Intangibles in the World of Transfer Pricing: Identifying - Valuing - Implementing 3319733311, 9783319733319

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Björn Heidecke Marc C. Hübscher Richard Schmidtke Martin Schmitt  Editors

Intangibles in the World of Transfer Pricing

Identifying - Valuing - Implementing

Intangibles in the World of Transfer Pricing

Björn Heidecke • Marc C. Hübscher • Richard Schmidtke • Martin Schmitt Editors

Intangibles in the World of Transfer Pricing Identifying - Valuing - Implementing

Editors Björn Heidecke Deloitte GmbH Hamburg, Germany

Marc C. Hübscher Deloitte GmbH Hamburg, Germany

Richard Schmidtke Deloitte GmbH Munich, Germany

Martin Schmitt Deloitte GmbH Frankfurt am Main, Germany

ISBN 978-3-319-73332-6 ISBN 978-3-319-73331-9 https://doi.org/10.1007/978-3-319-73332-6

(eBook)

© Springer Nature Switzerland AG 2021, corrected publication 2021 This work is subject to copyright. All rights are reserved by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors, and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, expressed or implied, with respect to the material contained herein or for any errors or omissions that may have been made. The publisher remains neutral with regard to jurisdictional claims in published maps and institutional affiliations. This Springer imprint is published by the registered company Springer Nature Switzerland AG. The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

“All over the world, German bread is valued for its unique diversity. The knowledge of raw materials, baking procedures and the awareness of tradition is passed on from generation to generation by the master and journeymen to the apprentice. In the baking craft, centuries-old traditions are united with the latest insights and practices,” states UNESCO1 in its Nationwide Inventory of Intangible Cultural Heritage for Germany. Not only is bread itself accorded, but also the baking techniques, recipes, and knowledge together. Traditional bakeries profit from their long traditions and expertise. They benefit from the existence of valuable intangibles. This not only applies to traditional bakeries, but also to multinationals’ trust in valuable intangibles as sources of sustainable profit and market share. Several studies have pointed out a positive relationship between intangibles and economic performance.2 A positive relationship is especially found in developed countries where the intangibles are better protected. The reason for this is that intangibles provide a competitive advantage that cannot be copied easily. Knowing the relevance of intangibles for the success of multinationals has at least three consequences: companies focus on the development and maintenance of intangibles, governments debate how to foster the development of intangibles within companies, and individuals invest more in human capital by studying for higher educational degrees to obtain higher paid jobs. The increasing relevance of intangibles from a business perspective has resulted in an increasing focus on intangibles in the world of transfer pricing as well as on a global tax agenda with think tanks such as the OECD, the UN, the World Bank, the

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https://www.unesco.de/en/culture-and-nature/intangible-cultural-heritage/nationwide-inventoryintangible-cultural-heritage 2 Marrocu, Paci, and Pontis (2012); Oliner, Sichel, and Stiroh (2007); O’Mahony and Vecchi (2009). v

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IMF, and governments alike. Hence, guidance is needed on how to deal with intangibles in the world of transfer pricing considering the latest developments on an OECD level but also within local countries. This handbook aims to help practitioners in tax, legal, and finance departments, tax advisors, tax administrations, and tax inspectors, but also academics and students, to navigate through intangibles in the world of transfer pricing. The focus is practical guidance with examples. This handbook is also intended to support and enrich the debate on a tax policy level. The handbook focuses on six parts, each with several chapters. Part I provides an overview of the definition and identification of intangibles. The DEMPE concept introduced by the OECD is explained. Applied to intangibles the DEMPE acronym stands for development, enhancement, maintenance, protection, and exploitation. Typical models for how intangibles are traded within multinationals are presented. Relevant examples of intangibles in selected industries are provided. Part II explains how arm’s-length prices for intangibles can be derived in typical transactions such as outright sale, licensing, contract R&D, and joint development. The nitty-gritty of the valuation is provided in Part III, providing an overview of state-of-the-art valuation techniques as well as their fundamentals such as planning data and interest rates. Part IV summarizes the relevant legislation from a tax perspective for over 20 countries, with a focus on transfer pricing. Part V gives practical guidance on how to implement a system with intangibles. The interfaces to inter alia customs and M&A transactions are shown. This handbook reflects changes in legislation applicable on April 1, 2020. We would like to thank Springer for publishing this handbook. We appreciate that all authors and contributors have spent many hours and days drafting the chapters, alongside their normal jobs and often in their spare time, to produce really excellent articles. We thank Nina Werner, Marc Heine, Henrik Abeln, and Alan Frostick (Frostick & Peters, Hamburg) for their assistance in proofreading and editing this handbook. Finally, we would like to thank our girlfriends and families for understanding and being patient while we were writing it. You have been a massive support for us. As this is the first edition of this handbook, we would be grateful for any comments and feedback. Especially in a digital era of simple likes and dislikes, we would appreciate more detailed debate on the rights or wrongs on all issues surrounding intangibles in the world of transfer pricing, maybe with a tasty slice of fresh bread and a lavish dab of butter. Hamburg, Germany Hamburg, Germany Munich, Germany Frankfurt am Main, Germany

Björn Heidecke Marc C. Hübscher Richard Schmidtke Martin Schmitt

Preface

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References Marrocu, E., Paci, R., & Pontis, M. (2012). Intangible capital and firms productivity, Working paper University of Cagliari. Oliner, S. D., Sichel, D. E., & Stiroh, K. J. (2007). “Explaining a productive decade,” brookings papers on economic activity, economic studies program. The Brookings Institution, 38(1), 81–152. O’Mahony, & Vecchi. (2009). Output, input and productivity measures at the industry level: The EU KLEMS database. The Economic Journal, 119(538), 374–403.

Contents

Part I

Intangibles in the World of Transfer Pricing

Definition and Identification of Intangibles . . . . . . . . . . . . . . . . . . . . . . Dulce Miranda

3

Allocation of IP for TP Purposes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Susann Karnath

11

Overview of IP Migration Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Martin Schmitt, Anna-Katharina Christen, and Merten Zenker

27

Empirical Evidence on Various Models . . . . . . . . . . . . . . . . . . . . . . . . . Jost Heckemeyer, Pia Olligs, and Michael Overesch

49

What Is Different?: Intangibles in the Mid-Market . . . . . . . . . . . . . . . . Alexander Reichl

61

Understanding the Reporting of Intangibles from a Business Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Thomas M. Fischer and Kim T. Baumgartner Intangibles in Different Industries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marc C. Hübscher and Niklas Martynkiewitz The Miracle of Brand Value Creation: Where Does the Value Come From? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Anton Nagatkin, Roman Kral, and Janine Stockmeier Valuation: Understanding, Assessing, and Documenting . . . . . . . . . . . . Marc C. Hübscher and Björn Heidecke Part II

75 115

141 163

Finding the Arm’s Length Price for Intangibles

Structuring a License System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tim Eggebrecht, Markus Kircher, and Julia Kaiser

181

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Contract Research and Development . . . . . . . . . . . . . . . . . . . . . . . . . . . Richard Schmidtke, Benjamin Protte, and Janis Sussick

199

Pool Concept . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Richard Schmidtke, Benjamin Protte, and Janis Sussick

215

Transactional Profit Split Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Heike Schenkelberg and Anna Rottke

231

Part III

The Nighty Gritty Details on Valuation

Please Mind the Gap: Arm’s Length Prices and Fair Market Value . . . Björn Heidecke

263

Market Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marc Hayn and Oliver Schlegel

273

Relief from Royalty . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marc C. Hübscher and Stella Ehrhart

283

MEEM . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Andreas Becker

299

Incremental Cash Flow Method . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marc Hayn and Oliver Schlegel

315

Cost Approach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stefan Brauchle, Marcel Merkle, Magdalena Treyer, and Daniel Schlänger

325

Calculating Planning Data and Its Plausibility . . . . . . . . . . . . . . . . . . . . Marc C. Hübscher and Björn Heidecke

345

Discount Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marc C. Hübscher and Björn Heidecke

355

Part IV

Country Perspective of Intangibles from a Transfer Pricing Perspective

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Björn Heidecke, Marc C. Hübscher, Richard Schmidtke, and Martin Schmitt

367

Austria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Karin Andorfer and Andreas Gregshammer-Salomon

369

Belgium . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ann Gaublomme, Maria Panina, and André Schaffers

391

Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cristiane Drumond Vieira and Luis Fernando Cibella

407

Canada . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Bruno Amancio de Camargo and Émilie Granger

419

Contents

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China . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . James Yi Min Zhao and Claire Fan Yi Liu

441

East Africa . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fred Omondi and Doris Gichuru

451

France . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Julien Pellefigue and Jean-Edouard Duvauchelle

459

Germany . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Björn Heidecke

475

Ghana . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Taiwo Okunade, George Ankomah, Arowolo Oluseye, and Udo Abarikwu

493

India . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Anis Chakravarty, Amit Dattani, and Dilip Sutar

497

Italy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Aldo Castoldi, Giovanni Quattrin, and Federico Mariscalco Inturretta

513

Mexico . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Jorge González García

525

Middle East . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Mourad Chatar, Jan Van Abbe, and Alex Law

535

Nigeria . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Taiwo Okunade, Joseph Alatishe, Arowolo Oluseye, and Udo Abarikwu

549

Poland . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Iwona Georgijew, Robert Nowak, Tomasz Adamski, and Aleksandra Skrzypek

553

Russia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Yulia Sinitsyna, Dmitry Kulakov, Nikita Piskovets, and Anastasia Kopysova

561

Spain . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ramon Lopez de Haro, Alejandro Pons Mestre, and Jon Diaz de Durana

577

Sweden . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . David Godin and Michael Lindgren

593

United Kingdom . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . John Henshall, Daniela Griese, Phil Henderson, and Shaun Austin

603

CJEU Court Cases: IP and Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . Patrick Uwe Wittenstein

621

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Part V

Contents

Implementing Intercompany Intangible Systems

Withholding Tax Aspects of License Models . . . . . . . . . . . . . . . . . . . . . Thomas Jansen

639

A Legal Review of IP Migrations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Stefan Wilke and Klaus Gresbrand

661

IP from an M&A Tax Perspective . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Andrea Bilitewski and Mark Heinemann

691

Intellectual Property from a Customs Perspective . . . . . . . . . . . . . . . . . Bettina Mertgen and Philipp Hamann

705

Correction to: Brazil . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cristiane Drumond Vieira and Luis Fernando Cibella

C1

Part I

Intangibles in the World of Transfer Pricing

Definition and Identification of Intangibles Dulce Miranda

What Will the Reader Learn? • • • •

How can an intangible be defined for transfer pricing purposes? How can intangibles be identified? What relevance for transfer pricing has the protection of intangibles? How do intangibles and services interact?

1 Introduction Within the core of multinational groups operating in the global economy, ownership of intangible assets, their assignment or license, and the benefits derived from using or licensing the assets between different group entities form the basis for and affect the distribution of the group’s tax burden. This might lead to an allocation of profits derived from the use of intangibles that is not in line with economic reality. Actions 8 and 10 of the BEPS Project were designed to address these practices, as they could give rise to a considerably negative impact on tax collection in some countries. The underlying objective of these actions is for profits to be reported for tax purposes in the country in which the economic activities generating the profits actually took place, i.e., where the value was created. In particular, Action 8 sets out the criteria for avoiding base erosion and profit shifting in connection with the movement of intangibles within multinational groups. This is done by adopting a clear definition of the different intangible assets encompassed by the concept of intangibles, ensuring that the profits associated with the assignment and use of intangibles are properly allocated and reflect the

D. Miranda (*) Deloitte Legal, Madrid, Spain e-mail: [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_1

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reality of value creation, and by the development of specific rules or measures for hard-to-value intangibles.

2 Definition of Intangibles Given that intangible assets contribute to the generation of economic profit in intragroup transactions, any analysis of a related-party transaction involving intangible assets must start by precisely identifying the assets. Therefore, the identification of intangibles becomes a salient and essential issue for companies, given that they form the basis for the functional analysis that must be carried out later. Chapter VI of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations defines “intangible” as “something (i) which is not a physical or a financial asset; (ii) which is capable of being owned or controlled for use in commercial activities, and (iii) whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances”.1 I must say that, although it does not purport to be a legal definition, the necessary fulfillment of all three requirements or characteristics is very useful for identifying intangibles and for determining whether certain assets should be classified as intangibles for the purposes at hand. In this sense, allow me to cite an example of issues that, though they need considering when determining the price of a transaction between related parties, should not be classified as intangibles from this particular standpoint: synergies between group companies. Such synergies help to reduce costs, integrate systems, and optimize the purchasing power of entities within a group and therefore are relevant from the point of view of transfer pricing, but do not fulfill the definition of intangibles as set out above, given that synergies are neither owned nor controlled by any entity. Therefore, under these circumstances, they cannot be considered an intangible. For identification, the OECD Transfer Pricing Guidelines not only offer a definition of “intangible,” but also provide an open list of what can be considered an intangible asset for transfer pricing purposes. This list includes patents, know-how and trade secrets, trademarks, trade names and brands, rights under contracts and government licenses, licenses and similar rights in intangibles, goodwill, and ongoing concern value. Even so, this is not a closed list and it could be extended with any other immaterial asset that meets the requirements for being classified as an intangible asset. We have referenced the OECD definition of intangibles set out in the Transfer Pricing Guidelines. However, it is important to note that other international regulations also define principles for identifying and valuing intangibles. For example, the

1

OECD Transfer Pricing Guidelines. Chapter VI, paragraph 6.6.

Definition and Identification of Intangibles

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International Financial Reporting Standards (IFRS). In particular, IFRS 3 Business Combinations is an international standard for accounting activity, resulting from a joint undertaking between the International Accounting Standards Board (IASB) and the US Financial Accounting Standard Board (FASB). In particular, the objective of IFRS 3 is to “improve the relevance, reliability and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects.” Consequently, it is applied to transactions that meet the definition of a business combination but not to the acquisition of an asset or group of assets that does not constitute a business.2 With respect to the concept of intangible assets, the Standard establishes that identifiable assets acquired in a business combination must be recognized and for that purpose, it clarifies what is meant by “identifiable” intangible assets as those that meet either of the following two requirements: • It is separable: the asset 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. • It arises from contractual or other legal rights. IFRS 3 includes examples of identifiable intangible assets under the following five categories: (a) Marketing-related: intangible assets used primarily in the marketing or promotion of products or services, such as trademarks, trade names, service marks, collective marks, and certification marks; trade dress; newspaper mastheads; domain names; and non-competition agreements. (b) Customer-related: intangible assets such as customer lists; order or production backlogs; customer contracts and related customer relationships; and non-contractual customer relationships. (c) Artistic-related: intangible assets such as plays, operas, and ballets; books, magazines, newspapers, and other literary works; musical works such as compositions, song lyrics, and advertising jingles; pictures and photographs; video and audio-visual material including motion pictures or films, music videos, and television programs. (d) Contract-based: intangible assets such as licensing, royalty, and standstill agreements; advertising, construction, management, service or supply contracts; lease agreements; construction permits; franchise agreements; operating and broadcast rights; servicing contracts; employment contracts; rights of use such as drilling, water, air, timber cutting, and route authorities. (e) Technology-based: intangible assets such as patented technology; computer software; unpatented technology; databases; and trade secrets.

2

A business is defined as an integrated set of activities and assets capable of being conducted and managed for the purpose of providing goods or services to customers, generating investment income (such as dividends or interest) or generating other income from ordinary activities.

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However, as indicated above, the identification and valuation of intangibles is not generally for tax purposes in such cases, rather for an external third party, from the point of view of the company. Moreover, it is important to note that the recognition or nonrecognition of such intangible assets for accounting purposes is not crucial for the transfer pricing purposes at hand. In fact, it is common for intangibles that arise from in-house development, research, or from advertising and promotion activities to not be classified as intangible assets for accounting purposes. Even so, the defined intangibles for transfer pricing purposes should be cross-checked with other available definitions of intangibles such as for accounting purposes. Nevertheless, once an intangible is identified the next step is to define whether it is a “hard-to-value intangible” (HTVI). According to the relevant definition in the OECD Transfer Pricing Guidelines,3 this term covers intangibles that “at the time of their transfer between associated enterprises, (i) no reliable comparable exists, and (ii) at the time the transaction was entered into, the projections of future cash flows or income expected to be derived from the transferred intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of the transfer.” There are certain intangibles that, due to their characteristics, present valuation problems at the moment the related transaction takes place. This is the case, for example, with a product whose likelihood of effective use is uncertain and would not be immediately manufactured, such as a patent on an active ingredient of a new medicine still under clinical trials (that has yet to obtain marketing authorization); or a product that is only partially developed, such as software, at the time the assignment takes place. In fact, any type of intangible asset may be classified as an HTVI in such circumstances. These scenarios make it difficult for tax administrations to determine the factors that the taxpayers considered when pricing an HTVI asset in a transaction between related entities, and whether or not the price was established on an arm’s length basis. Therefore, if an HTVI is involved in a transaction, it will be necessary to apply the kind of contractual measures that independent enterprises would have implemented, aimed at adjusting price deviations during the development of the contractual relationship (shorter agreement terms, milestone payments, running royalties, e.g., ranges of royalties, etc.). This matter will not be further analyzed in this section, as there is another chapter in this document devoted to HTVIs.

3

OECD Transfer Pricing Guidelines (2017), paragraph 6.189.

Definition and Identification of Intangibles

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3 Identification of Intangibles Having defined intangible assets, how to identify the intangibles involved in a transaction should now be analyzed. This identification is fairly straightforward when the rights are registered. It is important to note that, for example, for rights over a trademark,4 a patent, or a design to exist they must be duly registered.5 For these types of rights, the legal owner and the intangible can be easily identified. The situation is more complex with intangibles that do not require registration. Such cases must, therefore, be analyzed from a legal standpoint, taking into consideration legal statutes and case law, in order to determine whether an exclusive right exists, its protection, legal ownership, etc. This is particularly relevant for know-how and trade secrets. In the course of their activities, companies develop information that is commercially valuable and that is treated as confidential in order for the companies that control such information to have a competitive advantage. In general, SMEs and start-ups rely on secrecy more than larger companies, as they usually lack the resources to obtain and manage a portfolio of patents or to defend against patent infringement. Therefore, competitiveness increasingly depends on trade secrets. But what features must information have to be qualified as a trade secret? Transfer Pricing Guidelines6 establish the following: Knowledge 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. Knowledge and trade secrets generally consist of undisclosed information of an industrial, commercial or scientific nature arising from previous experience, which has practical application in the operation of an enterprise. Knowledge and trade secrets may relate to manufacturing, marketing, research and development, or any other commercial activity.

Furthermore, the Agreement on Trade-Related Aspects of Intellectual Property Rights (TRIPS), which is an international convention that lays out the minimum standards for many forms of intellectual property applicable to World Trade Organization members, defines7 trade secrets as information that (i) is secret, in the sense that is not generally known or easily accessible, (ii) has a commercial value because it is secret, and (iii) the person that controls it has taken reasonable measures to keep such information secret. However, the protection of undisclosed information is not homogeneous in all countries. Some countries have specific legislation on trade secrets while others

4

With certain exceptions such as the protection of non-registered but well-known trademarks, or the protection of non-registered designs under the EU Regulation 6/2002. 5 Examples: https://worldwide.espacenet.com for patents or https://euipo.europa.eu/eSearch/ for EU trademarks and designs. 6 OECD Transfer Pricing Guidelines. Chapter VI, paragraph 6.20. 7 Agreement on Trade-Related Aspects of Intellectual Property Rights. ART. 39.

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protect trade secrets as intellectual property rights, and still others rely on unfair competition law. In view of the foregoing, in 2016 the European Parliament and Council approved Directive (EU) 2016/943 for protection of undisclosed knowledge and business information against unlawful acquisition, use, and disclosure. The definition of a trade secret that is set out in this Directive8 is almost identical to the one provided in the TRIPS agreement. Consequently, trade secrets exist and are protected without any kind of registration, provided the information fulfills the requirements for legal protection. Accordingly, it is necessary to refer to the regulations established in each country and the related case law and to verify the characteristics that information must have and requirements it must meet to be protected as a trade secret. In general in all jurisdictions the concept of a trade secret is broad, encompassing many different types of information, broken down into two categories: (a) Technical information: manufacturing methods, prototypes, non-patented inventions, formulas, drawings, etc. (b) Commercial information: lists of suppliers or customers, business strategies, information about prices, etc. The above paragraphs are dedicated to the identification, but in our opinion, this must be taken further: Merely identifying intangibles considered abstractly is not sufficient; it is necessary to verify that the intangibles are protected, and their protection is valid.

4 Valid Protection of Intangibles Once intangibles involved in a given transaction have been identified, it is necessary to ensure that the intangibles are properly protected and this protection remains in force. Otherwise, the requirement that its “use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances”9 would not otherwise be met or justified, i.e., why would a third party be willing to pay for it if it were not protected? A third party would be unlikely to pay a royalty for an intangible over which no exclusive rights are held and therefore can be utilized free of charge as its use is not prohibited. Some of the aspects that must be verified to this end are discussed below: • Registration. As previously mentioned, the existence of many intellectual and industrial property rights is governed by the principle of registration, whereby 8

EU Directive 2016/943 of the European Parliament and of the Council of 8 June 2016 on the protection of undisclosed know-how and business information (trade secrets) against their unlawful acquisition, use and disclosure. Article 2. 9 OECD Transfer Pricing Guidelines. Chapter VI, paragraph 6.6.

Definition and Identification of Intangibles

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registration has the effect of creating the right. It would not be possible to speak of the existence, for example, of a patent or a trademark10 if the owner had not applied for registration. However, as this does not apply to all intangibles,11 it is necessary to consult the regulations applicable to each asset in each jurisdiction. • Territoriality. This principle states that rights are granted in each territory, under the requirements set out in that jurisdiction’s legal statutes or in applicable international agreements and conventions. The registration of a particular right in a certain territory implies protection in one territory, but not in others (unless covered by international conventions for certain IP rights). Therefore, it is important to pay attention to this particular issue when analyzing the effective existence of an intangible in a particular transaction. • Validity. The vast majority (but not all) of these rights are subject to time limits, whereby after a certain period has elapsed, the right is extinguished. This period depends on the right in question and the applicable legislation. Furthermore, the effective existence of a right may be subject to certain legal limits, so it is necessary to consult the regulations that apply to each asset under each jurisdiction. Among the various legal limits in place, the exhaustion of rights should be considered. Within the European Union, for example, rights to a patent, trademark, or copyright do not extend to actions regarding a product protected by that right once the product has been placed on the market within the European Economic Area, by the owner of the right, or by a third party with the owner’s consent.12 To conclude, not only do we need to identify an intangible asset, we must also determine its effective existence. Here it is interesting to assess the enforceability of a contract that imposes a payment of royalties for an intangible asset that has expired. The case law in different jurisdictions varies in this respect.13

5 Interaction of Intangibles and Services A further issue that can complicate the matter is the customary concurrence of auxiliary services provided in transactions that involve intangible assets. Quite often the assignment or license of intangible assets such as trade secrets or patents implies the need for the licensor to provide some kind of technical assistance to the licensee on how to apply or how to use the licensed or assigned information. From the perspective of the first step of identifying intangibles in any agreement, it is 10

Except for unregistered but well-known trademarks. For example, trade secrets, unregistered designs under certain circumstances, etc. 12 EU Regulation 2017/1001 of June 14, 2017. On the European Union Trademark Article 15.1 establishes the following: “An EU trade mark shall not entitle the proprietor to prohibit its use in relation to goods which have been put on the market in the European Economic Area under that trade mark by the proprietor or with his consent.” 13 See US Supreme Court, Kimble vs Marvel Entertainment LLC, 2015. 11

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crucial to clearly differentiate between the license of the intangible and the provision of technical assistance, training, or any other kind of service or support. The difference between the two is that the service is the expert assistance a company receives from another company, to better carry out the activity. In other words, technical assistance implies that one of the parties undertakes to carry out an engagement or provide a service to the other party. In contrast, licensing means that one of the parties undertakes to share its specific experience and knowledge with the other party, so the other party can use this information by itself. In the latter, the assignor or the licensor is not involved in the use the assignee or licensee makes of the information provided, as its only obligation is to transmit the information. Software licensing agreements usually include an arrangement for the provision of services tied to the intangible asset license; e.g., software maintenance services. As regards trademarks, it is common practice for the licensor to undertake to provide marketing services related to the product. However, the difference is not always so clear cut and it is often complex to distinguish between service provision and license. In order to correctly determine the substance of the arrangement, the different concepts discussed above must be considered in full. In short, it will be necessary to ascertain the extent to which the licensee is authorized to use the intangible asset in question by itself (license), and the extent to which the licensor undertakes to cooperate in some way with the licensee (service).

