Transfer Pricing in a Post -BEPS World

Transcription

1 Transfer Pricing in a Post -BEPS World Intangibles Perspective Ajit Kumar Jain

2 About the Author Ajit is a Chartered Accountant and Company Secretary. He has done his graduation from Jai Narayan Vyas University, Jodhpur. He is also awarded certificates in International Taxation and Transfer Pricing by the Chartered Institute of Taxation, UK. Contact Details Address: 101 Sai Mahal CHS, Nadiyaadwala Colony Road No.2, S.V. Road, Malad (West) Mumbai Phone : Mobile: cajainajit@gmail.com Page 2

3 Disclaimer: The views expressed in this document are not intended to be used as professional advice and also, represent only the personal views of the author. Table of Contents List of abbreviations 4 1. Introduction OECD s Pre-BEPS Guidance New Guidance on intangibles Indian Perspective Alternative to the Arm s Length Principle Case Study Conclusion 31 Page 3

4 List of abbreviations AE ALP APA BEPS CRO CUP DEMPE EU FAR MNE OECD PSM R&D RPM TNMM Associated Enterprise Arm s Length Price Advance Pricing Agreement Base Erosion and Profit Shifting Contract Research Organization Comparable Uncontrolled Price Development Enhancement, Maintenance, Protection and Exploitation European Union Functions Assets and Risk Multinational Enterprise Organization of Economic Corporation and Development Profit Split Method Research & Development Resale Price Method Transactional Net Margin Method Page 4

5 1. Introduction In the past two decades, with the development of information technologies and efficient communication system, the countries across the globe became interdependent. As a consequence, the multinational enterprises established integrated supply chain models. This has led to increase in the cross-border transactions between affiliate entities located in different jurisdictions. Such transactions give opportunity to the multinational enterprises to shift profits from one jurisdiction to another jurisdiction, since profit shifting may be favorable for the entity located in the high tax jurisdiction. Such profit shifting can be achieved by manipulating transfer prices on intra-group transactions, strategically concentrating intangible assets (and associated income) in low-tax countries, concentrating internal & external debt in high-tax countries. Any shifting of profit leads to loss of tax revenue to the country from where profit is shifted. Tax authorities across the globe are very much concerned regarding tax avoidance and tax evasion. As per the OECD, the net tax revenue lost from tax planning is estimated at 4% to 10% of global corporate tax revenue. The OECD and G20 countries acknowledged this issue and agreed to find out a unanimous resolution for the same. With the involvement of more than 60 countries, the OECD published its final report on BEPS. In the final report, fifteen action points have been developed, each action point has its own specific subject. Some of the action points that are presented by the OECD are applied immediately, such as the changes in the Transfer Pricing Guidelines. While some other actions need to be implemented in treaties, such as for example the multilateral instruments. The OECD and G20 have agreed on cooperating on the BEPS project until at least 2020, to make sure that efficient monitoring upon the agreed measures can be done. In last two decade, transfer pricing has gained a lot of importance and many countries introduced transfer pricing regulations to avoid shifting of profits and to safeguard the tax base or tax revenue. For transfer pricing, four specific action points in the OECD s BEPS report are of importance. Action point 8 will provide renewed guidance for transfer pricing of intangibles. Action 9 will explain the arm s length principle in a post-beps world. The third relevant action point, namely action point 10, explains how low-value-adding transactions should be priced. Lastly, in action point 13 renewed guidance for transfer pricing documentation has been provided in order to improve the transparency. 1.1 Motivation for research In last one decade, there have been significant changes in the way MNEs conducting their businesses. Intangibles played a key role in the overall value chain of business operations. Physical assets became less important as compared to intangible assets One cannot imagine globalization without intangibles. There is no doubt that brand, R&D, IT system, employees and management skills are crucial to any company s success. Page 5

6 In the world of transfer pricing, intangibles is a complex area. A lot has been discussed and debated over the definition of intangibles, identification of intangibles and the arm s length nature of intangibles. Amongst the transfer pricing transactions of MNE Groups, transactions related intangibles are the most significant and susceptible to dispute with tax authorities. In the post BEPS world, there would be a change in the way we apply the arm s length principle to related party transactions. I believe, in the post BEPS world, intangibles would be the heart of the transfer pricing analysis. Therefore, my interest arose to write a paper on Transfer Pricing in a post BEPS world Intangibles perspective. 1.2 Research area The research matter for this thesis will be: Analyzing the guidance issued by the OECD under action plant 8 to 10 in relation to intangibles and discussing the practical implication of the same. Whether BEPS guidance addresses the issues faced by taxpayers in relation to intangibles. Is there any alternative to arm s length principle Page 6

