Intellectual Property (5th Edition)

Transcription

1 Tax Reference Library No 32 Intellectual Property (5th Edition) Published in association with: Baker & McKenzie Ballentine Barbera Ernst & Young NERA Economic Consulting

2 How transfer pricing can create value By Pim Fris and Jean-Sébastien Lénik of NERA Economic Consulting In a global economy where companies compete for funds to fuel growth, value creation drives the heart of company strategy. Value creation is achieved when positive economic return on investment is generated for capital investors. A value-creating business is able to attract the capital contributions it needs to achieve sustainable growth. A value-destroying business will disappear due to lack of capital funding. So value creation ensures a firm s survival. Value creation can be achieved in different ways. Mergers and acquisitions are one option available to capital investors and managers. This option is particularly attractive in market structures where market shares are dispersed among many players and where large economics of scale are potentially available. This dispersion provides opportunities for complementary and successful business combinations. The pharmaceutical industry, where the largest player owns less than 10% of the total worldwide market share, provides an example of ongoing consolidation that creates value. Notable deals in 2006 include the purchase by Merck of Switzerland s Serono for 10.6 billion ($14 billion), the acquisition by the Danish niche player Nycomed of Altana s drug unit for 4.5 billion, Bayer s acquisition of Schering for 16.5 billion, UCB s acquisition of Schwarz Pharma for 4.4 billion, and more recently Abbott s acquisition of Kos Pharmaceuticals for $3.7 billion. At first glance, value creation might seem related more closely to purely financial and strategic concerns than to a concern that agitates the domain of transfer pricing. How does transfer pricing contribute to value creation? A closer look at the value creation paradigm in light of transfer-pricing concerns sheds light on the strong connections that exist between value creation and transfer pricing. Transfer pricing directly contributes to value creation in making sustainable tax savings achievable: the transfer-pricing planning paradigm. In the highly competitive environment that characterizes the global economy, the tax charge often represents one of the biggest profit-and-loss expenditures for multinational enterprises (MNEs), larger than research and development, and marketing expenses. Studies on MNEs effective tax rates (ETR) show big ETR differences across multinational groups that compete in the same industry, in the same markets and facing the same operational challenges. What makes one MNE facing similar operational constraints and challenges more tax-efficient than another? ETR differences can be explained by different factors that can be categorized as one-time effect factors and long-run effect factors. One-time effect factors on ETR usually have little to do with transfer pricing and pertain to the tax treatment of exceptional situations or events. These effects are dif- 21