References EU regulation 2017/100112 of June 14. (2017). Article 15.1 on the European Union Trade Mark. OECD. (2017). Transfer Pricing Guidelines.

Allocation of IP for TP Purposes Susann Karnath

What Will the Reader Learn? • Definition of economic and functional ownership • Identification of economic and functional owner • Consequences of reassessment of the economic and functional ownership by the tax authorities • Implications for a consistent and arm’s length transfer pricing system

1 Introduction The notion of ownership of an intangible asset is of particular importance in a transfer pricing analysis. The ownership of an intangible asset has a significant influence on the characterization of the group company for transfer pricing purposes and the selection of an appropriate transfer pricing method for the intercompany transactions, such as whether the company is characterized as a routine or an entrepreneurial entity. It also directly assigns the residual profits that result from the use of the asset. Ownership of an intangible asset thus defines the level of remuneration that should be allocated to the respective owner of the asset.1 According to both the OECD Transfer Pricing Guidelines 2017 and German tax law, legal ownership of an intangible asset does not in fact have any relevance to the taxation of profits in a multinational group. An intangible asset is instead allocated to the economic owner for tax accounting purposes according to German tax law,

1

See Pankiv (2016), p. 471.

S. Karnath (*) Flick Gocke Schaumburg, Munich, Germany e-mail: [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_2

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whereas the profits resulting from that intangible asset are allocated to the functional owner according to the OECD Transfer Pricing Guidelines 2017. The following will first include a definition of economic and functional ownership and then discuss the determination of the economic and functional owner in outsourcing transactions, as well as the reallocation of the economic or functional ownership in tax audits. Thereafter, implications of the OECD’s DEMPE approach for setting up a transfer pricing system will be shown.

2 Definition of Economic and Functional Ownership 2.1

Economic Ownership as Defined by German Tax Law

Section 39 paragraph 1 of the German Fiscal Code stipulates that economic goods shall be attributed to the (legal) owner. The benefit to the legal owner, however, can be eroded due to legal or factual circumstances in such a way that it is actually of no value to the owner.2 According to Section 39 paragraph 2 number 1 sentence 1 of the German Fiscal Code this is the case when a person other than the owner exercises effective control over an economic good in such a way that he can, as a rule, economically exclude the owner from affecting the economic good during the normal period of its useful life. In this case, the economic good shall be attributed to this person, i.e., the economic owner. Analysis of the effective control over an economic good generally depends on who has possession of the good and who assumes the risk, benefit, and expenses in connection with that good, based on the overall facts and circumstances.3 This assumes that any third party would claim to receive a share of the ownership of a good for his contribution to the development of the good.4 In order to economically exclude the (legal) owner from affecting the good, it is necessary that the (legal) owner does not have the right to recover possession over the good or that this right is economically of no significance.5 The economic owner of an intangible asset, in turn, regularly bears the costs associated with the development of the asset and receives profits resulting from its exploitation.6 The notion of economic ownership, according to Section 39 paragraph 2 number 1 sentence 1 of the German Fiscal Code, therefore strongly depends on economic, i.e., monetary, See Ratschow (2020), §39 note 16. See BFH, 13.10.1972, BStBl II 1973, p. 209; BFH, 11/29/1973, BStBl II 1974, p. 202; BFH, 4/28/ 1977, BStBl II 1977, p. 553; BFH, 11/7/1991, BStBl II 1992, p. 398; BFH, 10/13/2016, BFHE 255, p. 386. 4 See Lagarden (2014), p. 695. 5 See BFH, 2/27/1991, BStBl II 1991, p. 628; BFH, 9/12/1991, BStBl II 1992, p. 182; 7/28/1993, BStBl II 1994, p. 164. 6 See BFH, 9/24/1991, BStBl II 1992, p. 330; BFH, 9/28/1995, BFH/NV 1996, p. 314; BFH, 25.1.1996, BStBl II 1997, p. 382. 2 3

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criteria. This view was also confirmed in a recent court case relating to the economic ownership of securities lending where the German Federal Fiscal Court stressed the economic aspects of the arrangement in order to determine the economic owner of the securities, i.e., which entity receives income from the securities and which entity has the chances and risks associated with these securities.7 This rather vague definition and description of economic ownership has yet to be put in more concrete terms by German fiscal authorities or German case law with respect to intangible assets for transfer pricing purposes. In order to determine the economic ownership of an intangible asset in a licensing transaction, in practice the general judgments of the German Federal Fiscal Court and the associated letters of the German Ministry of Finance relating to economic ownership in cases of leasing and hire purchase transactions8 are therefore often applied. The principles established therein are also applicable to film rights9 and could therefore also be used for other types of intangible assets.10 Using several criteria it is possible to analyze whether the licensor, as the legal owner of the licensed intangible asset, is in fact also the economic owner of that asset or whether the economic ownership has shifted to the licensee due to the specific terms of the license agreement.11 These criteria are: • Term of the license agreement • Type of the license agreement (exclusive, single, or simple license) • Sum of royalty payments for the intangible asset over the term of the agreement in relation to the value of the intangible asset • Right to grant sublicenses • Assumption of chances and risks relating to changes in the value of the licensed intangible asset • Assumption of activities and costs in connection with the maintenance of the legal protection of the intangible asset • Ordinary and extraordinary termination rights of the licensor • Purchase option of the licensee and tender right of the licensor Allocation of economic ownership to the licensor or the licensee, therefore, depends on the overall facts and circumstances of the case. The more of the following criteria are fulfilled, the more likely it is that the licensed intangible asset would be allocated to the licensee as economic owner and not to the licensor as the legal owner of the asset:

7

See BFH, 18.8.2015, BFHE 251, p. 190. See Circular of the German Ministry of Finance of 4/19/1971, BStBl. I 1971, p. 264. 9 See Circular of the German Ministry of Finance of 1/23/2001, BStBl. I 2001, p. 175, notes 16, 53. 10 See Greinert (2014), Immaterielle Wirtschaftsgüter, note 6.555. 11 See Greinert and Metzner (2015), p. 257. 8

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• The term of the license agreement is relatively long compared to the useful life of the licensed intangible asset (more than 90% of the normal period of its useful life). • It is an exclusive license. • The sum of royalty payments is relatively high compared to the value of the intangible asset. • The licensee can grant sublicenses and has a purchase option for the intangible asset. • The licensee enjoys the chances and bears the risks related to any changes in the value of the licensed intangible asset. • The licensee is responsible for activities and costs in connection with the legal protection of the intangible asset. • The licensor does not have any extraordinary termination rights. Based on the criteria described above, if the licensee of an intangible asset qualifies as an economic owner of the licensed asset, the corresponding intercompany transactions would need to be reassessed. The licensing transaction and the associated license payments to the legal owner of the intangible asset, for example, would not be valid anymore and might qualify as installment payments on the purchase price of the intangible asset (see also Sect. 4 below). To conclude, the notion of economic ownership as defined in German tax law strongly refers to the economic aspects of an arrangement, i.e., the allocation of benefits, costs, chances, and risks relating to the intangible asset, taking into account the legal and/or contractual rights of the parties involved. Based on existing case law and administrative practice, a company that receives contract R&D services from a related party and pays an arm’s length service fee that is based on the actual costs incurred by the related party in connection with R&D activities would thus become the owner of the intangible assets resulting from these activities.12 Contractual arrangements, therefore, play an integral role in the determination of economic ownership according to German tax law. Whether, from a transfer pricing perspective, the economic owner of an intangible asset is also entitled to the residual profits resulting from this asset, has to be determined on the basis of the functional ownership and the OECD’s DEMPE approach.

2.2

Functional Ownership of the OECD

According to earlier guidance of the OECD, for transfer pricing purposes the allocation of an intangible asset was primarily based on legal ownership and the contractual arrangements between the companies of a multinational group. For example, if a group company performed contract R&D services for a related party 12

This is also in line with the Circular of the German Ministry of Finance of 2/23/1983, BStBl. 1983 I, p. 218, note 5.3.

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and that related party assumed the associated R&D risk and became the legal owner of the developed intangible asset, this would generally have also been accepted for transfer pricing purposes. The allocation of residual profits resulting from an intangible asset thus followed the legal ownership of that asset. This regulation, however, led to a situation where a group company could become the legal owner of intangible assets of the group and could earn the respective residual profits, although it was not involved in any R&D activities and merely provided funding for these activities. As this could lead to a shifting of profits to group companies in low-tax jurisdictions based on contractual arrangements without any further substance, the OECD revised its transfer pricing guidelines and its regulations regarding the ownership of intangible assets as part of its Base Erosion and Profit Shifting project. According to the new regulations in the OECD Transfer Pricing Guidelines 2017, legal ownership of an intangible asset no longer confers any right to retain returns derived by the multinational group from exploiting this asset.13 Contractual arrangements within a group of companies are thus effectively of no significance anymore for the arm’s length allocation of residual profits. Instead, the performance of functions, the use of assets, and the assumption of risks in connection with the development, enhancement, maintenance, protection, and exploitation (“DEMPE approach”) of an intangible asset are now the key criteria for determining the functional owner of an asset. Functional ownership corresponds to “entitlement” for transfer pricing purposes, i.e., it defines which company of the multinational group is entitled to the residual profits from the use of the intangible asset.14

2.2.1

Performance and Control of Functions

The performance of functions relating to the development, enhancement, maintenance, protection, and exploitation (“DEMPE functions”) of an intangible asset is a key criterion for determining the functional owner. For this purpose, all activities in a multinational group relating to these functions have to be analyzed in detail. In particular, the role of each of these functions within the whole value chain of the group has to be assessed, as well as the functional contributions of all group companies. If various members of a multinational group contribute to the performance of these functions, certain functions are considered to be of special significance by the OECD.15 For self-developed intangible assets, or for self-developed or acquired intangible assets that serve as a platform for further development activities, among others, the more important functions may include:

13

See OECD Transfer Pricing Guidelines (2017), note 6.42. See Wilkie (2012), p. 236. 15 OECD Transfer Pricing Guidelines (2017), note 6.56. 14

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• Design and control of research and marketing programs • Direction of and establishing priorities for creative undertakings, including determining the course of “blue sky” research • Control over strategic decisions regarding intangible development programs • Management and control of budgets For any intangible, other important functions may also include: • Important decisions regarding the defense and protection of intangible assets • Ongoing quality control over functions performed by independent or associated enterprises that may have a material effect on the value of the intangible asset The performance of these important functions by a group company is a strong indicator that this entity should be considered as the functional owner of the relevant intangible asset. The outsourcing of one of these functions to a related party without any impact on functional ownership is therefore only possible to a limited extent, as described below.

2.2.2

Use of Assets

The use of assets in the development, enhancement, maintenance, protection, and exploitation of an intangible asset is the second criterion for the determination of functional ownership of an intangible asset. Such assets may include, without limitation, intangibles used in research, development, or marketing (e.g., expertise, customer relationships), physical assets, or funding.16 The provision of funding is thereby the most relevant factor. Contrary to the notion of legal ownership relevant for transfer pricing purposes under previous versions of the OECD Transfer Pricing Guidelines, a company that only provides funding, does not perform any of the DEMPE functions and does not control significant risks in connection with these functions is no longer entitled to the residual return from the intangible asset. According to the OECD, the appropriate return for purely funding activities should be based, for example, on the cost of capital or return on a realistic alternative investment.17

2.2.3

Assumption of Risk

Assumption of risk is still the most critical factor in a transfer pricing analysis. The principles for the allocation of risks within a multinational group, however, have developed over time. Initially, a risk was allocated to the group company that contractually assumed the risk, based on a contractual arrangement, for example.

16 17

OECD Transfer Pricing Guidelines (2017), note 6.59. OECD Transfer Pricing Guidelines (2017), note 6.62.

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In the OECD Transfer Pricing Guidelines 2010, the OECD changed its guidance on the allocation of risks in a multinational group. A company was henceforth only deemed to assume a certain risk if it had control over the risk and the financial capacity to bear the risk. This regulation, however, only applied to business restructurings (Chapter IX of the OECD Transfer Pricing Guidelines 2010). The allocation of R&D risks to a group company on the basis of a contractual arrangement, for example, was thus no longer possible in the context of a business restructuring if the company did not also fulfill these two conditions. Within the framework of the Base Erosion and Profit Shifting project, the OECD has adopted this regulation for all types of intercompany transactions and incorporated it into the first chapter of the OECD Transfer Pricing Guidelines 2017. The allocation of risk in a multinational group for transfer pricing purposes now depends on these two factors: control over the risk and the financial capacity to assume the risk.18 Control over risk is defined by the OECD as the capability to make decisions to take on, lay off, or decline a risk-bearing opportunity, together with the actual performance of that decision-making function and the capability to make decisions on whether and how to respond to the risks associated with the opportunity, together with the actual performance of that decision-making function.19 In order to exercise control over risk, it is not necessary that day-to-day risk mitigation activities are performed by the same company. These activities can be outsourced to a related or unrelated party. In this case, however, the outsourcing company should have the capability to determine the objectives of the outsourced activities, to decide to hire the provider of risk mitigation functions, to assess whether the objectives are being adequately met, and, where necessary, to decide to adopt or terminate the contract with that provider. In addition, the outsourcing company should actually perform these assessment and decision-making activities. The decision-makers should thus possess competence and experience in the area of the particular risk. Neither a mere formalizing of the outcome of decision-making in the form of meetings organized for formal approval of decisions that were made in other locations, nor the setting of the policy environment relevant for the risk is deemed to be sufficient to fulfill the criterion of control-over-risk.20 This control-over-riskapproach of the OECD, however, has been widely criticized in the literature, as it would not reflect arm’s length behavior.21 The financial capacity to assume risk is defined as access to funding to take on or lay off the risk, to pay for risk mitigation functions and to bear the financial consequences of a risk if one materializes.22 It is therefore not necessary that a company has the financial capacity to bear the full consequences of a risk

18

OECD Transfer Pricing Guidelines (2017), note 1.60. OECD Transfer Pricing Guidelines (2017), note 1.65. 20 OECD Transfer Pricing Guidelines (2017), note 1.66. 21 For example, see Schön (2015), pp. 81–82, Monsenego (2014), p. 14. 22 OECD Transfer Pricing Guidelines (2017), note 1.64. 19

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materializing, as it can be sufficient if it has the financial capacity to protect itself from the consequences of a risk materializing, e.g., through external insurance.23 In order to determine the functional owner of an intangible asset, the OECD lists several types of risk that might be of particular importance and should be considered in detail:24 • Risks related to the development of an intangible asset, including the risk that costly R&D and marketing activities will prove to be unsuccessful. • The risk of product obsolescence, including the possibility that technological advances of competitors will adversely affect the value of the intangible assets. • Infringement risk, including the risk that defense of intangible rights or defense against other persons’ claims of infringement may prove to be time-consuming, costly, and/or unavailing. • Product liability and similar risks related to products and services based on the intangible assets. • Exploitation risks, uncertainties in relation to returns to be generated by the intangible assets. In particular, with respect to these risks, multinational companies should analyze whether the company that should receive the residual profits from an intangible asset also has control over the respective risks and the financial capacity to bear the risks.

2.2.4

Summary

The relevant criteria for the identification of the functional owner of an intangible asset as described above are summarized in Fig. 1.

3 Economic and Functional Ownership in Outsourcing Transactions 3.1

Economic Ownership

A typical outsourcing transaction that involves intangible assets in a multinational group is an intercompany contract R&D agreement. Under such an arrangement, one group company performs R&D activities as a service for a related party. The latter bears all costs, risks, and benefits in connection with the R&D activities and becomes the legal owner of the results of these R&D activities. The contracted R&D company, on the other hand, is not entitled to use the results of its R&D 23 24

Bullen (2010), p. 487. OECD Transfer Pricing Guidelines (2017), note 6.65.

Fig. 1 Determining functional ownership. (Based on OECD Transfer Pricing Guidelines (2017), notes 6.56, 6.59 and 6.65)

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activities for its own commercial benefit and cannot economically exclude the legal owner from affecting the intangible asset. The principal, as the legal owner of the intangible asset, is therefore also the economic owner of the asset in accordance with Section 39 paragraph 2 of the German Fiscal Code. As a consequence, the intangible asset that results from the contract R&D arrangement is allocated to the principal, i.e., the legal and economic owner. From a transfer pricing perspective, however, the principal is only entitled to residual profits in connection with the intangible asset if the principal is also the functional owner of the asset.

3.2

Functional Ownership

In order to be qualified as the functional owner of an intangible asset, a company has to perform the DEMPE functions related to the asset, as described above. It is, however, not necessary that the functional owner physically performs all of these functions with its own personnel.25 Outsourcing certain functions relating to the development, enhancement, maintenance, protection, and exploitation of an intangible asset to a related party, e.g., under a contract R&D arrangement, is therefore still possible. In this case, however, the functional owner still has to control the risks associated with the outsourced function (“control-over-risk”). The group company that physically performs the outsourced function has to operate under the control of the functional owner of the intangible asset. In addition, the functional owner needs to have the financial capacity to bear the consequences if risks related to the outsourced function materialize. The notion of control over the outsourced risk corresponds to the concept of control-over-risk as described above.26 The outsourcing company thus needs to have the capacity to make all strategic decisions related to the outsourced function and has to actually perform this decision-making and control function. It, therefore, needs sufficient substance in the form of qualified personnel with sufficient experience and decision-making power related to the outsourced function. The functional owner must be able to assess the outcome of the outsourced services and must be actively involved in the selection of the related party that acts as a service provider. This includes specifying the scope of the related party’s assignment and regularly controlling and assessing the work performed by the related party.27 In this context, it is crucial to analyze the actual decision-making process within a multinational group and to determine the persons and functions that are part of this process. For example, the board and executive committees of the group might in some cases not be in the position to effectively perform the control function, which might, instead, be carried out by the line management in business segments, operational activities, and

25

OECD Transfer Pricing Guidelines (2017), note 6.65. OECD Transfer Pricing Guidelines (2017), note 6.63. 27 Bullen (2010), p. 503. 26

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functional departments.28 In addition, in cases of long-term outsourcing transactions, it is necessary to monitor that the control function is not gradually shifted to the company performing the outsourced function, e.g., by gradually shifting decision-making functions and competencies abroad, as this might have significant consequences for functional ownership of the intangible asset and intercompany transactions involving the intangible. In general, even functions considered as important functions within the DEMPE approach can be outsourced to a related party. As the OECD considers these functions to make a significant contribution to the value of the intangible asset, the company performing these functions should receive appropriate compensation. If this compensation cannot be derived from comparable data, the profit split method or valuation techniques should be applied to reward the performance of these functions.29 The transfer price for the performance of a specific important DEMPE function would thus be based on the sharing of the profits derived from the use of the intangible asset. As the assessment of the effective control over outsourced functions is deemed to be an important part of the transfer pricing analysis under the new DEMPE approach,30 taxpayers should be very careful that respective requirements are actually met and also thoroughly documented for future tax audits. If the outsourcing company cannot be qualified as a functional owner under the DEMPE approach, it is not entitled to residual profits that relate to the intangible asset and would only earn a routine return for its funding activities. In practice, there is a rather high threshold for outsourcing transactions to be accepted as such in the context of the determination of the functional owner of an intangible asset for transfer pricing purposes. In particular, it is essential to clearly differentiate between the outsourcing of activities to a related party under the control of the outsourcing company that will still be considered the functional owner of the intangible asset and mere funding activities, which are not deemed sufficient to create functional ownership. Therefore, taxpayers should perform a detailed functional analysis of the DEMPE activities of the group as well as an analysis of the persons involved and the respective reporting lines, decision-making authority, and competence in order to identify the functional owner of an intangible asset.

4 Reassessment of Intercompany Transactions As shown above, the allocation of an intangible asset within a multinational group of companies based on the latest guidance of the OECD depends on a rather subjective evaluation of the factual background. This increases the risk that tax authorities will

28

OECD Transfer Pricing Guidelines (2017), note 1.76. OECD Transfer Pricing Guidelines (2017), note 6.57. 30 OECD Transfer Pricing Guidelines (2017), note 6.63. 29

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assess the case in a different way than the group itself and reallocate the economic and/or functional ownership of the intangible asset to a different entity in the group. In cases of reallocation of the economic ownership of an intangible asset to another group entity, the type of intercompany transactions that involve the intangible asset would also have to be reassessed and adjusted accordingly. Example: An intercompany licensing transaction between two group companies is structured in such a way that the licensee is qualified as the economic owner of the intangible asset by the tax authorities, based on the criteria described above (Sect. 2.1). The licensing transaction would thus not be accepted as such but would be requalified as a sales transaction. The intangible asset would be transferred from the licensor to the licensee and would be shown in the tax balance sheet of the licensee. The royalty payments would be requalified as installment payments to the legal owner. If the intangible asset is also licensed to other group companies, those licensing transactions would also have to be reassessed with respect to whether the other licensees qualify as economic co-owners of the intangible asset or whether the license transactions are accepted as such, but with the economic owner as the new licensor. The reassessment of intercompany licensing transactions might also entail other tax questions, e.g., with respect to withholding taxes on the royalty payments. It is therefore crucial to structure the legal and economic framework of an intercompany transaction that involves intangible assets in such a way that the legal owner also qualifies as an economic owner, in order to avoid major changes to the intercompany transaction structure years later during a tax audit. Irrespective of the allocation of the economic ownership, the tax authorities might also reassess the allocation of functional ownership. In this case, they would analyze whether the group company that receives the residual profits from an intangible asset is entitled to those profits from a transfer pricing perspective under the new DEMPE approach. If the group company does not qualify as the functional owner of the intangible asset, the transfer prices for the intercompany transactions that involve the intangible asset would have to be adapted accordingly. The legal setup of intercompany transactions would thus remain unchanged and only the allocation of residual profits within the group would be reassessed. A reassessment, not only of the transfer prices of a given intercompany transaction but also of the type of intercompany transaction itself—as is the case for the concept of economic ownership—is not included in the OECD’s DEMPE approach. Such a reassessment would not be covered by the arm’s length principle as stipulated in Article 9 Section 1 of the OECD MTC and the corresponding provisions in double tax treaties. Article 9 Section 1 of the OECD MTC stipulates that where “conditions are made or imposed between the two [related] enterprises in their commercial or financial transactions which differ from those which would be made between independent enterprises,” the respective profits may be adjusted. This provision thus only covers an adjustment of the conditions (i.e., transfer prices) between two related companies. An adjustment of the commercial or financial relations themselves, i.e., the type of intercompany transactions, on the other hand, is not

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Fig. 2 Setting up a transfer pricing system for intangible assets

possible.31 This interpretation is also in line with former judgments of the German Federal Fiscal Court that argue that the arm’s length principle as stipulated in Article 9 Section 1 of the OECD MTC only allows for a correction of the actual amount of transfer prices and not a correction of other aspects of the transaction, e.g., whether the transaction itself was at all customary.32

5 Implications for Setting up a Transfer Pricing System Intangible assets are the key determinant in every transfer pricing system. Setting up a new transfer pricing structure for a multinational group should therefore always start with the allocation of intangible assets of the group and determination of the related intercompany transactions. This includes the following steps (Fig. 2):

31

Rasch (2015), Artikel 9 DBA-MA, note 72; Eigelshoven and Ebering (2015), OECD Chapter I, note 101/1.49. Wittendorff (2010), p. 397. 32 BFH, 10/11/2012, BStBl II 2013, p. 1046. Similar: BFH, 12/17/2014, BStBl II 2016, p. 261; BFH, 6/24/2015, BStBl II 2016, p. 258. However, according to recent decisions of the German Federal Fiscal Court, also other conditions of the intercompany transaction as well as commercial or financial relations themselves could be subject to a transfer price adjustment; ruling of the German Federal Fiscal Court of 2/27/2019, I R 73/16, Federal Tax Gazette II 2019, p. 394.