7 2. OECD s Pre-BEPS Guidance In the last two decades, the global business scenario has changed significantly. The OECD has made significant efforts time to time in evaluating arm s length principle. Based on the pre- BEPS guidance and local transfer pricing laws, taxpayers and tax authorities have spent a considerable amount of time in reviewing contracts and debating over functions, assets and risk for justifying the transfer prices. However, a lot has been debated whether the pre-beps OECD guidance was helping MNEs and tax authorities to find out most appropriate arm s length price of the related party transactions and whether the substance of the transaction has been considered while the performing comparability analysis. However, it has been realized globally by countries and OECD that pre-beps guidance lacks clarity in relation to conduct vis-à-vis contract while allocating the arm s length return between the related parties. In the pre-beps world, excessive market returns were allocated to affiliates ( entrepreneurs ) who only invested in the capital and did not participate in business related risks. In other words, legal owners of intangibles were entitled to more than normal routine returns irrespective of their contribution in the overall value creation of intangibles. Allocation of return in a pre-beps world E.g. Company A is based in USA and it is the legal owner if the intangibles developed over the period of years. The role of Company A is only to protect the legal ownership of intangibles and make the required investment for the development of intangibles. Company A licenses the use of such intangibles and related technology to Company B based in India. The role of Company B is to conduct further R&D for the development of intangibles, develop a customer market in India for the product and also assumes related risks. Company A reported significant profit on account of legal ownership of intangibles and funding for the development of intangibles. While Company B reported routine returns in relation to R&D and market development of the product irrespective of the significant value creation. Particular Company A Company B Legal owner of intangible - Funding for development of - intangibles and assumes funding related risks Further development and - exploitation of intangibles - R&D - Market development Assumes related risks Allocation of return Whether related party Yes Yes Page 7

8 Particular Company A Company B transactions are arm s length ( pre-beps world) In the aforesaid example, one can clearly see that even if the related party transactions are at arm s length, the allocation of returns are not as per the value created. Most of the returns are allocated to Company A which adds little value in the overall development of intangibles. The fundamental point is that whether countries are getting fair share of revenue on account of crossborder transactions. Eventually, the OECD realized that pre-beps guidance related to arm s length computation is not aligned to the actual conduct of the parties or value creation. Further, the OECD mentioned that legal owner cannot be entitled significant returns of the intangible assets unless significant contribution has been made in creating further value to the said intangibles. Taxation should place where value is created. With the 2015 final BEPS reports, the OECD attempted to address the following key challenges by making significant changes in the arm s length related guidance. - The difficulties in adequately assessing the economic value of intangibles - The fact that intangibles and respective profits can comparatively easily be shifted to low tax jurisdictions This paper examines the OECD s guidance in relation to intangibles and evaluate the practical application of the same. Page 8

9 3. New Guidance on intangibles New guidance on intangibles under Action 8 of the BEPS Action Plan is provided in the OECD/G20 Final Reports. The guidance in the Actions 8-10 Final Reports taken the form of revisions to chapters I, II, VI, VII and VIII of the OECD Guidelines In respect of Action 8, the provisions of the previous version of chapter VI of the OECD Guidelines are deleted in their entirety and replaced by the language of the Intangibles section of the Actions 8-10 Final Reports. The key provisions of the new guidance are discussed as under: 3.1 Meaning of intangibles In the final report of BEPS, first time the OECD has provided a definition of intangibles. Definition of intangibles has been a contentious issue for taxpayer and tax authorities. Economist consider the value driver of market as intangibles. According to them, value driver of the market in which any company trades their product and services, constitute intangibles. Accountants, on the other hand, tend to think that if the intangible is not reflected on the balance sheet, it does not exist and value cannot be attributed to it. The BEPS final report provides a helpful guidance in relation to definition of intangibles. As per the OECD s BEPS report on Aligning Transfer Pricing Outcome with Value Creation, the definitions 1 of intangibles and marketing intangibles as follows: Intangibles 2 Intangible is intended to address something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances. 1 New definitions as compared to the definition provided in the OECD transfer pricing guidelines [2017] 2 Paragraph 6.6 of the OECD s report on BEPS Page 9

10 A flow chart depicting identification of intangibles is as under: Not an intangible (for transfer pricing purposes) No No No A physical assets or financial assets Yes Whether capable of being owned or controlled for use in commercial activities Yes Would a transfer (of the item) be compensated in a transaction between independent parties in comparable circumstances? Yes A relevant intangible (for transfer pricing purposes) With the new definition of intangibles, the OECD s focus has now shifted from a more detailed definition to a more principled-based approach specifically involving the determination of conditions and pricing that would be agreed upon between independent parties for a comparable transaction. Marketing Intangibles 3 An intangible (within the meaning of paragraph 6.6) that relates to marketing activities, aids in the commercial exploitation of a product or service, and/or has an important promotional value for the product concerned. Depending on the context, marketing intangibles may include, for example, trademarks, trade names, customer lists, customer relationships, and proprietary market and customer data that is used or aids in marketing and selling goods or services to customers. The above definition is the new definition of marketing intangibles prescribed by the OECD in its BEPS report. Here, it would be also important to look at the following earlier definition of the marketing intangibles as prescribed in the OECD Transfer Pricing Guidelines. 3 Glossary of the OECD s report on BEPS Page 10

