International Management Forum (IMF)
Distance Course
Future Battlefields: Transfer Pricing and
Intangibles
9 August 2012
Course Editors: Steef Huibregtse, Rudolf Sinx, Vladimir Zivkovic,
Joel Wilpitz, Raheem Farishta
Lesson 1: Introduction
Authors: Steef Huibregtse, Vladimir Zivkovic, Louan Verdoner, Joel Wilpitz (TPA
Amsterdam)
Lesson 2: Transfer Pricing Labels of intangibles, identification of intangibles, ownership of
intangibles
Authors: Steef Huibregtse (TPA Amsterdam), Lukasz Kubicki (TPA Switzerland)
Lesson 3: Valuation of Intangibles
Authors: Steven van Wijk, Sjoerd de Jong (TPA Amsterdam), Steven Carey (TPA Asia)
Lesson 4: Business models: Intangible Property configurations
Authors: Steef Huibregtse (TPA Amsterdam), Steven Carey (TPA Asia), Elizabeth King
(Beecher Consulting LLC)
Lesson 5: Intellectual Property Law and Transfer Pricing
Authors: Eric Master, Dorus van der Burgt (Witlox Van den Boomen)
Lesson 6: Accounting definitions of IP and transfer pricing
Authors: Steven van Wijk (TPA Amsterdam), Lukasz Kubicki (TPA Switzerland), Alon
Wexler, Ryan Abrams (Richter Consulting Inc)
Lesson 7: Corporate Income Tax Aspects of IP and Transfer Pricing
Authors: Rudolf Sinx, Louan Verdoner, Raheem Farishta (TPA Amsterdam)
1
Table of Contents
1
Introduction .......................................................................................................................... 7
1.1
Introduction .............................................................................................................................. 8
1.2
The evolution of the MNE and the importance of intangibles ................................................. 9
1.3
OECD Definition of Intangible Property .................................................................................. 11
1.3.1
Chapter VI of the July 2010 OECD Transfer Pricing Guidelines ..................................................... 11
1.3.2
Discussion Draft of the Proposed Revisions to Chapter VI of the OECD Transfer Pricing Guidelines
(6 June 2012) ................................................................................................................................................ 12
1.4
How do emerging jurisdictions (i.e. BRICS) deal with intangibles .......................................... 14
1.5
Transfer Pricing & Intangibles: four functional variables ....................................................... 15
1.5.1
Label.............................................................................................................................................. 17
1.5.2
Identification ................................................................................................................................. 18
1.5.3
Ownership ..................................................................................................................................... 19
1.5.4
Valuation....................................................................................................................................... 20
1.6
Locating IP in tax advantaged jurisdictions ............................................................................ 22
1.7
Transfer Pricing Risks (1): Court Cases on Intangibles ............................................................ 24
1.7.1
DHL................................................................................................................................................ 24
1.7.2
Maruti-Suzuki ................................................................................................................................ 25
1.7.3
Veritas ........................................................................................................................................... 27
1.7.4
GlaxoSmithKline ............................................................................................................................ 28
1.8 Transfer Pricing Risks (2): Corporate Reputation at Risk Through SEC Disclosure of
Intercompany Transactions ............................................................................................................... 28
1.9
Introduction to lessons 2-7 ..................................................................................................... 30
Lesson 2: Transfer Pricing Labels of intangibles, identification of intangibles, ownership of intangibles .... 30
Lesson 3: Valuation of intangibles ................................................................................................................ 30
Lesson 4: Business models: IP configurations ............................................................................................... 30
Lesson 5: Intellectual Property Law and Transfer Pricing ............................................................................. 31
Lesson 6: Accounting Definitions of Intellectual Property and Transfer Pricing ........................................... 31
Lesson 7: Corporate Income Tax Aspects of IP and Transfer Pricing............................................................. 31
1.10 Questions ................................................................................................................................ 31
1.11 Answers .................................................................................................................................. 32
1.12 Literature ................................................................................................................................ 33
2
Transfer Pricing Labels of intangibles, identification of intangibles, ownership of intangibles 35
2.1
Introduction ............................................................................................................................ 36
2
2.2
2.2.1
Legal perspective .......................................................................................................................... 36
2.2.2
Accounting perspective ................................................................................................................. 38
2.2.3
Tax perspective ............................................................................................................................. 38
2.2.3.1
Trade intangibles ....................................................................................................................................... 39
2.2.3.2
Marketing intangibles ............................................................................................................................... 39
2.2.3.3
Article 12 of the OECD Model Tax Convention ......................................................................................... 40
2.2.4
Local Tax Perspective .................................................................................................................... 40
2.2.5
Conclusion ..................................................................................................................................... 41
2.2.6
Alternative labelling ...................................................................................................................... 43
2.3
3
Definition of intangibles ......................................................................................................... 36
Labelling of intangibles........................................................................................................... 44
2.3.1
Legal ownership ............................................................................................................................ 45
2.3.2
Economic ownership ..................................................................................................................... 45
2.3.3
Nominal Ownership: ..................................................................................................................... 46
2.3.4
Process Ownership: ....................................................................................................................... 46
2.3.5
Entitlement to Intangibles related returns:................................................................................... 46
2.3.6
Special Case: Subcontracting ........................................................................................................ 47
2.3.7
Special Case: Cost contribution arrangement ............................................................................... 48
2.4
Questions ................................................................................................................................ 49
2.5
Answers .................................................................................................................................. 50
Valuation of intangibles....................................................................................................... 51
3.1
Introduction ............................................................................................................................ 52
3.2
When and Why Intangible Assets are Valuable ..................................................................... 53
3.3
Companies with highly valued intangibles ............................................................................. 55
3.3.1
3.3.1.1
3.3.2
Microsoft Corporation................................................................................................................... 55
Market value of Microsoft ........................................................................................................................ 56
Veritas v Commissioner ................................................................................................................. 57
3.4
Why and when are intangibles valued? ................................................................................. 58
3.5
Price, Value and Cost .............................................................................................................. 61
3.6
Generally Accepted Valuation Approaches ............................................................................ 62
3.6.1
The Cost Approach Valuation Methods ........................................................................................ 62
3.6.2
Market Approach Valuation Methods .......................................................................................... 64
3.6.3
Income Approach Valuation Methods .......................................................................................... 67
3.6.3.1
Example of the Income Approach, the Discounted Future Benefits Method ........................................... 70
3.6.3.2
Example of the Income Approach, Capitalized Royalty Income Method for Trademark Valuation .......... 70
3
3.6.4
Valuation Synthesis and Conclusion Procedures ........................................................................... 71
3.6.5
Intangible RUL Considerations ...................................................................................................... 71
3.6.6
The Valuation of Intangibles for Tax Purposes ............................................................................. 72
3.6.7
Discussion Draft on Intangibles, OECD Chapter VI ........................................................................ 74
3.6.8
Summary ....................................................................................................................................... 75
3.7
Determining the Discount Rate and Capitalization Rate ........................................................ 77
3.8
Business Restructuring and Valuation, Chapter IX, OECD ...................................................... 78
3.8.1
Generating a functional and factual analysis ............................................................................... 79
3.8.2
Economic analysis ......................................................................................................................... 80
3.8.2.1
Transfers with economic value in isolation ............................................................................................... 80
3.8.2.2
Transfers that require a renegotiation or termination of existing contracts ............................................ 81
3.8.3
3.9
Determine arm's length treatment ............................................................................................... 83
Questions ................................................................................................................................ 85
3.10 Answers .................................................................................................................................. 85
4
Business models: Intangible Property configurations............................................................ 86
4.1
Introduction ............................................................................................................................ 87
4.2
Overview of business models from a commercial perspective: .............................................. 87
4.2.1
Licensing-in model ........................................................................................................................ 87
4.2.2
In house development model ........................................................................................................ 88
4.2.3
Contract R&D model ..................................................................................................................... 89
4.2.4
Cost sharing model ....................................................................................................................... 90
4.3
Transfer pricing and general corporate tax considerations of each model............................ 91
4.3.1
Licensing in.................................................................................................................................... 91
4.3.2
In-house development .................................................................................................................. 91
4.3.3
Contract R&D ................................................................................................................................ 92
4.3.4
Cost sharing .................................................................................................................................. 92
4.4 Model implementation – high level guidance on implementing each of the above models,
including: ........................................................................................................................................... 93
4.4.1
5
Legal framework for managing IP ................................................................................................ 93
4.5
Case Study .............................................................................................................................. 94
4.6
Questions with model answers............................................................................................... 96
4.7
Multiple choice questions ....................................................................................................... 97
4.8
Answers to open and multiple choice questions .................................................................... 97
4.9
Literature ................................................................................................................................ 99
Intellectual Property law and Transfer Pricing .................................................................... 100
4
5.1
Introduction .......................................................................................................................... 101
5.2
Brief History of IP .................................................................................................................. 101
5.3
Future of IP ........................................................................................................................... 102
5.4
Appearance of IP .................................................................................................................. 103
5.4.1
Copyright and rights related to copyright. .................................................................................. 103
5.4.2
Industrial property. ..................................................................................................................... 103
5.4.3
Copyright..................................................................................................................................... 104
5.4.4
Patent ......................................................................................................................................... 106
5.4.5
Design ......................................................................................................................................... 107
5.4.6
Trade mark .................................................................................................................................. 109
5.4.7
Short summary of other Intellectual Property rights: ................................................................. 111
5.5
Neighbouring rights ................................................................................................................................ 111
5.4.7.2
Plant breeders’ rights or plant variety rights .......................................................................................... 111
5.4.7.3
Database rights ....................................................................................................................................... 112
5.4.7.4
Trade name ............................................................................................................................................. 112
IP exploitation ....................................................................................................................... 112
5.5.1
IP-rights for own use ................................................................................................................... 113
5.5.2
IP-rights granted to third parties ................................................................................................ 113
5.5.3
Transfer of IP-rights .................................................................................................................... 114
5.6
IP management .................................................................................................................... 114
5.6.1
Action against infringement ....................................................................................................... 114
5.6.2
Prolonging and expanding IP-rights............................................................................................ 115
5.6.3
Positioning of IP-rights ................................................................................................................ 116
5.7
6
5.4.7.1
IP transfer ............................................................................................................................. 116
5.7.1
Transfer by deed ......................................................................................................................... 116
5.7.2
Reasons for transfer .................................................................................................................... 116
5.7.3
Risks assessment and valuation issues ....................................................................................... 117
5.8
Questions .............................................................................................................................. 118
5.9
Answers ................................................................................................................................ 119
Accounting definitions of IP and transfer pricing ................................................................ 120
6.1
Introduction – Intangibles .................................................................................................... 121
6.2
Recognition of Intangibles .................................................................................................... 122
6.2.1
Intangibles acquired externally ................................................................................................... 123
6.2.2
Intangibles generated internally ................................................................................................. 125
6.2.3
Intangibles acquired as part of business combination ................................................................ 128
5
7
6.3
Goodwill ................................................................................................................................ 131
6.4
Subsequent measurement .................................................................................................... 133
6.5
Questions .............................................................................................................................. 134
6.6
Answers ................................................................................................................................ 135
6.7
Literature .............................................................................................................................. 135
Corporate Income Tax Aspects of IP and Transfer Pricing .................................................... 136
7.1
Introduction .......................................................................................................................... 137
7.2
Initial Intangible Asset Value ................................................................................................ 137
7.3
Amortization/Decrease in Value of Intangible Assets .......................................................... 138
7.3.1
Methods of Amortization ............................................................................................................ 139
7.4
R&D Tax Credit ..................................................................................................................... 139
7.5
Innovation Box/Other Incentives .......................................................................................... 141
7.6
Replacement Reserve ........................................................................................................... 143
7.7
Withholding Tax on Royalty Payments................................................................................. 144
7.8
Capital Gains Tax .................................................................................................................. 144
7.9
Business Restructuring and Related Taxes ........................................................................... 145
7.10 VAT ....................................................................................................................................... 146
7.11 Purchase Price Allocation ..................................................................................................... 147
7.12 Beneficial/Economic/Legal Ownership ................................................................................. 148
7.12.1
Beneficial Ownership .................................................................................................................. 148
7.12.2
Legal Ownership ......................................................................................................................... 149
7.12.3
Economic Ownership................................................................................................................... 149
7.12.4
Differences between Economic and Legal Ownership ................................................................ 150
7.12.5
Centralized vs. Distributed Ownership ........................................................................................ 152
7.13 Conclusion............................................................................................................................. 152
7.14 Questions .............................................................................................................................. 152
7.15 Answers ................................................................................................................................ 153
6
1 Introduction
Authors: Steef Huibregtse/Vladimir Zivkovic/Louan Verdoner/Joel Wilpitz
7
1.1
Introduction
Today, intangible property (IP) 1 generally represents between 40 and 80 percent of ‘valueadd’ of multinational enterprises (MNEs), making it a key component of a MNE’s valuechain. Intangible property includes business rights associated with commercial activities,
including marketing activities. Intangible property will not always be shown on the balance
sheet of a company, and often intangible property attracts a considerable risk, e.g. contract
or product liability. There are numerous legal, accounting and tax related definitions of IP.
However, most of these are typically purpose specific.
In the context of transfer pricing, the four main questions relating to intangibles include:
•
How to label different types of intangibles?
•
How to recognize or identify intangibles?
•
What ownership types of intangibles can exist?
•
How to determine the arm’s length value of intangibles?
The OECD Transfer Pricing Guidelines, July 2010 (Chapter VI and VIII) is the leading reference
document which provides guidance on the treatment of intangible property in the context
of transfer pricing. The two categories of intangibles the OECD has identified in the Transfer
Pricing Guidelines, July 2010 include:
•
Commercial intangibles: e.g. patents, know-how, designs and models that are used
for the production of a good or the provision of a service;
•
Marketing intangibles: e.g. trademarks and trade names which enhance the
commercial exploitation of a product or service, customer list, distribution channels,
and unique names, symbols, or pictures that have an important promotional value.
Given that transfer pricing issues pertaining to intangibles are a key area of concern to
governments and taxpayers, the OECD found that updating Chapter VI and VIII has become
an increasingly important issue in the evolution of new business realities and subsequent
adaptations to the transfer pricing regulations. In addition to offering guidance on
intangibles in the general sense, Working Party No. 6 of the OECD Committee on Fiscal
Affairs (Working Party) is focusing on four main areas pertaining to intangibles: goodwill,
brands, ownership, and synergies. The Working Party has passed the halfway mark of their
proposed four-year rewriting project, i.e. target publication date before end of 2013.
1
In the context of Lesson 1, the terms “intangible property,” “IP,” and “intangibles” are used interchangeably.
8
On June 6, 2012, the OECD released a discussion draft “Revision of the Special
Considerations for Intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and
Related Provisions,” (Discussion Draft) 2. This draft is the result of a series of meetings with
the public and has been influenced by the discussions that have taken place. The OECD has
requested comments from the public regarding the Discussion Draft by 14 September, 2012.
The Discussion Draft contains a variety of considerable changes that, if implemented, could
have major impacts on transfer pricing considerations for intangibles. The contents of the
Discussion Draft provide valuable guidance on particular topics relating to intangibles.
However, at the same time the Discussion Draft raises more questions due to specific
changes that are presented in the new wording.
There are far-reaching implications on how the Working Party decides to define intangibles
and word the guidelines surrounding them. If the OECD aligns with a strict definition of
intangibles, this could cause alienation of the BRIC countries (Brazil, Russia, India, and
China). These countries typically favour a wider definition of intangibles because they have
not traditionally been active in the protection of IP through patents, trademarks,
registrations or copyrights. The BRIC countries potentially could threaten to become active
members of the UN Charter on Transfer Pricing instead of OECD members. The difference in
regulations between the two bodies has the potential to cause double taxation for MNEs
operating in both BRIC countries and OECD-member countries, i.e. introducing two sets of
transfer pricing standards.
With the dynamic nature of intangibles and transfer pricing, it is clear that this is an
increasingly important area of transfer pricing, and one which will gain increasing attention
from tax authorities and MNEs across the world for years to come.
1.2
The evolution of the MNE and the importance of intangibles
Today’s typical MNE is a reflection of the evolution of the global economy over the last few
decades. Rapid technological innovation has vastly contributed towards the integration of
the global economy and has had important implications for the everyday operations of
MNEs across the world.
Whereas firms competed only with players in their local markets, today MNEs compete with
companies from all over the globe. Sometimes this competition extends across industries as
2
The OECD discussion draft is an interim draft. The OECD has invited public comments on this draft by the 14
September 2012.
9
well, as firms have started diversifying their operations and entering into various industry or
market segments. This increased competition has led firms to significantly reduce the
timeframes for decision-making and execution across various segments of the value chain,
to compete more on costs, as well as to invest more into market research and product
innovation and development. In other words, a shorter product life cycle has forced
internationally operating companies to maximize the efficiency and cost benefits of their
global production and supply chain footprint. Practical issues which are addressed by MNEs
on a daily basis include questions on how to operate more efficiently, how to cut costs and
how to create a sustainable competitive advantage in today’s global marketplace.
During this period, the value and importance of intangibles has come to the forefront of the
value chain of many MNEs operating in a wide array of industries. Product and process
related intangibles have become important ways to differentiate one’s offering in the
marketplace. As such, intangibles such as patents, know-how, designs, models, trademarks
and trade names, all of which enhance the potential for commercial exploitation of a
product or service, as well as customer lists and distribution channels are all important
factors contributing to the value- add of an MNE in the marketplace.
A modern example of the value that can be added with intangibles is the Apple iPod. The
following image provides evidence as to how the “Apple” brand creates value and how the
know-how, design and channel of distribution that is at Apple’s disposal adds a considerable
amount of value to this product. The real value of the iPod does not reside in its parts or
even in putting those parts together, but in the know-how, design, brand and channel of
distribution of the iPod. That is the reason why Apple receives $80 for each iPod it sells,
which is by far the largest piece of value added in the entire supply chain.
10
Source: Varian, Hal R, The New York Times, June 28, 2007. An IPod Has Global Value. Ask the
(Many) Countries That Makes It.
1.3
OECD Definition of Intangible Property
1.3.1 Chapter VI of the July 2010 OECD Transfer Pricing Guidelines
The July 2010, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations (“OECD Guidelines”) provide a standard reference for intangibles and how
to apply transfer pricing methods to intangibles.
In the context of transfer pricing, intangibles are typically examined in four components. The
four functional variables are the label, identification, ownership and value of a given
intangible and are the basis of evaluating an intangible in the realm of transfer pricing.
Chapter VI of the OECD Guidelines provides two categories of intangibles:
•
Commercial intangibles e.g. patents, know-how, designs and models that are used
for the production of a good or the provision of a service.
•
Marketing intangibles e.g. trademarks and trade names which enhance the
commercial exploitation of a product or service, customer list, distribution channels,
and unique names, symbols, or pictures that have an important promotional value.
11
Rather than relying strictly on the categories provided by the OECD Guidelines, it is
worthwhile to develop a characterization of intangibles that reflects practical labels based
on how the intangible adds value to the business. There are a variety of labels that can be
applied to an intangible. The labels are typically process related, product related, market
related or a combination of the different labels.
When identifying an intangible, the initial step is typically the available legal and accounting
information. Because of the unique nature of intangibles and the process of generating and
developing intangibles, they are often not present in legal agreements or balance sheets. In
order to asses internally created IP, it is typically necessary to conduct a thorough functional
analysis of the MNE and evaluate where intangibles exist in the company’s value chain.
The next aspect of an intangible that is evaluated according to the OECD Guidelines is the
ownership of the intangible. The two types of ownership that are addressed are economic
ownership and legal ownership. Legal ownership is centred on contracts or agreements that
lead to an entity being designated as the holder of legal rights to use, exploit, or prevent
others from using an intangible. An economic owner has the rights to claim or receive
income that can be attributed to an asset that is owned.
Finally, in addressing the value that is assigned to an intangible, the OECD emphasizes that
the arm’s length principle should still be maintained for determining the value or price of
any transaction between related parties involving intangibles. The OECD recognizes the
difficulty of accurately valuing an intangible because of the inherently unique nature of
intangibles. It is still recommended to search for comparables in order to determine a fair
market value of a given transaction.
1.3.2 Discussion Draft of the Proposed Revisions to Chapter VI of the OECD Transfer
Pricing Guidelines (6 June 2012)
In Paragraph 5 of the Discussion Draft, the OECD writes, “the word “intangible” is intended
to address something which is not a physical asset or a financial asset, and which is capable
of being owned or controlled for use in commercial activities.”
The OECD chooses to not provide any particular categories of labels of intangibles in the
Discussion Draft. “No attempt is made in these Guidelines to delineate various classes or
categories of intangibles.” 3 This is a considerably different stance than in Chapter VI of the
OECD Guidelines, 2010.
Source: Par. 13 OECD Discussion Draft, 6 June, 2012
12
The OECD also addresses the issue of identifying intangibles by introducing a list of factors
that should be considered. These factors are:
•
“Intangibles that are important to consider for transfer pricing purposes are not
always recognised as intangible assets for accounting purposes.” 4
•
Having legal or contractual mechanisms to protect an intangible does not affect the
importance of the intangible in the context of transfer pricing.5
•
“Transferability is not a necessary condition for an item to be characterised as an
intangible for transfer pricing purposes.” 6
•
The importance of separating intangibles from market specific conditions or other
variables that are not transferrable or capable of being owned.7
•
Not all intangibles require or justify remuneration or add value in all situations or
circumstances. 8
These considerations provide the foundation for a modified perspective on what intangibles
are relevant to transfer pricing and how to handle the intangibles that are still considered to
be significant in the context of transfer pricing.
Paragraph 29 of the Discussion Draft described the concept of “entitlement to intangible
related returns.”
(i) The terms and conditions of legal arrangements including relevant registrations, licence
agreements, and other relevant contracts; (ii) whether the functions performed, the assets
used, the risks assumed, and the costs incurred by members of the MNE group in
developing, enhancing, maintaining and protecting intangibles are in alignment with the
allocation of entitlement to intangible related returns in the relevant registrations and
contracts; and (iii) whether services rendered, in connection with developing, enhancing,
maintaining and protecting intangibles, by other members of the MNE group to the
Source:
5
Par. 6 OECD Discussion Draft, June 6, 2012
5
Par. 7 OECD Discussion Draft, June 6, 2012
6
Par. 7 OECD Discussion Draft, June 6, 2012
7
Par. 8 OECD Discussion Draft, June 6, 2012
8
Par. 9 OECD Discussion Draft, June 6, 2012
13
member or members of the MNE group entitled to intangible related returns under the
relevant registrations and contracts, are compensated on an arm’s length basis under the
relevant circumstances. 9
This concept outlines the requirements to be entitled to claim returns that are a result of an
intangible. In order for an entity to have the rights to these returns, they must hold the set
of legal rights, contracts or other agreements to the intangible while performing and
controlling the functions related to developing, enhancing, maintaining and protecting the
intangible. The party claiming entitlement to the returns must also assume the risks that
correspond to the functions associated with the intangible. In this context the Discussion
Draft is aligned with the “control over risks” concept found in paragraph 9.23 10. When these
factors are aligned an entity within an MNE is entitled to intangible related returns.
Section D of the Discussion Draft provides new guidance regarding the valuation of
intangibles. It is still required to apply the arm’s length principle to any transactions that
take place between related parties involving an intangible. The first step of assessing the
value of the intangibles is also expected to utilize market based comparables in order to
achieve a suitable arm’s length valuation of the intangible.
Readers of the Discussion Draft should keep in mind that the contents are likely to be
modified and have not been enacted by members of the OECD. It is clear that the OECD has
taken into account feedback from practitioners and is continuing to work towards guidelines
that are beneficial for tax authorities and taxpayers alike. With this Discussion Draft, there
are sizeable changes that will have a profound impact on issues relating to transfer pricing
and intangibles.
1.4
How do emerging jurisdictions (i.e. BRICS) deal with intangibles 11
As emerging countries like India, Brazil and China develop more complex tax legislation and
advanced regulations on transfer pricing, the challenges of handling transfer pricing risk in
these countries also increases.
9
Source: Par. 29 OECD Discussion Draft, 6 June, 2012
10
Source: Par 9.23 Chapter XI July 2010 OECD Transfer Pricing Guidelines
11
Contributions from Dr. Jian Li of TPA Asia and Mr. Vishnu Bagri of ACCRETIVE Business Consulting
14
As China continues to develop its tax laws and legislation, there are likely to be more
transfer pricing controversies in China in the coming years. Some current issues include the
number of local tax authorities that collect taxes and the overlay of the State Administration
of Taxation (SAT), the difficult legal framework for the protection of intellectual property
rights in general, and the speed with which the Chinese economy is creating value for
Chinese businesses and the country as a whole. As the number of consumable products that
bear the label “Made in China” has increased over the past decade, it is clear that there is a
very strong incentive for the SAT to capitalize on the large potential tax revenue. The SAT is
looking closely at how intangibles of MNEs are being used in the context of transfer pricing
in China.
An additional country with emerging transfer pricing challenges is India. There have been
considerable changes to this tax jurisdiction among which is an evolving view of how
intangibles should be dealt with as well as an increase in scrutiny of intra-company
transactions in general.
The term intangible property has been broadened by Indian tax authorities to include the
following intangible assets: marketing, technology related (process patents, technical
documentation etc.), artistic related, data processing related, engineering related, customer
related, human capital related (trained work force, agreements, union contracts, etc.)
location related (leasehold interest, water rights, etc.), contract related, goodwill related,
methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates,
customer lists or technical data, anything which derives value from intellectual content
rather than physical attributes.
These and other changes have given rise to a more advanced tax system that will certainly
increase the challenges of transfer pricing that takes place in India.
1.5
Transfer Pricing & Intangibles: four functional variables
In addressing intangibles, a distinction between the following four functional variables can
be made:
1. Label: What is the label of the intangible? Example: a patent.
2. Identification: How do you identify an intangible? Example: a logo on a sports shoe.
3. Owner: Who owns the intangible? Example: a company who has registered the trade
name.
4. Valuation: What is the value? Example: when a transfer of intangibles occurs the value
needs to be determined.
15
The following types of professionals, however, might have a different view on handling each
of the four functional variables described above.
•
•
•
•
•
•
IP lawyers;
Accountants;
Tax/transfer pricing professionals;
IP management professionals;
Bankruptcy consultants;
Anti-trust lawyers.
As a result, a total of 24 different ways to approach and discuss the topic of intangibles can
be created. The following IPR Matrix (see www.iprplaza.com 12) provides a summary of the
four functional variables according to the various disciplines of professionals involved.
12
IPR Plaza is a multidisciplinary portal that provides free-of-charge qualitative and quantitative information
on intangibles. IPR Plaza is empowered by different leading IP advisory firms and delivers up-to-date guidance
on intangibles from IP Law, Accounting, IP Management, Antitrust, and Tax/Transfer Pricing perspectives. The
first block filters information from public sources, while the second block allows users to go back to the original
definition of an intangible. The third block provides quantitative information on intangibles, which can be
applied by doing your own valuations, and provides a practical quickscan on how to manage intangibles.
16
Source: www.iprplaza.com
1.5.1 Label
From a tax or transfer pricing perspective, intellectual property has a broader perspective
and more often than not, it is difficult to label intangibles since not all valuable intangible
assets are legally protected and registered or recorded on balance sheets. OECD Guidelines
do not provide any specific definition of intangibles; however, list different kinds of
intangibles:
•
Rights to use industrial assets such as patents, trademarks, trade names, designs or
models;
•
Literary and artistic property rights; and
•
Intellectual property, such as know-how and trade secrets.
In order to better understand intangibles from a tax and transfer pricing perspective the
OECD Guidelines (2010) categorizes different types of intangibles into commercial
intangibles and marketing intangibles.
17
Commercial Intangibles: include patents, know-how, designs, and models that are used for
the production of a good or the provision of a service, as well as intangible rights that are
themselves business assets transferred to customers or used in the operation of business
(e.g. computer software).
Marketing Intangibles: include trademarks and trade names that aid in the 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.
Commercial intangibles other than marketing intangibles are considered as trade
intangibles.
In the Discussion Draft, the OECD chose to not include or focus on any categories relating to
the labelling of intangibles.
1.5.2 Identification
From a tax or transfer pricing perspective, the identification of intangibles is a critical step in
determining ownership, and in turn, determining which party is eligible to receive income
from that IP. Intangibles can either be remunerated, i.e. royalty payments, or used free of
charge by other group companies (often in good faith). In case of free of charge access to
the intangible, no agreement will be in place, which makes it difficult to determine the
existence of such intangible assets.
In the Discussion Draft, there are new factors used to identify and categorize intangibles.
The factors prescribed by the OECD assist in the process of identifying intangibles and will
have a notable impact on how intangibles are identified in the context of transfer pricing.
The OECD introduces the idea of economically significant intangibles and delineates the fact
that not all intangibles contribute to the creation of economic returns. It is also stressed that
there must be a thorough functional analysis and justification for the aggregation of various
intangibles, and that “it is not sufficient to suggest that vaguely specified or undifferentiated
intangibles have an effect on arm’s length prices or other conditions.” 13
There are also procedures that are used by tax and transfer pricing specialists to further
identify intangibles. The procedures are:
•
13
Interviews with relevant officers involved with the development, usage or management
of IP. For example, the responsible person for research & development in an MNE will be
Source: Par. 12 OECD Discussion Draft, 6 June, 2012
18
•
•
able to provide indications of protected/unprotected patents or not yet finalized R&D
projects, which may ultimately result in a registered patent.
An industry analysis investigating relevant industry IP could provide details about
existing IP within the multinational, particularly in cases where it has not been
registered, protected, or capitalized in the balance sheet.
A functional analysis can identify IP according to its functional characteristics
(protectable or not, published or not, registered or not, willingness from customer to
pay a premium or not, multiyear positive contribution of cash flow of multinational).
1.5.3 Ownership
The process of determining the owner of an intangible can become difficult when one entity
is the legal owner and another is the economic owner. The legal owner refers to the entity
that is considered the owner under intellectual property law, while the economic owner
refers to the entity that has the right to the income attributable to the ownership of the
asset, such as royalties.
