SMU-TA Centre for Excellence in Taxation Inaugural Conference 2015

Taxing and Pricing of Intangibles

Alan Ross

17 September 2015

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Outline of Discussion Areas Today

• Address the various BEPS documents impacting intangibles and touch on some of the key issues addressed in the research paper

• Focus on Functions, Assets and Risks and Value Creation

• Intangible Valuation Issues

• Asia Pacific : Some Research Aspects

• Asia Pacific : Some Closing Thoughts

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Asia Pac: Intangibles are Important

• Asia–Pacific Network Meeting on BEPS in Seoul in Feb

2015 endorsed aligning taxation with value creation

• Most Asia Pac countries No 1 concern is TP especially

offshore payments for IP royalties or technical fees

• China, India and Australia have made it clear that

overseas affiliates must have substance –other SE Asian

countries have also awakened to this

• Most countries in the region need access to technology

and other IP

• In Singapore IPOS Mission: to provide infrastructure,

build expertise and grow an ecosystem in support of the

creation , protection and exploitation of IP

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Key BEPS Actions on Intangibles

BEPS

ACTION #

Date

Issued

Description

Action 8 16/9/14 Guidance on TP Aspects of Intangibles

Action 10 16/12/1

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Use of Profit Splits for Global Value

Chains

Actions 8-

10

19/12/1

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Draft re Risk, Recharacterisation and

Special Measures

Action 8 29/4/15 Revisions to TP Guidelines on Cost

Contribution Arrangements (CCAs)

Action 8 4/6/15 Hard-to-Value Intangibles

Action 13 29/4/15 CbCR Implementation Package 5

CbCR Issues for Intangibles

• CbCR reporting details include revenue, profit, tax, number of employees and tangible assets

• Highlighting payments to low tax jurisdictions with minimal tangible presence

• Question then is whether employees in the jurisdiction are contributing to creating value in intangibles

• Local TP file needs to disclose material inter-company agreements

• OECD : CbCR only for high level TP risk assessment

• Will Asia Pacific tax authorities respect this or drive towards formulaic adjustments?

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Guidance on TP Aspects of Intangibles

• Key areas of Sept 14 draft included:

-definition of intangible (think about domestic legislation)

-ownership attributes necessary to secure entitlements to returns; and

-most importantly, to align economic outcomes and TP with value creation

• Included useful analysis of comparability factors

• Clear focus on substance, important DEMPE functions and contributions to value creation

• Nothing dramatically new from the July 13 draft on intangibles; however BEPS as the harbinger of change

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Issues re Profit Splits and Global Value

Chains

• Fear (or desire?) that direction will lead to automatic

application of profit split or worse, formulary approaches

• Asian/Developing countries’ concerns over lack of

experience /obtaining info to apply profit split

• More guidance needed on allocation factors

• Inevitable disputes with taxpayers and between

countries

• Alignment with Customs : Customs do not use profit split

• Application as corroboration tool?

• Retain as method of last resort?

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Risk, Recharacterisation and Special Measures

• Draft requirement that risks should be analysed across the value chain of MNE group rather than focusing on transacting parties seems onerous

• Must have proper identification of risks and impact

• Conduct of parties must be consistent with contractual allocation of risks

• Party taking on risk must have control over that risk but what constitutes “control”?

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Draft on Cost Contribution Arrangements (CCAs)

• More important area for Asia in future?

• Asia already has a number of issues with CCAs: e.g.

-Uncertainty re tax deductions for payments

-Potential Withholding taxes around Region

• OECD Discussion Draft very contentious on two points:

-Participants must have capability and authority to

control the risks is a major change

-Contributions to a CCA to be made at AL value

• Differences from USA rules also creates difficulties

• USA TP litigation around cost sharing “buy-ins”

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Key Issues with Action 8: Hard-to-Value

Intangibles

• Potential use of ex post projections

• Unless taxpayers produce “satisfactory” evidence that any “significant” differences between ex ante and ex post were “unforseeable” or “extraordinary” ….

• Terms are subjective and also onerous for taxpayers

• Avenues for much debate between tax authorities

• Para 5 of draft giving power to tax administrations to reconstruct but would they have the knowledge to do so?

• Are these proposals really needed at all?

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Intangibles Functions

• AL compensation for “ DEMPE” functions

• “DEMPE”-Development, Enhancement, Maintenance,

Protection and Exploitation (Exploitation now added)

• Funding IP ownership or development only justifies a

financial return

• Holding legal title to IP will not attract a return (or

possibly nominal).

• Is this anything new or just articulated better?

• SG IPOS definition of IP management: “..ascertaining

the company's intangible assets, designing management

processes to safeguard them, and utilising the IP assets

to help determine the competitive edge and formulate

the growth strategy for the company”

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Which Functions?