11 An intangible that is concerned with marketing activities, which aids in the commercial exploitation of a product or service and/or has an important promotional value for the product concerned The new definition has widened the scope of marketing intangibles and it is most likely to give rise to increase in transfer pricing scrutiny of such intangibles since it provides illustrative examples of marketing intangibles such as customer lists, customer relationships, and proprietary market and customer data as marketing intangibles. The illustrations are critical for MNE groups operating in developing markets since these markets have very large consumer bases that may give rise to significant amounts of consumer-related data, which may be treated by the tax authorities as marketing intangibles. Thus, marketing intangibles may include any kind of intellectual property which indicates the origin of the product or service, promotes the marketing, sale or advertising, and adds value to the business itself. Marketing intangibles are a result of extensive marketing campaigns and efforts made to promote and sell products or services. As per the OECD s BEPS related guidance, certain items are not considers as intangibles for transfer pricing purposes. The discussion in relation to those items are as under: Item Goodwill and going concern value 4 OECD s Report Goodwill and going concern value should be attributed to intangibles to which they relate i.e. value driver in the particular market under consideration. Goodwill and going concern are not individually identified and separately recognised. Group Synergies 5 Goodwill and going concern value, if they exist, cannot be transferred separately from the intangibles to which they relate. Accordingly, it is very crucial that goodwill and going concern should be appropriately considered while conducting valuation of intangibles to which such goodwill and going concern relate. The group synergies that can be attributed to 4 Para 6.27 to Para 6.29 of the OECD TP Guidelines 2017 Page 11

12 Item Specific market conditions 6 OECD s Report deliberate concerted group actions should generally be shared between the members of the group in proportion to their contribution to the creation of the synergy. Just because any entity is based in low cost market, it is not to be considered as a separate intangibles. Any market specific circumstances should be captured in the analysis of arm s length compensation. Company Name 7 No payment for a company name is appropriate when it merely shows that the legal entity is a member of the MNE group. Where the name provides a financial benefit, however, a payment for use of the name may be appropriate. Whether a payment is needed is, essentially, related to the amount of financial benefit that the user of the name receives through use of the name. 3.2 Key characteristics of intangibles With regard to comparability of intangibles or rights in intangibles, the specific features listed in the guidance and to be taken into consideration are: - Exclusivity; - Extent and duration of legal protection; - Geographic scope; - Useful life; - Stage of development; - Rights to enhancements, revisions, and updates; and - Expectation of future benefit Further, below is the summary of the OECD s guidance in relation to definition of intangibles: Intangibles must not be a tangible asset or financial asset ; Intangibles must be capable of being used in commercial activities 5 Para 6.30 of the OECD TP Guidelines Para 6.31 of the OECD TP Guidelines Para 6.81 to 6.84 of the OECD TP Guidelines 2017 Page 12

13 Intangibles use or transfer would be compensated in transactions between independent parties Intangibles do not have to be legally protected to be valuable ; Intangibles need not to be separately transferred Intangibles do not have to be recorded in company s balance sheet for considering as intangibles Value drivers of market can be considered as intangibles regardless of whether they are legally protected or recorded in balance sheet. The identification of an item as an intangible is separate and distinct from the process for determining the price for the use or transfer of the item under the facts and circumstances of a given case In certain instances these Guidelines refer to unique and valuable intangibles. Unique and valuable intangibles are those intangibles (i) that are not comparable to intangibles used by or available to parties to potentially comparable transactions, and (ii) whose use in business operations (e.g. manufacturing, provision of services, marketing, sales or administration) is expected to yield greater future economic benefits than would be expected in the absence of the intangible A thorough functional analysis, including an analysis of the importance of identified relevant intangibles in the MNE s global business, should support the determination of arm s length conditions Following items are the illustrative list of items considered in transfer pricing analysis - Patents ; - Know-how and trade secretes ; - Know-how and trade secret ; - Customer relationship ; - Rights under government license and concessions ; and - Rights under contract with suppliers and key customers Although the OECD has made significant efforts in introducing a broad definition of intangibles, one need to evaluate the practical difficulties in identifying intangibles. The new guidance mentions that transfer pricing analysis should carefully consider whether an intangible exist and whether an intangibles has been used or transferred. For example, not all research and development expenditure produce or enhance intangibles and not all marketing activities result in enhancement of intangibles. Overall, the OECD attempted to bring an economic definition of intangibles. Such intangibles could be identified through a detailed function, assets and risk analysis. Page 13