Another way to determine ownership is looking at the degree of centralization. Centralized
ownership can have the following attributes: a single company in the group that owns the
intangibles legally and economically and has license agreements with other group entities, a
situation which can create opportunities for tax planning. A distributed or joined ownership,
on the other hand, has the following attributes: a number of group companies that share
ownership of intangibles on a pre-determined basis, always involves some form of shared
economic ownership, usually takes the form of a R&D cost contribution or cost-sharing R&D
arrangement.
In addition, the OECD Guidelines offer two standards about the ownership of intangibles:
Legal ownership is typically assigned according to the legal title and legal protection of the
intellectual property. Thus, the intellectual property can be legally protected in the country
it is registered, such as patents and trademark. For patents and trademarks, the owner can
protect their intellectual property by registering them; however, for embedded intangibles
like know- how, it may be harder to use a legal system to protect it. Legal ownership offers
the owner the protections and the rights to utilize the IP to generate further benefits and
prevent others from using the intangible.
Economic ownership refers to a situation when the intangible is not legally protected or it is
difficult to identify the legal owner of the intangible so economic ownership is then
considered. Economic ownership can be determined by analysing the relative contributions
to the intangibles by each party.
19
Though legal ownership is usually the starting point of defining ownership, there are cases
where ownership lies elsewhere, such as with the licensee.
The following circumstances describe instances when the ownership does not lie with the
legal owner but with the economic owner.
•
The license is issued exclusively,
•
The license is issued for an indefinite period or at least a period that concurs with the
expected economic life of the intangible,
•
The licensor has no economic interest in the intangible, for instance when the
royalties are not dependent on turnover, and
•
The licensee is allowed to transfer the license without the licensor’s permission.
In the Discussion Draft, the OECD has introduced a new concept of “entitlement to
intangibles related returns.” This concept requires an entity that is claiming the right to
returns that stem from an intangible to poses the legal agreements and contracts that are
related to an intangible, exercise control over the risks borne and costs incurred while
performing the functions related to developing, enhancing, maintaining and protecting an
intangible. If the functions, risks and legal agreements are aligned, the entity is entitled to
the returns related to intangibles.
1.5.4 Valuation
Tax and transfer pricing professionals are mainly concerned with the valuation of intangible
assets in the intra-group context. In assessing the appropriate value for any IP transferred
between related parties, professionals refer to the "fair market value", a concept that is
defined by the OECD Guidelines 14. Fair market value is the estimated amount for which an
asset could be exchanged in arm's length transactions as if the two parties were unrelated.
The challenge is that intangibles are not priced by standard pricing mechanisms in the open
marketplace, so the perspectives of both the transferor of the property and the transferee
must be taken into account in order to determine a proper price for the IP. The three
methods that are used by tax and transfer pricing professionals when determining the value
of IP are: the cost method, the market method, and the income method.
The general guidance for applying the arm's length principle, as outlined in Chapter 1 of the
OECD Guidelines, pertains equally to the determination of transfer pricing between related
14
Source: OECD Guidelines, paragraph 1.42 ‘Evaluation of separate and combined transactions’, “(...) in order
to arrive at the most precise approximation of fair market value, the arm's length principle should be applied
on a transaction-by transaction basis (...)”
20
parties for IP related transactions. This principle can however be difficult to apply to
controlled transactions involving intangible property because such property has a special
character complicating the search for comparables and in some cases making it difficult to
accurately determine the value at the time of the transaction.
Arm's length pricing for IP-related transactions should take into account, for the purposes of
comparability, the perspective of the transferor of the property and the transferee. From
the perspective of the transferor, the arm's length principle would examine the pricing at
which a comparable independent enterprise would be willing to transfer the property. From
the perspective of the transferee, the transferee will generally be prepared to pay for the IP
if the benefit it reasonably expects to secure from the use of the intangibles is satisfactory
having regard to other options realistically available. According to paragraph 9.80 of the
OECD Guidelines, “an essential part of the analysis of a business restructuring is to identify
the significant intangible assets that were transferred (if any), whether independent parties
would have remunerated their transfer, and what their arm’s length value is.”
In the Discussion Draft on intangibles, assigning value to intangibles is addressed in section
D. The OECD chose to focus on transactional value, factors for addressing valuation,
methods of assessing value and valuation techniques. The factors that are related to
assessing the value of the intangibles for comparability include:
•
exclusivity
•
extent and duration of legal protection
•
geographic scope
•
useful life
•
stage of development
•
rights to enhancements, revisions, and updates;
•
expectation of future benefit
In the context of valuation, the Discussion Draft provides some freedom in circumstances
when reliable comparables are not available to apply the appropriate valuation technique to
accurately price an intangible. “It should be emphasised that the characterisation of the
transaction as the provision of products or services or the transfer of intangibles or a
combination of both does not necessarily dictate the use of a particular transfer pricing
method.” 15 The Discussion Draft presents explanations and examples of various valuation
15
Source: Par. 75 OECD Discussion Draft, 6 June, 2012
21
methods, but emphasizes that seeking a comparable transaction to evaluate the tested
party is the first step that should be taken in determining the value of an intangible for an
intercompany transaction.
1.6
Locating IP in tax advantaged jurisdictions
Because a high percentage of value-add within an MNE is created by intangibles, there is a
considerable incentive for MNEs to reduce their tax burdens by shifting IP related functions
to tax jurisdictions with lower tax considerations. In response to this, the OECD and its
member countries have taken specific steps to address this view.
The first issue that tax authorities have begun to evaluate is the effective place of
management. When evaluating the functions and risks that are assumed by companies, tax
authorities have focused on the alignment of risk and assets with effective management.
This is a shift of focus from the previous standard of purely legal agreements. The criterion
that is applied to these types of companies is the level of decision making and management
power that the foreign controlled company has. In the Laerstate BV court case, brought
before the UK Tribunal in 2009, the evaluation of the management functions of the
company proved to be the most important component of the Tribunal’s decision. 16 The
Tribunal wrote,
“An objective way of testing whether this is the case is to ask whether the directors
have the absolute minimum amount of information that a person would need to have
in order to be able to make a decision at all on whether to agree to follow the
shareholders wishes or to decide not to sign.”
As companies have increased their distribution of risks and functions related to IP, there has
also been an increase in the number of cases and regulations that deal directly with this
issue. One set of rules that was designed to focus on limiting the practice of tax avoiding is
the Controlled Foreign Corporation (“CFC”) law that was introduced by major industrial
countries. For example under UK tax law a CFC is defined as a company, which is a resident
outside the UK, while being controlled for 50 percent or more by a UK company. There are
tax incentives that are associated with this ruling. One of the tax incentives for a CFC is the
fact that it is subject to a lower level of taxation, roughly three quarters of the
corresponding UK corporate income tax.
16
Source: Laerstate BV v. HMRC (2009) UKFTT 2009 (TC).
22
As the number of companies that are handling IP and functions related to it has increased,
the OECD and tax authorities around the world have also placed a greater focus on the
substance of the company that is responsible for the IP. In order to be entitled to economic
returns that are related to intangibles, the company typically must meet a certain number of
specific requirements. These requirements are generally:
•
payroll requirements/number of full time equivalents;
•
minimum capital requirements;
•
minimum revenue thresholds;
•
minimum amount of investment/spending;
•
reporting requirements;
•
requirements in relation to activities/number of activities; and
•
other requirements.
These requirements are a good point of evaluation to determine the alignment of
managerial functions, risk assumed and legal agreements between the parties involved.
Tax authorities are most interested in the concepts of “substance” and “control over risk.”
In order to determine if the risk that is transferred is aligned with the legal, managerial and
accounting systems, tax authorities evaluate the structure of the company and where the
actual control of risks takes place. The OECD Guidelines make it clear that the entity
designated as the owner of the IP must be in control of the management functions related
to the IP and that it has the financial capability to assume the risk of decisions that are
associated with investment in IP. If these essential components are not established, tax
authorities will likely raise questions over the commercial substance of the agreement
between the two parties. ‘‘Control’’ in this context is elaborated on in paragraph 9.23 of the
OECD Guidelines where it is defined as,
‘‘… the capacity to make decisions to take on the risk (decision to put the capital at
risk) and decisions on whether and how to manage the risk, internally or using an
external provider. This would require the company to have people– employees or
directors – who have the authority to, and effectively do, perform these control
functions.”
Chapter 9 further explains that not all of the functions must be performed by employees or
directors, but that managers must be able to evaluate the performance of the outsourced
functions on a day-to-day basis and have the ability to make decisions regarding that
performance. The OECD, as outlined in the Discussion Draft, now states that the functions
that relate to the development, enhancement, maintenance and protection of an intangible
23
and the entity controlling these functions, as well as exercising control over risks relating to
those functions should be the entity which is entitled to intangible related returns.
1.7
Transfer Pricing Risks (1): Court Cases on Intangibles
In recent years, tax authorities around the world have challenged taxpayers on various
issues in relation to intercompany transactions involving intangibles. This has resulted in a
sizeable increase of transfer pricing court cases on intangibles. Some of the key court cases
and trends relating to transfer pricing and intangibles include:
•
USA: DHL, Veritas and Glaxo court cases
•
Europe: Various court cases pending
•
Asia: Maruti-Suzuki, various valuation of intangibles which are being transferred to
tax favourable hubs such as Singapore
The remainder of this chapter presents a summary of the facts, key arguments and decisions
pertaining to four landmark court cases dealing with intangibles from a transfer pricing
perspective: DHL, Veritas, Maruti-Suzuki and GlaxoSmithKline.
1.7.1 DHL 17
The DHL case positioned around a split of a trademark value between a US headquarter
office, called DHL and its Hong Kong subsidiary, called DHLI, which needed the trademark for
handling a courier business outside the US. DHLI bore the publicity cost of the network
outside the US. DHLI had obtained a license under the trademark in its territory. On July 9,
1990, DHL and DHLI executed an agreement, granting DHLI an option to purchase the DHL
trademark for $ 20 million, based on an internal valuation exercise and confirmed by an
external valuation firm.
The U.S. Tax Court of First Instance provided a step-by-step reasoning of its valuation
method.
First, the U.S. Tax Court attained a $ 300 million value for unbooked intangibles, based on a
third party consortium payment for DHLI’s excess value. Second, the U.S. Tax Court
determined that one half thereof was attributable to the trademark. Third, the U.S. Tax
Court determined that two-thirds of the value of the trademark, i.e. $ 100 million, was
attributable to the non-US rights to the trademark. Fourth, the U.S. Tax Court discounted
the non-US rights by 50% to take account of marketability constraints possibly connected
17
Source: DHL Corp, 76 CCHTCM 1122, 89 AFTR 2d 2002-1978, 285 F3d 1210, 2002-1 USTC.
24
with DHL’s ownership of the foreign trademark rights. As a result the U.S. Tax Court
concluded that domestic and foreign trademark rights amounted to $ 50 million each.
The next point to decide concerned the imputation of royalty payments from DHLI to DHL,
being the legal owner of the trademark. The U.S. Tax Court held that such imputation was
justified with reference to the legal ownership of the trademark by DHL. Therefore it
allocated $ 50 million in addition to DHL to account for imputed royalty payments.
The Tax Court imputed substantial understatement penalties for unpaid royalties and a
gross valuation misstatement penalty for the amount allocated to DHL in respect of the sale
of the trademark itself.
The Court of Appeal affirmed the valuation by the U.S. Tax Court of the trademark at the
amount of $ 100 million, based on a $ 50 million figure for the domestic rights and a $ 50
million figure for the foreign rights. However the 9th Circuit Court of Appeals principally
reversed the full allocation of both amounts to DHL only. Instead it allocated the $ 50 million
value of the foreign trademark rights to DHLI, based upon the old IRS regulations section
482 developer-assistor regulations as DHLI had incurred major expenditures to develop the
trademark outside the US.
With respect to the imputed royalty payments the Court of Appeal rejected the imputed
royalty payments following a similar reasoning concerning the developer-assister doctrine.
The party that incurred the costs and risks of developing the intangible should not be
required to pay a royalty to use the intangible.
The penalties were rejected in total. The first one, because no imputation of royalty
payments was justified and the second one because DHL showed good faith by obtaining a
comfort letter from its external appraisal firm.
1.7.2 Maruti-Suzuki 18
Maruti, an Indian company engaged in the manufacture and sale of automobiles, entered
into a license agreement with Japanese-based competitor Suzuki for the manufacture and
sale of cars. On the strength of this license agreement Maruti was allowed to use the Suzuki
trademark in combination with the Maruti trademark thus reinforcing the local market
position for the relevant cars. In effect Maruti used the Suzuki trademark/logo in
18
Source: Maruti Suzuki India Ltd. v. Additional Commissioner of Income Tax Transfer Pricing Officer New
Delhi, W.P. (C) 6876/2008 High Court of Delhi at New Delhi, 2010.
25
combination with the Maruti trademark/logo on the front side whereas it continued to use
the mark ‘Maruti’ along with the word ‘Suzuki’ on the rear side of the cars.
According to the Transfer Pricing Officer (“TPO”) the trademark ‘Suzuki’ had piggybacked on
the trademark “Maruti” without payment of any compensation. In addition the TPO came to
the conclusion that the trademark “Maruti” had acquired the value of a super brand
whereas the trademark “Suzuki” was a relatively weak brand in the Indian market. The TPO
concluded that the promotion of the co-branded trademark “Maruti-Suzuki” had resulted in
impairment of the “Maruti” trademark. Ultimately Maruti, according to the TPO, incurred
major expenditures on account of marketing/promotion in excess of standard norms and
should have been rewarded for the development of the resulting marketing intangible.
The High Court decided in favour of Maruti. The Court made the following considerations:
•
There is no justification for any payment from Suzuki to Maruti on account of use
and application of the Maruti trademark or logo to the benefit of Suzuki. The Court
cannot agree that Maruti had become a “superbrand.” Maruki faced intensified
competition from major foreign passenger car manufacturers and felt the need
therefore to reinforce its position by in-licencing the technical know-how, trademark
and logo of Suzuki in order to uphold its customer base.
•
If an independent domestic entity uses a foreign trademark or logo, no payment is
necessary unless it is agreed;
•
If an associated domestic entity uses trademarks or logos on its products no
payment to the foreign owner should be made in case the use of the foreign
trademark or logo concerned is discretionary for the domestic entity. However the
income from such international transactions must be determined at arm’s length.
•
If the domestic entity is mandatorily required to use the foreign trademark or logo
on its products, appropriate payment should be made by the foreign entity to the
domestic entity on account of the benefit it derives from the marketing intangibles
relating to the respective products.
•
In the case described in the foregoing paragraph, the arm’s length price with respect
to the international transaction between the two entities should be determined
taking into consideration the value of the marketing intangibles obtained by the
foreign entity on account of its compulsory use of the trademark or logo by the
domestic entity.
•
Compensation of promotional, advertising and/or general marketing expenses by
the foreign company is required only if and insofar the corresponding expenses
exceed the expenses which a similarly situated and comparable independent
domestic entity would have incurred.
26
1.7.3 Veritas19
Veritas Software Corporation (“Veritas Software”), a US entity, entered into a cost sharing
agreement (“CSA”) with its wholly owned subsidiary Veritas Ireland to enable the latter to
use its pre-existing intangible assets. The CSA was part of a comprehensive set of
transactions entailing the transfer of all sales agreements with its European-based
subsidiaries to Veritas Ireland. In addition Veritas Software and Veritas Ireland entered into
a research and development agreement and a technology license agreement. On the verge
of the technology license agreement Veritas Software granted Veritas Ireland the right to
use certain covered intangibles as well as certain trademarks, trade names and service
marks.
Veritas Software charged Veritas Ireland a buy-in payment of US $118 million on the
strength of the then prevailing US Cost-Sharing Regulations calculated, applying the
Comparable Uncontrolled Transaction method pursuant to US 482, section 4-a Regulations.
The Internal Revenue Service (IRS) disputed the methodology and calculation implemented
by Veritas Software using the income valuation method analysis resulting in a US$ 2.5 billion
(round figure) present value for US corporate taxation purposes. The reasoning of the IRS
boiled down to the following components:
•
•
•
•
The intangible assets, derived from research and development in the US, were
unique in providing perpetual useful life characteristics.
Synergetic effect with other assets was basic in ascertaining value of the shared
assets.
The buy-in transaction was considered to be akin to a sale of assets.
Approach of the IRS was package-related and applied a multiplier in order to reach a
profitability profile.
The Court found that the akin to a sale doctrine misconceives the fact that the intangible
assets should be characterized as short-lived and could therefore not be considered as
perpetual life assets. The Court also asserted that in such cases, future intangibles were
included in the calculation base.
The Court estimated the average lifetime of the pertaining intangible assets to be four (4)
years. In addition it found that the IRS used the wrong “beta’’ and equity risk premium.
19
Source: Veritas Software Corp. 133 TC 297, Dec. 58.016 (2009).
27
Finally, the Court concluded that the IRS departed from unrealistic growth rates. The Court
therefore ruled in favour of Veritas.
1.7.4 GlaxoSmithKline 20
This major case centred around the question whether the drug called ‘Zantac’, derived its
primary value from marketing efforts in the US instead of from research and development
performed by its UK headquarters. The IRS asserted that GlaxoSmithKline (“Glaxo”) US took
full responsibility for the marketing of the drug on the US market. Glaxo US should have
invoiced Glaxo UK a marketing services fee. Further, the IRS converted the transfer price to
a contract manufacturing mark-up and lowered the royalty percentage from the license
agreement concluded between Glaxo US and Glaxo UK.
Glaxo US applied the resale price method whereas the IRS applied the residual profit split
method to arrive to their respective profit allocation.
In its deficiency note the IRS claimed that Glaxo US was the economic owner of the US
marketing intangible since Glaxo US was considered to be the developer of said intangible
which was tantamount to a royalty-free license under the intangible and the trademark
from Glaxo US to Glaxo UK.
The case was ultimately settled in 2006 at US$3.1 billion and as such there is no verdict of
the Court and ensuing transfer pricing jurisprudence.
As marketing and its connected expenditures are more than once at the centre of discussion
with respect to their (embedded) intangible characteristics it is unfortunate that the Court
was not in a position to enunciate proper guidelines. However, the case will remain to play a
leading role in upcoming disputes about the core issue whether the critical success factor of
a drug is to be attached to research, development or design achievements or to
comprehensive strategic marketing decisions at the domestic level.
1.8
Transfer Pricing Risks (2): Corporate Reputation at Risk Through SEC Disclosure of
Intercompany Transactions
In recent years governments around the world have increased documentation and
disclosure requirements related to transfer pricing. As of Fiscal Year (FY) 2010, the United
States Internal Revenue Service (IRS) introduced Schedule UTP, which requires the
disclosure of detailed information on uncertain tax positions, including transfer pricing
20
Source: GlaxoSmithKline Holdings (Americas) Inc., TC Nos 5750-04 and 6959-05, 2006.
28
positions. In September 2011, the first group of US taxpayers filing Form 1120, 1120-F,
1120-L, or 1120-PC were required to disclose their uncertain tax positions on Schedule UTP
when the taxpayer or a related party had (1) one or more uncertain tax positions as part of
their 2010 ASC 740/FIN 48 analyses and (2) total assets equal to or in excess of $100 million.
The total asset threshold will be reduced to $50 million in FY 2012 and to $10 million
starting with FY 2014. In the United States, the IRS has also increased penalties for failure to
accurately file related-party disclosure forms (Forms 5471 and 5472).
According to an article in the February 2012 BNA Tax Management Transfer Pricing Report
titled “SEC Comment Letters Show Inquiries into Firms’ Transfer Pricing Activities” 21, the
Securities and Exchange Commission (SEC) investigated seven U.S. public companies
regarding transfer pricing disclosures made within their financial statements or other
related government filings. These seven companies include Amazon.com, Inc.; China United
Insurance Service, Inc.; Google, Inc.; Honda Motor Co., Ltd.; Pitney Bowes, Inc.; Red Hat,
Inc.; and VASCO Data Security International, Inc. In the case of Amazon.com, the
corporation had a $1.5 USD billion tax increase related to transfer pricing. The SEC rejected
the China United Insurance Services original IPO request due to the fact that it failed to fully
disclose the relationship between its management and one of its Chinese affiliates in the
registration papers. The Google case involved a SEC inquiry about the proper disclosure of
its 2006 Advance Pricing Agreement (APA) in the company’s financial statements. Honda
Motors was scrutinized about a $7.7 USD billion provision for a transfer pricing dispute
dating back from 2001-2006.
Additionally, some other well-known corporations have also recently made the headlines for
their transfer pricing practices. According to the 2011 Boston Scientific Annual Report, the
IRS proposed a $581 USD million tax liability in connection with the transfer pricing of
technology license agreements between domestic and foreign subsidiaries of Guidant
Corporation. The September 2011 10Q for Cardinal Health reported that the IRS had
proposed additional taxes of $849 USD million for transfer pricing arrangements between
foreign and domestic subsidiaries, including the transfer of intellectual property, based on
an audit of fiscal years 2001 through 2010. Stryker Corporation, in its 2011 SEC filings,
mentioned IRS proposed adjustments on the company’s 2006 and 2007 income tax returns
due to tax positions taken on its cost sharing arrangements with entities operating in
Ireland.
21
Bloomberg BNA, Tax Management Transfer Pricing Report, “SEC Comment Letters Show Inquiries into Firms’
Transfer Pricing Activities”, Volume 20 Number 20, February 23, 2012.
29
As seen from the examples above, transfer pricing has become one of the key topics that US
tax authorities have scrutinized in recent investigations. In testimony to Congress earlier this
year, IRS Commissioner Douglas Shulman stated that Section 482, allocation of income
including transfer pricing, was one of the top three IRS Code sections disclosed by taxpayers
on their 2010 Schedule UTP and that 19% of all issues disclosed were transfer pricing issues.
Furthermore, the proposed 2013 IRS budget specifically noted the goal to enhance oversight
of complex financial situations, including transfer pricing and uncertain tax positions. These
current situations have forced taxpayers to review their transfer pricing transactions in
more detail, in order to prevent their corporate reputation from being harmed by such
public disclosures, which can be perceived as negative in the eyes of the general public.
1.9
Introduction to lessons 2-7
Lesson 2: Transfer Pricing Labels of intangibles, identification of intangibles, ownership of
intangibles
This Lesson evaluates the labels that are applied to intangibles in the context of transfer
pricing by utilizing four functional variables. The definitions of intangibles are evaluated
from a legal, tax, and accounting perspective. The lesson then examines methods for
applying labels to intangibles and how to properly identify the rightful owners and which
entity is entitled to the returns related to an intangible.
Lesson 3: Valuation of intangibles
Lesson 3 provides the reader a clear picture of the various aspects of assessing the value of
an intangible for transfer pricing purposes. This is accomplished through providing relevant
background information, introducing components of valuation methods and applying these
ideas to real world examples of highly valued companies that utilize intangibles in their
business models. After introducing these concepts, practical methods of assessing value are
examined.
Lesson 4: Business models: IP configurations
Lesson 4 describes how and where intangibles are located in the value chain of
multinational enterprises. This is accomplished through evaluating these business models
from a general business/commercial perspective as well as from a transfer pricing
perspective. The reader then is presented with case studies and questions to evaluate
different practical examples.
30
Lesson 5: Intellectual Property Law and Transfer Pricing
Lesson 5 examines the legal system surrounding intellectual property (IP) rights. The lesson
provides a brief history of IP rights in the legal context, discusses the future of IP rights, and
looks at the different types of legally recognized IP rights. The lesson also further explores
on the legal aspects of IP exploitation, IP management, and IP transfer. How to protect
intangibles through IP law, corporate law, contract law and labour law is also examined.
Lesson 6: Accounting Definitions of Intellectual Property and Transfer Pricing
Lesson 6 provides a high level overview of the accounting standards relating to intangible
assets. The lesson focuses on the recognition and measurement of intangibles according to
accounting principles. The lesson also examines the differences in the valuation of IP
according to IFRS, US GAAP, and Canadian GAAP.
Lesson 7: Corporate Income Tax Aspects of IP and Transfer Pricing
This Lesson outlines the corporate income tax aspects related to intangibles and transfer
pricing. The lesson touches on many tax aspects including amortization, tax credits, capital
gains tax, value-added tax, and more. This is done by providing several examples from
different countries to highlight how intangible property is taxed around the world.
1.10 Questions
1. Which court case resulted in a tax valuation of domestic and foreign trademarks in the
amount of $100 Million:
A. DHL Ltd.
B. GlaxoSmithKline
C. Maruti-Suzuki
D. Veritas Software Corporation
2. Which of the following is not a functional variable of intangibles:
A. Ownership
B. Identification
C. Label
D. Value
E. All of the above are functional variables
31
3. Which of the following is not a factor related to comparability in valuation according to the
Discussion Draft:
A. Exclusivity
B. Stage of Development
C. Geographic Scope
D. Amount of innovation
E. All of the above are factors relating to comparability in valuation according to
the Discussion Draft.
4. True or False: India has a more narrow definition of intangibles than what is outlined in the
OECD Guidelines Chapter VI and the Discussion Draft:
A. True
B. False
5. The term “control over risk” is explained in which paragraph of the OECD Guidelines:
A. Paragraph 4.15
B. Paragraph 9.23
C. Paragraph 6.39
D. Paragraph 3.78
6. Which of the following is a company with recent SEC disclosures on “Uncertain Tax
Positions”:
A. Microsoft Corporation
B. Lockheed Martin
C. Pitney Bowes Ltd.
D. Toyota Motor Corporation
1.11 Answers
1. A.
2. E.
3. D.
4. B.
32
5. B.
6. C.
1.12 Literature
Mandatory Reading:
•
6 June 2012 Discussion Draft of the Proposed Revisions to Chapter 6 of the OECD
Transfer Pricing Guidelines
•
Chapter VI OECD Transfer Pricing Guidelines July, 2010
Optional Reading:
•
TPA’s Press Release regarding Discussion Draft of the Proposed Revisions to Chapter
6 of the OECD Transfer Pricing Guidelines
•
Public Comments found on the OECD website regarding intangibles:
http://www.oecd.org/document/5/0,3746,en_2649_33753_46030661_1_1_1_1,00.
html
•
IP companies and substance: no-fly zones? Steef Huibregtse, Mark Peeters, Louan
Verdoner and Steven Carey. http://www.tpa-global.com/PDF/Publications/TPAIPcompanies.pdf
•
Bloomberg BNA, Tax Management Transfer Pricing Report, “SEC Comment Letters
Show Inquiries into Firms’ Transfer Pricing Activities”, Volume 20 Number 20,
February 23, 2012
33
34
2 Transfer Pricing Labels of intangibles,
identification of intangibles, ownership
of intangibles
Authors: Steef Huibregtse/Lukasz Kubicki
35
2.1
Introduction
When interacting with intangibles in a transfer pricing context, it is best to evaluate the
intangible with four functional variables. These functional variables are:
•
The label associated with an intangible;
•
The Identification of an intangible;
•
The owner of an intangible; and
•
The value of an intangible.
These labels provide a clear method for understanding the various aspects that are
important to the intangible and allow for the creation of an effective transfer pricing
solution. This lesson will examine the functional variables in order to provide a better
understanding of the methods to evaluate an intangible.
2.2
Definition of intangibles
There are many definitions of intangibles for legal, accounting, and tax/transfer pricingrelated purposes. In practice, MNEs have to deal with all of these definitions when for
example protecting its intellectual property, recognizing intangibles on a balance sheet or
determining tax consequences of intra group licensing policies. Below we will discuss in
more detail existing definitions and their origin.
2.2.1 Legal perspective 22
IP law focuses on the protection of the intellectual property and the pursuit of infringement
of the owner’s intellectual property. In order to proper protect any owner’s intellectual
property, IP law offer different definitions of different kind of intellectual property. We will
use IP law in the U.S. and international conventions as examples to illustrate how
intellectual property can be defined.
Patent: In order to qualify for a patentable invention, the invention should have three
characteristics: 1) Novelty; which means that the subject matter is new taking into account
the publicly available state of the art; 2) non-obviousness, the invention has to be nonobvious to a person skilled in the art; and 3) utility, meaning that the invention should be
capable to being applicable in the field of industry (including agriculture).
22
For more information about U.S. IP Law, please visit http://www.uspto.gov/. For more information about
European IP Law, please visit
http://europa.eu/legislation_summaries/internal_market/businesses/intellectual_property/index_en.htm
36
Copyrights: Under U.S. law, the author of a work is automatically the owner of the
copyright in the work. If an employee creates a work as part of his employment, the
employer is considered to be the "author" for copyright purposes. Under U.S. copyright law,
software is considered to be a “literary work” and is protected by the copyright law.
Trademarks: A trademark includes any word, name, symbol, device, or any combination,
used, or intended to be used, in commerce to identify and distinguish the goods of one
manufacturer or seller from goods manufactured or sold by others, and to indicate the
source of the goods.
Trade Secrets: Trade secret is protected by contract law. Trade secret law protects any
secret process, technique or information which gives the owner a competitive advantage. If
the owner of a trade secret fears that his trade secret is being used by a competitor or by an
employee or customer in an improper manner, he can bring suit to enforce his rights under
the applicable contracts and, under appropriate circumstances, obtain an injunction
preventing use of the trade secret and requiring that all matters pertaining to the trade
secret be returned to the owner.
Industrial design: An industrial design is the ornamental or aesthetic aspect of an article.
The design may consist of three-dimensional features, such as the shape or surface of an
article, or of two-dimensional features, such as patterns, lines or colour.
Industrial designs are applied to a wide variety of products of industry and handicraft: from
technical and medical instruments to watches, jewellery, and other luxury items; from
housewares and electrical appliances to vehicles and architectural structures; from textile
designs to leisure goods.
To be protected under most national laws, an industrial design must be new and/or original.
Novelty or originality is determined with respect to the existing design corpus. An industrial
design is primarily of an aesthetic nature, and does not protect any technical features of the
article to which it is applied.
Geographical indications: A geographical indication (GI) is a sign used on goods that have a
specific geographical origin and possess qualities, reputation or characteristics that are
essentially attributable to that origin. An appellation of origin (AO) is a special kind of GI.
GIs are protected in accordance with international treaties and national laws under a wide
range of concepts, including laws specifically for the protection of GIs or AOs, trademark
laws in the form of collective marks or certification marks, laws against unfair competition,
consumer protection laws, or specific laws or decrees that recognize individual GIs.
