Transfer pricing of intangibles

32E30000 - Tax Planning of International Enterprises Transfer pricing of intangibles Aalto BIZ / May 2, 2016 Petteri Rapo Alder & Sound Mannerheimintie 16 A FI-00100 Helsinki firstname.lastname@aldersound.fi www.aldersound.fi The Finnish Transfer Pricing Firm of the Year in 2015 & 2011 The European Tax Innovator of the Year in 2013 The Best European Newcomer in 2012

Agenda May 2, 2016 Transfer pricing of intangibles Introduction Background Definition of intangibles in transfer pricing Ownership (legal, economic, functional) Valuation of intangibles Intra-group development & licensing of intangibles Transfer pricing of intangibles May 2, 2016 Page 1

Guest speaker Petteri Rapo, Senior Associate, Acting CEO, Alder & Sound Master of Science (Business Law, Finance) Aalto University, School of Business (former HSE) Joined A&S in 2011, previous work experience from accounting and financial administration. Acting CEO as of January 1, 2016 Professional experience from working with multinational corporations from a range of industries, including construction, consumer goods, chemicals, food products, engineering, mining and software. Specialized in demanding transfer pricing engagements, intra-group financing, intangible assets and tax considerations related to operating in BRICS and other developing regions. Selected recent reference work: Assumed the overall responsibility for managing the transfer pricing compliance of a multinational group as an in-house resource (TP BackOffice) Assisted a multinational corporation in a tax optimization process, with over 3.3 million Euros in estimated annual cash tax savings Assisted a multinational corporation in a tax audit process regarding intra-group financing, with estimated tax risk exceeding 7 million Euros Designed a calculation model for determining arm s length intra-group charges on intangibles in a highly decentralized operating model Participated in APA negotiations involving multiple jurisdictions Transfer pricing of intangibles May 2, 2016 Page 2

Transfer pricing of intangibles May 2, 2016 Page 3

Background External factors for international tax planning Changing corporate tax rates create constantly changing operating environment for MNEs Transfer pricing of intangibles May 2, 2016 Page 4

Background Increasing economic importance of intangibles Example The effect of transfer price used in the intra-group transaction on the profitability of the parties Group company 1 Group company 2 100 150 50 150 Sales 100 50 150 - COGM 50 50 50 = Gross profit 50 0 100 - Operating expenses 30 30 30 = Operating profit 20-30 70 Sales 150 150 150 - COGS 100 50 150 = Gross profit 50 100 0 - Operating expenses 30 30 30 = Operating profit 20 70-30 Transfer pricing of intangibles May 2, 2016 Page 5

Background Increasing economic importance of intangibles (cont d) Example The effect of transfer price used in the intra-group transaction on the profitability of the parties Group company 1 Group company 2 100 150 50 150 250 + 100 Sales 100 50 150 - COGM 50 50 50 = Gross profit 50 0 100 - Operating expenses 30 30 30 = Operating profit 20-30 70 Sales 150 150 150 - COGS 100 50 150 = Gross profit 50 100 0 - Operating expenses 30 30 30 = Operating profit 20 70-30 Transfer pricing of intangibles May 2, 2016 Page 6

Background Royalty payments & receipts in 2013 (monetary value) When observing the global royalty payments & receipts, the United States is a clear net recipient whereas Ireland is a net payer Roylties Top10 net receipts Country Royalty balance in 2013 (difference, USD million) 1. United States + 88 928 2. Japan + 13 756 3. United Kingdom + 6 574 4. Switzerland + 5 143 5. Sweden + 5 012 6. Germany + 4 689 7. Finland + 1 881 8. France + 1 406 9. Mexico + 820 10. Denmark + 705 OECD members + 51 362 musd Developing countries - 44 musd EU Euro Zone - 40 262 musd - 48 602 musd Royalties Top10 net payments Country Royalty balance in 2013 (difference, USD million) 1. Ireland - 41 120 2. China - 20 146 3. Singapore - 18 826 4. Russia - 7 633 5. The Netherlands - 7 336 6. Canada - 6 805 7. South Korea - 5 509 8. Thailand - 4 364 9. India - 3 458 10. Brazil - 3 071 Source: World Bank statistics (Charges for the use of intellectual property, payments & receipts) Transfer pricing of intangibles May 2, 2016 Page 7