14 3.3 Returns on Intangibles After identification of intangibles, evaluating the returns on intangibles is the key and complex exercise. In the pre-beps world, FAR analysis has been given due importance for identification of intangibles and evaluating appropriate returns. As per the OECD s guidance on BEPS, group companies performing important functions, controlling economic significant risks and contributing assets in DEMPE of intangibles shall be entitled to appropriate return in line with value of their contribution. It is very clear that there is no short-cut for computing the returns on intangibles, it is a detailed exercise which require significant efforts to understand entire value chain of group entity from DEMPE perspective. The OECD provided a framework for analysing transactions involving intangibles and can be summarised as follows 8 : Framework for analyzing transaction involving intangibles (i) (ii) Identify the intangibles used or transferred in the transaction with specificity, and the specific, economically significant risks associated with DEMPE functions Identify the full contractual arrangements, with special emphasis on determining legal ownership of intangibles. (iii) identify the parties performing functions, using assets and managing risks related to DEMPE functions by means of a functional analysis (iv) Confirm the consistency between the terms of the relevant contractual arrangements and the conduct of the parties, and determine whether the party assuming economically significant risks controls the risks and has the financial capacity to assume the risks relating to the DEMPE functions. (v) Delineate the actual controlled transactions related to the DEMPE functions in light of the legal ownership of the intangibles (vi) Where possible, determine arm s length prices for these transactions consistent with each party s contributions of functions performed, assets used and risks assumed. 8 Para 6.81 to 6.84 of the OECD TP Guidelines 2017 Page 14

15 3.3.2 FAR analysis from DEMPE perspective In the pre-beps world, emphasizes was also given to a detailed FAR analysis. However, the taxpayers have been conducting FAR analysis from tested party perspective (one side analysis) without giving special importance to DEMPE and value creation. In the post BEPS world, if the conduct of the parties is inconsistent with the contract or there is no written contract or the contract is silent in some respect then the transaction has to be identified by the conduct. This requires examination of the functions performed by the parties to the transaction, taking into account assets employed and risks assumed and managed, including how those functions relate to the wider generation of value by the MNE group to which the parties belong, the circumstances surrounding the transaction, and industry practices. As per the OECD s BEPS guidance, returns on intangibles are allocated to entity that: Perform intangible activities (DEMPE) Manage and control risk associated with performance of intangible activities (Operation Risk) Manage and control financing the intangibles activities and is able to bear the risk associated with financing activities (Finance Risk) The table below identifies companies within the MNE which perform and exercise control over DEMPE; provide the necessary funding and other assets; and bear and control the various risks associated with the intangible. Intangible X Functions Funding Risk Development Enhancement Maintenance Protection Exploitation Perform Control Control Bear DEMPE of intangibles - In the functional analysis from DEMPE perspective it is very important to focus on the critical functions (e.g. formulate overall strategy for productions) and the critical risks (e.g. assuming market risk) which contribute in the overall development of the intangibles. Further, in order to identify the value creation, it is important to conduct two side analysis by conducting functional interviews of both the parties involved in affiliated transaction. Two side analysis of functions and risk will only give true picture regarding economic value Page 15

16 added by the parties. Following are the key functions which have special significance for the purpose of functional analysis while arriving at arm s length compensation: - Design and control of research and marketing programmes - Management and control of budgets - Control over strategic decisions regarding intangible development programmes - Important decisions regarding defence and protection of intangibles - Ongoing quality control over functions performed by associated enterprises that may have a material effect on the value of the intangible In the whole process of DEMPE analysis, entity has to clarify: - Which group entities are performing the DEMPE functions or contributing a part of DEMPE function, - Using the assets related to the DEMPE functions and - Controlling the economically significant risks related to the DEMPE functions. Therefore, MNEs are now required to identify specific activities for each DEMPE function and ascertain the relative importance of each DEMPE function. Such detailed analysis may be required not only involving group entities, which are currently involved in DEMPE activities, but also entities which performed DEMPE activities in the past. Risks Analysis - With regard to risks, the key factor is the control of the risk in determining which legal entity is entitled to the return to risk-bearing. The OECD s report suggests that the entity that controls over risk of DEMPE functions should bear the risk. As per the OECD s report, separate arm s length test of risk allocation is required. Under this test, actual conduct of the parties is decisive. The below table provides details regarding risk allocation: Particular Determining Factor Meaning Basis of risk allocation Control over Risk - Capability to take decision to take loan - Capability to make decision on whether and how to respond the risk Financial Capacity to assume the risk - Capability to mitigate the risk - Take on the risk - Lay off the risk - Pay for the risk mitigation functions and to bear Page 16

