability of rulings/

advance pricing agreements (APAs).Given the importance of any reorganisation of intangible

assets, groups commonly first undertake a feasibility analysisexploring possible options. This would include an assess-ment of the benefits and risks of those options (includingmaintaining the existing structure) and modelling theexpected impact on cash tax and ETR.

Inherited structuresThe acquired group may have had TP structures in placethat are no longer appropriate. This may be because the his-toric structures have not previously been updated by thevendor group to reflect the changes in the global TP envi-ronment, or because changes in the business mean that poli-cies need to change.Many of these risks may have been identified during the

due diligence phase for the acquisition, and historic expo-sures may be dealt with through the terms of the sale andpurchase agreement. However, work may be necessary toavoid a continuing exposure accruing to the business. Many US groups have cost sharing arrangements in place

whereby the intangible assets are legally owned in the USbut the costs and risks of development, and the right toexploit those intangible assets (within a geographic region,e.g. EMEA) is shared with a cost share participant. Thesestructures may have involved the cost share participantbeing located in a jurisdiction where there is limited controlover economically substantial risks. The changes in the TPenvironment and the revised OECD TP guidelines in rela-tion to cost contribution arrangements may put pressure onthe future sustainability of such structures. Careful consider-ation and planning as to how these structures can be adapt-ed may therefore be required.In addition, a number of groups have historically oper-

ated a sales principal and commission agent structure,whereby the sales principal (and, potentially, intangibleasset owner) is responsible for concluding all contracts withcustomers and the commission agent’s role is that of mar-keting and demand generation. The way in which the fieldsales teams within the commission agents operate may havechanged over time (i.e. before the acquisition) or maychange because of an integration of the team into the newgroup’s go-to-market organisation. Such changes maymean that the go-to-market structure is no longer sustain-

able without creating a substantial permanent establish-ment (PE) risk for the group (the work around PEs underthe OECD’s BEPS project is also a key consideration here).It is not uncommon for short-term transitional service

agreements to be put in place between the acquirer and ven-dor groups. These can be helpful in providing internal com-parable transactions to support future intra-grouparrangements, but may also present a risk of underminingexisting pricing mechanisms within the group.

Operational transfer pricingAcquisitions can result in a number of challenges from anoperational TP perspective. It may well be the case that TPprocesses are managed in very different ways within the twogroups, which can create inefficiencies and risk.

Greg Smith Director Deloitte in the UK

London, United Kingdom Tel: +44 (0)20 7007 3800 Fax: +44 (0)20 7007 [email protected]

Greg Smith is an economist and a director with Deloitte in theUK, specialising in the transfer pricing of intangible assets. Greghas more than 20 years of experience with Deloitte, andextensive experience across a variety of industries. Greg has worked exclusively on UK and pan-European trans-

fer pricing issues, including planning and documentation stud-ies, audit defence, and advance pricing agreements. He hasmanaged the implementation of a number of complex transferpricing analyses including the valuation of intellectual property,profit split policies, and transactional pricing methodologies.Greg also has experience working with clients to identifyopportunities and to design centralised IP business models. Greg focuses primarily on clients in the consumer product,

TMT, and manufacturing sectors and on the valuation and pric-ing of intellectual property. He has advised a number of majorFTSE 100 clients on transfer pricing issues relating to theirbrands, trademarks, patents, software, know-how, and otherintangible assets.

Education• University of Nottingham: Bachelor of Economics andEconometrics

Professional Accreditation and Certifications• Qualified Chartered Financial Analyst

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It will be important for the tax and finance function toquickly gain a detailed understanding of the various poli-cies and procedures and consider whether any changes arerequired.Different pricing policies and/or different teams operating

those policies can create a weakness in the internal controlenvironment, and additional checks may be required to ensurethat each group company is earning the appropriate amount ofprofits. It may be advisable to align the way in which the poli-cies are operated, which will require the various teams to eitherbe consolidated or educated on the new processes. Furthermore, the acquired group may use a different

accounting system. Where this is the case, setting up inter-company accounts to allow transactions to take place and bebooked between the legacy groups can cause complexities.

Exceptional costs Acquisition and restructuring/integration costs can besubstantial and involve a number of different workstreams and many different advisors. It will be necessaryto understand all the costs, what they relate to and wherethey have been booked. An exercise is then needed todetermine to which company the costs should be chargedfrom a TP perspective (i.e. which entity is benefitting

from those costs, which can often be multiple entities)and the tax deductibility of those costs assessed.

Compliance The group’s compliance responsibilities will also obviouslyincrease. The master file is likely to need updating to reflectthe acquisition, changes in the business, any additional sup-ply chain structures and any restructuring of intangibleassets. The process for collating the information required inthe group’s country-by-country report may need to beadapted, particularly where the enlarged group is operatingmultiple accounting systems. The local file for each groupcompany will also need updating to the extent that there areany changes in the way in which the company operates andtransacts with other group companies.

ConclusionMergers and acquisitions activity can often involve a num-ber of different work streams and put strain on a businessfrom both a commercial and a finance perspective. Whilethe complexity of acquisition structuring, financing andthe structural integration of the groups is often anticipat-ed, the complexity from a TP perspective should not beunderestimated.

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Revisiting intangibles in thefinancial services sector

There is a lot of discussionabout the future of thefinancial services sector,write Ralf Heussner andEnrique Marchesi-Herceof Deloitte. Newtechnologies andautomation, a changingregulatory landscape,and the entry of newmarket players arereshaping the industry.On top of this, theindustry is undergoingfurther consolidationwhile having to respondto shifting customerdemands and newdistribution models.

I n addition to these industry developments, the OECD BEPS ActionPlan is fundamentally reshaping the international tax landscape. Underthe work performed by the OECD and G20 countries on BEPS Action

8, the spotlight is on transfer pricing (TP) issues related to intangibles,with the aim of aligning taxation with the economic activity that pro-duces profits. BEPS Action 8 introduced new concepts regarding theownership and valuation of intangibles, as well as a substantially broaderdefinition of intangibles that is expected to lead to the emergence of agreater range of intangibles for tax purposes. Although the BEPS ActionPlan is applicable to all industries, there are some aspects that are uniqueto the financial services sector that warrant a renewed look at the topic inlight of these recent changes. The complexity inherent to the financialservices sector is also reflected by the continuing discussions at the levelof the OECD where it has not yet been possible to reach a consensusregarding the TP treatment of related party financial transactions.

In this article, the authors revisit the TP dimension of intangibles inthe financial services sector and provide insight into key issues, recent taxaudit developments, and important takeaways for financial institutions.

Key driversThe four key drivers that require financial institutions across the banking,asset management, and insurance space to revisit their TP approaches tointangibles are discussed below.

Industry-specific operating modelIn many respects, the financial services industry is unique regarding itsoperating model. In other sectors such as the consumer goods, industrial,or technology sectors, there has been a growing trend since the 1990s totransition to so-called principal structures that centralise a range of func-tions, risks, and assets in a principal company. The particularly importantresult of this trend has been a gradual decline in the number of intercom-pany licensing transactions. Instead, the TP focus in many non-financialsectors is on the question of economic ownership of intangibles or settingthe remuneration for support functions (for instance, for their contractresearch and development (R&D) functionality).

The financial services sector is different. Because it faces unique reg-ulatory requirements that range from organisational, management, cap-ital, and liquidity to reporting requirements based on the supervision bylocal regulators, it typically requires a more stand-alone business model

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in local jurisdictions, especially for retail banking and insur-ance. This results in a broader range of transactions withinlarger financial institutions regarding the use of potentialintangibles and the provision of services. Consequently, thegreater number of potential intangibles-related transactionsalso requires more attention from a TP perspective.

Nonetheless, many financial institutions may have not yetpaid sufficient attention to the topic of intangibles to be pre-pared for the new TP challenges resulting from the OECDBEPS initiative, as well as the rising importance of intangi-bles in the financial services sector.

It is also essential to remember that the operating model ofthe financial services sector is different with respect to thestronger reliance on branches instead of legal entities as ameans of efficiently using capital, putting additional pressureon the application of profit attribution between branches andhead offices, the recognition of dealings and the relationshipbetween Articles 7 and 9 of the OECD model tax convention.

Historic role of intangiblesHistorically, the discussion of intangibles in the financialservices sector pivoted primarily on customer relationshipsand regulatory licences. Regulatory licences typically includebanking licences or licences for management companiesunder the UCITS or AIFMD regimes.

From a practical standpoint, there has been a noticeablydifferent view in the financial services industry on the recog-nition and value of other marketing-related intangibles cov-ering trade marks and trade names. While some financialinstitutions recognised trade marks as intangibles for TPpurposes and established remuneration policies (for exam-ple, in the form of licensing fees), other financial institutionsdecided to treat marketing and other branding-related activ-ities as services, and include related costs in group internalservice recharges. The main argument for considering trademarks to have limited value is based on factors such as cus-tomer inertia, implying that customers have historically beenslow to change financial providers due to switching costs.Particularly in mature markets, consumers have historicallygravitated toward established and enduring brands in thebanking or insurance space that were regarded as bulwarksof stability in times of economic or financial turbulence.Thus, marketing and branding-related efforts often focus onmaintaining or rebuilding trust or serve as a means to attractemployees. To put it differently, the argument is that thefinancial services sector is not an industry in which emotionsare key drivers for customers` purchase decisions.

Instead, customers often tend to make their decisions basedon criteria such as proximity of retail branches, fees, or thetrack record of investment funds (in the asset management sec-tor). Consequently, the argument for not considering trademarks a key intangible is that they serve only as a form of entryticket to being recognised as one of the financial institutions ofchoice, but that they provide limited additional financial ben-efits with respect to attracting customers, lowering acquisitioncosts, increasing volume, or sustaining price premiums.

It is clear that the question of the value of marketing-relat-ed intangibles needs to be examined on a case-by-case basisdepending on the facts and circumstances. Nonetheless, theincreasing level of consolidation in the financial services sectoris expected to further drive branding/re-branding activities inthe aftermath of mergers and acquisitions. In addition, therise of FinTechs, new distribution channels, lower switchingcosts, and the need to establish a customer experience andsocial media presence will bring more attention to the role oftrade marks and branding in the financial services space.

