Baker & McKenzie Consulting LLC provides tax advisory and economic services and does not provide...

Baker & McKenzie Consulting LLC provides tax advisory and economic services and does not provide legal advice or services. Baker & McKenzie Consulting LLC is a subsidiary of Baker & McKenzie LLP, a member firm of Baker & McKenzie International, a Swiss Verein of member law firms around the world.

Marc M. Levey Partner - Baker & McKenzie, LLP1114 Avenue of the AmericasNew York, New York 10036Email: [email protected]

6th Asia/Africa IFA Conference

Transfer Pricing Developments

Meeting at Hilton Hotel – Wolmar – MauritiusMay 10 – 11, 2012

2

Outline

A. Types of Transfers of Intangible Property

B. Deemed Payments Under §367(d)

C. Definition of Intangible Property

D. Transfer Pricing Methods

E. Valuation Concerns

F. Marketing Intangibles

G. Cost Sharing

H. Services – Hot Topics

3


– Examples of business situations where there might be a transfer of IP Product development based on initial research done by a related entity Manufacturing using proprietary processes developed by a related party Marketing and sale of a tangible product in new market that incorporates

technology developed by a related party

– Facts-based evaluation is very important to understand the functions performed and risks borne by each related party before and after transfer

– Transactions can be structured as an intercompany Sale or License or IP for R&D, Manufacturing, Marketing or Distribution

– Facts-based evaluation is very important to understand the functions performed and risks borne by each related party before and after transfer

4


– Joint Venture for development of intangibles: Cost-Sharing

– Related parties share the costs and risks associated with IP development Cost-sharing vs. Contract R&D

– Each party has rights to the intangible property developed from the joint venture based on the ex-ante division of rights

– Costs are shared based on each party’s anticipated benefit

– Shared economic ownership eliminates the need for transfer of intangibles across entities Cost-sharing that commences after one party has started developing

intangibles will involve transfer of the pre-existing intangible (“platform”)

5

B. Deemed §367(d) Payments

– Taxable to transferor annually

– Considered contingent payments

– Continue throughout the useful life of the intangible asset, but not in excess of 20 years

– Commensurate with income attributable to intangibles §482 Principles – Arm’s Length Contingent on Productivity, etc Periodic Adjustments

– Ordinary income

– Foreign source

6

B. Historical Background §367(d)

– Congressional concern with taxpayers that developed intangibles or other assets in the U.S. and then transferred the intangibles or appreciated assets to a low-tax foreign jurisdiction

– General case: Expenses for developing IP or improving/increasing value of other assets

incurred and deducted in the U.S. Outbound transfer of IP allowed nonrecognition treatment under §351 or

§361 Foreign transferee corporation located in a low-tax jurisdiction U.S. income deferred or avoided on sales generated by IP/assets or sale

of appreciated IP/assets

– Poster child for “abuse” v. Eli Lilly & Co. v. Commissioner, 84 T.C. 996 (1985); rev’d in part, aff’d in part, & remanded, 856 F.2d 855 (7th Cir. 1988).

7

C. What Is Intangible Property?

– Intangible property governed by §936(h)(3)(B) intangibles:

Patent, invention, formula, process, design, pattern or knowhow;

Copyright, literary, musical, or artistic composition;

Trademark, trade name or brand name;

Franchise, license, or contract;

Method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or

Any similar item

8

C. What is NOT Intangible Property?

– § 367(d) does not apply to the transfer of foreign goodwill or going concern value because: Goodwill and going concern value are not specifically identified in

§936(h)(3)(B); Goodwill and going concern value are not covered by “Any Similar Item”

provision under §936(h)(3)(B); and Treas. Reg. §1.367(d)-1T(b) expressly excludes them

– Workforce-in-place?

– Business opportunity?

– Domestic goodwill and going concern value?

– Subject to §367(a)?

9

D. Transfer Pricing Methods

– Comparable Uncontrolled Transaction (“CUTs”)

– Comparable Profit Methods (“CPM”) or Transactional Net Margin Method (“TNMM”)

– Profit Split Methods (“PSM”)

10

– Valuation Approaches

Three valuation approaches:

– Cost approaches

– Market approaches

– Income approaches

A primary methodology is often selected and an alternative methodology is used to check it


11

– Cost approaches

– Direct expenditure

Materials needed in the development process

Labor costs

Overhead and management costs

Include abortive developments?

– Opportunity costs:

Required return on investment

Include profit mark-up?