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• In the first step, a value chain analysis of the multinational group should be performed with a focus on the performance of DEMPE functions related to the intangible assets of the group. From this analysis, the functional owner of each intangible asset can be determined, as well as the legal and economic owner. To have a consistent transfer pricing system, which is reflected in the intercompany agreements and balance sheet of the group companies, it is advisable that legal, economic, and functional ownership of an intangible asset are a single company of the multinational group.33 This means that countries which do not apply the functional ownership and DEMPE approach, only accepting legal or economic ownership for transfer pricing purposes, would not reassess the transfer pricing system as a whole due to IP ownership issues. Separating legal and economic ownership from functional ownership is therefore only a second-best option. Since determining the functional owner of an intangible asset fully depends on the managerial and operational setup of a multinational group, which often cannot be changed easily, it is generally advisable that legal and economic ownership follow the functional ownership. This may make it necessary to transfer legal and economic ownership of the intangible asset to the functional owner. If more than one company is identified as a functional owner of a specific intangible asset, the respective value contribution of each functional owner has to be determined. All co-owners of the asset should then participate in residual profits associated with the intangible asset, according to their relative value contributions. • In the second step, intercompany transactions relating to the intangible asset should be determined. This includes, for example, contract R&D arrangements and licensing transactions, as well as other functions relating to the development, enhancement, maintenance, protection, and exploitation of the specific intangible asset that are outsourced by the functional owner to a related company. Furthermore, arm’s length transfer prices relating to these transactions have to be determined. The transactions should be documented in intercompany agreements. • Finally, the multinational group should regularly monitor that requirements for functional ownership remain fulfilled by the group company that receives the residual profits related to an intangible asset. This is especially the case with respect to DEMPE functions that are outsourced to another group entity. In this case, it should be regularly monitored whether the functional owner still has control over the outsourced function, i.e., whether the functional owner has the capacity to make all strategic decisions relating to the outsourced function and whether it actually performs this decision-making function. Furthermore, in cases of changes to the operational setup of the group, e.g., due to relocation of certain activities to a related party, it needs to be verified whether the functional owners of the intangible assets in the group are affected by these changes and whether they still fulfill the prerequisites for functional ownership.

33

Lagarden (2014), p. 696.

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References BFH (1972) Ruling of the German Federal Fiscal Court of 10/13/1972, Federal Tax Gazette II 1973, I R 213/69 BFH (1973) Ruling of the German Federal Fiscal Court of 11/29/1973, Federal Tax Gazette II 1974, IV R 181/71 BFH (1977) Ruling of the German Federal Fiscal Court of 4/28/1977, Federal Tax Gazette II 1977, IV R 163/75 BFH (1991a) Ruling of the German Federal Fiscal Court of 11/7/1991, Federal Tax Gazette II 1992, IV R 43/90 BFH (2016) Ruling of the German Federal Fiscal Court of 10/13/2016, Federal Tax Gazette II 2018, IV R 33/13 BFH (1991b) Ruling of the German Federal Fiscal Court of 2/27/1991, Federal Tax Gazette II 1991, XI R 14/87 BFH (1991c) Ruling of the German Federal Fiscal Court of 9/12/1991, Federal Tax Gazette II 1992, III R 233/90 BFH (1993) Ruling of the German Federal Fiscal Court of 7/28/1993, Federal Tax Gazette II 1994, I R 88/92 BFH (1991d) Ruling of the German Federal Fiscal Court of 9/24/1991, Federal Tax Gazette II 1992, VIII R 349/83 BFH (1995) Ruling of the German Federal Fiscal Court of 9/28/1995, not published, IV R 34/93 BFH (1996) Ruling of the German Federal Fiscal Court of 1/25/1996, Federal Tax Gazette II 1997, IV R 114/94 BFH (2015a) Ruling of the German Federal Fiscal Court of 8/18/2015, Federal Tax Gazette II 2016, I R 88/13 BFH (2012) Ruling of the German Federal Fiscal Court of 10/11/2012, Federal Tax Gazette II 2013, I R 75/11 BFH (2014) Ruling of the German Federal Fiscal Court of 12/17/2014, Federal Tax Gazette II 2016, I R 23/13 BFH (2015b) Ruling of the German Federal Fiscal Court of 6/24/2015, Federal Tax Gazette II 2016, I R 29/14 BFH (1971) Circular of the German Ministry of Finance of 4/19/1971, Federal Tax Gazette I 1971, IV B/2-S 2170-31/71 BFH (2001) Circular of the German Ministry of Finance of 2/23/2001, Federal Tax Gazette I 2001, IV A 6 - S 2241 - 8/01, note 16 and 53 Bullen, A. (2010). Arm’s Length Transaction Structures. Amsterdam: IBFD. Eigelshoven, A., & Ebering, A. (2015). OECD-Kapitel I. In H.-K. Kroppen (Ed.), Handbuch internationale Verrechnungspreise. Cologne: Otto Schmid. Greinert, M. (2014). Immaterielle Wirtschaftsgüter. In F. Wassermeyer & H. Baumhoff (Eds.), Verrechnungspreise international verbundener Unternehmen. Cologne: Otto Schmid. Greinert, M., & Metzner, S. (2015). Eigentum an IP im Steuerrecht. IP-Rechts-Berater, 11, 256–260. Lagarden, M. (2014). Immaterielle Wirtschaftsgüter und Verrechnungspreise. Internationales Steuer- und Wirtschaftsrecht, 18, 689–700. Monsenego, J. (2014). The Substance Requirement in the OECD Transfer Pricing Guidelines: What Is the Substance of the Substance Requirement? International Transfer Pricing Journal, 21(1), 9–23. OECD. (2017). Transfer Pricing Guidelines. Pankiv, M. (2016). Post-BEPS Application of the Arm’s Length Principle to Intangibles’ Structures. International Transfer Pricing Journal, 23(6), 463–476. Rasch, S. (2015). Artikel 9 DBA-MA. In D. Gosch, H.-K. Kroppen, & S. Grotherr (Eds.), DBAKommentar. Herne: NWB. Ratschow, E. (2020), § 39, In F. Klein (Eds.), Abgabenordnung. Munich: C. H. Beck

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Ratschow E (2020) § 39, In F. Klein (Eds) Abgabenordnung. C. H. Beck, Munich Schön, W. (2015). Konzerninterne Risikoallokation und internationales Steuerrecht. Steuer und Wirtschaft, 92(1), 69–89. Wilkie, S. (2012). The Definition and Ownership of Intangibles: Inside the Box? Outside the Box? What is the Box? World Tax Journal, 4(3), 222–248. Wittendorff, J. (2010). Transfer Pricing and the Arm’s Length Principle in International Tax Law. Austin: Wolters Kluwer.

Overview of IP Migration Models Martin Schmitt, Anna-Katharina Christen, and Merten Zenker

What Will the Reader Learn? • What are the business reasons for IP migration? • Overview of stylized IP migration models • What are the typical IP migration models and practical examples of IP migration? • What are the advantages and limitations of the various models?

1 Introduction Today’s economic life is characterized by increased globalization and the digitalization of business models and value chains. Often IP (the term IP will be also used as a synonym for intangibles within this chapter) is a key value driver of the value chain and therefore of high importance to multinationals. Due to acquisitions, the IP of multinationals might be spread all around the globe, resulting in complex structures and giving rise to the need to centralize and consolidate the group’s IP. Besides MNEs for themselves, national governments have an incentive to support research and development activities that accrue IP as this generally leads to

M. Schmitt (*) · M. Zenker Deloitte GmbH, Frankfurt am Main, Germany e-mail: [email protected]; [email protected] A.-K. Christen Deloitte, Hamburg, Germany e-mail: [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_3

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economic growth and an increased tax base, resulting in an international competition for IP. However, tax administrations fear that IP, due to its highly mobile nature, could be transferred to low tax jurisdictions and therefore have in place or are implementing measures to restrict undesirable IP movements. Before outlining the various IP migration models, several reasons for IP migration are explained. Following this, there is an overview of a variety of options for IP migrations and the possible obstacles to consider from a transfer pricing perspective in the context of historic and current developments.

2 Reasons for IP Migrations A management’s decision to perform an IP migration is frequently motivated by various operational reasons and the common drivers for this are: • Material simplification in the administration of intellectual property: When there are large numbers of IP-owning entities within a group—often caused by acquisitions—the administration of IP becomes extremely complex and this results in increasingly complicated intercompany processes for tracking and charging of various IP rights and components, as well as inefficiencies in administration of the various rights. Accordingly, many groups aim for a material simplification of the administration of its intellectual property by centralizing IP within one legal entity. • Central management of intellectual property rights—normally covering thirdparty intellectual property rights licensed within the group in addition: The legal registration and protection of IP within an MNE is often the responsibility of a global IP department, which is responsible for global legal registration, protection, and enforcement of IP rights. Typically, the same department also deals with the management of third-party licenses. • More streamlined research and development activities: As acquired entities and products are integrated into the overall product portfolio of an MNE, there is usually increasing cross-utilization and leveraging of R&D centers throughout the world as well as the increased potential for co-development (synergy considerations are common among the main drivers for acquisitions). Centralizing the IP rights normally facilitates the ability to create efficiencies in the development of integrated products and the leveraging of existing development resources, including mixed IP cases. • More efficient and centralized enforcement of future intellectual property rights: The IP owned by MNEs are usually critical to the operation of the group’s business and success. Infringement by third parties would likely cause significant harm to the success of an MNE. By centralizing future developments within one legal entity, the MNE often gains better control over the direction of enforcement of any future IP rights that are developed.

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• More sustainable integration of different technologies into an overall development concept: The strategies of many MNEs are based on one overall development concept instead of different silos (multiplied in order to realize additional synergies). Thus, within MNEs an integration effort is frequently part of an ongoing effort to integrate the group’s separate product-based IP into an overall development concept. These motives accord with the rationale for IP migrations as expressed by business representatives participating in the OECD consultation process between 2005 and 2009, who explained that “among the business reasons for restructuring are the wishes to maximize synergies and economies of scale, to streamline the management of business lines and to improve the efficiency of the supply chain, taking advantage of the development of internet-based technologies that has facilitated the emergence of global organizations.”1 In addition to the operational reasons mentioned above, various tax aspects are normally considered in the course of an IP migration, e.g., • Alignment of DEMPE2functions with intellectual property allocation: According to the OECD, “in transfer pricing cases involving intangibles, the determination of the entity or entities within an MNE group which are ultimately entitled to share in the returns derived by the group from exploiting intangibles is crucial.”3 In this context, the OECD established what it calls the DEMPE concept, which determines “that the ultimate allocation of the returns derived by the MNE group from the exploitation of intangibles [. . .] is accomplished by compensating members of the MNE group for functions performed, assets used, and risks assumed in the development, enhancement, maintenance, protection and exploitation of intangibles.”4 The DEMPE concept, introduced in 2015,5 typically creates the necessity of post-merger alignments once acquired entities are operationally integrated into the MNE framework. • Reduction of tax risks resulting from split intellectual property ownership within a group: The development of new products and evolution of existing ones in a world with more than one (stand-alone) IP owner requires complex tracking of costs and revenue allocation, especially in cases of mixed IP products. The level of complexity increases exponentially with the number of IP owners involved. In the light of this, tax authorities worldwide increasingly scrutinize and challenge the arm’s length revenue and R&D cost allocation in mixed IP cases, while the recent profit split initiatives by the OECD still lack consensus-based guidelines on various levels to ensure the avoidance of double taxation.

1

OECD Transfer Pricing Guidelines, Chapter IX, section 9.4. Development, Enhancement, Maintenance, Protection, Exploitation. 3 OECD Transfer Pricing Guidelines, Chapter VI, sections 6.32 ff. 4 OECD Transfer Pricing Guidelines, Chapter VI, section 6.32. 5 OECD (2015a), Aligning Transfer Pricing Outcomes with Value Creation, sections 6.32 ff. 2

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• Optimization of the effective tax rate in the group, for example, by drawing on tax incentives provided by various countries, especially those designed to attract R&D activities and IP (see also Sect. 3 for more details).

3 IP Migration Models 3.1

Overview

When considering IP from a transfer pricing perspective, it is necessary to differentiate between already existing IP, i.e., (partly) developed IP (right side of the figure) and the process of developing IP (left side of the figure). Typically stylized intercompany transactions related to (partly) developed IP are either a transfer of already developed IP, stand-alone or jointly with related functions and risks, or according to a license model. In contrast, IP can either be developed by one entity directly, outsourced to a contract R&D company, or alternatively jointly developed within a development pool. Each of these concepts has different transfer pricing implications, including typical functional and risk profiles and analysis of arm´s length prices, as well as further tax and legal consequences and preconditions. This guide outlines in Sect. 2 how the arm´s length price for the different models (i.e., licensing, sales, contract R&D, and joint development) can be derived. Further details on the valuation are provided in Sect. 3. The relevant legal and operational aspects are outlined in Sect. 5. Section 4 presents country-specific aspects for the various options, such as the acceptance of the transfer pricing method (Fig. 1). This chapter provides an overview of typical examples in practice that combine several of the aforementioned stylized models, i.e., the IP migration models as they are called. Although an IP migration itself concerns already existing IP (and its exploitations rights), it could be influenced by considerations for the future development, enhancement, and maintenance of IP.

Fig. 1 Stylized IP models

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Typical Models in Practice

In the context of IP migration models, it is necessary to differentiate between the direct and indirect transfer of IP and/or relevant knowledge. In the first case, the reorganization of the relevant IP is in the foreground, e.g., by an outright IP sale. In the second case, certain functions (and risks) are primarily transferred and the IP, or specific knowledge, is required to exercise these (e.g., in the case of conversion of a fully fledged distributor to a low-risk distributor). The following section will focus on the first case, i.e., the direct transfer of IP and/or knowledge.

3.2.1

Principal Model

A manifestation of the principal model is the immediate IP consolidation by onetime “buy outs” of IP from other group entities (e.g., recently acquired entities). In this case, the principal buys the entire IP of other group entities at once. Despite potential onetime tax impacts on revenue due to the potential taxation of hidden reserves inherent in the transferred IP (which might be subsequently offset by potential tax amortizations by the principal), this model immediately realizes the operational target structure with its advantages as described above (Fig. 2).6

Stand-alone IP Valuation According to appraisal literature, there are three traditional valuation approaches for determining the value of intangibles: the market, cost, and income approaches. Under the market approach, the fair market value of transferred intangibles can be determined in several ways. One method, the comparative transaction method, determines the fair market value based on actual transaction prices of guideline transactions being conducted in the marketplace. Another, referred to as the capital markets method, utilizes stock prices of comparable guideline companies to determine a market value. However, this is usually more appropriate in the context of the outright sales of shares. Under the cost approach, the fair market value is reached by determining the cost that would be incurred if the transferred assets were to be replaced. This concept assumes that a prudent investor would pay no more for an asset than the amount that it would cost to replace it. This approach is more appropriate for the determination of tangible asset values, but can also be applied for valuation of intangibles in some instances, particularly in connection with routine intangibles. In connection with the valuation of non-routine IP, a cost approach would likely undervalue the IP as it does not account for its current and future profit potential.

6

See also Engler and Kachur (2015), Chapter O, paragraphs 161–180.

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Fig. 2 Buy out model

The income approach is based on the premise that the appropriate price is the present value of the future economic income expected from the asset (i.e., the current value of the future cash generated by the asset). There are several income approaches available, including the capitalization of normalized earnings, the capitalization of normalized cash flows, discounted future cash flows, and capitalized dividendpaying capacity. The income approach differs from other approaches in the regard, in that it looks at the expected future financial results instead of past performance. One variation of the income approach in connection with the valuation of IP is the “Avoided Royalty Method.” The basic principle of this method is that without the ownership and/or control of the rights to the intangible asset, the user of the intangible asset would have to make a stream of payments to the owner in return for rights to use the asset. By acquiring the intangible asset, the user avoids these payments. Using this method arm’s length royalty or license agreements are analyzed. The net revenue expected to be generated by the intangible asset during its expected remaining life is then multiplied by the selected benchmark royalty rate. The estimated royalty stream after tax is then discounted to the present value, which results in an indication of the value of owning the intangible asset.

Tax Specifics During a Business Restructuring Scenario The OECD Transfer Pricing Guidelines outline certain business restructurings, e.g., the setup of a principal structure that eventually requires more consideration than mere valuation and transfer of the IP itself.7 In this respect, the guidelines state that business restructurings sometimes involve the “transfer of assets, bundled with the ability to perform certain functions and bear certain risks.”8 While it is recognized that “an independent enterprise does not necessarily receive compensation when a change in its business arrangements results in a reduction in its profit potential or expected future profits,”9 the guidelines consider the question of whether a compensation beyond the payment for the value of the IP itself actually arises, depending on the factual situation of the restructuring at hand, “including the changes that have taken place, how they have affected the functional analysis of the parties, what the business reasons for and the anticipated benefits from the restructuring were, and what options would have been realistically available to the parties.”10 According to the OECD, “the fact that centralization of legal ownership of intangibles may be

7

OECD Transfer Pricing Guidelines, Chapter IX. OECD Transfer Pricing Guidelines, section 9.683. 9 OECD Transfer Pricing Guidelines, section 9.39. 10 OECD Transfer Pricing Guidelines, section 9.42. 8

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Table 1 Exit tax provisions Countries Czech Republic Estonia

Hungary

Poland

Romania

Implicit provisions OECD Transfer Pricing Guidelines approach with specific local provisions OECD Transfer Pricing Guidelines approach with specific local provisions OECD Transfer Pricing Guidelines approach with specific local provisions OECD Transfer Pricing Guidelines approach with specific local provisions OECD Transfer Pricing Guidelines approach with specific local provisions

Explicit provisions Yes, ATAD Yes, ATAD

Comments As of 1/1/2020, exit tax will be applicable, mainly in line with Directive (EU) 2016/1164 (ATAD 1) As of 2018, mainly in line with Directive (EU) 2016/1164 (ATAD 1)

TBD, ATAD

Pending approval, mainly in line with Directive (EU) 2016/1164 (ATAD 1)

Yes, ATAD

As of 1/1/2019 exit tax is applicable, mainly in line with Directive (EU) 2016/1164 (ATAD 1) As of 2018, mainly in line with Directive 2016/1164/UE (ATAD 1)

Yes, ATAD

motivated by sound commercial reasons at the level of the MNE group, it does not answer the question of whether the conditions of the transfer are arm’s length, from the perspectives of both the transferor and the transferee.”11 Thus, the transfer pricing analysis “should take account of both the perspectives of the transferor and of the transferee.”12 Several jurisdictions have introduced specific legislation for transfers of function that specify concrete valuation steps to be undertaken and go beyond a mere valuation of IP. Recently, several eastern European jurisdictions have introduced exit taxation rules to prevent companies from avoiding tax when relocating assets, following the Anti-Tax Avoidance Directive (ATAD) of the European Council (Table 1).13 German legislation for transfers of function, for example, requires under certain business restructuring scenarios a two-sided valuation from the perspectives of the transferor and the transferee called a “transfer package” that includes tangibles, intangibles and other advantages (e.g., locational advantages, synergies, tax rate differentials, etc.).14

11

OECD Transfer Pricing Guidelines, section 9.59. OECD Transfer Pricing Guidelines, section 9.93. 13 Council Directive (EU) 2016/1164 of July 2016 laying down rules against tax avoidance practices that directly affect the functioning of the internal market, Official Journal of the European Union. 14 Regulation on the Application of the Arm’s Length Principle under §1(1) of the Foreign Transactions Tax Law in Instances of Cross-Border Transfers of Function (Transfer of Function Regulation—FVerlV), BGBl I 2008, p. 1680, section 3. See in detail: Heidecke et al. (2017). 12

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Implementation of Target Structure Subsequent to the acquisition of the IP, the principal regularly enters into service agreements with the other, local entities engaged to perform routine services (e.g., contract R&D or contract manufacturing or sales support services). Pursuant to the future service agreements, all future IP rights to or arising out of any work performed by the local entities are regularly assigned to the principal. Such routine functions performed at the local entity level, such as contract R&D services, contract manufacturing, or sales support services on behalf of the principal are regularly considered as “routine functions” to be remunerated on a cost-plus basis. Accordingly, the principal bears all strategic and technical risks with respect to the acquired “legacy IP” as well as the future “new IP” related to the business.

3.2.2

Variation to the Principal Model: Structuring as a “license model”

One regularly seen modification of the principal model in practice is a “license model” structure of the subject IP. While the target structure is comparable to the “standard” principal model as outlined above, the main difference is it lacks a onetime purchase of the subject IP, which is instead licensed from the local entities. The reasons for such a modified principal model usually lie in avoidance of upfront cash tax payments. To achieve this target, implementation structures have to take into account the tax specifics in the respective jurisdictions to avoid reclassification as “pro rata purchases.” Examples of tax specifics are that the duration of the license is shorter than a percentage of the average useful life (e.g., 90%15) or that the “transferor retains any significant power, right, or continuing interest with respect to the subject matter of the franchise, trademark, or trade name.”16 German legislation for transfers of function17 acknowledges, for example, that a transfer (onetime purchase) or a license can be subject to relocation of function. In Sect. 4 paragraph 2 the legislation states that in cases of doubt a license shall be assumed upon request by the taxpayer. In cases where no written agreements are available, the entire circumstances of the particular case need to be analyzed to determine whether a transfer or license is applicable.18 Due to classification as a license, the onetime payment can be avoided. 15

See income tax handling of lease contracts regarding movable assets, BMF IV B/2-S 2170-31/71, BStBl. I p. 264. 16 Section 1253(a) of the Internal Revenue Code. 17 See Section 1 paragraph 3 sentence 9 of the Foreign Transaction Tax Act in connection with Section 1 paragraph 2 sentence 1 of the Transfer of Function regulation. 18 Administrative Principles on the Guidelines for the Examination of Income Allocation between Affiliated Persons in Cases of Cross-Border Relocations of Functions, dated October 13, 2010, BMF IV B 5—S 1341/08/10003, BStBl. I p. 774, recital 100.