The new OECD guidance under BEPS Action 8 providesthat a TP analysis should carefully consider whether anintangible exists and whether an intangible is being used.The notion is important that not all development or market-ing-related expenditures will necessarily result in the cre-ation or enhancement of an intangible. Reference can be

Ralf HeussnerPartner, transfer pricingFinancial services transfer pricing andvalue chain alignmentDeloitte Luxembourg Tax &Consulting

560, rue de NeudorfL-2220 LuxembourgGrand Duchy of LuxembourgTel: +352 45145 [email protected]

Ralf Heussner is a partner with Deloitte based in Luxembourgspecialising in the financial services sector. Ralf worked formany of the key players in the asset management industry(ranging from traditional to private equity, real estate, andhedge funds), and the banking and insurance sectors duringhis previous tenure in Tokyo, Hong Kong and Frankfurt. Overthe last 15 years, Ralf gained extensive experience advisingclients on a range of transfer pricing (TP), valuations, interna-tional tax, and value chain alignment engagements.Ralf’s experience covers TP planning and policy setting, risk

reviews, operationalisation, documentation, restructurings, anddispute resolution engagements. He has worked on more than25 advance pricing agreements and numerous high profilecontroversies on both the local and competent authority levelswith the authorities in China, the EU, Japan, the US, and otherkey jurisdictions.Ralf is a frequent speaker at tax seminars, has participated

in government consultation projects about tax reform, and hascontributed to thought leadership on TP issues.

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made to Section 6.10 of the OECD guidelines, which statesthat ‘the identification of an item as an intangible is separateand distinct from the process for determining the price forthe use or transfer of the item under the facts and circum-stances of a given case.’

It is also important to differentiate between trade marks(that are registered and legally protected) and the use of agroup or company name. The OECD expands on this pointin Section 6.81 of the OECD TP guidelines, stating that nopayment per se should be recognised merely for the use ofthe group or company name when the use is only intendedto reflect membership in the group (passive association). Inaddition, the extent to which the activities of the local affil-iates contribute to the further development of the trademark will also need to be considered.

The above discussion shows that financial institutions willneed to consider carefully whether the use of a registeredtrade mark/brand provides a financial benefit for which apayment would be made between unrelated parties, andhow to remunerate the use of the trade mark/brand.

Tax audit developments and the issue of ‘missingtransactions’Increased tax audit activity in the financial services sector hasbeen observed across various jurisdictions. While the taxauthorities’ level of experience and sector-specific knowl-edge greatly varies from one jurisdiction to another, a recentcommon focus in some tax audits has been what the author-ities call ‘missing transactions’.

For example, some tax authorities examined under auditmarketing and investor-related materials (such as annualreports and investor presentations). In some cases, the taxauthorities found marketing-oriented language on the keysuccess factors and value drivers (especially in the bankingand asset management areas) where the trade mark/brandwas described as one of the key assets in the business and adriver of growth and profitability.

The tax auditors then compared these descriptions withthe information contained in the TP documentation, andoften identified inconsistencies with the position taken fortax purposes. Although foreign affiliates used the registeredtrade mark, the TP analysis/documentation did not identifyit as an intangible and the trade mark holder was not remu-nerated for its use. Some tax authorities refer to this situa-tion as ‘missing transactions’, and use the argument ofnon-timely documentation as the basis for their tax adjust-ments and applying presumptive taxation.

Rise of trade-related intangiblesBanking has historically been one of the business sectorsmore resilient to disruption by technology, partially due tothe important role that scale, trust, and regulatory expertisehave traditionally played.

Nonetheless, technology is becoming a key driver ofchange in the financial services sector. Examples includethe rise of robotics and automation-related technologiesto reduce operating costs, investment platforms and algo-rithmic models that evolved from internal risk manage-ment tools to key tools for investment decisions andportfolio management, and new payment systems androbo-advisors.

The future will entail employing digital technologies toautomate processes, improve regulatory compliance, trans-form customers’ experiences, and disrupt key componentsalong the value chain. According to recent news, bankscould be expected to reduce up to half of their operationsstaff in the next five years, as machines replace human work-force and automation takes over ‘lower-value tasks’ (see theFinancial Times article entitled ‘Citi issues stark warning onautomation of bank jobs’ dated June 12 2018).

Enrique Marchesi-HerceDirector, transfer pricingFinancial services transfer pricing Deloitte Luxembourg Tax &Consulting

560, rue de NeudorfL-2220 LuxembourgGrand Duchy of LuxembourgTel: +352 45145 [email protected]

Enrique Marchesi-Herce is a transfer pricing (TP) director spe-cialised in advising multinational enterprises in terms ofdesigning and implementing their TP policies and assistingwith documentation. With more than 11 years of experience,Enrique has led a wide array of complex TP projects includingintellectual property (IP) valuation, value chain alignment, globaldocumentation and other tax planning projects. He has workedon multiple advance pricing agreements for multinationals inthe automotive and financial services industries and participat-ed in complex tax audit disputes (negotiation, mediation andlitigation), notably assisting a leading telecom group in thedefence of its TP position in Spain.Over the last five years, Enrique has focused on the financial

services sector advising a wide range of clients such as privateequity houses, management companies, funds, banks and assetmanagement firms. He has advised clients in complex tax mat-ters including TP planning, negotiations with local tax authorities,the assessment of BEPS’ impact on existing structures and align-ment of TP policies from a tax and regulatory perspective.As a TP specialist, Enrique regularly presents at tax seminars

and contributes to Deloitte’s publications.

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The technological upheaval will require heavy invest-ment and raise the question of how to structure suchinvestments from a TP perspective with respect to owner-ship and use of the resulting intangibles within the group.The scale of the investments required is also expected tofurther drive consolidation in the financial industry.Interestingly, new financial institutions or those fromemerging economies might achieve this transition moreeasily, given the relative absence of legacy investment andintegration with older systems.

As in the area of marketing intangibles, only a fewfinancial institutions have already probed the appropriate-ness of their existing TP policies/models to reflect theincreased importance of technology, how the develop-ment activities should be structured (for example, under acontract development agreement to centralise economicownership or under cost sharing arrangements) andif/how their use should be remunerated. While somefinancial institutions have already introduced TPapproaches for the licensing of platforms using compara-ble uncontrolled price (CUP) approaches, others are con-sidering including related costs in recharges forinfrastructure services

Challenges may arise if certain platforms or systems aredeveloped in pioneer jurisdictions (based on new regula-tory requirements) that are then rolled out globally orregionally. It is also important to keep in mind that somebanks and assets managers already started to license outcertain of their trade intangibles (such as end-to-endinvestment platforms) to third parties. Theoretically, thisshould contribute to a greater spectrum of potential inter-nal CUP data that would also need to be examined for TPpurposes.

Practical implicationsWith the above in mind, the key takeaways for financial insti-tutions are as follows:• Re-examine the existence of potential intangibles in light

of the broader definition under the OECD BEPS Action8 and the use of such intangibles (also in the context ofbranches and attributing licence fees under the newOECD separate entity approach);

• Revisit existing TP positions regarding remuneration forthe use of intangibles, depending on the financial benefitor whether related costs should be included in internalcost recharges;

• Identify all relevant intangibles and their use in TP analy-sis/documentation, even if use of those intangibles is notbeing remunerated (with supportive argumentation forthe non-remuneration);

• Track development and branding-related activities, espe-cially if performed out of pioneer locations;

• Ensure consistency between marketing and tax-relatedmessaging, and coordinate with other stakeholders (forexample, the public relations and marketing function); and

• Review the appropriateness of existing TP documenta-tion and inter-company agreements.

ConclusionThe changes resulting from OECD BEPS Action 8, togetherwith industry developments, will have a profound impact onthe financial services sector. The key message for financial insti-tutions is that additional effort should be devoted to analysingthe appropriateness of existing TP approaches with respectto intangibles. If not, many financial institutions may findthemselves exposed to more intangible-related tax disputesand controversies in the future across various jurisdictions.

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The hypothetical arm’s-lengthtest: Germany’s way ofcalculating the ALP for IPThe German approachto determining thearm’s-length price forintangibles/intellectualproperty (IP) is basedon the relevant Germantax code and relatedadministrativeguidance, explainRichard Schmidtke,Bjorn Heidecke andOskar Glaser ofDeloitte. If othermethods are used todetermine the arm’s-length price for IP, thismay result in non-compliance inGermany.

Method selectionIn Germany, the determination of an arm’s-length price for IP follows atransfer pricing (TP) method hierarchy (see first sentence onwards ofSection 1 Paragraph 3, Foreign Tax Code). The comparable uncon-trolled price (CUP) method, the cost plus method, and the resale priceminus method are the highest ranked methods in the hierarchy. If thosemethods are not applicable, other methods, such as the transactional netmargin method and the profit split method, must be applied (see firstsentence of Section 1 Paragraph 3, Foreign Tax Code), always based onunlimited or limited comparable third-party data.

If none of the aforementioned methods is applicable, for example dueto the lack of third-party data, the so-called hypothetical arm’s-lengthtest must be performed (see the fifth sentence of Section 1 Paragraph 3Foreign Tax Code). The hypothetical arm’s-length test was introduced aspart of Germany’s ‘company tax reform’, and is applicable for financialyears starting after December 31 2007.

Generally, the hypothetical arm’s-length test is used in cases of ‘relo-cation of functions’ in the course of business restructurings to evaluatethe ‘transfer package’ made available by the transferor to the transferee.A relocation of functions is assumed if an entire function, including risksand opportunities as well as assets, is transferred (see the ninth sentenceonwards of Section 1 Paragraph 3, Foreign Tax Code). Given the uniquefeatures of a transfer package, limited or unlimited comparable third-party data is often unavailable, making the hypothetical arm’s-length testthe standard method in practice. Therefore, a plethora of additionalguidance on the relocation of functions and its application of the hypo-thetical arm’s-length test has been published by the German tax admin-istration. In particular, the Decree on Relocation of Functions issued onAugust 12 2008 needs to be considered. The 80-page administrativeprinciples issued by the German Ministry of Finance on October 13 2010are binding on the tax administration but not on the taxpayer.

Despite the availability of general guidance, specific guidance regardingthe application of the hypothetical arm’s-length test in cases other than arelocation of functions is limited. Below, the authors propose an analogousinterpretation of the available guidance when dealing with IP transfers.

An economic way of thinking: The hypothetical arm’s-length testThe idea behind the hypothetical arm’s-length test is to simulate negotia-tions between seller and buyer in consideration of potential alternative

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options. Thus, the hypothetical arm’s-length test employsfunctional analysis and internal company planning calculationsto determine a minimum selling price for the seller and a max-imum buying price for the buyer, under the assumption thattwo conscientious business managers will negotiate. In addi-tion, the legislation assumes that the two conscientious busi-ness managers have complete transparency of informationwithin the framework of the simulated price negotiations.Hence, the pricing is based on the assumption that the busi-ness managers are aware of all material circumstances of thebusiness relationship (third sentence of Section 1 Paragraph 1,Foreign Tax Code) in this two-sided approach.