37
2.2.2 Accounting perspective
According to IAS 38 intangible assets are “identifiable nonmonetary assets without physical
substance.” 23 An asset is a resource that is controlled by the entity as a result of past events
(for example, purchase or self-creation) and from which future economic benefits (inflows
of cash or other assets) are expected. Additionally, IAS 38 states that “requires an entity to
recognize an intangible asset if, and only if, specified criteria are met.” 24 Thus, the three
critical attributes of an intangible asset are:
•
Identification,
•
control (power to obtain benefits from the asset),
•
future economic benefits (such as revenues or reduced future costs).
IAS 38 provides practical guidelines and standards of how to handle intangible assets from
an accounting perspective. The areas that IAS 38 focuses on are the process of recognition
and measurement, specific guidance on internally generated intangible assets,
measurement after recognition, the useful life of an intangible and how to evaluate
intangible assets with finite and indefinite useful lives. This standard provides clarity on how
to view intangible assets in the discipline of accounting.
2.2.3 Tax perspective
OECD model tax convention provides principles of international taxation and transfer
pricing. Article 9 of the model convention defines the arm’s length principle which is further
elaborated in the OECD TP Guidelines which in turn, are followed by most of the OECD
countries.
The commentary to the OECD model tax convention provides examples of the intangible
assets. Accordingly the intangible asset is a “property such as patents, procedures and
similar property”. Also the OECD model tax convention provides the definition of know-how
which is described as “undivulged information of an industrial, commercial or scientific
nature arising from previous experience, which has practical application in the operation of
an enterprise and from the disclosure of which an economic benefit can be derived”. The
OECD Model tax convention further deals with the intangible assets in Chapter 12. Although
it does not define intangibles directly, it defines term royalties as “consideration for the use
of, or the right to use, any copyright or literary, artistic or scientific work including
23
Source: IAS 38, (IASB April 2009)
24
Source: IAS 38, (IASB April 2009)
38
cinematograph films, any patents, trade mark, design or model, plan secret formula, or
process, or for information concerning industrial, commercial or scientific experience”.
According to the OECD TP Guidelines an intangible is defined as the asset “that is used in
commercial activities such as the production of a good or the provision of a service, as well
as an intangible right that is itself a business asset transferred to customers or used in the
operation of business.“ Also, according to the OECD TP Guidelines, the term "intangible
property" includes rights to use industrial assets such as patents, trademarks, trade names,
designs or models. It also includes literary and artistic property rights, and intellectual
property such as know-how and trade secrets. These intangibles are assets that may have
considerable value even though they may have no book value in the company's balance
sheet. There also may be considerable risks associated with them (e.g., contract or product
liability and environmental damages).
OECD identifies two main categories of intangibles i.e. trade and marketing intangibles.
These categories are further discussed below.
2.2.3.1 Trade intangibles
Trade intangibles often are created through risky and costly research and development
(R&D) activities, and the developer generally tries to recover the expenditures on these
activities and obtain a return thereon through product sales, service contracts, or licence
agreements. The developer may perform the research activity in its own name, i.e. with the
intention of having legal and economic ownership of any resulting trade intangible, on
behalf of one or more other group members under an arrangement of contract research
where the beneficiary or beneficiaries have legal and economic ownership of the intangible,
or on behalf of itself and one or more other group members under an arrangement in which
the members involved are engaged in a joint activity and have economic ownership of the
intangible. Reciprocal licensing (cross-licensing) is not uncommon, and there may be other
more complicated arrangements as well.
2.2.3.2 Marketing intangibles
Marketing intangibles include trademarks and trade names that aid in the 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.
Some marketing intangibles (e.g., trademarks) may be protected by the law of the country
concerned and used only with the owner's permission for the relevant product or services.
The value of marketing intangibles depends upon many factors, including the reputation
and credibility of the trade name or the trademark fostered by the quality of the goods and
39
services provided under the name or the mark in the past, the degree of quality control and
ongoing R & D, distribution and availability of the goods or services being marketed, the
extent and success of the promotional expenditures incurred in order to familiarize
potential customers with the goods or services (in particular advertising and marketing
expenditures incurred in order to develop a network of supporting relationships with
distributors, agents, or other facilitating agencies), the value of the market to which the
marketing intangibles will provide access, and the nature of any right created in the
intangible under the law.
2.2.3.3 Article 12 of the OECD Model Tax Convention
Article 12 of the OECD Model Tax Convention defines intangibles in terms of royalty
payments. The term “royalties” as used in Article 12 refers to any payment received as a
consideration for the use of, or the right to use any copyright of literary, artistic, or scientific
work. The royalty definition applies to payments whether or not they are publicly
registered. Additionally, the definition covers both payments made under a license and
compensation for infringing upon a copyright.
2.2.4 Local Tax Perspective
Below we provide examples of intangibles’ definitions as provided in the local legislation of
European countries.
Under Section 266.II.A of the German Commercial Code (Handelsgesetzbuch), "intangibles"
are identified as concessions, industrial property and similar rights, the licenses referring to
such rights, goodwill, and advance payments. Section 5 of the 1983 Administrative
Guidelines lists industrial property and similar rights, design protection rights, copyrights,
business secrets, and other rights and benefits not legally protected.
The US Income Tax Regulations section 1.482-4(b), the final section 482 regulations[fn. 1]
define an intangible as an asset with substantial value “independent of the services of any
individual,” and as comprising any of the following six categories:
•
Patents, inventions, formulae, processes, designs, patterns or know-how,
•
Copyrights and literary, musical or artistic compositions,
•
Trademarks, trade names or brand names,
•
Franchises, licenses or contracts,
•
Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts,
estimates, customer lists or technical data and
40
•
Other “similar” items. An item is considered “similar” if it derives its value not from
“physical attributes”, but from its “intellectual content or other intangible
properties.”
2.2.5 Conclusion
Based on our comparison of the definitions of intangibles referred above, one could
conclude that although there are some common features in these definitions, there are still
many inconsistencies which make dealing with the intangibles by MNEs very difficult.
To address this issue, the OECD Committee on Fiscal Affairs decided to commence a new
project examining the transfer pricing aspects of intangibles, to be carried out by Working
Party No. 6 on the Taxation of Multinational Enterprises.
Conclusion: There are different IP definitions for different purposes, which leads to a variety
of issues.
The following is an excerpt from the recently released Discussion Draft of the proposed
revisions to chapter 6 of the OECD guidelines25:
In these Guidelines, the word “intangible” is intended to address something which is not a
physical asset or a financial asset, and which is capable of being owned or controlled for use
in commercial activities. Rather than focusing on accounting or legal definitions, the thrust
of a transfer pricing analysis in a matter involving intangibles should be the determination of
the conditions that would be agreed upon between independent parties for a comparable
transaction.
Intangibles that are important to consider for transfer pricing purposes are not always
recognized as intangible assets for accounting purposes. For example, costs associated with
developing intangibles internally through expenditures such as research and development
and advertising are sometimes expensed rather than capitalized for accounting purposes
and the intangibles resulting from such expenditures therefore are not always reflected on
the balance sheet. Such intangibles may nevertheless carry significant economic value and
may need to be considered for transfer pricing purposes. Furthermore, the enhancement to
value that may arise from the complementary nature of a collection of intangibles when
exploited together is not always reflected on the balance sheet. Accordingly, whether an
item should be considered to be an intangible for transfer pricing purposes under Article 9
25
Source: Discussion Draft on Proposed Revisions to chapter 6 of the OECD Transfer Pricing Guidelines
Paragraphs 5-11 (6 June 2012, OECD)
41
of the OECD Model Tax Convention can be informed by its characterization for accounting
purposes, but will not be determined by such characterization only. Furthermore, the
determination that an item should be regarded as an intangible for transfer pricing purposes
does not determine or follow from its characterization for general tax purposes, as, for
example, an expense or an amortizable asset.
The availability and extent of legal, contractual, or other forms of protection may affect the
value of an item and the returns that should be attributed to it. The existence of such
protection is not, however, a necessary condition for an item to be characterized as an
intangible for transfer pricing purposes. Similarly, while some intangibles may be identified
separately and transferred on a segregated basis, other intangibles may be transferred only
in combination with other business assets. Therefore, separate transferability is not a
necessary condition for an item to be characterized as an intangible for transfer pricing
purposes.
It is important to distinguish intangibles from market conditions or other circumstances that
are not capable of being owned, controlled or transferred by a single enterprise. For
example, features of a local market, such as the level of disposable income of households in
that market or the size or relative competitiveness of the market, may affect the
determination of an arm’s length price for a particular transaction and should be taken into
account in a comparability analysis. They are not, however, intangibles for purposes of
Chapter VI.
The identification of an item as an intangible is separate and distinct from the determination
of the value of the item or the return attributable to the item under the facts and
circumstances of a given case. Depending on the industry sector and other facts specific to a
particular case, intangibles can account for either a large or small part of the MNE’s value
creation. It should be emphasized that not all intangibles deserve separate compensation in
all circumstances, and not all intangibles give rise to premium returns in all circumstances.
For example, consider a situation in which an enterprise performs a service using nonunique know-how, where other comparable service providers have comparable know-how.
In that case, even though know-how constitutes an intangible, it may be determined under
the facts and circumstances that the know-how does not justify allocating a premium return
to the enterprise, over and above normal returns to the functions it performs. See TPG 1.39.
Care should be taken in determining whether or when an intangible exists and whether an
intangible has been used or transferred. For example, not all research and development
expenditures produce or enhance an intangible and not all marketing activities result in the
creation or enhancement of an intangible.
42
In a transfer pricing analysis of a matter involving the use or transfer of intangibles, it is
important to identify the relevant intangibles with some specificity. The functional analysis
should identify the economically significant intangibles at issue, the manner in which they
contribute to the creation of value in the transactions under review, and the manner in
which they interact with other intangibles, with tangible assets and with business operations
to create value. While it may be appropriate to aggregate intangibles for purposes of
determining arm’s length conditions for the use or transfer of the intangibles in certain
cases, it is not sufficient to suggest that vaguely specified or undifferentiated intangibles
have an effect on arm’s length prices or other conditions. A thorough functional analysis,
including an analysis of the importance of identified economically significant intangibles in
the MNE’s global business, should support the determination of arm’s length conditions.”
The work will focus on the following aspects:
•
The development of a framework for analysis of intangible-related transfer pricing
issues;
•
Definitional aspects;
•
Specific categories of transactions involving intangibles, such as research and
development activities, differentiation between intangible transfers and services,
marketing intangibles, other intangibles and business attributes;
•
How to identify and characterise an intangible transfer;
•
Situations where an enterprise would at arm’s length have a right to share in the
return from an intangible that it does not own;
•
Valuation issues.
The intention is to release a discussion draft for public comment by the end of 2013.
2.2.6 Alternative labelling
In practice, it is difficult to allocate an intangible asset either as a trade or marketing
intangible. Often the intangibles are combination of both (so called hybrid intangibles).
Therefore an alternative view may be required to distinguish between various intangible
assets. To characterize intangibles in a practical, overarching way, the following labels may
be used:
•
Product-related Intangibles: those intangibles that are embedded in a particular
product, such as product design or patent.
•
Process-related Intangibles: those intangibles that are related to unique or valuable
know-how used in specific business processes, such as manufacturing know-how or
procedures.
43
•
Market-related Intangibles: intangibles that are linked to a way that a
company/product name is positioned and recognized in the market, such as
company name and logo.
•
Hybrids: intangibles that do not fit clearly within one of the above categories and
exhibit characteristics of more than one group, such as franchise or license.
Product related intangibles
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Patent
Invention
Pattern
Methods
Copyright
Design / Model
Formulae/Recipes
Software
Literary, musical, or artistic
composition / film
Technical data / documentation
Prescription drug files
Library
Natural resources
Database
Permit
Regulatory license e.g. from
central bank
Trade secrets
Process related intangibles
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Know-how
Software
Method
Procedure
System
Supplier relationships
Procedural manuals
Technical data / documentation
Training manuals
Managerial skills and core
competencies
Airport gates and slots
Financial instruments
Embedded work force
Supply chain intelligence
Market and Marketing intangibles
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Logo
Trade mark
Trade name
Brand
Campaign
Survey
Customer list
Import quota
Customer relationships
Distribution network & agreements
Retail shelf space
Subscription lists
Publications/thought leadership
Reputation
Book of business
Hybrids
•
•
•
•
Franchise
Permit / right / license (air, water,
land, drilling, emission,
broadcasting)
Domain name
Unique location
Source: TPA’s contribution to OECD on scheduled update of Chapters VI of the OECD Transfer
Pricing Guidelines
2.3
Labelling of intangibles
The process of determining the owner of an intangible can become difficult when one entity
is the legal owner and another is the economic owner. The legal owner refers to the entity
that is considered the owner under IP law, while the economic owner refers to the entity
that has the right to the income attributable to the ownership of the asset, such as
royalties.
Another way to determine ownership is looking at the degree of centralization. Centralized
ownership can have the following attributes: a single company in the group that owns the
intangibles legally and economically and has license agreements with other group entities, a
situation which can create opportunities for tax planning. A distributed or joined
ownership, on the other hand, has the following attributes: a number of group companies
that share ownership of intangibles on a pre-determined basis, always involves some form
of shared economic ownership, usually takes the form of an R&D cost contribution or costsharing R&D arrangement.
In addition, the OECD guidelines offer two standards about the ownership of intangibles:
44
2.3.1 Legal ownership
Legal ownership is defined according to the legal title and legal protection of the intellectual
property. Thus, the intellectual property can be legally protected in the country it is
registered, such as patents and trademark. From a transfer pricing perspective, the legal
owner of the intellectual property is considered as the owner of the IP. For patent and
trademark, the owner can protect their intellectual property by registering them; however,
for embedded intangibles like know- how, it is usually hard to use legal system to protect it.
Legal ownership offers the owner the protections and the rights to utilize the IP to generate
further benefits.
In the context of IP law, ownership is defined and based on the types and the circumstances
of the intellectual property laws in place. Patents, trademark and copyrights are defined
differently in Europe, the U.S., and Asia. Below is a quick comparison of the ownership
terms of the different law systems in the United States and Europe.
2.3.2 Economic ownership
Economic ownership refers to a situation when the intangible is not legally protected or it is
difficult to identify the legal owner of the intangible so economic ownership is then
considered. Economic ownership can be determined by analysing the relative contributions
to the intangibles by each party.
Though legal ownership is usually the starting point of defining ownership, there are cases
where ownership lies elsewhere, such as with the licensee.
The following circumstances describe instances when the ownership does not lie with the
legal owner but with the economic owner.
•
The license is issued exclusively,
•
For an indefinite period or at least a period that concurs with the expected economic
life of the intangible,
•
The licensor has no economic interest in the intangible, for instance when the
royalties are not dependent on turnover, and
•
The licensee is allowed to transfer the license without the licensor’s permission.
The developer may perform the research activity in its own name, i.e. with the intention of
having legal and economic ownership of any resulting trade intangible, on behalf of one or
more other group members under an arrangement of contract research where the
beneficiary or beneficiaries have legal and economic ownership of the intangible, or on
behalf of itself and one or more other group members under an arrangement in which the
45
members involved are engaged in a joint activity and have economic ownership of the
intangible.
The most common structures used in transfer pricing to manage legal and economic
ownership of intangibles include contact R&D services and cost contribution arrangements.
2.3.3 Nominal Ownership:
An additional level of ownership is what can be described as nominal ownership. This type
of ownership is strictly in name only and is very limited in functions performed, assets
involved and risks assumed. A hypothetical example of nominal ownership could be
described as follows: Company A operates in Country B and holds the legal title of a
particular trade name intangible. Company C operates in Country D. Company A has agreed
to license the use of the trade name to Company C for a nominal percentage of gross third
party sales by Company C. Company C performs functions, employs assets and assumes risks
related to developing, enhancing, maintaining and protecting the rights while Company A
merely holds the legal title to the intellectual property. In this example, Company A would
be strictly nominal owners of the intellectual property.
2.3.4 Process Ownership:
Process ownership refers to the owner who is responsible for the functions that are related
to an intangible. The OECD in the June 6th, 2012 Discussion Draft on the Proposed Revisions
to Chapter 6 of the OECD Guidelines states that there are certain functions directly linked to
intangibles. The functions provided by the OECD are development, enhancement,
maintenance, and protection of intangibles. These four functions must be under the control
of the process owner. The functions do not have to be directly performed by the process
owner, but they must be under the supervision or control of the entity that is the process
owner. The OECD also writes about four different risks that are assumed by the process
owner. These risks are developmental, obsolescent, protection and product liability risk.
2.3.5 Entitlement to Intangibles related returns:
In the recently published Discussion Draft from the OECD regarding the proposed changes
to Chapter 6 of the OECD Transfer Pricing Guidelines, the idea of entitlement to intangibles
related returns has been introduced. This principal of entitlement is threshold that must be
reached in order for an entity to have a claim on residual returns that are related to an
intangible. Paragraph 29 of the Discussion Draft explains that there are three factors that
should be considered in order to determine if an entity is entitled to the intangible related
returns. The first factor to be evaluated is the legal agreements, contracts, licenses
registrations related to the intangible. In order to have entitlement to the returns, the entity
46
must have some legal claim to the intangible. The second component of entitlement to the
intangible related returns is “the functions performed, the assets used, the risks assumed,
and the costs incurred by members of the MNE group in developing, enhancing, maintaining
and protecting intangibles are in alignment with the allocation of entitlement to intangible
related returns in the relevant registrations and contracts.” 26 The last factor is the
compensation of other members of the MNE group who rendered services in connection
with developing, enhancing, maintain and protecting intangibles. It is required that the
entity claiming entitlement to the returns compensates the MNE group members on an
arm’s length basis. The following diagram summarizes the requirements to surpass the
threshold in order to be entitled to the intangible related returns.
2.3.6 Special Case: Subcontracting
Contract R&D services are often put in place to minimize local ownership of valuable
intangibles created by the R&D activities. This construction is useful when the group wishes
to conduct R&D activities in various locations worldwide and at the same time retain
centralized legal ownership and management of the group’s intangibles. The providers of
26
Source: Discussion Draft on Proposed Revisions to chapter 6 of the OECD Transfer Pricing Guidelines (6 June
2010, OECD)
47
the R&D services usually do not bear significant risks related to their operations and are
often remunerated on cost plus basis where total costs are covered plus small profit margin.
Paragraph 41 of the Discussion Draft also explains the requirement that “it is expected that,
in a situation where contractual entitlements and functions are in alignment, the party or
parties claiming contractual entitlement to intangible related returns will exercise control
over the performance of those functions and the associated risks, will bear the necessary
costs required to support the performance of the function, and will provide arm’s length
compensation to any associated enterprise physically performing a relevant function.” 27
There is also additional guidance provided in paragraphs 9.23 through paragraph 9.28 of the
OECD Transfer Pricing Guidelines. These two sections from the OECD provide clarity that in
order to receive the returns related to an intangible, an entity must have some control and
responsibility in the functions that are employed and simply bearing financial risk and costs
does not entitle a company to the returns.
2.3.7 Special Case: Cost contribution arrangement
A CCA is a framework agreed among business enterprises to share the costs and risks of
developing, producing or obtaining assets, services, or rights, and to determine the nature
and extent of the interests of each participant in those assets, services, or rights. A CCA is a
contractual arrangement rather than necessarily a distinct juridical entity or permanent
establishment of all the participants. In a CCA, each participant’s proportionate share of the
overall contributions to the arrangement will be consistent with the participant’s
proportionate share of the overall expected benefits to be received under the arrangement,
bearing in mind that transfer pricing is not an exact science. Further, each participant in a
CCA would be entitled to exploit its interest in the CCA separately as an effective owner
thereof and not as a licensee, and so without paying a royalty or other consideration to any
party for that interest. Conversely, any other party would be required to provide a
participant proper consideration (e.g. a royalty), for exploiting some or all of that
participant’s interest. The end result of a CCA is the existence of one legal owner and
multiple economic owners who are entitled to various portions of the returns related to the
intangible or some level of remuneration for various activities and assets employed as a
result of the intangible.
27
Source: Discussion Draft on Proposed Revisions to chapter 6 of the OECD Transfer Pricing Guidelines (6 June
2010, OECD)
48
2.4
Questions
1. Which of the following is not a requirement for an invention to qualify for a patent:
E. Novelty
F. Non-obviousness
G. Utility
H. Business plan
I. All are needed
2. Which of the following is not a risk associated with the functions related to an intangible:
F. The risk of obsolescence(the intangible becoming obsolete)
G. Developmental risk, (i.e. exceeding a budget, poor performance of those
involved in developing)
H. Stakeholders that are unsatisfied with the developed intangible
I. Product Liability Risks
3. Which of the following is not a factor to determine if an entity is entitled to intangibles
related returns:
F. The Functions, assets and risks assumed relating to Developing, Enhancing,
Maintaining and Protecting an intangible
G. The location of the company in relation to the intangible
H. The compensation to other group companies at an arm’s length basis
I. The legal holdings, agreements and contracts of the entity in question
4. What are the three critical attributes of an intangible asset:
C. Identification, control (power to obtain benefits from the asset), and
trademark
D. Identification, control (power to obtain benefits from the asset), and legal
registration of intangible
E. future economic benefits (such as revenues or reduced future costs), control
(power to obtain benefits from the asset), and legal registration of intangibles
F. Identification, control (power to obtain benefits from the asset), and future
economic benefits (such as revenues or reduced future costs)
49
2.5
Answers
1. D.
2. C.
3. B.
4. D.
50
3 Valuation of intangibles
Authors: Steven van Wijk/Sjoerd de Jong/Steven Carey
51
3.1
Introduction
The importance of MNEs in the world economy is reflected in the production and transfer of
intangible assets. Intangible assets are nonphysical assets that allow an enterprise to earn
profits above the profits the enterprise would have earned with only its physical assets.
However, intangible assets are difficult to value for several reasons:
•
They are seldom traded on external markets;
•
They are often transferred in bundles with tangible assets and;
•
They are sometimes even difficult to detect.
Because of these difficulties professionals try to track intangibles by certain proxies such as
royalties, license fees and dividends. UNCTAD’s yearly-published World Investment Report
(World Investment Prospects Survey 2009-2011) and much research on MNEs provide
empirical analysis about MNEs’ intangible production and trade. For example more than 75
per cent of all private R&D expenditures worldwide are accounted for by MNEs.
Additionally, most royalty licenses and management fees are intra-firm payments, flowing
from foreign affiliates to their parent companies. The ratio of R&D investments has
exceeded physical investments by large MNEs in the 1980s. Values of patents and
trademarks mostly have risen over the second half of the last century. The phenomena
behind these statistics are subject to much research in various disciplines, namely
economics, organizational theory, history and politics. Theoretical and empirical evidence
lead to two findings:
•
The development of intangible assets plays a major role for enterprises in their
building of competitive advantages;
•
Second, the existence of intangible assets helps to explain the determination of the
boundaries of an enterprise.
Due to the boost in the value of intangibles, the issue of how to value something which
cannot be seen becomes more important. Several internal and external drivers exist to value
intangible assets:
•
financing securitization and collateralization;
•
management information and planning;
•
transfer pricing and structuring for sale and licensing; and
•
tax planning and compliance.
52
Probably the most controversial issue in the context of intangible valuation is the
application of an appropriate valuation method. Three basic methods are commonly
mentioned to determine the value of intangible assets, namely:
•
The market approach;
•
The income approach; and
•
The cost approach.
Given the increasing number of intangibles and the magnitude of their values, a ‘fair’
valuation of these transfers is, not surprisingly, crucial for both tax authorities and
taxpayers. Since the tax liability can vary significantly depending on the value assigned to
the transfers, it is clear that taxpayers and tax authorities have opposing objectives.
The differences in transfer pricing policies illustrate one point where all transfer pricing
specialists agree: The valuation of intangible assets for transfer pricing purposes is a difficult
and controversial issue. The main discussions stem from the following:
3.2
•
The nature of MNEs as integrated businesses that derive synergies from being part
of a wider group means that comparing intra-group transactions with a market
reference of independent transactions is not logical.
•
Most intangibles are unique assets and comparable transactions rarely exist. This
creates obvious challenges in both the selection of an appropriate transfer pricing
methodology and in the identification of external price references and application of
the arm’s length principle.
When and Why Intangible Assets are Valuable
In Chapter 1 it is pointed out the important role intangibles play in the context of
globalization. A closer look at the academic literature, financial markets and firm’s
behaviour reveals an increasing awareness of the importance of intangibles on a national
and international level. However, intangibles are harder to measure, quantify and manage
than their tangible counterparts. In the majority of cases intangibles are not recorded in the
balance sheets and thus do not contribute to the book value of a company. This being said,
the question arises whether with respect to these types of assets the main requirements
imposed by transfer pricing provisions can be fulfilled, which is comparing one institutional
situation of a transfer with a second or even a third one, i.e. finding comparables.
The existence and ownership of an intangible does not automatically imply that the
intangible possesses a marketable economic value. To find out whether an existing
intangible has a sustainable and measurable economic market value, several measures have
been developed. A general starting point is to ask if an independent party is willing to pay to
53
acquire either the intangible itself or rights to exploit it. If so, there will be - at least
theoretically - a market to transfer the intangible. If the answer is negative, the intangible
might have some positive economic value to the owner, but this does not necessarily
translate into a positive economic value for the intangible.
The reason why some intangibles have positive economic values in the sense that a third
party would offer a positive price to buy or exploit them lies in the future. An intangible’s
value heavily depends on the investor’s expectation to earn a higher profit by employing the
intangible than compared to a situation in which he only relies on the physical and
monetary assets of the enterprise. This implies that the intangible is expected, on the one
hand, to generate a measurable increase in income or decrease in costs, and on the other
hand to enhance the combined value of the other assets with which it is associated.
The market value of intangibles has three major determinants, which are:
•
Market demand;
•
Existence or absence of close substitutes; and
•
The economic environment in which the intangible is embedded.
Addressing market demand, as an example in the pharmaceutical industry, Bayer undertook
long lasting and expensive R&D activities that resulted in the patent for Lipobay, a
cholesterol medication. The formula was highly valuable until the medication was suspected
to be responsible for the sudden death of several patients. With the pharmaceutical
supervisory body’s withdrawal of the approval, demand dropped to zero, and with it the
value of the formula. Domain names, in contrast, are intangible with very little
sophistication, but if somebody possesses a domain name which is of importance to a
company, the company’s demand might generate a high economic value although the
degree of sophistication is very low.
The second key factor to give an intangible economic value is the existence of close
technical or economic substitutes, which affect the uniqueness of the intangible.
Uniqueness is often linked to the intangible owner’s ability to realize higher than normal
profits by employing the unique intangible. Such scenarios occur when potential rivals are
not able to quickly or efficiently imitate the innovators’ intangibles. The so-called above
normal profits, however normally provoke market entry of competitors. If in such case the
intangibles owner is able to protect the rights to his unique intangibles by law through
trademarks or patents or by preventing competitors from market entry through an input or
output monopoly, the value of the intangibles rises, because substitutes are not available. If
there were, however, close substitutes for the intangible, the intangible’s value would
54
vanish (even despite unambiguous defined property rights), because investors could chose
to invest in the - probably cheaper – substitute. In these cases the intangibles profit
potential is not higher than that of the economically equivalent substitute. An example for
such substitute can be found when we look at the market for attire. If the market for attire
only comprised a high-end quality brand like Chanel and a low-end brand like H&M,
investors with a preference for high quality products would attribute a positive economic
market value to the Chanel brand. If, however, there were Chanel and another competitor
in the high quality segment such as Dior, the latter one could be considered as a close
substitute and the value of the Chanel brand would partly diminish.
Finally, the value of the intangible may vary with the economic environment in which it is
embedded. Geographic location and historical and political factors are all relevant here. The
knowledge needed for the development of Lipobay mentioned above might have no
economic value at this point, but its value might rise if Bayer were able to demonstrate that
the utility risk ratio of the intake of the medication is reasonable and hence gets reapproved by the pharmaceutical supervisory body, to use the knowledge to modify the
formula and hence patent it under an adjusted patent, or to develop a completely new
formula.
3.3
Companies with highly valued intangibles
The market value of a company is generally determined by combining the total value of
shareholders’ equity and the book value of long-term debt. This combination has been
defined previously as the invested capital or business enterprise value for the company.
When this value is compared to the balance sheet for different asset categories, a huge gap
of value is often identified. Companies with highly valued intangibles represent a broad
cross-section of industries.
3.3.1 Microsoft Corporation
Microsoft has developed a broad line of systems software and applications software for
computers. The system software of the company began with the MS-DOS operating system,
which was the most widely used system for IBM-compatible computers. From that base, the
company has expanded its product offerings beyond operating software. Applications
software produced by the company includes highly acclaimed spreadsheet programs, word,
file managers, database management, games, etc. The company also sells a large
assortment of books that help customers get the most out of the company’s programs. The
company also sells a large assortment of books that help customers get most out of the
company’s programs. In addition, the company sells interface products, and other
peripheral hardware. Microsoft has interests in every form of information collection and
55
manipulation service or product that exist; all derived from a $ 10,000 investment in the
basic code for its original disk operating system.
In 1994, revenues for Microsoft exceeded $4.6 billion. By 1998, revenues were $14.5 billion.
Operating profits were 47.9% for 1998, better than the profit level achieved by the world’s
leading pharmaceutical company. Total assets of the company for the year ending June
1998 were $22.4 billion. Cash ($13.9 billion) represented over 60% of that amount. Fixed
assets totalled $1.5 billion, with less than $0.5 billion shown as investment in other longterm assets. The business enterprise value, on an accounting basis, was $15.0 billion.
3.3.1.1 Market value of Microsoft
The value of invested capital for Microsoft is calculated below. Equity is valued at the end of
June 1998, stock market price times the number of shares outstanding. The debt
component is valued at the book value of long-term debt. Together, the equity and debt
values indicate that the Microsoft enterprise value is over $535 billion.
Microsoft (values in millions)
Shares
4,940.0
Price
$108.38
Value of Equity
$535,372.5
Long-Term Debt
Value of Invested Capital
----535,372.5
Using the market value of invested capital and the book value of fixed assets, working
capital and other assets allows a calculation for intellectual property and intangible assets as
a residual. As shown below, a more accurate accounting for intangible assets and
intellectual property is a value of over $523 billion. The huge sales and profit margins
enjoyed by Microsoft are not derived from fixed assets. They come from the $523 billion
intangible asset base that is not mentioned in the financial reports.