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Fig. 3 Fade out model

Further considerations include the handling of the subject IP at the end of the license term given that the local entity still maintains legal title to the subject IP. After the end of the license term, the licensor and licensee generally have the options to: (1) conclude a purchase agreement for the subject IP; (2) extend the license period; or (3) decide to terminate the contractual relationship completely. The outcome and the assigned value of the respective options will be subject to the bargaining power and the expected benefit from the IP for the parties at that time. A related aspect concerns further development of the subject IP, which in many cases takes place at the principal and which, in many cases, directly draws on the legacy IP rights subject to the license. The legacy IP in this context is the IP already available. Regularly, this legacy IP (subject to the license) will be enhanced or used for further developments on the level of the principal (via its own R&D activities or via contract R&D by related or unrelated entities) contributing to what is termed “new IP.” The legal and economic ownership of these future developments (new IP) lies on the level of the principal. Consequently, it can be observed that over time legacy IP declines while new IP increases in relative terms (modeled via a statistical distribution function). In this regard, the main transfer pricing focus is usually on the handling of the business opportunities and profit potential19 related to the development of new IP— assuming that the licensed subject IP (legacy IP) will phase out over time (Fig. 3).20

19

See OECD Transfer Pricing Guidelines, Section 9.39 ff. for the OECD definition of profit potential. 20 In practice, a Weibull function is frequently used for modelling the obsolescence curve of IP, based on the useful average life and the gradient of obsolescence, i.e., the scale and shape parameters that reflect the characteristics of the IP. The scale parameter can be thought of as where the total expected life of a particular IP is the average area under the distribution function for which the IP has value. The implied average failure rate, or rate of obsolescence, is then obtained from the inverse of the scale parameter.

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As outlined above, Chapter 9 of the OECD Transfer Pricing Guidelines and legislation for transfer of function in many jurisdictions both consider the operational changes and changes in business arrangements in a broader context, which might lead to compensation entitlements beyond the remuneration of an arm’s length license rate for the contractual term of the license arrangement itself.

3.2.3

Variation to the Principal Model: Selective Buy Out

Another variant of the principal model is the “selective buy out model.” In this case, the principal only buys selected IP (e.g., production IP) while other IP/expertise (e.g., market-related knowledge/customer base) remains with the local entities. The first step in this analysis would include a delineation of different kinds of existing IP. In practice, differing nomenclatures can be found (e.g., trade intangibles versus marketing intangibles or routine intangibles versus nonroutine intangibles). Regularly, the existing IP can be categorized as technology IP (including patents, knowledge, and copyrights), trademarks and trade names, or customer base. This differentiation is important in order to be able to assign a respective value to the selective buy out. Commonly, market-related knowledge and the customer base does not form part of a selective buy out, due to the fact that the local entity, because of its close proximity to customers, shall remain the owner of these intangibles. In contrast technology IP, trademarks, and trade names are often subject to a selective buy out, as these intangibles allow for centralization benefits (e.g., central administration). A selective buy out can be structured as a onetime purchase or a license model.

3.2.4

IP Pool (Development Pool)

Different to the principal structure model as illustrated above, the “IP pool model” aims at a common ownership of IP among a group of IP pool members. In this context, the legacy IP is valued and then contributed to a “virtual pool” arrangement with joint economic ownership by all pool members, while the legal ownership stays with the original IP owning entities (Fig. 4). The OECD Transfer Pricing Guidelines address pooling concepts in Chapter VIII Cost Contribution Arrangements21 (“CCA”), as well as in the broader context of profit split arrangements.22 The IP pooling concept is also indirectly acknowledged by the OECD by the BEPS Actions 8–1023 that outline a scenario whereby the legal owner of the IP may have only limited rights to income associated with the exploitation of the IP (despite owning it). In the context of an IP pool, it has,

21

OECD Transfer Pricing Guidelines, section 8.1 ff. OECD Transfer Pricing Guidelines, section 2.114 ff. 23 OECD (2015a), Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10—2015 Final Reports, OECD Publishing, Paris, Sections 6.32 ff. 22

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Fig. 4 IP pool model

therefore, to be ensured that the pool members are jointly economically responsible for all functions, assets, and risks with respect to the DEMPE areas of the intangible lifecycle, in order to have full rights to any profits derived from the use of the intangibles. The OECD distinguishes between two types of CCA:24 • Development CCAs: CCAs where the development, production, or obtaining of intangibles or an ownership interest in any intangible or tangible assets resulting from the activity of the CCA, or rights to use or exploit the intangible or tangible assets, is contractually provided to each participant. • Service CCAs: CCAs that ensure that each participant is contractually entitled to receive service results from the activity of the CCA.

IP Valuation: Buy-in Payments/Buy-out Payments Whenever a party enters into an existing CCA, the question arises whether a compensation payment has to be made for the existing IP and currently being developed IP in the IP pool. The arm’s length principle dictates that a transfer of interests in IP has to be compensated as it would be between independent enterprises. The OECD refers to this compensation payment as “buy-in payment.”25 A buy-in payment can work in both directions, i.e., (1) the joining party to the CCA pays a compensation for benefiting from the developed IP and being developed IP, or (2) the joining party to the CCA brings in new IP to the IP pool, from which the other participants can benefit, and therefore receives a compensation payment. The OECD states the “amount of a buy-in payment should be determined based upon the value (the arm’s length price) of the interest in the intangible and/or tangible assets the new entrant obtains, taking into account the new entrant’s proportionate share of the overall expected benefits to be received under the CCA.”26 In practice, a valuation of the proportionate share of overall expected benefits is very complex.

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OECD Transfer Pricing Guidelines, section 8.5. OECD Transfer Pricing Guidelines, section 8.44. 26 OECD Transfer Pricing Guidelines, section 8.45. 25

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Similar to the question of compensation payments when a new party enters a CCA, the question of potential compensation payments whenever a party leaves the CCA has to be considered. In this case, the expected benefit to be received from the IP shifts to the remaining participants of the CCA. Therefore, it has to be analyzed, if in such a situation a compensation payment from the remaining participants of the CCA has to be made to the leaving party under the arm’s length principle as a “buyout payment.” The OECD states that in such cases the value of the buy-out payment has to be determined under the general guidance; however, there may be instances where no buy-out payment is required, e.g., “a CCA for the sharing of administrative services would generally only produce benefits to participants on a current basis, rather than any valuable ongoing results.”27

Mutual Benefit The concept of mutual benefit is fundamental to a CCA.28 Consequently, a participant to a CCA can only be a party that can expect benefits from the objectives of the CCA activity itself. In practice, it therefore has to be carefully evaluated whether all participants expect benefits from the CCA activity or certain entities are only contributing to the CCA (e.g., R&D activities), without benefiting from the results. In such a scenario the contributing entity would be regarded as a service provider and not a participant in the CCA, resulting in possible undesired outcomes with regard to the arm’s length remuneration.

Implementation of Target Structure In the target structure, there are basically two main options with regard to future R&D activities, but in most cases, a mix of both is observed in practice. IP pool members might themselves continue to engage in R&D activities. Alternatively, service providers outside of the pool might be contracted for R&D activities targeted to create new and/or enhanced IP on behalf of the IP pool. This in turn occurs on a contract R&D basis, wherewith the contract R&D providers in the MNE Group are regularly compensated, based on the cost-plus method. As regards the allocation of (expected) costs and (expected) profits resulting from the exploitation of the joint economic IP by the IP pool members, there are several approaches. The OECD generally outlines that in order “to satisfy the arm’s length principle, the value of participants’ contributions must be consistent with what independent enterprises would have agreed to contribute under comparable circumstances given their proportionate share of the total anticipated benefits they

27 28

OECD Transfer Pricing Guidelines, section 8.47. OECD Transfer Pricing Guidelines, section 8.14.

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reasonably expect to derive from the arrangement.”29 In practice, such an exercise is usually quite difficult and also subject to scrutiny and challenges by tax authorities, given that the anticipated benefits of the pool members are difficult to measure and compare in an objective manner and also regularly change over time. Many development CCAs that involve high IP values are therefore discussed and agreed upfront between the taxpayer and tax authorities (e.g., in unilateral, bilateral, or multilateral advance pricing agreements) to avoid the risk of double taxation.

3.2.5

IP Rights Manager

In contrast to the models illustrated above, an “IP rights manager” is a mere administrative function, which has only minimal influence over the group’s overall value chain. An IP rights manager might be installed—typically within the legal department of an MNE’s headquarters—with the responsibility for centrally registering, monitoring (execution), and protecting (execution) of the group’s IP, without having any impact on or change to the economic ownership of the IP within the various entities. In line with the Annex to Chapter VI of the OECD Transfer Pricing Guidelines “Examples to illustrate the guidance on intangibles” the legal registration, monitoring (execution), and protection (execution) of intangibles are considered service activities. With regard to the overall value chain, those service activities are routine in nature, could be outsourced, and therefore should receive only a limited-service remuneration based on the cost-plus method. By contrast, the IP rights manager should not share in any excess profits derived from the exploitation of the intangibles, including profits generated from the disposition of the intangibles.

4 Preferential IP Regimes More and more countries have created special preferential arrangements and have thus entered into tax competition with other countries. The use of preferential regimes might provide additional benefits or hurdles for the aforementioned IP migration models. A particularly frequent phenomenon is what are called “IP boxes,” “license boxes,” or “patent boxes.”30 This section describes the IP regimes before and after the BEPS action plans.

29 30

OECD Transfer Pricing Guidelines, section 8.12. In the following referred to as “IP box.”

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Background

Historically, an increasing number of countries have sought to attract companies by offering special tax considerations for income derived from IP. Consequently, companies had an incentive to transfer their IP to lower tax jurisdictions.31 These so-called IP regimes use a lower tax rate compared to the regular tax rate for the income derived from patents and other forms of IP. IP regimes encourage additional research investments by businesses, which are hoped to have a positive impact on the overall economy of that jurisdiction. Their objective is to reduce the corporate income tax burden for income generated from the use of IP, generally through a 40–80% deduction or exemption of qualified IP income. The granting of tax benefits by IP regimes has to meet country-specific requirements, e.g., patents have to be registered, own R&D activity, IP must be part of the local business assets, profits have to be higher than R&D expenses, etc. (1) Before BEPS Action Plan Many countries that created special preferential arrangements in the past have thus entered into tax competition with other countries. Intangibles are especially easy to transfer to other legal entities as well as across national borders, and therefore, the concern of potentially harmful IP regimes, in particular when preferential arrangements are applied without a minimum requirement of actual business activity of substance, was expressed by the OECD.32 The qualification requirements and operational mechanics of IP regimes differed significantly among jurisdictions, especially in the following categories: (i) amount of reduced tax rate; (ii) the types of eligible IP; (iii) the scope of qualifying income; and (iv) the requirements for R&D activities/substance. The amount of the effective tax rates of IP boxes varied from 0% in Malta to 15.5% in France (in 2014).33 The different types of eligible IP included patents and so termed supplementary protection certificates, other IP (copyrights) and business secrets or models. The computation of income related to IP consisted of revenues from licenses, compensation for damages of IP rights infringements, IP income embedded in sales of products or services, and IP income embedded in production processes. IP regimes had a patchwork of requirements of substance: some countries granted benefits only to self-developed IP while other countries only offered benefits for acquired IP. (2) Results of BEPS action plan

31

Hill (2016). See OECD (1998), Harmful Tax Competition: An Emerging Global Issue. 33 Evers et al. (2015), International Tax Public Finance, 22: 502. 32

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Nexus Approach

With Action 5 of the OECD BEPS Action Plan,34 the OECD aims to counter harmful tax practices more effectively, by taking into account transparency and substance. The report differentiated between “IP regimes” and “non-IP regimes.” According to the OECD, “regimes that provide for a tax preference on income relating to IP raise the base-eroding concerns [. . .] at the same time [. . .] IP-intensive industries are a key driver of growth and employment and that countries are free to provide tax incentives for research and development.”35 As a requirement for an IP regime, the OECD sets out the “nexus approach” in order to test substantial activity. The nexus approach “looks to whether an IP regime makes its benefits conditional on the extent of R&D activities of taxpayers receiving benefits.”36 The nexus approach determines which income may receive tax benefits by applying the following calculation: Income receiving tax benefits expenditures incurred to develop IP asset 37 = Qualifying Overall expenditures incurred to develop IP asset × Overall income from IP asset

According to this calculation, the ratio between own R&D activities and total expenses for the IP is dispositive for the requirement of substance and not the amount. When calculating the qualifying expenditures, a 30% uplift may be permitted by some jurisdictions, but limited to a maximum of overall expenditures. By the uplift, the OECD acknowledges that taxpayers who acquired IP or outsourced a portion of their R&D activity to a related party might still be responsible for much of the value creation.38

4.3

IP Assets

The OECD sets out prerequisites for IP assets that could qualify for tax benefits as: 1) qualify as a patent; or 2) other IP assets that are functionally equivalent to patents, provided those IP assets are legally protected and subject to a similar approval and

34 OECD (2015b), Countering Harmful Transparency and Substance. 35 OECD (2015b), Countering Harmful Transparency and Substance, point 26. 36 OECD (2015b), Countering Harmful Transparency and Substance, point 28. 37 OECD (2015b), Countering Harmful Transparency and Substance, point 30. 38 OECD (2015b), Countering Harmful Transparency and Substance, point 41.

Tax Practices More Effectively, Taking into Account Tax Practices More Effectively, Taking into Account Tax Practices More Effectively, Taking into Account Tax Practices More Effectively, Taking into Account Tax Practices More Effectively, Taking into Account

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registration process (i.e., patents defined broadly, copyrighted software and in certain circumstances IP assets that are non-obvious, useful, and novel).39

4.4

Qualifying Expenditures

What counts as “qualified expenditures” is largely defined by the respective jurisdiction. However, under the nexus approach, only expenditures that are incurred for the purpose of actual R&D can be regarded as qualifying expenditures and this excludes interest payments, building costs, acquisition costs, or any other costs that are not directly linked to a specific IP asset. The qualifying expenditures are included in the nexus calculation at the time they are incurred, irrespective of their treatment for accounting purposes.40

4.5

Inconsistent IP Regimes with Nexus Approach

Many of the IP regimes that existed prior to the BEPS Actions were not in accordance with the nexus approach and therefore qualified as inconsistent.41 For IP regimes considered inconsistent with the nexus approach, no new entrants (i.e., new taxpayers and new IP assets) were permitted after June 30, 2016.42 A transition period for existing IP regimes inconsistent with the nexus approach was granted by the OECD until June 30, 2021, at the latest. Consequently, countries classified as having an inconsistent IP regime have already changed their regulations or are in the process of considering how they can modify their IP regime to be in line with OECD BEPS requirements. In some cases, that can lead to the situation that the existing IP regime has to be abolished completely and replaced with a new IP regime as the changes may prove too extensive.43 In other cases, the OECD BEPS recommendations are implemented into existing IP regimes. In the case of the Netherlands, the renewed IP regime is effective as of January 1, 2017, and applies to intangible assets developed after June 30, 2016. The general framework of the former IP box was

39

OECD (2015b), Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, point 34. 40 OECD (2015b), Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, point 39. 41 An overview of classified harmful tax regimes is provided under “Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5—2015 Final Report,” p. 63 table 6.1 IP regimes. 42 OECD (2015b), Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, point 63. 43 See Liechtenstein (2016), Tax authorities to prepare consultation on implementation of BEPS measures, News IBFD.

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maintained, but some rules have become stricter, e.g., the requirement for substance has to be fulfilled by a mathematical approach.44 With requirements for BEPS OECD compliance, new IP regimes will become more transparent and comparable. Table 2 shows a selection of examples of current IP regimes.45 The following outlines several further restrictions, which might limit the use of preferential IP regimes:

4.6

Limitation of Deductibility of Royalty Payments to Related Entities: Germany

In order to disadvantage the use of IP regimes that are not consistent with the nexus approach, Germany introduced a new clause in 2017 to the German Income Tax Act (EStG § 4j—commonly referred to as “Lizenzschranke”) which limits the deductibility of royalty payments to related entities in certain situations. The new law applies to royalty payments incurred after December 31, 2017. The preconditions that have to be met in order to fall under this limitation of the deductibility of royalty payments are: (1) royalty payment to a related entity (share > 25%) and (2) that the royalty earnings in the receiving country are taxed under a preferential regime with less than 25%.46 The limitation of deductibility does not apply in cases where the preferential regime is in accordance with the nexus approach as outlined by the OECD.47

5 Automatic Disclosure of New cross-border Tax Schemes On June 5, 2018, the “Council Directive (EU) 2018/822 of May 25, 2018 amending Directive 2011/16/EU as regards mandatory automatic exchange of information in the field of taxation in relation to reportable cross-border arrangements” was published in the Official Journal of the European Union and took effect on June 25, 2018. The reasons for the directive were i.a. the release of the Paradise Papers and Panama Papers. According to this directive, the member states shall adopt and publish, by December 31, 2019, at the latest, laws, regulations, and administrative provisions necessary to comply with the directive. The primary objective of this directive concerns the reporting of potentially aggressive cross-border tax-planning arrangements, which will be automatically exchanged between the member states.

44

See Schrievers and Emonts (2016), p. 363 ff. See also an older overview of European IP box regimes in: Evers et al. (2013). 46 German Income Tax Act (EStG), section 4j paragraph 1 sentence 1. 47 German Income Tax Act (EStG), section 4j paragraph 1 sentence 4. 45

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Table 2 Selected examples of IP regimes

Country Belgiuma

Regular national tax rate 29% (2018), 25% (2020)

New regime effective from July 1, 2016

Italyb,c

24%

January 1, 2015

Hungaryd

9%

January 1, 2017

Types of eligible IP Income must be derived from qualifying intellectual property rights incl. qualifying patents, Supplementary Protection Certificates (SPCs), plant variety rights, orphan medicinal products, certain data or market exclusivity rights granted by the public authorities, copyright-protected computer programs Industrial patents, software covered by copyright, legally protectable drawings and models, legally protectable processes, formulas and information relevant to experience acquired in the industrial, commercial or scientific field and registered trademarks

patents, utility models, plant breeder rights, supplementary protection certificates, orphan drug designations and topographies of microelectronic semiconductor products

Substantial change of IP box regime • Percentage of deduction is set at 85% of net innovation income • With the headline corporate income tax rate going down to 25% in 2020, the effective tax rate on qualifying income should be as low as 3.75%

• IP regime has been extended to income derived from use or exploitation for trademarks in general by deleting the requirement of “functionally equivalent to patents” • The R&D cost for maintenance, improvement, and development of IP and the overall cost of the production of the IP must be relevant under Italian tax law In case of qualifying income from the direct or indirect use of qualifying IP assets a 50% exemption might apply • Half the profit resulting from licensing, sublicensing, and the sale of qualifying intellectual property defined above is deductible from the corporate tax base up to the ceiling of half the company’s total pre-tax profit. Qualifying intellectual property acquired or developed by a Hungarian entity may be sold free from corporate tax and (continued)

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Table 2 (continued)

Country

Regular national tax rate

New regime effective from

Types of eligible IP

Netherlandse

25%

January 1, 2017

Patents or plant breeder’s rights, software program(s), supplementary protection certificates for medicinal products for human use, or supplementary protection certificates for veterinary medicinal products, intangible assets that are related to intangible assets qualifying under the above, exclusive licenses to use an intangible asset qualifying under the above

Luxembourgf

18%

Tax year, 2018

Inventions protected domestically or internationally by patents, utility models, supplementary protection certificates for a patent on a pharmaceutical or phytopharmaceutical products, supplementary protection certificate extensions for pediatric medicines, plant variety certificates, or orphan drug designations, software protected by copyright under national or international norms

a

Heyvaert (2018) Zucchetti and Pallotta (2016) c Gallo and Balestieri (2015) d Csővári (2017) e Schrievers and Emonts (2016) f Vukovic and Mermet (2018) b

Substantial change of IP box regime local business tax. Limited deductibility because income has to be generated from IP rights • Qualifying income is determined per qualifying intangible asset or per coherent group of qualifying intangible assets Under the innovation box regime, a tax rate of 5% is imposed on income generated by qualifying intangibles to the extent that the income from the intangible exceeds the related R&D expenses, other charges, and amortization of the intangible. Qualifying income is determined per qualifying intangible asset or per coherent group of qualifying intangible assets. • Net income derived from eligible IP assets that will (subject to a “nexus ratio” restriction) enjoy an 80% exemption for corporate income tax and municipal business tax purposes. IP assets involved should have been constituted, developed, or improved after December 31, 2007. This now needs to have occurred as part of R&D activities carried out by the taxpayer

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The directive itself leaves a high degree of uncertainty with regard to the interpretation of certain terms such as “aggressive tax arrangement.” The directive only sets out certain indications (hallmarks) of what could classify as an aggressive tax arrangement. In Annex IV Part 2 letter E of the directive, specific hallmarks concerning transfer pricing and IP migrations are set out: • An arrangement that involves the use of unilateral safe harbor rules. • An arrangement involving the transfer of hard-to-value intangibles. The term “hard-to-value intangibles” covers intangibles or rights in intangibles for which, at the time of their transfer between associated enterprises: – No reliable comparables exist. – At the time the transaction was entered into, the projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain, making it difficult to predict the level of the ultimate success of the intangible at the time of the transfer. • An arrangement involving an intragroup cross-border transfer of functions and/or risks and/or assets, if the projected annual earnings before interest and taxes (EBIT), during the 3-year period after the transfer, of the transferor or transferors, are less than 50% of the projected annual EBIT of such transferor or transferors if the transfer had not been made. As can be seen, transactions involving intangibles should be analyzed in particular in terms of disclosing information. Even so, it remains to be seen in the future how the new regulations will be implemented into national law and to what degree it will help tax authorities to implement measures against harmful tax practices and close loopholes within the tax legislation. Critical voices in the literature fear that the directive will lead to a disproportionate administrative burden for taxpayers as well as tax authorities compared to the informational gains.48

6 Summary A variety of reasons can result in the need for an IP migration, both from a business perspective as well as from a tax perspective. A number of IP migration models are seen in practice, designed to meet the specific needs of the multinational concerned. Tax administrations have recognized the importance of intangibles and compete with other tax administrations by granting incentives. However, due to the highly mobile nature of intangibles, measures against base erosion and profit shifting have to be considered when planning and implementing an IP migration.

48

See Kaeser et al. (2018).

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References Csővári, I. (2017). After Plastic Surgery: The BEPS-Proof Hungarian Intellectual Property Tax Regime. International Transfer Pricing Journal, 24(1). Engler, & Kachur. (2015), Verrechnungspreise (4th ed). München: Verlag C.H. Beck. Evers, L., Miller, H., & Spengel, C. (2013). Intellectual Property Box Regimes: Effective Tax Rates and Tax Policy Considerations. ZEW Discussion Paper Nr. 13-070. Evers, L., Miller, H., & Spengel, C. (2015). Intellectual Property Box Regimes: Effective Tax Rates and Tax Policy Considerations. International Tax and Public Finance, 22(3), 502–530. Gallo, G., & Balestieri, S. (2015). New Preferential Intellectual Property Regime. European Taxation, 55(5), 213–214. Heidecke, B., Schmidtke, R., & Wilmanns, J. (2017). Verrechnungspreise und Funktionsverlagerung. Springer. Heyvaert, W. E. C. (2018). Belgium’s New Innovation Income Deduction Regime. European Taxation, 58(5), 206–209. Hill, D. (2016). IP Migration Strategies—Pre-and post-BEPS. International Tax Review. Retrieved August 7, 2017, from http://www.internationaltaxreview.com/Article/3556018/IP-migrationstrategiespre-and-post-BEPS.html Kaeser, C., Orlicm M., & Schnitger, A. (2018). DAC 6 Reporting Requirements Pose Numerous Compliance Problems. International Tax Review. OECD. (1998). Harmful Tax Competition: An Emerging Global Issue. Paris: OECD Publishing. OECD. (2015a). Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10—2015 Final Reports, OECD Publishing, Paris. OECD. (2015b). Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance, Action 5—2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. OECD. (2017). Transfer Pricing Guidelines. Schrievers, P., & Emonts, M. (2016). Amendments and Developments Involving Netherlands Tax Incentives Promoting R&D Activities. European Taxation, 56(8), 1–5. Vukovic, F., & Mermet, V. (2018). An Overview of the Future Luxembourg Intellectual Property Tax Regime. International Transfer Pricing Journal, 25(1), 1–5. Zucchetti, S., & Pallotta, A. (2016). Italian Patent Box Regime: Thinking Outside the Box or Just More Harmful Tax Competition? International Transfer Pricing Journal, 23(1).