Background Royalty payments & receipts in 2013 (% of total trade) When observing the global royalty payments & receipts, the United States is a clear net recipient whereas Ireland is a net payer Roylties Top10 net receipts Country Royalty balance in 2013 (% of total trade) 1. United States + 3,55 2. Finland + 1,93 3. Sweden + 1,63 4. Japan + 1,54 5. The Netherlands + 1,13 6. United Kingdom + 0,60 7. Israel + 0,53 8. Denmark + 0,38 9. Germany + 0,22 10. Mexico + 0,21 Royalties Top10 net payments Country Royalty balance in 2013 (% of total trade) 1. Ireland - 19,68 2. Singapore - 3,40 3. South Africa - 1,64 4. Russia - 1,43 5. Canada - 1,26 6. Switzerland - 1,24 7. Brazil - 1,02 8. Australia - 1,00 9. China - 0,87 10. South-Korea - 0,85 Source: WIPO, INSEAD & Cornell University (Global Innovation Index, GII) Transfer pricing of intangibles May 2, 2016 Page 8

Background Intangibles & BEPS Intangibles are addressed under multiple actions in the OECD BEPS Action Plan 1. Tax challenges of the digital economy 2. Neutralize the effects of hybrid mismatch arrangements 3. Strengthen CFC rules 4. Limit base erosion via interest deductions and other financial payments 5. Counter harmful tax practices more effectively, taking into account transparency and substance 6. Prevent treaty abuse 7. Prevent the artificial avoidance of PE status 8. [Transfer pricing & value creation] Intangibles 9. [Transfer pricing & value creation] Risks and capital 10. [Transfer pricing & value creation] Other high-risk transactions 11. Establish methodologies to collect and analyse data on BEPS and the actions to address it 12. Require taxpayers to disclose their aggressive tax planning arrangements 13. Re-examine transfer pricing documentation 14. Make dispute resolution mechanisms more effective 15. Develop a multilateral instrument Transfer pricing of intangibles May 2, 2016 Page 9

Transfer pricing of intangibles Big picture Correct identification and treatment of intangibles is of importance from compliance and planning point of view Intangibles Identification & development Transfer / licensing - Definition of intangibles in transfer pricing - Ownership (legal / economic / functional) - Design of intra-group charging model for development activities - Valuation of intangibles - Design of intra-group charging model for intra-group licensing of intangibles Transfer pricing of intangibles May 2, 2016 Page 10

Transfer pricing of intangibles Expanding definition of intangibles in transfer pricing Ongoing concern value Group synergy Know-how Distribution channel Goodwill Intangibles Customer list Intangible assets Market-specific characteristics Assembled workforce Client relationship Operating model Location savings Intellectual property rights (IPR) Transfer pricing of intangibles May 2, 2016 Page 11

Transfer pricing of intangibles Pre- and post-beps guidance on definition Pre-BEPS Previous definition of intangibles ( intangible property ) in Chapter VI (paragraph 6.2) of OECD Transfer Pricing Guidelines: -- [T]he term intangible property includes rights to use industrial assets such as patents, trademarks, trade names, designs or models. It also includes literary and artistic property rights, and intellectual property such as know-how and trade secrets. Marketing and trade intangibles (according to the Glossary of the Guidelines): - Marketing intangibles = 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. (e.g. trade marks, trade names, marketing materials). - Trade intangibles = A commercial intangible other than a marketing intangible (e.g. patents, designs, models) Differences between marketing and trade intangibles illustrated with examples involving patents and trademarks. Post-BEPS Updated definition of intangibles in Chapter VI (paragraph 6.6) of OECD Transfer Pricing Guidelines now contains a three-step test (numbering here): -- [T]he word intangible is intended to address something which is not i. a physical asset or a financial asset, ii. which is capable of being owned or controlled for use in commercial activities, and iii. whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances. Under the revised text of the OECD Transfer Pricing Guidelines, an effort is made to steer away from the legal and accounting definitions of intangibles, as well as from specific categories. However, a similar reference to marketing and trade intangibles is made as with previous version, with the addition of proprietary market and customer data for the scope of marketing intangibles. An illustrative list of items often considered in transfer pricing analyses involving intangibles: - Patents; - Know-how and trade secrets; - Trademarks, trade names and brands; - Rights under contracts and government licenses; - Licenses and similar limited rights in intangibles; - Goodwill and ongoing concern value; - Group synergies; - Market specific characteristics. In addition, location savings, other local market features and assembled workforce are mentioned in the new guidance inserted to Chapter I of the OECD Transfer Pricing Guidelines. Transfer pricing of intangibles May 2, 2016 Page 12