Two values are then derived – a minimum value fromthe seller’s perspective and a maximum value from thebuyer’s perspective, constituting the range of agreementthat results from the differing profit expectations (profitpotential). German tax legislation assumes the midpoint ofthis price range to be the actual transfer price if no otherprice can be substantiated as the arm’s-length price withthe highest likelihood.

The minimum value claimed by the selling entity is influ-enced by the expected loss of profit potential from the exer-cise of the IP, that is, the minimum price is determined bycompensation for the potential profits forgone. Realisticalternatives must be considered.

The maximum value representing the buyer’s willingnessto pay is affected by expected additional profit potentialconsidering own contributions such as the receiving compa-ny’s IP or workforce, as well as synergies expected to arisefrom the transferred IP. As with the minimum value, realisticalternatives must be considered.

Figure 1 illustrates the hypothetical arm’s-length princi-ple as described above.

Because both the loss and additional profit potentialmust be calculated, a four-sided valuation is common: boththe minimum and maximum value can be established bycomparing the profit potential before and after the intendedtransfer of IP, requiring two valuations for each party.

The next section outlines a numerical example based onthe administrative guidelines for relocation of functions to

Figure 1: The hypothetical arm’s-length principle

Illustrative margin

Minimum remuneration

The minimum remuneration for the IP claimed, representing the seller’s value for the IP. Where the transferring enterprise could expect to earn a profit from the exercise of the IP, the minimum price is determined by compensation for the potential profits foregone and realistic alternatives.

Most likely value

The price in the range of agreement that reflects the arm’s-length principle with the highest degree of probability is the price that is actually applied. The midpoint in the range of agreement is determinative unless a credible showing can be made in favour of another value.

Maximum remuneration

The maximum remuneration for the IP, representing the buyer’s willingness to pay, is affected by own contributions such as the receiving company’s IP or workforce, as well as synergies expected to arise from the transfer as well as realistic alternatives.

Seller BuyerMostlikelyvalue

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illustrate the application of the arm’s-length test. Becausethe administrative guidelines are not binding on the taxpay-er, the taxpayer can also apply other valuations to calculatethe minimum and maximum prices.

Application of the hypothetical arm’s-length testThe following simplified example illustrates the hypotheticalarm’s-length test in the case of an IP transfer when applyingthe available guidance for relocation of functions by analogy(see Administrative Principles Relocation of Function 2010,Appendix, Case C). More details on the application can befound in Schmidtke et al (2017), Transferpaketbewertung, inHeidecke et al (editors) Funktionsverlagerung undVerrechnungspreise, Springer. The latter have presented ahypothetical arm’s-length test application considering thecommon valuation practice.

AssumptionsA parent company (Company S) transfers IP to a foreign sub-sidiary (Subsidiary B). The IP has been fully developed andno additional development costs are necessary during the useof the IP over a five-year period. Company S’s profit poten-tial with the IP would be €0.6 million ($700,000) perannum higher than without the IP for five years.Correspondingly, Subsidiary B’s profit potential wouldincrease by €0.9 million per annum for five years if the IPwas transferred. For both companies, it is assumed that therisk-free interest rate is 4% and the appropriate risk premiumis 5%. In the case of post-transfer development costs, the pre-and post-transfer discount rate will often need to be adjustedto reflect the difference in systemic risk between the realisticalternatives. Company S’s tax rate is assumed to be 30%, andSubsidiary B’s 20%. The example assumes that Compamy S’sbook value of the IP amounts to €1,372,818.

SolutionCompany S’s minimum price before tax impact amounts tothe net value of the profit potential tansferred, that is, dis-counting €0.6 million with a discount rate of 9% for five

years results in a net present value of €2,333,791. Giventhat it is assumed that the IP transfer is a taxable event andthe capital gains are taxed at 30%, the minimum priceamounts to (€2,333,791 – 30% × €1,372,818)/0.70% =€2,745,636.

Subsidiary B’s maximum price before tax amounts tothe net value of the profit potential received, that is, dis-counting €0.9 million with a discount rate of 9% for fiveyears results in a net present value of €3,500,686. Underthe assumption that the transfer price paid for the IP canbe capitalised and the resulting amortisations would be taxdeductible by Subsidiary B, the net present value of the taxamortisation benefit would amount to 1/(1-0.1556) =18.43% (see Figure 2).

This results in a maximum price to Subsidiary B of€3,500,686 × 1,1843 = €4,145,699.

The resulting midpoint between €2,745,636 and€4,145,699 is €3,445,688, which the taxpayers wouldhave to apply.

SummaryAs result of the amendment of the Foreign Tax Code in2007, Germany introduced the hypothetical arm’s-lengthtest into the Code. The hypothetical arm’s-length testmust be applied if no limited or unlimited comparablethird-party data is available. It is a two-sided approach thatconsiders both the minimum ask price from the seller’sperspective and the maximum willingness to pay from thebuyer’s side. The most likely value within that range mustbe chosen. In its practical application, the followingparameters should be carefully analysed and documented:• Profit potential expectations associated with the IP pre-

and post-transaction;• Realistic alternatives;• Capitalisation rate for a risk-free investment, increased

by a premium that adequately reflects functions andrisks;

• Capitalisation period associated with the useful life; and• Tax gross-up approach.

Figure 2

Year 1 Year 2 Year 3 Year 4 Year 5

Amortisation in % 20% 20% 20% 20% 20%

Discount factor 9% 9% 9% 9% 9%

NPV factor 0.917 0.842 0.772 0.708 0.650

Tax rate 0.2 0.2 0.2 0.2 0.2

Amortisation benefit 0.037 0.034 0.031 0.028 0.026

NPV amortisation benefit 0.1556

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German legislation goes beyond what is stipulated byArticle 9 of the OECD’s Model Tax Convention on Incomeand on Capital. Thus, it is debatable whether the hypothet-ical arm’s-length test is covered by typical double taxtreaties. This issue should be further investigated, especiallybecause the analysis must hold for both jurisdictionsinvolved in the transaction. Practical experience in thatregard is limited. Court cases on the application of the hypo-thetical arm’s-length test and its compliance with double taxtreaties are not available yet.

Dr Richard Schmidtke PartnerMunich, GermanyDeloitte

Tel: +49 (89) 29036 8690Fax: +49 (89) 29036 [email protected]

Dr Richard Schmidtke is a partner with Deloitte’s German trans-fer pricing service line and leads the local transfer pricing teamin Munich. Richard has advised clients mainly in the areas ofbusiness model optimisation, IP transfer pricing planning, docu-mentation work for various companies including support in taxaudits, mutual competent authority procedures and advancedpricing agreements. As part of his work, Richard also assistedmultinationals defining and implementing transfer pricing poli-cies and related corporate governance processes. Richard’sclients include European, Japanese and US multinational corpo-rations in a wide range of industries, including manufacturing,pharmaceuticals, chemicals, wholesale/retail, consumer goodsand logistics.Richard studied economics and business informatics in

Munich and Toulouse and holds a PhD in economics from theUniversity of Munich. He further holds a master’s degree inaccounting and taxation from the Business School Mannheimand is a chartered financial analyst charterholder of the CFAInstitute. Richard is a certified German tax adviser and memberof the German Chamber of Tax Advisors. He is also a memberof the German Chartered Financial Analyst Society.He is a leader of the intellectual property group, an interna-

tional group of Deloitte transfer pricing experts focusing ontransfer pricing and intellectual property. Further, Richard teachestransfer pricing at the Business School of Mannheim and trans-fer pricing valuation of intangibles for tax auditors at the internaluniversity of the Federal Tax Office (Bundesfinanzakademie).Richard has published various articles in national and inter-

national tax and transfer pricing journals. Most of his publica-tions deal with business restructurings, compensationpayments and IP migration topics. He is a regular speaker atnational and international conferences.Richard is recognised as one of the world’s leading transfer

pricing advisers by Euromoney/Legal Media Group.

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Bjorn HeideckeSenior manager, transfer pricingHamburg, GermanyDeloitte

Tel: +49 40 [email protected]

Bjoern Heidecke is a senior manager in the transfer pricingpractice of Deloitte’s German member firm and is based inHamburg. He focuses on issues relating to valuations, business restruc-

turings, and intangibles. Bjoern serves clients from all industries, including fast-mov-

ing consumer goods, pharmaceuticals, and the digital sector.He is a frequent speaker at the German Training Center for TaxAuditors (Bundesfinanzakademie) as well as at universities.Bjoern is a regular contributor to international tax publicationson transfer pricing topics, and is the editor of a compendiumon transfer pricing and restructurings.Bjoern holds a PhD in economics.

Oskar GläserManagerTax and legal, transfer pricingDeloitte

Leipzig, GermanyTel: +49 341 992 7092Mobile: +49 151 5807 [email protected]

Oskar Gläser is a transfer pricing manager in the Leipzig office.He joined Deloitte in January 2018 after gaining nine years ofprofessional experience as a transfer pricing adviser withanother Big 4 firm. Oskar has general experience in all areas of transfer pricing.

He advised large DAX companies as well as mid-sized compa-nies in a wide range of industries. Oskar has mainly beenengaged in projects focusing on tax audit defence and imple-mentation projects in Germany.

Recent relevant experience• Tax audits, administrative appeals and criminal tax proceedings.• Support regarding the design of franchise fees, trademarklicenses and service charges.

• Transfer pricing advisory with focus on inter-company finan-cial transactions as well as BEPS Action 13 (MF/LF/CbCR).

Academic background• External PhD student at TU Dresden.• Diplom-Wirtschaftsjurist (FH) at Trier.

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Outright sale of IP: practicalconsiderations post-BEPS

Transfer pricing (TP)for intangible propertyis an increasinglyrelevant and complexarea of taxation formultinationalenterprises (MNEs)and taxing authorities,writes Bruno A deCamargo of Deloitte.The main policy driverfor the existing andevolving state ofintangible propertytaxation globally is theOECD’s BEPSinitiative, and itsensuing adoption bylocal governments.