17 Particular Determining Factor Meaning the consequences Contractual risk allocation is disregarded if inconsistent with the actual conduct of the parties The fundamental principle coming out from the OECD s guidance is that entity assuming the risk in relation to DEMPE of intangibles must exercise control over the risk and have the financial capacity to assume the risk for getting return on intangibles. In author s view, DEMPE analysis involves analysis of both functions (performance), control over functions, control & assumption over risks of DEMPE. Analysis of functions and risks should go hand in hand with analyzing the DEMPE of intangibles. In author s view, risk cannot be outsourced while functions can be, the entity controlling the risk must assume the risk. E.g. If a parent company (legal owner) also control the operational risk in relation to distribution of product by subsidiary company. Any losses incurred by subsidiary on account of market downturn shall be borne by parent company. However, a detailed FAR analysis should be documented to justify business decision, controlling key decision, assumption of risks etc. for appropriate allocation of losses. Conducts prevails over Contract- once the DEMPE analysis for intangibles is performed, it is important to compare the DEMPE of intangibles ( conduct ) with contractual arrangements. Once the contractual arrangements and the conduct of the party/-ies have been reviewed within the DEMPE analysis context, the MNE has to confirm that there is consistency between legal and economic reality. Delineate the actual controlled transactions related to the DEMPE of intangibles is the key outcome of the analytical framework. In this step, the MNE has, on the basis of the steps performed so far, access to all the key elements to accurately delineate the actual controlled transaction(s) related to the DEMPE of intangibles. The new OECD guidance has moved away from concept of ownership, and has adopted an approach looking at who is contributing to the value of the intangible, i.e. a clear focus on substance for conducting TP analysis of intangibles. The focus is shifted from testing stand-alone entities ( tested parties ) to mapping the relative position of group entities involved in the process of jointly creating value. Page 17

18 3.3.3 Returns on intangibles The Final Report states that legal ownership alone does not entitled to returns on intangibles i.e. entities that fund but do not perform functions (DEMPE of intangibles)relating to the intangibles should be allocated a risk-adjusted return on their funding. Entities that provide funding, but do not control the risks should receive a risk-free return. The final report distinguishes between controlling functions and performing the functions. If the legal owner of the intangibles only controls the functions and actual functions are outsourced, the legal owner shall be entitled for the returns in relation to controlling the functions. If the legal entity does not control or perform the functions related to the intangibles, it is not entitled to the benefit attributable to these outsourced functions. The parties who perform DEMPE functions are entitled for the returns on the relevant contributions (value creation) to the intangibles. Two associated enterprises embark on a joint intangible development project. One party owns the intangible and provides the funding for the development. It performs the functions necessary to control its financing risk. The other party manages the development project, performs all the relevant research activities, controls the development risks, and is responsible for exploiting the intangible once the development is complete. Hence, it performs most, if not all, of the DEMPE functions. Under these circumstances, the largest share of the anticipated returns from exploiting the intangible are allocated to the doing participant, rather than to the owning participant. The key outcome of the OECD s BEPS final report in relation to the returns of intangibles are as under: Contribution Return Details - Entity funding the intangibles - Taking control over risk related to intangibles Risk adjusted return Only Funding of intangibles Risk free return Perform DEME functions related to intangibles Return from exploitation Legal ownership alone does not determine entitlement to returns from the exploitation of intangibles, i.e. entities that fund but do not perform functions relating to the intangibles should be allocated a risk-adjusted return on their funding. Entities that provide funding but do not control the risks should receive a risk free return Return attributable to intangibles based on contribution in DEMPE Page 18

19 Contribution Return Details - Development - Enhancement - Maintenance - Protection; and - Exploitation of intangibles of intangibles functions The new BEPS guidance provides that associated enterprises contributing to the value of the intangibles must be rewarded substantially. Such reward must be aligned with the value addition or contribution made to the intangibles. Based on the above, the report seeks to reverse a perception of pre-beps world that the owner of a key intangible can claim all of the residual profit of the business after rewarding certain low-risk or routine functions. In the whole process of identification of intangibles and evaluating the returns, value chain analysis plays a very important role. In the pre-beps world, we used to refer FAR analysis, however in the post BEPS scenario, analysis of the whole value chain of group is very important to (i) understand DEMPE functions & control, operational risk, financing risks (ii) Identifying intangibles and delineate actual inter-company transactions (iii) To allocate arm s length returns Functions and risk analysis would not determine not only how much profit would be allocated but also amongst whom Two side Analysis One of the key messages of the supplemental guidance is that the transfer pricing analysis must consider the perspectives of each party to a transaction when looking for comparables. In particular, the options realistically available to each of the parties to the transaction should be taken into account before arriving at the appropriate comparable for the relevant transaction. According to the new guidance, a comparability analysis focusing only on one side of a transaction may not provide a sufficient basis for evaluating a transaction involving intangibles, including in those situations for which a one- sided method is ultimately determined. At the same time, the specific business circumstances of one of the parties should not be used to dictate an outcome contrary to the realistically available options of the other party. Page 19

