FUTURUM - Tax event tax seminar and training fe ui - intangibles in transfer pricing (21 juni 2012)

INTANGIBLES
IN TRANSFER PRICING
21 Juni 2012
Tax Event: Tax Seminar and Training FE UI
Sukarnen
www.futurumcorfinan.com
1

“In theory, there is no difference
between theory and practice.
But, in practice, there is”
Manfred Eigen (scientist)
2

The transfer pricing rule is quite simple to state:
The optimal transfer price for a product or service is
ITS OPPORTUNITY COST –
it is the value forgone by not using the transferred
product in its next best alternative use.
Unfortunately, as we will see, this simple rule is often
difficult to implement in practice. But determining
opportunity costs is itself an expensive undertaking,…
Jerold L. Zimmerman
(Accounting for Decision Making and Control, 2003)
3

“The first sign we don’t
know what we are doing
is an obsession with
numbers”
(Johann Wolfgang von Goethe)
4

One of the easiest and fastest ways for monetizing
individual intangible assets outside of the capital markets
is by creating revenue streams through
LICENSING.
Jarboe and Furrow (2008)
5

One critical issue:
How much fee that is to be paid by the licensee
(who utilizes the intangibles) to the licensor (who
owns legally the intangibles)
6

 To demonstrate that the
object upon which the royalty
fee is paid, exists (existence
test).
FAQs DURING THE TAX AUDIT ON INTANGIBLES
 To demonstrate how much
the value of the object upon
which the royalty fee is paid
(valuation test)
7

Valuation Test has 3 implications
Benefit Test
Payment Structure Test
Arm’s Length Test
PER-43/PJ/2010 membedakan antara transaksi
pemanfaatan harta tidak berwujud dan transaksi
pengalihan harta tidak berwujud. Keharusan adanya
manfaat ekonomis atau komersial disebutkan dalam
transaksi pemanfaatan harta tidak berwujud, tapi
tidak dalam transaksi pengalihan harta tidak
berwujud.
8

 To demonstrate the owner of the intangibles –
legal vs economic/beneficial ownership
(ownership test).
 To demonstrate whether the object upon which
the royalty fee is paid, has been transferred
(delivery or transfer test). This is usually
commonly found for soft intangibles – such as
know-how, trade secrets.
9

Definisi royalti dalam Undang-undang Nomor 36
Tahun 2008 Tentang Perubahan Keempat Atas
Undang-Undang Nomor 7 Tahun 1983 Tentang Pajak
Penghasilan (UU PPh), Pasal 4 (1), dimana disebutkan
bahwa royalti adalah:
10

IMBALAN atas:
• Penggunaan atau hak menggunakan hak cipta di
bidang kesusastraan, kesenian atau karya ilmiah,
paten, desain atau model, rencana, formula atau
proses rahasia, merek dagang, atau bentuk hak
kekayaan intelektual/industrial atau hak serupa
lainnya;
• Penggunaan atau hak menggunakan
peralatan/perlengkapan industrial, komersial,
atau ilmiah;
• Pemberian pengetahuan atau informasi di bidang
ilmiah, teknikal, industrial, atau komersial;
11

• Pemberian bantuan tambahan atau pelengkap
sehubungan dengan penggunaan atau hak
menggunakan hak-hak tersebut, berupa:
 Penerimaan atau hak menerima rekaman gambar atau
rekaman suara atau keduanya, yang disalurkan kepada
masyarakat melalui satelit, kabel, serat optik, atau
teknologi serupa;
 Penggunaan atau hak menggunakan rekaman gambar
suara atau keduanya, untuk siaran televisi atau radio yang
disiarkan/dipancarkan melalui satelit, kabel, serat optik,
atau teknologi yang serupa;
 Penggunaan atau hak menggunakan sebagian atau
seluruh spectrum radio komunikasi;
12

