23 rd Annual Health Sciences Tax Conference
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1 23 rd Annual Health Sciences Tax Conference Approach and process for intangible property alignment December 9, 2013
2 Non-reliance disclosure Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. These slides are for educational purposes only and are not intended, and should not be relied upon, as tax or accounting advice. Page 2
3 Disclaimer EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. Ernst & Young LLP is a clientserving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit ey.com. This presentation is 2013 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are not necessarily those of Ernst & Young LLP. Page 3
4 Presenters Margaretha Haeussler Vice President Economic Analysis Olympus Corporation of the Americas Center Valley, PA Mark Volpe Executive Director, Tax Regeneron Pharmaceuticals, Inc. Tarrytown, NY Cedric Bernardeau Ernst & Young LLP 5 Times Square New York, NY cedric.bernardeau@ey.com Natalia Perez Ernst & Young LLP 5 Times Square New York, NY natalia.perez@ey.com Siv Schultz Ernst & Young LLP 5 Times Square New York, NY siv.schultz@ey.com Page 4
5 Agenda 1. IP alignment: what, why, when and how 2. Update on the OECD intangibles initiative 3. IP alignment for life sciences companies Page 5
6 IP alignment: what, why, when and how Page 6
7 IP alignment What is it? Intangible property (IP) ownership, risks and functions are aligned with business operations. The enterprise s tax and treasury profile is aligned with its operational footprint to optimize the after-tax return of strategic business initiatives. The starting point is a clear understanding of a company s operational and financial goals and its business transformation initiatives to accomplish those goals. From there, the objective is to integrate tax into the overall planning process to ensure that the planning outcomes accomplish the organization s business, treasury and tax objectives. IP alignment concepts and designs are scalable and can be applied on a product line, geography and/or supply chain functional basis in a manner that is consistent with a company s business management, operating model and desired business transformation profile. Page 7
8 IP alignment Why? Align with most companies strategic goals Boost current and long-term operating performance Create a platform for future growth and development Enhance current and long-term cash flow Simplify the tax and legal structure Commercial and regulatory Page 8
9 IP alignment When? Opportunities are triggered by multiple business transformation events e.g.: Cost reduction initiatives Performance improvement initiatives Centralization or regionalization of functions Merger and acquisition (M&A) activity, including post-merger integration Creation of new or enhanced information technology (IT) systems Expansion into new markets or geographies New product lines Page 9
10 IP alignment How? Six-stage, holistic process: 1. Identify IP value drivers and other value drivers 2. Evaluate and quantify potential transfers of IP, change in functions, or assumption of risks 3. Align IP development and exploitation with supply chain management 4. Consider impact of IP on valuable tax attributes 5. Validate business purpose and economic substance of current and future structure 6. Appropriate management and control (e.g., day-to-day and strategic) Consider impact of Organisation for Economic Co-operation and Development (OECD) base erosion and profit shifting (BEPS) and intangibles initiatives and potential US tax reform Page 10
11 IP alignment Outbound transfers and the current environment US tax reform Anti-base erosion proposals Impact on modeling? OECD BEPS and intangibles projects Stakeholder inquiries C-Level, board Shareholders Customers Press exposure Expanded disclosure Country-by-country reporting Public versus tax authorities Page 11
12 Update on the OECD intangibles initiative Page 12
13 Background The OECD states that intangibles raise complex transfer pricing (TP) issues, because: They account for a high proportion of the value/profits of multinational enterprises (MNE) in many industries. They are hard to price a multi-period perspective is usually necessary and there are rarely reliable comparables. The OECD s intangibles initiative builds on some fundamental changes in transfer pricing laid out in the new guidance on business restructuring issued in Functional control of key business decisions/risks is the starting point for method selection. This results in radical changes in perceptions of which entities are entitled to residual profit from intangibles. Page 13
14 The intangibles initiative and BEPS The OECD has been working to develop revised guidance on transfer pricing of intangibles since 2010, but this has assumed greater importance and impetus as a result of the BEPS initiative. Intangibles initiative BEPS June 2012 initial draft issued November 2012 public consultation July 30, 2013 revised draft October 1, 2013 final date for comments November 2013 further consultation meeting September 2014 revised guidance to be issued Transfer of intangibles to low tax countries seen as a source of BEPS, and the Action Plan (item 8) provides for: Broad definition of intangibles Profits from intangibles to be allocated in line with value creation Development of valuation rules Updated guidance on cost contribution arrangements Page 14