20 Key changes to ALP DEMPE of intangibles Risk allocation Intangible profit allocation New Approach- Example 17 of the revised OECD Guidelines The author refers to example 17 of the OECD Guidelines to explain how the allocation of profits from IP transfers differ between a pre- and post-beps world. In the example, the following facts are assumed: Parent is a large Pharma company and conducts operations in country A. Parent regularly retains independent (unrelated) CRO for R&D activities, including designing and conducting clinical trials. CROs are not engaged in the blue sky research to identify new compounds. When retained, Parent actively participates with CRO engaged in clinical research activities. CROs are paid a negotiated fee for services and do not have an ongoing interest in the profits. Parent transfers patents related to Product to Subsidiary operating in country B. Product is early stage pharmaceutical drug (high risk, low probability of commercialisation). Payment based on anticipated future cash flows expected cash flow discounted by appropriate discount rate. Subsidiary has no technical personnel for ongoing research activities. Subsidiary contracts with Parent to carry out research related to Product. Subsidiary funds all Product research, assumes risk, and pays Parent based on cost plus margins earned by similar CROs. Above is a classic example of an early stage pharma company wanting to realise future profit in a low-tax jurisdiction. In the pre-beps world, a significant portion of the profits would have moved to Country B. Given that subsidiary was legal owner, it was entitled to any excess profit or loss after paying routine returns for the R&D activities even when the subsidiary is not playing role for DEMPE of intangibles and control over intangibles. In the per-beps world, parent was entitled to cost plus margin for the R&D services. While Subsidiary legally owns the patents it lacks the capability to control research risks while Parent performs key decision making functions and thus should be appropriately compensated. Page 20

21 In the post-beps world, less emphasis given to legal ownership and more on economic aspect of substance. In the example above, the parent controls functions and manages patent risks owned by Subsidiary and is entitled to a healthy compensation. The Amended OECD s Guidelines, including the analysis to example 17, will support that Parent's compensation is not appropriately recognised by the profits earned by a CRO. Parent's transactions with CROs are not comparable to the Subsidiary/Parent arrangement given that the functional profiles differ, i.e. parent is in control of function and is the more appropriate party to assume the risks of success or failure. Clearly there has been a fundamental shift in the way we look at the division of profits due to the introduction of BEPS. In a pre- BEPS environment, Subsidiary would be better able to keep profits given it legally owned the intangibles and paid arm's length prices for development functions. Post-BEPS, it is clear this will change with an emphasis on functions, including control of those functions and risks. A summary of the new guidance in dealing with intangibles is as under: Legal ownership of intangibles alone does not determine entitlement to returns from the exploitation of intangibles; Associated enterprises performing important value-creating functions related to the DEMPE can expect appropriate remuneration; An associated enterprise assuming risk in relation to the DEMPE of the intangibles must exercise control over the risks and have the financial capacity to assume the risks An associated enterprise providing funding and assuming the related financial risks, but not performing any functions relating to the intangible, could generally only expect a risk adjusted return on its funding; and If the associated enterprise providing funding does not exercise control over the financial risks associated with the funding, then it is entitled to no more than a risk-free return Debatable issues There are certain points in the OECD s guidance on which more clarity is required from a practical implication perspective. These are discussed as under: Particular Value creation Debatable Issues The fundamental principle of the revised OECD guidance is that the transfer pricing outcome should be aligned to the value creation. However the value creation is not defined by the OECD. In the pre-beps scenario, the arm s length price of the related party Page 21

22 Particular Debatable Issues transactions were computed without evaluating DEMPE and value creation. As per the new guidance, the value creation will be performance of functions (DEMPE) and controlling the functions. However, from an arm s length perspective and also from the perspective of economics, it is not clear that why capital contribution and assuming related risks not considered as a value creation. In the Post BEPS scenario, it would be important to see changes in the margin of the taxpayer after allocating returns based on DEMPE and control of risk (based on value creation) and whether it will have any impact on the overall arm s length results vis-à-vis the arm s length results in pre-beps scenario. Pursuant to the intention of the new OECD s guidance, the author believes in conducting a detailed value chain analysis of a MNE for identifying the intangibles and finding out actual value creation of the group entities in inter-company dealings. However, value chain analysis is not discussed by OECD. DEMPE Risk OECD has not discussed DEMPE in detail. Further, if part of DEMPE function performed by one entity and part of DEMPE function is performed by another entity of same group, whether PSM would be appropriate for allocation of return. It is not clarified in the OECD report. Further, as per the OECD guidance, if a legal owner outsource the DEMPE functions to another entity of the group, legal owner shall be compensated for controlling the functions and the entity performing the outsourced functions shall be entitled to the return on overall value creation. However, it is not clarified to what extent a legal owner can outsource. The arm s length principle refers to commercial and financial relationships between entities within a group. Such relations must be assessed through a detailed value chain analysis, which comprises of functions (including people) as well as risks and assets. OECD s BEPS related guidance recommends to review risk allocation from a purely controlling perspective, ignoring the fact that an arm s Page 22