• Penggunaan atau hak menggunakan film gambar
hidup, fim atau pita video untuk siaran televisi, atau
pita suara untuk siaran radio; dan,
• Pelepasan seluruhnya atau sebagian hak yang
berkenaan dengan penggunaan atau pemberian
hak kekayaan intelektual/industrial atau hak-hak
lainnya sebagaimana telah disebutkan.
13

Maka royalti jelas merupakan pembayaran terkait
dengan pemberian hak (bukan pengalihan
kepemilikan) untuk menggunakan, membuat atau
menjual suatu produk atau jasa yang melibatkan
intangibles
(termasuk atau hak kekayaan intelektual - HAKI)
dalam proses pabrikasi, pemasaran, penjualan
dan/atau distribusi.
14

Transaction Flow in a MNC– Simplified Model (Brem and Tucha, 2005, p. 10)
15

Toll
Manufacturer
Contract
Manufacturer
Licensed
Manufacturer
Functions
and
risks
Intangibles
Sales
Inventory
Manufacturing
Principal
Intangibles
Sales
Inventory
Manufacturing
Intangibles
Sales
Inventory
Manufacturing
Manufacturer
Intangibles
Sales
Inventory
Manufacturing
Entrepreneur
Manufacturing Function
16

Article 12 of the OECD Model Tax Convention
The term “royalties” as used in this Article means
payments of any kind received as a consideration for
the use of, or the right to use, any copyright of
literary, artistic or scientific work including
cinematograph films, any patent, trade mark, design or
model, plan, secret formula or process, or for
information concerning industrial, commercial or
scientific experience.
17

DIFFERENT DEFINITIONS FOR
DIFFERENT PURPOSES, OR EVEN
COUNTRIES?
19

• Legally protected intangibles? (too narrow)
• Intellectual Property that can be transferred from
one business enterprise to another for a positive
price?
• Intangibles related to the business enterprise itself
such as goodwill and going concern? (too broad)
• Accounting : capitalized asset, deferred expenses,
or expensed off?
• Intangible for transfer pricing purposes, need
another definition?
Intangibles are:
20

International Accounting Standard
No. 38 (adopted by PSAK 19 (revisi
2010) Aset Takberwujud)
Intangible asset:
• Identifiable
• Non-monetary asset
• Without physical substance
21

What is IDENTIFIABLE (IAS 38)?
An asset is identifiable if it either:
 Is separable, that is CAPABLE of being separated or
divided from the entity and sold, transferred,
licensed, rented or exchanged, either individually or
together with a related contract, identifiable asset
or liability, regardless of whether the entity
intends to do so; or
 Arises from contractual or other legal rights,
regardless of whether those rights are
transferable or separable from the entity or from
other rights and obligations.22

What is an ASSET (IAS 38)?
An asset is a resource:
• Controlled by an entity as a result of
past events; and
• From which future economic benefits
are expected to flow to the entity.
23

What is a CONTROL (IAS 38)?
The power to obtain the
future economic benefits
flowing from the
underlying resource and to
restrict the access of others
to those benefits
24

An item that meets the definition of an intangible asset
should only be recognized (on balance sheet) if (IAS 38):
 It is probable that the expected future economic
benefits that are attributable to the asset will flow
to the entity; and
 The cost of the asset can be measured reliably.
25

Example of Intangible Assets
26

CONTRACT-BASED INTANGIBLES
• Licensing, royalty and standstill agreements
• Advertising, construction, management, service or supply
contracts
• Lease agreements
• Construction permits
• Franchise agreements
• Operating and broadcast rights
• Use rights such as drilling, water, air, mineral, timber-cutting
and route authorities
• Servicing contracts such as mortgage servicing contracts
• Employment contracts that are beneficial contracts from the
perspective of the employer because the pricing of those
contracts is below their current market value.
27

Why Intangible
now becomes a
matter to
everybody?
28

intangible
Assets 20%
tangible Assets 80%
tangible Assets
20%
intangible Assets 80%
Knowledge Economy
Yesterday – manufacturing
based economy
Today – technology and
innovation driven economy
29

