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Transfer Pricing – Advanced Topics

Transfer Pricing:

Advanced Topics

Agenda1. Practical Approaches to Transfer Pricing Documentation and U.S.

Regulatory Update• Steve Allen – BKD LLP (Denver, Colorado)

2. IRS Transfer Pricing Enforcement: A First-Hand Perspective• Paul Tew – Dixon Hughes Goodman LLP (High Point, North Carolina)

3. The Queen v. GlaxoSmithKline Inc.• Angeline Zioulas – MNP LLP (Vancouver, British Columbia)

4. Transfer Pricing for Intangible Property• Will James – BKD LLP (St. Louis, Missouri)

5. Questions

Practical Approaches to Transfer Pricing Documentation and US Regulatory Update

Steve Allen

BKD LLPDenver, Colorado

Determining the Transactions to DocumentTaxpayers should develop consistent policies when deciding which transactions to document for transfer pricing purposes and monitor the type and amount of transactions annually.• What was originally a “small” transaction can increase quickly in a short period of

time.No specific materiality threshold exists for U.S. transfer pricing regulations (in other words, the Regulations are silent on this point).• Transfer pricing penalties may apply if a tax adjustment exceeds certain thresholds.

Items to consider:• Type of transaction (valuable IP transfer vs. low-margin administrative services)• Amount of transaction, especially in relation to overall legal entity results.• Countries involved – is the transaction with a low-tax jurisdiction or a perceived tax

haven country?• Taxpayer’s history with transfer pricing enforcement/audits.• Riskiness of transfer pricing results – is the price within a reasonable range and/or

are losses being incurred by one or both entities?

Documentation OptionsFull report that complies with all relevant transfer pricing regulations.• Only way to achieve full penalty protection under U.S. Sec. 6662 regulations.

Economic analysis• Analyzes only the pricing for a transaction and benchmarks against results from

comparable companies or transactions.• Does not include a functional analysis, industry analysis, or selection of the “best

method.”Taxpayers typically have other internally prepared documents, such as intercompany agreements, spreadsheets showing intercompany charges, and invoices for intercompany transactions.• While these are not considered “documentation” per the transfer pricing regulations,

they can and should be part of a taxpayer’s support file for transfer pricing.If a full report is not prepared, often a taxpayer may prepare an economic analysis in Year 1 and supplement that with the additional information needed for full documentation in Year 2.

Considerations for Taxpayer-Prepared Documentation

• Taxpayers who prepare some or all components of their documentation internally should be careful that all pertinent Regulations are being followed.• IRS may imposes penalties, even if a taxpayer has documentation, if it does not believe

the documentation has made a reasonable attempt to support the intercompany pricing.

• For US purposes, the report must satisfy all 10 ‘principal documents’ that are required for contemporaneous transfer pricing documentation

• In essence, IRS and other tax authorities will consider the quality of the documentation in assessing the transfer pricing results.

• Some parts of a documentation study may be more difficult to prepare internally due to lack of available databases to evaluate comparable companies.• Other components, such as the company background and transaction description, may

be done more easily internally.

Other Documents for the Transfer Pricing File• Maintaining other types of files and documents is important for a

taxpayer’s overall approach to transfer pricing documentation.• These may include the following:

• Spreadsheets or other documents showing the amounts for a given tax year for each transaction documented.

• Intercompany legal agreements or contracts.• Intercompany invoices (or other documents noting the terms of sale).• Service fee allocation spreadsheets for the charging of administrative, management,

technical, or engineering fees.• Third-party contracts and other documents for transactions used as a comparable

uncontrolled price (CUP) or comparable uncontrolled transaction (CUT).

• These documents may prove particularly useful in the event of a transfer pricing audit, as the IRS and other tax authorities routinely ask for additional information besides a documentation report.

Other Documentation Considerations• In many cases, it is possible to prepare a single transfer pricing report

that fulfills the documentation requirements of multiple countries.• Often, reports are prepared that conform to both U.S. and OECD transfer pricing

regulations.• European Union ‘Master File’ concept.