T he bulk of the OECD’s recent guidance on TP for intangibles iscontained in the 2017 Transfer Pricing Guidelines forMultinational Enterprises and Tax Administrations (TPG), specif-

ically Chapter VI: Special Considerations for Intangibles, released fol-lowing BEPS Action 8. In Paragraph 6.6 of the TPG, the OECDdefines an intangible as “something which is not a physical asset or afinancial asset, which is capable of being owned or controlled for usein commercial activities, and whose use or transfer would be compen-sated had it occurred in a transaction between independent parties incomparable circumstances”.The purpose of this article is to outline certain practical considerations

in the context of a TP analysis of an outright sale of intangibles, with aview to helping MNEs operating in countries that follow the OECD’sTPG to navigate the guidance (primarily Chapter VI) and the inevitablecontroversy with tax authorities. The intent of the author is not to com-ment on the policy merits of the guidance, nor to identify any perceivedshortcomings that it may contain. For simplicity, let us assume that our hypothetical case study of an

outright sale of intangibles reflects an accurately delineated transactionunder Section D of the TPG’s Chapter I: The Arm’s-Length Principle.Let us also assume that the intangible being sold has been appropriatelyidentified and its ownership appropriately determined, per the guidanceunder Sections A and B of Chapter VI of the TPG. Although extremelyrelevant for any TP analysis involving intangibles, the questions of delin-eation of the transaction, and identification and ownership of the intan-gibles, are outside the scope of this article. As such, the commentscontained herein pertain to the pricing analysis of a properly delineatedoutright sale transaction of specifically identified intangibles, the owner-ship of which has been clearly established.

Transfers of intangiblesAn outright sale of an intangible in the context of an inter-companytransaction generally involves the transfer of all substantial rights andobligations in the intangible, including the exclusive right to use, devel-op, or otherwise exploit in an unencumbered manner (often only limitedby a geographical restriction). It may be advisable to establish the termsof the transfer taking into account how independent parties might struc-ture this type of transaction, as well as the practical limitations surround-ing the availability of reliable data to price the transaction.

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Where more than one type of intangible will be exploitedin an integrated fashion and the possibility of disaggregationis remote (e.g., for a pharmaceutical product, the patent forthe active ingredient and the regulatory approval), framingthe transfer as a combination of the intangibles may be desir-able. Aggregation rules provided in the OECD TPG or theUS regulations, for example, must be considered in suchcases. The intent is to reflect the commercial reality of thesituation and facilitate the pricing exercise.Contracts are paramount in defining the parameters of the

transfer. It is also important to understand the commercialrationale for the transfer, ascertain the realistically availableoptions of both buyer and seller, and consider whether thetransfer constitutes a business restructuring for which compen-sation is due to the seller in excess of the price for the isolatedsale of the intangible(s). (See TPG, Chapter IX: TransferPricing Aspects of Business Restructurings). Note that when abusiness restructuring, including a licence of intellectual prop-erty (IP) rights, is priced at arm’s length, there cannot possiblybe an ‘exit charge’ consideration above and beyond the arm’s-length consideration (Philippe G Penelle, The Economics ofBusiness Restructuring and Exit Charges, Bloomberg BNATransfer Pricing Report, Vol 23 No 3, May 29 2014).

Transfer pricing methodsIn terms of TP methods, the TPG’s Paragraph 6.145 states:“The transfer pricing methods most likely to prove useful inmatters involving transfers of one or more intangibles arethe CUP method and the transactional profit split method.Valuation techniques can be useful tools.” Unless the trans-fer follows an open market transaction such as an acquisitioninvolving the intangible in question, it is improbable thatthe comparable uncontrolled price (CUP) method can bereliably applied. It should be noted that, if the transfer follows the acqui-

sition of a business of which the intangible is a part, an MNEmay be able to rely on the acquisition price and an appropri-ate allocation thereof to the intangible in question, under anapplication of the CUP method. However, it is likely that theconcomitant application of another method would berequired in these circumstances.Similarly, although in theory the transactional profit split

method could be applied for an outright sale of intangibles,it is unlikely that its isolated application would suffice in prac-tice due to data limitations. In its revised guidance on profitsplits, released under BEPS Action 10, the OECD acknowl-edges that “[a] weakness of the transactional profit splitmethod relates to difficulties in its application”. (See TPG,Paragraph 2.123, as amended by the report, RevisedGuidance on the Application of the Transactional Profit SplitMethod – BEPS Action 10, June 21 2018). Where traditional transactional or profit-based methods do

not apply, the most common alternative methods used to

determine an arm’s-length transfer price for an outright sale ofintangibles are the various methods used in the area of businessvaluation. (Most comments on valuation practice contained inthis article, other than those referencing the TPG, are sourcedfrom: Smith, G and Parr, R [2005], Intellectual Property:Valuation, Exploitation, and Infringement Damages, JohnWiley & Sons.) The three primary valuation methods used inthe valuation of intangibles are the cost approach, the marketapproach, and the income approach. The OECD seems tofavour such methods, specifically the income approach, havingdedicated 25 full paragraphs to guidance on its application inthe revised TPG (Paragraphs 6.153 to 6.178). The first suchparagraph reads: “In particular, the application of incomebased valuation techniques, especially valuation techniquespremised on the calculation of the discounted value of project-ed future income streams or cash flows derived from theexploitation of the intangible being valued, may be particularlyuseful when properly applied.”In many cases, the income approach may be the most

appropriate method to analyse an outright sale of intangi-bles. Nevertheless, it may be prudent to consider the costapproach and market approach in the context of a broadervaluation exercise. In situations where the value of an intan-gible cannot be reliably assessed directly, the relationshipbetween the value of the intangibles and the value of thebusiness as a whole may be useful in informing the valuationexercise. However, the enterprise value of the business is notalways informative of the bundle of rights being transferred. Finally, it may be helpful to perform a ‘before-and-after’

analysis in line with the “realistic alternatives principle”under the OECD TPG, and the US regulations, if the trans-action involves the US (see TPG, Chapter IX: TransferPricing Aspects of Business Restructurings). At arm’slength, the buyer and seller must be exactly indifferentbetween the ‘before’ and the ‘after’ on a risk-adjusted basis. The application of the valuation/pricing method is sus-

ceptible to the underlying valuation standard. In most of thecountries endorsing the OECD TPG, the valuation standardfor TP is the arm’s-length principle (ALP). In applying amethod derived from valuation practice, care should betaken to adhere to the ALP. If a different standard than theALP (such as fair market value, or FMV) has been followed,it is necessary to reconcile the defining elements of the stan-dards in order to ensure that the same conclusions arereached. The guidance provided in the OECD TPG and theUS regulations regarding the use of the income methodincorporates FMV concepts, and thus makes such conceptsrelevant for the application of the ALP in certain contexts.Fair market value is defined as “the price, expressed interms of cash equivalents, at which property would changehands between a hypothetical willing and able buyer and ahypothetical willing and able seller, acting at arm’s lengthin an open and unrestricted market, when neither is under

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compulsion to buy or sell and when both have reasonableknowledge of the relevant facts. (Note: In Canada, the term‘price’ should be replaced with the term ‘highest price’)”.This definition is sourced from the International Glossary ofBusiness Valuation Terms, published by a consortium ofbusiness valuation organisations.The author is of the view that the conclusions arrived at

by following the ALP could be successfully reconciled to theconclusions arrived at under the most broadly used valuationstandard, FMV, and vice versa. However, the author wouldcaution the reader that there is no consensus among practi-tioners as to how the defining elements of each standardshould be interpreted, and therefore what the reconciliationof these standards should entail (although some judicialguidance exists, it is not entirely formed and solidified).

Form of paymentMany taxpayers that enter into an outright sale of intangi-bles transaction may have a preference for structuring theform of payment as a lump sum (a noteworthy exceptionmay be in the case of US outbound transfers, due to US

sourcing rules). In Paragraph 6.179 of the TPG, the OECDstates: “In transactions between independent parties, it iscommon to observe payments for intangibles that take theform of a single lump sum.”Notwithstanding the above, the OECD links the evalua-

tion of the form of payment back to the delineation of thetransaction principles under Chapter I of the TPG, andseems to endorse price adjustment clauses/contingent pric-ing in valuation cases of high uncertainty (see Paragraph6.183 of the TPG). As such, it is worthwhile to considerwhether the transaction in question has economic character-istics that would favour the form of payment as a lump sum.Furthermore, it is helpful to compile market evidence of thearm’s-length nature of the form of payment, for examplethrough a search for reportable open-market transactionsconcluded under similar circumstances. Ultimately, underthe OECD TPG (and the domestic TP rules of many juris-dictions, including the US), MNEs are free to select theform of payment they desire, regardless of whether or notmarket participants are observed to opt for the same form ofpayment.

Hard-to-value intangiblesOne of the more controversial additions to the new ChapterVI of the TPG is the section on hard-to-value intangibles(HTVI), which aims to solve the problem of informationasymmetry between taxpayers and tax authorities for intan-gible valuations that are highly uncertain and for which nocomparables exist. The OECD’s HTVI guidance allows taxauthorities to “consider ex post outcomes as presumptive evi-dence about the appropriateness of the ex ante pricingarrangements” (see TPG, Paragraph 6.192). Paragraph 6.193 of the TPG outlines the available exemp-

tions from the HTVI approach. For MNEs structuring atransfer of an intangible that would fit the HTVI conditionsdefined by the OECD, it is imperative to document thedetails of the ex ante projections used to determine the pric-ing arrangement for the transfer, including how risks wereaccounted for and the consideration of reasonably foresee-able events and circumstances, and their respective probabil-ities of occurrence. Due to the lack of clarity with respect tothe burden of proof on the taxpayer to ‘satisfactorily demon-strate’ that the ex ante projections considered all ‘foreseeable’events, it is prudent to compile extensive evidence in supportof the key items of input underlying the projections (seeTPG, Paragraph 6.194). It is curious that the OECD’sHTVI guidance is silent on cases characterised by such anextreme degree of uncertainty that projections cannot bereliably prepared by the MNE. In these situations, a practical– albeit possibly insufficient – solution would entail extrapo-lating the types of actions aimed at meeting the first HTVIexemption condition to the assumptions used in the valua-tion methodology that does not rely on projections.

Bruno A de CamargoPartnerTransfer pricingDeloitte LLP – Canada

La Tour Deloitte1190 avenue des Canadiens-de-Montréal,Suite 500, Montréal QC H3B 0M7Tel: +1 514 393 [email protected]

Bruno A de Camargo is a partner with Deloitte’s global transferpricing (TP) group based in Montreal. He has 12 years of experi-ence in international tax and TP across a variety of industries,including aerospace, retail, technology, manufacturing, media,and life sciences, among others. His fields of competenceinclude TP planning and optimisation, dispute resolution, compli-ance, due diligence, and consulting, with a specific focus on thevaluation of intangibles and business model structuring. Brunoserves all nature of clients with cross-border tax and businessneeds, from promising start-ups to well-established public corpo-rations. He advises Canadian corporate clients in developinginternational restructuring and expansion strategies, includingsetting up operations in the US and emerging markets.