Sales of products
Consulting agreements
Purchase of raw
materials
Services provided
offshore on behalf
of onshore
Intellectual property
Subsidiary to holding
company
Transfer Pricing
Purchase of products
Royalties agreements
Services provided
onshore on behalf
of offshore
TYPES OF TRANSFER PRICING ARRANGEMENTS
30

For Transfer Pricing Purposes:
Profits attributable to intangibles, either:
 Embedded in a product or service (e.g. sport shoes,
luxury goods)
 Used in a transaction (e.g. in a manufacturing
transaction)
 Subject to the transaction itself (e.g. license
agreement, cost contribution arrangement,
disposal of intangible property rights)
31

ARM’S
LENGTH
VALUATION
THREE INTER-
RELATED
TRANSFER
PRICING ISSUES
OWNERSHIP
CHARACTE
RIZATION
32

What is the purpose of
characterizing an “intangible” for
transfer pricing purposes?
33

Determining the arm’s-length price for a transaction
that INVOLVES intangibles: factors contributing value
(whether intangibles or not)
 Functional analysis
 Identification of implicit and explicit commitments
within and outside the group
 Value drivers
Determining an arm’s-length price for a TRANSFER of
intangible : License, long-term service commitment,
outright sale.
(OECD, Paris, 21-22 September 2009)
34

OECD TP Guidelines :
No definition of intangibles but a list of commonly encountered ones
1) Commercial
intangibles
Either used for the
production of a good or
the provision of a
service,
Or
2) business assets
transferred to
customers or
3) used in the operation
of business (e.g.
software)
Trade intangibles: e.g. Patents, Know-
how, Designs, and Models
Marketing intangibles: e.g.
trademarks and tradenames,
customer lists, distribution channels,
unique names, symbols, or pictures
35

US Income Tax Regulations section 1.482-4(b)
the final section 482 regulations
An Intangible : an Asset with substantial value independent of the services
of any individual , and as comprising any of the following six categories:
• Patent, 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, program, systems, procedures, campaigns, surveys,
studies, forecasts, estimates, customer lists or technical data, and
• Other similar items. An item is considered similar if it derives its
value not from physical attributes, but from its intellectual content
or other intangible properties.
Note : The final definition of intangible property does not include language
from the temporary regulation definition which required intangible property
to be “commercially transferable”. 36

Consequences of a dispute on the Transfer Pricing
characterization of Intangibles
Determination of the Arm’s-Length
Remuneration
Can the existence of differing
definitions of intangibles trigger
double taxation?
37

Characterisation Issues : Illustrations
Source: Transfer Pricing and Treaties in the changing world
OECD, Paris, 21 – 22 September 2009
38

Rent a Brand
46

Allocating
ECONOMIC/BENEFICIAL OWNERSHIP
OF INTANGIBLES
 Between
Associated
Enterprises
 Between a
Permanent
Establishment and
the rest of the
enterprise
47

Example :
Marketing activities undertaken by
enterprises not owning trademarks or
tradenames
(OECD Transfer Pricing Guidelines 6.36 –
6.39)
Allocating the economic ownership of
intangibles between associated enterprises
48

Allocating the economic ownership of
intangibles to a permanent
establishment
Significant People Functions relevant
to the ownership of assets
(OECD Report on Attribution of
Profits to Permanent Establishments,
July 2008)
53

Parameters for application of the concept of
economic ownership
• Hallmarks/features
• Example: Extent to which
mere performance of an
activity may or may not
give rise to full or partial
economic ownership of a
marketing intangible
54

