1. 1 Transfer Pricing Workshop Cairo 14-25 February 2010 Identifying Intangibles Legal vs. Economic Ownership

2. 2 Transfer Pricing Background OECD Transfer Pricing Guidelines, Chapter VI, March 1996: “Special considerations for Intangible for Property” Chapter VIII, August 1995: “Cost Contribution Arrangements” Examples in Annex (AN-15), February 1998: “Intangible property and uncertain valuation”

3. 3 The functional analysis and the portable profit potential Functions Risks Assets $ Low Added Value High Added Value Tangibles Intangibles Operational Entrepreneurial $$$ $ $ Mobile Mobile?

4. 4 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 in ‘No Logo’ London, © 2000).

5. 5 Issues for tax practitioners and tax authorities How to define intangibles? How to identify intangibles? How to determine ownership? How to value intangibles?

6. 6 How to identify intangibles?

7. 7 Starting point will be legal and accounting information, but… Intangibles can be protected or not –Examples: patent / know-how 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) Where they are not protected and not on the balance sheet, identification and determination of ownership can be difficult

8. 8 To identify intangibles, a thorough functional analysis must be performed It is not sufficient to rely on the balance sheet It is not sufficient either to rely on the P&L accounts (in case the taxpayer omits to charge some valuable intangibles used by related parties): Risk assessment forms which are filed with tax returns in some countries often prove insufficient in this respect

9. 9 Interviews Historical background of the company Financial information released for investors (e.g. IPOs) To identify intangibles, a thorough functional analysis must be performed

10. 10 Where intangibles are used in a controlled transaction, they must be taken into account:  In the functional analysis (“functions performed taking account of assets used and risks assumed”),  In the selection of the transfer pricing method,  Comparable uncontrolled price  “One-sided” methods: cost plus, resale price, TNMM  “Two-sided” methods: profit split e.g. if both parties use unique, valuable intangibles  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 (comparable means: no material difference or differences can be adjusted in a reasonably accurate manner)

11. 11 Examples 1. A sells sport shoes with valuable trademark. B sells similar sport shoes with no trademark. 2.X is a large retail store that purchases personal computers for display in its stores and sale to customers. Y is a licensed distributor that purchases and distributes similar personal computers, exploits the trademark, participates in the development of new products.

12. 12 How to determine ownership? Economic vs. Legal ownership Centralized vs. Distributed ownership

13. 13 Legal ownership for registered intangibles (e.g. registered patent, trademark, copyright) Economic ownership: who is entitled to the economic benefits? For transfer pricing purposes, a party that bears the costs and risks of developing an intangible should be entitled to a corresponding beneficial interest, even if it is not the legal owner of the intangible. For transfer pricing purposeseconomic ownership! Ownership legal vs. economic

14. 14 Reasons for taxpayers to segregate legal and beneficial ownership: –Handle all intangible registrations centrally –Cost Contribution Arrangement (CCA) where economic ownership is shared but legal ownership cannot be under multiple names (para. 8.6 OECD TP Guidelines) Taxpayer must provide sufficient documentation! 14 Ownership legal vs. economic

15. 15 The OECD TP Guidelines recognise the difference between legal and economic ownership, and provide specific comments in this respect in relation to marketing intangibles (marketing activities performed by a party that does not own the trademark). This will be discussed in further detail later. Ownership legal vs. economic

16. 16 In the treaty context, useful (although different) notion of beneficial ownership –For the purposes of determining treaty benefits, a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties. Ownership legal vs. economic

17. 17 Ownership centralised vs. distributed Centralised ownership –Single company in the group owns the intangibles, both beneficially and legally. –License agreements with other group entities need to determine arm´s length price –Opportunity for tax planning 17

18. 18 Distributed ownership –A number of companies (operating companies) would share ownership of intangibles on a pre-determined basis (e.g. geographic territory or product application) –It always involves shared beneficial ownership –Usually take the form of CCA –Less tax driven 18 Ownership centralised vs. distributed

19. 19 Various intra-group scenarios to develop intangibles

20. 20 A developer may perform a research activity: In its own name, i.e. with the intention of having legal and economic ownership of any resulting trade 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

21. 21 Case 1: Development in its own name R&D centre Korea  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  The manufacturer gets manufacturing reward  The distributor gets distribution reward (The parent company gets dividends)

22. 22 Case 2: Contract research R&D centre Korea  Provides no funding (finance the R&D)  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  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

23. 23 Case 3: Joint research  All provide funding (finance the R&D)  All share risks of failure  If successful: co-ownership (generally economic) of intangible developed R&D centres x countries

24. 24 Case 4: Cost Contribution Arrangement Marketing or manufacturing companies R&D centre  All provide funding (finance the R&D)  All share risks of failure  If successful: co-ownership (generally economic) of intangible developed Can be  a contract researcher, or  one or more of the CCA members

25. 25 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, or –as a member of a CCA?

26. 26 Illustration: CCA among R&D Centers Clients Market Companies R & D Manufacturing Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies R & D

27. 27 Illustration: CCA among R&D Centers Clients Market Companies R & D Manufacturing Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies R & D

28. 28 Illustration: CCA among R&D Centers Clients Market Companies R & D Manufacturing Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies Market Companies R & D

29. 29 Conclusion Multinational enterprises have the freedom to fund and organise the development of intangible property, subject to –the legal form of the arrangement to be consistent with the substance of the transaction and –the arrangements, viewed in their totality, to be arm’s length (see in particular whether consistent with functional analysis and whether achieves an arm’s length allocation of risks) Legal and economic ownership are increasingly disconnected from the location where R&D is performed. The location of legal and economic ownership of intangibles developed have huge transfer pricing consequences. This is a policy issue for fiscal attractiveness.

30. 30  Decision where to locate R&D activities is generally based mainly on non-tax factors (e.g. skilled personnel), although tax factors (specific tax breaks for R&D activities) might help. Conclusion

31. 31 But what are the tax factors taken into account by MNEs when deciding to locate IP ownership? Depreciation, amortisation of developed or acquired intangible Deduction of license fees Treaty network Withholding tax on inbound (and outbound) royalties Tax rate on benefits from exploitation (business profits or royalties) Repatriation of earnings to shareholders Future disposal of intangibles (exit scenarios) Others (VAT, registration duties…)