Bruno has a bachelor’s of arts in economics and philosophyfrom Emory University in Atlanta, GA and has completed theChartered Business Valuator programme. He is a nativeBrazilian, fluent in English, French, and Portuguese.

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Taking the transfer of a clinical Phase 1 pharmaceuticalcompound as an example of a transaction that would likelybe subject to the HTVI framework, the supporting evidencereferred to above may include, among other things: rep-utable market research and industry reports, industry sur-veys, market forecast data, scientific research, managementexpectations, and other expert opinions, as well as publicdata regarding comparable transactions and companies. The valuation analysis of the pharmaceutical asset may

consider elements such as:• Key parameters affecting future cash flows to be derivedfrom commercialising the intangible (i.e., regulatoryapproval, unique market conditions, competition, and soon);

• Different probability factors related to the respective like-lihood of success of the various indications reaching eachremaining stage of clinical and regulatory approval,including market commercialisation; and

• Discount rates that are different for each indication basedon both market data and widely-accepted valuationmethodology.Multinational enterprises may be well served by thor-

oughly documenting in writing any input gathered throughinterviews. Furthermore, it is helpful to perform sensitivityanalyses to determine the reasonableness of the projectionsand assumptions underlying any key input derived internally,for instance by reference to external market and scientificpublications.

Indicators of valueIrrespective of the TP method selected, in the case of intangi-bles, it is advisable to consider other value indicators and cor-roborating methods, as applicable. For instance, if the MNE ispublicly listed, in certain circumstances the company’s shareprice and market capitalisation may provide a relevant indica-tion of value that should be considered as a data point in the

analysis (with appropriate adjustments). In addition, there maybe third-party analyses available in the public domain, such ascapital market broker/analyst reports covering the company’sstock, which may contain a value indication.The purpose ofsuch reports is to provide a forward-looking view in light of aprospective investment decision in the shares of the company,and therefore potentially incorporate assumptions on theachievement of certain milestones. Generally, broker analy-ses do not employ detailed valuation methods, instead rely-ing on high-level estimates often based on markettransactions of dubious comparability from a TP perspec-tive. In any case, the reports rarely contain full disclosure onthe approach used. Nevertheless, tax authorities may haveaccess to such reports, and proactively addressing their con-tents could prove useful in mitigating controversy risk.

ConclusionThe ability of tax authorities to challenge the pricing ofintercompany transactions involving the outright sale ofintangibles has been greatly expanded with the advent ofBEPS. Careful action is required by MNEs entering intosuch transactions in order to mitigate controversy risk, par-ticularly in the following areas (as indicated, these areasrelate to pricing only. The questions of delineation of thetransaction, and identification and ownership of the intangi-bles, should also be considered):• Structuring of the scope and terms of the transaction;• Selection and application of the most appropriate TPmethod (including due consideration of valuationapproaches and their reconciliation with the ALP);

• Supporting analysis of the form of payment;• Documentation of input, assumptions, and analyses (forHTVI cases, this includes extensive evidence in supportof ex ante projections used); and

• Corroboration/reconciliation of results with externalmarket data.

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Moving away from traditionalmethods: lessons from recentJapanese TP casesThe Tokyo DistrictCourt recently issuedtwo judgmentsregarding transferpricing (TP) cases,both in relation to thetreatment ofintangibles. Thesedecisions provideinsights into how theJapanese tax authoritieswill evaluateintangibles whendealing with TP issuesin audits goingforward, explainYutaka Kitamura andJun Sawada ofDeloitte.

Tokyo District Court judgment of April 11 2017Summary of the caseA taxpayer entered into a foreign related-party transaction to importEnglish-language learning materials for children from a foreign related partyand resold them through door-to-door sales in Japan. The tax authorityargued that the resale price method (RP method) should be used for calcu-lating the arm’s-length price for the foreign related-party transaction.

The arm’s-length price under the RP method alleged by the taxauthority was the price at which the taxpayer resold the English-languagelearning materials to an uncontrolled party, minus the amount of a nor-mal profit margin multiplied by such price. A normal profit margin in thiscase means the weighted average ratio of gross margin to the total rev-enue for multiple transactions, where the party that purchased inventoryassets, which were the same as the English-language learning materials,or of a similar sort, then resold them to an uncontrolled party.

The tax authority argued that transactions to procure learning mate-rials for children and sell them door to door should be deemed compa-rable transactions to the import and door-to-door sales ofEnglish-language learning materials for children, and an appropriateadjustment could be made to the difference between the two in this case.However, one important distinction was that a famous character featuredin the English-language learning materials, while the characters used forthe comparable materials were not known to the public.

Judgment of the courtThe court held that, under the RP method, the arm’s-length price wascalculated based on the normal profit margin in similar transactionsconducted over a certain period of time. This is a calculation methodbased mainly on the similarity of the functions performed by the seller,focusing on the fact that the profit margin relating to the resale trans-action has a close relation to the functions performed and risksassumed by the seller, rather than the type of inventory assets relatingto the transaction. Therefore, it is important to ensure that no gapexists between the comparable transaction and the resale transactionconducted by the purchaser of inventory assets relating to the foreignrelated-party transaction, in terms of the functions performed or risksassumed by the seller.

Accordingly, upon selection of a comparable transaction, it is nec-essary to analyse whether there are any differences which cause a gap

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between the profit margins and, if there is any gap,whether that gap can be adjusted. Note that the gap isadjusted only when it is objectively obvious that such adifference affects the calculation of a normal profit mar-gin. However, if such a difference exists, the gap in profitmargin resulting from the difference must be adjusted. Ifthe difference cannot be rationally quantified for appro-priately adjusting the profit margin, the arm’s-length priceshould not be calculated based on the comparable trans-action in question.

In this case, it was determined that the functions per-formed by the respective sellers in each transaction were notsubstantially different because both transactions were door-to-door sales by sales representatives, learning materialswere developed and produced by respective suppliers, andthe seller did not perform the manufacturing function.However, as the method and content of advertising and thecompensation of sales representatives differed between thesetransactions, the differences in functions performed by thesellers, affecting the calculation of the normal profit margin,were deemed objectively obvious differences.

Analysis showed that the gap between the gross profitmargins that arose depending on whether nationwide saleslocations were involved was not appropriately adjusted.Analysis also demonstrated that the gain in gross profit

margin arising from differences in name recognition andthe customer appeal of characters (intangibles) used in thelearning materials was not appropriately adjusted.

In particular, the court underlined that, since the factthat intangibles used in a transaction may impact various fac-tors like sales price of inventory assets, gross revenue, adver-tisement expenses, sales expenses, negotiations with a sellerand royalties, it was difficult to measure precisely the gapbetween the gross profit margins that arose depending onthe intangibles used, and therefore that gap may not havebeen adjusted appropriately.

Based on such analysis, the comparable transactionsselected by the tax authority were rejected as inappropriate,and the court ruled in the taxpayer’s favour.

Tokyo District Court judgment of November 24 2017Summary of the caseA taxpayer entered into a series of foreign related-partytransactions to grant licences to use intangible assets, includ-ing technology or know-how, relating to product manufac-turing and sales, and to otherwise provide services to aforeign related party. The taxpayer argued that the compa-rable uncontrolled price (CUP) method should be used forthese transactions and that there were internal comparabletransactions between the taxpayer and uncontrolled parties.

The arm’s-length price under the CUP method in thiscase should be the price charged in an uncontrolled transac-tion for granting licences and providing services which wereof the same sort as the licences granted and services provid-ed by the taxpayer, under circumstances equivalent to thoseof the foreign related-party transactions, specifically in termsof trade stage, trade volume, and other similar factors.

The taxpayer argued that the above requirements for theCUP method were satisfied in this case. However, the taxauthority denied the taxpayer’s argument and insisted ratherthat the residual profit split method (RPSM) should be used.

The arm’s-length price under the RPSM in this case wascalculated in the following two steps. First, a routine returngenerated in the transaction between uncontrolled partieshaving no unique functions was allocated to the taxpayerand the foreign related party. Second, the amount remainingafter the allocation of the routine return (i.e. residual profit)was distributed to each party according to its unique func-tions. Residual profit was allocated to each party based onthe allocation factors relating to each party, such as amountof expenses incurred and value of fixed assets used, whichwere sufficient to presume the degree of contribution to thegeneration of the profit.

Judgment of the courtFor the following reasons, the court pointed out that in thiscase the arm’s-length price should be calculated for onepackaged deal granting licences and providing services for

Yutaka KitamuraDirector at Deloitte Tohmatsu Tax CoGlobal tax services/tax controversy teamDeloitte Tohmatsu Tax Co

Tel: +81 (0)70 3192 [email protected]

Yutaka Kitamura is an attorney at law admitted in Japan andthe State of New York, and a certified public tax accountant.

He has worked at: Nagashima Ohno & Tsunematsu (2000to 2009); the Financial Tax Office, in the policy and legaldivision; the Planning and Coordination Bureau; the FinancialServices Agency (deputy director, 2009 to 2012); KyotoUniversity Law School, as part-time lecturer in tax case stud-ies (2010 to 2015); Ernst & Young Tax Co; and EY Law Co(2012 to 2017). In June 2017 he joined Deloitte TohmatsuTax Co. There, he is in the tax controversy team, supportingclients in managing tax controversy issues regarding a rangeof foreign and domestic tax matters.

He has written many articles, including Foreign ExchangeIssues in International Taxation (IFA branch report for Japan),and Cahiers de droit fiscal international (Volume 94b, 2009).

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multiple products, and not separately calculated for eachproduct. It was vital to the deal that the taxpayer disclosedknow-how for the manufacturing, use and management of acertain series of products, providing training for manage-ment on customer relationships, and dispatching technicalexperts. Therefore, in order to put an appropriate value onthe deal, it was necessary to consider the deal as a whole, asit would not be possible to understand the value accuratelyif each transaction was looked at separately. The flavour ofthese arguments is the same as the ‘pricing the real deal’ tagline of the OECD during the BEPS project and is consistentwith the general notions of ‘aggregation’ in TP analyses,rather than a ‘fragmented’ valuation, which, in the contextof the ‘most appropriate’ method selection of the OECD,creates an aversion to transactional methods such asCUP/CUT (comparable uncontrolled transaction) and theresale price method (RSM), in favour of profit splits andincome approach valuations.