Microsoft
Invested Capital
100.0%
$535,372.5
Net Working Capital
1.9%
$ 10,159.0
Fixed Assets
0.3%
$
56
1,505.0
Other Assets
0.0%
$
260.0
Intellectual Property & Intangible Assets
97.8%
$523,448.5
The total amount of invested capital is allocated among general asset categories of the
company. For Microsoft, an enormous 97.8% of the value of the enterprise is associated
with intellectual property and intangible assets.
3.3.2 Veritas v Commissioner 28
In November 1999, Veritas Software Corp. (Veritas US) and its wholly owned foreign
subsidiary Veritas Ireland entered into a cost sharing agreement (CSA). Under the terms of
the CSA Veritas US granted Veritas Ireland the right to use certain existing intangibles and
charged Veritas Ireland a buy-in payment.
Veritas alleged that the value of the buy-in payment in question should be US$118 million
based on their CUT (comparable uncontrolled transaction) pricing method.
The IRS alleged that the buy-in payment in question should be valued at US$ 2.5 billion
based on their income-based valuation method that took into account a comparison to
comparable 3rd party acquisitions, the useful life of the intangibles and the workforce in
place.
The US Tax Court supported the CUT pricing method applied by Veritas and rejected the
income method applied by the IRS. As a result Veritas US prevailed against the
Commissioner.
This case laid some of the groundwork for determining when a bottom-up (Veritas) versus a
top-down (IRS) approach should be used. The distinction is illustrated below.
28
Source: Veritas Software Corp. 133 TC 297, Dec. 58.016 (2009)
57
3.4
Why and when are intangibles valued?
There are many reasons for which a value needs to be determined for intangibles. The
following diagram captures some of the key valuation triggers, with further examples of
each provided below.
58
Source: TPA Playbook
a.
Financing collateralization and securitization
•
Using intangibles as collateral in either cash flow based or asset based debt financing
•
Sale-and-license-back financing of intangibles.
An example of where an intangible valuation has been used in this context was for
Thomas cook. In order to fund its pension liabilities the Company was able to transfer
some of its brand intangibles into a special purpose vehicle and then lease these
intangibles back. This enabled the company to use the intangibles as collateral in loans
to provide the lenders with the needed level of security and thereby continue trading.
(http://www.accountancyage.com/aa/opinion/2141656/tangible-benefits-intangibles)
b.
Taxation planning and compliance
•
The establishment of an intangible- or IP-holding company and the licensing of the
intangibles or IP to the taxpayer’s operating companies.
•
Tax based purchase price allocations (among acquired tangible assets and intangible
assets) in a taxable business acquisition.
•
Amortization deductions for purchased intangibles
•
Determining the arm’s length price (ALP) for the cross border transfer and use of
multinational taxpayer corporation intangibles (in compliance with Section 482).
The OECD Discussion Draft of 6 June explores the above and their interaction with other
drivers of valuation in detail.
c.
Regulatory compliance and corporate governance
•
Estimation of the fair market value of intangible sale, license or any other transfer
between a profit and non-profit entity.
•
Custodial inventory of owned and licensed intangibles
•
Assessment of adequate insurance coverage for owned and licensed intellectual
property.
•
Defence against infringement, torts, breach of contract and other wrongful acts.
•
Defence against allegations of dissipation of corporate assets.
d.
Bankruptcy and reorganization
•
Collateralization of intangibles for secured creditor financing
•
Use of intangibles as collateral for debtor-in-possession secured financing.
•
Fairness opinion on the sale or license of intangibles.
59
•
The usage of intangibles in the assessment of the debtor corporation solvency or
insolvency with respect to fraudulent transfers and preference actions
•
Impact of intellectual property on the bankrupt owner plan or reorganization
An example in this category is the recent bankruptcy of Nortel Networks Inc. Despite the
fact that the business was no longer considered a going concern the liquidators were
able to realise a significant recovery on the sale of the patents, thereby paying off
creditors (although not shareholders). The patents were purchased by Apple, Microsoft
and various other parties. One interesting observation from this is that a value was
recognised from the patents in bankruptcy that was not able to be exploited by Nortel
while it was in business.
e.
Financial accounting and fair value reporting
•
Acquisition purchase accounting allocation among acquired tangible assets and
intangible assets.
•
Impairment testing of goodwill and intellectual property
Note that it is relevant to be aware of potential differences in valuations performed for
financial accounting purposes and tax/transfer pricing purposes. The OECD in the 2012
Discussion Draft at paragraph 110 notes that “Caution should therefore be exercised in
accepting valuations performed for accounting purposes as necessarily reflecting arm’s
length prices or values for transfer pricing purposes without a thorough examination of
the underlying assumptions. In particular, valuations of intangibles contained in
purchase price allocations performed for accounting purposes are not relevant for
transfer pricing purposes.”
Forensic analysis and dispute resolution
•
Intangible assets lost profits, royalty rate or other economic damages in
infringement claims.
•
Intangibles, lost profits or other economic damages in breach of contract; license or
non-compete and non-disclosure agreement damages claims.
Strategic planning and management information
•
Formation of intangibles joint venture, joint development or joint commercialization
agreements
•
Negotiation of inbound or outbound intangible asset use, development,
commercialization or exploitation agreements.
•
Identification and negotiation of intangible license, spin-off, joint venture and other
commercialization opportunities.
60
3.5
Price, Value and Cost
The diagram shows the distinction between price and value.
Price is the result of demand versus supply directly or via negotiations. Market
circumstances like liquidity, efficiency and the level of control acquired, affect the demand
versus supply and therefore the price. Valuation methodologies based on price include
trading multiples and transaction multiples.
Value is buyer specific and based on expected cash flow in general, including the synergies,
against risk perception and return requirements over the long term. In other words,
companies create value by investing capital they raise from investors to generate future
cash flows at rates of return exceeding the cost of capital. The faster a company can
increase their revenues and deploy more capital at attractive rates of return, the more value
they create. The combination of growth and return on invested capital (ROIC) relative to its
cost is what drives value. This is how competitive advantage, the core concept of business
strategy, links to the guiding principle of value creation.
Cost is an amount that has to be paid or given up in order to get something.
In business, cost is usually a monetary valuation of:
•
Effort,
•
Material,
•
Resources,
•
Time and utilities consumed,
•
Risks incurred, and
•
Opportunity forgone in production and delivery of a good or service.
61
All expenses are costs, but not all costs (such as those incurred in acquisition of an incomegenerating asset) are expenses.
3.6
Generally Accepted Valuation Approaches
Valuation analysts typically attempt to use all three valuation approaches to value the
intangibles. When that is possible, the analyst can develop mutually supportive evidence
and a multifaceted perspective regarding the intangible value. However, due to data
constraints, it is common in a valuation to rely on only one or two valuation approaches in
the intangible valuation process.
3.6.1 The Cost Approach Valuation Methods
The cost approach belongs to the category of input indicators of measuring intangible assets
as opposed to output indicators. This approach proxies the value of an intangible by the
costs of creating and transferring it. The method implies that the intangible’s value is equal
to its costs of development and hence is built on the assumption that the higher the
development costs, the higher the value of the intangible. It already can be anticipated that
this does not always accurately reflect reality when it comes to the valuation of intangibles.
Within the cost approach, there are several intangible valuation methods. Each valuation
uses a specific definition of cost. The two most common definitions are:
•
Reproduction cost new and
•
Replacement cost new.
Advantage 1 - The total cost, at current prices, to develop an exact duplicate of the
intangible is the reproduction cost.
Advantage 2 - The total cost, at current prices, to develop an asset having the same
functionality or utility as the intangible is the replacement cost.
Functionality in this case, means the ability of the intangible to perform the task for which it
was originally designed and is an engineering concept. Utility refers to the ability of the
intangible to provide an equal amount of satisfaction and is an economic concept.
Some valuation analysts also consider cost avoidance as a cost approach. In this case the
historical or prospective costs that have been avoided because of the ownership of
intangibles are the quantification for this cost measure.
The cost measurement consists out of four cost components:
62
•
Direct costs (e.g. materials)
•
Indirect costs (e.g. engineering and design labour)
•
The intangible developer’s profit (on the direct cost and indirect cost investment)
•
An opportunity cost/entrepreneurial incentive (to motivate the development
process)
Normally, the intangible development material, labour and overhead cost are easy to
identify and quantify. The developer’s profit can be estimated using several procedures. The
material, labour and overhead costs can be estimated as a percentage of return on the total
investment. The entrepreneurial incentive is often valued as the lost profits during the
replacement intangible development period. As an example, let’s assume it takes five years
to develop a replacement patent. If the developer of the new patent buys an actual patent,
the developer can start directly earning income with the actual patent; this can be operating
income or license income. If the developer “builds” its own hypothetical replacement patent
or new patent, the developer will not earn any income during the development period of
five years. The five years development period represents the opportunity cost of developing
a new replacement patent, in comparison to purchasing the actual seasoned patent.
All four cost components (direct costs, indirect costs, developer’s profit and opportunity
cost) should be taken into consideration in the intangible cost approach valuation. In other
words there are also economic analyses included in the cost approach. These economic
analyses provide indications of both:
•
The correct levels of opportunity costs (in case there are)
•
The correct amount of economic uselessness (in case there are)
The intangible cost new should be adjusted for losses in value due to:
•
Physical weakening
•
Functional uselessness
•
Economic uselessness
Physical weakening is the reduction in value as a result of physical wear and tear. It is
unlikely that physical weakening will happen with intangibles.
Functional uselessness is the reduction in value as a result of the intangible’s inability to
perform the function for which it was originally designed. The technological side of
functional uselessness is a reduction in value as a result of improvements in technology that
make the intangible less valuable than the ideal replacement for itself.
63
Economic uselessness is a decrease in value due to the effects, event or conditions that are
external and out of the control of the intangible owner.
The valuation analyst will estimate the amounts of intangible physical weakening, functional
uselessness and economic uselessness.
A general accepted approach for quantifying intangible replacement cost new is:
Reproduction cost new – Curable functional uselessness = Replacement cost new
Estimating the intangible value, the following cost approach formula is generally accepted:
Replacement cost new – Physical weakening – Economic uselessness – Incurable functional
uselessness = Intangible value
Example of the cost approach
3.6.2 Market Approach Valuation Methods
In the valuation of intangibles, valuation analysts try to apply market approach methods
first. The reason is that the market that is the economic environment where arm’s length
transactions between unrelated parties occur is considered to provide the best indicator of
value. However, the market approach only provides useful valuation evidence when the
valued intangible is sufficient comparable with similar intangibles that are transacting in the
market. In that case the comparable transactions may indicate the price that can be
expected for the intangible in the transaction.
The two principal intangible market approach valuation methods are:
•
The comparable uncontrolled transaction (CUT) and
•
The comparable profit margin method (CPM)
64
In the CUT, the search is for the arm’s length sales or licenses of benchmark intangible
assets. In the CPM method, the search is for companies that provide benchmarks to the
valued intangible.
In the CUT method, it is more likely that the valuation will rely on CUT license transactions
than sale transactions, due to the fact that third party licenses of intangibles are more
common than third party sales of intangibles. Nevertheless, for sale as well as license
transactions, the systematic process in the CUT method has to be followed in a valuation.
Research the appropriate exchange markets to get information about similar sale or license
transactions, involving guideline, similar in investment risk and expected return, or comparable,
because the intangible is almost comparable with the valued intangible. Comparison attributes can
include:
•
Intangible type
•
Intangible use
•
Kind of industry
•
Date of license or sale
•
Verifying the transactional information i.e.:
•
Whether the transactional data are really accurate and
•
That the sale or license exchange reflect arm’s length market considerations.
This verification procedure can also extract additional information about the current market
conditions, for the sale or license of the intangible.
Selection of the relevant units of comparison, for example income pricing multiples, dollars
per unit or any other unit of comparison.
Comparing the selected guideline or comparable intangible sale or license transaction with
the subject intangible, using the selected elements of comparison. Declare the differences
between the sale and license price of each guideline transaction, for every selected
element. If such comparison cannot declare the differences in the comparison, the valuation
analyst may eliminate the sale or license transaction as a guideline for future valuation
considerations.
Selecting pricing metrics for the subject intangible from the range of pricing metrics
indicated from the guideline or comparable transactions. Pricing multiples in three ranges
will be selected; in the low end, midpoint or high end of the range of pricing metrics,
indicated by the transactional sale or license data. Summarizing, selection of the subject-
65
specific pricing metrics based on the analyst’s comparison of the owner intangible to the
guideline intangible.
•
Applying the selected subject-specific pricing metrics to the subject intangible
financial or operational fundamentals, for example:
•
Revenue
•
Income, Number of drawings
•
Number of lines of code
•
Reconciling the various value indications provided by the analysis of the guideline
sale or license transactions into a single market approach value indication
In the CUT method, databases or other sources will be used to search in order to select
intangible license CUTs. Besides, the valuation analyst will also confer with the owner
management to explore whether the owner has entered into any intangible license
agreement (either inbound or outbound). These owner license agreements could relate to
either the subject intangible or to comparable intangible.
Although the CPM method is also based on a comparative analysis, the analyst is searching
for comparable or guideline companies. The objective of the CPM method is to identify
guideline companies that are comparative to the owner company in all ways, except the
ownership of the subject intangible. The optimal situation should be that the CPM method
guideline companies operate in the same industry, having the same types of raw materials
and the same type of products or services and customers.
In the ideal situation, the owner has an established trademark and the guideline companies
only have generic trademarks or the owner owns a subject patent and the guideline
companies produce unpatented products. As a result, the owner should have earned a
higher profit margin than the selected guideline companies. This profit margin comparison is
normally made at the earnings before interest and taxes (or EBIT) level of income. This EBIT
margin typically reflects the pre-tax operating income of the comparative companies. The
incremental profit margin earned by the owner can then be converted into an intangible
implied royalty rate. Typically, all of the excess profit margin is assigned to the intellectual
property, depending on the fact whether the intangible is the only reason for the owner’s
superior profit margin.
The implied royalty rate is the first result, in the search and comparison. The implied royalty
rate is then multiplied by the owner revenue in order to estimate the amount of implied
royalty income generated from the intangible. This hypothetical royalty is capitalized over
66
the expected useful life of the intangible. The result of this capitalization procedure is an
estimate of the intangible value, according to the CPM method.
3.6.3 Income Approach Valuation Methods
In this valuation approach, the intangible value is estimated as the present value of the
future income from the ownership of the intangible. The present value calculations are
based on three principal components:
•
An estimate of the duration of the projection period, typically measured as the
expectation of the intangible’s remaining useful life (RUL).
•
An estimate of the intangible related income for each period in the projection,
typically measured as the owner income.
•
An estimate of the appropriate capitalization rate, typically measured as the
required rate of return on an investment in the intangible.
For purposes of the income approach, the RUL relates to the time period over which the
owner expects to receive any income related to the intangible:
•
License
•
Use or
•
Forbearance of use.
In addition to the term of the RUL, the analyst is also interested in the shape of the RUL
curve. That is, the analyst is interested in the annual rate of decay of the future intangible
asset income.
For purposes of the income approach, different intangible income measures may be
relevant. If property applied, these different income measures can be used in the income
approach to derive a value indication. Some of the different income measures include:
•
Gross or net revenues
•
Gross income (or gross profit)
•
Net operating income
•
Net income before tax
•
Net income after tax
•
Operating cash flow
•
Net cash flow
•
Incremental income
67
•
Differential income
•
Royalty income
•
Excess earnings income and
•
Several others (such as incremental income)
Because there are different income-measures that may be used in the income approach, it is
important for the capitalization rate (either the discount rate or the direct capitalization
rate) to be derived on a basis consistent with the income measure used.
Regardless of the measure of income considered in the income approach, there are several
categories of income based valuation methods that are typically used:
Valuation methods that quantify an incremental level of intellectual property income: That
is, the owner will expect a greater level of revenue (however measured) by owning the
intangible as compared to not owning the intangible. Alternatively, the owner may expect a
lower level of costs, such as capital costs, investment costs or operating costs, by owning
the intangible as compared to not owning the intangible.
Valuation methods that estimate a relief from a hypothetical license royalty payment: That
is, these reliefs from royalty (RFR) methods estimate the amount of hypothetical royalty
payment that the owner (as licensee) does not have to pay to a third party licensor for the
use of the intangible. The owner is “relieved” from having to pay this hypothetical license
royalty payment for the use of the intangible. This is because the owner, in fact, owns the
intangible.
Valuation methods that estimate a residual measure of intangible income: That is, these
methods typically start with the overall business enterprise income. Next, the valuation
analyst identifies all of the tangible assets and routine intangible assets (other than the
particular intangible) that are used in the overall business. These assets are typically called
contributory assets. The analyst then determines a fair rate of return on all of the
contributory assets. The analyst then subtracts the fair return on the contributory assets
from the owner business enterprise total income. This residual (or excess) income is the
income that is associated with the intangible.
Valuation methods that rely on a profit split: That is, these methods typically also start with
the overall business enterprise income. The valuation analyst then allocates this total
income between:
•
The owner tangible assets and routine intangible assets and
•
The intangible. The profit split percent (e.g., 20% 25 %, etc.) to the intangible is
typically based on the valuation analyst’s functional analysis of the business
operations. This functional analysis identifies the relative importance of:
•
The intangible
68
•
The contributory assets to the production of the total business income.
Valuation methods that quantify comparative income. That is, these methods compare the owner
income to a benchmark measure of income (that, presumably, does not benefit from the use of the
intangible). Common benchmark income measures include:
•
The owner income before the intangible development
•
Industry average income levels
•
Selected publicly traded company income levels.
A common measure of income for these comparative analyses is the EBIT margin. This EBIT
income is considered to be a pre-tax measure of operating income. When publicly traded
companies are used as the comparative income benchmark, the method is often called the
CPM method.
All of these income approach valuation methods can be applied using either the direct
capitalization procedure or the yield capitalization procedure.
In the direct capitalization procedure, the valuation analyst:
•
Estimates a normalized income measure for one future period (typically one year)
and
•
Divides that measure by an appropriate investment rate of return. The appropriate
investment rate of return is called the direct capitalization rate. The direct
capitalization rate may be derived for:
•
A perpetual time period or
•
A specified finite time period.
This decision will depend on the valuation analyst’s estimate of the intangible RUL.
Typically, the analyst will conclude that the intellectual property has a finite RUL. In that
case, the analyst may use the yield capitalization procedure. Alternatively, the analyst may
use the direct capitalization procedure with a limited life direct capitalization rate.
Mathematically, the limited life capitalization rate is typically based on a present value of
annuity factor (PVAF) for the intangible property RUL.
In the yield capitalization procedure, the valuation analyst projects the appropriate income
measure for several future time periods. This discrete time period is typically based on the
intangible RUL. This income projection is converted into a present value by the use of a
present value discount rate. The present value discount rate is the investor’s required rate
of return or yield capitalization rate over the expected term of the income projection.
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The result of either the direct capitalization procedure or the yield capitalization procedure
is the income approach value indication for the intangible.
3.6.3.1 Example of the Income Approach, the Discounted Future Benefits Method
Estimated Variables
in TUSD
Item
1. Estimated Benefits
2. Expected Growth Rate
3. Estimated Discount Rate
4. effective Income Tax
Results
Revenue
(income Tax Rate)
Estimated After-Tax Benefits
/Discount Factor
Discounted Benefits
Present Value of the
Intangible
3.000
3.50%
18%
35%
Year 1
€ 3.000
€ 1.050
€ 1.950
0.847457627
€ 1.653
Year 2
€ 3.105
€ 1.087
€ 2.018
0.71818443
€ 1.449
Year 3
€ 3.124
€ 1.125
€ 2.089
.0608630873
€ 1.271
€ 4.374
3.6.3.2 Example of the Income Approach, Capitalized Royalty Income Method for
Trademark Valuation
Item
1. Arm's Length Royalty
(Range)
2. Estimated Net Revenue
3. Market-derived Discount
Rate
4. Estimated Growth Rate
5. Effective Income Tax Rate
Estimated Variables in TUSD
Results
Estimated Royalty Income p.a.
(income Tax Expense)
Estimated After-Tax Royalties
/Capitalization Rate (3.-4.)
Range of Value
70
5%
7%
€ 12.000
€ 12.000
22.50%
22.50%
2.50%
35.00%
2.50%
35.00%
€ 600.000
€ 210.000
€ 390.000
20.00%
€ 840.000
€ 294.000
€ 546.000
20.00%
€ 1.950
€ 2.730
3.6.4 Valuation Synthesis and Conclusion Procedures
In the valuation synthesis and conclusion process, the valuation analyst should consider the
following question: does the selected valuation approach(es) and method(s) accomplish the
analyst’s assignment? That is, does the selected approach and method actually quantify the
desired objective of the analysis such as:
•
A defined value
•
A transaction price
•
A third party license rate
•
An intercompany transfer price
•
An economic damages estimate
•
An intellectual property bundle exchange ratio
•
An opinion on the intellectual property transaction fairness.
The valuation analyst should also consider if the selected valuation approach and method
analyses the appropriate intangible asset(s). The valuation analyst should consider if there
were sufficient empirical data available to perform the selected valuation approach and
method. That is, the valuation synthesis should consider if there were sufficient data
available to make the analyst comfortable with the analysis conclusion. And, the valuation
analyst should consider if the selected approach and method will be understandable to the
intended audience for the intellectual property valuation.
3.6.5 Intangible RUL Considerations
The valuation analyst should also consider which approaches and methods deserve the
greatest consideration with respect to the intangible RUL. The intangible RUL is an
important consideration of each valuation approach.
In the income approach, the RUL will affect the projection period for the intangible income
subject to either yield capitalization or direct capitalization. In the cost approach, the RUL
will affect the total amount of uselessness, if any, from the estimated “cost” measure i.e.
the intangible reproduction cost or replacement cost. In the market approach, the RUL will
affect the selection, rejection and/or adjustment of the comparable or guideline intangible
sale or license transactional data.
The following factors typically influence the intangible expected RUL:
•
Legal factors
•
Contractual factors
71
•
Functional factors
•
Technological factors
•
Economic Factors
•
Analytical Factors
Each of these factors is normally considered in the valuation analyst’s RUL estimation.
Typically, the life factor that indicates the shortest RUL deserves the primary consideration
in the valuation synthesis and conclusion.
Ultimately, the experienced valuation analyst will use professional judgment to weight the
various valuation approach and method value indications to conclude a fair value based on:
•
The analyst’s confidence in the quantity and quality of available data
•
The analyst’s level of due diligence performed on that data
•
The relevance of the valuation method to the subject intangible life cycle stage and
degree of marketability
•
The degree of variation in the range of value indications
Based on the valuation synthesis, the intangible final value conclusion can be either:
•
Point estimate (which is common for fair market valuations)
•
A value range (which is common for transaction negotiations or license/sale fairness
opinions).
3.6.6 The Valuation of Intangibles for Tax Purposes
In an international framework, the prices at which tangible and intangible assets are
transferred internally (transfer prices) not only determine the income of each party
participating in a particular transfer, but also influence the tax base of the jurisdictions
where these parties are located. Theoretically, a properly calculated transfer price should
“reasonably” allocate profits resulting from such a transfer among all parties involved.
Consequently, each jurisdiction should receive a ‘fair’ proportion of the tax revenues based
on these profits.
Practically, there are several pitfalls that prevent income and expenditure allocation among
MNEs and tax jurisdictions from being easily resolved. The crucial point why transfer pricing
appears to be matter of concern for both taxpayers and tax authorities occurs because tax
jurisdictions have different corporate income systems and tax rates. Profit maximizing MNEs
can and – assuming economically rational behaviour – will take advantage of tax
differentials by applying tax planning techniques in which they attempt to shift income from
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the higher tax jurisdiction to the lower taxed one. As governments of jurisdictions with
higher tax rates fear an erosion of their tax base, they react to these techniques by
formulating new or reforming already existing tax legislation, attempting to render the
usage of tax avoidance activities more difficult.
Transfer pricing rules are supposed to provide guidance to MNEs on how the values of
transferred items have to be calculated. The principal underpinning of basically all national
regulatory policies is the arm’s length standard (ALS). The ALS requires MNEs to value a
transaction like independent parties engaged in the same (or very similar) transaction under
the same (or very similar) circumstances would have valued such a transaction. Tax
authorities recommend that MNEs find either an internal comparable (a product that is
traded both inside and outside the multinational enterprise) or an external comparable (two
unrelated third parties trading the identical product) as a benchmark against which to
measure the transfer price.
If no comparable can be found so that a real arm’s length comparison is not possible, MNEs
have to hypothesize how independent parties would have valued the transaction
(hypothetical arm’s length comparison). Various regulatory policies further provide a range
of valuation methods, which taxpayers have to apply when calculating arm’s length values.
These methods are usually categorized into two groups: the (traditional) transaction-based
methods and the profit- or income-based methods. The transactions-based methods
embrace the comparable uncontrolled price method (CUP) and the comparable
uncontrolled transaction method (CUT), the resale minus method and the cost plus method.
CUP and CUT can be considered as the most direct applications of the ALS since they use
product comparables as arm’s length benchmarks. The resale minus and the cost plus
method, in contrast, ask for functional arm’s length comparables. These methods focus on
either the distributor’s or the manufacturer’s side of a transaction and determine a transfer
price by comparing the tested party’s functions with competitors performing the same
functions. The comparable profits method (CPM), the transactional net margin method
(TNMM) and the profit split method belong to the group of profit-based methods. These
methods compare profits of controlled and uncontrolled parties.
For the valuation of intra-company intangible asset transfers, the range of applicable
transfer pricing methods is limited to the CUT and CUP, the CPM and TNMM and profit split.
When the ALS is applied via the use of these methods, several difficulties occur, namely:
•
How should comparable transactions be identified?
•
How should comparables or transactions be adjusted, when they are not the same
but reasonably similar?
73
•
What should be done when comparables do not even exist, which is likely to be the
case when it comes to intangible assets?
•
Which of the provided methods is best to apply?
•
How should it be documented why a certain method was chosen over an alternative
one?
3.6.7 Discussion Draft on Intangibles, OECD Chapter VI
The Organization for Economic Cooperation and Development on June 6 issued a discussion
draft containing proposed revisions to Chapter VI of Transfer Pricing Guidelines, Transfer
Pricing Considerations for Intangibles. The 60-page discussion draft is organized into four
sections:
•
Identifying intangibles;
•
Identification of parties entitled to intangible –related returns;
•
Transactions involving the use or transfer of intangibles; and
•
Determining arm’s length conditions or prices in cases involving intangibles.
Below we focus on point 4 above to highlight how the discussion draft relates to intangible
valuation for tax and transfer pricing purposes.
The OECD acknowledges that challenging comparability issues are at stake, but that
restraint should be exercised in rejecting potential comparables. Comparability adjustments
may be necessary but a different transfer pricing method may also be required if any such
adjustments represent a large percentage of the compensation of the intangible. The
revised chapter states that it is important to note that
•
A tested party, even if it is the least complex party, may still be entitled to intangible
related returns,
•
Unrelated parties may also have intangibles at their disposal, and no comparability
adjustments may be necessary, and
•
The specific features of intangibles that may be important are:
•
Exclusivity,
•
The extent and duration of legal protection,
•
Geographic scope,
•
Useful life,
•
Stage of development,
•
Rights to enhancements, revisions and updates, and
74
•
Expectation of future benefits.
According to the OECD, when selecting a transfer pricing method, tax authorities and
taxpayers should not too readily assume that all residual profits are to be allocated to the
party entitled to intangible related returns. A functional analysis can also identify other
factors that influence value creation for example, risks borne, specific market
characteristics, location, business strategies, group synergies, etc.
The OECD discusses the use of valuation techniques drawn from financial valuation practice.
These techniques may be used either as part of one of the five OECD approved transfer
pricing methods, or as a tool that can be applied in identifying the arm’s length price. The
OECD expresses concern about valuations performed for accounting purposes, as these
“valuation assumptions may sometimes be biased in favour of conservative estimates of the
value of assets in a company’s balance sheet”.
The OECD mentions that the use of cost plus methods or resale price methods is generally
discouraged in the valuation of intangibles. In contrast, the comparable uncontrolled price
(CUP) method and the transactional profit method will most likely be useful when valuing
intangibles. The OECD provides a description of factors that impact the valuation of
intangibles (for example: partially versus fully developed intangibles and the related
discount factor; growth rate; accuracy of financial projections; useful life of intangibles and
terminal values; tax rates; etcetera.).
Finally, the OECD comments on arm’ s-length pricing for transfers of intangibles for which
the valuation is extremely uncertain at the time of the transaction (for example, the
reliability of projections of anticipated benefits versus price adjustment clauses or
renegotiations). Once again, the application of hindsight is explicitly disallowed. The authors
note that while the OECD provides valuation guidance, the facts and circumstances
(functional analysis) remain of critical importance.
3.6.8 Summary
Shortcomings are found in all the identified valuation methods. If the economic benefits
generated by the intangibles and the costs of producing them were linked, the resulting
values should be similar, regardless of which of the approaches mentioned above is used.
Due to the nature of intangibles, however, economic benefits and production costs are not
necessarily interrelated so that the three approaches might provide differing results. The
uniqueness of intangibles translates into the fact that they are not easily reproducible, and
value chains usually cannot be traced.
75
Obviously, first-best solutions for the intangible asset valuation do not exist. The question
coming up then is: “Which of the approaches presented above is under current conditions
the most appropriate second-best method to calculate a ‘fair’ market value for intangibles?
Again and probably not surprisingly the answer is very contentious among specialists. Tax
authorities and some business appraisers clearly prefer the market approach because of its
arm’s length quality, which is supposed to guarantee the highest degree of objectivity.
Other appraisers tend to favour the income approach. They argue that this approach is
conceptually superior since it focuses on future variables, which would better correspond
with:
•
The nature of intangibles, i.e. with their uniqueness and their future profit
orientation, and
•
The perspective an investor assumes when buying an intangible.
However, combinations of market and income approach are also possible when external
transfers exist, which then would unite both aspects.