Empirical Evidence on Various Models Jost Heckemeyer, Pia Olligs, and Michael Overesch

What Will the Reader Learn? • Empirical evidence on various approaches to avoid tax • Effects of legislation such as anti-avoidance legislation and IP-box on companies’ behavior • Empirical evidence on the allocation of IP

1 Introduction The existence of various tax planning models suggests that multinational firms employ IP to reduce their tax expenses. The public debate about tax avoidance usually refers to cases of prominent firms that, for instance, report very low effective tax rates. Going beyond anecdotal insights, several empirical studies have provided more general evidence for the profit shifting and tax avoidance of multinational firms. Empirical research employs several strategies to provide evidence for tax-motivated profit shifting and tax avoidance. Although secrecy in tax matters limits the evaluation of tax planning techniques, several studies have provided

J. Heckemeyer University of Kiel, Kiel, Germany e-mail: [email protected] P. Olligs Ebner Stolz, Cologne, Germany e-mail: [email protected] M. Overesch (*) University of Cologne, Cologne, Germany e-mail: [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_4

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evidence for tax planning that involves IP. Shifting techniques relate to IP because IP is difficult to price and highly mobile due to its nonphysical nature. In what follows, we will distinguish between studies that provide evidence for: • Profit shifting and tax avoidance using IP • Tax considerations for the geographical allocation of IP First, we discuss studies that analyze the potential profit shifting and tax avoidance of multinational firms. Various studies provide evidence for profit shifting by confirming a negative correlation between reported parent or subsidiary profits and local tax levels. Additional research directly studies the structures that are used to shift profits from high to low tax jurisdictions. Second, we present evidence on the geographical allocation of IP. These studies investigate whether tax incentives and profit shifting opportunities associated with IP determine the assignment of intangibles assets such as patents and trademarks.

2 Profit Shifting and IP 2.1

Tax Elasticity of Subsidiary Profits

Several studies have compared and analyzed the profitability of multinational subsidiaries. This literature investigates whether host country taxes affect the reported profitability. The basic rationale for the common specification underlying these estimates is the assumption that reported profits of a subsidiary can be explained by many companies and market-specific factors. Tax planning activities exert an additional effect on the reported profitability. More precisely, we expect a negative relationship between the local tax rate and reported profits if a firm reports less profit in high-tax countries at the expense of additional profit in low-tax countries. A broad stream of research used subsidiary level information of multinationals and has confirmed an adverse effect of host country taxes on reported profitability. The early empirical literature on profit shifting of multinational firms dates back to the 1990s. Most of the pioneering studies in this field focus on US company data. Grubert and Mutti (1991) and Hines and Rice (1994) showed that the pre-tax profitability reported by the foreign subsidiaries of US multinationals was associated with host country tax rates. In particular, Hines and Rice (1994) employed earnings before interest and taxes (EBIT) as a dependent variable. The effects identified must have been caused by tax planning strategies built around intrafirm transactions because EBIT is unaffected by financial policy. For the first time, their results substantiated the hypothesis that multinational firms had engaged in profit-shifting. Several studies followed this up, each with a slightly different contribution. Huizinga and Laeven (2008), for example, considered data on the European subsidiaries of multinational firms. They found that reported profitability in a given host country was influenced by the tax rate difference vis-à-vis all other locations in which the firm was present. Maffini and Mokkas (2011) substantiated the hypothesis

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that European firms shift revenues into low-tax countries and input costs into hightax jurisdictions. Moreover, Weichenrieder (2009) exploited data on German inbound and outbound FDI. To conclude, the literature provides general evidence on profit shifting. The main outcome of these studies is an estimated number that reflects the percentage change in locally reported pre-tax profits that can be predicted in response to a one percentage point change in the tax differential exploitable for tax arbitrage. However, magnitudes of estimated responses to tax avoidance incentives differ significantly. Heckemeyer and Overesch (2017) presented a consensus of estimates for the tax response of subsidiary profits based on the results of 27 empirical studies. They used meta-analysis techniques to explore the central tendency in previous research, i.e., they go beyond taking averages of previously reported findings. Potential biases can be identified and corrected for by the econometric techniques used in a metaanalysis. After correcting for these potential biases and some other issues related to data and methodologies, Heckemeyer and Overesch (2017) predicted that local pre-tax profits decrease by about 0.8% if the benefit from tax arbitrage, as expressed by the difference between domestic and foreign tax rates, increases by one percentage point. This effect can be interpreted as a form of a consensus estimate on the response of reported profits to tax incentives. Multinational firms can employ different models to manipulate the book income of their subsidiaries. Only a few studies have attempted to figure out the relative importance of different shifting channels. Grubert (2003) argued that the shifting volume of US firms can be almost equally attributed to financial structures and nonfinancial shifting techniques. By contrast, Dharmapala and Riedel (2013) stated shifting effects should be mainly attributed to the strategic use of debt. Nonetheless, there are a number of arguments in support of a high economic significance of tax-avoidance structures using IP. The analysis by Heckemeyer and Overesch (2017) disentangles the tax response by means of financial planning from the transfer pricing and licensing channel. The study refers to the distinction between earnings before interest and taxes (EBIT) and pre-tax profits net of interest expenses. While the response of pre-tax profits is potentially driven by several shifting techniques, EBIT cannot reflect shifting via the route of financial structures. Stylized calculations by Heckemeyer and Overesch (2017) suggested that transfer pricing and licensing, not intercompany debt, is the dominant profit shifting channel. Heckemeyer and Overesch (2017) found a share of profit shifting that can be attributed to nonfinancial shifting mechanisms of at least two-thirds or more. A few studies confirmed that intangible assets are associated with additional profit shifting opportunities. Harris (1993) and Grubert (2003) showed that large amounts of intangible assets or R&D-intensive businesses facilitate the profit shifting activities of multinational firms. A recent study by Beer and Loeprick (2015) investigated firm-specific determinants of the tax response of subsidiary profits. They found that supply chain complexity and in particular intangible asset endowment explains the profit-shifting. Consequently, the empirical results suggest that tax planning models involving IP contribute much to the observed profit shifting

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behavior of multinational firms because transfer pricing and licensing are important sources of profit shifting.

2.2

Transfer Pricing

A number of empirical studies have tried to analyze tax avoidance by multinational firms in a more direct way. Accordingly, their focus is on the potential shifting mechanisms. The international differences in corporate tax rates create a particular incentive to alter the transfer prices on intrafirm transactions. Transfer pricing guidelines following the internationally accepted arm’s length principle aim at restricting extensive profit shifting via transfer price manipulation. However, the arm’s length principle might fail if transactions are unique or difficult to observe. Shifting techniques therefore mostly relate to IP, e.g., patents and trademarks, because these are difficult to price and highly mobile due to their nonphysical nature. Investigation of the tax effects on intrafirm trade and prices is, however, hampered by data limitations, because publicly available accounting data provide no information on intrafirm transactions or underlying prices and quantities. Nevertheless, a few studies have estimated the effect which international tax incentives exert on intrafirm trade and transfer prices. Collecting data on US international intrafirm and interfirm trade, Clausing (2003) tested how the prices in intrafirm transactions differ from those applied in third-party transactions, and how such differences are related to tax influences. The study finds that intrafirm transfer prices are consistently above arm’s length prices when taxes abroad are lower than US taxes, and vice versa. Recent studies also provide evidence that for European firms transfer prices respond to tax incentives. Davies et al. (2017) analyzed French data on export prices, while Cristea and Nguyen (2015) considered Danish export data. Both studies confirmed a tax effect on transfer prices. The results by Davies et al. (2017) suggest that most of the profit shifting is concentrated in transactions with tax haven subsidiaries. Overesch and Schreiber (2010) analyzed intrafirm trade of German firms and found that the tax response is more pronounced for firms with higher R&D expenses. This finding suggests that IP models are of particular importance for profit shifting by means of intrafirm transactions.

2.3

Tax Avoidance

We expect that multinational firms pay significantly less tax when they use profit shifting techniques. A strand of mainly accounting-related literature evaluates the scope of tax avoidance of multinational firms. These studies considered effective tax rates (ETRs)—tax expenses divided by pre-tax income—as the dependent variable

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and identified patterns of tax avoidance. Information was taken from consolidated financial accounts. The results, therefore, provide evidence for the overall tax avoidance of these firms. These studies again refer to R&D expenses or intangible assets as proxies for international tax planning using IP. A study by Markle and Shackelford (2012) confirmed that the amount of intangible assets is an important determinant of low ETRs. Especially firms in the high-tech and pharmaceutical industries (“income mobile industries”) are expected to be best positioned to implement long-term tax avoidance strategies as they have significant IP and products with global demand, which allow them to shift profits to low tax jurisdictions by transfer pricing. De Simone et al. (2014) show that firms from these industries have in fact lower ETRs. Several attempts have been made to clarify how relevant the problem of tax avoidance in terms of shifted paper profits and lost revenues really is. Given that true profits before tax avoidance are not observable, clear identification of the scale and volume of base erosion and profit shifting is challenging. As a consequence, there is no reliable estimate for the amount of tax base erosion due to international profit shifting and aggressive tax planning, although there is clear evidence these types of business behavior exist.1 A small number of estimates have relied on aggregated statistics or similar sources. Although these estimates have received great attention in public debate, their results have to be treated with caution, due to serious methodological flaws (Fuest et al. 2013). For example, Murphy (2008) claimed that the United Kingdom loses GBP 12 billion of corporate income tax each year. With respect to Germany, the German Institute for Economic Research (DIW 2007, 2013) put forward an estimated revenue loss associated with profit-shifting of up to EUR 90 billion. For developing countries, Oxfam (2000) attributes a revenue loss of USD 50 billion to tax avoidance of multinationals. Essentially these studies compared taxable profits or actual tax payments with inadequate benchmarks (Heckemeyer and Spengel 2008; Fuest et al. 2013). For instance, taxable income before tax avoidance is computed on the basis of national accounts or foreign capital stocks multiplied by a deemed return and an average tax rate. The differences between the taxable profits and the proxy for benchmark profits in the absence of tax avoidance might reflect conceptual differences between the profit measures, but they are not necessarily linked to tax avoidance behavior. More elaborate studies that exploit micro-level firm data and employ methodologically sophisticated matching procedures or simulations2 hint at profit shifting amounts that fall considerably short of what the less reliable estimates suggest.

1 2

Fuest et al. (2013). e.g. Huizinga and Laeven (2008), Egger et al. (2010).

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Effects of Anti-avoidance Legislation

With the goal of restricting tax planning activities, and to prevent erosion of their corporate tax bases, most countries have implemented anti-avoidance legislation. Regarding well-known IP models that are associated with transfer pricing and royalties, transfer pricing rules are of particular importance. An important feature of transfer pricing legislation is the obligation to document and explain the transfer pricing methods and databases applied. These obligations, however, significantly differ across countries. Beer and Loeprick (2015) considered the introduction of documentation requirements for transfer prices between 2003 and 2011. According to their results, the profit response to taxes was reduced by more than 50% after the introduction of mandatory documentation requirements. However, profit shifting is unaffected by documentation requirements for subsidiaries with a high intangible endowment. Consequently, their results suggest that documentation requirements are not very effective in restricting profit shifting when the IP endowment is high. Lohse and Riedel (2013) constructed a detailed measure of documentation requirements. They found a significant reduction of profit shifting activities, in particular when strict documentation requirements are applied in a host country. Further studies analyzed the potential impact of controlled foreign company (CFC) rules on the income shifting of multinational firms. CFC rules restrict tax-planning opportunities of controlled affiliates which are located in foreign countries. The effect of CFC legislation on international tax planning is widely discussed. In particular, the ineffective US CFC rules are often mentioned as one of the main causes of low foreign tax expenses for US multinational firms. Studies by Grubert (2012) and Dunbar and Duxbury (2015) suggest that after introducing the “Check-the-Box” option for US firms, the ETRs of US firms significantly declined. Overesch et al. (2020) investigated the reform effects of CFC legislation in Europe and the USA. They found that European multinational firms reduced their tax expenses significantly after the ECJ judgment in the case of “Cadbury Schweppes.” Moreover, according to their results, the introduction of “Check-theBox” in the USA led to lower effective tax rates for US multinational firms. This means that both European and US CFC rules became less effective. What is more important, the treatment effects of the CFC reforms are more pronounced for firms with more IP measured by R&D expenses or intangible assets.

3 Evidence on the Geographical Allocation of IP 3.1

General Tax Effects on IP Allocation

Typically, intangible assets such as trademarks and patents are associated with tax planning opportunities. Mostly these intangible assets are not only used by one

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subsidiary, but by several entities in a multinational group of companies at once. Accordingly, royalties have to be paid. Depending on the tax rate differential between the owner of the intangibles and the user, taxes can be saved by reducing the overall tax burden of the multinational group. Bearing in mind that the value of the underlying intangible asset is reflected in the amount of the license fee paid, this might have a real impact on the effective tax burden of the whole group. Several empirical studies show robust evidence that tax considerations are indeed important for the intracompany allocation and pricing of intangible assets. Dischinger and Riedel (2011) provided empirical evidence that the location of intangible assets within multinational entities is distorted toward low-tax affiliates. They measured intangible asset ownership in each company’s individual annual financial statement. Their results show that a subsidiary’s stock of intangible assets rises by around 1.7% if the average tax rate difference of the subsidiary to all other members of the group decreases by one percentage point. Conclusions similar to these findings, especially in the case of patents, were inferred by Karkinsky and Riedel (2012). The European Patent Office’s Worldwide Patent Statistical Database (PATSTAT) contains information on all patent registrations to the European Patent Office. Studies by Karkinsky and Riedel (2012) as well as Griffith et al. (2014) used this database to extract specific information on patent applications filed by multinational firms. The results provided by Griffith et al. (2014) suggest that a tax rate increase of 1% results in a decrease of patent applications by about 0.2–1.2%. In addition to these findings, their results also show that firms are more likely to hold patent ownership in countries of real innovative activity. Heckemeyer et al. (2018) investigated the location of trademark ownership within multinational US firms. They used trademark applications of USA-based S&P 500 firms to the US Patent and Trademark Office between 2003 and 2012. Similar to prior studies on the location of patents, they found a strong home country concentration of US trademark ownership. However, they found that a higher trademark value increases the probability of locating trademark ownership outside of the USA. Furthermore, that being incorporated in Delaware, having generally intense foreign activities and belonging to an income-mobile industry increases the probability that a firm chooses an offshore trademark location. They further analyzed whether host country tax incentives determine the geographical allocation of US trademarks. Their results suggest that profit shifting with the use of trademarks is limited. US firms would have reacted to a tax rate cut of one percentage point in the USA by only 250 less trademark assignments to foreign subsidiaries over a period of 10 years. A further study by Pfeiffer and Voget (2016) compared the influence of tax considerations on the locational choice of patents and trademarks. They used a database that combines all trademark and patent applications filed at the European Patent Office, the Office for Harmonization in the Internal Market and the United States Patent and Trademark Office. Their results suggest that the location of trademarks is more strongly affected by corporate tax characteristics than the location of patents.

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Effects of IP-Boxes

In 2017, more than 12 European countries were operating Intellectual Property (IP) Box regimes that provided substantially reduced rates of corporate tax for income derived from important forms of IP. Two principal reasons why a government may introduce an IP Box are recognized in the literature:3 first, to foster domestic investment in innovative activities which are associated with high-skilled jobs and knowledge creation; and second, to reduce erosion of the tax base by differentiating tax rates on more mobile income streams. However, the effectiveness of IP Boxes in achieving the policy goal of incentivizing or attracting investment to fund innovative activity may be limited. First, the large reductions in effective tax burdens will have a positive effect on innovative activity only to the extent that they actually co-locate real activities alongside the ultimately resulting income streams. A more general argument against IP boxes as an effective tax policy instrument to foster R&D investment is that these regimes actually target successful R&D projects. They are much less effective in alleviating potential liquidity problems during the development phase of an R&D process. However, according to a recent global survey of large innovative multinational companies, tax incentives for R&D are considered most attractive if they have an immediate impact on liquidity (Heckemeyer et al. 2015). To date, there is only a small but growing amount of empirical literature that has investigated the effects of IP boxes on business behavior, particularly on investment and profit shifting activity. A first empirical study was put forward by Bradley et al. (2015). Using aggregate country-level data on all patent applications filed with any patent office in the world from 1990 to 2012, they examined whether IP boxes increase the attractiveness of a country as a location for innovation or (not mutually exclusive) as the location of patent ownership. The findings suggest that the implementation of an IP box regime increases the responsiveness of patent activity to tax rates on patent income, though this effect appears to be confined to patents for which the inventors and patent owners are located in the same host country. Importantly, the authors acknowledged that an increase in patent applications following the implementation of patent box regimes does not necessarily imply an increase in de novo innovation, but the primary margin for responding to patent box incentives could be through the patenting of preexisting, unpatented IP. On the other hand, no measurable impact was identified on the propensity for patents to be owned and invented in different countries. The authors interpreted this result as the first evidence that patent box regimes have been relatively less successful at deterring base erosion by cross-border patent reattributions. Research put forward by Alstadsaeter et al. (2015) confirms these results on the basis of data on the top corporate R&D investors worldwide. Their results suggest that IP boxes have a strong effect on attracting patents, especially high-quality patents. Consistent with Bradley et al. (2015), however, they found that 3

For example, Evers et al. (2015), Bradley et al. (2015).

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multinationals tend to shift more patents toward IP box regimes without a corresponding growth in the number of local inventors or a shift of research activities. Moreover, the study documents evidence that these regimes even deter local innovative activities. Interestingly, adverse effects on domestic innovation are attenuated if some nexus requirements are imposed, i.e., certain levels of local IP development. Schwab and Todtenhaupt (2016) put forward consistent new evidence in line with previous work on the interaction of profit shifting opportunities and real investment. Their findings suggest that IP box regimes without nexus requirements bring about positive cross-border spillover effects on R&D activity within multinational groups. Therefore, IP boxes might have positive implications on R&D investment in other group locations when leeway for income shifting exists, but positive implications for local R&D are less certain, at least when no nexus requirements are imposed.

4 Summary This survey provides an overview of the empirical evidence on tax avoidance associated with the use of IP. Various studies have confirmed a shifting of taxable profits and several empirical results support the view that IP plays an important role in profit-shifting activities. Moreover, empirical investigations have confirmed that the allocation of IP is also affected by tax incentives. Studies have also shown that tax legislation affect tax planning using IP. Transfer pricing documentation can help to reduce the tax avoidance of MNEs, while IP allocation is sensitive to tax incentives like IP box regimes. Empirical investigations are a means of ex post evaluations of newly introduced tax legislation. Therefore, the potential effects of new transfer pricing guidelines and transparency initiatives in the aftermath of the OECD BEPS process are still unexplored and are a task for future research.

References Alstadsaeter, A., Barrios, S., Nicodème, G., Skonieczna, A. M., & Vezzani, A. (2015). Patent Boxes Design, Patents Location and Local R&D. CESifo Working Paper No. 5416. Beer, S., & Loeprick, J. (2015). Profit Shifting: Drivers of Transfer (Mis)Pricing and the Potential of Countermeasures. International Tax and Public Finance, 22(3), 426–451. Bradley, S., Dauchy, E., & Robinson, L. (2015). Cross-Country Evidence on the Preliminary Effects of Patent Box Regimes on Patent Activity and Ownership. National Tax Journal, 68 (4), 1047–1072. Clausing, K. A. (2003). Tax-Motivated Transfer Pricing and US Intrafirm Trade Prices. Journal of Public Economics, 87(9–10), 2207–2223. Cristea, A. D., & Nguyen, D. X. (2015). Transfer Pricing by Multinational Firms: New Evidence from Foreign Firm Ownerships. American Economic Journal: Economic Policy, 8(3), 170–202.

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Davies, R. B., Martin, J., Parenti, M., & Toubal, F. (2017). Knocking on Tax Haven’s Door: Multinational Firms and Transfer Pricing. CEPR Discussion Paper No. DP10844. De Simone, L., Mills, L. F., & Stomberg, B. (2014). What does Income Mobility Reveal about the Tax Risk-Reward Tradeoff? Working Paper No. 3310. Deutsches Institut für Wirtschaftsforschung DIW. (2007). Unternehmensbesteuerung: trotz hoher Steuersätze mäßiges Aufkommen. DIW Wochenbericht, 5, 57–65. Deutsches Institut für Wirtschaftsforschung DIW. (2013). Unternehmensbesteuerung: Hohe Gewinne—mäßige Steuereinnahmen. DIW Wochenbericht, 22(23), 3–12. Dharmapala, D., & Riedel, N. (2013). Earnings Shocks and Tax-Motivated Income-Shifting: Evidence from European Multinationals. Journal of Public Economics, 97(1), 95–107. Dischinger, M., & Riedel, N. (2011). Corporate Taxes and the Location of Intangible Assets within Multinational Firms. Journal of Public Economics, 95(7–8), 691–707. Dunbar, A. E., & Duxbury, A. (2015). The Effect of “Check the Box” on US Multinational Tax Rates. Working Paper. Egger, P., Eggert, W., & Winner, H. (2010). Saving Taxes Through Foreign Plant Ownership. Journal of International Economics, 81(1), 99–108. Evers, L., Miller, H., & Spengel, C. (2015). Intellectual Property Box Regimes: Effective Tax Rates and Tax Policy Considerations. International Tax and Public Finance, 22(3), 502–530. Fuest, C., Spengel, C., Finke, K., Heckemeyer, J., & Nusser, H. (2013). Profit Shifting and “Aggressive” Tax Planning by Multinational Firms: Issues and Options for Reform. World Tax Journal, 5(3), 307–324. Griffith, R., Miller, H., & O’Connell, M. (2014). Ownership of Intellectual Property and Corporate Taxation. Journal of Public Economics, 112(1), 12–23. Grubert, H. (2003). Intangible Income, Intercompany Transactions, Income Shifting, and the Choice of Location. National Tax Journal, 56(1), 221–242. Grubert, H. (2012). Foreign Taxes and the Growing Share of US Multinational Company Income Abroad: Profits, not Sales, are being Globalized. National Tax Journal, 65(2), 247–282. Grubert, H., & Mutti, J. (1991). Taxes, Tariffs and Transfer Pricing in Multinational Corporate Decision Making. Review of Economics and Statistics, 73(2), 285–293. Harris, D. G. (1993). The Impact of US Tax Law Revision on Multinational Corporations’ Capital Location and Income Shifting Decisions. Journal of Accounting Research 31(1), 111–140 Heckemeyer, J. H., Olligs, P., & Overesch, M. (2018). “Home Sweet Home” versus International Tax Planning: Where Do Multinational Firms Hold their U.S. Trademarks? National Tax Journal, 71(1). 485–520. Heckemeyer, J. H., & Overesch, M. (2017). Multinationals’ Profit Response to Tax Differentials: Effect Size and Shifting Channels. Canadian Journal of Economics, 50, 965–994. Heckemeyer, J. H., Richter, K., Schätzler, M., Schmidt, F., & Spengel, C. (2015). A Survey of Taxation and Corporate Innovation. Frankfurt at the Main: PwC. Heckemeyer, J. H., & Spengel, C. (2008). Ausmaß der Gewinnverlagerung multinationaler Unternehmen—empirische Evidenz und Implikationen für die deutsche Steuerpolitik. Perspektiven der Wirtschaftspolitik, 9(1), 37–61. Hines, J. R., & Rice, E. M. (1994). Fiscal Paradise: Foreign Tax Havens and American Business. The Quarterly Journal of Economics, 109(1), 149–182. Huizinga, H., & Laeven, L. (2008). International Profit Shifting within Multinationals: A MultiCountry Perspective. Journal of Public Economics, 92(5–6), 1164–1182. Karkinsky, T., & Riedel, N. (2012). Corporate Taxation and the Choice of Patent Location within Multinational Firms. Journal of International Economics, 88(1), 176–185. Lohse, T., & Riedel, N. (2013), Do Transfer Pricing Laws Limit International Income Shifting? Evidence from European Multinationals. CESifo Working Paper No. 4404. Maffini, G., & Mokkas, S. (2011). Profit Shifting and Measured Productivity of Multinational Firms. Oxford Bulletin of Economics and Statistics, 73(1), 1–20.

