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OECD Guidance Response: Practical Considerations
The OECD's work on intangibles in 2012 has included several important steps, including the issue in June of a draft revised Chapter 6 of the OECD Guidelines, followed by a consultation in November with representatives of organisations that submitted written comments to the draft. A further draft may be expected in 2013, with perhaps a final new Chapter 6 in 2014. It was evident in the recent consultation that there is still some uncertainty regarding the content of the final version, particularly with respect to valuation methods. However, it was clear that many of the key points in the draft revised Chapter 6 will appear in the final version.
The changes are significant and will have a fundamental impact on the transfer pricing arrangements of groups with cross-border transactions involving intangibles. While there are important changes to the pricing guidance, intended to more closely align the methods used with those used in the field of asset valuation, the most significant changes relate to the guidance as to which entities are entitled to receive the financial rewards related to intangible ownership. Taxand's Global Transfer Pricing team discusses these changes, and their expected impact, below.
While there are many important issues in the revised draft Chapter 6 of the OECD Guidelines that may impact the transfer pricing of companies with cross-border transactions involving intangibles, two issues stand out in particular as fundamental and require careful evaluation. It is our expectation that in many cases, the results of an evaluation will indicate a need to change either the transfer pricing policies themselves, or the documentation supporting the policies. The two issues, discussed in detail below, are the guidance on entitlement to intangible related returns, and the requirement to test the commercial sense of a transaction by considering the options realistically available to both parties to a transaction.
Entitlement to Intangible Related Returns
Historically, companies have tended to consider both legal ownership as well as economic ownership, with the latter largely based on funding the development of an intangible, as the key determinants of which entity should receive the rewards of ownership of an intangible. The new guidance relegates these factors to a secondary status, with the primary emphasis placed on identifying:
- The entity bearing and exercising control over the key risks related to the development, enhancement, maintenance and protection of the intangibles
- The entity performing the most significant functions with respect to the development, enhancement, maintenance and protection of the intangibles
These requirements focus on the need to identify where people perform the key functions, recognising that the guidance is not concerned with potentially routine elements of the functions listed above, but the important day-to-day decision making and significant high value contributions.
What it Means To Companies
For groups in which the parent company is the owner of the intangibles, the change in guidance may have less impact, as there is a high likelihood that the key functions are also performed in the head office. Even if this is the case, companies will need to evaluate whether their documentation is structured to consider the appropriate functions as the rationale for rewarding the head office. At a minimum, the documentation will require changes to the functional analysis and the characterisation of the contributions of the various entities.
For groups that attribute ownership of intangibles to specialised holding companies or other selected companies within the group, there is likely to be a need for a detailed consideration of whether the people employed by these companies have the seniority, capability and authority to undertake the required activities. These standards will not be easy to satisfy if the company in question lacks the relevant people to satisfy these detailed substance requirements.
Options Realistically Available
Companies entering into transactions involving intangibles are now required to assess whether the transaction makes commercial sense by comparing the expected economic impact of the transaction with other options that are realistically available to the company, including not entering into the transaction at all. For example, if a company is considering paying a royalty to licence a marketing or technical intangible, it would be expected to demonstrate that it is no worse off with the licensing arrangement in place than it would be if it did not licence the intangible. Alternatively, a company considering selling an intangible to a related party and licensing it back, would be expected to undertake a discounted cash flow analysis to show that the arrangement did not lead to a clear reduction in value compared to the option of retaining ownership.
What it Means To Companies
The requirement to test the commercial sense of a transaction from the perspective of all parties to the transaction imposes a range of difficult considerations. The mere expectation of loss of income does not necessarily fail this standard. If a corresponding reduction of functions performed, risks borne or assets used can be shown to justify the reduction in income, then one does not have to conclude that the company is worse off.
Where this standard may raise significant challenges is the requirement to economically equate the reduction in functions, assets and risks with the reduction in profit. Tax authorities may not take the view that simply benchmarking the post-restructuring model necessarily addresses the issue. Instead, they may want to see an analysis of the reduction of income that can be attributed directly to the functional changes.
Your Taxand contacts for further queries are:
Antoine Glaize, Taxand Global Transfer Pricing Service Line Leader
T. 33 (0) 1 70 38 88 28
Taxand recently performed a market survey related to transfer pricing for intangibles. The survey revealed that a majority of the respondents expect intangibles to be covered soon in a tax audit. However, only a small minority of the respondents have a clear picture of the intangibles in their group, while a great majority devote less than 5% of their time to intangibles-related issues. These results suggest that a majority of companies are under-prepared for the challenges ahead.
Some groups are likely to find it difficult to assert that the company in their group receiving payments for the use of intangibles meets the standards outlined in this article. This presents a very real risk that tax authorities will recharacterise the transaction and attribute the income to a different group company, potentially leading to compliance challenges and the risk of double taxation.
Taxand recommends that groups take the opportunity during 2013, while the OECD continues the process of finalising its guidance, to take stock of their intangibles and review the transfer pricing policies that apply to these assets. If they then take the remedial action required to align their polices with the important principles described above, they should find themselves in a sound position in 2014 when we expect the revised Chapter 6 to be finalised.