Some professional intangible appraisal offices and consultants developed their individual
valuation approaches, partly focusing on brand valuations. Names of alternative valuation
models are Value-Dynamics, Balanced Scorecards or the Skandia Navigator approach. These
approaches use multistage factors, scoring or index models partly including variations of the
aforementioned methods to approach the problem including both quantitative and
qualitative measures. However, none of these models, so far, is recognized across the board
as uniform, standardized and especially objective enough. Any presented value that was
derived by means of one of these methods provokes the question: Which proxies were used
with what weight and on what grounds?
In fact, no matter, which method is chosen, a substantial degree of uncertainty and
subjectivity exist when it comes to the estimation of the variables and the assessment of the
methods, relevant proxies, and useful life. Every buyer or licensee has a different set of
parameters with regard to how much he/she would pay for an intangible than sellers or
licensors have when they calculate their price. Finally even objective analysts judge the
described underlying factors of an intangible differently. Because of the unavailability of
reliable information and publicly accessible data on intangibles, a market for these assets,
such as it exists, will be full of subjectivity, guesswork and sometimes inconsistencies. A nice
illustration of this is the valuation of Facebook before initial public offer.
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3.7
Determining the Discount Rate and Capitalization Rate
In discounting available cash flow, an appropriate rate of return must be determined. The
rate of return expected by an investor from an investment is related to:
•
The general level of interest rates;
•
A premium for perceived financial risk; and
•
A premium for perceived business risk.
The appropriate rate of return for valuing an investment is the cost of capital for that
investment. This rate of return is referred to as the discount rate, which is most often
determined by using either the capital asset pricing model (CAPM) or the build-up method.
Both of these methodologies are variations of the basic summation concept. The summation
concept essentially "builds" a discount rate using the various components which comprise
the total rate of return required on an investment. These components are:
•
The total return required on a long-term, risk-free investment;
•
Equity risk premium; and
•
Increments for risk differentials of the particular business or investment.
For the business or intangibles, these risk differentials result from risk factors that are
specific to the business and related to its advantages and disadvantages over other
companies on the open market. These factors should include, but are not limited to, the
following:
•
The industry;
•
The diversification of the licensing of the intellectual property;
•
The characteristics of the intellectual property;
•
The financial risks;
•
The diversification of the operations;
•
Lack of management depth;
•
Lack of access to capital markets;
•
Geographic diversification;
•
Risk of assets; and
•
Years in business.
Based on the factors listed above, an intangibles’ discount or capitalization rate can greatly
vary. An established intangible widely licensed may use an industry rate of return, while an
77
intangible in an emerging technology area with high obsolescence may have a rate of return
similar to venture capital.
Developing a discount rate applicable to intellectual property is normally a two-step
process. First, the valuer must develop the discount rate applicable to the entire business,
which includes a company specific risk premium accounting for the company’s unique risk
differentials. Next, the valuer must isolate the discount rate applicable to the specific asset
being valued, by identifying and quantifying the relative risks of investments in the
Company’s various assets and in similar assets measured in the open market. The discount
rate applicable to the intellectual property should reflect the rate of return an investor
would require for an investment in the asset. For any individual asset, this rate must be
determined in the context of the discount rate of the business overall. Conceptually, the
discount rate for the business may be viewed as a weighted average of a series of discount
rates applicable to the individual assets of the business from the least risky (e.g., cash,
receivables) to the most risky (e.g., goodwill). The capitalization rate, the rate used as the
divisor in the Direct Capitalization Method, is derived from the discount rate and is
determined by subtracting from the discount rate the projected average annual compound
growth rate of an earnings stream. The reciprocal of the capitalization rate is the valuation
multiple.
3.8
Business Restructuring and Valuation, Chapter IX, OECD
Chapter IX of the OECD Guidelines sets out the OECD’s approach to business restructuring
and in this context includes a discussion on valuation.
Figure 1 outlines a general approach to determining arm's length compensation for a
business restructuring, as described in parts 2 – 4 of Chapter IX.
We have mapped the key issues identified in Chapter IX against three broad headings that
make up a typical transfer pricing analysis.
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3.8.1 Generating a functional and factual analysis
The purpose of the functional and factual analysis is to explore whether “something of
value” (9.48) has been moved as part of the restructuring. To do this, a thorough review of
the functions, assets and risks before and after the restructuring is required (9.54). Legal
rights are stated to be relevant under contract and commercial law (9.54). Where there is a
contract in place that has been altered, whether it contains a termination, non-renewal or
renegotiation clause (and whether it was respected) should be considered (9.104). Whether
that contract was arm's length should also be considered (9.106). The guidance also
suggests that contractual arrangements can be inferred or modified to conform with arm's
length behaviour (but without using hindsight, 9.56) and with actual conduct (9.55). Such
modification of actual contractual rights may prove to be a contentious area in practice. The
motives behind the change should be identified. Anticipated business synergies are noted as
typical motivation, and it would be good practice for taxpayers to maintain documentation
of the assumptions driving expected synergy benefits at the time of restructuring (9.57). It is
helpful that the OECD acknowledges that profits may not actually increase for the MNE
group after the restructuring, and could even fall, either because the restructuring is aimed
more at maintaining competitiveness than increasing it, or because expected synergies do
79
not always materialize in practice (9.58). Lastly, and most challenging, the OECD requires an
assessment of realistic alternatives for each party in a restructuring (9.59). This stage asks
the taxpayer to identify the next best realistic alternatives to the original or restructured
business arrangement.
This analysis acts as a prelude to a calculation of potential losses in profit potential,
discussed below, and impacts the bargaining power of each party operating at arm's length.
The OECD does not require an exhaustive search, rather: “if there is a realistically available
option that is clearly more attractive, it should be considered in the analysis of the
conditions of the restructuring” (9.64). In practice it is likely that relative bargaining power
of the parties, taking into account features such as the uniqueness of the function in the
open market, may be perceived as affecting the options available. If, after consideration of
the facts, a conclusion can be drawn that nothing of value (in terms of rights and
obligations) has been transferred as part of the restructuring, then it has no compensable
profit potential (9.67). In this case, and assuming the above information is clearly
documented, the further analysis discussed below would not be necessary.
3.8.2
Economic analysis
The second phase of analysis evaluates the potential compensation due when it is
concluded that valuable rights or obligations have been transferred. Two types of
restructuring are considered. First, transfers of something with economic value in isolation
i.e. transfers of tangible and intangible assets or an ongoing concern (9.74 – 9.99). Second,
where contracts are renegotiated or terminated, for example in restructuring of risk around
a group, i.e. converting a fully-fledged operator to limited risk (9.100 – 9.122). Sometimes,
restructurings will encompass both types of transfer, in which case both should be
considered together (9.101).
3.8.2.1 Transfers with economic value in isolation
Where a transfer has economic value in isolation, the challenges appear more
straightforward. The guidance focuses attention on what has been transferred, whether
specific assets or an ongoing business and then on identification of appropriate pricing and
valuation methodologies. Tangible assets are considered not to raise much difficulty (9.75),
although transfers of inventory (perhaps as part of a de-risking) present challenges around
arriving at an appropriate price for transferred raw materials and finished goods. Market
based pricing, resale minus or cost plus methods could be used, depending on the facts and
circumstances of the business (9.78). Intangible assets receive particular attention. Sound
business reasons for transferring intangible assets within a group are explored (9.83), and
restructuring where an intangible asset is transferred and then licensed back is not rejected
80
as non-commercial. However, the OECD does suggest that the two transactions are likely to
be negotiated concomitantly, and gives an example that a transfer of an intangible for 100
which is licensed back at 100 a year is unlikely to be consistent with the arm's length
principle (9.86). The reference to a transfer of an ongoing concern (defined as a functioning,
economically integrated business unit, 9.93) suggests that the valuation of an ongoing
concern can be greater than the sum of the separate elements (9.94). It goes on to state
that: “Valuation methods that are used in acquisition deals between independent parties
may prove useful to valuing the transfer of an ongoing concern between independent
parties (9.94)”
These methods would include income and market based valuation methods that value the
transferred function as a separate business. This type of analysis rewards any goodwill in the
transferring business. This could be problematic in a group situation, where both parties are
likely to have existing relationships with other parts of the group and with third-parties, and
so it can be difficult to identify goodwill for which the recipient would be prepared to pay
over and above the value of the assets transferred.
3.8.2.2 Transfers that require a renegotiation or termination of existing contracts
Where the restructuring does not involve the transfer of a specific asset or ongoing concern,
but a renegotiation or termination of existing contractual arrangements (and where these
have, as above, been determined to be rights and obligations with demonstrable value) the
analysis is more complicated. A starting point will be to consider changes in profit potential
that result from this analysis. However, the guidance (9.65) makes some very significant
cautionary statements that the case for compensation under the arm's length principle is
not determined by a reduction in profit potential: “An independent enterprise does not
necessarily receive compensation when a change in its business arrangements results in a
reduction in its profit potential or expected future profits.”
It follows, therefore, that:
“The arm's length principle does not require compensation for a mere decrease in the
expectation of an entity's future profits.”
The section goes on to emphasize that what is important in the first instance are the
elements captured in the functional and factual analysis. However, given that this hurdle has
been met:
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“... an entity with considerable rights and/ or other assets at the time of the restructuring
may have considerable profit potential, which must ultimately be appropriately
remunerated in order to justify the sacrifice of such profit potential (9.67)”.
The analysis suggested by the OECD attempts to calculate whether an entity is at least as
well off as under other realistically available alternatives (9.71). If, after a proposed
restructuring that involved de-risking, a distributor was expected to be left worse off (on a
risk adjusted basis), this implies that either the post-restructuring is mispriced or additional
compensation (by way of exit charge) would be required to remunerate the distributor
(9.71).
This example highlights the trade-off between the post-restructuring transfer price and any
indemnification charge that may be due. In theory, a post-restructuring transfer price can be
calculated that reflects properly the relative riskiness of the expected returns (as well as
other realistically available alternatives –which in turn impacts the bargaining power of each
of the parties)so that the restructuring is a zero sum game, with no separate indemnification
charge being payable.
This may mean that for de-risking scenarios, finding an appropriate post-restructuring
transfer price will negate the need for an indemnification charge. However, Part 3 of the
Chapter states a principle that post-restructuring transfer prices should in most cases be
identical to newly structured transfer prices (9.123). To the extent that adopting this
principle limits the appropriate post-restructuring transfer price to an amount that leaves
the de-risked operator worse off than under its next best realistic alternative, an
indemnification charge may be required to bridge the gap.
The mechanics of calculating a post-restructuring transfer price is an area where the
realities of a true third party scenario may be hard to recreate in transfer pricing situations
between multinationals. For third parties there would likely be: uncertainty and dispute
over profit forecasts; each party would have different information; different approaches to
managing risk; and different attitudes towards risk. In multinationals these differences may
not be present, or may not be fully understood, and are certainly unlikely to be reflected in
financial forecasts that will be used to apply transfer pricing and valuation techniques (such
as discounted cash flow), in any analysis of pre and post-restructuring profit potential.
Another possible approach for assessing the value of any indemnification charge is to
consider information on comparable restructurings. This can assist with identifying whether
the terms of a restructuring are arm's length (9.50), as well as likely indemnification. As an
example, if a manufacturer is considering outsourcing functions to a low cost country,
examination of how such outsourcing transactions are structured at arm's length would be
82
relevant information. Independent parties do not necessarily require explicit compensation
from a transferring entity, in particular where that entity also benefits from cost savings
from the relocation (9.99).
3.8.3
Determine arm's length treatment
This stage pulls together the analysis under the functional and factual analysis and the
economic analysis, in order to conclude whether any indemnification payment would be
due. In short, the answer depends on whether two parties would have agreed an
indemnification payment in comparable circumstances at arm's length.
To arrive at an assessment as to whether third parties would have agreed an
indemnification payment, the first step is to conclude whether or not something of value (in
terms of contractual rights and obligations) has been transferred. The second step (only
necessary if the first step is answered in the affirmative) is to use established transfer
pricing and valuation techniques to price transfers in isolation and/ or changes in profit
potential.
The Guidelines note that commercial/ case law could also help in determining how third
parties would settle similar contract re-negotiations or terminations at arm's length (9.115).
An example from Chapter IX
Paragraphs 9.72 and 9.73 include a detailed example highlighting how these calculations
may work in practice:
83
Source: July 2010, OECD Transfer Pricing Guidelines
In case no. 1, the distributor is surrendering a profit potential with significant uncertainties
for a relatively low but stable profit. Whether an independent party would be willing to
surrender this profit potential would depend on its anticipated return under both scenarios,
on its level of risk tolerance and on its options realistically available and on possible
compensation for the restructuring itself.
In case no. 2, it is unlikely that independent parties in the distributor’s situation would agree
to relocate the risks and associated profit potential for no additional compensation if they
had the option to do otherwise.
Case no. 3 illustrates the fact that the analysis should take account of the profit potential
going forward and that, where there is a significant change in the commercial or economic
environment, relying on historical data alone will not be sufficient.
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3.9
Questions
1. Which of the following is not a method for assigning value to an intangible:
A. Income Based Method
B. Market Based Method
C. Cost Based Method
D. All of the above are accepted methods
2. True or False: The price of an intangible equals the value of an intangible:
A. True
B. False
3. Which of the following are not factors of Determining the Discount Rate and
Capitalization Rate:
A. The general level of interest rates
B. A premium for perceived financial risk
C. The holder of the patents
D. A premium for perceived business risk
E. All of the above are factors in determining the discount rate and
capitalization rate
4. The present value calculations in the income based method are based on how many
principal components:
A. 5
B. 2
C. 7
D. 3
3.10 Answers
1.
2.
3.
4.
D.
B.
C.
D
85
4 Business models: Intangible Property
configurations
Authors: Steef Huibregtse/Steven Carey/Elizabeth King
86
4.1
Introduction
Once it is identified that a business has a need for Intangible Property (IP”) 29 in order to
grow, establish a brand and client base or develop proprietary technology, the next critical
question is what is the optimal business model/IP configuration from a commercial, transfer
pricing and tax perspective.
This chapter explores the four broad IP business models that are typically applied as well as
their transfer pricing and tax implications.
4.2
Overview of business models from a commercial perspective:
4.2.1 Licensing-in model
The first and simplest model is based on the concept of the IP that is being used being
owned by another party (either related or unrelated) and access being provided typically
through payment of a royalty or license fee. The model could be applied to any type of IP
including brand, technology or know how. This model enables the licensee to benefit from
access to IP immediately without the need to incur the cost and the risk of developing it inhouse. From the perspective of the licensor it provides an opportunity to earn a return
through a royalty/license fee stream for the cost and risk of developing the IP.
Licensor
License
fee/Royalty
Provision of IP
Licensee
Below is an example of a business model by using a Dutch company as an IP company or
intermediary royalty collector for Chinese/Taiwanese multinationals.
29
In the context of Lesson 4, the terms “Intangible Property,” “Intangibles” and “IP” are used interchangeably.
87
Parent Company
China/Taiwan
License
Royalty
Dutch Company
(IP company)
Interest/Royalty
Directive
License
Royalty
Company B1, B2, B3...
EU
Tax treaty
License
Royalty
Company C1, C2, C3...
Non-EU
In this model, the Dutch company acts as an IP company or intermediary royalty collector to
provide license to relevant group companies in EU countries or non EU-countries. According
to the EU country Interest/Royalty Directive and extensive tax treaty network with non-EU
countries, the royalty paid to the Dutch company is subject to zero or lower Withholding
Tax.
4.2.2 In house development model
This second model is based on the idea that the entity develops its own IP in-house. This
could be over an extended period such as the development of a brand through marketing
expenditure or through a more deliberate establishment of an R&D team to develop a
specific product such as a pharmaceutical compound, method of production or software
code.
This model shifts all the risk to the entity performing the development, with potentially
significant upside if the development is successful and a sunk cost if unsuccessful. The
entity is then free to utilize the IP as they see fit without restriction and would not be
incurring royalty/license fee costs going forward.
88
4.2.3 Contract R&D model
The third model involves using a third or related party contract R&D provider to undertake
the R&D work. The R&D provider acts under contract with the principal and is remunerated
based on total costs plus a profit mark-up (or an alternative model such as hourly rates).
The principal is responsible for all decisions on what products are to be developed and how
resources are allocated.
In this model the economic and legal ownership of any IP developed remains with the
principal. The benefit of such a model is that the principal is not required to recruit and
train an R&D team and as with the above model is not required to incur royalty/license fee
costs for IP owned by a third party. The downside is that a cost is incurred for R&D which
may prove to be unsuccessful and not lead to creation of any IP.
Service Fee
Contract R&D
entity
Licensor
(Principal)
Provision of
contract R&D
services
License
fee/Royalty
Provision of IP
Licensee
Example:
Below is an example used in the business model of Chinese/Taiwanese multinationals, it is
by using a related contract R&D company (normally based in China/Taiwan) to provide the
R&D work. The R&D company will be remunerated based on cost plus mark up.
89
S
(IP1)
Investment
Centre
Contract R&D
(cost recharge + mark-up)
Contract R&D
(cost recharge
+mark-up)
R&D
Manufacturing
CN/TW
CN/TW
(IP2 for
European
products)
Investment
Centre
Principal
Company
SG/HK
Country of
origin
HQ/Cost Centre
Sales of finished goods
(cost plus mark up)
Stepping
stone
Matchmaker/
Profit Centre
Holding
NL
Logistics
Europe
NL
Sales of finished goods;
Reinbursment of
brand advertising
Legal title
S&M
NL
S&M
C
GER
S&M
Residual
IP1: Manufacturing IC
Principal Company PC
IP2: Principal Company PC/IC
IT
The manufacturing company (based in China/Taiwan, normally they are also the
headquarters of the group) would use the related contract R&D company to provide
product related IP. In this case, the manufacturing company is entitled to receive residual
profit together with the profit centre.
On the other hand, the Principal Company (based in Hong Kong or Singapore, acting as a
profit centre) would also use the related contract R&D company to provide product related
IP; however, it is more from design or function’s perspective customized for the European
market. To this end, the Principal Company is entitled to receive all residual profit.
4.2.4 Cost sharing model
Finally, the cost sharing model is based on the idea that various (generally related) parties
may be in a position to contribute funding and/or resources to a cost sharing model in
respect of the IP development. The resultant IP would be owned respectively by each of the
parties in proportion to their contribution. This avoids the need for royalty/license fee
payments to access the IP developed and spreads the risk and funding cost across several
entities.
90
Provision of
resources
Cost sharing
participants
Cost sharing
Arrangement
Commensurate
access to IP
4.3
Transfer pricing and general corporate tax considerations of each model
4.3.1 Licensing in
The licensor is typically subject to corporate tax on the royalty/license fee payments
received. In some countries this may qualify for concessional or zero tax treatment under
certain tax regimes to encourage ownership and development of IP.
From the perspective of the licensee the following considerations apply:
•
There is typically an obligation to withhold tax at a prescribed rate under domestic
law. This may be nullified or reduced under certain tax treaties. The tax is withheld
on behalf of the licensor and is generally re-charged in some form.
•
A deduction is generally allowed for the amount of the royalty.
For both the licensor and licensee transfer pricing guidelines are a significant consideration.
The royalty amount needs to be considered arm’s length and ideally supported by evidence
that the IP being licensed is actually used in the business of the licensee and by a
benchmarking study supporting the rate charged.
In some countries such as India and China such arrangements may also face challenges from
a foreign exchange perspective.
4.3.2 In-house development
Under this model the expenses incurred in the development of the IP, such as marketing
costs to develop brand intangibles, or R&D costs for product IP, are generally a deductible
expense. In some cases this can also be accelerated as countries through their tax regimes
attempt to encourage further R&D and to encourage taxpayers to take a longer term view of
IP development.
It is important from a transfer pricing perspective that at some point in time the R&D efforts
lead to the development of a valuable intangible which generates premium profitability for
91
the entity. For example, the Chinese authorities have a very clear view of marketing
intangibles generated by MNCs through marketing expenditure in China and expect a
premium profit to be recognized at some point in return for the deductibility of marketing
spend.
4.3.3 Contract R&D
The tax implications of contract R&D are relatively straightforward.
For the entity performing the contract R&D the remuneration received should lead to an
arm’s length mark-up on total costs, which is subject to corporate tax. For the principal in
this transaction, the spending on contract R&D should be deductible and expected to
produce in due course some IP that enables it to generate a premium return.
The payments are not typically subject to withholding tax.
In this model it is important that the principal is genuinely controlling the key decision
associated the R&D process, including what to develop, prioritization of work and in broad
terms how to develop it. If the principal is not seen to be in control of this process the
question may arise whether this is genuinely a contract R&D arrangement and therefore
which party ultimately owns the IP resulting from such process.
4.3.4 Cost sharing
A cost sharing arrangement generally requires an agreement between the parties stipulating
contributions and shares of any output, as well as details on buy in payments if applicable.
In several countries for an entity to be a part of a cost sharing arrangement the agreement
must be lodged with the relevant tax authority.
Subject to the above compliance steps, contributions are generally deductible. One
attractive feature of a cost sharing arrangement is that the payments are not subject to
withholding tax and no mark-up is applicable (in contrast to a royalty or contract R&D
structure).
To the extent that there is existing IP that is to form part of the arrangement, any new
participants will be required to make a buy-in payment based on the value of the existing IP
at the date of commencement.
92
4.4
Model implementation – high level guidance on implementing each of the above
models, including:
4.4.1
Legal framework for managing IP
Although beyond the scope of this course it is important that the portfolio of IP also be
addressed from a legal and contractual perspective.
Some legal considerations include:
•
Ensuring that appropriate contracts are in place to create consistency between the
legal and economic reality of the business model – although in transfer pricing it is
well established that economic reality is leading, it is common for tax authorities to
use the legal agreements and contracts as the starting point for any investigation
into the ownership of IP. Ensuring that the legal framework is rigid and consistent
with how the business operates also helps to avoid various risks such as the creation
of a permanent establishment for tax purposes.
•
Addressing whether certain IP such as trademarks etc. need to be registered and in
which jurisdictions.
•
To the extent that the IP is valuable and unique, should a patent be sought, how is
this maintained and what level of protection can it provide?
•
What to document and benchmark?
Regardless of the model selected, as indicated above there is a need to provide the
appropriate level of transfer pricing support for the structure in order to withstand scrutiny
from tax authorities. Depending on the model this may include:
•
Benchmarking studies for royalty rates based on one of the available databases of
royalty and licensing agreements.
•
Benchmarking studies for cost plus mark-ups for contract R&D activities typically
performed using a database to identify net margins of independent companies
performing comparable functions.
•
Valuation studies for buy in payments under a cost sharing arrangement – refer to
separate chapter on valuation methodologies.
The table below illustrates how to locate intangibles in value chain 30.
30
Source: TPA Playbook, 2012.
93
Supplier
•
•
•
•
•
•
•
Profit Center
+
Investment Center
‘Cost Center” contractors
Manufacturing
R&D
Logistics
Packaging
“Revenue Center” sales/
services hubs
Sales/Marketing
Repair & Warranty
Call Center
Customer
• SSC
Supplier
IP Company / “Investment Center”
•
IP creation & management
Royalty
•
•
•
•
•
‘Cost Center” contractors
Manufacturing
R&D
Logistics
Packaging
SSC
“Profit Center”
•
Dashboard/Matchmaker
•
•
•
“Revenue Center” sales/
services hubs
Customer
Sales/Marketing
Repair & Warranty
Call Center
access to residual result
no access to residual result
The table below is an example of product intangibles 31, which illustrates how R&D activities
lead to ownership of intangibles through determining a policy for single versus shared
ownership.
R&D Cost
Centralized
Decentralized
Centralized
Sole owner
Cost contribution
/cost sharing
Decentralized
Sole owner + contract
R&D
Cost Contribution
/cost sharing
R&D Activities
4.5
Case Study
Case Study 1
Overview:
31
Source: TPA Playbook, 2012.
94
Our client is a NYSE listed company that has recently established an IP management
company in Singapore. The company in Singapore was granted a tax incentive award by the
Singapore Economic Development Board (EDB) for a certain period of time. In particular, in
order to qualify for the tax incentive award as an IP management company, the company is
required to undertake certain tasks which includes, and is not limited to, the following:
•
Conduct R&D activities in Singapore; and
•
Own and manage an intellectual property (IP) portfolio with a value of at least S$100
million and maintain this portfolio until the end of the incentive period.
We have been engaged by the client to assist them in determining the value of IP as it is
progressively transferred to Singapore. In addition, we have assisted them in designing their
IP management policy, by taking into consideration the nature of the IP, the current
ownership rights as well as future plans and objectives of the company.
Key issues that we dealt with:
•
Definition and labelling of IP
Given the complicated nature of the company’s operations, we first had to understand the
nature of IP and in order to determine how to best configure the IP within the client’s
business model and value it. Some IP was characterized as process related IP while others
were product intangibles. This was done through a detailed analysis of the IP by speaking
with several senior people. In some cases, the IP was legally protected through patents.
However, in most cases, the IP owned in this company was not legally protected, yet the
company believed that they had valuable IP, which could be proxied by significantly higher
operating margins. A key aspect of the IP was the fact that the ability to reverse engineer
the IP was strongly protected not by patents but by customer contracts and Non-Disclosure
Agreements (NDAs).
•
Valuation of IP
The IP owned by the entities is varied. This suggests that the valuation techniques that are
used to value the IP need to take into account the varied nature of the IP as well as the data
that is available. Situations that we faced were as follows:
1. A new product was being manufactured based on IP that was in existence in the market
place for more than 15 years. The new product involved new R&D and parts that
enhanced the marketability of the existing IP which was being used competitively. A
prototype was built to market this new product to new and existing customers. Given
that no revenues had been generated in more than 6 months since the prototype was
95
created, and given that it was a recent R&D project, it was determined that the cost
based method was the most appropriate in this case.
2. The company had decided to stop manufacturing a particular product line in Europe due
to cost reasons. Rather, due to lower manufacturing costs in China, the company
decided that on an going basis the products will be manufactured in China. The Chinese
manufacturing entity will continue to sell the products to existing customers in Europe
as well as to new customers in Asia. It was determined that the best method in this case
was the income based method, where we analysed the revenues that were foregone by
the European manufacturer to proxy for the minimum amount that the IP would be
valued at.
3. In the third example, we had a technology that was not being commercially marketed in
the US very successfully, although it was protected through a patent. Market analysis
seems to suggest that selling the product in China would be a more commercially viable
option and the company wanted to transfer the Asian rights to this IP to Singapore. In
this case, we envision having to value to patent per se which may provide the minimum
value that the seller would expect.
•
Selection of IP business model
It should be noted that in all the cases we also helped the company determine what was the
most appropriate IP transfer methodology. For example in (a) given that new revenues have
yet been recognized by any of the entities as a result of the IP, it was determined that it
would be most conservative to enter into a buy-in cost share arrangement between the US
and Singapore in relation to the IP. This would enable both parties to reap the benefits
arising from the IP.
However, in (b), given that the company had made a commercial decision that they would
only manufacture the product in Asia on a going forward basis, due to cost reasons, it was
determined that a lump sum payment for this IP would be most appropriate.
4.6
Questions with model answers
1. Company ABC, an Italian clothing brand, has through marketing expenditure over several
years, developed a recognised global brand. Company ABC understands the market
opportunities in the Chinese market and has recently established a Chinese subsidiary in
order to market and distribute the product in China. What is the optimal business model
from an IP perspective for the company to give the Chinese subsidiary access to its brand,
and what are the transfer pricing implications?
2. Company XYZ, a Swiss pharmaceutical MNC, is involved in the development of several drug
compounds and in the various testing phases of pharmaceuticals prior to release. Company
96
ZYZ has a US subsidiary that has set up a team to perform some development and testing of
the same drugs concurrently with the Swiss team. The group is seeking guidance on how to
configure this IP model to manage transfer pricing risk going forward.
4.7
Multiple choice questions
1. Which of the following is not a feature of the licensing in-model:
A. Licensor has exclusive ownership of the IP
B. Licensee pays a royalty to the licensor for access to IP
C. Licensor and licensee jointly fund R&D through a cost sharing
arrangement
D. Risk of IP development is borne by the licensor
2. Which of the following is not an advantage of a cost sharing arrangement:
A. Can be effective means for funding R&D through excess cash in the group
B. Ensures that resulting IP is owned and managed exclusively by the
licensor
C. Eliminates need for withholding tax on royalty payments
D. Enables participants to share in the IP commensurately with their
contribution.
3. What typically needs to be benchmarked or valued in relation to a licensing-in IP model?
A. The value of the buy-in payment for the existing IP
B. The mark-up on costs of the contract R&D provider
C. The royalty rate to be paid by the licensee to licensor
D. Both a and c
4. What is the optimal model from a tax planning perspective?
A. The cost sharing model as it eliminates withholding tax
B. The licensing in model as it isolates IP ownership in one entity
C. In-house development as it may allow for accelerated deductibility
D. It depends.
4.8
Answers to open and multiple choice questions
Answers to open questions:
97
1. A: On the assumption that the company wishes to retain legal and economic
ownership of the brand and other marketing intangibles in Italy, the optimal model is
a licensing model whereby the Italian company charges a royalty for the brand and
other marketing intangibles to the Chinese company. This royalty needs to be
benchmarked and fully supported from a transfer pricing perspective.
The company should also note that over time, to the extent that local marketing
spend is being incurred in China, the Chinese tax authorities may determine that a
local marketing intangible is also being developed, expecting a premium profit from
this intangible and perhaps questioning whether a benefit is being received from the
payment of the royalty i.e. the risk that the Chinese adaptation of the brand has
evolved into a new brand that is economically owned in China.
2. A: The optimal model depends on a number of factors:
•
Is the group willing to have joint legal/economic ownership of the IP going
forward?
•
How is the R&D being funded? Is there cash in the US subsidiary that could
be efficiently used to fund the R&D?
•
Who is making key decisions on the R&D and drug development and where is
this person/team based?
Responses to the above questions enable a decision to be made between a contract R&D
model, whereby the US entity would act as the contract service provider with all key
decisions being made in the Swiss company or a cost sharing model. Under a contract R&D
model, the US company receives a cost plus return on total costs of the R&D effort,
regardless of the success or failure. The Swiss company owns the outcomes of the R&D
process and is entitled to all future royalties etc. resulting from a successful outcome.