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Markle, K., & Shackelford, D. A. (2012). Cross-Country Comparisons of the Effects of Leverage, Intangible Assets, and Tax Havens on Corporate Income Taxes. Tax Law Review, 65(3), 415–432. Murphy, R. (2008). The Missing Billions—the UK Tax Gap. TUC Report. Overesch, M., Strueder, S., & Wamser, G. (2020). Do US Firms Avoid more Taxes than their European Peers? On Firm Characteristics, Profit Shifting Opportunities, and Tax Legislation as Determinants of Tax Differentials. National Tax Journal, 73(2), 361–400. Overesch, M., & Schreiber, U. (2010). Asset Specificity, International Profit Shifting, and Investment Decisions. Zeitschrift für Betriebswirtschaft, 80(Special Issue 2), 23–47. Oxfam. (2000). Tax Havens: Releasing the Hidden Billions for Poverty Eradication. Oxfam International Policy Paper. Pfeiffer, O., & Voget, J. (2016). Corporate Taxation and Location of Intangible Assets: Patents vs. Trademarks. ZEW Discussion Paper No.16–015. Schwab, T., & Todtenhaupt, M. (2016). Spillover from the Haven: Cross-border Externalities of Patent Box Regimes Within Multinational Firms. ZEW Discussion Paper No.16–073. Weichenrieder, A. (2009). Profit Shifting in the EU: Evidence from Germany. International Tax and Public Finance, 16(3), 281–297.

What Is Different?: Intangibles in the Mid-Market Alexander Reichl

What Will the Reader Learn? • Characteristics of the German mid-market • IP strategies used in the mid-market • Difficulties in transfer pricing and valuation of intangibles within the mid-market

1 The Meaning of Mid-market In order to discuss aspects of IP strategies and valuation difficulties for the German mid-market, it is first necessary to explain the meaning of “mid-market” or “midmarket enterprise” and the characteristics of such enterprises. A mid-market enterprise differs from a large enterprise and the typical features of a mid-market enterprise affect its business strategy accordingly. Although there is no generally accepted definition of the term “mid-market enterprise”1 in literature, the conceptual delineation between a mid-market enterprise and a large enterprise is normally carried out according to quantitative and qualitative criteria. As quantitative criteria, mainly the number of employees, the volume of revenue, and/or the balance sheet total apply. The Institute for Mid-Market Research (in German “Institut für Mittelstandsforschung”) identifies a mid-market enterprise on the basis of the following cumulative measures: • Number of the employees < 500 • Revenue < EUR 50 million

1

See Gantzel (1962), p. 7, Berlemann and Jahn (2014), p. 23.

A. Reichl (*) PSP, Munich, Germany e-mail: [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_5

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The European Commission suggests as differentiation criteria for small- and medium-sized enterprises:2 • Number of employees < 250 • Either an annual revenue of no more than EUR 50 million or an annual balance sheet total up to a maximum of EUR 43 million However, to assess these quantitative criteria, the relevant sector and the structure of the enterprise (low or high real net output ratio) must also be considered. Thus, these quantitative criteria may need adapting, depending on the relevant sector. Although quantitative criteria should indeed be analyzed, a simple quantitative delineation is inappropriate in view of the nature and image of the mid-market in Germany. Thus, qualitative criteria are also needed. The most significant qualitative criterion regularly considered is the strong intertwining between the enterprise and its owner3 which is reflected in a combination of ownership, management, liability, and risk that results in responsible participation of management in all decisions related to enterprise policy. Due to this nexus of ownership and management, significant investment by other entrepreneurs is regularly excluded. Management of the enterprise is carried out by the owner. Therefore, the personal influence of the entrepreneur is impressed on all enterprise-relevant decisions. In fact, mid-market enterprises are also referred to as “owner-managed companies.” In addition, the entrepreneur bears the risk. The economic situation of the entrepreneur is, generally speaking, closely connected with the economic situation of the enterprise. The requirements of economic and legal independence, which normally implies the exclusion of group-dependent enterprises from mid-market enterprises, is also recognizable. However, one person having full ownership is not essential. It is also not a must that the owner is the sole director of the enterprise. It is also deemed an “ownermanaged company” when one of the owners possesses a significant proportion of the enterprise and is also involved in the management. However, all (co-)owners must be able to participate in decision-making processes related to enterprise policy. The term “mid-market” is closely associated with the term “family enterprise.” The most significant difference between the terms “mid-market enterprise” and “family enterprise” is that “family enterprise” does not indicate the size of the enterprise, whereas “mid-market” mostly excludes large enterprises.4 Another characteristic of mid-market enterprises is the connection between the economic existence of the owners and the economic existence of the enterprise. This criterion is also deemed as being met with respect to the companies with limited liability since the financing of limited liability companies is at least partly underwritten by the private property of the entrepreneur.

2

See EU (2003 (1)), p. L 124/39. See Institut für Mittelstandsforschung (2015), p. 4. 4 See Berlemann and Jahn (2014), p. 23. 3

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A mid-market enterprise has a strong value basis, typically shown in a mid-market enterprise by the existence of a special enterprise culture. This culture is usually characterized by the influence of the founder or his/her family and fosters a strong value basis that is supported by all employees, often without any written guidelines. Mid-market enterprises frequently follow a long-term strategic orientation, due to its ownership structure, which usually has developed over several generations. Such enterprises are not subject to the pressure of the capital market and are capable of planning and executing projects, for which the results are only perceptible at a much later stage. Sustainable corporate development is assigned priority over the shortterm generation of profits.

2 Internationalization Efforts in the Mid-market and IP Strategies 2.1

Importance of Internationalization for Mid-market Enterprises

Similar to large companies, mid-market enterprises operate on a cross-border basis, due to increasing globalization. At the same time, increasing globalization presents opportunities and risks to mid-market enterprises, because the liberalization of markets can develop new market potential as well as increase competition from foreign enterprises. Furthermore, mid-market enterprises that operate in the supply industry may find themselves confronted by the fact that their major customers are moving abroad, due to more favorable conditions. Therefore, mid-market enterprises are continuously forced to plan their internationalization strategy realistically. Technical progress and the decreasing costs of transport and communications have also enhanced the attractiveness of direct investments abroad, due to decreasing fixed costs. As a consequence, market entry barriers are reduced. This especially facilitates activity abroad for mid-market enterprises, which usually have smaller investment volumes than large companies. In this way, mid-market enterprises strive to stay competitive with cross-border activities and to develop further market potential. In so doing each enterprise decides a “market entry strategy” to penetrate a new market or a “market development strategy” to develop a market in which it already operates. Prior to entering international markets by direct investments, German mid-market enterprises are usually engaged in international activities with lower levels of commitment in the form of exports. However, this fact is hardly surprising with the owner-managed structure of mid-market enterprises. With direct exports, the management and control of operations abroad remain domestic and therefore with the owner of the mid-market enterprise. That is the reason why a direct export is also very often the first step toward internationalization.

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Mid-market enterprises can in this way establish initial customer relationships and better understand how to adapt their products and services best to the foreign market. An enterprise can, for example, enter a certain country through exports. Moreover, it can also choose other ways to develop the market. The most important strategies include exporting, licensing, franchising, joint ventures, foreign branches, and subsidiaries.5 Entering an international market with foreign direct investments can be achieved by setting up a new branch or a wholly owned subsidiary. However, it requires a large (and riskier) investment, offering in return a stronger local presence for networking, with proximity to suppliers and customers. In spite of the available ways to develop a market in a foreign country, direct exporting is still the main internationalization strategy for mid-market enterprises, who consider the establishment of a subsidiary as the second step toward internationalization. In many cases, the first functional area that mid-market enterprises dare to lay a finger on with direct investment in a foreign subsidiary is for distribution. Once the distribution function is successfully established abroad, most mid-market enterprises start to build or move their manufacturing abroad. The building or moving of manufacturing abroad can be especially attractive, considering the lower costs of production. This observation explains the relevant business models and IP strategies with regard to the relocation of these two business functions from a transfer pricing perspective.

3 Relevant Business Models for Foreign Distribution Units There are various forms for performing a distribution function. In general, distribution units can be structured as commercial or commission agents or as distributors. From a transfer pricing perspective, a distributor can be further differentiated as a fully-fledged distributor or low-risk distributor.6 A fully-fledged distributor usually has decision-making power on distribution and marketing strategies, employs the relevant marketing intangibles, owns the goods to be sold, and is the contract partner of the customer. In contrast, the low-risk distributor has no decision-making power on distribution and marketing strategies and does not use or own any marketing intangibles, but becomes the owner of goods to be sold and contract partner of the customer. Commercial or commission agents have no decision-making power on distribution and marketing strategies and they do not become the owner of the goods to be sold. The difference between these types of agents is that the commission agent acts in his own name, but on account of the principal, and thus becomes the contracting

5 6

See Weber and Kabst (2000), p. 17 ff. See Baumhoff et al. (2012), pp. 676–680.

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party with the customer. The commercial agent does not act in his own name but in the name of the principal. These different ways of structuring a distribution unit, which are associated with different functional and risk profiles, are accompanied by different tax consequences. Like a principal, the remuneration of the distribution unit and thus the profits attributable to it should increase according to the rising functional and risk profile.7 While a distribution unit in the form of a low-risk distributor should only be remunerated with a small but stable margin, a fully-fledged distributor is entitled to the residual profits generated by the relevant marketing intangibles employed. According to the latest developments in international taxation, it must be pointed out that the contractual relationship between commercial as well as commission agents and the principal bears a significant PE risk for the principal.8

4 Relevant Business Models for Foreign Manufacturing Units The production function abroad can be organized either as a fully-fledged manufacturer or as a contract or toll manufacturer.9 A fully-fledged manufacturer can cover the entire value chain, from research and development through production planning and manufacturing of the products to marketing and sales. In this case, the fullyfledged manufacturer can be classified as an entrepreneur in relation to the corresponding product group when it determines the essential strategic and business decisions and consequently bears all market opportunities and risks of the product group. Since the fully-fledged manufacturer is the owner (or at least user within a licensing model) of relevant manufacturing intangibles, he is entitled to the residual profits. Alternatively, the functions and risks of a manufacturing unit can be limited to operate only as a contract or toll manufacturer. Typically, a toll manufacturer does not bear production risks, does not develop products by itself, does not assume any marketing functions and bears no marketing risks, does not have discretionary competence and receives the necessary raw material, consumables, and supplies as well as whole or part of the production facilities from the principal.10 A contract manufacturer differs from a toll manufacturer in that it acquires the resources and materials itself on its own behalf and on its own account.11 Toll and contract manufacturers are usually qualified as low-risk manufacturers. That means they

7

See Vögele et al. (2015), pp. 1282–1284. See Sennewald (2018), Steuerliche Risiken der Ausweitung des Betriebsstättenbegriffs, p. 68 ff, in: Lüdicke, Internationale Geschäftstätigkeiten in der Nach-BEPS-Welt. 9 See Baumhoff et al. (2012), pp. 173–178, Jacobs (2016), pp. 680–685. 10 See Administrative Guidelines (2010), note 204. 11 See Administrative Guidelines (2010), note 205. 8

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should only receive an appropriate return for providing their manufacturing services, which should result in a small but stable routine margin.

5 IP Strategies for Mid-market Enterprises in the Internationalization Process When considering the goal of optimizing their global tax burden independently, companies seek to maximize the share of profits attributable to low-tax jurisdictions. In this respect, enterprises located in a jurisdiction with a lower tax burden than is applicable to its headquarters should be designed as fully-fledged units in cases of stable profits. However, this might trigger an exit tax as a result of a business restructuring. For instance, in Germany the requirements of relocation of function, according to Foreign Tax Act (“FTA”) Section 1 Paragraph 3 Sentence 9 should be analyzed. When establishing a foreign company as a fully-fledged unit, the opportunities and risks associated with the function and the related assets and other benefits are transferred abroad. In this case, a relocation of function according to FTA Section 1 Paragraph 3 Sentence 9 takes place, which leads to disclosure and taxation of significant hidden reserves in the intangibles transferred to the foreign unit. By contrast, if the investment abroad is established as a low-risk enterprise, the intangible assets and opportunities and essential risks remain domestic. As a result, the requirements of relocation of function according to FTA Section 1 Paragraph 3 Sentence 9 can be assumed to be met as well, but the escape clauses of FTA Section 1 Paragraph 3 Sentence 10 may apply, and in that case, no negative tax consequences should result from the disclosure of hidden reserves. Considering such tax aspects may not be the first priority for mid-market enterprises in determining internationalization strategies. Owner-driven mid-market enterprises are often focused on centralized management and control at the level of headquarters. Therefore, the management of direct foreign investments is often by remote control of the owner of the business. For this reason, foreign units are often structured as routine enterprises and not as fully-fledged enterprises, because the decision-making power granted to foreign management is usually limited. As a consequence, the relevant IP stays at headquarters. For example, when setting up a foreign low-risk distributor that becomes the owner of goods to be sold and thus the contracting party with local customers, the German tax authorities are of the opinion that a low-risk distributor does not dispose of his own customer base for distribution, because he is included in the sales organization of the principal.12 Another situation can arise when foreign managers are able to build strong personal relationships with the business owner of a mid-market enterprise. In cases where trust has been established a foreign unit is sometimes converted to a fullyfledged enterprise, which employs the relevant business intangibles to some extent. 12

See Administrative Guidelines (2010), note 213.

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To avoid a change in ownership of such business intangibles, which would trigger tax payments due to taxation of hidden reserves of the relevant IP, mid-market enterprises regularly choose the option of licensing. Such a licensing model is not only preferred, due to the tax savings but also chosen because IP management stays centralized at headquarters. It appears most unlikely that a typical mid-market enterprise would establish or develop a foreign business unit to become a fullyfledged manufacturer that runs its own R&D department with full decision-making power on the development of its own products and designs. The reason for this is the typical importance of the management role to mid-market business owners, their strong involvement in the R&D process, and comprehensive knowledge of their products, which are among their key success factors.

6 IP Valuation Within the Mid-Market from a Transfer Pricing Perspective 6.1

Specific mid-market Considerations on Valuation

The specific characteristics of mid-market enterprises could be taken into consideration for the valuation of IP for transfer pricing purposes. In Germany, for example, the explanations on “Characteristics in the Determination of an Objective Enterprise Value for SMEs” published by the Institut der Wirtschaftsprüfer in Deutschland e. V.13 give helpful advice in this regard. According to this IDW paper, less quantitative characteristics but more qualitative features of mid-market enterprises can play an important role in considering IP valuation.14 An important aspect in this regard is that in the business of mid-market groups the owner and/or members of the family are typically involved in managing on their own, or at least play a significant role in management. As a result, the management skills of the business owner are an essential success factor for the business. Moreover, in many cases, the business owner of a mid-market enterprise has substantial knowledge about products, manufacturing processes, services rendered in the markets, customers and marketing strategies, because he built up the firm with its business case from the outset and developed the business of the mid-market group throughout all stages. Taking this into account, the question may arise whether cash flows can be generated sustainably without the involvement of the business owner.15 Another important aspect is that in many cases the business and private spheres in a mid-market enterprise are mixed up, e.g., family members of the business owner are remunerated not in line with market requirements and may receive services or

IDW Praxishinweis (2014), IDW FN (2014), 282, hereinafter “IDW PH 1/2014”. See IDW PH 1/2014, note 2. 15 See IDW PH 1/2014, note 26. 13 14

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goods under conditions not in line with the arm’s length principle.16 This aspect can be important for the segregation of adequate business cash flows. One characteristic of mid-market enterprises is that such enterprises usually have not the option to participate in the capital markets. As a result, in many cases debt is a direct investment of the business owner or a guarantee is given by the business owner to external creditors. In such cases, the conditions of shareholder debt financing need careful analysis, because in some cases such shareholder debt can qualify as equity from a financial perspective. The qualification of shareholder debt as equity can have a significant impact on the determination of the discount rate in DCF models, for example. Another consideration is that the validity of the accounts and financial reporting of mid-market enterprises can be questionable or contain less information. One reason for this is that in many cases no financial audit is required by law and it is not requested by stakeholders (e.g., banks) due to size criteria or because no bank financing is used. In addition, several disclosure exemptions that apply to certain items in profit and loss accounts or a status report are not required.17 Another reason in some cases is that the most relevant aim for mid-market enterprises during the preparation of financial accounts is to reduce the relevant tax liabilities for the business owner. Thus, existing accounting options and valuation ranges are used to reduce the tax base or shift tax burdens into the future.18 From practical experience, the biggest issue regarding the valuation of IP for mid-market enterprises results from the absence of business planning or it is undocumented. In many cases, the business owner does not prepare a business plan, because he is not required to present it to external stakeholders (e.g., banks). Since the business owner is usually strongly involved in the day-to-day business of the company and usually has a clear roadmap for the near future of the business in mind, in many cases the management of a mid-market enterprise does not prepare a formal business plan.19

6.2

Impact on Valuation of IP in the Mid-Market from a German Transfer Pricing Perspective

In general, a transfer of intangibles can take place within a licensing model or as a sale. In case the cross-border transfer of intangibles involves two related parties, the price and the conditions agreed between these related parties must be in line with the arm’s length principle. If the price agreed does not meet this requirement, the transfer

16

See IDW PH 1/2014, note 13. See IDW PH 1/2014, note 17. 18 See IDW PH 1/2014, note 18. 19 See IDW PH 1/2014, note 20. 17

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price is to be adjusted for tax purposes. The following outlines the typical considerations from a German perspective.

6.2.1

Transfer Pricing for Intangibles within the Factual Arm’s Length Test

According to FTA Section 1 Paragraph 3 Sentence 1, the transfer price for business transactions between related parties shall primarily be determined by applying the comparable uncontrolled price method, the resale price method or the cost-plus method in cases where unrestrictedly comparable arm’s length data may be determined for these methods, after having made the appropriate adjustments with regards to the functions performed, the assets employed and the assumed opportunities and risks (functional analysis); several of such values will constitute a range. If such arm’s length data cannot be determined, the application of a suitable transfer price method shall be based on restrictedly comparable data, derived by making the appropriate adjustments. In this case, the resulting range of comparable arm’s length values shall be narrowed (FTA Section 1 Paragraph 3 Sentences 2 and 3). Each specific value within such a range or within a narrowed range can be taken as the relevant transfer price for the transaction under review. In case the chosen transfer price lies outside the range, the median of the range of values shall prevail as the relevant transfer price for an adjustment (FTA Section 1 Paragraph 3 Sentence 4). As defined by FTA Section 1 Paragraph 3 Sentences 1 to 4, this approach is called the “factual arm’s length test.”20 The most relevant assumption for the factual arm’s length test is that limited comparable arm’s length data can be determined for the transaction under review. In cases of a transfer of intangibles, it is often quite difficult to find such comparable arm’s length data. However, with regard to intangibles the factual arm’s length test is important for the determination of an appropriate royalty rate and there are several public databases available that provide information on license agreements and royalties. Examples of such databases: RoyaltyStat, RoyaltySource, and ktMine. In this regard, it must be remembered that information provided by these databases is collected from information and documents disclosed by companies that are listed in stock exchanges that have to disclose the information and from documents on relevant company contracts in compliance with statutes or the disclosure rules of stock exchanges. It can be assumed that these companies are large or very large corporations with capital market-driven management. As a result, it should be analyzed whether license agreements signed by such corporations are not comparable or have only limited comparability to IP transactions taking place between mid-market group members and whether the underlying conditions of such contracts can be adjusted accordingly. Taking this into account, it is most likely that for IP

20

In German: tatsächlicher Fremdvergleich.

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transactions within mid-market groups there is no or only limited comparable data is available.

6.2.2

Transfer Pricing for Intangibles within the Hypothetical Arm’s Length Test

In cases where no or only limited comparable data can be determined, the taxpayer is obliged to perform a hypothetical arm’s length test to determine his income according to the arm’s length principle (FTA Section 1 Paragraph 3 Sentence 5). For this, the taxpayer must determine the minimum price for the supplier and the maximum price for the recipient (known as the range of mutual consent) based on a functional analysis and on internal planning data. The range of mutual consent is determined according to respective profit expectations (profit potentials) of both supplier and recipient (FTA Section 1 Paragraph 3 Sentence 6). The income determination shall be based on the price within the range of mutual consent that, with the highest probability, complies best with the arm’s length principle; unless another value can be shown on a reliable basis, the mean value of the range of mutual consent shall be taken as a basis (FTA Section 1 Paragraph 3 Sentence 7). In accordance with the explanation above, it becomes apparent that in many cases a determination of transfer prices for intangibles transferred between mid-market group members has to follow the hypothetical arm’s length test, due to lack of or only limited availability of comparable data to be applied to the transaction under review. IDW S 5 provides the direct cash flow prognosis method,21 the relief from royalty method,22 the incremental cash flow method,23 and the multi-period excess earnings method24 to identify the relevant profit potentials to allocate to the intangibles under review. The respective profit potentials need to be capitalized with an adequate discount rate defined as “weighted average cost of capital,” WACC.25 German tax authorities agree with these methods and point out explicitly that transfer price determination within the hypothetical arm’s length test can be based on the principles defined under IDW S 5.26 Taking this into account, it becomes apparent that the specific characteristics of mid-market enterprises mentioned under Section III.1 can have a major impact on the valuation of intangibles from a transfer pricing perspective. In particular, the significant influence of the business owner on the success of the business as well as a mixing up of business and private affairs can make the

21

See IDW S 5, note 30. IDW S 5, note 31–32. 23 See IDW S 5, note 33–36. 24 IDW S 5, note 37–40. 25 See IDW S 5, note 41. 26 See Administrative Guidelines (2010), note 63. 22

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allocation of cash flows to business intangibles very difficult. A situation may arise where the owner-managed headquarters can exploit higher profits with the employment of the intangible under review than a foreign-affiliated enterprise can use the same intangible, because the business owner has a better understanding of the business than a manager at the foreign enterprise. In such a situation, the price expectation of the supplier (minimum price) could be higher than the price expectation of the buyer (maximum price). Such a situation would trigger a “negative” range of mutual consent, which is not explicitly regulated and therefore leads to significant uncertainty for the taxpayer.27 Certainly, the basis for a transfer price determination within the hypothetical arm’s length test should be proper business planning for the seller side as well as for the buyer side. As business planning for mid-market groups—in particular a standalone enterprise—usually does not exist, a very careful analysis of the historical performance is required to form a starting point for the projection of future developments and for undertaking plausibility checks.28 In this respect, it must be remembered that the relevant documents on which an analysis of historical performance would be based on (e.g., annual accounts) may not include the required level of reliability, or perhaps not contain the necessary level of detail. Taking the described uncertainties regarding business planning into account, it seems that there is a high risk for cross-border sales of intangibles between mid-market group members to meet the requirements of the statutory price adjustment clause according to FTA Section 1 Paragraph 3 Sentences 11 and 12. Since the effect of this retroactive adjustment clause is only to the disadvantage of the taxpayer, it is highly recommended for transfers of intangibles in mid-market-groups to agree on an appropriate individual price adjustment clause in the underlying sales and purchase agreement. This is because individual price adjustment clauses can also take effect in favor of the taxpayer, provided they have been agreed on. In this regard, it should be pointed out that according to Section 9 of the Ordinance on the Relocation on Functions29 a licensing arrangement that includes a revenue or profitbased royalty calculation regularly qualifies as an individual price adjustment clause. Consequently, such an arrangement could be a solution for mid-market enterprises to reduce the transfer pricing risk with regard to the statutory price adjustment clause.

