According to OECD model for tax convention, intangibles are intended to address things that are not physical assets or financial assets; but which are capable of being owned or controlled for use in commercial activities. In addition, the use or transfer of these intangible assets would be compensated had it occurred in a transaction between independent parties in comparable circumstances.
Intangibles therefore affect nearly every aspect of economic activity in the twenty-first century and has become a major source of sustainable competitive advantage for many firms. The importance of intangibles in the economy has been growing for decades in a number of sectors. For instance, the information and communication technology (ICT) revolution has made some technologies cheaper and more powerful; hence enabling the improvement of business processes, and boosting innovation across virtually all sectors of the economy. This technological evolution has made intangibles increasingly important profit drivers in many individual businesses. It is therefore necessary to give careful consideration to intangibles when conducting a transfer pricing analysis.
Transfer pricing issues can arise in a number of different ways when MNEs develop, acquire, exploit or transfer intangibles.
Therefore, in carrying out a transfer pricing analysis involving intangibles it is necessary to consider the following:
- The identification of the specific intangibles involved: the identification of intangibles is often a crucial part of the functional analysis and will commonly be important in determining the most appropriate transfer pricing method. It should be noted however that a common distinction should be made between legally registered (Intellectual Property such patents and trademarks) and unregistered intangibles (Copyrights or legal rights).
In considering transfer pricing matters, certain intangibles may be categorized as below:
- Trade intangibles: may be created through testing and research and development (R&D) activities. The developer may try to recover the expenditures on these activities and obtain a return thereon through manufacturing and selling products, service contracts, or licensing out.
- Marketing intangibles: may be created by marketing activities, can aid in the commercial exploitation of a product or service, and/or may have an important promotional value for the product concerned. Depending on the facts and circumstances of the case, marketing intangibles may include trademarks, trade names, customer lists and customer relationships as well as proprietary market and customer data that is deployed in marketing activities and in selling goods or services to customers.
It is also important to note there are items which are not intangibles, as defined by the OECD, which include:
- Market features: such as low prevailing labour costs, purchasing power of households, favourable weather conditions or proximity to markets
- Group synergies: such as streamlined management, purchasing power or integrated systems
- Workforce in place: a team of highly skilled and experience employees (referred to as “assembled workforce”)
Whilst these items are not intangibles, they may however be important factors in conducting a comparability analysis. It should however be noted that:
- Not all legal protections over, for example, a product or a brand or trademark create a valuable intangible. Value is created only if the intangible creates or enhances profit for whoever uses it. An independent party would not be expected to pay for the use of an intangible which does not have the effect of creating or enhancing its profit.
- Not all intangibles are created by legal protection. Legal protection often formalises ownership or control but an intangible does not necessarily need legal protection in order to be controlled.
- An intangible is valuable only if it is unique and competitors are not able to use it or replicate it.
- The legal ownership of intangibles within the MNE: While legal rights associated with an intangible provide a starting point for the analysis, it is not the single determining factor in establishing who has the right to the returns generated by a valuable intangible.
Legal ownership may be found in registrations, contracts or other communications between the parties, which may establish the legal owner of the intangible and describe the roles, responsibilities, and rights associated with parties to the transaction involving the intangible.
Contractual payment terms (for example, licensing terms) may establish how receipts and expenses of the MNE are allocated. These contractual terms may indicate, for example, the party or parties entitled to unanticipated gains or losses from the exploitation of the intangible.
- The contribution of the various entities in the Development, Acquisition, Enhancement, Maintenance, Protection and Exploitation of the intangible (sometimes called the ‘DAEMPE’ functions)
- Where the risks associated with the intangible are borne and managed
- The arrangements for funding the creation of the intangible, or any enhancements.
It should also be noted that the transfer pricing principles applied in analyses involving intangibles are the same as those applied in other transfer pricing analyses. This means that:
- The transfer pricing analysis must apply to the substance of transactions rather than their form
- Risk should be allocated to where in practice it is managed and controlled. This means that the allocation of returns to an intangible will need to take into account the location of people who take key decisions associated with the acquisition, development, management and enhancement of that intangible
- These analyses should inform the selection of the most appropriate method. For instance, when using the following methods:
- Comparable Uncontrolled Price Method: this method holds water if comparable data in relation to transfer or rights of use of intangibles is available and therefore used to determine the arm’s length principle (ALP). Where information regarding reliable comparable uncontrolled transactions cannot be identified, the arm’s length principle requires use of another method to determine the price that uncontrolled parties would have agreed under comparable circumstances.
- Other one-sided methods such as the Resale Price Method and the Transaction Net Margin Method (TNMM), are generally not reliable methods for directly valuing intangibles.
- Profit split methods may be utilized to determine an arm’s length allocation of profits for the sale of goods or the provision of services, where both parties to the transaction make unique and valuable contributions to the transaction.
According to OECD, in situations where reliable comparable uncontrolled transactions for a transfer of one or more intangibles cannot be identified, it may also be possible to use valuation techniques to estimate the arm’s length price for intangibles transferred between associated enterprises.
Author: Edwin Opiyo