OECD- Revised Discussion Draft on Transfer Pricing aspect of Intangible

OECD- Revised Discussion Draft on Transfer Pricing aspect of Intangible

Chapter VI- Transfer Pricing Guidelines

The purpose of this Chapter VI is to provide guidance specially tailored to determining arm’s length conditions for transactions that involve the use or transfer of intangibles

In order to determine arm’s length conditions for the use or transfer of intangibles it is important to consider as part of the comparability and functional analysis:

(i)                   the identification of specific intangibles;

(ii)   the legal ownership of intangibles and the contributions to their development,       
 enhancement, maintenance and protection; and

(iii) the nature of the controlled transactions involving intangibles including the manner in which such transactions contribute to the creation of value.

These steps appear to be at most important in the sense that intangibles have unique characteristics quite distinct from tangible goods. The tangible goods are easily identifiable , which is not the case with intangible.

i)                   Identification of Intangibles

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.

In a transfer pricing analysis of a matter involving intangibles, it is important to identify the relevant intangibles with specificity. The functional analysis should identify the relevant intangibles at issue, the manner in which they contribute to the creation of value in the transactions under review, and the manner in which they interact with other intangibles, with tangible assets and with business operations to create value.

Types of Intangibles

1.       Patents

A patent is a legal instrument that grants an exclusive right to its owner to use a given invention for a limited period of time within a specific geography. A patent may relate to a physical object or to a process.

2.       Know-how & Trade Secrets

Know-how and trade secrets are proprietary information or knowledge that assist or improve a commercial activity, but that are not registered for protection in the manner of a patent or trademark

3.       Trademark, Trade names and Brands

A trademark is a unique name, symbol, logo or picture that the owner may use to distinguish its products and services from those of other entities

4.       Rights Under Contract and government licence.

Rights and obligations under contracts and government licences and concessions may be important to a particular business. Such contract rights and licences can cover a wide range of business relationships. They may include, among others, contracts with suppliers and key customers, agreements to make available the services of one or more employees, or a government grant of rights to exploit specific natural resources or public goods (e.g. a licence of band width spectrum) to carry on a specific business activity.

5.       Licence and similar limited rights in intangibles

Limited rights in intangibles are commonly transferred by means of a licence or other similar contractual arrangement, whether written, oral or implied. Such licensed rights may be limited as to field of use, term of use, geography or in other ways.

6.       Goodwill and on going concern value

Goodwill is sometimes described as a representation of the future economic benefits associated with business assets that are not individually identified and separately recognized

The term on going concern value is sometimes referred to as the value of the assembled assets of an operating business over and above the sum of the separate values of the individual assets.

Items- Which are not intangibles

1.       Group Synergies-

2.       Market Specific Characteristics.- For example, the high purchasing power of households in a particular market may affect the prices paid for certain luxury consumer goods. Similarly, low prevailing labour costs, proximity to markets, favourable weather conditions and the like may affect the prices paid for specific goods and services in a particular market. Such market specific characteristics may not, however, be owned or controlled by an individual enterprise.

ii)     Legal ownership of intangibles and the contributions to their development, enhancement, maintenance and protection

In order to properly attribute return attributable to intangible or Intangible related Return among legal owner of intangible and other associated parties, understanding of following is essential:-

a)      identifying the legal owner of intangibles based on the terms and conditions of legal  arrangements, including relevant registrations, licence agreements, other relevant contracts, and other indicia of legal ownership

b)      identifying the parties performing functions, using assets, and assuming risks related to developing, enhancing, maintaining and protecting the intangibles by means of the functional analysis.

c)       identifying the controlled transactions related to the development, enhancement,  maintenance, protection, and exploitation of intangibles in light of the legal ownership of the intangibles under relevant registrations and contracts and the relevant contributions of functions, assets, risks and other factors contributing to value

The Legal owner of an Intangible is entitled to all returns attributable to the intangible only if, in substance, it

·         Performs and controls all of the important functions related to the development, enhancement, maintenance and protection of the intangibles as under:-

a)      Design and control of research and marketing programmes

b)      Management and control of budgets

c)       Control over strategic decisions regarding intangible development programmes

d)      Important decision regarding defence and protection of intangibles

e)      On-going quality control over functions performed by independent or associated enterprises.