• Taxpayers should still consider country-specific differences that should be incorporated into the documentation.

• For example, using single-year results in Canada vs. three-year results in U.S. for comparables ranges.

• Also, taxpayers under audit in a specific country may want to consider the practical implications of submitting a ‘global’ report to a local country tax authority.

• Also must consider whether a country requires documentation to be prepared in a specific language.

Other Documentation Considerations (cont.)

• Transfer pricing documentation should be updated on an annual basis• Necessary to reflect the results of intercompany transactions for the most recent tax

year.• In addition, financial data for comparable companies should be updated

• Practically speaking, many taxpayers prepare a full report in the first year and prepare updates to that report in the next 2-3 years.

• An ‘update’ should be done only if the facts and circumstances of the transactions have not materially changed from year to year.

• The update shows the most recent financial data for the intercompany transactions as well as the comparable companies/transactions.

• After approximately 3 years, taxpayers should conduct a more comprehensive overhaul of the documentation by (at least) conducting new functional interviews and new comparables searches.

Recent US Transfer Pricing Audit Developments

• IRS has significantly increased its resources devoted to transfer pricing in the past 1-2 years.• In 2011, it hired its first Transfer Pricing Director (Sam Maruca).• In 2012, it hired a number of new economists for transfer pricing audits, and it has also

increased its hiring of international examiners.

• More small and medium-sized companies are being audited as part of IRS’ transfer pricing mandate.• Reviewing Form 5471/5472 for data consistency with transfer pricing documentation.• Imposing more penalties where applicable.

• Transfer pricing audits are becoming broader, with more IRS personnel involved.

• IRS is also issuing a greater number of and more far-reaching information data requests (IDRs) for transfer pricing.

Recent US Transfer Pricing Audit Developments (cont.)

• Enforcement efforts have continued to focus on valuable intangibles owned by US taxpayers.• Remains the “most important issue” for transfer pricing enforcement according to

Transfer Pricing Director Maruca.• Evidence of the IRS approach can be seen in the Veritas and Amazon litigations.

• IRS believes that the results of many transactions, especially those with intangibles, lack “common sense” and are “too good to be true.”• Poses difficulties for taxpayers that have structured intercompany transactions under

traditional transfer pricing methods.• Suggests that interpretations of financial results for intercompany transactions will be

highly subjective.

IRS Transfer Pricing Enforcement:

A First-Hand Perspective

Paul Tew

Dixon Hughes Goodman LLP

High Point, North Carolina

IRS’ Reboot in the Transfer Pricing Arena

Organizational Realignment Formation of Transfer Pricing Operation.Realignment of Advanced Pricing Agreement (APA) and Mutual Agreement teams under Transfer Pricing Operation.

Enforcement StrategyStaffing and mobilization of Transfer Pricing Operation.Formation of Transfer Pricing Council.Establishment of web-based Transfer Pricing Center.

GoalsFacilitation of enhanced internal collaborationEnhanced control over development of transfer pricing audit issues and APA’s.Control of case outcome deeper into the issue resolution process.

The Queen v. GlaxoSmithKline Inc.

Angeline Zioulas

MNP LLP

Vancouver, British Columbia

• Taxation years: 1990-1993

• Legislation: former ss.69(2), replaced by new s.247

• At issue: • Intercompany price paid by Glaxo Canada to

Swiss affiliate for purchase of ranitidine drug (generic price $300 vs. branded price $1500)

• Relevancy of License Agreement between Glaxo UK and Glaxo Canada

• Transfer pricing adjustment: • $51 million

Background and Facts

Glaxo UK • Parent company• Owns IP related to drug business.

Glaxo Canada • Granted license by Glaxo UK to

manufacture and sell branded drug, Zantac, in Canada.

• Purchases ranitidine (required to produce Zantac).

Adechsa SA • Swiss affiliate responsible for

selling ranitidine to related parties on a world-wide basis.