3 Biography Pim Fris NERA Economic Consulting Tel: (Brussels) (Paris) Fax: (Brussels) (Paris) pim.fris@nera.com Pim Fris is a special consultant in NERA s global transfer-pricing practice. He established and leads the firm's European transfer-pricing services, and operates from Paris and Brussels. Previously, he was a leader of Ernst & Young's (E&Y s) global transfer-pricing practice. He is one of the most experienced and recognized transfer-pricing experts in Europe. Fris retired from E&Y at the end of 2002, after having been a partner in the tax practice for 23 years. He established E&Y s transfer-pricing practice in Amsterdam, which grew to be the largest dedicated transfer-pricing practice in continental Europe. He was also the leader of the firm s European transfer-pricing network and a member of the global leadership team. His responsibilities covered handling transfer-pricing controversies, as well as the design, implementation, and documentation of transfer-pricing policies. He has worked across most commercial and industrial sectors, including the automotive, pharmaceutical, retail, and consumer products industries. After obtaining his degree in 1972, Fris worked for the Netherlands Ministry of Finance, where he served as a tax inspector. He joined Moret Gudde Brinkman International in 1976 to establish their Paris office. From 1980, he was responsible for building a tax consulting practice based in Amsterdam, which specialized in serving multinational corporations operating in Europe. Fris is a frequent lecturer and has published extensively in the area of transfer pricing tax and economics. His publications include Transfer Pricing a Manifesto for Europe, Dealing with arm s-length Comparability in the Years 2000, How Analysis Can Define the Nature, Use and Pricing of Intangibles in publications such as Transfer Pricing Review and International Transfer Pricing Journal. Fris completed his degree in economics at Groningen University in the Netherlands, where he specialised in tax and transfer pricing for multinational enterprises. ficult to anticipate because of the exceptional nature of operations to which they are connected. On the contrary, long-run effect factors, which are related essentially to transfer pricing, play a role in the geographic location of profits and the corresponding taxation profile of multinational groups. Positive long-run effects on the ETR are the result of the design and implementation of efficient transfer-pricing structures. This means that a potentially large part of successful ETR management is dependent on transfer pricing: an issue that relates to tax in its outcome and its compliance aspects, but that fundamentally builds on insights from business and economics for designing sustainable solutions. How much does ETR/transfer pricing contribute to value creation? Adjusted for one-time effects, ETR differences are in some sectors up to twice the average R&D intensity ratio of the sector (Diagram 1 on page??). This means that the best performers in these sectors have potentially up to four times additional R&D and marketing investment capacity than their competitors. Additional investment capacity might result in the opportunity for a multinational group to fund the next generation of products and services, constituting the intangible property that might represent tomorrow s competitive advantage in the marketplace, a source of immense value. So, due to its impact on the sustainable ETR, transfer pricing has an impact on value creation in providing MNEs with additional investment capacity. Transfer pricing contributes to value creation by avoiding value destruction that would result from transfer-pricing exposures: the transfer-pricing risk management paradigm. Globalization has amplified competition between tax authorities. Over the past few years, tax authorities have intensified their transfer-pricing enforcement and audit activity to fight for a larger share of the worldwide taxable profit generated by MNEs, resulting in transfer-pricing reassessments. The focus has been first on the US and, most visibly, on the pharmaceutical industry, but tax administrations around the world are now targeting other industries, resulting in similarly large transfer-pricing reassessments. Transfer-pricing exposure has become a big financial risk for MNEs, representing in some cases up to few percentage points of their market capitalization. If not appropriately managed, the negative cash impact of transfer-pricing assessments can be as financially damaging for value creation as many other operational risks. The pharmaceutical industry is illustrative in this respect. Major operation risk for the ethical pharmaceutical industry arises when blockbuster drugs become generic and open to competition. In addition to a product going off-patent at the end of its natural patent life cycle (natural-entry in generic competition), the risk of top-selling product patents being successfully challenged by generic companies before their natural patent expiration also intensifies early-entry by generic competition. Early-entry by generic competition can represent an unexpected evaporation of several years of profits for a particular blockbuster. Realization of this risk results in substantial negative cash impacts for pharmaceutical companies, in the loss of future profits. 22