7 Summary and Conclusion (1) German mid-market enterprises are characterized by quantitative and qualitative criteria. The financial indicators of mid-market enterprises exhibit small and medium business cases. In addition, the most significant of their qualitative

27

See Reichl (2013), p. 155–157. IDW PH 1/2014, note 15. 29 BStBl. I 2008, p. 1680. 28

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criteria is a strong involvement of the business owner in the management of the firm. For various reasons, many mid-market enterprises follow internationalization strategies. However, they tend to avoid transferring valuable intangibles abroad, since they pursue the aim to control the business and centralize management on the level of the owner-managed headquarters. For this reason, the internationalization strategy of a mid-market enterprise typically operates with low-risk entities abroad. In most cases, a “factual arm’s length test” is not applicable for the determination of transfer prices of intangibles in mid-market groups, as no or only limited comparable data is available. In such cases, the “hypothetical arm’s length test” will apply. The “hypothetical arm’s length test” is based on a two-sided approach, by considering the price acceptance of both potential seller and buyer derived from the net present value of the profit potentials allocated to the specific intangible under review. Using this approach, the nature of mid-market enterprises such as personal involvement of the owner and a possible lack of proper planning documents would need to be factored in. As a result, it becomes apparent that the German transfer pricing regulations for intangibles are quite sophisticated and do not match the everyday business reality of mid-market enterprises. If they available, more simplified transfer pricing solutions for small and medium-sized enterprises (e.g., safe harbor rules, rules of thumb) would reduce the complexity and also provide certainty for mid-market enterprises.

References Administrative Guidelines. (2010). Administration circular on the guidelines for examination of income allocation between affiliated persons in cases of cross-border relocation of functions (Administrative Guidelines – Relocation of Functions 2010), published on 13.10.2010, Federal Tax Gazette 2010 I, p. 774. Baumhoff, H., Ditz, X., & Liebchen, D. (2012). Internationale Verrechnungspreise kompakt. Köln. Berlemann, M., & Jahn, V. (2014). Ist der deutsche Mittelstand tatsächlich ein Innovationsmotor? ifo Schnelldienst, 17, 22–28. BStBl, I. (2008). Ordinance on the relocation of functions: Verordnung zur Anwendung des Fremdvergleichsgrundsatzes nach § 1 Abs. 1 des Außensteuergetzes in Fällen grenzüberschreitender Funktionsverlagerungen (Funktionsverlagerungsverordnung) (Ordinance on the Relocation of Functions), published on 12. August 2008, Federal Law Gazette 2008 I, p. 1680. EU. (2003). Commission recommendation of 6 May 2003 concerning the definition of micro, small and medium-sized enterprises, OJ L 124, 29. May 2003, p. 39. Gantzel, K. J. (1962). Wesen und Begriff der mittelständischen Unternehmung. Opladen Westdeutscher Verlag: Köln u. IDW. (2014). Characteristics in the Determination of an Objective Enterprise Value for SMEs. IDW Praxishinweis 1/2014, IDW FN 2014, 282.

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IDW, Grundsätze zur Bewertung immaterieller Vermögenswerte (IDW S 5), last supplemented on May 23, 2011, IDW FN 2011, pp. 467–484. Institut für Mittelstandsforschung. (2015). Mittelstand zwischen Fakten und Gefühl. IfM-Materialien Nr. 234, Bonn. Jacobs, O. H. (2016). Internationale Unternehmensbesteuerung (8th ed.). Munich: C.H. Beck. Reichl, A. (2013). Verrechnung immaterieller Wirtschaftsgüter im internationalen Konzern. BoD– Books on Demand. Sennewald, D. (2018). Steuerliche Risiken der Ausweitung des Betriebsstättenbegriffs, p. 68 et seq., in: Lüdicke, Internationale Geschäftstätigkeiten in der Nach-BEPS-Welt, Köln, 2018. Weber, W., & Kabst, R. (2000). Internationalisierung mittelständischer Unternehmen. In J. Gutmann & R. Kabst (Eds.), Internationalisierung im Mittelstand, Wiesbaden, p. 17 et seq. Vögele, A., Borstell, T., & Engler, G. (2015). Verrechnungspreise (4th. ed.). Munich: C.H. Beck.

Understanding the Reporting of Intangibles from a Business Perspective Thomas M. Fischer and Kim T. Baumgartner

What Will the Reader Learn? • Intangibles from an accounting and controlling perspective • Tools for controlling and internally reporting intangibles • Overview of selected legislation on corporate disclosure of intangibles and concepts for voluntary external reporting of intangibles • Empirical evidence on the content of intellectual capital reporting and implications for corporate practice

1 Relevance of Intangibles In recent decades, companies have realized that high firm value can only be generated when economic, social, and environmental objectives are achieved simultaneously (triple bottom line). Intangibles affect all dimensions of the triple bottom line (see Fig. 1). Therefore, they are considered the most important strategic resources for acquiring and maintaining a sustainable competitive advantage.1 In the transfer pricing context, intangibles are characterized as nonphysical assets or financial assets. Such assets are also capable of being owned or controlled for use in commercial activities and their use or transfer would be compensated if it had occurred in a comparable transaction between independent parties.2 Unlike financial assets, these nonphysical assets may be difficult to identify. This chapter shows what

1 2

Barney (1991), p. 105, Hall (1992), p. 135. OECD (2015), p. 67.

T. M. Fischer · K. T. Baumgartner (*) Friedrich-Alexander-University Erlangen-Nuremberg, Nuremberg, Germany e-mail: [email protected]; [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_6

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Fig. 1 Intangibles in the context of the triple bottom line. (See also Duhr and Haller 2013, p. 13)

Company value

Economic value

Social value

Ecological value

Intangibles

information about intangibles could be provided by a firm beyond the requirements of tax departments and transfer pricing. It discusses the reporting of intangibles from an accounting and controlling perspective. In this context, intangibles are defined as resources that lack physical substance and have a non-monetary character.3 Examples are knowledge, culture, and reputation. Intangibles are important for a firm’s competitive position4 and have a strong impact on firm value.5 In previous literature, a variety of terms for intangibles were used, including intangible assets, intellectual capital, intellectual property, knowledge-based assets, and knowledge-based capital.6 Two categories of intangibles are now distinguished: intangible assets, which are recognized in the balance sheet, and intellectual capital, which is not recorded in the balance sheet.7 An analysis of the components of the S&P 500 (Standard and Poor’s 500) market values over the last four decades reveals the importance of intangibles for firm value (see Fig. 2). In 1975, only 17% of the market value resulted from intangibles, but this ratio had increased to 87% by 2015. The market-to-book ratios of these firms also illustrate the major importance of intangibles. Today, the market value of listed firms frequently exceeds their book value (see Table 1 for selected examples from the S&P 500), resulting in market-tobook ratios much higher than 1. Intangibles are one explanation for this phenomenon. In the case of Coca-Cola, for example, the high market-to-book spread mainly

3

Lev (2001), p. 5, WGARI (2004), p. 225. Marr and Schiuma (2001), p. 3. 5 E.g., Ellis and Seng (2015). 6 WGARI (2004), p. 225. 7 Fischer et al. (2015), p. 597, Coenenberg et al. (2016, p. 1203, 2018), p. 1229. 4

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100%

Percentage of market value

90% 80% 70% 60%

13%

20% 32% 68% 83%

50% 40% 68%

30% 20% 10%

87%

80%

32% 17%

0% 1975

1985 Intangible

1995

2005

2015

Tangible

Fig. 2 Components of S&P 500 market value (OCEAN TOMO, LLC 2015) Table 1 Selected market-tobook-ratios from S&P 500 (Thomsen Reuters Datastream)

Company Netflix Amazon.com Nike Coca-Cola Microsoft Apple Reference date: July 12, 2019

Market-to-book ratios 28.61 20.44 15.64 11.23 11.22 8.85

results from its well-known and highly valuable brand, which is based on a secret formula and an exceptional marketing strategy.8 Apple and Microsoft can also draw on their valuable brands. These firms hold the first (brand value: US $205.5 billion) and third place (US $125.3 billion) in the Forbes World’s Most Valuable Brands ranking (Forbes 2019). In addition, Apple’s high market value stems from its successful innovation efforts, which are reflected in the huge amount of its total research and development (R&D) expenses (US $14.2 billion in 2018), and its experienced and highly skilled employees. Another significant driver of market value is a firm’s reputation:9 In the Fortune magazine’s 2019 ranking of the World’s Most Admired Companies, Apple (1), Amazon.com (2), Microsoft (6), Netflix 8

Lev (2001), p. 6. The reputation of a firm has to be distinguished from the corporate brand. While brands describe a set of associations that customers have with a firm’s products (including awareness and functional appeal), reputation is formed through stakeholders’ assessments of a firm’s ability to meet their

9

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(8), Nike (13), and Coca-Cola (15) are listed in the top 20.10 Another important economic strength of Netflix and Amazon.com lies in their strong customer relationships and highly efficient customer service. Netflix is a customer-centric company,11 whose business model consequently focuses on the demands of its customers. Intangibles form the basis of the success of Netflix because, for example, analytics of customer data are used to predict the popularity of its original series, like House of Cards.12 These examples illustrate that intangible values are a major driver of firm value and highly important for a firm as a going concern. Intangibles are also important for transfer pricing purposes. To avoid base erosion and profit shifting, the OECD has developed new transfer pricing guidelines, including regulations for the identification of transfer pricing relevant intangibles. The difficulty arises in this respect that some intangibles might not be identifiable at first glance, as they are not always recognized as intangible assets in the balance sheet.13 Therefore, the question arises as to how firms should design their internal and external reports in order to provide useful information about intangibles to stakeholders. Internal managerial reporting of intangibles is necessary to transfer information to management and other employees to affect behavior and improve decision-making consistent with the firm’s goals.14 If information about intangible values is provided in internal reports, the management can develop resource-based strategies as the value drivers become visible. In addition, the business strategy can be translated into actions, the effects of actions become obvious, and the management of intangibles will be improved.15 For tax departments, the internal reporting of intangibles may help to identify the transfer pricing relevant intangibles, especially those that are not recorded in the balance sheet. Moreover, financial statements and intellectual capital reports that include the values of intangibles (e.g., values from purchase price allocations) may provide a useful starting point for the valuation of intangibles within transfer pricing.16 From the external perspective, firms are also well advised to communicate relevant information about their intangible values to stakeholders such as investors, creditors, and customers. By giving stakeholders a better understanding of the real value and future performance of the firm,17 the asymmetry of information and hence risk for stakeholders are reduced. A firm might gain better credit ratings due to this

expectations (Fombrun and van Riel 2004, p. 4). Hence, firms can have a strong brand, but simultaneously a weak reputation or vice versa. 10 Fortune (2019). 11 Debruyne (2014), pp. 207–209. 12 New York Times (2013). 13 OECD (2015), p. 67. 14 Duhr and Haller (2013), p. 23. 15 Andriessen (2004), p. 232. 16 Levin and Weise (2013), p. 57. 17 Lev and Gu (2016).

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and thereby increase its ability to raise capital in general.18 This would reduce a firm’s costs of capital. Moreover, reporting about intangibles enhances a firm’s reputation and has a beneficial impact on its stock price and firm value.19 Regarding the level of detail in the provided information, firms should differentiate between their internal and external reporting. Internally, comprehensive reports and detailed descriptions are necessary. However, externally each firm must carefully determine the amount of voluntary information provided in addition to mandatory disclosures of intangible values. Detailed knowledge about intangibles, for example, could prove useful for competitors, as it reveals the firm’s strengths and weaknesses.20 A firm should always balance the costs and benefits of the reporting system.21 The remainder of the chapter is structured as follows: Section 2 presents an overview of the tools for internal reporting of intangibles and describes their compilation as well as their application. Section 3 focuses on external disclosures of intangibles, with a discussion of reporting regulations for intangibles and an illustration of the integration of the intellectual capital statement into management commentary. It also explains the design of a strategic resources and consequences report and the concept of integrated reporting, including the connectivity of financial and nonfinancial indicators. This section then provides an analysis of the empirical results regarding the external reporting of intangibles in corporate practice and its beneficial consequences for firms. Section 4 concludes the chapter with a short summary.

2 Internal Reporting of Intangibles To control and monitor a firm’s intangibles, managers must choose from the various tools available. We provide an overview of different approaches in Sect. 2.1 and take a closer look at two selected tools in Sect. 2.2: the balanced scorecard/strategy map and the intellectual capital statement. As intangibles are major drivers of firm value, firms are well advised to incorporate adequate measures in value-based management to avoid any dysfunctional developments of intangible resources. Sect. 2.3 illustrates how the intellectual capital statement provides the basis of an approach to monitor intangibles as part of value-based management and captures the impact of intangibles on firm value.

18

Bhasin (2016), p. 5. Andriessen (2004), p. 234. 20 Rylander et al. (2000), Vergauwen and van Alem (2005), p. 92. 21 Duhr and Haller (2013), p. 24. 19

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Tools for Controlling and Monitoring of Intangibles

There are two types of approaches to measure and evaluate intangibles for controlling and monitoring purposes: mono-indicator approaches with only a single indicator, and multi-indicator approaches that rely on several indicators (see Fig. 3). The mono-indicator approaches are comprised of market, income, and cost approaches that value one single intangible, and other approaches that capture intangibles on an aggregate basis, for example, market-to-book ratio.22 Monoindicator approaches are mainly used for corporate valuations, while multi-indicator approaches represent sets of quantitative indicators to monitor the intangibles. The latter provide detailed frameworks that are used to analyze a firm’s most important intangibles in detail and these are frequently employed for controlling and reporting purposes. In the following, we focus on multi-indicator approaches. To illustrate their practical use, we have selected two concepts: the balanced scorecard/strategy map, which supports management control and internal reporting, and the intellectual capital statement, which is applied for internal and external reporting.

2.1.1

Balanced Scorecard and Strategy Map

In the information age, intangibles like employee knowledge and customer relationships have become major sources of competitive advantage.23 The balanced scorecard was developed to capture these intangibles and describe the value they can create (see Fig. 4). Its main aim is to supplement financial measures of a firm’s past or current performance with measures for the drivers of the firm’s future performance. The balanced scorecard offers a suitable tool to link long-term strategic objectives with short-term operational actions.24 Intangibles play a crucial role in this regard as they provide the basis for future financial performance.25 The framework of the balanced scorecard consists of four perspectives that provide a comprehensive measurement of a firm’s overall performance:26 • The Financial Perspective represents the starting point of the balanced scorecard and describes the firm’s long-term financial objectives. It reveals whether the implementation and execution of the strategy lead to an improvement in the firm’s financial performance. The measures of this perspective are typically related to profit margins or the value contributions of a firm and its business units. Examples of key figures are Return on Capital Employed (ROCE) and Economic Value

22

Duhr and Haller (2013), p. 44. Kaplan and Norton (2000), pp. 168–169. 24 Kaplan and Norton (1996b), p. 75. 25 Duhr and Haller (2013), p. 76. 26 Kaplan and Norton (1996a), pp. 25–29. 23

Relief from royalty method

Market transaction comparisons

Market-to-book ratio

Incremental cash flow method

Fig. 3 Approaches to measurement and valuation of intangibles. (See also Duhr and Haller 2013, p. 43)

etc.

Knowledge capital

Multi-period excess earnings method

Real options method

Multiple approach

Reproduction cost method

Method of direct cash flow forecast

Market prices on active markets Repurchase cost method

Other approaches

Cost approach

Income approach

Market approach

Mono-indicator approaches

etc.

Intellectual Asset Monitor

Intellectual Capital Navigator

Skandia Navigator

Intellectual Capital Statement

Balanced Scorecard / Strategy Map

Multi-indicator approaches

Approaches to measurement and valuation for controlling and reporting of intangibles

Understanding the Reporting of Intangibles from a Business Perspective 81

Objectives

Measures

Targets

“To achieve our vision, how will we sustain our ability to change and improve?“

Initiatives

Measures

Objectives

Targets

“To satisfy our shareholders and customers, what business processes must we excel at?“

Initiatives

Measures

Targets

Initiatives

Learning and Growth

Vision & Strategy

Objectives

Objectives

Measures

Targets

Initiatives

Internal Business Processes

Fig. 4 Balanced scorecard framework used to translate vision and strategy into operational terms. (Kaplan and Norton 1996b, p. 76)

“To achieve our vision, how should we appear to our customers?“

Customers

“To succeed financially, how should we appear to our shareholders?“

Financial

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Added (EVA). These measures are the superordinate target for the other three scorecard perspectives. Hence, every measure of the customer, internal business processes, and learning and growth perspectives should be linked via a causeand-effect relationship that ultimately leads to the achievement of the goals in the financial perspective (an explanation of the strategy map is provided later in this section). • The Customer Perspective deals with the analysis of important customer and market segments in which a firm wants to compete. The objectives and measures for the targeted segments must be defined. In general, companies draw on two sets of measures: first, core customer outcome measures as they are known, such as customer satisfaction, customer loyalty, and customer retention; and second, measures that represent the performance drivers of customer outcomes. These attributes must be delivered to achieve high degrees of customer satisfaction, loyalty, and retention. Hence, the customer perspective should also include measures regarding specific customer requirements like on-time delivery, short lead times, and customized product features. • The Internal Business Process Perspective deals with internal processes, which are critical for a firm’s value added to achieve the stakeholder objectives. In general, the internal process value chain comprises the innovation process (identifying customer needs and developing new solutions to meet them), the operations process (producing and delivering existing products), and the after-sales service process (offering services that extend the value customers receive from a firm’s delivered products). Each firm draws on a unique set of processes to create value for its customers and to generate financial results. Examples of measures in this perspective are the quality of processes, response time, and level of digitization. • The Learning and Growth Perspective identifies the infrastructure required to fulfill the goals of the other three perspectives (to finally achieve long-term growth and an improvement in the firm’s performance). In general, this perspective includes three aspects—people, systems, and organizational procedures— resulting in the following three categories for the learning and growth perspective: employee capabilities, information systems capabilities, and the organizational climate to foster employee motivation and initiative. Key measures include employee satisfaction, employee productivity, and improvements due to business analytics. The objectives and measures of each perspective should be derived from the firm’s vision and strategy.27 The balanced scorecard is used to articulate and communicate the strategy of the business and to assist with the alignment of individual, organizational, and cross-departmental actions toward the achievement of the firm’s goals. The final outcome is a balance between strategy formulation and strategy implementation, short-term and long-term objectives, and financial and

27

Kaplan and Norton (1996b), p. 76.

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nonfinancial measures, which leads to a fit between result figures and their performance drivers.28 The strategy map, which is derived from the balanced scorecard, is a visual framework for cause-and-effect links between the four scorecard perspectives and the firm’s strategic goals (see Fig. 5). It shows how a firm intends to convert its initiatives and resources, including intangibles like employee knowledge and corporate reputation, into tangible outcomes.29 At the top of the strategy map is the financial perspective, which contains a firm’s financial strategy for increasing shareholder value. Two levers are important here: productivity, which means improving the cost structure and increasing asset utilization; and revenue growth, which means expanding revenue opportunities and enhancing customer value. To achieve its strategic goals, a firm has to determine its customer value proposition, which describes the firm’s unique mix of product and service attributes and customer relations. In other words, the customer value proposition shows how a firm differentiates itself from competitors.30 It also provides the basis for a firm’s internal processes, which are classified under four categories: operational management, customer management, innovation, and regulatory and social processes. The outcomes of internal processes ensure that a firm achieves the customer value proposition and its financial objectives.31 The learning and growth perspective is the foundation of any strategy map32 and this drives the success of internal processes.33 It describes the firm’s intangibles and their role in the strategy. Three categories of intellectual capital are distinguished in this regard: human capital (e.g., skills and knowledge of employees), relational capital (e.g., supplier network and investor relations), and structural capital (e.g., databases and technology infrastructure).34 In summary, the balanced scorecard and the strategy map are suitable tools for controlling intangibles, the relations among them and with financial performance. Fig. 6 illustrates how a strategy map might be applied in the context of intangibles, by linking various intangible value drivers with financial targets. In the example shown in Fig. 6, the main financial objective is to increase Return on Investment. This can be achieved by increasing revenues and the contribution margin per customer. Revenues are determined by the size of a firm’s customer base (existing and new customers) and its customer-based reputation. The contribution margin per customer is influenced by customer satisfaction, which in turn depends on the quality of products and comprehensive customer service and support. To achieve high quality in products, an acceleration of processes is beneficial, which is

28

Kaplan and Norton (1996a), p. 25. Kaplan and Norton (2000), p. 168. 30 Kaplan and Norton (2000), p. 172. 31 Kaplan and Norton (2004), p. 12. 32 Kaplan and Norton (2000), p. 175. 33 Duhr and Haller (2013), p. 78. 34 Kaplan and Norton (2004), p. 13; see also Sect. 2.1.2. 29

Quality

Supply Production Distribution Risk Management

Availability

Increase Asset Utilization

Long-Term Shareholder Value

Selection

Selection Acquisition Retention Growth Opportunity ID R&D Portfolio Design/Develop Launch

Structural Capital

Relational Capital

Environment Safety and Health Employment Community

Regulatory and Social Processes

Image

Brand

Enhance Customer Value

Partnership

Relationship

Service

Expand Revenue Opportunities

Growth Strategy

Innovation Processes

Human Capital

Customer Management Processes

Functionality

Customer Value Proposition

Product / Service Attributes

Operations Management Processes

Price

Improve Cost Structure

Fig. 5 Strategy map. (Adapted from Kaplan and Norton 2004, p. 11)

Learning and Growth Perspective

Internal Perspective

Customer Perspective

Financial Perspective

Productivity Strategy

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Increase Return on Investment

Financial Perspective

Increase contribution margin per customer

Increase revenues

Improve customerbased reputation

Customer Perspective

Improve customer satisfaction

Increase amount of new customers

Bind existing customers in the long run

Improve quality Provide comprehensive customer service and support

Internal Perspective

Increase amount of new products

Accelerate processes

Learning and Growth Perspective

Extend technological infrastructure

Build and train capabilities regarding professional customer service and support

Attract and retain highly qualified employees

Improve work climate

Fig. 6 Example application of a strategy map. (See also Kaplan and Norton 2006)

based on an adequate technological infrastructure (e.g., digitization of manufacturing processes). To provide a high level of service and support, each firm needs to build and train the respective capabilities, such as high expertise, reasonable dealings with customers, and a strong solution orientation. The existing level of capabilities is largely determined by the qualification of current employees. Highly qualified employees are more attracted to the firm and are more likely to stay with it if the work climate is good. High potential employees also help to increase the number of new products, which in turn supports the acquisition of new customers. This (simplified) example illustrates the links between the financial and nonfinancial objectives of a firm. Based on the strategy map, firms can define the appropriate measures and corresponding targets and initiatives.