23 Particular Debatable Issues length negotiation between entities would take into account their bargaining positions that are being extensively influenced by their history, their legal rights, and the intangibles they have built over time. Article 9 of OECD Model Convention As per the OECD guidance, risk bearing entities have a superior claim to residual profit vis-à-vis the entities which is funding the capital. As per the new guidance, investor should earn only risk adjusted return if it has not contributed in the overall development of intangible through DEMPE. But in an independent economy, investor gets maximum returns irrespective of his contribution whether he is skilled investor or not. As per the article 9 of the OECD Model Tax Convention on Income and Capital, the arm s length principle is a bilateral concept and is aimed at the appropriate allocation of profits between source and residence countries. By its nature, it is not anti-avoidance rule. It is not clear whether the OECD s BEPS related guidance is aligned with the arm s length principle embedded in Article 9. The new guidance is focusing on labor and not capital. It is focusing on DEMPE, value creation, control and risk based approached for computing the arm s length price. With all these development, it is not discussed whether the interpretation of the arm s length principle will remain same and whether it enforce conditions that independent parties would have agreed upon. The OECD BEPS report is a guide to help taxpayer and tax authorities and cannot substitute commentaries of the OECD Model Convention. It can be stated that the subjectivity of the new arm s length principle will lead to more legal uncertainty for taxpayers. Besides, it leads to more compliance burdens and the increase of crossborder tax disputes Transfer Pricing Method and Valuation of Intangibles Which method shall be the future of transfer pricing methods? Given that we perform one side transfer pricing analysis with TNMM, RPM and Cost Plus Method, the appropriateness of the same may not be continue with OECDs BEPS related guidance which focuses on two side Page 23

24 analysis and value creation. The OECD s BEPS related guidance urging taxpayer to consider CUP or PSM while performing benchmarking analysis, wherever they seems appropriate. Considering the changing business scenarios and the overall objectives of G20 nations, the authors agree that PSM could be the future of transfer pricing method. However, appropriateness of the said method require a detailed analysis and evaluation of entire value chain. There are certain open issues related to applicability of PSM, those issues are debatable and guidance on the same is required from OECD. With regard to valuation of intangibles for transfer pricing purposes, the Actions 8-10 Final Reports state that it is not the intention to set out a comprehensive summary of the valuation techniques utilized by valuation professionals, nor to endorse or reject one or more sets of valuation standards. Rather, valuation techniques can be seen as useful tools in a transfer pricing analysis where reliable comparable uncontrolled transactions are not available. In particular, the application of income-based valuation techniques (i.e. discounted value of projected future income streams or cash flows methods) are considered to be particularly useful when properly applied. According OECD s BEPS related guidance, depending on the facts and circumstances, valuation techniques may be used by taxpayers and tax administrations as a part of one of the five OECD transfer pricing methods described in chapter II, or as a tool that can be usefully applied in identifying an arm s length price. However, where valuation techniques are utilized in a transfer pricing analysis involving the transfer of intangibles or rights in intangibles, it is necessary to apply such techniques in a manner that is consistent with the arm s length principle and the principles of the OECD Guidelines. In the case of transactions involving intangibles for which valuation is highly uncertain at the time of the transaction, the Actions 8-10 Final Reports provide a number of mechanisms that independent enterprises might adopt to address the high level of uncertainty at the time of the transaction. The OECD specifically defines so-called hard-to-value intangibles as those for which, at the time the transaction was entered into by related parties, no reliable comparable exists and projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible, are highly uncertain. This also includes intangibles used in connection with or developed under a cost contribution arrangement. Page 24