12

– Cost approaches

– Uses/advantages

Simple and objective (if costs can be estimated)

Appropriate for early-stage technology

– Limitations/disadvantages:

Cost alone does not provide a reasonable indication of value

Difficulty of estimating all the costs

Difficulty to allocate costs to specific IP assets

– Cost approach is often rejected because no direct correlation exists between the costs of IP and value


13

– Methods for Evaluating Intangible Property Transactions – Transaction-Based and Profit-Based Methods (Generally) Comparable Uncontrolled Transaction (“CUT”):

– CUTs are preferred– Intercompany price is based on the price charged in a comparable

transaction between uncontrolled companies that involves Comparable intangible property and Comparable circumstances

– Internal vs. External CUTs – External CUT strongest evidence– Inexact CUTs and Adjustments– Very difficult to identify

Comparable Profit Split Method– Intercompany pricing is based on a division of system profit– Division of system profits is determined by evaluating the profits

retained by uncontrolled comparable companies engaged in comparable transactions


14

– Methods for Evaluating Intangible Property Transactions – Transaction-Based and Profit-Based Methods (Generally) Residual Profit Split Method

– Intercompany pricing is based on division of intangible profit

– Intangible Profit is determined as residual profit after carve-out of ‘routine’ profit

– Division of intangible profit based on relative contributions to intangible development


15

– Standard Valuation Topics

Specific issues

– Useful life / decay rates

– Declining royalty

– DCF

– MCM

– Buy-in timing

– Business purposes/economic substance

– CWI standard


16


– What is a Marketing Intangible?

Marketing intangibles include trademarks and trade names that aid in commercial exploitation of a product or service, customer lists, distribution channels, and unique names, symbols, or pictures that have an important promotional value for the product concerned (OECD – Para 6.4)

Marketing intangibles can also include: know-how, distribution networks, contract rights, etc.

Marketing intangibles generally include an evaluation of legal vs. economic ownership of intangibles

The goal is the matching principles; that is to determine how income generated by an intangible should be divided among the parties who make the investment and enjoy the benefits

17

F. Marketing Intangibles– Historical Preparation

IRS regulations “Cheese Examples” DHL vs. Commissioner, US Tax Court Glaxo Smithkline Inc. vs. Commissioner, US Tax Court Glaxo Smthkline Inc. vs. the Queen, Canadian Federal Court of Appeals Maruti Suzuki India, Ltd. High Court of Delhi

– How should compensation for marketing activities undertaken by enterprises not owning trademarks or tradenames be determined? Issue 1 – Whether the marketer should be compensated as a service

provider, i.e., for providing promotional services or whether the marketer should share in any additional return attributable to marketing intangibles?

Issue 2 – How would the additional return attributable to marketing intangibles be identified?

18


– Where did the Court in India go wrong?

They misinterpreted the “Bright Line Test”

The key analysis is what are “routine vs non-routine expenses”?

Fail to understand:– What AMP expenses actually contribute to the success of the

product?– That each company may account for AMP differently– That each company may have significantly different branding

policies– That companies operating in different segments of the market may

market differently– That each companies products may have different product life

cycles– That conduct of a company’s products must be viewed over years

19


– Key Factors To Address:

What are the true value drivers of a company – its “DNA”?

What really are the brand building expenses of the company?

Does the economic right have legal substance, i.e. is it transferable?

Is the economic right embedded in the transfer price?

What efforts have been made to economically benchmark to marketing intangible?

Where do we go from here?

20

F. Planning for Ownership of Marketing Intangibles

– Should the legal IP owner directly pay/support marketing IDCs for the economic owner? Who is the developer? Should a Market Support Payment (“MSP”) be included in the Distribution

Agreement? Should the MSP distinguish between non-routine and routine expenses or

be built into the transfer pricing compensatory adjustment?

– What costs/expenditures result in an economically valuable asset?

– Should you simply reimburse all expenses above a specific amount or identify specific expense codes with allocation keys?

Can the MSP be deducted locally or will it be a capitalized amount? What is “the base” for the marketing intangibles? What is the expected use of the asset by the developer? What is the obsolescence factor for the asset?

21


What is the level of maintenance expenditures? What are the customs and VAT ramifications? Can the economically owned marketing intangible be legally transferred?

– Intercompany Agreements must spell out who is responsible for marketing expenses and who owns resulting intangibles

Agreements should spell out risk–mere use of CPM/TNMM method to true–up margin after fact not sufficient?

– Arm’s Length result – Profit Splits can provide support

Agreements should distinguish this reimbursement from typical transfer pricing adjustments

22


Should the Agreements include Expense Code Identifications to distinguish between routine and non-routine expenses?