·         Provides all assets necessary to the development, enhancement, maintenance, and protection of the intangibles

·         Bears and controls all of the risks and costs related to the development, enhancement, maintenance and protection of the intangible as under:-

a)      risks related to development of intangibles, including the risk that costly research and development or marketing activities will prove to be unsuccessful.

b)      the risk of product obsolescence, including the possibility that technological advances of competitors will adversely affect the value of the intangibles

c)       infringement risk, including the risk that defence of intangible rights or defence against other persons’ claims of infringement may prove to be time consuming, costly and/or unavailing

d)      product liability and similar risks related to products and services based on the intangibles

Examples

Ø  Development and enhancement of Marketing Intangible – AE (Distributor) performs marketing or sales functions that benefit the legal owner of trade mark

Question-  Whether AE is entitled to any return related Intangible Trade mark or not

a)      Where a distributor acts merely as an agent, being reimbursed for its promotional expenditures and being directed and controlled in its activities by the owner of the trademarks and other marketing intangibles. In such case the distributor ordinarily would be entitled to compensation appropriate to its agency activities alone. It would not bear or control the risks associated with the further development of the trademark and other marketing intangibles, and would therefore not be entitled to additional remuneration in that regard

b)      When the distributor actually bears the cost of its marketing activities. In such a situation the distributor’s efforts may have enhanced the value of its own intangibles, namely its distribution rights. In such cases, the distributor’s share of benefits should be determined based on what an independent distributor would receive in comparable circumstances.  Such remuneration could take the form of higher distribution profits (resulting from a decrease in the purchase price of the product), a reduction in royalty rate, or a share of the profits associated with the enhanced value of the trademark or other marketing intangibles, in order to compensate the distributor for its functions, assets, risks, costs, and anticipated value creation.

iii)              Transaction Involving use or transfer of intangibles

There are two general types of transactions where the identification and examination of intangibles will be relevant for transfer pricing purposes. These are: (i) transactions involving transfers of intangibles or rights in intangibles; and (ii) transactions involving the use of intangibles in connection with the sale of goods or the provision of services

A.      Transaction involving transfer of intangible or right in intangible

1.       Transfer of intangible or right in intangible

2.       Transfer of combination of intangibles

In transaction involving transfer of combination of intangibles, two related issues often arises:-

a)      The first of these involves the nature and economic consequences of interactions between different intangibles. It may be the case that some intangibles are more valuable in combination with other intangibles than would be the case if the intangibles were considered separately. It is therefore important to identify the nature of the legal and economic interactions between intangibles that are transferred in combination.

b)      A second and related issue involves the importance of assuring that all intangibles transferred in a particular transaction have been identified.

Example of (a)

For example, a pharmaceutical product will often have associated with it three or more types of intangibles. The active pharmaceutical ingredient may be protected by one or more patents. The product will also have been through a testing process and a government regulatory authority may have issued an approval to market the product in a given geographic market and for specific approved indications based on that testing. The product may be marketed under a particular trademark. In combination these intangibles may be extremely valuable. In isolation, one or more of them may have much less value. For example, the trademark without the patent and regulatory marketing approval may have limited value since the product could not be sold without the marketing approval and generic competitors could not be excluded from the market without the patent. Similarly, the value of the patent may be much greater once regulatory marketing approval has been obtained than would be the case in the absence of the marketing approval. The interactions between each of these classes of intangibles, as well as which parties performed functions, bore the risks and incurred the costs associated with securing the intangibles, are therefore very important in performing a transfer pricing analysis with regard to a transfer of the intangibles. It is important to consider the relative contribution to value creation where different associated enterprises hold rights in the intangibles used.

Example (b)

The transfer of rights to use a trademark under a licence agreement will usually also imply the licensing of the reputational value, sometimes referred to as goodwill, associated with that trademark, where it is the licensor who has built up such goodwill. Any licence fee required should consider both the trademark and the associated reputational value

3.       Transfer of intangibles or rights in intangibles in combination with other business transactions.

Intangibles or rights in intangibles may be transferred in combination with tangible business assets, or in combination with services.