Critical Issues Arising in Practice regarding Economic Ownership
 Refusal of trademark royalties paid to IP owner, on basis that the local
distributor created value in the local market (e.g. established brand
recognition of the trademark).
 “Elevated” marketing expenses of the distribution entity (e.g., Selling,
General and Admin expenses to Sales Ratio greater than those of the
benchmark comparables).
 Claimed by tax authorities to justify treatment of local distributor as
entrepreneur, or to refuse deductibility of “excess” marketing expenses, etc.
 Focus on where local marketing intangible rights/property can be
established as likely to have resulted from arm’s length dealings.
 Claims that compensation is due to local distributor in context of business
restructuring, on the basis that it had developed marketing intangibles
deserving of compensation upon conversion to limited risk distributor.
 Goodwill versus marketing intangibles?
55

Marketing Intangible
MARUTI SUZUKI INDIA LTD. VS. ADDL. CIT (DELHI)
233 CTR 105 – HC DELHI, 328 ITR 210
56

• MSIL engaged in business of manufacturing and sale of automobiles and its
spareparts and components.
• MSIL is a joint venture company in India of Suzuki Motor Corporation (SMC),
Japan (54.20%).
• The trademark/logo “M” is the registered trademark of MSIL.
• SMC granted composite license in 1992 for technical know-how and use of
Suzuki (“S”) trademark under an agreement.
• The salient features of the said agreement are:
 SMC to provide all technical information and know-how for
manufacture, sale and after-sale service.
 Responsibility of MSIL is to develop and promote sales of
vehicles/spares.
 Exclusive right granted by SMC to use the licensed information and
licensed trademarke “Suzuki”.
 All products, parts, containers, packages, etc. to bear the trademark
“MARUTI SUZUKI”.
Background – Maruti Suzuki Case
57

• The agreement obligated MSIL to use trademark “Maruti Suzuki” on all
vehicles sold in its territory.
• Before entering into said agreement with SMC, MSIL were using brand
“Maruti”.
• MSIL started to use brand “Maruti Suzuki” on rear side of the vehicles
manufactured and sold by MSIL in India.
• Post agreement, MSIL also started using logo of SMC “S” instead of “M” in
the front of new models manufactured.
• For technical assistance and license, MSIL agreed to pay one time lump sum
amount as well as running royalty to SMC for the licensed information and
the use of the licensed trademarks provided by SMC.
• MSIL has incurred advertisement expenditure to promote the brand.
Background – Maruti Suzuki Case
58

Maruti Suzuki Case – Tax Authority (audit year 2004-2005)
• Suzuki was a weaker brand in India as compared to brand “Maruti” which
was a superbrand.
• Trademark “Suzuki” piggybacked on the MSIL’s trademark.
• Co-branded trademark “Maruti Suzuki” led to impairment of MSIL’s
trademark in India.
• The initial approach of the Tax Authority – “Deemed Transfer Theory”,
transfer of “Maruti” brand name to Suzuki for which MSIL should receive an
arm’s length consideration based on the fair market value of the brand.
• Tax Authority considering Cost Plus Method as the Most Appropriate
Method calculated the brand value of “Maruti” with 8% margin over cost.
• Later, the Tax Authority proposed to make an adjustment under “Assister in
Development Theory”. Under this approach, Tax Authority disallowed the
royalty paid (50% adjusted) to SMC for use of trademark and the Advertising-
Marketing and Promotion (AMP) Expenses incurred in promoting “Suzuki”
intangibles in India market.
59

• As it is MSIL that develops the market and promote the brand, SMC should
have compensated MSIL for the assistance provide in developing the
marketing intangibles. Non-routine AMP expenses was adjusted as being
the value of the marketing intangible accruing to the benefit of Suzuki.
• Tax Office uses “Bright Line Test” [referring to the US case law DHL Inc. and
Subsidiaries vs Commissioner (TCM 1998-461)] to determine non-routine
AMP expenses resulting in marketing intangibles.
Maruti Suzuki Case – Tax Authority (audit year 2004-2005)
60

