Transfer pricing of intangibles
A significant proportion of the business value of multinational enterprises (MNEs) is based on the intangibles. Therefore, the matters concerning transfer pricing of intangibles are considered pivotal in the taxation perspective.
In transfer pricing, an arm’s length price must be determined for the intangibles
Broadly speaking, intangibles mean all assets that generate business value and are not tangible assets or financial assets. Intangibles may be generated in research and development activities, production and manufacturing as well as in sales and marketing. Patents, trademarks, copyrights, business names, design rights, know-how and trade secrets are typical intangibles. Not all intangibles are registerable and not all intangibles are reflected on the balance sheet. Within the texts concerning transfer pricing published on the vero.fi website the concept "intangibles" has the same relevance as the concept "intangibles" referred to in the transfer pricing guidelines of the OECD. It is not intended to limit the concept “intangibles” to comprise only to cover, for example, the rights registerable under private law.
Due to the unique character of the intangibles, it is often difficult to price the business transactions containing them. The aim of transfer pricing of the intangibles is to determine an arm's length price for business transactions on a case-by-case basis. An arm's length price must be determined based on what independent enterprises would have agreed in similar conditions when considering the special characteristics of the intangibles.
The most pivotal aspects to be examined in transfer pricing of intangibles
As a rule, the owner of the intangibles is entitled to the income generated by intangibles. However, along with the legal owner of the intangibles, other group companies may also have been involved in the development, enhancement, maintenance, protection and exploitation ("DEMPE-functions") of the intangibles. Therefore, it is important to identify along with the legal owner all the other group companies involved in the DEMPE-functions of the intangibles. For example, several companies may have shared the research and development costs and development risks although the resulting intangibles are registered to a single company. In such case, it must be ensured that the parties to the efforts of the DEMPE-functions will receive an arm's length compensation for their contributions and risk-taking.
When considering transfer pricing, it is important to recognise whether the intangibles generate any such business benefits for which an independent enterprise would be willing to pay. The broad perspective of transfer pricing should always be considered when the transfer prices are set so that no proportion of the income generated by the intangibles remains out of consideration.
The type of transaction is also an essential aspect to consider in transfer pricing. When determining the arm's length pricing, consideration should be given to what has actually been agreed between the parties to the business transaction. Two common examples of intra-group transactions involving intangibles are licensing and sale.
Licensing of intangibles
A company may grant another company a right to utilize its intangibles (a licence). The licensee typically pays the licensor compensation for the licence as running royalty. In transfer pricing it is assessed whether the licence has been granted under conditions that independent enterprises would have agreed on in similar circumstances.
When the arm's length nature of the licence is assessed, consideration must be given to the licensing terms and conditions as whole. When the licensing terms and conditions are assessed as whole, it is possible to assess whether independent enterprises would have agreed on similar terms and conditions, including those concerning pricing. The following matters are generally included, but not limited to, in a licensing agreement: object of licensing and the rights and obligations of the parties, amount of the licensing fees, and geographical scope of the licence, sub-licensing rights and whether the licence concerned grants an exclusive right or is a parallel licence.
Sale of intangibles
In the sale of intangibles, the seller surrenders its rights in the intangibles and all the profits they would generate in the future. When the arm's length nature of an intra-group transfer is assessed, it must primarily be determined at what price an independent enterprise would be willing to dispose of its intangibles and the profits that they are expected to generate in the future. The sale of intangibles often involves the transfer of other assets or a business activity (ongoing concern) as well.
The following matters should be considered when the arm's length nature of the terms and conditions of the sale is assessed:
- The type of the intangibles involved in the sale
- Are the intangibles unique?
- Is it easy to utilize the intangibles commercially?
- Does the transfer include also other assets, functions and risks?
- What is the economical useful life of the intangibles transferred?
- What risks are related to the development and maintenance of the intangibles?
- How much profits are the intangibles expected to generate in the future?
Determining the arm's length price of intangibles
There are number of different methods for verifying that transfer pricing is at arm's length. The different methods are described in the transfer pricing guidelines of the OECD. The OECD guidelines are internationally accepted, important source of interpretation when the arm's length principle is applied. Determining the arm's length price of licensing and sale is discussed below.