• Issue is identifying and agreeing the “important”

functions and the location where they are carried out

• High Potential area for disputes between countries

• For example: Outsourcing- should be Ok as long as

owner directs and controls but room for interpretation

• Old question : what substance is enough? But now front

and centre?

• Functional analyses in many TP reports are often vague

and ambiguous ..need to be more specific.

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OECD Action 8 Deliverable (Sept ‘14),Paragraph 6.4

• Identify the legal owner of the intangibles based on legal, agreements, contracts and other indicia of ownership;

• Identify the parties performing the important functions, using assets and assuming risks;

• Confirm that the parties’ conduct is consistent with the legal agreements;

• Identify the relevant transactions and the conduct of the parties involved and their contribution to the creation of value;

• Determine the arm’s length price for the transactions consistent with each party’s contributions

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Roles/Functions –A Development Spectrum -Identify Value

and Location (Real Example)

Product

Concepts

Business Plan

Manage Implement

Monitor

Build Architect

Engineer

Resource Plan

Market

Strategy

Analyze Price

Performance

Conceive

Plan

Determine future plans, leverage, market strategy

Evaluate prices in light of competition, costs, etc.

Assess financial and operational performance

Deploy solution, get feedback and propose enhancements

Develop, construct and test product to schedule and budget

Design product architecture and quality plans

Determine project priorities, schedule, and resources

Estimate revenue and costs and determine investment risk

Propose products and solutions

Conduct market research and competitive analysis

Which Risks , Who Assumes and Who

Controls?

• What are the specific risks included in the commercial or

financial relations of the parties?

• How are those specific risks allocated in contractual

arrangements? What is the potential impact of those

specific risks?

• Are the contractual arrangements in relation to the risk

allocation aligned with the conduct of the parties

• How is each risk actually managed by the members of

the MNE group?

• Does the party contractually assuming the risks, manage

them and assess, monitor, and direct risk mitigation?

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Major Risks –A Spectrum…Identify Importance and Where

Managed (Real Example) • Failure to adequately assess market and competition

• Failure to capitalize on opportunities

• Failure to accurately estimate development scope, cost, and schedule

• Failure to protect IP

• Failure to assess economic and political environment

• Development may exceed scope, cost, or schedule

• Inadequate capabilities to execute plan effectively

• Failure of deployed solution to function according to specification

• Failure to track performance and take appropriate action

• Failure to anticipate competitor reaction

• Failure to have IP rights agreements in place

Manage

Build

Analyze

Conceive

Plan

Case Study –Fact Pattern

• Company A, a parent company in Country A, has legal

ownership of intangibles; plans development of the core

intangibles, manages risk and relevant legal matters.

• Asian rights for the intangibles are licensed to Country B

(Company B) which acts as the Asian RHQ. B tailors the

intangibles for Asia and takes all decisions relating to

their exploitation in Asia

• B pays a fixed percentage royalty to Company A.

• B licenses its intangible rights along with strategic

services (provided by its experienced management) to

Company C..

• C is involved in the manufacture and sale of the products

in Country C and also has local marketing intangibles.

C

Case Study-Example of Possible

Pricing Considerations

• For Company A to enjoy a return beyond that of a

financier, A should have relevant people functions to

prove its value creation including managing risks

• A market comparable (benchmarked) royalty based on a

fixed percentage of sales might be appropriate payment

for A. Alternatively, the value of the R&D and on-going

development work may point to a profit split method.

• Pricing of the “packaged” transaction from Company B to

Company C might be benchmarked against similar

franchise arrangements; or

• Company C ‘s operations might be benchmarked using

TNMM /CPM with residual going to B-effectively a

variable royalty (possibly to be split with A ?) 19

Will Profit Split Become the Default

Method?

• Traditionally, profit split methods were considered if both parties to the transactions had valuable intangibles or if the parties” operations were highly integrated.

• It now seems that unless there is a robust internal or external CUP/CUT, a profit split method may be the default

• China specifically mentioned a desire to use the method more in future in their recent APA report !

• Yet PSM also has subjectivity re allocation factors

• However APA reports to date e.g. China, USA, Canada all indicate a very high proportion of cases are settled using TNMM (but only 20% cases (av. ) are intangibles)

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Intangible Valuation Methods

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Cost Approach

• Historical Costs

• Reproduction Cost

• Replacement Cost

Market Approach

• Market transactions

• Rules of Thumb?

Income Approach

• Discounted cash flows

• Relief from royalty

• Multi-period excess earning method

• Real options

• Game theory

• Others

Intangible Valuation-Income Approaches

• Income approaches and DCF models have layers of uncertainty but remain favoured for tax purposes

• Forecasts and discount rates ..big areas of dispute

• Do taxpayers do enough due diligence on forecasts?