In some situations it may be both possible and appropriate to separate transactions in tangible goods or services from transfers of intangibles or rights in intangibles for purposes of conducting a transfer pricing analysis. In these situations, the price of a package contract should be disaggregated in order to confirm that each element of the transaction is consistent with the arm’s length principle.

 In other situations transactions may be so closely related that it will be difficult to segregate tangible goods or service transactions from transfers of intangibles or rights in intangibles.

Reliability of available comparables will be an important factor in considering whether transactions should be combined or segregated.

Example:-

Franchise agreement

Under such an arrangement, one member of an MNE group may agree to provide a combination of services and intangibles to an associated enterprise in exchange for a single fee. If the nature of the services and intangibles made available under such an arrangement are sufficiently unique that reliable comparables cannot be identified for the entire service/intangible package, it may be necessary to segregate the various parts of the package of services and intangibles for separate transfer pricing consideration.

Software

In other situations, the provision of a service and the transfer of one or more intangibles may be so closely intertwined that it is difficult to separate the transactions for purposes of a transfer pricing analysis. For example, some transfers of rights in software may be combined with an undertaking by the transferor to provide on going software maintenance services, which may include periodic updates to the software. In situations where services and transfers of intangibles are intertwined, determining arm’s length prices on an aggregate basis may be necessary

B.      Transaction involving the use of intangibles in connection with sales of goods or provisions of services

Intangibles may be used in connection with controlled transactions in situations where there is no transfer of the intangible or of rights in the intangible. For example, intangibles may be used by one or both parties to a controlled transaction in connection with the manufacture of goods sold to an associated enterprise, in connection with the marketing of goods purchased from an associated enterprise, or in connection with the performance of services on behalf of an associated enterprise

Example

Assume that a car manufacturer uses valuable proprietary patents to manufacture the cars that it then sells to associated distributors. Assume that the patents significantly contribute to the value of the cars. The patents and the value they contribute should be taken into account in the comparability analysis of the transaction consisting in the sales of cars by the car manufacturer to its associated distributors, in selecting the most appropriate transfer pricing method for the transactions, and in selecting the tested party. The associated distributors purchasing the cars do not, however, acquire any right in the manufacturer’s patents. In such a case, the patents are used in the manufacturing and may affect the value of the cars, but the patents themselves are not transferred

As another example of the use of intangibles in connection with a controlled transaction, assume that an exploration company has acquired or developed valuable geological data and analysis, and sophisticated exploratory software and know-how. Assume further that it uses those intangibles in providing exploration services to an associated enterprise. Those intangibles should be taken into account in the comparability analysis of the service transactions between the exploration company and the associated enterprise, in selecting the most appropriate transfer pricing method for the transaction, and in selecting the tested party. Assuming that the associated enterprise of the exploration company does not acquire any rights in the exploration company’s intangibles, the intangibles are used in the performance of the services and may affect the value of services, but are not transferred

Supplemental guidance for determining Arm’s length Conditions in cases involving intangibles

After identifying the relevant transactions involving intangibles, specifically identifying the intangibles involved in those transactions, and identifying which entity or entities legally own and contribute to the value of those intangibles, it should be possible to identify arm’s length conditions for the relevant transactions.

The use or transfer of intangibles may raise challenging issues regarding comparability, selection of transfer pricing methods, and determination of arm’s length conditions for transactions.

General Principle applicable in transactions involving intangibles

In applying the principles of the Guidelines related to the content and process of a comparability analysis to a transaction involving intangibles, a transfer pricing analysis must consider the options realistically available to each of the parties to the transaction.

In considering the options realistically available to the parties, the perspectives of each of the parties to the transaction must be considered. A one-sided comparability analysis does not provide a sufficient basis for evaluating a transaction involving intangibles.

Supplemental guidance regarding transfer of intangibles or rights in intangibles

A.      Comparability of intangibles or rights in intangibles

Some of the specific features of intangibles that may prove important in a comparability analysis involving transfers of intangibles or rights in intangibles are as under:-

i)                    Exclusivity

Some intangible allow the legal owner of the intangible to exclude others from using the intangible. A party with non-exclusive rights to intangibles will not be able to exclude all competitors and will generally not have the same degree of market power or influence. Accordingly, the exclusive or non-exclusive nature of intangibles or rights in intangibles should be considered in connection with the comparability analysis.

ii)                  Extent and duration of legal protection.