Transfer pricing of intangibles Identification process for intangibles in the post-beps world Yes Not an intangible (for transfer pricing purposes) Potentially relevant for comparability and / or arm s length analysis Yes Yes Yes No Can the item in question be considered as... A physical or financial asset? No A registered or unregistered intellectual property right? No Goodwill or ongoing concern value? No A market specific characteristic (incl. location savings)? No A group synergy -related benefit? No An assembled workforce -related benefit? Yes Yes Is it capable of being owned or controlled for use in commercial activities? No Yes Would a transfer (of the item) be compensated in a transaction between independent parties in comparable circumstances? No A relevant intangible for transfer pricing purposes Transfer pricing of intangibles May 2, 2016 Page 13

Transfer pricing of intangibles Ownership in the post-beps world Section B of renewed Chapter VI provides guidance on allocation of economic profits earned through exploitation of intangibles Section B of renewed Chapter VI provides guidance on which of the entities in an MNE group should be entitled to retain the economic profits from intangibles. The updated guidance (paragraphs 6.32 and 6.42) on ownership now states that : - Although the legal owner of an intangible may receive the proceeds from exploitation of the intangible, other members of the legal owner s MNE group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible; and that - For transfer pricing purposes, legal ownership of intangibles, by itself, does not confer any right ultimately to retain returns derived by the MNE group from exploiting the intangible, even though such returns may initially accrue to the legal owner as a result of its legal or contractual right to exploit the intangible. According to the guidance, the key functions with regard to intangibles are: - Development; - Enhancement; - Maintenance; - Protection; and - Exploitation of intangibles. Three types of intangible ownership: 1) Legal; 2) Economic; and 3) Functional (DEMPE) Transfer pricing of intangibles May 2, 2016 Page 14

Transfer pricing of intangibles Valuation and arm s length testing in the post-beps world Section D provides supplemental guidance for determining arm s length conditions in cases involving intangibles Section D of the renewed Chapter VI provides supplemental guidance for determining arm s length conditions in cases involving 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. The updated guidance acknowledges explicitly that the application of a valuation technique, either as part of one of the five approved OECD methods or as a useful tool, may prove more reliable than any other transfer pricing method, as long as applied in a manner that is consistent with the arm s length principle. Transfer pricing of intangibles May 2, 2016 Page 15

Transfer pricing of intangibles Valuation OECD methods CUP Cost Plus Resale Price TNMM PS Comparable uncontrolled price method (CUP) A method of pricing that compares the price for property or services in a controlled transaction to the price charged for property or services transferred in a comparable uncontrolled transaction in comparable circumstances. Cost Plus method (C+) A method of pricing based on the costs incurred plus an appropriate mark-up. Resale Price Method (also Resale Minus, R-) A pricing method based on the price at which a product that has been purchased from an associated enterprise is resold to an independent enterprise. The resale price is reduced by the resale price margin. Transactional net margin method (TNMM) A profit-based method that compares the profitability of a taxpayer to the profits of comparable entities undertaking similar transactions. Profit Split Method (PS) A method of pricing where the profit or loss of a multinational enterprise is divided in a way that would be expected of independent enterprises in a similar, highly integrated relationship (e.g. joint venture). + Other method Internal vs. external transfer pricing method OECD / the most appropriate method vs. YK / the most suitable method vs. IRS (US) / the best method -principle Transfer pricing of intangibles May 2, 2016 Page 16

Transfer pricing of intangibles Valuation Specific methods Appropriate valuation analysis aims at ensuring arm s length compliance of the transaction (licensing / transfer) Approach Income based Market based Cost based Relief from royalty method Reproduction costs method Method Profit split method Comparable market transactions method Replacement cost method Incremental cash flow method Price premium Most common approach Not very common due to the lack of comparable market transactions Does not take into account the future income potential The income approach determines the fair value from future cash flows generated by the asset The market approach determines fair value by comparing transactional assets to the subject asset The cost approach estimates the value of an asset based on the current cost to reproduce / replace that asset Transfer pricing of intangibles May 2, 2016 Page 17

Transfer pricing of intangibles Valuation Process Appropriate valuation analysis aims at ensuring arm s length compliance of the transaction (licensing / transfer) Identification of asset to be valued Selection of appropriate valuation method Valuation analysis Valuation results - Determination of economic / useful life - Determination of economic benefit (i.e. cash flows) - Determination of discount rate (e.g. WACC) Transfer pricing of intangibles May 2, 2016 Page 18