15 The revised discussion draft on intangibles The draft guidance is closely aligned with the commitment in the BEPS Action Plan A. Identifying intangibles B. Ownership of intangibles C. Transactions in intangibles D. Pricing of intangibles transactions The guidance is supported by 27 examples Discussion draft also includes proposed changes to Chapters I II on local market, location savings, assembled workforce and group synergies. and with the TP documentation white paper released on July 30 that calls for transparency so that authorities can assess risk for transfers of IP to related parties Page 15
16 Changing perceptions of entitlement to profit from intangibles 1980 s 1990 s 2015 Owner Legal Owner Economic owner Legal Owner Controller/functional contributor Investor Developer Developer Developer/functional contributor Routine Developer User Non-routine (residual claimant) Routine User Value contributor Pure User Page 16
17 Potential impact on MNEs Page 17
18 What questions should you be thinking about? 1. Can you demonstrate that key value drivers are controlled by the licensee and its IP licensor? 2. Do you have entities performing high-value functions as service providers to IP owners? 3. Does your definition of intangibles extend beyond legal or accounting definitions? 4. Do you plan the transfer of any (further) intangibles? 5. Does your structure leverage a low cost base in new/emerging markets? 6. Do you derive key benefits from an operating structure that relies on group synergies e.g., centralized purchasing? 7. Do you plan the transfer of individuals between jurisdictions in conjunction with a new operating model/ip strategy? 8. Do you have inter-company transactions where one or both parties uses intangibles in connection with the sale of goods or provision of services? Page 18
19 Can you demonstrate that key value drivers are controlled by the licensee and its IP licensor? As their collective title suggests ( Assure that Transfer Pricing Outcomes are in Line with Value Creation ), a unifying theme underpinning Actions 8,9 and 10 is a likely increase in substance requirements. The concept of functional alignment is reiterated in the revised Guidelines on intangibles. It establishes (draft) criteria to be used to test whether legal ownership of an intangible should be accepted. Alignment between functional and legal ownership requires bearing cost and risk and fulfillment of important functions by the contractual owner, including: Performs and controls the important functions described in paragraph (79) related to the development, enhancement, maintenance and protection of the intangibles Controls other functions outsourced to independent enterprises or associated enterprises and compensates those functions on an arm s-length basis Provides assets necessary to the development, enhancement, maintenance and protection of the intangibles Bears and controls the risks and costs related to the development, enhancement, maintenance and protection of the intangible Page 19
20 Does your definition of intangibles extend beyond legal or accounting definitions? Action 8 includes: Develop rules to prevent BEPS by moving intangibles among group members Adopting a broad, clear definition of intangibles Ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in line with value creation Developing rules for transfers of hard-to-value intangibles Updating guidance on cost contribution arrangements No longer founded on third-party comparability, but focused on fairness of results In the revised Intangibles Draft, legal and accounting definitions of intangibles are rejected in favor of one focusing on what unrelated parties would have agreed. Legal enforceability or separate transferability is not the focus. Accounting concepts, such as goodwill and going concern value, are not relevant for transfer pricing purposes (although they are included in the OECD definition of intangibles). Group synergies and market characteristics, such as low labor costs, should be taken into account when pricing. Assembled workforce may provide a benefit and may affect the price. Page 20
21 Does your operating structure benefit from local market features and location savings, group synergies and assembled workforce? These comparability factors should be taken into account. They are not by themselves intangible assets. In certain situations, they can involve intangible assets. Examples: Regulatory license required to operate in a specific market may constitute an intangible. Transfer or secondment of employees may result in the transfer of valuable know-how. Group synergies Focus on how these would be shared at arm s length. Group synergy benefits simply from being part of the MNE should not be shared with other group members (credit enhancement due to parent s balance sheet). Where MNE takes active steps to activate synergy (central purchasing organization), benefits should be shared according to contribution. Page 21