25 4. Indian Perspective MNEs have positioned their brand in India for further development. Indian tax authorities have been raising various issues in relation to the arm s length price of intangibles with the objective getting fair share of taxes. The concept of value creation will change the way transfer pricing is dealt across the globe including India. Author is discussing impact of BEPS guidance in relation to certain India related issues. 4.1 Issue of marketing Intangibles The OECD s BEPS report stipulates guidance related to the issue of marketing intangibles. The guidance addresses issue of marketing activities undertaken by an enterprise not owning the trademark by responding the following question: Whether a marketer/distributor should be compensated only for providing promotional and distribution services or the marketer/distributor should also be compensated for enhancing the value of the trademarks and other marketing intangibles by virtue of its functions performed, assets used and risk assumed The OECD s BEPS report prescribes that the analysis of the marketing issue requires assessment of following: - The obligations and rights implied by the legal registrations and agreements between the parties; The functions performed, the assets used, and the risks assumed by the parties; - The intangible value anticipated to be created through the marketer/distributor s activities; and - The compensation provided for the functions performed by the marketer/distributor (taking into account of the assets used and risks assumed. Based on the above guidance, obligation, conduct and the characterization of the party are the key elements which determine whether a separate compensation for AMP expenses shall be required or not. If the distributor merely acting as an independent agent there may not be any issue pertaining to the marketing intangibles, since the distributor is entitled to a compensation for all the AMP expenditure it has incurred from the owner of the brand. Page 25

26 On the other hand, when the distributor actually bears the cost of marketing activities (i.e., there is no arrangement for the owner to reimburse the marketing expenditure), the issue is to find out to what extent the distributor is contributing in the brand owned by its parent entity by functions performed, assets used and risk assumed currently or in future. In general, the party that is not the legal owner of the trademark or marketing intangible, to obtain any benefit (compensation for marketing efforts) of marketing intangibles will depend upon the substance of the rights and obligation of that party. An independent comparable analysis should also be required to find out whether the distributor is entitled for any compensation for its marketing efforts. The OECD s guidance brings clarity on various aspects (i.e. need for compensation, methodology for compensating distributor for the marketing efforts, etc.) for dealing with the issue of marketing intangibles. The key question that needs to be raised and answered in the context of marketing intangibles is whether the licensee of the brand had incurred the AMP expenses in the capacity of a service provider or on its own account as an entrepreneur. For analyzing the whole issue, the OECD has given emphasis on assessing the rights, obligations and conduct of parties by performing a detailed FAR analysis. 4.2 Contract R&D The OECD BEPS related guidance, emphasizes supplementing the contractual arrangement through examination of the actual conduct of the parties based on DEMPE and control over risks. This approach finds support in the Indian context as the CBDT Circular No. 6/ 2013 ( Circular ) issued to classify the contract R&D centres of overseas MNEs as R&D centres bearing insignificant risk, does emphasize on the conduct of the parties rather than the contractual arrangement. The alignment of functional contributions and funding with legal ownership is seen in the circular as well. Contribution for the important functions by the foreign principal and control over service providers are factors that are in line with the OECD Guidelines. 4.3 Assembled Workforce In the OECD s guidance, assembled workforce has been considered as a comparability factor and not an intangible, likely because work force cannot be owned or controlled by a single enterprise as per the definition of intangibles in the revised guidance on intangibles. However, the Indian TP regulations consider trained and organized work force as an intangible property requiring compensation for any related transaction. Page 26

27 5. Alternative to the Arm s Length Principle The revised guidance by OECD on BEPS is hard to comply with and lead to increased controversy. This could be reason to evaluate alternative to the arm s length principle. The contentious nature of arms-length pricing regime post-beps should be compared to other alternative methods of allocating multinational income among taxing jurisdictions. The alternative to the Arm s Length approach is a unitary method or a global formulary apportionment system. In this system, affiliate entities within an MNE are taxed as if they were a single corporation. The worldwide income of the MNE is attributed by a predetermined formula among all of the countries where the MNE engages in meaningful economic activity. By using a formula to distribute total profits across locations, the company does not need to calculate the profits earned by each member of the group in each location If all countries could agree on the use of this system and could also agree on a reasonably uniform definition of taxable income, the global taxable earnings/ profits of the MNEs would be taxable only once. Formulary apportionment method is used by provinces of Canada, Switzerland and the states within the USA. It has been proposed for internal use within the North-America Free Trade Agreement and the EU. The Arm s Length Principle, is based on the idea of national economies and independent enterprises and not on that of integrated organizations and global trade. Objections against Arm s length pricing, such as the search for comparables and the difficulty in applying the Principle to global financial trading, are largely absent with formulatory apportionment. The administrative burden for the MNEs and also the task of the tax authorities would be much lighter under formulatory apportionment because the apportionment takes place on the basis of internal, available data. Some of the problems with the use of this alternative method are: 1. The arbitrariness of predetermined formulas; 2. Reliance on foreign based information; 3. It almost guarantees that the amount of profits attributed to each member of a MNE will differ, from the income shown on its books of accounts, even if those books are kept in good faith and in accordance to accounting standards. The OECD mentions that the formulary apportionment method has often been proposed of the administrative convenience it should deliver and stated that the methodology is more in accordance to economic reality than the arm s length principle. The OECD points out that it will be very difficult to create an international accepted formula that satisfies all countries. Each Page 27