Transfer Pricing Case studies Workshop SAN Jose 31 March - 4 APRIL 2014 8-a. Intangibles - Basic OECD freely authorises the use of this material for non-commercial purposes. All requests for commercial uses of this material or for translation rights should be submitted to rights@oecd.org. The opinions expressed and arguments employed herein are those of the author and do not necessarily reflect the official views of the OECD or of the governments of its member countries.

Importance of Intangibles Importance of intellectual property rights (trademarks, patents and copyrights) to business has increased. ‘Key value drivers’ within international groups. 30% of world trade relates goods and services associated with intellectual property. Intangible assets account for 50%-70% of the market value of public companies. Opportunities for tax planning. For transfer pricing, profit potential can be more easily re- allocated in the case of intangibles than production facilities.

Most Valuable Brand Names (in million US$) 77 839 76 568 75 532 69 726 57 853 43 682 40 062 39 385 32 893 30 280 (Source: Best Global Brands 2012, Interbrand) Coca-Cola brand constitutes 60% of the market value of the company!

Transfer Pricing Aspects of Intangibles Initial Discussion Draft published June 2012 Public consultation November 2012 Revised Discussion Draft (RDD) published July 2013 Public consultation November 2013 in Paris Targeted completion by September 2014 as part of work on BEPS

Basic Definition of an Intangible “The word intangible is intended to address something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.” RDD para. 40

Elements Required to be an Intangible Capable of being owned or controlled Does not include local market conditions (eg good weather; structure of market) Does not include MNE group synergies which are not owned or controlled by a single member of an MNE group Capable of being used in commercial activities Use or transfer would be compensated in transactions between independent parties Not a physical asset or a financial asset

Types of Intangibles OECD TP Guidelines (Chapter VI): no definition, but a list of commonly encountered intangibles: COMMERCIAL INTANGIBLES: Used for the production of a good or the provision of a service. Business assets transferred to customers or used in the operation of business (e.g. software) TRADE (MANUFACTURING) INTANGIBLES E.g. patents, know-how, designs and models MARKETING INTANGIBLES E.g. trademarks and trade names, customer lists, distribution channels, unique names, symbols, pictures.

Illustrations Quiz (not comprehensive/complete list) Intangibles for TP Not intangibles for TP Patents? Know-How / Trade Secrets? Trademarks, Trade Names and Brands? Licenses and similar limited rights in intangibles? Assembled workforce? Group Synergies? Market specific characteristics?

Illustrations: Know-How / Trade Secrets If information or knowledge meets 4 conditions: secret or not widely known has commercial value identifiable not registered Value depends on confidentiality, may be protected by Competition law Employment contracts Economic and technological barriers to competition

Illustrations: Trademark Unique name, symbol, logo or picture (any sign, or any combination of signs) capable of distinguishing the goods or services Generally registered Examples are the following trademarks: In some countries it is sufficient to file a description or designation of the trademark, e.g. in the United States, a lion’s roar at the beginning of a MGM-produced film, the sound of a Harley-Davidson motorbike.

Illustrations: Trade Name / Brand Often name of an enterprise, e.g. Generally registered Brand Often used interchangeably with term “trademark” or “trade name” But a ‘brand’ is a combination of intangibles, generally including a trade name, customer relationship, reputation, goodwill

Example: “Less in the business of clothes manufacturing than he is in the business of signing his name. The company is run entirely through licensing agreements with Hilfiger commissioning all its products from a group of other companies: Jockey International makes Hilfiger underwear, Pepe Jeans London makes Hilfiger jeans, Oxford Industries makes Tommy shirts, the Stride Rite Corporation Makes its footwear. What does Tommy Hilfiger manufacture? Nothing at all.” (Naomi Klein, No Logo, London, 2000)

Illustrations quiz (not comprehensive/complete list) Intangibles for TP Not intangibles for TP Patents Group Synergies Know-How / Trade Secrets Market specific characteristics Trademarks, Trade Names and Brands Assembled workforce Licenses and similar limited rights in intangibles - In cases where a structural advantage or material synergistic benefit or burden can be clearly identified and is attributable to deliberate concerted group actions, a comparability adjustment is likely to be warranted. (para20 of RDD) - Where (such) a transfer of know-how or other intangibles results from the transfer or secondment of employees, the redulting transfer of know-how or other intangibles should be separately analysed under the provision of Chapter VI and an appropriate price should be paid for the transferred know-how or other intangibles. (para17 of RDD)