Based on the above determination, the court comparedthe foreign related-party transactions as a whole with compa-rable transactions specified by the taxpayer. It found that theproduct lines, how to use them and frequency of dispatchingemployees to support the foreign related party were not nec-essarily the same between the two, rather they were different,and this may have resulted in differences in how to supportthe foreign related party in selling products and the value ofintangibles provided. The court also found that the circum-stances could be different in terms of the countries or areaswhere products were manufactured or sold and whether ornot the taxpayer granted exclusive licences.

Accordingly, the court concluded that there were dif-ferences to a considerable extent between the foreignrelated-party transactions and comparable transactions interms of licences, services and circumstances in which thetransactions were conducted, and therefore the CUPmethod was inappropriate.

The taxpayer further argued that, even if the CUPmethod was inappropriate, the method corresponding tothe CUP method (the Quasi-CUP method) should beapplied, thus relaxing the requirement that the same sort oflicences should be granted and that services should be pro-vided under equivalent circumstances.

However, the court raised the question of whether it wasacceptable to apply the Quasi-CUP method, since thealleged comparable transactions would not be appropriatecomparable transactions unless the requirement of defining‘same sort’ or ‘equivalent circumstances’ was relaxed. Evensetting this point aside, the court held that the Quasi-CUPmethod was inappropriate because the foreign related-partytransactions and the alleged comparable transactions weresubstantially different in terms of licences, services and cir-cumstances. Therefore, the court supported the applicationof the RPSM and ruled in favour of the tax authority.

The taxpayer has appealed the court’s decision to theTokyo High Court.

How would TP audits involving intangibles evolve?These two cases are typical in terms of recent trends in howto deal with intangibles when applying a method for calcu-lating an arm’s-length price. The court seems to emphasisethe uniqueness of the intangibles and rigorously analysewhether there is a difference between a foreign related-party transaction and a comparable transaction. As a result,the court may prefer not to uphold traditional transactionmethods like the CUP or RP methods, but rather use theRPSM and income methods (DCF) when dealing withintercompany transactions involving intangibles.

The RPSM is applicable when two or more related par-ties contribute to the creation of important intangibleassets or otherwise perform unique functions. Especiallywhen a related party transaction concerns the licensing ofimportant intangible assets, application of the RPSM is

Jun SawadaPartner at Deloitte Tohmatsu Tax CoInbound client service leaderTransfer pricing

Deloitte Tohmatsu Tax Co

Tel: +81 3 6213 3927 [email protected]

Jun Sawada is a partner of Deloitte Tohmatsu Tax Co, and leadsthe inbound client service team. His main practice area is trans-fer pricing (TP). Since starting his career with Arthur Andersen in1999, Jun has been advising both foreign and Japanese multi-nationals on various TP and cross-border taxation issues. Beforejoining Deloitte Tohmatsu Tax Co in October 2013, he had alsoworked with Ernst & Young and White & Case.

Jun has represented clients in various discussions with theJapanese tax authorities. He has defended companies underaudit, assisted companies in their negotiations with tax author-ities to obtain advance approval of their TP arrangements (uni-lateral/bilateral advance pricing arrangements (APAs)), andsupported companies in domestic tax appeals. In particular, hehas assisted clients in industries such as pharmaceuticals,medical devices, software, luxury goods, apparel, media, andentertainment. Jun has also assisted clients with their compli-ance needs, establishing TP policies, and determining tax effec-tive supply chains and IP migration.

Jun has contributed articles to Tax Analysts, the InternationalTax Review, and several major Japanese tax magazines, andhas also co-authored several books in Japanese regarding TP.

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often considered as it is difficult to identify appropriatecomparable transactions.

Historically, the Japanese tax authorities have demon-strated a preference for applying different types of profitsplit methods when evaluating intercompany transactionsinvolving intangibles and it is further expected that theprofit split methods will be used for scrutinising TP analy-ses that are based on one-sided approaches (i.e. applyingthe transactional net margin method (TNMM) whichallows a routine return in the tested party and full alloca-tion of the residual profit to the IP owner). The taxauthorities have available both qualitative and quantitativeinformation obtained from master files and country-by-country reporting, and also have stronger authority inrequesting overseas financial information based on thelegislated local file requirements, which allows them toperform both high-level analyses of the profit allocationsituation among the related parties, and in-depth analysisof the appropriate allocation of profits based on globalvalue chain analyses. However, at the same time, it is unre-alistic to expect the tax authorities to apply highly sophisticatedprofit split analyses due to a lack of resources and experience.Accordingly, it is likely that the RPSM or contribution profitsplit method will be applied in practice, with some tweaks to

reflect recent developments under the BEPS initiative, whendetermining the profit allocation factors (i.e. assets, capital, andcosts). It should be noted that the final guidance on the appro-priate application of the transactional profit split (TPS)method, released by the OECD on June 21 2018, did not fun-damentally change the guidance on when TPS is appropriate.

If a taxpayer wishes to apply the traditional transactionmethods to intercompany transactions involving intangibles(i.e. a one-sided approach or CUP/CUT) in Japan, it mightbe recommended to rigorously analyse the various compo-nents of the comparable transactions and prepare support-ing documents to provide more detailed explanations thanpreviously required. In addition, conducting an analysisregarding applying a profit split method is prudent in orderto mitigate surprises from TP audits in Japan. The caveat isthat other jurisdictions may have inconsistent treatment; forexample in the US, the judicial preference has been theopposite of that in Japan. The US Tax Court has over-whelmingly favoured transactional-type methods of directprice comparison, even if not very comparable in relation tothe profit splits and income methods that the IRS favours.This difference in preference of TP methods suggests thepotential for additional controversy and compliance burdensfor taxpayers.

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Embedded IP

Andre Schaffers andFilip Vanluydt ofDeloitte explain theconcept of embeddedintellectual property(IP), providingdetailed guidelines forreaders on how toidentify and quantify it.

Definition of embedded IPEmbedded IP is intellectual property that contributes to the value of atangible asset, financial asset or service, or personal service. Its value ischarged in a bundled price along with that of the property in which it isembedded. Embedded IP is therefore not subject to a separate chargelike in the case of an IP licence. For transfer pricing (TP) purposes, we should look to the aggregation

rules in the US Treasury regulations (and Inland Revenue Code (IRC)Section 482 after the US 2017 Tax Act), and the OECD TP guidelines formultinational enterprises and tax administrations (OECD TPG). Referenceto these, combined with an application of the best method rule (US) ormost appropriate method (OECD) will most often result in a conclusionthat the party buying – or licensing a ‘make and sell’ licence – from a relat-ed party property with embedded IP and reselling such property is onlyentitled to a routine return for its routine buy-sell activities. This conclu-sion eliminates the need to analyse the value of the IP separately from thevalue of the property that embeds the IP, as one-sided methods such as thetransactional net margin method (TNMM)/comparable profits method(CPM) allow benchmarking the arm’s-length return for the buy-sell func-tions. Any residual value is related to the embedded IP.

Example 1: a manufacturer sells a TV set embedding various IP in theform of technology and trade marks/trade name to related and unrelateddistributors performing comparable functions, using comparable assets,and assuming comparable risks. For TP purposes, both the manufacturerand related distributor must support the arm’s-length nature of the priceused between them. The selling price used for sales to unrelated distrib-utors can be used as an arm’s-length measure of the appropriate sellingprice for sales to the related distributors. Under this one-sided TP com-parable uncontrolled price (CUP) method, there is no need to attemptto determine the arm’s-length value of the embedded IP.

Example 2: a manufacturer sells a TV set embedding various IP to a relat-ed distributor only. For TP purposes, again, both the manufacturer andits related distributor must support the arm’s-length nature of the con-sideration paid and received. In the absence of internal comparableuncontrolled price transactions – the price paid by unrelated comparabledistributors in the previous example – the arm’s-length considerationcould be determined by reference to the profit generated by independent

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TV set distributors performing broadly comparable func-tions, using broadly comparable assets, and assuming broad-ly comparable risks as the related distributor. Note that it isirrelevant whether the TV sets distributed by the uncon-trolled comparable companies embed IP of the same valueas that embedded in the TV sets subject to the controlledtransaction because the value of the distribution functionsperformed by the related distributor and comparable com-panies is the same (by assumption, in this example).Therefore, here again, under this one-sided transfer pricingmethod (TNMM/CPM), there is no need to attempt todetermine the arm’s-length value of the embedded IP.

In many cases, however, the manufacturer owning the IPmay be selling finished TV sets to unrelated distributors, andlicensing at the same time the make and sell rights to the IPto related manufacturers. In such cases, can the uncon-trolled transaction be reliably used to determine the value ofthe controlled IP licence? The controlled and uncontrolledtransactions are very different in that the controlled transac-tion is the licensing of make and sell rights to IP, while theuncontrolled transaction is a tangible property transactionthat happens to embed the IP subject to the controlledlicence. The extent and nature of the rights transacted inboth cases are also different. In the controlled transaction,the rights transacted are make and sell rights to IP (no rightto further develop the IP is transacted); in the uncontrolledtransaction, the rights to sell a product are transacted (noright to make a product using the IP or right to furtherdevelop the IP are transacted).A similar question can be examined when the property

transacted is not a tangible product but is a financial or per-sonal service that embeds certain IP. In such cases, theuncontrolled transaction may be the provision of a servicewith embedded IP to an unrelated party while the con-trolled transaction may be the licensing of the IP to a relatedparty allowing that related party to provide comparableservices as provided in the uncontrolled transaction to otherrelated parties.

Cases of embedded IPGiven the very broad definition of intangible property andassets in US law and in the OECD TPG, embedded IP islikely to be found in a number of controlled tangible andservices transactions. In these controlled transactions, con-sideration paid reflects the return to many economically sub-stantial risks arising from assets used and functionsperformed by the participants in the controlled transactions.The use of assets and the performance of functions obligatesthe participants to incur costs such as material cost, labourcosts (salaries and benefits), depreciation of fixed assets andamortisation of intangible assets (in some cases), interest ondebt, research and development (R&D) expenses and

André SchaffersPartner, transfer pricingDeloitte, Belgium

Tel: +32 2 600 67 15Mobile: +32 497 51 52 [email protected]

André Schaffers is a partner in the transfer pricing practice ofDeloitte Touche Tohmatsu Limited’s Belgium member firm. Heis in charge of the economics practice and coordinatesDeloitte’s global innovation group.After working in the financial industry, André Schaffers joined

Deloitte’s transfer pricing group in 1998. He has worked on var-ious engagements, including setting up of global transfer pric-ing policies, advance pricing agreements, audit defence ofexisting or new transactions, documentation, and businessalignment projects. In addition to his role in Deloitte’s Belgianfirm, André has had various EMEA and global roles withinDeloitte’s transfer pricing practice.