Legal protections associated with some intangibles can prevent competitors from entering a particular market. The duration of legal protections can be important since the duration of the intangible rights will affect the expectation of the parties to a transaction with regard to the future benefits attributable to the intangible. For example, two otherwise comparable patents will not have equivalent value if one expires at the end of one year while the other expires only after ten years

iii)                Geographic Scope

A global grant of rights to intangibles may be more valuable than a grant limited to one or a few countries, depending on the nature of the product, the nature of the intangible, and the nature of the markets in question.

iv)                Useful Life

Apart from nature and duration of legal protection, the useful life of some intangibles can also be affected by the rate of technological change in an industry and by the development of new and potentially improved products.

v)                  Stage of Development

As a general rule, intangibles relating to products with established commercial viability will be more valuable than otherwise comparable intangibles relating to products whose commercial viability is yet to be established. In conducting a comparability analysis involving partially developed intangibles, it is important to evaluate the likelihood that further development will lead to commercially significant future benefits. In certain circumstances, industry data regarding the risks associated with further development can be helpful to such evaluations.

vi)                Rights to enhancements, revisions and updates

an important consideration in a comparability analysis involving intangibles relates to the rights of the parties with regard to future enhancements, revisions and updates of the intangibles. In some industries, products protected by intangibles can become obsolete or uncompetitive in a relatively short period of time in the absence of continuing development and enhancement of the intangibles. As a result, having access to updates and enhancements can be the difference between deriving a short term advantage from the intangibles and deriving a longer term advantage.

A very similar question, often important in a comparability analysis, involves whether the transferee of intangibles obtains the right to use the intangibles in connection with research directed to developing new and enhanced intangibles

vii)              Expectation of Future benefits

If for any reason there is a significant discrepancy between the anticipated future benefit of using one intangible as opposed to another, it is difficult to consider the intangibles as being sufficiently comparable to support a comparables-based transfer pricing analysis in the absence of reliable comparability adjustments.

Intangibles that provide a basis for high profit products or services are not likely to be comparable to intangibles that support products or services with only industry average profits

B.      Comparison of risk in cases involving transfer of intangible or rights in intangibles

The following types of risks, among others, should be considered in evaluating whether transfers of intangibles or combinations of intangibles are comparable, and in evaluating whether the intangibles themselves are comparable.

i)                    Risk Related to Future Development of intangible

Development risk is particularly important in situations involving transfer of partially developed intangibles.

This includes an evaluation of whether the intangibles relate to commercially viable products, whether the intangibles may support commercially viable products in the future, the expected cost of required future development and testing, the likelihood that such development and testing will prove successful and similar considerations

ii)                  Risks related to product obsolescence and depreciation in the value of the intangibles

This includes an evaluation of the likelihood that competitors will introduce products or services in the future that would materially erode the market for products dependent on the intangibles being analysed

iii)                Risk related to infringement of the intangible rights.

This includes an evaluation of the likelihood that others might successfully claim that products based on the intangibles infringe their own intangible rights and an evaluation of the likely costs of defending against such claims. It also includes an evaluation of the likelihood that the holder of intangible rights could successfully prevent others from infringing the intangibles, the risk that counterfeit products could erode the profitability of relevant markets, and the likelihood that substantial damages could be collected in the event of infringement.

C.      Selecting the most appropriate transfer pricing method in a matter involving the transfer of intangibles or rights in intangibles

 In selecting the most appropriate transfer pricing method in a case involving a transfer of intangibles or rights in intangibles, attention should be given to (i) the nature of the relevant intangibles, (ii) the difficulty of identifying comparable uncontrolled transactions and intangibles in many, if not most, cases, and (iii) the difficulty of applying certain of the transfer pricing methods described in Chapter II in cases involving the transfer of intangibles.