22 Case studies from the Intangibles Draft Page 22
23 Impact of functions, assets and risks on returns Chapter VI Annex Example 14 1 Third-party contract research organizations (CROs) Research and development (R&D) activities Transfer patents and related intangibles related to Product M in exchange for arm s length payment 2 Co. A Country X Co. S Country Y Research program related to Product M (status quo from before the transfer of intangibles) in exchange for cost plus fee No technical personnel capable of designing, conducting or supervising ongoing research activities related to Product M 3 Facts Co. A, a fully integrated pharmaceutical company hires third-party CROs to perform R&D activities Co. A controls and manages the CRO activities (e.g., actively participates in designing the studies, establishes budgets and timelines and conducts quality control) and pays the CRO a negotiated fee for services Co. A transfers Product M intangibles to Co. S Co. S agrees to fund all of the ongoing Product M research, assume the financial risk of potential failure of such research, and pay for Co. A s services a fee comparable to that which the CROs receive Conclusion Co. S is the legal owner of Product M intangibles. However, Co. A continues to perform and control functions and to manage risks related to the intangibles owned by Co. S, including the important functions that may have a material effect on intangible value (e.g., design and control of research and marketing program, management and control of budgets, control over strategic decisions regarding intangible development program, important decisions regarding defense and protection of intangibles and ongoing quality control over functions performed by third parties Para 79 of Draft) Therefore, Co. S should not be entitled to all of the returns attributable to the intangibles In determining appropriate compensation of Co. A, Co. A s relationship with the CROs may not be used as a benchmark (Co. S s activity vis-a-vis Co. A does not reach the level of Co. A s activity vis-a-vis the CROs) Page 23
24 Marketing and distribution Chapter VI annex examples 5 7 Example 5: Five-year royalty-free, exclusive marketing and distribution with option to renew; Co. S receives a service fee reimbursement of marketing expenditure, plus profit element Example 6: Five-year royalty-free, exclusive marketing and distribution with option to renew Primair Co. S Country X Example 7: Five-year royalty-free, exclusive marketing and distribution with option to renew Country Y Sale Third-party customers Country Y Examples 5-7 In example 5, Co. S purchases watches with the R trademark and trade name from Primair (manufacturer and owner of the R name), takes title to and distributes the watches in Country Y and acts as a marketing agent, to execute Primair s marketing plan under Primair s direction The compensation to Co. S from reselling the watches and service fee for marketing activities is arm s length. Primair retains all other income In example 6, Co. S develops and executes the marketing plan at its own expense and without extensive design and budget review by Primair As a result of the greater risk to Co. S, the price of watches is lowered and Co. S earns greater profit Since Co. S performs functions and bears risks under a long-term contract of exclusive distribution rights, it has the opportunity to benefit (or suffer a loss) from the activities it undertakes. Therefore, no additional compensation is due, assuming third-party comparables support the level of functions and expenses incurred, and the return is arm s length. In example 7, Co. S undertakes/ incurs increased functions/expenses, but realizes profits significantly lower than those of potential comparables. Therefore, its margins on resale of R watches need to be supplemented. A transfer pricing adjustment is appropriate in the form of higher distribution profits (i.e., decrease of product price of watches), a share of profits based on relative contributions or direct compensation for the excess market expenditure, including a profit element Page 24
25 IP alignment for life sciences MNEs Page 25
26 Key value drivers in the LS supply chain Discovery Product development Manufacturing Marketing and distribution Startup company Research organization Manufacturing organization Sales organization Intangible property Manufacturing expertise Commercialization Key value drivers Page 26
27 Common life science IP ownership frameworks Licensing and cost sharing Licensing Cost sharing USCo USCo License of IP Royalty Platform payments Platform contribution Cost sharing Non-US IPCo Non-US IPCo USCo licenses existing IP to non-us IPCo in exchange for royalties. IPCo undertakes and funds development for its market on its own. USCo identifies its assets for certain non-us markets and sells them to a non-us IPCo that will: Exploit them in the local marketplace Share the costs of future development Often attractive where IP exploited in the two territories is not common (e.g., different characteristics needed for each territory) Often used and attractive for common IP used in both territories for which substantial development still needed Also, often attractive if IP is near fully developed and only limited future investment remains Not as high scrutiny from IRS Taxable and Tier 1 issue for IRS; strict scrutiny Advanced pricing agreement options available Page 27