Identifying intangibles Intangibles can be legally protected or not Examples: patent / trade secrets They can be on the balance sheet or not Examples: acquired / created and capitalised / created and expensed They can be remunerated or used free of charge by other group companies (often in good faith) Identification and determination of ownership, and who should be entitled to associated rewards, can be difficult

To identify intangibles, a thorough functional analysis must be performed It is not sufficient to rely on the balance sheet or the P&L accounts “Do not forget that probably half of the companies do not have a well-articulated procedure in place to charge other group companies for their use of IP “ (Source: PricewaterhouseCoopers / Landwell survey of intellectual property, March 2002) Requires a thorough functional analysis

Functional analysis Interviews Historical background of the company Financial information released for investors Other publicly available information

Identifying intangibles Review financial information Balance Sheet Not all intangibles are recognised as intangible assets for accounting purposes Must meet definition of intangible asset (identifiable, control over a resource, and existence of future economic benefits) Must meet recognition criteria

Identifying intangibles Income Statement Example – Exclusive License License execution fee Royalty revenues/expenses Regulatory milestone payments (exclusive development rights) Product milestone payments (exclusive manufacturing rights) Execution fees on sublicensing (right to sublicense) Other Write-down of development costs Impairment loss Amortisation expense pertaining to intangibles (e.g. amortised development costs)

Identifying intangibles Cash Flow Statement Project development costs Notes to financial statements (e.g. purchase price allocations) Annual reports Marketing activities (brochures) Internal valuation Royalty / license agreements Franchise agreements Interviews Management/owners R & D team

Where intangibles are identified, they must be taken into account: In the functional analysis In the selection of the transfer pricing method In the selection of the “tested party” for a one-sided method: the less complex party to the transaction In the selection of uncontrolled transactions that can be used as comparables

Characterisation of Transactions Use of intangibles in connection with sales of goods or services Transfer of intangibles Sale of intangibles Transfer of rights in intangibles (eg a licence) Transfer of combinations of intangibles Transfer of intangibles in combination with other transactions

Determining ownership or rights to returns?

Patent and trademark registrations Example 1: Rights of an enterprise to share in the return of an intangible it does not own Company A: Patent and trademark registrations Country A Country B Country C Company B: R&D activities Company C: Marketing activities Legal ownership / registrations in A Are there situations where B and C have rights to share the return (and if so, what is the extent of such rights)?

Example 2: Who is entitled to the intangible related returns? Parent Development Sub Co Sub Co Sub Co Funding INDIA IRELAND 100 m $ Patent Registration Contract R&D

Identification of the party(ies) entitled to returns from intangibles Legal ownership or bearing of costs alone: generally not sufficient to be entitled to all the returns related to the intangible Factors to be considered: Terms and conditions of legal arrangements Functions, risks and costs related to intangibles who performs functions? who bears risks and costs? who controls the risks?

Examples: a developer may perform a research activity: In its own name, i.e. with the intention of having full legal and ‘economic’ ownership of any resulting intangible On behalf of one or more other group members under an arrangement of contract research where the beneficiary or beneficiaries have legal and ‘economic’ ownership of the intangible, or On behalf of itself and one or more other group members under an arrangement in which the members involved are engaged in a joint activity and have economic ownership of the intangible

Case 1: Development in its own name (The parent company gets dividends) R&D centre The manufacturer gets manufacturing reward The distributor gets distribution reward Provides funding (finance the R&D) Bears risks (failure) If successful: owns intangible developed Exploits (itself or though license out) and gets the residual profit attributable to the intangible

Case 2: Contract Research Provides funding (finance the R&D) Bears risks (failure) If successful: owns intangible developed Exploit (itself or though license out) and gets the residual profit Foreign IP company Contract R&D Provides no funding Bears limited risks (no risk of failure, only responsible for correct performance) If successful: no ownership of intangible developed No exploitation, No residual profit attributable to the intangible

Case 3: Joint research R&D centres x countries All provide funding (finance the R&D) All share risks of failure If successful: co-ownership (generally ‘economic’) of intangible developed

Case 4: Cost Contribution Arrangement R&D centre Marketing or manufacturing companies can be a contract researcher, or one or more of the CCA members All provide funding (finance the R&D) All share risks of failure If successful: co-ownership (generally economic) of intangible developed

Discussion These 4 scenarios have different transfer pricing consequences. Assuming you are auditing a company that performs R&D functions, how would you assess whether it does so in its own capacity, as a contract researcher, through joint research, or as a member of a CCA?