Representative experienceAndré’s projects include the analysis of all types of transactions:tangible goods and services, with a special emphasis on financingand intangible property. His projects cover a variety of industries,including the automotive, pharmaceuticals, chemicals, constructiongoods, consumer goods, electronics, energy, financial services,industrial equipment, medical equipment, mining, and retail sectors. André is Deloitte Belgium’s primary contact for transfer pricing

analysis of intercompany financial transactions including pricingof debt, cash pooling arrangements, and other complex finan-cial instruments. In recent years, André has focused increasinglyon the link between the Belgian patent/innovation incomededuction regimes and transfer pricing. Indeed, the applicationof these regimes – primarily designed to create tax incentivesfor companies with significant research and development activi-ties – requires the determination of an arm’s-length return onself-generated intangible property; thus, OECD-inspired economicmodels and analyses are needed.André is in frequent contact with the tax authorities to dis-

cuss issues involving financial transactions, intangibles, theinnovation income deduction, and transfer pricing documenta-tion in general. He is a frequent speaker at external andDeloitte-sponsored events and seminars.

Education• 1991: Master in Applied Economics, ICHEC (Brussels)• 1997: Master in Business Administration, Solvay BusinessSchool, University of Brussels

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expenses associated with the development of other intangi-ble assets, and taxes. For this discussion, we will assume theexistence of embedded IP in an otherwise tangible or serv-ices transaction. Whether or not a controlled transactionconcerns embedded IP is a factual issue discovered duringthe functional analysis and the process of accurately delineat-ing a controlled transaction. The exact nature of the embed-ded IP is not of particular relevance to this discussion as wefocus our discussion specifically on conceptual considera-tions. Note, however, that insofar as the embedded IP isconcerned, the economically substantial risks arise out of theperformance of the so-called DEMPE functions (develop-ment, enhancement, maintenance, protection and exploita-tion). We will come back to DEMPE shortly. For the timebeing, we will assume that the same legal entity performsand controls all DEMPE functions – there is no fragmenta-tion of DEMPE. The word ‘control’ is used within its mean-ing in Chapter I of the OECD TPG.The value of IP is reflected in the profit-over-costs ele-

ment captured by the controlled distributor redeemed tothe manufacturer as the return to the risks it faced as a resultof the costs it incurred. Different IP will have different mar-ket values and will require different levels of continuouscosts in the form of maintenance and enhancement.Intellectual property may create barriers to entry for com-petitors. How long that barrier to entry is effective variesdepending on the nature of the IP. Marketing intangibles forexample are often believed to require more intensive andcontinuous maintenance than technology IP that is legallyprotected by patent. The value of IP therefore depends on:(i) the level of costs required to develop it and the systemicrisk associated with such costs commitments; (ii) the leveland frequency of maintenance and enhancement costs, andassociated systemic risk, required to support the continuedexpectation of probability – weighted cash inflows reflectinga premium over marginal cost; (iii) the level of IP develop-ment competition in the market; and (iv) the availability oflegal protection of such expectation of cash inflows. Thus,the level and duration of expected cash inflows, probabilityof success and failure, and legal barriers to entry are criticaldeterminants of IP value.

Extracting embedded IP valueThe assessment of the value of embedded IP can be per-formed in a reliable way by reference to well-accepted valu-ation techniques found in the asset pricing and corporatefinance literature. Such methods have authority under USTreasury regulations and the OECD TPG. In the corporatefinance world, these approaches can be classified in threegroups, each possibly containing different variants:• The market approach seeks to evaluate the value of IP byreference to the price paid for comparable IP exchangedbetween unrelated parties. If that approach is appealing

for its simplicity, its usefulness is limited by the require-ment that the IP must be sufficiently comparable to pro-vide a meaningful data point. Since IP is often unique –and hard-to-value-intangibles that have received enor-mous attention in the BEPS discussions at the OECD areby definition unique and valuable – it is often unreliableto adopt a market approach (only) to value IP, with theexception of cases where an IP owner would be licensingthe IP, under similar circumstances, to both related andunrelated parties;

• The cost approach seeks to evaluate the value of IP byreference to the costs incurred in developing the IP. Thiscost approach may be reliable to value IP at the veryearly stages of development, but for more developed IPit is generally unreliable unless the IP is not unique orparticularly valuable. Investments in IP are typically risky

Filip VanluydtDirector, global business tax, BelgiumDeloitte Touche Tohmatsu

Tel: +32 2 600 65 63Mobile: +32 476 53 00 [email protected]

Filip Vanluydt is a director in the transfer pricing practice ofDeloitte Touche Tohmatsu’s Belgian member firm.

ExperienceFilip Vanluydt is an economist, specialising in the managementof a wide range of transfer pricing projects. He has completedseveral local, regional (European), and global transfer pricingdocumentation studies and supply chain restructuring projects,involving, for example, the establishment of shared servicesand central procurement companies, the migration of intellectu-al property and the design and implementation of centralentrepreneur structures.Filip has also been involved in a number of audit defence

projects, competent authority, and unilateral and bilateraladvance pricing agreements involving negotiations with rev-enue authorities in Europe and Japan.Filip has worked with many clients from a wide range of

industries, including the manufacturing, technology, telecommu-nications, energy and resources, pharmaceuticals, chemicals,retail and services sectors.He has a master’s degree in commercial enginerring from

the University of Hasselt and a Master in Tax Law degree fromKatholieke Universiteit Leuven.Filip speak Dutch and is fluent in English and French.

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(especially for technology IP that carries technical risk),which means that typically no stable relationship existsbetween the costs of developing IP and the value of theIP when developed; and

• The income approach seeks to evaluate the value of IPby reference to the expected discounted net cash flowsthe IP is projected to produce. Given the type of IPsubject to controlled transactions, this approach isoften the most reliable. This is reflected in the guid-ance provided in US Treasury regulations and by theOECD that focuses on discounted cash flow (DCF)valuation to give effect to an income approach. Themain challenge in using a DCF approach is the devel-opment of probability-weighted financial projections.A financial projection is different from a forecast. Afinancial projection is the probability-weighted averageof all possible forecasts a company can envision forevery year for which there is a reasonable expectationof cash flows associated with the subject IP.One of the merits of the income approach is that it is rel-

atively simple to implement. In addition, income approacheshave a long history in other contexts (e.g. purchase priceallocation valuation, and M&A), including non-tax con-texts, are well understood and accepted, and are often theonly reasonable valuation option available. The OECD TPGpublished in 2017 as a result of the OECD BEPS workrecognised the usefulness of the income approach by provid-ing new guidance on its use for TP purposes (see ChapterVI). The market approach is often analogised to the CUPmethod, and the cost approach is often analogised to thecost plus method. The income approach can be associatedwith the TNMM/CPM approach in that they all assess prof-itability of a tested party at the (net) profit level.In summary, in the case where a manufacturer sells prod-

ucts with imbedded IP to a related party, one can evaluatethe reliability of the derivation of the value of that IPobtained using the following three categories of methods:• Market approach: the IP owner is licensing comparableIP separately to a third-party manufacturer, or compara-ble IP is licensed under comparable circumstances

between two unrelated parties. Databases exist that mayprovide such market evidence, if reliable comparable IPtransactions can be found;

• Cost approach: the IP owner capitalises all costs incurredin developing the IP using a discount rate reflecting itsexpected return. That return can be reliably estimatedusing financial metrics such as cost of debt and cost ofequity (weighted average cost of capital); and

• Income approach: financial projections (probability-weighted) are developed and the value of the IP is calcu-lated as the difference between the total net present valueof the combined transactions and the net present value ofthe non-IP related expected cash flows (using CUP orTNMM/CPM).

Embedded IP and IP regimesBeing able to identify and quantify embedded IP is of greatimportance to a taxpayer qualifying for IP regimes. Indeed,in the application of IP regimes, the taxpayer assumed to beperforming R&D activities may have to be able to identifyembedded IP income that will serve as a basis for the appli-cation of the regime.It may be worthwhile considering, at this stage, if the

embedded IP income measured covers a R&D function onlyor a broader set of functions associated to that IP, like a salesfunction of the proceeds of the R&D function. If such is thecase, one can wonder if the full IP income needs to be con-sidered as a basis for the application of the regime, or onlythe portion attributable to the ‘pure’ R&D function.

ConclusionsEmbedded IP is everywhere. Its valuation – benchmarking– is not straightforward and resorts to approaches that, alsounder the OECD regulations, are akin to corporate financeapproaches.Although not always necessary, in quite a few cases, separate

benchmarking of embedded IPs is necessary for TP purposes. That same separate benchmarking is likewise of great

importance in the application of national IP regimes allow-ing deductions on the basis of the IP income.

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Brand value, brand equity, andbrand IP

Brands are complexintangible assets. Asexplained by TimHeberden and CamSmith of Deloitte,robust valuations androyalty opinions shouldincorporate analysis ofthe legal rightsunderpinning thebrand, together withthe associatedreputational stock thatdrives purchasebehaviour.

Transfer pricing backdropWith revisions to the OECD’s transfer pricing (TP) guidelines on specialconsiderations for intangibles and global tax authorities’ compliancefocus on intangibles, it is important to confirm that these assets areappropriately valued by multinationals – particularly in related-party dis-posal and licensing contexts. In this article we explore important valua-tion matters, including quantifying the role of brands in value chains, andexamine why effective TP analyses can require input from intellectualproperty (IP) and brand specialists.

Valuation backdropThe international ‘Guidance Note on the Valuation of IntellectualProperty Rights’ (issued by the Royal Institution of CharteredSurveyors, or RICS) states that brand valuation requires multi-discipli-nary inputs because of the importance of the underlying legal rights,and the impact of the asset’s functional and economic characteristicson commercial utility.

In addition to corporate finance expertise, the multi-disciplinaryinputs identified by RICS are an assessment of the IP protecting thebrand (brand IP), and an assessment of the brand’s impact on consumerattitudes and behaviour. The rationale is that the value of a brand is afunction of the earnings that it is expected to generate, together with theassociated risk. These functions are directly influenced by consumer atti-tudes toward a brand, and the legal remedies that prevent third partieseroding its distinct identity.