In contrast, if there is cash available to fund the R&D in the US and the group wishes to have
joint ownership going forward, a cost sharing model could be considered. The Swiss and US
company would contribute in an agreed proportion to the R&D and testing cost and have
proportionate ownership in the resulting IP.
Answers to multiple choice questions:
1. C
2. B
3. C
4. D
98
4.9
Literature
•
TPA Playbook
•
TPA’s “Transfer Pricing Workshop for Chinese and Taiwanese Multinationals –
Inbound Investments into Europe.”
99
5 Intellectual Property Law and
Transfer Pricing
Authors: Eric Matser/Dorus van der Burgt
100
5.1
Introduction
This lesson outlines of the basic legal system of Intellectual Property (“IP”)32 rights. The legal
system in respect to Intellectual Property may not be determining in all Transfer Pricing
cases, but in any event the significance should be determined wittingly. The objective of this
lesson is to cover the following topics:
•
•
•
•
•
•
5.2
a brief history of Intellectual Property (5.2)
the future of Intellectual Property (5.3)
appearance of Intellectual Property rights (5.4)
legal aspects of IP exploitation (5.5)
legal aspects of IP management (5.6)
legal aspects of IP transfer (5.7)
Brief History of IP
Intellectual Property law is part of the much broader competitive trading law. The general
purpose of competitive trading law is to create or maintain a fair, open and accessible
market. Intellectual Property law generally aims to protect, stimulate, encourage and
reward amongst others creative achievements, technical inventions, industrial design and
distinctive signs. Protection, stimulation encouragement and reward are achieved by
granting (exclusive) rights to the creators of any of these efforts. One competitor having an
exclusive right has a direct and restrictive influence on competitive trading.
The term “Intellectual Property” is relatively new and came into existence in the midst of
the 19th century. Towards the end of the 19th century, several (mostly European) countries
realized the necessity for an international approach to Intellectual Property Rights. The first
international efforts to regulate and harmonise Intellectual Property law (avant la lettre)
were the Paris Convention of 1883 on the protection of Industrial Property and the Berne
Convection of 1986 on the protection of literary and artistic works. The administrative
secretariats established by these two conventions merged in 1893 and adopted the term
Intellectual Property as a collective noun for the different rights governed by both
conventions. Eventually this organization evolved into the World Intellectual Property
Organization (WIPO), located in Geneva, Switzerland.
32
In the context of lesson 5, the terms “intellectual property” and “IP” are used interchangeably.
101
Since the Paris and Berne Convention came into existence, the importance and
manifestation of specific Intellectual Property rights has changed. Trademarks have become
ever more important. New technologies gave rise to whole new areas of research and
accompanying patents, the choice of products available to the public has grown, making
design and innovation more important. The introduction of computers and the internet
made information readily available in previously unattainable quantities. These changes
were met with many attempts by legislators and international organizations to regulate this
growing importance. In Europe, The European Committee issued a large amount of
Directives and Guidelines to harmonize and regulate Intellectual Property Law. 33
Internationally, the member states of the WIPO concluded 24 treaties to further develop an
international consensus on the use and protection of Intellectual Property 34.
This contribution focuses on the international aspects of Intellectual Property rights.
Although there are a number of treaties and for Europe Directives and Regulations,
Intellectual Property law is mostly national law. Within the scope of this contribution, it is
not possible to inventory the many differences between national regulations of intellectual
property rights. Instead, this contribution only regards the international similarities.
5.3
Future of IP
Globalization and more close to home Europeanization of Intellectual Property rights will
continue. More and more treaties, including European Directives and Regulations will come,
that will further harmonize Intellectual Property law. One of the clear benefits of this
development is the gradual disappearance of differences in national law, thus generating
equality and predictability of rights for international competitors. Since the midst of the 19th
century, Intellectual Property has become a valuable asset to the persons or companies that
own or control them. In the wake of this development, focus has shifted from the pure
protection and stimulation of creative achievements, technical inventions, industrial design
and distinctive signs to the protection of investments (e.g. databases) and other purely
economic interests (e.g. geographical indications). Lobbying has had and will continue to
have a profound influence on the international development of Intellectual Property rights
and law.
33
For example some regulations include Directive 2004/48/EC of the European Parliament and of the Council
of 29 April 2004 on the enforcement of intellectual property rights, The Information Society Directive
(2001/29/EC 22 May 2001), and Directive 98/71/EC of the European Parliament and of the Council of 13
October 1998 on the legal protection of designs
34
Source: World Intellectual Property Organization, http://www.wipo.int/treaties/en/
102
Another aspect of globalization is the fact that the internet and modern transportation
methods invite companies to not only focus on their traditional regional or national market,
but to enter international or even worldwide markets. Where it used to be hard to expand
the market for certain, nowadays it’s more of a challenge to limit sales to a specific area.
This may cause problems when products – intentionally or unintentionally - enter markets
where other competitors - with their own exclusive rights - are already active.
The evolution and international importance of Intellectual Property rights will further
increase when globalization reaches Asia. Intellectual Property rights are not yet generally
regarded as a valuable asset or even an exclusive right that is to be respected. In 2006
Weerawit Weeraworawit of Thailand's Ministry of Commerce said on this matter: "A lot of
education is needed among the population at large to convince people that it's better to
earn a living from our own creation and innovation than copying from someone else". 35
5.4
Appearance of IP
Intellectual property rights are customarily divided into two main areas 36:
5.4.1 Copyright and rights related to copyright.
The rights of authors of literary and artistic works such as books and other writings, poems
and plays, films, musical compositions, computer programs (software) and artistic works
such as drawings, paintings, photographs and sculptures, and architectural designs are
protected by copyright.
5.4.2 Industrial property.
Industrial property can usefully be divided into two main areas:
•
One area can be characterized as the protection of distinctive signs, in particular
trade marks (which distinguish the goods or services of one undertaking from those
of other undertakings) and geographical indications (which identify a good as
originating in a place where a given characteristic of the good is essentially
attributable
to
its
geographical
origin).
35
Source: CNET News, “Asia warms up to intellectual property”, http://news.cnet.com/Asia-warms-up-tointellectual-property/2100-1030_3-6108596.html
36
Source: World Intellectual Property Organization,
http://www.wto.org/english/tratop_e/trips_e/intel1_e.htm
103
The protection of such distinctive signs aims to stimulate and ensure fair competition
and to protect consumers, by enabling them to make informed choices between
various goods and services. The protection may last indefinitely, provided the sign in
question continues to be distinctive.
•
Other types of industrial property are protected primarily to stimulate innovation,
design, and the creation of technology. In this category fall inventions (protected by
patents), industrial designs, and trade secrets.
The social purpose is to provide protection for the results of investment in the development
of new technology, thus giving the incentive and means to finance research and
development activities. A functioning intellectual property regime should also facilitate the
transfer of technology in the form of foreign direct investment, joint ventures, and licensing.
The protection is usually given for a finite term (typically 20 years in the case of patents).
This division is not ironclad. Many Intellectual Property rights have elements of both main
areas.
Inventory and definition of the most well-known Intellectual Property rights
In this inventory we will focus on Copyright, Patents, Designs and Trade marks. Although
there are many other, important, interesting Intellectual property rights, it is not possible to
analyse and describe them all in detail. Towards the end of this inventory, we will briefly
summarize some other Intellectual Property rights. The scope of this summary doesn’t allow
an in-depth review of other IP-related intangibles such as goodwill, trade secrets, and
knowhow.
5.4.3 Copyright
Copyright was one of the first Intellectual Property rights to become the topic of an
international treaty. The goal of the 1886 Berne Convention 37 was to create a Union for
protection of copyright, or as it reads in article 1: “the rights of authors in their literary and
artistic works”.
The term “works” is not really defined. The Berne Convention merely contains a list of
appearances of works that include “every production in the literary, scientific and artistic
domain, whatever may be the mode or form of its expression, such as books, pamphlets and
other writings; lectures, addresses, sermons and other works of the same nature; dramatic
or dramatico-musical works; choreographic works and entertainments in dumb show;
37
Source: http://www.wipo.int/treaties/en/ip/berne/trtdocs_wo001.html#P85_10661.
104
musical compositions with or without words; cinematographic works to which are
assimilated works expressed by a process analogous to cinematography; works of drawing,
painting, architecture, sculpture, engraving and lithography; photographic works to which
are assimilated works expressed by a process analogous to photography; works of applied
art; illustrations, maps, plans, sketches and three-dimensional works relative to geography,
topography, architecture or science” (Article 2, section 1 of the Berne Convention).
The term “author” is not defined in the Berne Convention. This causes significant differences
in national copyright regulation. One of the most important problems created by this
difference in definition of the term “author” is found when regarding the possibility of
copyright of a company or an employer. In some countries, an employer automatically
becomes the author of any works created by his employees while performing their – normal
– duties38. In other countries the employee is the author 39.
In Europe, multiple EC Directives where issued on Copyright or Copyright related topics,
mostly regulating specific forms of Copyright, or reacting to changes in modern
communication technology 40. In 2001 however, the EC issued the so-called “Copyright
Directive” in an effort to harmonize copyright in Europe 41.
Whatever the differences are on other issues regarding copyright, a copyright grants
essentially the same rights to authors in all states that signed the Berne Convention. Having
a copyright means that an author has the exclusive right of authorizing the reproduction of
these works, in any manner or form. This gives the author an exclusive right with both a
negative and a positive angle.
The negative angle is the authors right to forbid anyone to reproduce his works. His right is
exclusive. The author can choose to exploit his own works, where none of his competitors
are allowed to do so. The positive angle is that the author can authorize others to reproduce
his work within limitations or under conditions set by the author. This gives the author total
control over his works, even when they are being reproduced by others. Both angles can be
profitable.
38
For example: The Netherlands, UK and USA.
39
For example: Italy, France and Germany.
40
For example: the Council Directive of 14 May 1991 on the legal protection of computer programs
(91/250/EEC).
41
Directive 2001/29/EC of the European Parliament and of the Council of 22 May 2001 on the harmonization
of certain aspects of copyright and related rights in the information society.
105
In general copyrights are granted for a minimum period of 50 years after the death of the
author. For some specific works – such as films, photographs, and applied art – the period
of protection starts at the moment the work was first made available to the public.
5.4.4 Patent
Patent law has traditionally been a largely harmonized legal field. The Paris Convention
(1883) 42 formulated a minimal level of protection. Further regulation and harmonization
was achieved when the Patent Cooperation Treaty (PCT) was conceived in Washington
(1971) 43 , regulating cooperation between national patent agencies. The Strasbourg
Conventions of 1963 44 and 1971 defined key concepts of international patent law, paving
the way for the 1973 European Patent Convention (EPC) 45 that regulates a uniform granting
procedure in Europe. Although many treaties and conventions came to be, it never resulted
in an actual international or even European patent, although the PCT refers to a possibility
to apply for an “international patent”. This international patent application is in effect
nothing more than a bundle of national applications.
A patent – in the sense of these treaties and Conventions - is an exclusive right granted to
inventors. The Strasbourg Convention of 1963 regulates the conditions that have to be met
by an invention in order to qualify for a patent. The Strasbourg Convention defines several
criteria, of which these are the most important:
•
Patents shall be granted for any inventions which are susceptible of industrial
application, which are new and which involve an inventive step (article 1);
•
An invention shall be considered as susceptible of industrial application if it can be
made or used in any kind of industry (article 3);
•
An invention shall be considered to be new if it does not form part of the state of the
art (article 4 section 1); and
42
Source: World Intellectual Property Organization,
http://www.wipo.int/treaties/en/ip/paris/trtdocs_wo020.html#P83_6610
43
Source: World Intellectual Property Organization, http://www.wipo.int/pct/en/texts/articles/atoc.htm
44
Source: Council of Europe, “Convention on the Unification of Certain Points of Substantive Law on Patents
for Invention”, http://conventions.coe.int/treaty/EN/treaties/html/047.htm
45
Source: European Patent Office, “The European Patent Convention”, http://www.epo.org/lawpractice/legal-texts/epc.html
106
•
An invention shall be considered as involving an inventive step if it is not obvious
having regard to the state of the art (article 5).
A patent will only be granted after an application. Applications will generally be made by the
inventor himself, or his employer. In most of Europe countries, the ownership of an
invention made by an employee is granted to the employer by law, if the invention was
made in the course of the inventor's normal or specifically assigned employment duties. In
some countries it is necessary to expressly stipulate this in an employment agreement. In
the USA however, only the inventor himself can apply for a patent. In turn, this inventor can
be bound by contract to assign the patent to his employer.
A patent grants the holder an exclusive right with a certain negative and possible a positive
angle. On the one hand the negative angle of a patent gives the holder a possibility to
exclude others from using his invention. On the other hand, the patent may be based upon
an earlier patent by another inventor. In that case, the holder of the patent is not allowed to
use the earlier patent himself without consent of the holder of the older patent. Only when
a patent is not hindered or limited by earlier patents, the positive angle comes into play and
the holder can allow others to use the invention.
In general patents are granted for a period of 20 years. This minimum period was included
in the 1994 Agreement on Trade-Related aspects of Intellectual Property rights (TRIPs) 46. For
specific patents, such as patents for medication, it’s possible to get a one-time extension for
an additional 5 years.
5.4.5 Design
Just like patents, design rights are considered to be Industrial Property rights. Alongside
patents, design rights were also covered in the 1883 Paris Convention. International efforts
were made in the 1925 The Hague Convention to harmonize and to simplify the deposition
of design rights47. This convention wasn’t very appealing for countries like the USA, Japan,
and the UK that demand a prior review on substantive grounds before accepting a
deposition of a model. The original text of The Hague Convention doesn’t allow a prior
review. The ultimate goal of The Hague Convention (global harmonization) could therefore
not be reached. Subsequently, The Hague Convention was amended several times and was
46
Source: World Trade Organization, “TRIPS: AGREEMENT ON TRADE-RELATED ASPECTS OF INTELLECTUAL
PROPERTY RIGHTS” http://www.wto.org/english/tratop_e/trips_e/t_agm3_e.htm
47
Source: World Intellectual Property Organization, http://www.wipo.int/hague/en/legal_texts/wo_hal0_.htm
107
ultimately renewed in 1999 in Geneva 48 . This renewal facilitates the participation of
countries that demand a prior review.
In Europe, national law on design rights varies greatly. Where some countries have specific
national laws concerning design rights, other countries simply rely on copyrights for the
protection of designs. The EC intervened with the 1998 Design Directive 49 and the 2001
Design Regulation 50, defining design rights and creating the possibility of a Community
Design right.
For the purposes of the Design Regulation, a design means the appearance of the whole or a
part of a product resulting from the features of, in particular, the lines, contours, colours,
shape, texture and/or materials of the product itself and/or its ornamentation (article 3
Design Regulation). The Regulation only offers protection to designs that are “new” and
have “individual character”. A design is considered “new” if no identical design has been
made available to the public. A design has “individual character” if it’s overall impression
differs from the overall impressions by earlier designs. Designs that are dictated by their
technical function or must-fit criteria are not eligible for protection.
A Community Design right gives the holder an exclusive right. The registration of a design
shall confer on its holder the exclusive right to use it and to prevent any third party not
having his consent from using it. The aforementioned use shall cover, in particular, the
making, offering, putting on the market, importing, exporting or using of a product in which
the design is incorporated or to which it is applied, or stocking such a product for those
purposes (article 12 Design Directive and 19 Design Regulation). Registration of a
Community Design gives the holder an exclusive right for duration of five years. This
exclusive right can be extended with a maximum of four more periods of five years to a total
duration of 25 years.
The Design Directive and Design Regulation also created an exclusive right to an
unregistered Design. The unregistered Design is modelled after copyright and exists at the
48
Source: World Intellectual Property Organization, http://www.wipo.int/hague/en/legal_texts/wo_haa_t.htm
49
Source: European Union Law,
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31998L0071:en:HTML
50
Source: European Union Law,
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:32002R0006:EN:NOT
108
moment of creation. It lasts for three years but only protects against clear imitation, where
a registered Community Design will also give protection against derivative designs.
5.4.6 Trade mark
Trade marks are considered to be Industrial property, but not in the same way as Patents
and Designs. A trade mark doesn’t necessarily involve an invention or a creative effort. A
trade mark is a distinctive sign that identifies goods or services for the public. This allows the
industrial efforts of the Trade mark holder to communicate to the public that these products
or services are his.
As were patents and designs, trade marks were covered in the 1883 Paris Convention. Some
general agreements were made on the protection of well-known trade marks, the
impossibility to claim trade marks on crests, flags and other emblems of member states and
loss of rights to trade marks that haven’t been used for some time. In the 1981 Madrid
System an International trade mark bureau was created, making it possible to register
international trade marks 51. An applicant for an international trade mark has to have at least
one national trade mark first before he can apply for an international trade mark. The
applicant can choose the countries in which he wants his trade mark to be registered. The
international trade mark is not a right in itself. It is merely a bundle of national trade marks.
In every country the international trade mark is valid, the level and extent of protection is
based on the national law of that country and registration costs have to be paid. Due to
specific demands in national law, or the existence of older national trade marks, it is
possible that an international application will be awarded in some of the designated
countries, and denied in others.
In Europe, national law on trade marks traditionally differed greatly. For example, some
countries have a mandatory examination before approving a trade mark registration (e.g.
Spain, Germany, UK, and the Benelux countries), while others have no preliminary
examination at all (e.g. France and Italy). The countries that have a mandatory examination
tend to have different standards for approval or denial of applications, so it’s possible that a
trade mark that is valid in the Benelux countries can be denied in the UK for example,
because it is the name of an existing person. Harmonization of all these different national
traditions on trade mark law proved difficult if not impossible. The European legislators
therefore chose another approach. Instead of trying to change the national trade mark laws
of the member states, the 1993 Trade mark Regulation 52 created a completely new trade
51
Source: World Intellectual Property, http://www.wipo.int/madrid/en/
52
Source: European Union Council, http://oami.europa.eu/en/mark/aspects/reg/reg4094.htm
109
mark; the Community Trade mark. The Trade mark regulation creates its own European
Trade mark law, establishes its own trade mark bureau in Alicante, Spain (The Office for
Harmonization in the Internal Market (OHIM)) 53. The OHIM examines all Community trade
mark applications before allowing a preliminary registration. After examination and
preliminary approval by the OHIM, a three month opposition period begins in which trade
mark holders with a possibly conflicting older national or Community trade mark can oppose
against definitive registration of an application. A Community trade mark will be valid in all
Community countries and is therefore more likely to conflict with pre-existing national trade
marks. After the opposition period, it is still possible for the holder of an older trade mark,
to start legal proceedings against a Community Trade mark based on infringement. In case a
community trade mark is lost in a single country, the Community Trade mark is not
completely lost. The Community Trade mark itself ceases to exist, but the Trade mark
Regulation created a possibility for the trade mark to live on as a collection of national trade
marks in all remaining countries.
As mentioned earlier, a trade mark is used as a distinctive sign, used to identify goods or
services. Not every sign can be a trade mark though. A Community Trade mark may consist
of any signs capable of being represented graphically, particularly words, including personal
names, designs, letters, numerals, the shape of goods or of their packaging, provided that
such signs are capable of distinguishing the goods or services of one undertaking from those
of other undertakings (article 4 Trade mark Regulation). In article 7 the grounds for refusal
of a Community Trade mark are listed. Community Trade marks will for example be refused
because of a lack of distinctiveness, if they monopolise normal language or if they are purely
describing in the sense that they only describe the characteristics of the goods or service.
If however a Community Trade mark is granted, it gives the holder an exclusive right. The
holder
can
prevent
anyone
from
using
in
the
course
of
trade:
(a) any sign which is identical with the Community Trade mark in relation to goods or
services which are identical with those for which the Community Trade mark is registered;
(b) any sign where, because of its identity with or similarity to the Community Trade mark
and the identity or similarity of the goods or services covered by the Community Trade mark
and the sign, there exists a likelihood of confusion on the part of the public; the likelihood of
confusion includes the likelihood of association between the sign and the trade mark;
(c) any sign which is identical with or similar to the Community Trade mark in relation to
goods or services which are not similar to those for which the Community Trade mark is
53
Source: European Union Council, http://oami.europa.eu/ows/rw/pages/index.en.do
110
registered, where the latter has a reputation in the Community and where use of that sign
without due cause takes unfair advantage of, or is detrimental to, the distinctive character
or the repute of the Community Trade mark (article 9 section 1 Trade mark Regulation).
Article 9 describes the negative aspects of the exclusive right on a Community Trade mark.
The positive aspect is the possibility of granting third parties consent to use the Trade mark,
usually in the form of a license agreement. A Community Trade mark is granted for a period
of 10 years and can be extended indefinitely with consecutive periods of 10 years. A Trade
mark is an exclusive right, but only if actually used. A Community Trade mark can be lost if
the holder doesn’t use it in the first five years after registration or during a period of 5
consecutive years (article 15 Trade mark Regulation).
5.4.7 Short summary of other Intellectual Property rights:
5.4.7.1 Neighbouring rights
The rights of performers (e.g. actors, singers and musicians), producers of phonograms
(sound recordings) and broadcasting organizations are protected through copyright and
related or “neighbouring” rights. In the 1961 Rome Convention, these neighbouring rights
were outlined 54. Contracting states are obliged to implement the outlines of the Rome
Convention in their national law.
In Europe neighbouring rights also include producers of films. Neighbouring rights are
covered in the 1992 rental and lending Directive 55, later to be replaced by the 2006
Directive on rental right and lending right 56.
5.4.7.2 Plant breeders’ rights or plant variety rights
Plant breeders' rights are exclusive rights granted to the breeder of a new variety of plant,
giving the plant breeder exclusive control over all propagating material and harvested
material of a new variety of plant. Plant breeders’ rights were internationally harmonized in
54
Source: World Intellectual Property Organization,
http://www.wipo.int/treaties/en/ip/rome/trtdocs_wo024.html
55
Source: European Union Law,
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31992L0100:EN:HTML
56
Source: European Union Law,
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2006:376:0028:0035:EN:PDF
111
the 1961 International Union for the Protection of New Varieties of Plants (UPOV), revised in
1991 57.
The 1994 European Regulation on plant variety rights58 the possibility of a Community right
emerges, where the UPOV merely creates a possibility to file a collection of national rights.
5.4.7.3 Database rights
Databases can contain a wide variety of information. Some or even most of this information
will be protected under copyright. Where the creative aspect of copyright will generally be
lacking in databases, databases may be the result of a substantial effort or investment. It’s
these efforts and investments of the producer of a database that are the subject of the
European Directive on the legal protection of databases. 59 The Directive creates a sui
generis database right that gives the producer of a database an exclusive right. The Directive
defines a database as: “a collection of independent works, data or other materials arranged
in a systematic or methodical way and individually accessible by electronic or other means”.
5.4.7.4 Trade name
Although there is a reference to trade names in the 1883 Paris Convention, stating that
trade names will be protected in contracting states, international harmonization of trade
name rights never came to pass. The contracting states still differ greatly on every aspect of
trade names, even the definition. In some countries (e.g. France and The Netherlands) a
trade name right is granted from the first moment a name is used to identify a company. In
other countries (e.g. Switzerland and Germany) a trade name right is only granted after
formal registration. In the UK and other legal systems that are based in English law, a trade
name is merely a part of goodwill.
5.5
IP exploitation
With the possible exception of patents, all intellectual property rights have a negative and a
positive component. The negative component is the possibility to deny the use of the
57
Source: “INTERNATIONAL CONVENTION FOR THE PROTECTION OF NEW VARIETIES OF PLANTS”
http://www.upov.int/export/sites/upov/upovlex/en/conventions/1991/pdf/act1991.pdf
58
Source: World Intellectual Property Organization, http://www.wipo.int/wipolex/en/details.jsp?id=1415
59
Source: European Union Law,
http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=CELEX:31996L0009:EN:HTML
112
protected right to third parties, the positive is to right to grant the use of the protected right
to third parties.
5.5.1 IP-rights for own use
The negative component first creates a monopoly situation. The holder of the intellectual
property right is the only one that is allowed to use that right or to exploit the knowledge or
technique that is thereby revealed. The holder of the IP-right can then choose whether or
not he wants to exploit this right himself or not. Exploiting the IP-right himself, or in his own
organization gives the holder the assurance that he will be the only supplier of goods or
services protected by the IP-right for the duration of the protection. The economic
advantages of such a position are self-explanatory.
5.5.2 IP-rights granted to third parties
If however the holder of an IP-right, such as for example an inventor, or author doesn’t have
the possibility to produce or publish himself, he can choose to grant or transfer his rights to
a third party.
A contract by which the holder of an IP-right grants the right to use that IP-right to a third
party is usually called a license. Licenses come in all shapes and sizes. A license can be
restricted to the mere use of a product for specified purposes, such as for example private
or workspace related software licenses. A license can even be restricted to a single event,
for example a license to publicly show a movie on a specific date at a specific venue. It’s also
possible to grant exclusive licenses to for example distributors in specified areas or
countries, creating monopoly situations for every distributor in their respective areas. The
license agreement can also dictate the use of the IP-right by the licensee. For example, it can
dictate the way a trademark has to be used in advertisement, or the minimal technical
requirements of a product sold under that trademark. Within a corporate structure, IPrights can be licensed to all or some of the involved legal entities. In return for granting a
license, the holder of the licensed IP-right will usually demand compensation. The licensor is
within reasonable limits free to decide the method and extent of compensation, thus
making licenses a possibly profitable way of exploiting IP-rights.
Another form of contracts relating to the use of IP-rights by third parties is franchising. In
most franchising formulas, the franchise giver holds a collection of IP-rights, such as a trade
mark, a trade name, possibly a patent or design rights, but in any case copyright. The
franchise giver grants a franchise taker the right to use this collection of IP-rights under the
condition that the franchise taker uses these rights in such a way as was dictated by the
franchise giver to all of his franchise takers. Franchise formulas usually result in a uniform
appearance of the companies, services or products of all franchise takers, with collective
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advertisement and a recognizable image. Part of the franchise contract will always be a
license for the use of the IP-rights involved in the formula.
5.5.3 Transfer of IP-rights
Intellectual property rights are, as the term indicates, actual property rights, and therefore
transferable. The holder can choose to sell his IP-rights. For example, an inventor that
doesn’t have the means to produce a machine he invented can sell his patent rights. The
inventor will still be named as inventor in the patent, but will no longer have the exclusive
rights associated with the patent. It is also possible to sell off IP-rights related to production
or services that the holder, for whatever reason, stopped using. These can still be
interesting for former competitors or new-comers to a specific market. Later on in this
contribution, we will further discuss the ins and outs of IP-transfers. In this section we
merely state that transfer is one of the possibilities to exploit IP-rights.
5.6
IP management
Just like other kinds of property, IP-rights can diminish in value, or even be lost without
proper care and maintenance. With the proper care and maintenance, IP-rights can become
or remain a valuable asset. In other words, IP-rights require constant management.
5.6.1 Action against infringement
One way to lose an IP-right is to sit idly when third parties infringe upon an IP-right. If, for
example, the holder of a well-known trademark knows about an infringement, but does not
act, the trademark starts to lose its uniqueness, its distinctiveness (and part its value). Over
time the trade mark gets “diluted”. If diluted enough, the trademark holder loses the ability
to take action against any and all infringements by any third parties.
With all IP-rights, doing nothing can be explained as tolerance (or even permission). If at any
point, after having tolerated a competitor that infringed upon an IP-right for a certain
amount of time, the IP-right holder wants to take action to end the infringement, legal
action is not as straight forward as it should be. A simple request for a ban becomes more
complex the longer the infringement was tolerated. If tolerated too long, any action will be
denied. Until that threshold, the IP-holder may get the ban he’s after, but at a cost. Courts
may find it reasonable that the IP-rights holder reimburses investments of the infringing
party. The IP-rights holder will be held accountable for the fact that he did nothing while a
competitor was investing, thus willingly creating more damage than necessary.
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5.6.2 Prolonging and expanding IP-rights
All registrations of IP-rights have an expiry date. Some of these registrations, like trademarks
and design rights can be prolonged. A trade mark registration lasts for 10 years and can be
prolonged indefinitely, a design right lasts for 5 years and can be prolonged 4 times. This
prolongation has to be done before the registration expires. Although in many cases it is
possible to ‘heal’ a tardy prolongation, it is better not to risk anyone registering a conflicting
right in the period after the IP-right has expired.
When developing IP-rights, or simply using them on a day-to-day basis, it’s important to stay
alert. Any development, the slightest change, or even a difference in the daily use of an IPright may bring a possible new IP-right to life. For those IP-rights that need registering, it’s
important to do so as soon as possible. For example, trade marks sometimes get
abbreviated, creating a new distinctive sign that’s worth protecting, or a technician
stumbles upon a better solution for an already patented invention. In that case, it might be
worthwhile to also patent this improvement.
If an IP-rights holder wishes to fully exploit and expand his IP-rights, his organization should
be designed to support this wish. Knowhow that is present in the minds and skills of
employees has to be made available permanently. Employment contracts and contracts
with suppliers (and in some cases customers) have to contain secrecy and non-competition
clauses to stop knowhow and possible new IP-rights from falling into the hands of
competitors. The results of research and development are in danger of more than industrial
espionage. Protocols and non-disclosure agreements can be put in place to avoid any
leaking of research and development results. This is especially important in case of an
invention that could be patented. If for any reason, like a presentation, or even placement
of a proto-type next to a window that can be seen form a public space, a third party gets
wind of the invention, the possibility to obtain (or maintain) a patent is at risk. As soon as
the invention is made available to the public, it’s no longer new and is considered to be part
of the state of the art.
Another point of interest is the (annual) fees that are required for some of the IP-registers.
Not paying the fee can result in the loss of an IP-right. Maintaining international patents
may be a costly effort, as the patent holder has to pay an annual fee to all national patent
offices in the countries the patent is valid. If the patent holder chooses to limit his economic
efforts to specific countries, he can opt not to pay for some of the countries, thus losing the
patent registration there, but maintaining the patent in the countries where it is profitable.