4 Similar to the operational risk of early-entry in generic competition, the negative cash impacts resulting from recent transfer-pricing reassessments in the pharmaceutical industry have reached levels that represent several years of top-selling drugs consolidated sales, and many more years of profits. During 2006 for example, GlaxoSmithKline settled its US transfer-pricing dispute with the IRS for $3.4 billion. A month later, according to Merck Frosst s SEC filing, the Canada Revenue Agency issued the company a notice on October for $1.76 billion in back taxes and interest related to transfer-pricing issues. So transfer pricing contributes to value creation through its effect on the group effective tax rate and its potential positive contribution to risk management. The challenge for multinational groups is to ensure that their transfer-pricing structures are constantly delivering the optimal planning and risk management features to maximize value creation. The role of economic and value chain analyses Maximization of value creation through transfer pricing is achieved at each point of the tax-efficiency equation (the planning paradigm) when a transfer-pricing structure matches the lowest point on the scale of the transfer-pricing risk (the risk management paradigm). Every company has its own definition of planning and risk management objectives. The definition of these variables lies with management. Whatever planning/risk objectives are defined by MNE management, the interaction between tax knowledge and economic expertise always follow the same pattern: tax knowledge and sophistication creates the tax saving opportunity, while economic expertise enables it to be realized in a sustainable way that maximizes value creation. Economic analysis makes sustainable tax savings achievable in providing taxpayers with a defensible case, consistent with the internationally accepted arm s-length paradigm, to support the arm s-length nature of their intercompany dealings. What does maximizing value creation through insightful transfer pricing analysis mean in today s transfer-pricing environment? Transfer pricing today is characterized by increasing audit pressure and sophistication from tax administrations. The nature of audit challenges developed by taxing authorities has strengthened over recent years. This process was accompanied by the issuance of new transfer-pricing regulations requesting arm s-length practices and imposing related documentation, by one country after another. In the late 1990s, the typical transfer-pricing audit in most of those countries was a compliance checking exercise. Tax auditors focused on checking the consistency of taxpayer documentation with the overall functional profile of the company subject to audit. Documentation reports were considered acceptable when they contained a static description of the Biography Jean-Sébastien Lénik Principal NERA Economic Consulting 28 av Victor Hugo Paris Cedex 16 France Tel: jean.sebastien.lenik@nera.com Jean-Sébastien Lénik is a principal at NERA, specializing in economic analysis applied to transfer pricing. He specializes in transfer-pricing engagements focusing on complex transactions involving intellectual property, notably in the context of postmerger integration. He has managed many transfer-pricing engagements focusing on complex economic and business issues such as dealing with life cycle pricing of ethical drugs, the development of blueprints for a revised global transfer-pricing policy in the context of a global business review, and the design of transfer-pricing structures in the context of intangible property rationalization. Before joining NERA, Lénik worked in the global transfer-pricing practice of one of the Big Four firms. He also worked for a leading pharmaceutical group, where he was in charge of the inter-company pricing of intangible properties. Lénik holds a master s degree from McGill University (Canada) and a certificate in finance from the INSEAD executive education programme (France). He is a lecturer in transfer pricing at Paris Dauphine University (France). functions performed, assets used, and risks borne by the company under audit as well as a benchmark exercise supporting the corresponding level of profits generated by the taxpayer. Recently, tax authorities have focused more and more on an objective to capture a share of the MNEs consolidated profit that pertains to valuable intangibles developed by the taxpayer subject to audit. Today s discussions with tax administrations focus on how the taxpayer under audit has contributed potentially to the development of intangible properties that have taken shape in the more comprehensive environment of the multinational group s value chain. These new audit approaches trigger new types of transferpricing reassessments based on profit-split methodologies and can result in an increase in the magnitude of transfer-pricing reassessments. The corresponding escalation of economic double taxation has turned competent authority and arbitration procedures more and more into a necessity for taxpayers. Ironically, the bilateral context in which the discussions between domestic tax administrations take place has itself encouraged the use of profit-split approaches to assess the level of intercompany pricing. 23