Pricing royalties for TP purposes requires similar inputs. In thisarticle, the term ‘brand evaluation’ collectively refers to brand valua-tions and royalty determination, both of which evaluate the earningspotential of brands.

Brand IPThere is no generally accepted legal definition of the term ‘brand’, andthe OECD’s recent guidance arguably expands the definition of intangi-bles beyond legal concepts. Legal ownership flows from different types ofIP, including:• Registered trade marks (in each jurisdiction, trade mark registrations

are by class and in respect of specific goods and/or services);• Common law rights in trade marks (depending on the law in the

relevant jurisdiction);

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• Copyright in artistic works within the brand logo; and• Registered designs.

Although often bundled for arm’s-length transactions,these are distinct legal rights that can vary between jurisdic-tions and classes of product and service. A further complica-tion is that ownership of each right can be held by differentparties. For instance:• Trade marks for the same brand can be owned by differ-

ent parties in different jurisdictions; and• When a trade mark includes an artistic work, this might

also be protected by copyright, which is a separate anddistinct right that can be owned by a different party.Some brand transactions include a broader bundle of

rights, such as copyright in marketing collateral, confidentialinformation in recipes and/or formulations, and URLs andsocial media sites.

The ability of a brand to generate incremental earnings,compared to the underlying product or service, results fromits influence on consumer attitudes and purchasing behav-iour. Consumer response can be triggered by any aspect of abrand’s identity, including its name, logo, tag line, specificcolours, and other aspects of packaging. The broader anddeeper the legal protection held by a brand owner, the bet-ter it can protect brand differentiation and earnings.Breadth of protection enables differentiation of a variety ofelements of visual identity to be maintained. Deeper protec-

tion provides the brand owner with a variety of legal reme-dies to infringement of core elements of the brand identity.

The strength of brand IP influences the ability to protectbrand differentiation and the resulting earnings. As this drivesbrand value, it is necessary for evaluations to clearly identifyand assess the relevant rights. This mirrors the due diligencethat typically accompanies the sale or licence of brand IP.

The focus of this section is on the ability of legal rights toprotect brand value. It is recognised that the concept of eco-nomic ownership can also be relevant to TP.

Brand equity and brand economicsThe IP that protects a brand’s identity is fundamental to itsvalue, but the extent of its value depends on the associated‘brand equity’. This is a term used by marketers to describethe reputational stock that consumers hold towards a brand,and which is inextricably linked to the brand IP.

Market researchers use a layered approach to quantifybrand equity. A typical measurement hierarchy starts withbrand familiarity, which is a necessary foundation, but is oflittle value without positive associations. Measures of per-ceived quality represent the next layer, and are balanced bymeasures of brand image and relevance. Brand preferenceflows from the preceding brand attributes and is typically thebest predictor of consumer behaviour.

Sophisticated brand owners track the equity of theirbrands over time, and relative to competitors, throughquantitative consumer research. The value chain linkingbrand equity to consumer behaviour can be assessedthrough research techniques such as:• ‘Blind tasting’ studies, which use two panels to rate the

relative quality of products, and quantify the difference inresponses between the panel that had visibility of the test-ed brand compared to the panel that was ‘blind’ to thebrand identities;

• Conjoint (or trade-off) analysis, which is a statistical tech-nique used to determine the impact of brand equity onconsumer choice and willingness to pay a premium; and

• Econometric modelling, which isolates and quantifies thehistoric impact of changes in brand equity on a depend-ent variable, such as sales. The reliability of any such analysis depends on factors

that include the credentials and independence of theresearcher, the scope and methodology of the research, anddata quality.

Within a product or service category, strong brand equitydrives the earnings of the underlying product by influencingbuyer behaviour. In arm’s-length licences, this is a primaryfactor that influences the level of royalty that an independ-ent licensee is willing to pay. Valuation and TP practitionerscan use frameworks that quantify brand equity whenanalysing royalty comparables and when conducting profitsplit analysis.

Tim HeberdenPartner, financial advisory, M&ADeloitte Australia

Tel: +61 2 9322 3809Mobile: +61 405 [email protected]

Tim Heberden is a partner in Deloitte Australia and leads the IPadvantage team that specialises in quantifying, managing, andmonetising IP assets. He is the author of the Guidance Note onthe Valuation of Intellectual Property Rights (RICS), and a chap-ter on IP royalty determination for International Licensing &Technology Transfer. Tim is listed on the IAM Strategy 300 – theWorld’s Leading IP Strategists and has been recognised as aleading licensing expert in Asia. He has valued intangibleassets in a wide range of industries for purposes of tax compli-ance, litigation, M&A, IP strategy, financial reporting, and securi-tisation. He holds an MBA and is a registered business valuer,chartered accountant, fellow of the Australian MarketingInstitute, and fellow of the Royal Institution of CharteredSurveyors.

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Integrating these concepts into brand evaluationsThe following paragraphs summarise how brand IP andbrand equity should be integrated into brand evaluations.The first three subheadings are common to both valuationsand royalty determination; thereafter, consideration is givento other valuation assumptions.

Asset definition Definition of the subject asset is the cornerstone of a brandevaluation. Lack of clarity compromises all subsequent mar-ket and financial analysis. Without defining the asset, itsearnings are unlikely to be reliably forecast. Without reliableprojections of earnings, the asset cannot be reliably valued.For evaluations that cover several jurisdictions, it is necessaryto consider differences in the extent of brand IP, and itsownership. The impact of differences in the definition of thesubject asset are illustrated by the following examples:• The differential in an appropriate royalty rate for the same

brand in two jurisdictions if certain aspects of brand iden-tity are protected in one market, but not the other; and

• The differential in the value of all IP protecting a brand,compared to a subset of the brand IP that is the subject ofan assignment (for instance, an evaluation of a trade markexclusive of copyright subsisting in the brand identity).Should the scope of an engagement exclude a legal

assessment, it is important that this is disclosed.

Asset assessmentIt is inconceivable that an evaluation of a physical assetwould be carried out without careful assessment of the own-ership of all component parts, and of the asset’s commercialutility. For purposes of a brand evaluation, it is no lessimportant for the functional, legal, and economic character-istics of the asset to be considered.

Just as research techniques can estimate the impact ofbrand equity on earnings, the relationship can be establishedthrough careful analysis of royalty rates. This is most evidentin product categories where there is a large dataset of arm’s-length royalty rates. Although royalties are influenced by arange of factors, there is a strong relationship between brandequity and royalty rates.

Measures of market performance, such as market share,growth, price premium, and price elasticity are highly rele-vant to brand evaluations. However, these measures can beinfluenced by factors other than brand equity, for instance,differences in product performance.

Brand contribution to earningsWhen brand royalties are estimated using the comparableuncontrolled price (CUP) method, the strength of brand IPand brand equity are important comparability factors.

Even when arm’s-length licences exist for the same brand inother jurisdictions, it is recommended that analyses consider

the extent of brand IP, relative brand equity, and price posi-tioning in each market at the licensing date (in addition tofactors such as licence terms, market characteristics, and eco-nomic circumstances). In drawing comparisons with exter-nal CUPs, assessment of differentials in brand equity andpositioning is of even greater importance.

When available, quantitative consumer research can pro-vide actionable insights to assist with profit split analyses.For instance, conjoint analysis can be used to estimate therelative importance of different features in the purchasedecision for a brand.

Cam SmithPartner, transfer pricing, DeloitteAustraliaBachelor of Commerce and Laws(Hons.)Deloitte Australia

Tel: +61 3 9671 [email protected]

Cam Smith is a partner in Deloitte’s global transfer pricing prac-tice, with 22 years’ transfer pricing and international tax experi-ence working in Australia, Asia, New Zealand and Europe.Before joining Deloitte Australia, Cam worked with PwC

Australia and New Zealand, including leading PwC’s NewZealand transfer pricing practice. Prior to his time with PwC,Cam spent five years in Deloitte London’s transfer pricing team.Cam’s experience includes advising on a wide variety of

complex transfer pricing matters for some of the world’s largestmultinational corporations. Cam’s experience and expertiserelate to transfer pricing matters associated with:• Business model optimisation; • Revenue authority dispute resolution; • Negotiating bilateral and unilateral advance pricing arrange-ments;

• Designing, implementing, reviewing and supporting transferpricing policies;

• Preparing global, regional and local transfer pricing docu-mentation;

• Due diligence exercises; and• Pricing financial transactions.Cam is recognised in Euromoney’s World’s Leading Transfer

Pricing Advisors and has been a member of the AustralianTreasury’s BEPS advisory group.Cam has good relationships with the Australian Taxation

Office personnel and has worked with them in a variety ofcontexts to achieve successful transfer pricing outcomes.Cam has authored several transfer pricing articles and con-

tributed to a number of international transfer pricing books.

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Other valuation assumptionsThe income approach is usually most appropriate forbrand valuation. Other than for early-stage brands, thecost approach is not appropriate, as there is no linear rela-tionship between marketing expenditure, brand equity,and value. The market approach is complicated by a lackof publicly available data, together with the uniqueness ofbrand IP and brand equity.

In addition to brand earnings, income-based valuationmethods require consideration of the assumptions listedbelow:• Earnings growth: brand equity is a lead indicator of

consumer behaviour and earnings, so a review of brandequity over time, and relative to competitors, informsassumed growth in brand earnings;

• Useful economic life: declining brand equity and/orinadequate legal protection can be signals that it isinappropriate to assume that a brand will have an indef-inite useful life; and

• Risk: when considering an asset-specific risk premium, val-uers are advised to consider brand IP and brand equity.

Functions of brand managementWhen assessing the relative contribution of related partiesto brand earnings, it is informative to consider functionsassociated with managing brand IP and brand equity.

These include:• Registration of trade marks and designs;• Brand copyright protection through management of

contracts; • Maintenance and enforcement of brand IP;• Development of global brand strategy;• Maintenance and enforcement of brand guidelines;• Brand licensing;• Development and approval of local marketing plans;• Execution of annual plans;• Production of advertising collateral;• Media costs of marketing communications;• Consumer research; and • Brand audits and performance reviews.

For established brands, arm’s-length licences usuallyrequire licensees to fund many of the functions required toexecute the annual brand plan. Sophisticated brand licensorsmaintain control over management of the brand IP, brandstrategy, and brand assurance.

Conclusion: implications for robust TP documentationThe OECD’s recent guidance on intangibles requires multi-nationals to devote material resources to documenting theTP aspects of their intangibles. A critical component of thiswill relate to brand valuation, having regard to the mattersdiscussed above.

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