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5.6.3 Positioning of IP-rights
Another way to preserve, protect, and maintain IP-rights is to make sure that IP-rights are
safely positioned in an organization. Any company that is actively involved in trade is at risk
of running into legal disputes or financial problems. Since IP-rights are property in every
legal sense, it is possible for a creditor to seize IP-rights in order to ensure redress. If at any
given time, the creditor gains a right to foreclose, the seized IP-rights may be lost. To
prevent this, IP-rights can be strategically placed in a legal entity that is not involved in trade
of any kind, thus eliminating them as redress targets. This will also minimize the risk of loss
of IP-rights in case of bankruptcy. If a company goes bankrupt, its assets will be applied for
the benefit of all creditors. This usually means that the IP-rights will be sold off to the
highest bidder. If however, the IP-rights are located in another legal entity, and the bankrupt
company only has a license, the IP-rights stay under the control of the IP-rights holder to be
used again in the future. Due to different national legislation regarding IP-rights, it’s also
worth considering in what country the IP-rights are located.
If creditors can seek redress on IP-rights, the IP-right holder can also use IP-rights as security
interest to secure the payment of a debt or other obligation. In other words, IP-rights can be
encumbered with, for example, a lien in order to get credit facilities from a bank.
5.7
IP transfer
5.7.1 Transfer by deed
Previously we established that Intellectual Property rights can be sold, encumbered and
transferred like any other property. Since IP-rights are intangibles, transfer has to be
documented. A deed is required. In order to transfer registered IP-rights like trade marks,
design rights or patent, registration of the deed of transfer is required. Third parties must be
able to rely on the information in the public registrations of IP-rights. As long as the transfer
of a registered IP-right isn’t actually registered and the register is corrected accordingly,
third parties may in good faith consider the previous holder to still be the holder and act on
that.
5.7.2 Reasons for transfer
The most obvious reason for a transfer is of course a sale for a profit. But various other
reasons for transfer may arise. When restructuring a corporate structure, or when building
one, it’s important to strategically place IP-rights where they are at the lowest possible risk.
But it’s also possible to transfer them to a country or legal entity for tax-related reasons, as
IP-rights can be licensed for a fee. Internal licensing of IP-rights can thus generate cash flows
within a corporate structure and may cause tax-related benefits or risks.
116
Also, strategically placing IP-rights in a corporate structure makes it possible for a corporate
structure to sell or cast off unwanted legal entities, without risking the loss of IP-rights that
where developed in or registered to that legal entity.
Intellectual Property rights are usually transferred as a whole. In some cases it’s also
possible to partially transfer IP-rights. For example, the holder of a patent may have a
patent registration in 10 countries. In the last few years, his commercial efforts have been
limited to only five of these countries. It may be worth considering selling the patent in the
other five countries to third parties. If he’s not using it himself, he may as well exploit his
rights by selling them off country by country.
5.7.3 Risks assessment and valuation issues
First and foremost, parties need to verify whether or not the transferring party is actually
the owner or holder of the IP-right to be transferred. With registered IP-rights, this is pretty
straightforward; check the register. With copyrights and other non-registered IP-rights
verifying ownership of IP is more complicated. Employment agreements, especially with
research and development staff, hold important information. If IP-rights aren’t
automatically transferred to the employer by law, employment agreements have to provide
proof of transfer to the employer in order to be sure that the employer is authorized to
transfer copyrights.
When third parties are involved in the creation or development of IP-rights or product
involving IP-rights, it’s important to establish ownership of the IP-rights on any new
developments, creations or inventions that resulted in that involvement. If ownership isn’t
assigned in an agreement, the owner of the IP-right is – most likely - the party that was
responsible for or at least controlled and managed the actual creative or inventive work.
This may not be the party that merely commissioned or paid for the work.
Most IP-rights grant an exclusive right to the holder. IP-maintenance by the current holder
can be a relevant factor in assessing the value of such an exclusive right. If for example
competitors have been allowed to use a patented invention for years, exclusivity can
probably not be re-established. If a trade mark has not been used for more than five
consecutive years, new competitors are free to use the trademark. Finding out if others are
already using it can be a factor in assessing the purchase of such a trade mark. The
advantage being that after reusing the trade mark, the holder regains exclusivity, as long as
no new competitors started using the trade mark before the first time the trade mark was
used again.
An IP-rights holder is free to grant exclusivity to others, but also the exclude the possibility
of exclusivity by anyone. “Open source” software is an example of an IP-right (copyright)
117
that is made non-exclusive. Open source doesn’t mean that there are no limitations to the
use of such software. On the contrary, open source software is usually made available under
one of many open source licenses60. One common aspect of open source licenses is
obligation to keep open source software “open”. The user is not allowed to use open source
software in his own products and then exclude others from using the newly formed product.
When valuating software, it’s worthwhile to check for evidence of open source software in
the code. If the code holds large amounts of open source software or uses open source
tools, exclusivity of the copyright on the code as a whole is less likely.
IP-rights like design rights and patents have a limited duration. Exclusivity disappears at the
moment these rights expire. The remaining lifespan may be an indication of the value or
profitability of such an IP-right. Almost every IP-right will also have a geographical limitation.
When planning to expand the use of an IP-right, it is necessary to assess whether or not
conflicting IP-rights have been registered in target areas. Another issue when expanding the
use of an IP-right may be the language of a target area. Words can have very different
meanings in different languages. This may influence the chances of success for trade marks
from country to country.
A due diligence report on IP-rights by skilled professionals may offer a valuable insight,
necessary to establish amongst others validity, durability, exclusivity and value of IP-rights.
5.8
Questions
1. What are the two main areas Intellectual Property rights are divided into?
A. Designs and Patents
B. Customs and Tariffs
C. Tangibles and Intangibles
D. Industrial property and copyright (and related rights)
2. Which of the following are considered Intellectual Property rights?
A. Trademarks
B. Patents
C. Designs
D. All of the above
3. All registrations of IP-rights have an expiry date. (True/False)
A. True
B. False
60
For example: http://www.opensource.org/licenses/alphabetical
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4. In order to transfer registered IP-rights like trademarks, design rights, or patent,
which of the following is required?
A. Followers
B. Deed
C. High Revenue
D. Positive Cash Flows
5.9
Answers
1.
2.
3.
4.
D
D
A
B
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6 Accounting definitions of IP and
transfer pricing
Authors: Steven van Wijk/Lukasz Kubicki/Alon Wexler/Ryan Abrams
120
6.1
Introduction – Intangibles
According to IFRS, US and Canadian GAAP, intangible assets are defined as identifiable nonmonetary assets without physical substance. Examples of intangible assets include
trademarks, customer relationships and proprietary technologies. These assets can generate
significant cash flows for a business.
Different businesses have different portfolios of assets. Some businesses, such as
manufacturing companies, are rich in tangible assets such as property, plant and equipment.
Other businesses generate most of their cash flows from intangible assets. Consider a
pharmaceutical company. Their largest asset is an investment in research and development,
technologies and patents on their latest drugs.
In the past, accounting standards did not allow for the recognition of intangible assets due
to the complexity in measuring their future economic benefits. As a result, capital intensive
industries tended to show higher asset balances and higher earnings (since capital assets are
amortized rather than expensed immediately). Service companies appeared to have smaller
asset bases even though these companies continuously invest in intangible assets. As such,
new accounting standards, such as International Accounting Standard (IAS) 38, have
developed recognition and measurement criteria to allow for the recognition of intangible
assets. However, as stated in IAS 38, internally generated goodwill shall not be recognized as
an asset. Internally generated brands, mastheads, publishing titles, customer lists and items
similar in substance are not recognized as intangible assets.
The impact of these standards is significant on both the financial position of the Company
(balance sheet) and its performance (income statement). As such, these accounting
standards can affect the relevance of financial statements to different users as follows:
1. Creditors – use financial statements to make credit decisions (either to make or call a loan):
a. Creditors focus on a Company’s assets for collateral – they focus on the tangible
assets of a company but may consider some intangibles.
b. Creditors also focus on balance sheet ratios such as debt / equity. Since the
recognition of intangibles raises the equity value, the capitalize/expense decision of
intangibles becomes important.
c. Lastly, Creditors focus on a company’s earnings over the term of the loan to consider
whether interest and principal can be repaid. The recognition of intangible assets
tends to raise earnings by avoiding large initial expenses.
Investors – use financial statements to assess their return on investment
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a. Investors focus on future profitability – usually through a company’s earnings before
interest, taxes, depreciation and amortization (“EBITDA”). The recognition of intangible
assets has a direct effect on EBITDA. If not recognized as an intangible, a purchase could be
recognized as an operating expense and lower EBITDA.
b. Ratios such as return on assets (“ROA”) and return on equity (“ROE”) are significantly
affected through the recognition of intangible assets.
Most companies have a presumed bias to increase earnings in order to appear more
attractive to potential investors. Consequently, most companies would prefer to capitalize
intangible assets rather than expensing them. Recognizing the potential for earnings
management, accounting standards have created strict criteria in order to determine
whether or not an intangible asset can be recognized.
This chapter will summarize, at a high level, the accounting standards relating to intangible
assets. The chapter will focus predominantly on International Financial Reporting Standards
(IFRS). IFRS is used in most European countries. Canada also uses IFRS for public companies.
The chapter will also highlight key differences between IFRS, US GAAP and Canadian GAAP
for private enterprises.
6.2
Recognition of Intangibles
In order to recognize any asset on a company’s balance sheet (tangible or intangible), it
must meet the basic definition. An asset is a resource:
•
Controlled by an entity as a result of past events;
•
From which future economic benefits are expected to flow from the entity.
If the expenditure does not meet all the criteria, the amount is expensed immediately in the
income statement. If all the criteria are met, then an asset is created on the company’s
balance sheet and amortized over its useful life. An illustration of these criteria follows:
Example 1: Apple Company is a pharmaceutical business, researching the cure for a rare
disease. It believes to have found a formula that works on mice but does not have the cash
to continue development for human trials. Orange Company therefore purchases the
“formula” from Apple Company for $1 million USD. Note that probability of success of a
drug through human trials is only 10%.
Application of the criteria: The fundamental question in this example is whether Orange
Company can recognize an asset or not. Since the probability of success of the formula is
only 10%, we cannot establish that “there is a probable future economic benefit” from the
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formula. As such, an asset cannot be recognized. Orange Company would therefore show a
$1 million USD expense on its income statement at the time of purchase.
Had it qualified as an asset, the formula would have been considered an intangible, as it
arises from a contractual right and does not have any physical substance. There are three
different scenarios in which a company can acquire an intangible asset:
•
The company can generate it internally. For example, Orange Company could have
researched and developed the formula on its own.
•
A company can acquire it externally. For example, Orange Company can purchase
the rights to the formula from another company.
•
A company can acquire it in a business combination. Orange Company can purchase
the shares of another company, acquiring all of its assets and liabilities, including any
intangibles it may have.
The existence of intangible assets, from a purely economic perspective, does not necessarily
mean that these assets are relevant from an accounting perspective. For example, The Coca
Cola Company’s largest asset by far is it trade name (“Coke”). However, since the trade
name does not meet the definition of an intangible asset for accounting purposes, all
expenditures relating to its trade name are expensed. In this case, while the trade name is
of great economic significance, it is not recognized for accounting purposes. This is due to
the strict accounting standards relating to intangibles, of which a discussion follows.
6.2.1 Intangibles acquired externally
Externally acquired intangibles are purchased from outside the firm and usually have
identifiable costs and discernible benefits. However, there have been difficulties in
accounting for these assets. There has been a conservative tendency to expense many of
the costs involved, and for those capitalized there have been inconsistent approaches to
recording, revaluing, and amortizing these assets.
In order to be recognized as an intangible, IAS 38 requires the purchase to be identifiable.
An asset is identifiable if it:
a. is separable, i.e. is capable of being separated or divided from the entity and sold,
transferred, licensed, rented or exchanged, either individually or together with a related
contract, identifiable asset or liability, regardless of whether the entity intends to do so; or
b. arises from contractual or other legal rights, regardless of whether those rights are
transferable or separable from the entity or from other rights and obligations.
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If the purchase is identifiable, it is recognized as an intangible if it meets the definition of an
asset as stated above and all the following recognition criteria (you will note these criteria
are the same as the ones listed for any asset at the beginning of this section):
a. It must be probable that the expected future economic benefits that are attributable to the
asset will flow to the entity.
b. The cost of the asset must be measured reliably.
The cost of a separately acquired intangible asset comprises:
a. its purchase price, including import duties and non-refundable purchase taxes, after
deducting trade discounts and rebates; and
b. any directly attributable cost of preparing the asset for its intended use.
IFRS, Canadian GAAP and US GAAP are all converged on this issue.
Example 2: Consider the facts presented in Example 1. Let’s now assume that Apple
Company has successfully completed all phases of human trials. The drug is now ready for
production and marketing. However, since Apple has no experience in manufacturing or
marketing, it sells the patent on its formula to Orange Company for $300 million. In order to
complete the purchase, Orange Company was required to pay legal fees of $3 million.
Further, executive management spent a total of 150 hours on the deal, which is the
equivalent of $1 million in salaries.
Application of the criteria: In this example, the patent is clearly identifiable. It can be sold
separately as evidenced by its sale to Orange Company. Further, it also arises from a
contract.
The drug also meets all three recognition criteria: future economic benefits are likely since
the drug has passed human trials, Orange Company controls the patent and its costs are
known with virtual certainty. Therefore, the patent should be recognized as an intangible.
What should be the cost of the intangible? Clearly, its purchase price forms the basis of the
cost. To the purchase price, we would add any direct expenses. In other words, expenses
the company would only incur because of the purchase. This would include $3 million in
legal fees. The salaries of management are an indirect expense. Had the deal not gone
through, Orange Company would have still paid their management. As such, the cost is $303
million (purchase price plus legal fees).
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6.2.2 Intangibles generated internally
An internally generated intangible asset is developed by the company using its own
resources or by a service provider engaged by the company, or acquired externally and
subsequently significantly modified by the company.
Intangible assets are typically generated through research and development. Given a
company’s bias to recognize the highest possible amount of intangible assets, accounting
standards have given strict guidance on what qualifies as an internally generated intangible
asset. First, accounting standards separate a business’ activities into a “research phase” and
a “development phase.” All activities in the research phase are expensed as it cannot yet be
established whether future economic benefits are probable.
Examples of research activities are:
•
activities aimed at obtaining new knowledge;
•
the search for, evaluation and final selection of, applications of research findings or
other knowledge;
•
the search for alternatives for materials, devices, products, processes, systems or
services; and
•
the formulation, design, evaluation and final selection of possible alternatives for
new or improved materials, devices, products, processes, systems or services.
Activities in the development phase can be capitalized as an intangible asset if all of the
following criteria are met:
a. the technical feasibility of completing the intangible asset so that it will be available for use
or sale;
b. its intention to complete the intangible asset and use or sell it;
c. its ability to use or sell the intangible asset;
d. how the intangible asset will generate probable future economic benefits. Among other
things, the entity can demonstrate the existence of a market for the output of the intangible
asset or the intangible asset itself or, if it is to be used internally, the usefulness of the
intangible asset;
e. the availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset; and
f.
its ability to measure reliably the expenditure attributable to the intangible asset during its
development.
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If an entity cannot distinguish the research phase from the development phase, the
expenditure for that project should be treated as if it were incurred in the research phase.
Some operations occur in connection with the development of an intangible asset, but are
not necessary to bring the asset to the condition necessary for it to be capable of operating
in the manner intended by management. These incidental operations may occur before or
during the development activities. Because incidental operations are not necessary to bring
an asset to the condition necessary for it to be capable of operating in the manner intended
by management, the income and related expenses of incidental operations are recognized
immediately in profit or loss, and included in their respective classifications of income and
expense.
IAS 38 provides examples of costs directly attributable to a value of recognized intangible
assets. These include:
a. cost of employee benefits arising directly from bringing the asset to its working condition;
b. professional fees arising directly from bringing the asset to its working condition; and
c. cost of testing whether the asset is functioning properly.
d. Contrary, the costs which cannot be considered as a part of the cost of an intangible
asset include:
a. cost of introducing a new product or service (including costs of advertising and promotional
activities);
b. cost of conducting business in a new location or with a new class of customer (including
costs of staff training); and
c. administration and other general overhead costs.
Recognition of costs in the carrying amount of an intangible asset ceases when the asset is
in the condition necessary for it to be capable of operating in the manner intended by
management. Therefore, costs incurred in using or redeploying an intangible asset are not
included in the carrying amount of that asset. For example, the following costs are not
included in the carrying amount of an intangible asset:
a. costs incurred while an asset capable of operating in the manner intended by management
has yet to be brought into use; and
b. initial operating losses, such as those incurred while demand for the asset’s output builds
up.
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In some cases, expenditure is incurred to generate future economic benefits, but it does not
result in the creation of an intangible asset that meets the recognition criteria. Such
expenditures are often described as contributing to internally generated goodwill. Internally
generated goodwill is not recognised as an asset because it is not an identifiable resource
(i.e. it is not separable nor does it arise from contractual or other legal rights) controlled by
the entity that can be measured reliably at cost.
Therefore internally generated brands, mastheads, publishing titles, customer lists and
items similar in substance shall not be recognized as intangible assets unless they were
purchased or acquired as part of a business combination. As discussed previously, the Coke
trade name would need to be expensed as it is considered internally generated goodwill.
The following highlights the key differences between IFRS, US GAAP and Canadian GAAP as
it relates to internally generated intangible assets:
•
US GAAP does not allow for the recognition of development costs as intangible
assets (all are expensed). The exception to this rule is for website and software
development costs which are capitalized once technical feasibility is proven. The IFRS
development criteria would apply to website and software costs and would typically
arrive at the same conclusion.
•
Canadian GAAP allows companies to adopt an accounting policy decision (to expense
all development activities. This is done to simplify the bookkeeping process. If a
company does not select this option, it follows the same criteria as IFRS to capitalize
its development costs.
Example 3: Now let’s assume Orange Company decides to develop their own drug for a rare
disease. The following is a schedule of amounts spent on the process:
Activity
Date
A
B
C
D
E
F
G
H
I
01-Jan-10
30-Jun-10
30-Aug-10
31-Oct-10
01-Jan-11
30-Jun-11
01-Jan-12
28-Feb-12
31-Mar-12
Amount
Identify several possible compounds to cure the disease
$
Increase testing on compound X on mice
Engage consulting firm to audit results of lab tests
Create report/forms to proceed to human trials
Begin human trials
Passes first phase of clinical trials. Second phase begins.
Drug passes human trials. Enagage marketing firm for a market study
File for patent
Investigate manufacturing plants in China
300,000
200,000
400,000
200,000
500,000
700,000
400,000
500,000
300,000
$ 3,500,000
Application of criteria
127
The first challenge is to decide when the process switches from the research phase into the
development phase. Suppose we were told (because we are not experts in pharmaceuticals)
that there is a 70% chance of a successful drug once Phase One of clinical trials are
completed. In this case, we would consider everything prior to Phase One trials as research,
because we still don’t know if we have the correct compound and whether further research
will be required. Therefore steps A to E are clearly research and should be expensed. Once
we enter the second phase of trials (Step F), we will consider the criteria for development as
follows:
a. the technical feasibility of completing the intangible asset so that it will be available for use
or sale; at this point, we have demonstrated feasibility by getting to phase II. Further, the
company likely has the technical feasibility to advance to the next phase.
b. its intention to complete the intangible asset and use or sell it; the company has a clear
intention to complete the project.
c. its ability to use or sell the intangible asset; the company has a clear intention to sell the
drug.
d. how the intangible asset will generate probable future economic benefits. Among other
things, the entity can demonstrate the existence of a market for the output of the intangible
asset or the intangible asset itself or, if it is to be used internally, the usefulness of the
intangible asset; the company has completed a market study. Further, there is a 70% chance
of success, thereby meeting the “probable” criteria
e. the availability of adequate technical, financial and other resources to complete the
development and to use or sell the intangible asset; the company likely has the technical
feasibility to advance to the next phase. We will assume financing is not an issue in this
example.
f.
its ability to measure reliably the expenditure attributable to the intangible asset during its
development. As shown on the schedule, the expenditures are all known.
Since all the criteria are met, Step F and beyond would be considered development
activities. Any costs related to the development of the drug can be capitalized. Since Step I
does not relate to the drugs development (it relates to production), the amount cannot be
capitalized and would be expensed immediately.
6.2.3 Intangibles acquired as part of business combination
A business combination is defined as a transaction or other event in which an acquirer
obtains control of one or more businesses. Transactions sometimes referred to as true
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mergers or merger of equals are also business combinations. Often intangible assets are
acquired as part of the business combination.
The acquisition method is used to account for a business combination which is applied by
the following steps:
Identification of the 'acquirer' – the combining entity that obtains control of the acquiree
Determination of the 'acquisition date' – the date on which the acquirer obtains control of the
acquiree
Recognition and measurement of the identifiable assets acquired, the liabilities assumed and any
non-controlling interest (NCI, formerly called minority interest) in the acquiree.
a. As of the acquisition date, the acquirer should determine the fair value of the
consideration paid for the business. If less than 100% of the business is purchased, than
the acquirer should determine the implied consideration that would have been paid in
the event that 100% of the business was purchased. The consideration paid for the
business is then allocated to its assets and liabilities. Any residual amount is known as
goodwill.
The acquirer's application of the recognition principle and conditions may result in
recognising some assets that the acquiree had not previously recognised as assets in its
financial statements. For example, the acquirer recognises the acquired identifiable
intangible assets, such as a brand name, a patent or a customer relationship, that the
acquiree did not recognise as assets in its financial statements because it developed them
internally and charged the related costs to expense.
There is a presumption that the fair value (and therefore the cost) of an intangible asset
acquired in a business combination can be measured reliably. An expenditure (included in
the cost of acquisition) on an intangible item that does not meet both the definition of and
recognition criteria for an intangible asset should form part of the amount attributed to the
goodwill recognized at the acquisition date.
The fair value according to IFRS 13 is defined as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between market participants at
the measurement date.
Although the definition of the fair value provides a clear framework of valuation, in practice
however the valuation process requires a thorough analysis from an economic and financial
perspective. The detailed discussion about the valuation process is provided in Lesson 3.
129
IFRS, US GAAP and Canadian GAAP are converged on this issue. Any minor differences are
beyond the scope of this chapter.
Example 4: Fruit Company specializes in making storage containers which keep various fruit
fresh for a long period of time. The company has been owned since inception by Mr. Smith,
who would like to retire. As such, he agrees to sell 100% of his shares to a private equity
firm for $13 million in cash. A & A, a chartered accounting firm, was engaged to complete
the purchase price allocation. A purchase price allocation involves allocating the fair value of
the company ($13 million) to its assets and liabilities.
In order to complete the purchase price allocation, A & A first develops a complete
understanding of the business and identifies the identifiable intangible assets. A & A’s
findings were as follows:
•
Technology – The company’s technology in manufacturing its containers is the core
competency of its business, allowing them to have superior characteristics than
competing products such as superior strength and moisture/grease free surfaces.
The technology could be sold to a competitor looking to improve its operations and
are therefore identifiable and valuable.
•
Trade name – According to management, the company’s trade name has recognition
in the industry and helps the company generate sales. Therefore, the trade name
could be sold to a competitor looking to establish a higher market share. It is
therefore separable and valuable.
•
Customer relationships – The company maintains strong relationships with its
customers as its revenues are dependent upon repeat business. Relationships have
spanned more than 10 years, making these repeat orders key to the sustainability of
the business. A competitor would pay for these relationships in order to expand their
business, making them identifiable.
The next step in the purchase price allocation would be to determine the fair value of each
intangible asset separately, using valuation techniques learned in Lesson 3. Finally, A & A
would allocate the $13 million to the assets and liabilities of the company (see the table on
the following page). The residual value not allocated to any other assets or liabilities is
known as goodwill and is discussed in the next section.
130
FRUIT COMPANY
ADJUSTED PURCHASE PRICE ALLOCATION
AS AT THE ACQUISITION DATE
(in $000s)
Book
Value
Enterprise value
Fair Value
Adjustment Fair Value
A
$ 13,000
Purchase price allocated as follows:
Net tangible assets
Net Cash
Working capital
Accounts receivable
Sales taxes receivable
Inventory
Prepaid expenses
Accounts payable
Property, plant, and equipment
Intangible assets
Technology (know how)
Trade Name
Customer relationships
Book Value / Adjusted Book Value
Goodwill
Note 1
10
-
10
Note 1
Note 1
Note 2
Note 1
Note 1
1,000
150
2,300
100
(700)
700
-
1,000
150
3,000
100
(700)
Note 2
2,850
1,500
700
500
3,550
2,000
4,360
1,200
5,560
-
1,100
1,400
2,000
1,100
1,400
2,000
-
4,500
4,500
4,360
5,700
10,060
Note 3
Note 3
Note 3
B
A- B
$
2,940
Note 1: Book values taken from Fruit Company's balance sheet as of the acquisition date
Note 2: Inventory and property, plant and equipment were bumped to their fair market value
Note 3: Identifiable intangible assets recognized at the acquisition date because they meet the criteria
from Section 2.1. Note they had never been recognized on Fruit Company's balance sheet
pre-transaction.
6.3
Goodwill
According to the 6 June 2012 Chapter 6 draft of the OECD TP Guidelines, in most instances,
accounting and business valuation measures of goodwill and ongoing concern value are not
relevant for purposes of transfer pricing analysis. As discussed in section 2.3, goodwill is
only recognized as a result of a business combination.
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Goodwill is measured as the difference between:
•
The consideration paid for 100% of the business; and the
•
Net of the acquisition-date amounts of the identifiable assets acquired and the
liabilities assumed.
Occasionally, an acquirer will make a bargain purchase, which is a business combination in
which the amount of goodwill is negative. The acquirer shall recognize the resulting gain on
the acquisition date directly in the statement of profit and loss. The gain is recognized as a
bargain purchase in profit or loss.
In the case of a business combination where the acquirer does not achieve 100% control of
the acquiree, the non-controlling interest (NCI) has to be measured.
IFRS 3 allows an accounting policy choice, available on a transaction by transaction basis, to
measure NCI either at:
•
fair value (the full goodwill method), or
•
the NCI's proportionate share of net assets of the acquiree (the partial goodwill
method).
The fact that companies could elect how they will account for the NCI, leads to
discrepancies in the value of goodwill calculated under each of the methods. This is best
illustrated by the example provided below.
Example 5: P pays $800 to purchase 80% of the shares of S. Fair value of 100% of S's
identifiable net assets is $600. If P elects to measure non-controlling interests at their
proportionate interest in the net assets of S of $120 (20% x $600), the consolidated financial
statements show goodwill of $320 (800 +120 - 600). If P elects to measure non-controlling
interests at fair value and determines that fair value to be $185, then goodwill of $385 is
recognized (800 + 185 - 600). The fair value of the 20% non-controlling interest in S will not
necessarily be proportionate to the price paid by P for its 80%, primarily due to control
premium or discount as explained in paragraph B45 of IFRS 3.
IFRS, US GAAP and Canadian GAAP are converged on this issue. Any minor differences are
beyond the scope of this chapter.
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6.4
Subsequent measurement
When an intangible asset is recognized, the company would like to recover its value. The
company could recover the value of the assets during the normal course of the business
(e.g. trademarks will be used to increase sales of products which are manufactured by the
company) or through sale of the intangible assets in the future.
In case an asset is recovered during the normal course of the business, its value has to be
measured reliably throughout the business process. In principle an entity must choose
either the cost model or the revaluation model for each class of intangible asset. The cost
model assumes that after initial recognition intangible assets should be carried at cost less
any amortization and impairment losses. Under the revaluation model, intangible assets
may be carried at a revalued amount (based on fair value) less any subsequent amortization
and impairment losses only if fair value can be determined by reference to an active market.
In practice however such active markets are uncommon for intangible assets and therefore
most commonly a cost model is used.
The treatment of an asset depends on its useful life. IAS 38 differentiates between:
•
indefinite life when no limit is foreseen to the period over which the asset is
expected to generate net cash inflows for the entity; and
•
finite life where the period of benefit to the entity is limited.
The assets with indefinite life will be carried in the amount initially recognized. However, its
useful life should be reviewed each reporting period to determine whether events and
circumstances continue to support an indefinite useful life.
The assets with finite lives should be amortized on a systematic basis over their economic
useful life.
In the case that a company disposes of the asset, a gain or loss arising from the
derecognition of an intangible asset shall be determined as the difference between the net
disposal proceeds, if any, and the carrying amount of the asset. It shall be recognised in
profit or loss when the asset is derecognised. Gains shall not be classified as revenue.
Example 6: Going back to Example 4, let’s assume that Orange Company finally completes
the drug on December 31, 2012. Let’s further assume the total amount capitalized to
development costs by December 31, 2012 to be $4 million and that the company uses the
cost method. The patent on the drug lasts for 15 years, however Orange Company believes
(based on its extensive experience) that within 10 years, a better drug will come out,
thereby rendering the patent worthless. Therefore, the useful life of the drug is 10 years,
133
because this is the time period that the company can financially benefit from its patent.
Amortization expense would therefore be $400 thousand calculated as $4 million in total
cost divided by its 10 years useful life.
Let us further assume that by the end of December 31, 2016 (four years later), another
company buys the patent for $3 million. At that point, the patent would have a carrying
amount of $2.4 million (calculated as the initial $4 million less 4 years’ worth of amortization
of $400 thousand per year). Since the proceeds of the sale are higher than the patents
carrying amount, a gain would be recognized as the difference ($600 thousand) and would
show on the company’s income statement.
In this example it would be very rare for the revaluation method to be used, because there
is no active market for pharmaceutical patents on specific diseases. However, if the
revaluation method were to be used, the company would revalue the patent each year. For
example, suppose in December 31, 2013 the fair market value of the patent was $4.5
million. In that case, the value of the patent would be increased by $500 thousand and an
unrealized gain would be shown in the statement of other comprehensive income 61.
US GAAP and Canadian GAAP require the cost model for intangible assets. The revaluation
model is unique to IFRS.
6.5
Questions
1. Which of the following documents governs the recognition of intangibles for
accounting purposes?
A. International Accounting Standard (IAS) 38
B. Bill of Rights
C. Annual Reports
D. OECD Article 9
2. Which of the following is NOT a criterion needed to capitalize activities in the
development phase as an intangible asset?
