The rising role of transfer pricing in tax planning and litigation
By Philip de Homont
Posted: 21st January 2019 08:37
Transfer pricing has become a key point of tax planning, tax compliance, and tax transparency both because businesses are becoming ever more international, but also because tax authorities are increasingly focused on addressing perceived injustices towards their tax base. Consequently, transfer pricing challenges have increased substantially over the years.
Increasing transfer pricing scrutiny
The institutional framework of transfer pricing is given by the OECD, national tax law, and increasingly other parties such as the European Commission and the United Nations. Among these however, the OECD provides the global transfer pricing guidelines and is the most important global institution to shape the international discourse. In recent years, the Base Erosion and Profit Shifting (BEPS) initiative of the OECD has generated important impulses that are now being realised in practice by tax authorities around the world.
It is difficult to overstate the importance of the shift in transfer pricing thinking that comes with these changing guidelines. Overall, the BEPS project resulted in 15 reports for various topics ranging from a new documentation framework to the valuation of intangibles. The transfer pricing community has written to thousands of pages in reports, expert responses, implementation guidance, and revised reports. Overall economic principles and more thorough analysis of value contributions were enforced, however at a much higher compliance burden for multinationals.
Most importantly, tax authorities use these developments during audits and reference the “new” transfer pricing framework even for tax audits of historic fiscal years. The number of specialised tax auditors has increased substantially. For example, Germany has increased the number of specialised federal auditors to more than 600 – and States are increasing their capabilities as well. By now, the largest part of tax audit adjustments come from transfer pricing.
In addition, the European Commission has become involved in the field by opening state aid cases related to transfer pricing topics and cases like Starbucks or Apple are disputed in terms of the arm’s length standard, especially regarding the fair remuneration of intangibles.
The big trends in transfer pricing audits
Over the last years we have been involved in several high-profile transfer pricing litigation cases. We have identified several recurring themes, which tend to be focus points of transfer pricing auditors:
- “DEMPE” functions for intangibles
- Brand licensing and the proof of benefits for the licensee
- Hard to value intangibles
We briefly explain the background if each issue, why it is important for tax departments, and how it can be addressed.
DEMPE functions for intangibles
Tax authorities increasingly start to question the so-called “DEMPE functions” for licensed intangibles. The background to this is that the OCED has reaffirmed the economic importance of intangibles – and acknowledge that valuable intangibles can effectively be owned by more than one entity: The DEMPE (Development Enhancement Maintenance Protection and Exploitation) approach.
Tax authorities demand a DEMPE analysis to demonstrate the economic ownership of valuable intellectual property. License fees are frequently disputed based on the assertion that the local entities conduct some (or all) of the DEMPE functions, for example when a local entity also conducts some marketing while licensing the brand – and that there should be no or only a reduced license rate. Alternatively, tax authorities can argue that the local DEMPE functions would change the economic profile and transfer pricing classification of the local company, turning it from a “routine” into an “entrepreneurial” entity. The effect would often be to use a profit split instead of a relatively fixed margin, thereby increasing local profits.
Over the last years, NERA has created studies in various tax audits. A key insight is that the definition of the DEMPE functions by the OECD is so wide ranging and open that in many cases the local entity can be said to conduct some form of DEMPE locally. It becomes consequently futile to discuss the role of the local group entity in isolation and instead the focus must be shifted to the role of the wider group and the DEMPE functions of the licensors. Only when these functions are understood and demonstrated to the tax authorities does it make sense to start an analysis of the license rate. In many cases it can be shown that the distribution of DEMPE functions between licensors and licensee is actually compatible with what is observed between third parties.
Brand Licensing and the proof of benefits for the licensor
Brand licenses are classically paid by distribution companies to remunerate the brand owner for the usage of a brand. Due to valuable brands (and other licensed IP) distributors can enforce higher prices and sell more products, directly increasing their operating results. License fees are typically set as a fixed percentage of net sales and are often defended using benchmarking studies or profit splits.
However, multinationals often treat brand licenses as a remuneration of the strategic input of the central company and valuable management decisions. This often leads to a mismatch between legal contracts – which define the trademark and trade name rights – and the business rational of the license fee. Tax authorities challenge the brand license fees on the grounds that they question the economic benefit of the licensed brand. A non-deductibility of brand license payments has a direct impact on the tax base and can have huge consequences for the operating margins.
NERA has developed economic approaches to analyse the economic benefits of brands and to calculate arm’s length license fees. We analyse the effect of the trademark to enforce higher prices and increase the quantities sold. This shows that the licensor is responsible for the price strategy of the licensor, for example by introducing a customer differentiation price strategy which results in overall higher prices. The higher prices result in additional profits that are clearly attributable to the new sales strategy. Additionally, the licensor often enables market access in several countries where it has an established distribution network. The additional profits from higher prices and additional volumes can be calculated.
Hard to Value intangibles
Multinational groups frequently undergo business restructurings, which can result in assets being transferred between related entities. Following the OECD BEPS project, new guidance is now applied by tax authorities to reassess the transfer of “hard to value” intangibles. This guidance has proofed to be particularly challenging, since it allows tax authorities in certain circumstances to use ex-post evidence, i.e. facts that have only become known after the actual transfer of the intangible.
Tax payers, on the other hand are often confronted with significant uncertainty when they structure an asset sale, especially for partially developed intangibles. An active ingredient of a pharmaceutical company might turn out to be essential for a blockbuster drug or turn out to be essentially worthless. A piece of code can be the center of a new successful startup – or be rendered irrelevant quickly. Addressing and evaluating such risks is extremely difficult in standard valuation techniques, such as discounted cash flow analysis. This leaves significant room for tax authorities to challenge any ex-ante valuation.
We have addressed various such scenarios in which an asset sale was subject to significant uncertainty and the potential outcomes could vary wildly. In such cases, the risks of the business case need to be modeled explicitly through economic methods, such as Monte-Carlo simulation or real-option pricing. The advantage of an explicit model is that the reasonable foreseeable circumstances are part of the initial valuation, and the overall pricing becomes more robust.
Exciting times ahead
The described trends will undoubtedly result in increased litigation of companies transfer pricing, especially for transactions involving intangibles. NERA will continue to provide thorough economic advice in this changing landscape and help develop value-based transfer pricing solutions.