– What constitutes “routine” vs. “non-routine”? Ratio of marketing expenses to sales? Absolute dollars? Nature of expenditure? Identification of brand building expenses?

Comparables seldom provide necessary level of detail regarding marketing expenditures

– How should new products or product lines be addressed?

23


– Economic Valuation Principles/Benchmarking Compensation for marketing distributors must follow the arm’s-length

standard Prices and/or margins related to comparable transactions can provide

useful information Implementation can be complicated by deviation of actual results from

intended result

– Can MSP can address marketing expenses that exceed levels for a routine distributor?

– What is an arm’s length evidence of marketing expenses for distributors?

– What is the adequacy of MSP to achieve proper profit allocation to the distributor?

24

F. Economic Benchmarking Issues for Marketing Intangibles

– Hypothesis: Although we speak of “economic ownership” separate from “legal ownership,” examples of third party arm’s length business dealings are few

– Test: Is there evidence of unrelated distributors investing significant sums in AMP?

25


– It is virtually impossible to directly benchmarking profit to distributors that expend considerable sums on Advertising and Marketing Disclosure is not required

– This is particularly true outside the US Even when disclosed, it is very rare to find distributors with significant

AMP– This type of spending/investment is generally made by the

manufacturer/IP owner– Manufacturers sell to distributors at prices that include the value of

significant AMP

– Lesson: Consider having the manufacturer incur the AMP, not just adjusting distributor profitability (as in Glaxo); make distributor a clean, benchmark-able entity

26


– Conversion What transferrable intangibles have been created?

– Need to identify precisely (customer lists, databases, distribution channels, shelf space, etc)

Buy-outs may be required for identifiable intangibles What about “excess profit” not associated with separate identifiable

intangibles

– Goodwill?

– Enhancement of IP held by manufacturer?

27


– What valuation techniques can be used to value the marketing intangible? Royalties observed in independent transactions (Comparable

Uncontrolled Transactions)

– Are comparable property and rights being licensed under comparable conditions?

– Does the property under the CUT and the USCo / IPCo arrangements have comparable profit potential?

Comparable profit splits between licensor and licensee Residual methods – e.g., benchmark licensee profits

28

G. Cost Sharing

– Joint Venture for development of intangibles: Cost-Sharing– Related parties share the costs and risks associated with IP

development What if one party brings only cash to the table and the other party

performs research? Cost-sharing vs. Contract R&D

– Each party has rights to the intangible property developed from the joint venture based on the ex-ante division of rights

– Costs are shared based on each party’s anticipated benefit – Shared economic ownership eliminates the need for transfer of

intangibles across entities Cost-sharing that commences after one party has started developing

intangibles will involve transfer of the pre-existing intangible (“platform”)

– New Regulation for Cost-Sharing issued in 2011 – these regulations fairly track the 2009 Temporary Regulations Final

29

– USP licenses Existing IP to foreign cost sharing participant. USP is the legal title owner of the existing IP.

– Foreign Participant pays a “PCT” royalty to USP for the Existing IP.

– USP pays for R&D of New IP. USP is the legal, title owner of the New IP. Foreign Participant makes cost sharing payment to USP to cover its share of R&D expenses.

– USP owns legal title and exploitation rights to US Territory and Foreign Participant has exclusive, royalty-free license to New IP for its Territory (non-US).

– Foreign Participant licenses Existing and New IP to Regional OpCo (e.g., Ireland). Regional OpCo pays a royalty to Foreign Participant for license. Regional OpCo books revenues from non-U.S. customers.

– Regional OpCo engages Non-US subsidiaries to perform marketing/sales support functions in its territory, in exchange for an arm’s-length remuneration.

– Note: USP provides G&A Services, as well as Marketing Support to Foreign Participant.

[customer revenues]

US Parent Inc.(U.S. Participant)

Foreign Participant(e.g., Irish Non-Resident)

0% tax

Non-USSales/Marketing

Support SubsidiariesRegional OpCo

12.5% tax

[owner of existing IP; legal owner of new IP]

[licensee of old IP; exclusive licensee of new IP]

G. Cost-Sharing Transaction Flows

30

G. Cost Sharing: 2011 Cost Sharing Regulations

– Five focus areas: Sharing of intangible development costs Division of rights Pricing for pre-existing intangibles Periodic Adjustments Administrative Requirements

31

1. Sharing of Intangible Development Costs

– Scope of the joint-venture i.e. what is the intangible development activity (“IDA”) Narrow focus (project or product specific) vs. All-in Commingling across projects