Glaxo UK

Glaxo Canada

Royalty Payment

License

Supply Agreement

Adechsa

Ranitidine

$1,500/kg

License Agreement

Transaction Flow

Tax Court of Canada (2006-2008)

• CRA position: Generic price of ranitidine is arm’s length.

• Glaxo’s position: Generic price not appropriate as it ignores economic circumstances. License and Supply Agreements should both be considered in determining arm’s length price.

• TCC decision: In favour of CRA. License and Supply agreements are separate transactions, and transfer price = generic price + $25/kg.

Federal Court of Appeal (July 2010)

• Glaxo appeal: Trial judge erred in determining circumstances that are relevant for application of ss.69(2). “Reasonable person” test should apply.

• FCA decision: Agreed with Glaxo: trial judge erred and License Agreement should be considered in determining arm’s length price.

Lower Court Decisions

• Crown’s appeal: Arm’s length price should focus only on transaction at hand and economic circumstances should be ignored. “Reasonable person” test not applicable for TP matters.

• Glaxo’s cross-appeal: FCA erred in referring matter back to TCC; assessment should have been set aside.

• SCC decision: Agreed with Glaxo and FCA that economic circumstances should be considered. Referred back to TCC to determine reasonable price for ranitidine giving consideration to interplay of Supply and License Agreements.

Supreme Court of Canada Decision (October 18, 2012)

• TP is not an exact science; unlikely comparables will yield identical circumstances. Determining a range of arm’s length prices would be reasonable approach.

• TCC should bear in mind the roles and functions of each party in determining arm’s length price. TCC should consider whether compensation for IP is justifiable.

• Arm’s length parties establish price having regard to independent interest of each party; therefore, interests of Glaxo Group and Glaxo Canada must be considered.

• Evidence that arm’s length distributors have purchased ranitidine from Glaxo Group rather than generic companies; this suggests higher than generic price is justifiable.

SCC Guidance to TCC

Transfer Pricing for Intangible Property

Will James

BKD LLP

St. Louis, Missouri

Intangible Property and Transfer Pricing

Intangible property (IP) is one of the most difficult and controversial areas of transfer pricing planning, documentation, and enforcement.A company’s IP typically creates significant value, and therefore it can greatly affect profitability and taxable income.It can be difficult to identify intangibles that are subject to an intercompany transfer and even more difficult to evaluate arm’s length pricing for these intangibles. • “Unique” intangibles makes finding comparable transactions difficult.

Because intangible property can drive significant value and taxable income, tax authorities have increased enforcement of intangibles transfers in recent years. • Particularly common where an IP transfer is with an entity in a low-tax

jurisdiction.

Intangible Property Definition per Treas. Reg. §1.482-4(b)

• Patents, inventions, formulae, processes, designs, patterns or know-how.

• Copyrights and literary, musical or artistic compositions.

• Trademarks, trade names or brand names.

• Franchises, licenses or contracts.

• Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data.

• Other similar items.

Transfer of technology intangibles• Know-how• Patents• Processes• Formulations• Copyrights, etc.

Transfer of marketing intangibles• Trademarks

• Trade names

• Brand names

• Reputation

• Customer relationships

• Customer lists

• Sales force, etc.

Payment of royalty (transfer price)

License of technology

XYZ U.S.(Research &

Development Co.)

XYZ Germany (Manufacturing Co.)

Third Parties

Market price for sale of

goods

Example of Intangible Property Transfers

• Intangible assets are generally transferred between related parties under the following models:

1. Licensing

2. Provision of services that use intangibles

3. Cost sharing arrangement

4. Outright sale

Types of Intangible Property Transfers

• Comparable uncontrolled transaction method (“CUT”) (§1.482-4(c))

• Comparable profits method (“CPM”) (§1.482-5)

• Profit split method (“PSM”) (§1.482-6)

• Unspecified methods (§1.482-4(d))

• Generally speaking, these methods have parallels in the OECD Transfer Pricing Guidelines, which are used by most other countries outside the U.S.

Intangible Property Methods Specified in U.S. Transfer Pricing Regulations

• Similar to relief from royalty valuation approach under valuation principles.