28 US life sciences co. licensing US discoveries Contract manufacturing organization (CMO) USCo R&D Suppliers IP Raw materials CMO License Contract manufacturing Products Tolling services Toll Manufacturer (finishing) Toll manufacturing Non-US Principal Products MarketingCo Business strategy and planning Marketing strategy and brand management Strategic sourcing Supply chain management Production scheduling Quality control Products Local marketing and distribution Customers Pertinent features: USCo licenses the IP to Non-US Principal and receives a royalty at a percentage of net sales. CMO purchases raw materials from suppliers and contract manufacture products for Non-US Principal. Upon receiving products from active pharmaceutical ingredient (API), Non-US Principal consigns the products to Toll Manufacturer for finishing. Non-US Principal sells finished products to local MarketingCos for their on-sell to customers. Non-US Principal earns the residual profit and locates in a low-tax jurisdiction. The CMO and Toll Manufacturers earn a profit at a cost, plus mark-up. The Marketing Cos take limited risks and earn profit at a fixed margin. Page 28
29 US life sciences co. licensing US discoveries Principal as manufacturer (PAM) Suppliers Raw materials Toll Manufacturer (finishing) Tolling services IP USCo License PAM Manufacturer Products Logistics Hub Products MarketingCo Products Customers R&D Full-fledged manufacturing Logistics Marketing and distribution Pertinent features: USCo licenses the IP to principal PAM Manufacturer and receives a royalty at a percentage of net sales. PAM Manufacturer purchases raw materials from suppliers, manufactures products and sells products to the Logistics Hub. The Logistics Hub engages Toll Manufacturers to conduct finishing work (low value add). The Logistics Hub sells finished products to local MarketingCos for their on-sell to customers. PAM Manufacturer earns the residual profit and often locates in a low-tax jurisdiction. The Logistics Hub and MarketingCos take limited risks and earn profit at a fixed margin. Page 29
30 Biotech & medtech companies cost sharing US supply chain Suppliers Product USCo IP Product US MarketingCo Products US customers Platform payments (upfront) Platform contribution Cost sharing (ongoing) Rest of world supply chain Suppliers IP Non-USCo Product Non-US MarketingCo Products Non-US customers Pertinent features: USCo purchases raw materials from suppliers, manufactures products and sells products to US MarketingCo for its on-sell to US customers. Similarly, Non-USCo purchases raw materials from suppliers, manufactures products and sells products to Non-US MarketingCo for its on-sell to non-us customers. USCo and Non-USCo may outsource manufacturing activities to third-party manufacturers. USCo and Non-USCo enter into cost sharing arrangement, under which: Manufacturing R&D Logistics USCo makes platform contributions (i.e., the existing IP) to a Non-USCo located in a low-tax jurisdiction. Non- USCo makes platform payments to the USCo. USCo and Non-USCo share ongoing development costs based on reasonably anticipated benefits. Marketing and distribution Page 30
31 IP management and alignment Industry considerations related to IP IP API, drug formulation, medtech product design, manufacturing know-how, brand and other marketing intangibles IP often centralized R&D talent, infrastructure, relationships, molecule library typically in one location Contract content development fee-based or profit split? IP migration Wide spectrum of options franchising/full exploitation, local content acquisition/licensing, co-development/financing; lots of third-party activity Product lifecycles/categories, core contributions, marketing IP and risk profile of alternatives (cost sharing versus other) Buy-in Uncertainty around buy-in payments and administrative burdens Licensing has long history, is well understood and likely to produce more modest benefits (with muted downside risk vs. cost sharing) Co-development arrangements using profit splits must be distinguished from cost sharing, but offer some attractive features Page 31