               

                The guidelines discourage the use of Resale Price Method, Transactional Net margin
               method, Cost plus method

               

                Guidelines recommend the use of following methods

i)                    Comparable uncontrolled Price Method

ii)                   Profit Split Method

Use of Valuation Techniques - In situations where reliable comparable uncontrolled transactions for a transfer of one or more intangibles cannot be identified, it may also be possible to use valuation techniques to estimate the arm’s length price for intangibles transferred between associated enterprises

Taxation of Gift Transaction

Taxation of GIFT Transactions

In the Hands of Donor

1.       There is no separate tax in the hands of Donor on the amount of gift given, whether in cash or kind.

2.       The transfer of CAPITAL ASSET by way of GIFT is also not subject to Capital Gain Tax in the hands of Donor (Section 47(iii))

In the hands of Donee/Recipient

Recipient- Individual & HUF {Section 56(2)(vii)}

Type of Asset Received by way of Gift

1.       Any sum of money received in excess of Rs. 50,000- Entire amount is taxable in the hands of recipient as Income from Other Sources

2.       Any immovable property

a)      Property  received without consideration -  Stamp Duty Value of such property will be taxable in the hands of recipient as Income from Other Sources, ifsuch exceeds Rs. 50,000

b)      Property Received for Consideration ,consideration being less than Stamp Duty Value by more than Rs. 50,000- Stamp duty value less consideration given, will be taxable in the hands of Recipient as income from other sources

3.       Any other property, other than Immovable Property:-

a)      Property received without any consideration – Fair Market Value of such property will be taxable in the hands of recipient as Income from Other Sources, if FMV exceeds Rs. 50,000.

b)      Property received for consideration, consideration being less than Fair Market value by more than Rs. 50,000- Fair Market value less consideration given, will be taxable in the hands of Recipient as income from other sources.

Property ,other Immovable property, meaning

a)      Shares & Securities, both listed and unlisted

b)      Jewellery

c)       Archaeological collections

d)      Drawings

e)      Paintings

f)       Sculptures

g)      Any work of art

h)      Bullion

Fair Market value of Property,  other than immovable Property.

1)      Shares & Securities

A)     Listed Shares & Securities – Lowest price of such shares & securities on any recognised stock exchange on the date of gift

B)      Unlisted Equity Shares – Book value per equity share on the date of gift.

C)      Unlisted other securities – Value which such security will fetch, if sold in open market on the date of gift.

2)      Other than Shares & Securities – The value which it will fetch if sold in open market or value given by registered valuer.

Exception – Cases, where recipient will not be subject to tax on Gift received in cash or kind

a)      Received from Relative.

b)      Received on occasion of marriage of the Individual recipient.

c)       Received under will or by way of inheritance.

Recipient- Firm & Specified Company {Section 56(2)(vii)a}

Type of Asset Received by way of Gift

1.       Shares (Equity & Preference) of Specified Company received:-

a)      Without consideration and Fair Market value of shares exceeds Rs. 50,000- Fair Market Value of such shares will be taxable in the hands of recipient as income from other sources.

b)      For consideration which is less than Fair Market value by more than 50,000-  Fair Market value less consideration given, will be taxable in the hands of Recipient as income from other sources.

Meaning of Specified Company

1.       Private Limited Company

2.       Unlisted Public Company

3.       Unlisted public company, which is not a wholly owned subsidiary of listed company.

Fair Market value of Share

Shares & Securities

A)     Listed Shares & Securities – Lowest price of such shares & securities on any recognised stock exchange on the date of gift

B)      Unlisted Equity Shares – Book value of the date of gift

C)      Unlisted Preference shares – Value which such security will fetch, if sold in open market on the date of gift.

Taxation of Excess Consideration against Issue of shares (Section 56(viib))

1.       Applicability

a)      Entity- Specified Company

b)      Transaction – Issue of shares (equity or Preference) at a price more than the face value.

2.       Taxability – Consideration received against issue of shares, which is more than fair market value of such shares, then such consideration in excess of Fair market value will be taxable in the hands of specified company as Income from other sources.

3.       Specified Company

a)      Private Limited Company

b)      Unlisted Public Company

c)       Unlisted public company, which is not a wholly owned subsidiary of listed company.

4.       Fair Market Value – Fair market value is either of following value at the option of specified company

a)      Book value on the date of issue of shares

b)      Value determined by merchant banker  of practising FCA by way of DCF method

c)       Value justified by specified company before Assessing office based on the value of intangible assets being goodwill, know-how, patents, copyrights etc.