As a rule, comparable prices are utilized to indicate an arm's length price of a licence. Comparable prices are prices that are applied in business transactions between independent enterprises. This transfer pricing method is called the comparable uncontrolled price method (CUP).
The arm’s length price of a licence can be assessed in the most reliable manner when the object of licensing is licensed to parties outside the group under similar conditions and in similar circumstances. Adjustments may be made, if necessary, in such internal comparables to allow better comparability.
However, MNEs may often be reluctant to license the valuable and unique intangibles to companies outside the group. Therefore, the arm’s length level of royalties can be assessed by making comparisons with licensing agreements between independent enterprises in which the terms and conditions are as identical as possible with those laid out in the intra-group licensing agreements. For making comparisons, searches for licensing agreements between independent enterprises can be made for example in different commercial databases.
The CUP method sets extremely high requirements for similarity for the comparables. Due to the uniqueness of intangibles, it is not always possible to reliably ensure that the observable differences between the agreements under comparison would not have any impact on pricing. If comparable agreements are not available, the arm's length nature of the licence can be assessed also based on other transfer pricing methods described in the OECD guidelines.
When the arm’s length level of the royalties is determined it is essential to analyse, in addition to the object of the licence and the licensing terms, the licensor’s and the licensee’s functions performed, assets used and risks assumed in the transaction. If no such analysis is made, the suitability of different transfer pricing methods or the reliability of the comparison data cannot be assessed with sufficient accuracy.
In general terms, when verifying the arm's length level of the price applied in the sale of the intangibles, the CUP method should be applied. However, it can only be applied if the comparables are clearly similar. This means that there should be information available on business transactions between independent enterprises in which similar intangibles would have been transferred under similar conditions and in similar circumstances. Due to the uniqueness of the intangibles such comparison data is rarely available.
The valuation method based on the average of the net asset value and capitalized value presented in the valuation guidelines for inheritance and gift taxation issued by the Finnish Tax Administration is not sufficiently reliable method for assessing the arm's length prices for the intangibles in transfer pricing. Independent enterprises do not normally determine the sales prices of assets or business functions on the basis of guidelines issued for inheritance and gift taxation per se. Thus, the said guidelines cannot be used as a source of interpretation for situations involving transfer pricing. The valuation should be based on a valuation method in which consideration is given to the anticipated profits or a method that independent enterprises would use in similar circumstances.
The value of the intangibles is usually determined based on the profits they are expected to generate in the future. In most cases, the parties agree that the sales price is paid as a lump sum. The arm's length sales price of the intangibles in transactions between companies within the same group can be assessed applying similar methods that independent enterprises would use when determining the sales price. One example is the method in which the value is determined based on the net present value of the forecasted cash flows related to the intangibles.
OECD Transfer Pricing Guidelines (www.oecd.org)
Other considerations related to the transfer pricing of intangibles
Special arrangements related to cost contribution arrangements and package contracts should also be considered in the transfer pricing of intangibles.
Cost contribution arrangement
In transfer pricing cost contribution arrangement (CCA) means a special contractual arrangement under which the parties agree to share for example the costs of research and development. The aim is usually to create intangibles that benefit the individual businesses of each of the participants.
The parties to the arrangements will jointly own the resulting intangibles and the parties do not, as a rule, pay royalties for utilizing the created intangibles. From the perspective of transfer pricing, the cost sharing payments must be determined on an arm’s length basis in relation to the benefits that each of the parties can expect to derive from the arrangement.
Related parties may also agree on package contracts under which the rights of use to several different intangibles, such as trademarks, patents and know-how, can be transferred simultaneously. Package contracts may also contain other elements such as technical assistance or training services in addition to the intangibles.
In these situations, each element of the transaction in a package contract should be priced separately, in accordance with the arm's length principle. The best way to ensure that the arrangement is in accordance with the arm's length principle is to price the elements in a transparent manner. The arm's length pricing of the overall package can of course be assessed in a reliable manner if a comparable package contract between two independent enterprises is available for review.