5 Diagram 1: Effective tax rate and R&D intensity ETR differences generated by efficient transfer pricing structures (ETR adjusted for one-time effect factors) What does today s transfer-pricing environment mean for the taxpayer that is concerned with the design and implementation of tax-efficient arm s-length transfer-pricing structures? Two clear precepts can be articulated to help taxpayers find their way in today s transfer-pricing environment and to understand how economic and value chain analyses apply to transfer pricing. First, the time when transfer pricing could be addressed through a static analysis of functions performed, assets used, and risks borne by the taxpayer has been superseded. Traditional compliance approaches developed in the 1990s are no longer appropriate in a world where the focus of domestic tax authorities is to tax in their respective countries a share of the consolidated profit that pertains to a group s valuable intangible properties. Second, and as a consequence of the first precept, to be successful in defending their transfer-pricing structures before tax authorities in today s transfer-pricing environment, taxpayers have to be prepared to explain the contribution of the company/group entity subject to tax audit from the more comprehensive perspective of the group value chain: to confirm that the company under audit is appropriately compensated in generating routine returns; and/or to support the fact that the company under audit is appropriately compensated in capturing part of the return attributable to the group s economically valuable intangible property. What does the value chain concept mean in transfer pricing? The concept of the value chain itself and how it can be used as the fundamental tool in diagnosing the MNE s main value drivers has been extensively analyzed in business literature. The value chain analysis serves to define the industry structure in which the firm operates, to disaggregate the firm into the activities that underlie competitive advantage, and to identify the linkages among activities. These concerns are as central to x2 x2 transfer-pricing analysis as they are strategic business analysis. R&D Transfer-pricing analysis Intensity requires taking an additional step, however, to ascertain the arm s-length pricing of a particular transaction. What independent parties derive from similar Additional transactions in highly integrated investment relationships reflects what each capabilities of them contributes and the success of their combined activities. The value chain concept used in the context of financial and business analyses disaggregates activities at the consolidated group level. The objective of transferpricing analysis is to determine the consequences of disaggregating the firm activities at the level of the legal entities, the combination of which form the multinational group. As a result, understanding the MNE group entities risk profiles in relation to functions/assets they perform/use is necessary to complete a value-chain analysis in the transfer-pricing context. Understanding the value chain of the MNE group to draw transfer-pricing conclusions requires understanding three main factors that characterize economic analysis applied to transfer pricing: understanding the industry structure in which the group operates; understanding the value chain and value drivers at the group level; understanding the MNE group companies risk profile in relation to functions/assets they perform/use, that is, their responsibility profile. Diagram 2 on the next page provides a conceptual overview of economic analysis applied to transfer pricing. How each step of the value chain analysis contributes to the determination of the arm s-length level of intercompany pricing is a complex process specific to each industry, multinational group, and taxpayer. Among the factors that play a role in the identification of value drivers/functions in the group value chain, however, economic analysis focuses on the classic strategic considerations of the bargaining power of buyers and suppliers, the degree of integration (vertical or horizontal) of businesses within the industry, the identification of specific barriers to entry (such as capital intensity and patented products), and the impact of scale on taxpayers operations. In this respect, regression analyses can be enlightening in providing some quantitative evidence of direct relationships between the economic variables driving value in a particular sector. Regression analysis applied to transfer pricing can be used to: 24

6 Diagram 2:Economic analysis and transfer pricing Systemic factors Non-systemic factors R&D Manufacturing Marketing Distribution A B C D Arm s length pricing between A, B, C, D Level at which economic analysis is performed Group Industry Inter-company Objectives of economic analysis applied to transfer pricing Understanding industry structure Understanding value chain and key value drivers (competitive advantage) Understanding group companies risk profile in relation to functions/ assets they perform/use understand competitive behaviour in a particular industry in ascertaining what drives value in that industry; clarify the contribution and significance of each particular factor in the value (such as R&D and marketing). Diagram 3 provides an example of how regression analysis can be used to explain competitive behaviour in the pharmaceutical industry. (Regression analysis is based on the analysis of 10-year financial information of global pharmaceutical companies ( ) provided by the UK Department of Trade and Industry at The indicated downward-sloping relationship between scale (measured by the logarithm of sales on the horizontal axis) and R&D intensity (on the vertical axis) helps to explain the ongoing consolidation in the pharmaceutical industry. The regression analysis shows how size plays a role in value creation when it comes to R&D expenses in the pharmaceutical industry. Size allows pharmaceutical groups to generate positive economies of scale and scope. Regression analysis establishes the value of scale in R&D in the pharmaceutical business. This type of analysis can be used in the framework of transfer-pricing studies to align transfer-pricing structures with the principles governing the group value chain and to deliver the optimal transfer pricing planning/risk management ratio that maximizes value creation. New approaches needed Transfer pricing contributes to value creation through its effect on the group effective tax rate and its contribution to risk management. Diagram 3: The value of scale in R&D R&D Intensity Sales 25

7 The challenge for multinational groups is to ensure that their transfer-pricing structures are delivering the optimal planning/risk management trade-off that maximizes value creation. In today s transfer-pricing environment, maximizing value creation through transfer pricing requires that taxpayers develop new approaches to achieve successfully both their planning and their risk management objectives. The root origins of these new approaches can be found in economic analysis applied to the more comprehensive context of the group value chain. 26

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