– Identification of intangible development costs (“IDC”) Allocation of overhead Allocation of executive costs Cost Contributions, i.e., IDC vs. Operating Cost Contributions (e.g.,

marketing intangibles, manufacturing process intangibles) Stock Based Compensation

– Determination of reasonably anticipated benefit (“RAB”) shares Revenues, Profits Depends on the division of rights

G. Cost-Sharing

32

2. Division of Rights

– Divisional Interests Exclusive, Perpetual and Not Overlapping Types

– Territorial

– Field of Use

– Other clear, unambiguous, verifiable divisions Not Capable of Manipulation Capability Variations

G. Cost-Sharing

33

3. Pricing for Pre-existing Intangible (PCT Pricing)

– PLATFORM: Any resource, capability or right developed prior to commencement of the CSA or outside the CSA that is deployed in subsequent IDA under the CSA

– PCT: Platform Contribution Transaction

– Developer of the platform should be compensated through the PCT pricing

G. Cost-Sharing

34

3. PCT Pricing Methods

– Best Method Rule applies, with two additional considerations: Investor framework where the rate of return from the IDA should be consistent with

the ex-ante risk assessment (measured through a discount rate) Realistic alternatives to cost-sharing

– CUT Method:

– Acquisition price method

Based on the price paid for the acquisition of a company with comparable intangibles

– Market Capitalization method

Market capitalization less market value of tangible assets is used a benchmark for the valuation of underlying intangibles

G. Cost-Sharing

35

3. PCT Pricing Methods

– Income Method Applies where only one party contributes the platform intangible Similar to a discounted cash flow analysis (“DCF”) used in finance

– Residual Profit Split Method Can be applied when both parties contribute platform intangibles

– Current Audit Issues Applicable to Grandfathered CSAs Pre-existing intangible vs. Platform Allocation of profit between pre-existing intangibles and new intangibles

(Life, value erosion) VERITAS Case

G. Cost-Sharing

36

4. CWI and Periodic Adjustments

– Historical Standard: Commensurate with Income Standard

– New Periodic Adjustments Standard Applicable only to new CSA (effective after Jan 5, 2009) Does not apply to grandfathered CSAs

– Evaluate the gross profit earned from the platform intangible vis-à-vis intangible investment (Intangible investments includes PCT price and subsequent R&D cost)

– Should be within the band specified in the regulations (66% to 150%)

– Exceptions to the Periodic Adjustment Provisions CUTs 10 year rule Results not reasonably anticipated

G. Cost-Sharing Transaction Flows

37

5. CSA Administrative Requirements

– Contractual Provisions Written Cost Sharing Agreement

– Documentation Provisions

– Accounting Provisions

– CSA Statement

G. Cost-Sharing

38

– Deductibility of Cross-Border Service Fees Identifying the benefit received Questioning of the “management fee” Selection of the allocation keys Documentation challenges where services and cross charges are

buried in the transfer pricing CPM/TMNM approach

– Routine versus non-routine services Questioning the “routine” nature of services Intersection of intangibles and services Location savings


39

– Treatment of Restructuring Expenses Role of contracts

– Deductibility, especially where cross charges exists or no formal documentation created

– Respecting the transaction

– Multi-party arrangement versus two parties

– Use of clearing house versus subcontracting

– Preserving competent authority access

– VAT/GST aspect Stock based compensation

– US position

– Non-US position

– Extraordinary stock comp expense (IPO)


40

Markup of Pass-Through Expenses: when is it a pass-through expense

– Allocation of Costs of Implementing New Enterprise Software Systems such as SAP

– Database center costs

– Identification of stewardship expenses The new frontier:

– Financial Guarantee Fees

– Performance Guarantees Burden of Proof in Formalistic Countries


41

Transfer Pricing Universe for Services– Final Treasury regulations on intercompany services:

Section 1.482-9 Promulgated July 31, 2009 Effective for tax years beginning after July 31, 2009

– OECD Guidelines for Multinational Enterprises

– UN Transfer Pricing Manual (working drafts) http://www.un.org/esa/ffd/tax/documents/bgrd_tp.htm

– EUJTPF – Guidelines on low value-adding intra-group services http://ec.europa.eu/taxation_customs/resources/documents/taxation/

company_tax/transfer_pricing/forum/jtpf/2010/jtpf_020_rev3_2009.pdf

– Foreign rules (may or may not follow OECD Guidelines) BRICs

Baker & McKenzie Consulting LLC provides tax advisory and economic services and does not provide...

Documents

Transcript of Baker & McKenzie Consulting LLC provides tax advisory and economic services and does not provide...