-Identify the major uncertainties; eliminate bias

-Assess probability of outcomes/risk adjust

-Assess economic life and likely terminal values

-Document all rational and calculations

• Accounting valuations may not be appropriate for TP /Tax Purposes (but good guidance e.g. AICPA guide for In-process R&D)

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Intangible Valuation : Use of

Discount Rates

• Capital Asset Pricing Model (“CAPM”) model widely used

to derive Weighted Average Cost of Capital (“WACC”)

• WACC is often used as default discount rate in valuations

but is it the appropriate rate?

-it is an average and does not cater for riskier IP

• May be able to derive an implied discount rate for

intangibles from WACC

• Complex issues around pre or post tax cash flows and pre

and post tax discount rates

• Useful Paper to WP6 Committee of Fiscal Affairs in March

2011 by William Finan and Susan Launiau

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Implied Discount Rate for Intangibles

Using WACC

Balance

Sheet(

MV)

% Total

Value

(A)

ROR

(B)

WACC

(A)x (B)

Working

Capital

5 0.02 4%

0.08

Fixed

Assets

10000 33.33 5% 1.67

Other

assets

5000 16.67 6% 1,00

Intangible 14995 49.98 14.51% 7.25

Total

Market

30000 100.00 10.00

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Asia Pacific: Some Research Aspects -1

• Written research report contains a comparison of many intangible issues for Asia Pacific countries and certain Western jurisdictions. Significant findings from an Asian perspective are summarised below:

• Royalties:

-Asian countries require royalty rates validated in TP report and most look for external benchmarking; -Officially, rules of thumb are not used although some countries e.g. China, Thailand, Malaysia will focus where royalty rates exceed 3-5%

-Limited experience across Asia with variable royalties

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Asia Pacific: Some Research Aspects -2

• Valuations, Transfers of intangibles:

-Most countries prefer income based approaches

-Valuations experience in tax authorities varies

across region; much reliance on accounting

valuations ; some look for third party reports

-Market Based approaches not common due to

lack of comparables

- Differences across Asia Pacific in terms of tax

deductions available for IP acquisition costs

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Asia Pacific: Some Research Aspects -3

• Cost Sharing:

-Not common in Asia outside Japan

-Generally a lack of clarity of treatment in Asia

-OECD draft on CCAs does not help much !

-Need for greater clarity ; Cost sharing likely to increase?

• Withholding Taxes

- All Asian countries impose WHT on royalties under domestic law; treaties rarely reduce below 5-10%

- Some countries even impose WHT on overseas acquisitions of IP

- WHT position on cost share buy-ins /ongoing payments also unclear

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Asia Pacific: Some Closing Thoughts

• BEPS is likely to increase double taxation, disputes and controversy in Asia Pacific

• Countries at different stages of development may result in some using BEPS to advance domestic tax agendas

• Concerns re uses or abuses of CbCR info in developing countries

• Asia has a higher reliance on corporate taxation than many Western countries yet offers many tax incentives

• Some type of framework for regional coordination seems desirable at minimum to share knowledge, experience and principles re disputes

• Can Asean or AEC play a greater role in agreeing certain principles-intangibles are no exception

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Asia Pacific: Some Closing Thoughts

• Intangibles are a major area of potential disputes

• Some consensus from regional tax authorities would help in some areas ie

-what are acceptable comparables?(e.g. are global comps acceptable)

- principles re use of CbCR data

- guidance on recharacterisation

-cost sharing (especially buy-ins) and WHT

-intangibles valuations; i.e. reports required, structure, discount rates approach

• Countries to review what may qualify as IP and tax deductions/incentives available

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Asia Pacific: Some Closing Thoughts

• Review of withholding taxes on royalties: hindering

access to innovation?

• Reassurance of continued acceptability of TNMM at

least complex level to derive residual or is Profit Split the

end game?

• Should application of profit split require joint audits or

agreement with counterparty country ?

• More disputes will arise, so tax authorities will also have

to anticipate and reconcile views of other countries

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Asia Pacific: Some Closing Thoughts

• Taxpayers and/or advisors to be more specific in

preparing TP documentation especially around FARs.

• Should TP documentation format be more succinct?

• More robust comparability analysis required subject to

data availability?

• Inter-company contracts need to be more specific and

followed in conduct of parties

• Establish collaborative relationships with tax officials

where possible…settling taxes is no longer a poker

game or a war

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SMU-TA Centre for Excellence in Taxation Inaugural Conference 2015

© SMU-TA CET 2015. All rights reserved. No part of these materials may be reproduced or transmitted in any form or by any means, including photocopying and recording, or storing in any medium by electronic means and whether or not transient or incidentally, without the written permission of the copyright holder. These materials are for exclusive use of the conference participants. They do not in any way represent the official views of the SMU-TA CET or any other person or authority. The authors and the SMU-TA CET are not responsible for the results of any actions or omissions taken on the basis of information in these materials, nor for any errors or omissions. The authors and the SMU-TA CET expressly disclaim any liability to any person, whether a conference participant or otherwise, in respect of anything done or omitted to be done by any such person in reliance on any part of the contents of these materials.

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