A. Its ability to use or sell the intangible asset
B. Its ability to measure reliably the expenditure attributable to the intangible
asset during its development
C. Its intention to complete the intangible asset and use or sell it
D. Its ability to pay dividends to shareholders
61
Other Comprehensive Income is shown on a separate financial statement. It is beyond the scope of this
chapter.
134
3. Which of the following costs are directly attributable to a value of recognized
intangible assets?
A. Cost of employee benefits arising directly from bringing the asset to working
condition
B. Professional fees related to brining the asset to working condition
C. Cost of meals taken by the employees
D. Cost of testing whether the asset is functioning properly
4. Goodwill is only recognized as a result of business combination.
A. True
B. False
6.6
Answers
1.
2.
3.
4.
6.7
A
D
C
A
Literature
•
IAS 38
•
ASC 805
•
CGAAP Section 3064
135
7 Corporate Income Tax Aspects of IP
and Transfer Pricing
Authors: Rudolf Sinx/Louan Verdoner/Raheem Farishta
136
7.1
Introduction
This lesson outlines the corporate income tax aspects related to intellectual property and
transfer pricing. Corporate income tax is a major factor affecting the placement and types of
intellectual property in a business. Each country has its own rules regarding the taxation of
intangible property. This lesson provides several examples from different countries to
highlight how intangible property is taxed around the world. The following topics related to
corporate income tax aspects are covered in this lesson:
•
•
•
•
•
•
•
•
•
•
•
7.2
Initial Intangible Asset Value
Depreciation/Decrease in Value
Research and Development (R&D) Tax Credit
Innovation Box/Patent Box and/or Other Incentives
Replacement Reserve
Withholding Tax on Royalty Payments
Capital Gains Tax
Business Restructuring and Related Taxes
Value Added Tax (VAT)
Purchase Price Allocation (PPA)
Beneficial, Economic, and Legal Ownership
Initial Intangible Asset Value
According to International Accounting Standard (IAS) 38, as discussed in Lesson 6, an
intangible asset shall be measured initially at cost. Also, IFRS 3 Business Combinations states
that if an intangible asset is acquired in a business combination, the cost of that intangible
asset is its fair value at the acquisition date. Furthermore, internally generated goodwill
shall not be recognized as an asset.
For corporate tax purposes, each country has its own way of recognizing which intangible
assets are actually valid for taxing purposes.
In the United Kingdom, the book value of an intangible asset in question is the value in
accordance with UK GAAP. Most internally generated goodwill cannot be capitalized and
therefore have a book value of zero. An asset is a ‘chargeable intangible asset’ at any time if
a gain on its disposal gives rise to a taxable credit. 62
62
Source: HM Revenue & Customs, http://www.hmrc.gov.uk/manuals/cirdmanual/CIRD47020.htm
137
In the United States, Section 197 of the IRS Tax Code lists certain intangibles that should be
accounted for on the tax return. The following assets are considered Section 197
Intangibles63:
1. Goodwill;
2. Going concern value;
3. Workforce in place;
4. Business books and records, operating systems, or any other information base, including
lists or other information concerning current or prospective customers;
5. A patent, copyright, formula, process, design, pattern, know-how, format, or similar item;
6. A customer-based intangible;
7. A supplier-based intangible;
8. Any item similar to items (3) through (7);
9. A license, permit, or other right granted by a governmental unit or agency (including
issuances and renewals);
10. A covenant not to compete entered into in connection with the acquisition of an interest
in a trade or business;
11. Any franchise, trademark, or trade name; and
12. A contract for the use of, or a term interest in, any item in this list.
If the Section 197 intangible is created internally, then it has a zero tax or bookkeeping value
to the corporation.
7.3
Amortization/Decrease in Value of Intangible Assets
Amortization of intangible assets deals with deducting the cost of a qualifying asset over the
projected life of the asset. Along with determining which intangible assets to tax, each
country has its own rules about the amortization of intangible property.
In the United States, any Section 197 intangible held in connection with a trade or business
is amortized straight-line over 15 years (180 months). In the year the asset is acquired and
63
Source: Internal Revenue Service, http://www.irs.gov/pub/irs-drop/rr-04-49.pdf
138
sold, the amount of amortization deductible for tax purposes is prorated on a monthly
basis. 64
In the United Kingdom, taxpayers may elect to amortize intangible assets over 25 years for
tax purposes at 4% per annum. Upward revaluations of IP are taxable to the extent that
previous tax relief has been given. 65
According to the Dutch income tax system, self-created intangible assets (except for
goodwill), can be amortized at once in the year the intangibles are developed or created.
Goodwill can be amortized at a maximum rate of 10% of the purchase price. 66
7.3.1 Methods of Amortization
The most common methods of amortization include straight-line and accelerated.
Straight Line Depreciation = (Purchase Price – Salvage Value) / Useful Life.
Accelerated depreciation allows companies to write off their assets faster in earlier years
than the straight-line depreciation method and to write off a smaller amount in the later
years. The major benefit of using this method is the tax shield it provides early on in the life
of the asset.67
The USA and UK tax systems only permit a straight-line depreciation on intangible assets,
while the Dutch system allows a free choice of depreciation method as long as it follows
sound business practice.
7.4
R&D Tax Credit
Countries have R&D tax credit systems in place to encourage the development of intangible
property in their respective jurisdictions. Many different types of tax incentives are in place
to urge corporations to place their research and development facilities in certain locations.
Since 2004, a number of EU Member States have introduced new tax incentives or
substantially improved existing ones to stimulate investment in research. They now
64
Source: Internal Revenue Service, http://www.irs.gov/pub/irs-drop/rr-04-49.pdf
65
Source: Buzzacott Chartered Accountants, “ UK taxation of Intellectual Property”,
http://www.buzzacott.co.uk/insights/the-uk-taxation-of-intellectual-property--ip-/43
66
Source: PLC Cross-border Tax Handbook, http://www.stibbe.nl/upload/165ca5aaf011a06d6078e0113df.pdf
67
For more information please visit: www.Investopedia.com
139
constitute a substantial part of the total public effort to support business R&D in several EU
Member States.
According to the OECD Report on R&D tax incentives, the R&D tax benefits depend on
country-level variables such as overall innovation performance, perceived market failures in
R&D, industrial structure, size of firms and the nature of corporate tax systems. Some OECD
countries (e.g. Sweden, Finland) neither subsidize nor extend preferential tax treatment to
business R&D although these countries have high levels of private R&D expenditures. Most
OECD and emerging economies apply a system where an R&D tax credit is provided on the
volume of R&D expenditure undertaken (e.g. Canada, Japan, United Kingdom, France,
Norway, Brazil, China and India) while others target R&D tax credits to incremental R&D
expenditure (i.e. expenditure in excess of some baseline amount). R&D tax allowances are
available in Denmark, Czech Republic, Austria, Hungary, and the United Kingdom. Payroll
withholding tax credit for R&D wages, which are deduction from payroll taxes and social
security contributions, are also being used in Belgium, Hungary, the Netherlands and
Spain.68
The United States provides tax credits for qualified research expenses to offset corporate
income tax. The US provides two methods for computing R&D tax credit, a traditional 20%
credit equal to 20% of the amount of the R&D expenses exceeding a “base amount” or a
simplified 14% credit. These credits are not subject to a cap, and unused credits can be
carried back one year and carried forward twenty years. The US R&D credit has lapsed as of
January 1, 2012, but Congress can reinstate it retroactively as it has done nine times
previously. 69
A great example of the cross-national comparison of R&D expenses is seen in a 2004 article
called "A Cross-National Comparison of R&D Expenditure Decisions: Tax Incentives and
Financial Constraints" written in the Contemporary Accounting Research journal. The article
compares the R&D tax credit systems in place in the United States and Canada. The two tax
incentive mechanism designs are consistent with differing views of the degree of financial
constraints faced by firms in these economies. The research shows that the Canadian credit
system induces, on average, $1.30 of additional R&D spending per dollar of taxes foregone,
while the U.S. system induces $2.96 of additional spending, on average. Also, the findings
illustrate that firms that capitalize R&D costs in Canada spend, on average, 18% more on
68
Source: September 2011 Testimony by OECD at US Senate Committee, http://www.finance.senate.gov
69
Source: Deloitte Global Survey of R&D Tax Incentives, July 2011
140
R&D. Collectively, this evidence is important to the ongoing debates in both countries about
the appropriate design of incentives for R&D.
7.5
Innovation Box/Other Incentives
Many countries have special R&D tax incentives for certain taxpayers who meet special
conditions.
Netherlands 70
In the Netherlands, there are two important tax incentives for qualified taxpayers, the wage
tax benefits for innovation (WBSO) and innovation box. The WBSO reduces wage tax and
social security contributions for employees engaged in research. The Innovation Box,
formerly known as the Patent Box, allows a deduction on corporate income tax rates from
qualifying technology intangible asset profits. For the qualifying profits, companies
effectively owe only 5% income tax as of 2010 (2007-2009: 10%), instead of the general tax
rate of 25%. The incentive applies to certain self-produced (i.e., not purchased), technologybased intangible assets, such as the know-how for a new product or for a new production
process. The company need not report the technology asset in its financial statements in
order to qualify. Also, the volume of profits that is allowed to be included in the Box is, from
2010 onwards, no longer capped. There are two ways to access the Innovation Box benefits,
through patented assets and R&D certificate assets.
1. Conditions for qualifying for the Innovation Box - Patented assets
70
•
The company has a technology intangible asset that is expected to generate a
significant technology-based profit. In other words, at least 30% of the expected
future profits are expected to be derived from the new technology components,
as opposed to from marketing efforts, brands, trademarks, etc.
•
The company has a patent (whether Dutch or non-Dutch) for the intangible asset.
Patent applications that are still pending do not qualify.
•
The company produced the intangible asset; in other words, it did not purchase
the complete asset.
•
The "self-production test" is met if the company's staff performs the required
R&D work, or if they monitor the R&D work carried out by a third party ("contract
R&D") in the Netherlands or abroad.
Source: BOM Foreign Investments, http://www.foreigninvestments.eu/pages//ET---Innovations-Box.html
141
•
Brands, trademarks, logos, etc. are not qualifying technology assets.
2. Conditions for qualifying for the Innovation Box - R&D certificate assets
•
The company has received an R&D certificate for the R&D work.
•
The company can apply for an R&D certificate if it employs staff engaged in
qualifying research and development activities in the EU (this may include certain
software development). The R&D certificate also allows the company to receive a
certain tax credit against his wage tax obligations, so the company may, therefore,
benefit from two incentives.
•
The company, and not a third party, produces the intangible asset.
•
For contract R&D, the "self-production test" is met if the company's staff
performs the majority of the R&D work that is required for a particular R&D
project, or if they monitor the R&D work carried out by a third party (i.e., if they
organize and supervise the work).
Also, the 2012 Dutch Tax Plan introduced a new tax incentive called the research and
development deduction (“RDA”). The RDA incentive is an additional deduction to costs and
investments directly related to R&D (other than wage costs) and is calculated over costs and
investments that are currently deductible or depreciable.
United Kingdom71
The United Kingdom offers two volume-based incentives; one that is available to companies
falling within the definition of a Small-or-Medium-Sized-Enterprise (SME) and the other for
companies that do not fall within that definition (Large Companies). Generally, an SME
company must have fewer than 500 employees and either gross revenues of less than
€100M or gross assets of less than €86M. The UK offers a 130% super deduction for Large
Companies and a 175% super deduction for SME Companies.
Companies may claim the incentive for their expenditures on the following cost categories
as long as the total exceeds GBP 10,000 for the year:
71
•
Employing staff who are directly and actively engaged in carrying out R&D;
•
Paying a staff provider for the services of personnel who are directly and actively
engaged in carrying out R&D (limited to 65% of the payment);
Source: Deloitte Global Survey of R&D Tax Incentives, July 2011
142
•
Consumable or transformable materials used directly in carrying out R&D (broadly,
physical materials which are consumed or transformed in the R&D process);
•
Power, water, fuel, and computer software used directly in carrying out R&D;
•
Subcontract costs if they are paid to a university, health authority, charity, scientific
research organization, individual, or a partnership of individuals; and,
•
Payments to volunteers for participating in clinical trials.
Belgium and Luxembourg
In order to encourage R&D activities, the Luxembourg Government has recently passed a
law that provides for an 80% exemption of certain types of IP-related income (or of deemed
IP-income if a taxpayer creates IP for his own use). 72 Similarly, a patent income deduction in
Belgium allows taxpayers to deduct 80% of their qualifying patent income from their taxable
income.
7.6
Replacement Reserve
In general, as stated in IAS 38, if in accordance with the recognition principle an entity
initially recognizes in the carrying amount of an asset the cost of a replacement for part of
an intangible asset and then it derecognizes the carrying amount of the replaced part, there
may be a replacement reserve allowed. If it is not practicable for an entity to determine the
carrying amount of the replaced part, it may use the cost of the replacement as an
indication of what the cost of the replaced part was at the time it was acquired or internally
generated.
In the Netherlands, if fixed assets are lost, damaged, or sold at a price above book value,
profits may be set aside in a tax-free replacement reserve. The tax reserve does not apply to
intangible fixed assets that are kept as part of a portfolio investment. Although
contributions to the replacement reserve are deductible from taxable profits, the reserve
must be applied to the cost of replacing the assets and should be terminated within 3 years
of its creation.73
72
Source: Luxembourg Ministry of the Economy and Foreign Trade,
http://www.eco.public.lu/documentation/publications/broch_ip/MECO_FO_LUX_IP_DESTINATION.pdf
73
Source: Deloitte – Taxation in the Netherlands 201
143
7.7
Withholding Tax on Royalty Payments
According to Article 12 of the OECD Model Tax Convention, the term “royalties” as used in
this Article means payments of any kind received as a consideration for the use of, or the
right to use, any copyright of literary, artistic or scientific work including cinematograph
films, any patent, trade mark, design or model, plan, secret formula or process, or for
information concerning industrial, commercial or scientific experience. Some countries
apply a withholding tax on these cross-border royalty payments, while others do not to
encourage the flow of these incomes through their countries.
For example in the United States, royalty income falls under fixed or determinable annual or
periodical (FDAP) income and is subject to a withholding tax of 30%, although a reduced rate
or exemption may apply if stipulated in the applicable tax treaty. 74 On the other hand, the
Netherlands does not levy a withholding tax on outbound royalty payments.
Withholding taxes can complicate intentional set-offs of royalty receipts against
corresponding activated assets, such as sales receipts. According to chapter 3 of the OECD
TP Guidelines, an intentional set-off is one that associated enterprises incorporate
knowingly into the terms of the controlled transactions. It occurs when one associated
enterprise has provided a benefit to another associated enterprise within the group that is
balanced to some degree by different benefits received from that enterprise in return. The
terms of set-offs relating to international transactions between associated enterprises may
not be fully consistent with those relating to purely domestic transactions between
independent enterprises because of the differences in tax treatment of the set-off under
different national tax systems or differences in the treatment of the payment under a
bilateral tax treaty.
7.8
Capital Gains Tax 75
Capital gains tax is a type of tax levied on capital gains incurred by individuals and
corporations. Capital gains are the profits that an investor realizes when he or she sells the
capital asset for a price that is higher than the purchase price. Capital gains taxes are only
triggered when an asset is realized, not while it is held by an investor. An investor can own
shares that appreciate every year, but the investor does not incur a capital gains tax on the
shares until they are sold.
74
Source: Internal Revenue Service, http://www.irs.gov/businesses/article/0,,id=180219,00.html
75
For more information please visit www.investopedia.com
144
Most countries' tax laws provide for some form of capital gains taxes on investors' capital
gains, although capital gains tax laws vary from country to country. In the U.S., individuals
and corporations are subject to capital gains taxes on their annual net capital gains. It is
important to note that it is net capital gains that are subject to tax because if an investor
sells two stocks during the year, one for a profit and an equal one for a loss, the amount of
the capital loss incurred on the losing investment will counteract the capital gains from the
winning investment. Similarly, in the UK, on the sale of an intangible asset the difference
between the proceeds and the tax book value is taxed. 76 However, in the Netherlands there
is no capital gains tax.
7.9
Business Restructuring and Related Taxes
There is no legal or universally accepted definition of business restructuring. The OECD
defines business restructuring as the cross-border redeployment by a multinational
enterprise of functions, assets and / or risks and refers to the following typical business
restructurings:
•
Conversion of full-fledged distributors into limited-risk distributors
commissionaires for a related party that may operate as a principal;
•
Conversion of full-fledged manufacturers into contract manufacturers or toll
manufacturers or a related party that may operate as a principal;
•
Rationalization and / or specialization of operations (manufacturing sites and / or
processes, research and development activities, sales, services);
•
Transfers of intangible property rights to a central entity (e.g. a so-called “IP
company”) within the group.
or
When business restructuring results, a taxable event is illustrated through an example
whereby the response depends on the historical results of the activity of the transferor, the
historical volatility of such results, and the future profit / loss expectations of the transferor
and transferee in relation to the risk at hand.
The German tax authorities defined business restructuring in a slightly different way: “a
relocation of functions exists if an enterprise transfers or provides the use of economic
goods and other advantages as well as the chances and risks pertaining thereto to another
76
Source: Buzzacott Chartered Accountants, “UK Taxation of Intellectual Property”,
http://www.buzzacott.co.uk/insights/the-uk-taxation-of-intellectual-property--ip-/43
145
associated enterprise”. Rather than referring to “redeployment” of functions (OECD), the
German tax authorities refer to “transfer” whereby the emphasis is more on an actual /
physical movement of functions.
In the United Kingdom, the HMRC imposes a charge to the corporation on the unrealized
gains of a company which ceases to be a resident in the UK. The law creates an occasion of
charge immediately before the time when a company ceases to be resident in the UK.
Further, the rules deem the company to have disposed of all its assets at their market value
immediately before the relevant time and to have reacquired them at that value at the
relevant time. The resulting charge to the corporation tax is known as the “exit charge”. 77
Under US Treasury Regulations, to the extent that the transfer of a function between
affiliated entities across tax jurisdictions are accompanied by a transfer of (tangible,
intangible, or both) assets, both section 482 and section 367 require that the transferor
recognize arm’s length compensation for the transfer of intangible assets. However, the IRS
stops short of requiring exit charges for the transfer of routine services as shown by the
position in its coordinated issue paper (CIP) on buy-ins pertaining to cost-sharing
arrangements (commonly associated with research and development efforts). Further,
under the US Regulations, a transfer of a business opportunity by itself is not considered the
transfer of an asset and, therefore, does not seem to require compensation between
controlled parties. 78
7.10 VAT 79
A value-added tax (VAT) is a type of consumption tax that is placed on a product whenever
value is added at a stage of production and at final sale. Value-added tax (VAT) is most often
used in the European Union. The amount of value-added tax that the user pays is the cost of
the product, less any of the costs of materials used in the product that have already been
taxed.
OECD countries have agreed on two fundamental principles for charging VAT/GST on
internationally traded services and intangibles:
77
Source: HM Revenue and Customs, http://www.hmrc.gov.uk/manuals/cgmanual/cg42370.htm
78
Source: ONESOURCE Transfer Pricing Insider, “Services, Intangibles, and Exit Charges: The Evolving Views on
Intercompany Transfer of Services”, http://onesource.thomsonreuters.com/share/solutions/transferpricing/transfer-pricing/newsletter/42572/ExitChanges3-1-11
79
Source: OECD Centre for Tax Policy and Administration,
http://www.oecd.org/document/20/0,3746,en_2649_33739_39874324_1_1_1_1,00.html
146
•
For consumption tax purposes internationally traded services and intangibles should
be taxed according to the rules of the jurisdiction of consumption;
•
The burden of value added taxes themselves should not lie on taxable businesses
except where explicitly provided for in legislation.
Within the European Union, services are, in principle, taxed where the supplier is
established (“origin” rule). However, recognizing that this would breach neutrality in many
cases, there are a large number of exceptions to this basic rule. The zero rating of exports
and taxation of imports introduce a breach in the staged collection process. In most
countries where an invoice credit method is used, tax on several services and intangibles
provided from abroad are collected by to the so-called reverse charge mechanism.
Normally, taxpayers that deliver services in countries where they are not established have
to register for VAT purposes and fulfil all VAT obligations in that country. To avoid such
administrative burden to foreign providers, the reverse charge mechanism provides that the
VAT-registered customer is liable to account for the tax on supplies received from foreign
traders.
7.11 Purchase Price Allocation
Companies are generally required to allocate the purchase price of acquired corporations
among tangible and intangible assets. Typically, this allocation is derived from fair market
value estimates for the identifiable tangible and intangible assets held by the acquired firm.
Under a purchase price allocation (PPA), an acquirer allocates the purchase price to the
assets acquired and liabilities assumed at fair value (FV) on the acquisition date.
The PPA allocation process provides an incentive for colluding firms, e.g. subsidiaries of a
multinational firm, to shift profits to low corporate income tax countries in order to reduce
the total corporate income tax burden for the group. Thus, there are transfer pricing
constraints in place to prevent this. The US Internal Revenue Service has stated that
“allocations or other valuations done for accounting purposes may provide a useful starting
point, but will not be conclusive for purposes of the best-method analysis in evaluating the
arm’s length charge in a platform contribution transaction (PCT), particularly where the
accounting treatment of an asset is inconsistent with its economic value.” The IRS does not
provide any discussion of the relationship between financial reporting and tax standards
and, therefore, neither identifies, on the one hand, what parts of a PPA may provide “a
147
useful starting point” or, on the other hand, what changes have to be made to a PPA before
it can be used as the basis for a transfer pricing analysis. 80
7.12 Beneficial/Economic/Legal Ownership
The following questions arise when addressing Intellectual Property (IP) ownership:
•
How is ownership defined and determined?
•
Who is the owner of intangibles?
•
Who has the right to benefit from the ownership?
These questions are typically raised in a discussion how to treat IP for transfer pricing
purposes. The ownership of intangibles in general can be structured as:
•
Beneficial ownership; or
•
Economic or legal ownership; or
•
Centralized or joined ownership
7.12.1 Beneficial Ownership
The concept of “beneficial owner” found in Articles 10, 11 and 12 of the OECD Model Tax
Convention has given rise to different interpretations by courts and tax administrations. A
taxpayer could have legal ownership of a residence and yet not have equitable or beneficial
ownership. These articles generally provide for a reduced level of withholding tax on the
relevant category of income: however, the reduced tax is only available if the beneficial
owner of the dividends, interest or royalties is a resident of the state which is a party to the
treaty. One of the characteristics of this type of ownership is that there is an economic
effect. This would include such rights and obligations as: possession, obtain legal title upon
full payment of the purchase price, construct improvements, pay property taxes, risk of loss,
insure and maintain the property. 81
In the United States, a foreign beneficial owner can be established by filing Form W-8BEN
Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding. This
80
Source: BNA Bloomberg Transfer Pricing Watch, “Reconciliation of Purchase Price Allocation and Transfer
Pricing”, 4 May 2010.
81
Source: OECD Centre for Tax Policy and Administration,
http://www.oecd.org/dataoecd/49/35/47643872.pdf
148
potentially can allow a taxpayer to claim a reduced rate or exemption from withholding tax
under an income tax treaty. 82
7.12.2 Legal Ownership
Legal ownership is defined according to the legal title and legal protection of the intellectual
property. Thus, the intellectual property can be legally protected in the country it is
registered, such as patents and trademark. From a transfer pricing perspective, the legal
owner of the intellectual property is considered as the owner of the IP. For patent and
trademark, the owner can protect their intellectual property by registering them; however,
for embedded intangibles like know- how, it is usually hard to use legal system to protect it.
Legal ownership offers the owner the protections and the rights to utilize the IP to generate
further benefits. Thus, where the legal ownership is placed within an MNE is important for
tax planning purposes.
7.12.3 Economic Ownership
The OECD defines economic ownership of assets broadly as: “the right to the income
attributable to the ownership of the asset, such as royalties; the right to depreciate a
depreciable asset; and the potential exposure to gains or losses from the appreciation or
depreciation of the asset.”
In the context of intangibles, additional attributes associated with economic ownership
include:
•
Ability to benefit from the IP and any income stream created by those assets
•
Possibility of one party having both legal and economic ownership
•
Economic ownership may easily be transferred without change in legal ownership
•
A party that bears the costs and risks of developing an intangible should be entitled
to a corresponding economic interest, even if it is not the legal owner of the
intangible.
Economic ownership must be present in most tax jurisdictions to allow a company to gain
tax benefits, such as amortization deductions on the asset, and take advantage of tax
incentives that go along with the IP. For this reason, from a tax perspective economic
82
Source: Internal Revenue Service,
http://www.irs.gov/businesses/small/international/article/0,,id=105139,00.html
149
ownership is closely scrutinized to determine which entity should bear the tax related
consequences of the asset.
The reasons why taxpayers may segregate legal and economic ownership could be to
facilitate the centralized handling of all intangible registrations within a group. Another
reason is Cost Contribution Arrangements (CCA) where economic ownership is shared but
legal ownership cannot be registered under multiple names.
For US tax purposes, the IRS is supposed to analyse ownership in two distinct ways: 1) legal
registration and 2) the contribution, or economic substance, which an entity has made to
create or increase the value of the intangible. The US transfer pricing regulations provide
that the legal owner of intangible property pursuant to the intellectual property law of the
relevant jurisdiction, or the holder of rights constituting intangible property pursuant to
contractual terms, such as the terms of a license or other agreement, will be considered the
sole owner of intangible property for purposes of this section unless such ownership is
inconsistent with the economic substance of the underlying transactions. 83
According to the new OECD Chapter 6 discussion draft of the Transfer Pricing Guidelines 84,
the idea of “entitlement of intangible related returns” determines ownership. In this light,
the importance of the alignment of developing, enhancing, maintaining and protecting
intangibles with legal agreements is necessary to have the proper right of ownership of the
IP for transfer pricing purposes.
7.12.4 Differences between Economic and Legal Ownership
The primary area where the difference between legal and economic ownership arises is in
relation to marketing intangibles. This is addressed in both the US Internal Revenue Code
(IRC) and in the OECD Guidelines.
The US IRC provides guidance on the ownership of marketing intangibles in the so called
“cheese examples.”
•
83
FP, a foreign producer of cheese, markets the cheese in countries other than the
United States under the trade name Fromage Frere. FP owns all the worldwide
rights to this name. The name is widely known and is valuable outside the United
States but is not known within the United States. In 1995, FP decides to enter the
Source: Internal Revenue Service, IRC Section 1.482-4(f)(3)(i)(A)
84
Source: OECD Centre for Tax Policy and Administration, Revision of the Special Considerations for Intangibles
in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions, Discussion Draft, June 2012
150
United States market and incorporates U.S. subsidiary, US Sub, to be its U.S.
distributor and to supervise the advertising and other marketing efforts that will be
required to develop the name Fromage Frere in the United States. US Sub incurs
expenses that are not reimbursed by FP for developing the U.S. market for the
cheese. These expenses are comparable to the levels of expense incurred by
independent distributors in the U.S. cheese industry when introducing a product in
the U.S. market under a brand name owned by a foreign manufacturer. Since US Sub
would have been expected to incur these expenses if it were unrelated to FP, no
allocation to US Sub is made with respect to the market development activities
performed by US Sub.
•
The facts are the same as above, except that the expenses incurred by US Sub are
significantly larger than the expenses incurred by independent distributors under
similar circumstances. FP does not reimburse US Sub for its expenses. The tax
inspector concludes based on this evidence that an unrelated party dealing at arm's
length under similar circumstances would not have engaged in the same level of
activity relating to the development of FP's marketing intangibles. The expenditures
in excess of the level incurred by the independent distributors therefore are
considered to be a service provided to FP that adds to the value of FP's trademark
for Fromage Frere. Accordingly, the district director makes an allocation under
section 482 for the fair market value of the services that US Sub is considered to
have performed for FP.
•
The facts are the same as above, except that FP and US Sub conclude a long term
agreement under which US Sub receives the exclusive right to distribute cheese in
the United States under FP's trademark. US Sub purchases cheese from FP at an
arm's length price. Since US Sub is the owner of the trademark under paragraph
(f)(3)(ii)(A) of this section, and its conduct is consistent with that status, its activities
related to the development of the trademark are not considered to be a service
performed for the benefit of FP, and no allocation is made with respect to such
activities.
The OECD also makes reference to similar situations as those summarized in the USA
examples above. The following guidance is provided:
•
For example, if the distributor acts as an agent, it will earn a routine return for its
marketing activities only.
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•
If instead the distributor is entitled to obtain long term benefits from the intangible
through sole distribution rights then it is entitled to a return from its economic
ownership of those intangible assets
•
In practice it can be extremely difficult to determine which marketing expenditure
has contributed to the development of the intangible and over what time period.
7.12.5 Centralized vs. Distributed Ownership
Centralized ownership has the following key attributes:
•
A single company in the group owns the intangibles, both economically and legally;
•
License agreements with other group entities (arm´s length price to be determined)
are in place; and
•
Can create opportunities for tax planning.
Distributed or joined ownership has the following key attributes:
•
A number of group companies (operating companies) share ownership of intangibles
on a pre-determined basis (e.g. geographic territory or product application);
•
Always involves some form of shared economic ownership;
•
Usually takes the form of CCA; and
•
Less likely to be tax driven.
7.13 Conclusion
As can be seen from this lesson, the treatment of intangibles for corporate income tax
purposes varies from country to country. Each country has its own way of taxing intangibles
and providing tax incentives for the development of intangibles within their respective
jurisdictions. This lesson only provides an overview of how intangibles are taxed across
many countries, and we hope the information provided leaves you with a good basic
understanding of the aspects of corporate income tax relating to intellectual property.
7.14 Questions
1. Which section of the United States tax code lists certain intangibles that should be
accounted for on a tax return?
A. Section 197
B. Section 482
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C. Section 3
D. Section 201
2. What is a type of consumption tax that is placed on a product whenever value is
added at a stage of production and at final sale?
A. CCA
B. PPA
C. VAT
D. CAT
3. When is a capital gains tax triggered?
A. when assets increase in value
B. when assets decrease in value
C. when assets are sold
D. when assets are kept secret
4. In a centralized ownership system, a number of group companies share ownership of
intangibles on a pre-determined basis. True or False?
A. True
B. False
7.15 Answers
1.
2.
3.
4.
A
C
C
B
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