Valuation issues

Importance and difficulties of valuation Book value not always meaningful Historical costs do not necessarily represent value Accounting standards differ with respect to fair market valuation and can create significant differences: Daimler Chrysler which had net income of USD 733 millions in 2001 according to German accounting standards had a USD 589 million loss applying US GAAP; Vodafone Group PLC had a USD 10 billion loss for 2004 which became a USD 17 billion profit by applying IFRS Reason= different depreciation rules for intangible assets Source: Isabel Verlinden, Axel Smits and Bart Lieben, Mastering the IP life cycle, 2005

OECD TP Methods Comparable Uncontrolled Price Method (CUP) Can be used if the owner has transferred comparable intangibles under comparable circumstances to independent parties In practice it is unusual to find exact CUP for a controlled transactions Other methods might have to supplement or endorse the results of a CUP analysis Resale price method May be used in the case of sub-licensing by the associated enterprise to third parties 34

OECD TP Methods Cost plus method? TNMM Profit split method Caution! Cost does not necessarily reflect value TNMM Sometimes possible to apply, e.g. owner of a manufacturing process licenses the process to a related party for use in a particular market Profit split method Appropriate when the licensee contributes significant value to the intangible Residual profit split method is generally more appropriate Other methods may also be used where appropriate 35

Main non-tax valuation methods Practical valuation issues: Heterogeneous, often unique nature of intangibles Estimation of the remaining useful life of the asset Forecast of cash flows and measure of the risk 36

Valuing a licence The first step is to perform a thorough comparability analysis (9 steps). This will allow identification of: Type of property to be licensed (e.g. non-unique intangible or unique intangible) Rights granted to the licensee Relative value of the rights granted 37

License of an Intangible Example Licence agreement + technical know how Stainless AG (Germany) Irish Subsidiary Creates a grease stain remover which preserves the colour of the clothing Patents the invention Licence agreement + technical know how Gone for Always Inc (US) Gone for Always Inc (US) is an independent party 38

License of an Intangible Example (continued) Irish Subsidiary Gone for Always Profile Full-fledged manufacturer Type of arrangement License + related technical know how Type of license Exclusive Rights granted Manufacture, use and sale of products Duration Patent’s life + 20 workdays of technical assistance Geographic scope Europe US 39 39

License of an Intangible Example (continued) Questions: Are these two license agreements comparable? Which are the differences that should be examined in greater detail? 40

Considerations in valuing an Intangible Expected profits attributable to the technology Cost of developing the technology? Degree of protection provided under the terms of the license as well as the length of time the protection is expected to exist Terms of the transfer, including geographic limitations Uniqueness of the property Consider from the perspective of the transferee AND the transferor 41

Use of Valuation Techniques Use of valuation techniques specifically approved No comprehensive summary of acceptable valuation techniques No endorsement of particular valuation practices or standards Purchase price valuations are not determinative for transfer pricing purposes Techniques based on discounted value of cash flows can be especially useful But with an important caveat: Assumptions underlying application of valuation techniques must be carefully considered. Such techniques must be applied using assumptions that are consistent with the arm’s length principle

Valuation of Intangibles - Uncertainties - Valuation of intangibles can be highly uncertain What would independents have done? Possibilities: Value anticipated benefits (subsequent developments are foreseeable and predictable?) Short term agreement Price adjustment clause Sliding scale royalty (royalty rates increase or decrease with sales) Renegotiation of main contractual terms where major unforeseen developments, or transaction becomes uneconomic See explanation in paras. 6.28 6.35 OECD TP Guidelines 43

Valuation of Intangibles - Information Requests - The following information may assist in determining transfer price/value: Transfer pricing agreements Royalty/license agreements Development/exploitation contracts Financial statements Forecasts/projections (e.g. royalty revenues) Operational documents (e.g. manuals) Registration documents (e.g. patent application) Judicial decisions/court orders Technology data Product life cycle information Development costs Trade publications (in subject industry) 44

Transactions Involving Use But Not Transfer of Intangibles General rules of Chapters I – III apply Intangibles are an important comparability factor Comparables can often be found even where intangibles are used by one or both parties Where the existence of unique and valuable intangibles makes comparability difficult, methods not relying on comparables, including profit splits and valuation techniques may be necessary

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