Maruti Suzuki Case – High Court)
High Court remanded the matter to the Tax Authority for fresh abjudication while doing
so High Court also gave certain direction/guidelines to be followed as under:
 No obligation on SMC to pay if the use of logo is at the discretion of MSIL. If
MSIL is mandatorily required to use the foreign trademark/logo,
appropriate pay should be made by SMC for the benefit it derives in form of
marketing intangibles.
 The arm’s length pricing has to be determined taking into account all the
rights and obligations of the parties under the international transaction.
 Suitable adjustments to be made considering the individual profiles of the
entities and other facts and circumstances of the case.
 MSIL to be compensated only if the AMP expenses incurred by MSIL are
more than what a comparable independent domestic entity would have
incurred, the use of foreign trademark/logo is mandatory and the benefit to
SMC is not merely incidental.
 Appropriate comparables to be identified and suitable comparability
adjustments to be made.
 If MSIL obtained any concession from SMC to offset the extra expenditure
incurred, this would not automatically entail a payment by SMC.
61

Valuation Issues :
a few
considerations
62

Implications for Transfer Pricing Analysis?
64

Does the characterisation of an element as
an intangible or otherwise affect its
valuation?
A widely shared myth: services = Cost
Plus, and Intangibles = Profit Split
Yardstick : Would independent parties
at arm’s length remunerate the
element (whether or not qualified as
an intangible) and if ye, so how?
65

What would independent parties do at arm’s length?
• Cases where reasonably reliable comparables exist
• Cases where the same package of functions, assets,
risks assembles or can be adjusted to resemble open
market transactions
• Cases where comparables can be found for elements of
the package only
• Cases where no comparables could be found or even
exist?
66

=
IS IT?
APPLE-TO-APPLE COMPARISON!!!
IS IT POSSIBLE FOR INTANGIBLES?
67

What is a comparable?
68

COMPLIANCE – A STEP BY STEP APPROACH
69

Analysis of Comparability
(FAR = Function, Asset and Risk Analysis)
• Profitability
• Risks
• Awareness and strength of
the trademark
• Degree of trademark
protection
• Exclusivity
• Geographic reach (Local,
regional, Global)
• Industry
• Market size and
characteristics
• Growth outlook for relevant
products
• Channels of distribution
• Barriers to entry
• Company structure
• Timing
• Duration
• Scope and status of legal
protection
• Terms of agreements (e.g.,
field of use restrictions,
payment structure, etc.)
70

• Other IP needed
• Functions:
• R&D
• Product design and engineering
• Manufacturing, production and process engineering
• Product fabrication, extraction, and assembly
• Purchasing and material management
• Marketing and distribution functions, including
inventory management, warranty administration, and
advertising activities;
• Transportation and warehousing, and
• Managerial, legal, accounting and finance
Analysis of Comparability
(FAR = Function, Asset and Risk Analysis)
71

Profitability?
72

INTERACTION AMONG ASSETS AND RESOURCES!!!
75

Practical Valuation Issues
77

ASSETS – RISK AND RETURN
78

Cases where no comparables?
Not means that not arm’s length!!!
What would
independent
parties have done?
79

Would compensation have taken place between
arm’s length party?
• What are the rights and other assets of the parties?
• Is there an explicit or implicit long-term
commitment?
• Is there a benefit for the transferor (e.g.
transferring a loss-making activity)
If compensation would take place at arm’s length,
value based on sound economic theory (in the
absence of comparables)
80

The relevant Transfer Pricing
Question may not be:
Is this an intangible?
But rather:
Is this something that would
be remunerated at arm’s
length and if yes, so how?
✔
✖
82

THANK YOU
83

www.futurumcorfinan.com84
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This material was produced by and the opinions expressed are those of FUTURUM
as of the date of writing and are subject to change. The information and analysis
contained in this publication have been compiled or arrived at from sources believed
to be reliable but FUTURUM does not make any representation as to their accuracy
or completeness and does not accept liability for any loss arising from the use
hereof. This material has been prepared for general informational purposes only and
is not intended to be relied upon as accounting, tax, or other professional advice.
Please refer to your advisors for specific advice.
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