• Intercompany royalties are derived from comparable licensing arrangements:• Internal CUTs – involving taxpayer or taxpayer’s affiliate(s) and a third party.• External CUTs – based on licensing arrangements between third parties.

• External CUTs are often sourced from licensing databases• Such as RoyaltyStat, RoyaltySource or ktmine.

Comparable Uncontrolled Transaction MethodComparable Uncontrolled Transaction Method

• Requires significant comparability between the related and comparable transactions:

• Functions performed by the licensee and the licensor.• Risks borne by the licensee and the licensor.• Contractual terms of the agreement.• Economic conditions surrounding the license.

• The underlying intangibles must also be very comparable:– Must be used in connection with similar processes within the same industry

or market.– Must have similar profit potential – assuming that profit potential can be

measured.

Comparable Uncontrolled Transaction Method (cont.)

• Other comparability factors which must be considered include:

• Terms of transfer – including the rights granted in the intangible, exclusivity, restrictions, and territory.

• Stage of development of the intangible.• Rights to receive updates and modifications to the intangibles.• Uniqueness of the intangible and the period for which it remains unique.• Duration of the license.• Any economic and product liability risks to be assumed by the licensee.• Existence of any collateral transactions.• Functions to be performed by the licensee and licensor.

Comparable Uncontrolled Transaction Method (cont.)

The comparable profits method (CPM) benchmarks the profitability of the licensee against comparable third parties.

• Provides an ‘indirect’ way of testing the arm’s length nature of the intangibles transaction. • The compensation for the intangibles (i.e., royalty) may change from year to

year as the profitability of the comparable third parties changes.• Assumes that the transfer pricing of the licensee’s other intercompany

transactions are at arm’s-length.• Generally used to evaluate whether an already established royalty is

arm’s-length by benchmarking the profitability of the licensee against comparable third parties.

• Benchmarks operating profit (operating margin, net cost plus, Berry Ratio or return on assets).

Comparable Profits Method

• Example: USCo licenses its technology to its subsidiary, IrishCo, which uses the technology to manufacture products.

• Through a database search, five comparable companies with functionally comparable manufacturing activities to that of IrishCo are located.

• The median operating margin (OM) of these five companies is 14% .• IrishCo’s OM is 34%.• Therefore, the arm’s length royalty payment is assumed to be 20% (34% less

14%).• Significant issue is that this method assumes that the entire residual

profit of the licensee (IrishCo) relates to intangible property that is not owned by the licensee.

Comparable Profits Method (cont.)

• Generally used when both parties to the intercompany transaction own valuable non-routine intangible assets

• This method is covered in more detail later in the presentation.

Profit Split Method

• Unspecified methods should evaluate the related party transaction relative to any realistic alternatives that may exist (in other words, no other specified methods are available).

• An unspecified method should only be applied if it ensures the most reliable measure of the arm’s-length result.

Unspecified Methods

• In a CSA, compensation may be due to an IP owner for pre-existing intangibles that are contributed to the CSA. This represents a ‘platform contribution transaction’ (PCT) under U.S. regulations (often called a ‘buy-in’ transaction).

• Methods for valuing PCT payments:• Comparable uncontrolled transaction (CUT) method (§1.482-7(g)(3)• Income method (§1.482-7(g)(4))• Acquisition price method (§ 1.482-7(g)(5))• Market capitalization method (§1.482-7(g)(6))• Residual profit split method (§1.482-7(g)(7))• Unspecified methods (§1.482-7(g)(8))

• There is still much debate among transfer pricing practitioners and the IRS over the cost sharing regulations, especially in the area of the PCT valuation methodologies.

Valuation Methodologies under Regulations for Cost Sharing Arrangements (CSA)

• Consistent with the CUT method in intangible property regulations.

• Regulations suggest that the CUT method cannot often be applied to PCT valuations because stringent comparability methods cannot be met:

• Similar comparability criteria as discussed previously for CUTs.• CUTs used in the context of a PCT valuation must be “co-develop” CUTs as

opposed to “make-sell” CUTs.• It is much more difficult to identify these types of “co-develop” CUTs in

third-party transactions.• However, the concept of a CUT royalty is used in other PCT valuation

methods (notably the income method).