Transfer pricing of intangibles Service fee or license fee? The border line between service fees and license fees is often unclear, especially with respect of IT charges Service fee The basis for the fee is an identifiable activity (or series of activities) performed by the provider The value of benefit received is linked to the actual costs incurred by the provider in connection with performing the activities The legal and economic ownership of the benefit in question are usually not clearly defined or separable from each other License fee The basis for the fee is a right to utilize certain know-how or other intangibles owned by the provider The value of benefit received is determined based on the income or profit estimated to be generated through the licensing right in question The legal and economic ownership of the benefit in question are usually clearly defined and separable from each other Transfer pricing of intangibles May 2, 2016 Page 19

Transfer pricing of intangibles Alternative charging models for internal development activities Legal Contractual terms Development of intangibles Ownership Economic Centralized License fee Direct IRR Delayed CUP Access fee Shared Contract R&D / passthrough invoicing Direct Delayed IPR charge Credit financing Access fee Transfer pricing of intangibles May 2, 2016 Page 20

Transfer pricing of intangibles Alternative charging models for intangibles Under the license fee model, a license fee is charged by the owner of the intangibles in question Owner(s) of the intangibles The legal and economic ownership of IPRs is either a) kept with the developing entities or b) centralized to certain group entities or to a separate IP company (IPCo) which grants licenses and charges a license fee for the right to utilize the intangibles in question. Licensing of intangibles portfolio License fee: % of net / additional sales % of gross profit % of operating profit The license fee invoiced from the benefiting group companies may be defined as a percentage of net or additional sales, gross profit or operating profit (EBIT) and supported by an appropriate benchmarking study. In order to ensure single legal, economical and functional (DEMPE) ownership of intangibles, the contract development activities may be compensated on a cost plus basis containing a success element. Benefiting group entities Transfer pricing of intangibles May 2, 2016 Page 21

Transfer pricing of intangibles Alternative charging models for intangibles (cont d) Under the profit split model, an access fee is charged for the opportunity to utilize the intangibles portfolio Owner(s) of the intangibles The legal and economic ownership of IPRs is either a) kept with the developing entities or b) centralized to certain group entities or to a separate IPCo which grants licenses and charges a license fee. Excess profit attributable to local business operations Excess profit attributable to intangibles Max. payment threshold (% of net sales) Access fee The level of company-specific access fee is determined based on a two-step process: 1) First the excess profit (i.e. profit exceeding routine return of comparable companies) is determined based on an appropriate benchmarking study; 2) Then the value allocable to intangibles is determined by splitting (50/50) the excess profit; the excess profit attributable to intangibles shall correspond the company-specific access fee payment. Additional elements, such as (maximum) payment thresholds and supporting investment calculations may allow further refinement of the charges and more flexible allocation of the risk related to development activities. Profit split (50/50) Excess profit (i.e. profit exceeding routine return) In order to ensure single legal, economical and functional (DEMPE) ownership of intangibles, the contract development activities may be compensated on a cost plus basis containing a success element. Routine return (based on comparable companies) Transfer pricing of intangibles May 2, 2016 Page 22

Transfer pricing of intangibles Alternative charging models for intangibles (cont d) Under the concept fee model alternative, the concept provider charges a concept fee for business support services and intangibles Concept provider The service provision (self-performed or subcontracted) and ownership of intangibles is centralized to concept provider (an existing group entity or a separate IPCo) which provides a comprehensive business concept and charges an appropriate concept fee from the benefiting group entities. Provision of business concept: Business support services Relevant intangibles Concept fee payment: (% of net / additional sales) The concept fee invoiced from the benefiting group companies is defined as a percentage of turnover and supported by an appropriate benchmarking study. The concept fee payment may also be utilized to enable centralized operating model by setting guaranteed profit levels to benefiting group entities, efficiently transferring the residual income to the concept provider. In order to ensure single legal, economical and functional (DEMPE) ownership of intangibles, the contract development activities may be compensated on a cost plus basis containing a success element. Benefiting group entities Transfer pricing of intangibles May 2, 2016 Page 23

Transfer pricing of intangibles Recent cases on transfer pricing of IT development projects Transfer pricing of intangibles May 2, 2016 Page 24

Petteri Rapo Senior Associate, Acting CEO Mobile +358 44 333 7252 Email petteri.rapo@aldersound.fi Alder & Sound - Your trusted partner in international business The Finnish Transfer Pricing Firm of the Year in 2015 & 2011 The European Tax Innovator of the Year in 2013 Alder & Sound Mannerheimintie 16 A FI-00100 Helsinki firstname.lastname@aldersound.fi www.aldersound.fi