32 IP transfer methods Method of IP transfer Description of transaction Form/timing of payment Tax ownership (amortization) Source of income (to transferor) Sale for fixed consideration Sale for contingent consideration License (fixed or contingent consideration) Contribution to controlled corporation in exchange for shares Contribution to partnership in exchange for partnership interest Contingent services arrangement; Option pricing All substantial rights in IP (or an undivided interest therein) for a defined geographic area (country or countries) are transferred for a non-contingent amount All substantial rights in IP (or an undivided interest therein) for a defined geographic area are transferred for an amount contingent on use or productivity Less than all substantial rights in IP (or an undivided interest therein) are transferred for fixed or contingent amount IP rights are contributed to controlled corporation in exchange for (actual or deemed) shares section 351 IP rights are contributed to partnership in exchange for common interest or for common and preferred interests section 721 IP is developed under contract and consideration depends on future contingency Lump sum or installments paid over useful life Royalty (flat or declining rate) and/or milestones paid over useful life Fixed = lump sum or installments; contingent = declining or fixed royalty and/or milestones; non-lump sums paid over useful life Deemed license payments made to transferor for up to 20 years section 367(d) Depends on terms of partnership interests and partnership profits; no time limits, but section 482 principles likely apply to total consideration Small upfront fee (premium) + larger success-based fee if future contingency met/option exercised (strike price) Transferee Residence of transferor section 865(a) Transferee Transferor Transferee (assuming no rights are retained) Transferee (assuming no rights are retained) Transferor initially; transferee if exercise / future contingency met Place of use subject to US amortization recapture section 865(d) Place of use sections 861/862(a)(4) Place of use sections 861/862(a)(4) Look to distributable share of partnership income (foreign IP rights typically generate foreign source income) Place of performance likely location of R&D services Page 32
33 Trends in IP ownership IP ownership Illustrative structures Industry preferences Approximate effective tax rate Approximate usage Trend 1. Offshore Bermuda, Cayman, nonresident Irish company, partnership structures (Dutch CV and UK LP, ), Malta, Dubai 0% (no local corporate tax) 75% Decreasing 2. Swiss onshore company Life sciences, chemical, other manufacturing 3. Irish resident company Software, services, life sciences 5 12% (lower rates via principal company ruling) % (rate depends on amortization and interest deductions) 7% Increasing 5% Increasing significantly 4. Benelux resident Belgium or Dutch patent box regimes, Lux corporate or branch structures Consumer products, chemical 1 10% (Lux tends to be lower; Dutch patent box rate approximately 10%) 4% Increasing 5. Singapore onshore company Hardware, other manufacturing 0 / 5 / 10% (negotiated ruling) 2% Increasing 6. Other resident companies Malaysia, Puerto Rico, UK Rate will depend on nature of operations and specific tax incentives (e.g., holiday) and attributes (e.g., net operating losses) ~5-10% Increasing The reason for the decrease in the use of "offshore" structures is attributable to a variety of factors, including (1) increased sensitivity to the use of tax havens, (2) ensuring that IP returns are eligible for permanent establishment protection and reduced withholding tax rates under applicable income tax treaties, (3) responding to anti-tax haven legislation in many countries around the world and (4) anticipating direction of US international tax reform. These considerations are further validated by the OECD s recent publication of a report on Base Erosion and Profit Shifting (BEPS Report). The BEPS Report has been endorsed by major trading powers and further work and recommendations are being sought. Page 33
34 Overview of patent box regimes Patent box regime Qualifying income Substance requirement Pros Cons Belgium Self-developed and acquired/licensed patents and additional protective certificates, as well as connected know-how Acquired or licensed patents must be further improved in an R&D branch in Belgium or abroad this does not have to lead to new patents Work can be performed outside Belgium for foreign corporations with a Belgian permanent establishment Benefit applied to gross income Tax rate between 0% and 6.8% Benefit is calculated using TP/economic analysis; benefit would be sensitive to substance and overall R&D spend Netherlands Self-developed patents, further development of acquired IP, plant breeder rights or qualifying R&D activities Qualifying R&D activities consist of a broad range of activities for which an R&D declaration can be obtained Requires qualified oversight in the Netherlands of the subcontracted R&D, if R&D is not performed in the UK For tax purposes, 20/25% of net qualifying IP income is exempt from Dutch tax 5% tax rate for net qualifying income Benefit is calculated using TP/economic analysis; benefit would be sensitive to substance and overall R&D spend UK Patent box will apply to patents but not to other forms of IP, such as trade marks or designs, as they are perceived to be less directly linked to industrial innovation UK company must be actively involved in the ongoing decision making connected with the exploitation of the patent Benefit is calculated using formulaic approach; not dependent on spend 10% tax rate on patent income Higher taxable rate than in other jurisdictions Page 34
35 Questions? Page 35
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