Transcript International Fiscal Association New Delhi, India February

6th Asia/Africa IFA Conference
Transfer Pricing Developments
Meeting at Hilton Hotel – Wolmar – Mauritius
May 10 – 11, 2012
Marc M. Levey Partner - Baker & McKenzie, LLP
1114 Avenue of the Americas
New York, New York 10036
Email: [email protected]
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.
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
2
A. Types of Transfers of Intangible Property
– 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
3
A. Types of Transfers of Intangible Property
– 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”)
4
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
5
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).
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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
7
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)?
8
D. Transfer Pricing Methods
– Comparable Uncontrolled Transaction (“CUTs”)
– Comparable Profit Methods (“CPM”) or Transactional Net Margin
Method (“TNMM”)
– Profit Split Methods (“PSM”)
9
E. Valuation Concerns
– 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
10
E. Valuation Concerns
– 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?
11
E. Valuation Concerns
– 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
12
E. Valuation Concerns
– Methods for Evaluating Intangible Property Transactions – TransactionBased 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
13
E. Valuation Concerns
– Methods for Evaluating Intangible Property Transactions – TransactionBased 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
14
E. Valuation Concerns
– Standard Valuation Topics
 Specific issues
– Useful life / decay rates
– Declining royalty
– DCF
– MCM
– Buy-in timing
– Business purposes/economic substance
– CWI standard
15
F. Marketing Intangibles
– 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
16
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?
17
F. Marketing Intangibles
– 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
18
F. Marketing Intangibles
– 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?
19
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?
20
F. Planning for Ownership of Marketing Intangibles
 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
21
F. Planning for Ownership of Marketing Intangibles
 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?
22
F. Planning for Ownership of Marketing Intangibles
– 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?
23
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?
24
F. Economic Benchmarking Issues for Marketing
Intangibles
– 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
25
F. Economic Benchmarking Issues for Marketing
Intangibles
– 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?
26
F. Planning for Ownership of Marketing Intangibles
– 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
27
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
28
G. Cost-Sharing Transaction Flows
US Parent Inc.
[owner of existing IP;
legal owner of new IP]

(U.S. Participant)


Foreign Participant
[licensee of old IP;
exclusive licensee
of new IP]
(e.g., Irish Non-Resident)
0% tax


Regional OpCo
12.5% tax

Non-US
Sales/Marketing
Support Subsidiaries
–  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 (nonUS).
–  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 nonU.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]
29
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
30
G. Cost-Sharing
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
31
G. Cost-Sharing
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
32
G. Cost-Sharing
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
33
G. Cost-Sharing
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
34
G. Cost-Sharing
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
35
G. Cost-Sharing Transaction Flows
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
36
G. Cost-Sharing
5. CSA Administrative Requirements
– Contractual Provisions
 Written Cost Sharing Agreement
– Documentation Provisions
– Accounting Provisions
– CSA Statement
37
H. Services – Hot Topics
– 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
38
H. Services – Hot Topics
– 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)
39
H. Services – Hot Topics

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
40
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/com
pany_tax/transfer_pricing/forum/jtpf/2010/jtpf_020_rev3_2009.pdf
– Foreign rules (may or may not follow OECD Guidelines)
 BRICs
41