• IRS has strongly challenged the use of CUTs for valuing PCT or buy-in payments (such as in the Veritas case).

Comparable Uncontrolled Transaction Method

• Investor Model• Purpose of entering a CSA under the income method:

• To achieve an anticipated return appropriate to the risks.• Premise: Opportunity Cost

• Investor would not enter a CSA if its anticipated return would be less than it could achieve through an alternative investment (such as licensing).

• Arm's-length parties would not invest unless appropriately rewarded.• Need to analyze both perspectives (payment recipient and payor) – “best

realistic alternative”• Payor = is it better to license CSA IP from unrelated party or enter into CSA.• Payment recipient (payee) = is it better to bear all development risk and

license to third party or enter into CSA• In practice, the income method only looks at one perspective = the payor.

Income Method

• In particular, the Investor Model assesses:

• The reliability of a method based on its consistency with the assumption that the rate of return anticipated at the date of the PCT for both the licensor and licensee must be equal to the appropriate discount rate for the CSA activity.

• Furthermore, the investor model indicates that the present value of the income attributable to the CSA for both the licensor and licensee must not exceed the present value of income associated with the best realistic alternative to the CSA.

• Recognizes that discount rates used in the present calculation of PCTs can vary by different types of transactions and forms of payments.

• Overall, the Investor Model has made CSAs less attractive to taxpayers.

Income Method (cont.)

• Framework of income method

• Compares two realistic alternatives – typically a licensing and CSA model.• Based upon discounted cash flows.• Generally analyzes the participant to the CSA which is contribution the PCT.• Used when one participant owns all existing IP and makes the PCT• Uses similar approaches to CUT and CPM methods.• The appropriate present value of the PCT payment may be determined as the

difference between:1. The PCT payor’s expected present value of participating in the CSA before taking

into account its required PCT payments, and2. The PCT payor’s expected present value of licensing the intangibles for use in its

operations .

• It is also the preferred method of the IRS.

Income Method (cont.)

• Acquisition price less tangible assets less intangible assets which are not being transferred equals the value of the intangibles being transferred.

• Requires that the intangibles be transferred close to the date of the acquisition.

• Generally used if the majority of the value of the acquisition relates to the value of the IP.

• Often used in a scenario when there is an acquisition which has significant IP which will be used in an existing CSA.

Acquisition Price Method

• Market capitalization method determines the market value of intangibles by reference to the market value of equity.• A company must have publicly traded stock.

• A company’s market value is the net present value (“NPV”) of expected future earnings.

• The arm's-length payment for existing intangibles is the NPV of all expected future income associated with the identified intangibles being transferred.

• Market value of identified intangible assets:• Total Market Capitalization (market value of shares outstanding)

+ Total Liabilities (book value)- Book Value of Total Assets (gross or net value)= Market Value of Total Intangible Assets

- Excluded Intangible Assets = Market Value of Identified Intangible Assets

Market Capitalization Method

• The Residual Profit Split Method (RPSM) is applied when more than one participant makes non-routine platform or operating contributions.

• Regulations use the examples of:

1. One party contributing technology intangibles (manufacturer/developer) and the other contributing marketing intangibles (distributor).

2. Both parties contributing technology intangibles (along with operating intangibles).

• Serves to limit the applicability of the RPSM.

Residual Profit Split Method

Application of RPSM:

• Determine routine contributions (routine returns)• Non-IP generating activities.• Generally, determined using CPM comparables.• Can be a loss or profit.

• Determine the amount of the residual profit attributable to each party’s contribution to the IP• Would need to determine how much of total residual profit is attributable to

existing intangibles versus newly-created IP.• Measured by external benchmarks that reflect the fair market value of the IP,

or• Capitalized costs of developing the IP less an appropriate amount of

amortization based upon the useful life of the IP.

Residual Profit Split Method (cont.)

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

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