2.1.2

Intellectual Capital Statement

An intellectual capital statement (ICS) tabulates a firm’s intangibles. The ICS supplements traditional financial reporting with nonfinancial information. It allows

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for a holistic business analysis and can be used as an early warning system. Based on the ICS, the relationships between intangibles and firm value can be analyzed. In this way, intangible value drivers can be identified and planned for the future. The ICS is thus a suitable tool for internal reporting as it enhances transparency regarding intangibles. In addition, firms can disclose an ICS externally, which is further discussed in Sect. 3.2. When preparing an ICS, firms must follow eight steps: Step 1: Description of the initial situation and business model First, firms have to describe their business model.35 This includes information about the scope of the ICS (defining the parts of the organization included in the ICS, the entire company or only one specific business segment), the business environment, the vision and strategy, the business processes, and the expected business performance. As a result, the ICS reveals the opportunities and risks in the firm’s business environment, as well as the firm’s strategic objectives.36 Step 2: Identification of intellectual capital categories The following three categories of intellectual capital (mentioned while describing the strategy map in Sect. 2.1.1) are the most common:37 • Human capital indicates the knowledge, abilities, skills and experience of employees,38 which contribute to a firm’s performance and its increase in value.39 Examples are employee satisfaction, expertise, learning capacity, and loyalty.40 • Relational capital represents all external relationships with a firm’s stakeholders, which are important for business operations. Examples are relationships with customers, suppliers, investors, creditors, and the public. It also includes stakeholders’ perceptions of the firm.41 • Structural capital (or organizational capital) comprises the internal processes and systems for business operations. Examples are organizational routines, information technology (IT) systems, databases, and corporate culture.42 These intangibles belong to the firm and remain with the firm when employees leave the company.43

35

See Osterwalder et al. (2015). BMWi (2008), pp. 15–16. 37 Choong (2008), p. 622. 38 BMWi (2008), p. 18. 39 Sveiby (1997), p. 10. 40 Marr and Gray (2004), p. 103. 41 MERITUM (2002). 42 MERITUM (2002). 43 BMWi (2008), p. 18. 36

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Influencing factor 1

Human Capital

Influencing factor 2 Influencing factor … Influencing factor 1

Intellectual Capital Statement

Structural Capital

Influencing factor 2 Influencing factor … Influencing factor 1

Relational Capital

Influencing factor 2 Influencing factor …

Fig. 7 Structure of the intellectual capital statement’s categories. (Fischer and Baumgartner 2013, p. 28)

For each of the three categories, several influencing factors can be defined (see Fig. 7). Any change in these factors directly or indirectly influences the firm’s performance. Step 3: Assessment of intellectual capital Next, the identified influencing factors are assessed with regard to three dimensions (QQS): quality, quantity, and systematics.44 For example, the QQS assessment of human capital and the influencing factor of leadership competency entails the following questions: • Quality: Is the quality of our leadership competency sufficient to achieve our strategic objectives? • Quantity: Do we have enough management capacity to achieve our strategic objectives? • Systematics: Is a systematic building and development of leadership competency provided to achieve our strategic objectives and to avoid deteriorations? These questions are evaluated on a scale of 0% (quality/quantity/systematics are nonexistent or cannot be reliably assessed) to 120% (quality/quantity/systematics are higher than necessary).45 44 45

BMWi (2008), p. 21. BMWi (2008), p. 22.

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Influencing factors

Indicators

Professional expertise

Employee satisfaction

Methodical expertise

Working hours per employee

Human Capital

Average absenteeism per employee

Social competency

Intellectual Capital Statement

Structural Capital

Financial incentives

Leadership competency

Expenses for increasing employee motivation

Employee motivation

Number of days with external activities

Etc.

Etc.

Relational Capital

Fig. 8 Influencing factors and indicators for measuring human capital. (See also Fischer and Baumgartner 2013, pp. 194–199)

Step 4: Measurement of intellectual capital To measure the three categories of intellectual capital, indicators for each influencing factor must be identified. This allows an assessment of the development of intellectual capital and provides a basis for controlling the achievement of targets.46 When considering, for example, the influencing factors of human capital then professional expertise, methodical expertise, social competency, leadership competency, and employee motivation can be used.47 As a further example, the employee motivation influencing factor can be underpinned by the following indicators: employee satisfaction, working hours per employee, average absenteeism per employee, financial incentives, expenses for increasing employee motivation, and number of days with external activities (see Fig. 8).48 Step 5: Identification of cause-and-effect relations Identification of cause-and-effect relations includes the interactions between influencing factors and an analysis of the links between the influencing factors and

46

Danish Ministry of Science (2003), BMWi (2008), p. 27. Fischer and Baumgartner (2013), p. 29. 48 Fischer and Baumgartner (2013), p. 199. 47

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a firm’s business processes and success. The strength and time of each impact are also evaluated.49 Step 6: Analysis and interpretation of results Next, the results should be depicted in the charts QQS portfolios (showing the strengths and weaknesses of intellectual capital with regard to quantity, quality, systematics), potential portfolios (showing the potential for the development of each influencing factor), and interdependency networks (showing the relationships among influencing factors, business processes, and business success). These charts enable a firm to identify what the most important influencing factors are and where the greatest potential for improvement of each intellectual capital category lies.50 Step 7: Derivation of actions Using this analysis, the firm can develop adequate actions aimed at the strategic development of intellectual capital and, consequently, improve the firm’s financial performance.51 Step 8: Reporting of the intellectual capital statement Finally, the ICS should be reported internally to managers in a detailed version and externally in an aggregated and concise format.52 The ICS provides a comprehensive overview of intangible resources, their current status, and their linkages to business success. This enables a firm to fully capture the drivers of its future performance.

2.2

Linking the Intellectual Capital Statement with Value-based Management

An increase in firm value is the main goal of value-based management. In recent decades, the concept of Economic Value Added (EVA) has become established in corporate practice with regard to the measurement of value creation (or destruction). An intellectual capital statement is a suitable tool for integrating intangibles into value-based management and for analyzing how the development of intangibles affects firm value.53 Firm value can be split into an operational part, the current operations value (COV), and a strategic part, the future growth value (FGV):54 49

BMWi (2008), pp. 34–35. BMWi (2008), p. 37. 51 BMWi (2008), p. 44. 52 BMWi (2008), p. 48. 53 Fischer and Baumgartner (2014), p. 124. 54 Young and O’Byrne (2001), p. 36, Stern (2007), p. 116. 50

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Firm0 s value ¼ COV þ FGV ¼

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NOPAT 1 X ΔEVAtþ1 þ tþ1 r t¼1 ð1 þ r Þ 1

where NOPAT is Net Operating Profit after Taxes, r indicates the costs of capital rate, COV represents the perpetual annuity of the achieved NOPAT in period 1, and FGV represents the value of the expected EVA improvements in period t + 1. Hence, firm value can be increased by enhancing NOPAT or future EVAs, or by decreasing the costs of capital rate. These parameters are monetary value drivers and can be broken down into their (monetary) levers (Rappaport 1998; Stern et al. 1995). Thus, the starting points of value-enhancing measures are revealed.55 As intangible resources provide important potential for future increases in firm value, firms are well-advised to consider non-monetary drivers like customer satisfaction and corporate reputation in their value driver trees.56 The identification of these intangible resources and the establishment of links with the monetary drivers of firm value are facilitated by the intellectual capital statement (see Sect. 2.1.2). Fig. 9 illustrates how the selected intangibles affect firm value. The operational view reveals how resources contribute to the generation of EVA in the current period (COV), while the strategic view focuses on future success factors and generation of EVA in the long term (FGV). In the case of human capital, low employee turnover leads to a reduction in expenses due to less recruiting and fewer training costs. This positively influences NOPAT and ceteris paribus increases firm value. Moreover, high employee satisfaction leads to loyal employees who stay at and support the firm even during difficult times and thus provide a basis for future success. In the context of structural capital, product and process innovations positively affect firm value. Continuous improvement of processes and products leads to decreased expenses and ceteris paribus to higher NOPAT. To achieve a high value of the firm in the future a firm has to develop its structural capital in line with upcoming disruptive innovations. Similar associations can be identified regarding the relational capital. In that case, the generation of short-term value depends on current stakeholder relations and is influenced, for example, by the satisfaction of current customers. Future value generation is dependent on intensifying or building new stakeholder relations. For example, existing customers have to be bound to the firm while new customers are acquired by the firm.57 As a positive corporate reputation has a positive impact on all stakeholder relations, it contributes to the creation of firm value in the future.58 In summary, an intellectual capital statement enables a firm to supplement the monetary value driver trees with non-monetary value drivers, whereby the strengths and weaknesses as well as additional potential improvements are revealed.

55

E.g., Coenenberg et al. (2016), pp. 884–887. E.g., Chen et al. (2005). 57 Fischer and Baumgartner (2014), p. 129. 58 E.g., Su et al. (2016), Walsh et al. (2009). 56

Expenses

Costs of equity

Costs of debt

Weighted average costs of capital

Employee experience

Employee satisfaction Employee competence

Δ Human capital

IT-structure

Product innovation Process innovation

Δ Structural capital

Future potential improvements

Δ

Sustainability

Corporate reputation

Δ Relational capital

Strategic view

Fig. 9 Causal relations between the influencing factors of intellectual capital and the monetary drivers of firm value. (See also Fischer and Baumgartner 2014, p. 128)

Influencing factors of the intellectual capital statement as non-monetary value drivers Fulfillment of Employee rating turnover Customer Management requirements Employee satisfaction quality Disclosure of competence intangible Product quality Transparency Process strengths and innovation weaknesses

Revenues

NOPAT

Operational view

Firm value

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3 External Disclosures of Intangibles External reports have to be prepared to comply with national and international reporting regulations, which are outlined in Sect. 3.1. Moreover, firms must decide whether or not to voluntarily disclose additional information about their intangibles and thus reduce the information asymmetry between the firm’s management and its stakeholders. The following sections discuss various concepts to voluntarily report intangibles: Sect. 3.2 illustrates the integration of the intellectual capital statement into management commentary, while Sect. 3.3 demonstrates a new reporting instrument—the strategic resources and consequences report. Section 3.4 addresses the concept of integrated reporting, which aims to present a firm’s value creation process holistically by integrating not only its tangible but also its intangible resources. As a future reporting trend, the connectivity model in Sect. 3.5 supplements this concept by establishing links between financial and nonfinancial indicators. Finally, Sect. 3.6 presents empirical evidence regarding the content and implications of intellectual capital reporting.

3.1

Reporting Regulations for Intangibles

The criteria for recognition of intangible assets in the financial statements of German firms are regulated by §246 and §248 of the German commercial code (HGB) and the German Accounting Standard (GAS) 24 (“Intangible Assets in Consolidated Financial Statements”). While acquired intangible values must be capitalized, there is an option to capitalize internally generated intangible values (such as patents) unless German law explicitly prohibits their capitalization (e.g., for internally generated brands). Nevertheless, only the development expenses can be capitalized; the recognition of research expenses is prohibited (§255 of the HGB). According to §284 of the HGB, a firm must explain the exercise of an option to capitalize in the notes. With regard to International Financial Reporting Standards (IFRS), International Accounting Standard (IAS) 38 is especially decisive.59 According to this, intangible values must be capitalized with their development expenses if the definition of an intangible asset (identifiable, with control over a resource and existence of future economic benefits) is met (IAS 38.10). Similar to the HGB, recognition of expenditures of the research phase (IAS 38.54) and the capitalization of some internally generated intangibles (e.g., internally generated customer lists) are prohibited (IAS 38.63). To supplement financial statements, firms must provide further information in management commentaries. The reporting requirements for intangibles according to the German commercial code are stipulated in §289.III and §315.I of the HGB. Corporations that fulfill the size criteria of §267.III of the HGB must disclose 59

Coenenberg et al. (2018), pp. 183–197.

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nonfinancial performance indicators such as information about environmental and employee matters if they are essential for understanding the business development or the situation of the firm. Moreover, a firm that fulfills the criteria of §289b or §315b of the HGB60 must supplement its management commentary with a nonfinancial statement. This statement must describe the corporation’s business model and contain as a minimum information about environmental (e.g., greenhouse gas emissions), employee (e.g., working conditions), and social matters (e.g., dialog at regional level), respect for human rights (e.g., prevention of human rights violations), as well as anti-corruption and bribery matters (e.g., existing mechanisms to prevent corruption and bribery) (§289c.I, §289c.II, and §315c.I of the HGB). Details for each of these nonfinancial aspects must be provided, which are essential for an understanding of the business development, operating result, the situation of the firm, and impact of the business activity on the nonfinancial aspects mentioned. This information should cover the policies pursued (including the due diligence process implemented), the outcomes of those policies, the risks, and the most significant nonfinancial performance indicators (§289c.III and §315c.II of the HGB). A firm can choose from among four options regarding the manner of disclosing nonfinancial aspects (KPMG 2017, p. 4): • Nonfinancial declaration as a separate section of the management commentary • Integrated nonfinancial declaration in the management commentary • Stand-alone nonfinancial report not included in the management commentary, but which is disclosed in combination with the management commentary • Stand-alone nonfinancial report not included in the management commentary, which is published for a minimum of 10 years on the firm’s website (the management commentary has to refer to the nonfinancial report) All parent companies that are required to prepare a group management commentary in accordance with §315 of the HGB must also apply GAS 20 (“Group Management Report”) (GAS 20.5). A voluntary application is recommended for all management commentaries in accordance with §289 of the HGB (GAS 20.2). According to GAS 20.106, a firm must report on nonfinancial performance indicators that are used for internal management and are essential for understanding the business development and the situation of the firm. Examples of nonfinancial performance indicators provided in GAS 20.107 include: customer concerns (e.g., customer satisfaction), environmental issues (e.g., emission values), employee matters (e.g., employee turnover), indicators with respect to R&D, and the firm’s reputation (e.g., fulfillment of social responsibility). If quantitative data are available

According to §289b of the HGB a firm has to be classified as large (see §267.III of the HGB) and a capital-market oriented corporation (see §264d of the HGB) with an annual average number of employees of over 500. §315b of the HGB concerns groups whereby the parent company has to be a capital-market oriented corporation (see §264d of the HGB) and the consolidated companies must not exercise the exemption option that is available pursuant to §293.I of the HGB as well as have an annual average number of employees of over 500. 60

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and used for internal management, the data must be reported in cases of materiality for addressees (GAS 20.108). To close the previous gap with respect to management reporting in the international accounting rules, the International Accounting Standards Board (IASB) published the Practice Statement (PS) “Management Commentary” in 2010. This is a nonbinding framework, meaning firms are not required to comply with the PS unless it is specifically required by their jurisdiction (PS MC.IN2). In this way, potential conflicts with national accounting rules are avoided.61 According to the IASB, the management commentary is a narrative report that extends and supplements the IFRS financial statements. It should include information about five (nonbinding) key elements: nature of the business (PS MC.26), objectives and strategies (PS MC.27–28), resources, risks, and relationships (PS MC.29–33), results and prospects (PS MC.34–36), performance measures and indicators (PS MC.37–40). The latter should comprise financial and nonfinancial measures that reflect the firm’s critical success factors (PS MC. 37). As regards resources, a firm should set out its nonfinancial resources alongside its financial ones and illustrate how it uses those resources to meet the firm’s objectives. When describing the firm’s results and prospects, the firm should include its financial and nonfinancial performance as well as its targets for financial and nonfinancial measures. For German companies that prepare their consolidated financial statements according to IFRS, the PS “Management Commentary” is not relevant as the firms are already mandated to disclose a group management commentary in accordance with §315 of the HGB.

3.2

Integration of the Intellectual Capital Statement into the Management Commentary

In addition to mandatory reporting, a firm can integrate an intellectual capital statement within its management commentary. In so doing a firm voluntarily provides additional information to its stakeholders to reduce information asymmetry and thus lower the firm’s costs of capital. In this regard, a firm also has to consider the principles of proper accounting such as clarity, validity, completeness, and consistency. Voluntary reporting of intangibles should include an illustration of the firm’s strategies for managing these intangibles and identification of value drivers (the links between intangibles and financial performance or firm value). Any capitalized intangibles and intangibles that are not recorded in the balance sheet should be reported.62 Fig. 10 shows an example of the structure of an additional reporting section for intangibles. 61 62

Coenenberg et al. (2018), pp. 963–964. WAGRI (2004), pp. 240–241.

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1.

Business model Objectives and strategies Description of intangibles Relevance of intangibles in general and of each category (human, structural, and relational capital) for the firm Presentation and analysis of the influencing factors in each category including the definition and assessment of corresponding indicators Human Capital

2.

Structural Capital

Relational Capital

Influencing factor 1 Influencing factor … Influencing factor 1 Influencing factor …

Indicator 1 Indicator … Indicator 1 Indicator … Indicator 1 Indicator … Indicator 1 Indicator …

Influencing factor 1

Indicator 1 Indicator …

Influencing factor …

Indicator 1 Indicator …

Illustration of the causal relations between the influencing factors and the links with financial performance measures

3.

Assessment of development and future prospects of intangibles

Fig. 10 Structure for reporting of intellectual capital in the management commentary. (See also WGARI 2005, p. 87; Wulf and Rentzsch 2013, p. 51)

First, a firm should describe its business model (e.g., organizational structure, business processes, sales markets) followed by an analysis and assessment of its business development. In this regard, a firm should also report which of the intangibles are most critical for business success. Moreover, an explanation of a firm’s main objectives (e.g., increase in firm value) and an illustration of its strategies are required. However, overlaps with other parts of the management commentary should be avoided. Hence, this reporting item can be shortened or even skipped if the related information is already discussed elsewhere.63 Second, firms should describe their intangibles in greater detail. As a starting point, a firm should elaborate on the relevance in general of intangibles to the firm and subsequently the relevance of each category of intangibles (human, structural, and relational capital). Moreover, a short explanation of the assessment methodology for the influencing factors may prove helpful, including assessment dimensions (quality, quantity, and systematics) and the aims of the assessment (identification

63

Wulf and Rentzsch (2013), pp. 51–52.

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of strengths and weaknesses and need for improvement). The next step is the presentation of the influencing factors per category. This should include the QQS assessments for the reporting period and (if available) assessments of prior years.64 In addition, the indicators must be described that were used to measure the development of the intangibles. Thus, actual data for the reporting period compared to past periods as well as targets for future periods should be reported. An explanation of the calculation formulas of indicators is recommended.65 To provide a comprehensive picture of the firm’s intangibles the presentation should also illustrate the causal relations between the influencing factors and their links with financial performance measures. Third, the reporting section should contain an assessment of the development of the intangibles (e.g., if targets were achieved or if the development is favorable or unfavorable for the firm). The reporting section about the firm’s intangibles should end with an illustration of the future prospects, including a description of planned actions to improve the respective influencing factors.66

3.3

Strategic Resources and Consequences Report

In recent decades, corporate financial information has lost much of its relevance and usefulness for investors. According to an empirical analysis of most US public companies, financial reports (especially 10-Y and 10-K Securities and Exchange Commission (SEC) filings) provided only 5% of the information relevant to investors, while SEC non-accounting filings (e.g., 8-K filings for announcing new developments such as new products or director changes) and analysts’ forecasts contributed 26% and 20%, respectively, to the total information investors could use for decision-making.67 In response to this loss of relevance, Lev and Gu (2016) proposed a new form of reporting—the Strategic Resources and Consequences Report—which should provide investors with the actionable and up-to-date information required for today’s investment decisions. The focus of the report is on strategic resources that enable a firm to gain sustained competitive advantages. According to the resource-based theory, these resources share the following attributes: valuable, rare, difficult to imitate, non-substitutable, and firm-specific.68 Examples of these are patents, brands, and customer relationships, which are mostly not reported in the accounting system (except when these resources were acquired rather than internally developed). The

64

Wulf and Rentzsch (2013), pp. 52–54. WGARI (2005), pp. 87–88. 66 Wulf and Rentzsch (2013), p. 54. 67 Lev and Gu (2016), pp. 45–46. 68 Barney (1991), Barney and Clark (2007). 65

Brands Number Market share Brand values ($)

Proven Oil & Gas Reserves ($) Exploration rights No. of rigs

Customers Additions Terminations Total Churn

Patents & Trademarks Quantity Applied Approved Stock Patent attributes (quality)

RESOURCES STOCKS

Maintaining Workforce Quality In-house and external training ($) Employee turnover

Knowledge Management No. of employees participating

Resources Decay programs

Disruption Mitigation programs

Infringement Detection programs

RESOURCE PRESERVATION

Fig. 11 Strategic Resources and Consequences Report. (Lev and Gu 2016, p. 128)

RESOURCE DEPLOYMENT

Movie/TV Content No. streams to customers Serialization International

Alliances & Joint Ventures Investment in alliances ($) No of alliances R&D Manufacturing

Oil & Gas Rights % explored % producing % abandoned

Patents Developed Sold/licensed Donated Expired

Note: The information in squares is quantitative ($ denotes monetary values), and in circles is qualitative (narrative).

Spectrum Acquisition ($) Broadband

TV & Movie Content ($) New Sequels

Oil & Gas Exploration ($) Exploration Successful Unsuccessful Rights acquisition

Customer Acquisition Costs ($)

R&D ($) Internal Research Development Acquired technology

DEVELOPING RESOURCES

Resources Value Changes ($) Lifetime value of customers Value of oil & gas reserves Brand value

Plus:

Value Created in Period ($) Cash flows from operation Plus: Expensed investments Minus: Capital expenditures Minus: Cost of equity capital

VALUE CREATED

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Strategic Resources and Consequences Report contains five columns (see Fig. 11), which should provide information about the following aspects:69 (a) Developing resources: The report should provide information about the investments that were made during the development of a firm’s strategic resources (e.g., costs for customer acquisitions). (b) Resource stocks: A firm’s strategic resources should be outlined, including their characteristics, value, and related attributes (e.g., number of brands, their market shares, and brand values). (c) Resource preservation: The report should clarify the risks to a firm’s strategic resources arising from competitors, disruptions by new technologies, or regulatory changes. Moreover, measures taken by the management to mitigate these risks should be mentioned. (d) Resource deployment: The report should include information about the ways in which each strategic resource creates value for the firm (the specific deployment of resources should be outlined). (e) Value created: The consequences of the management’s activities in creating, preserving, and deploying strategic resources should be quantified and reported. The report contains both monetary (denoted by $ in Fig. 11; e.g., the amount of R&D expenses) and quantitative information (listed in squares in Fig. 11; e.g., the number of patents) as well as qualitative and narrative aspects (listed in circles in Fig. 11; e.g., description of the disruption mitigation program). Strategic resources and the resulting competitive advantages vary among industries due to differences in fundamental business models. Thus, the reporting system must be attuned to a firm’s industry. The following case of Sirius XM, which is a major provider of satellite radio services in North America, demonstrates by example the application of a Strategic Resources and Consequences Report in the specific context of the media and entertainment industry. The case is based on figures for the second quarter of 2013 along with an analysis of primarily non-accounting data that was disclosed voluntarily by Sirius and its answers to analysts’ questions.70 As customer management is the most important driver of competitive advantage in the media and entertainment industry, the main strategic resource of Sirius is its customers. Hence, the firm should report the number of its newly acquired customers (2.7 million), terminations (1.9 million), and the total number of subscribers (20.3 million); preferably with additional information regarding the previous period. The monthly churn rate (1.7%) is also an interesting aspect in the column resource stocks: Compared to the previous period, Sirius registered an increase in customer acquisition, while customer termination and the churn rate decreased. In the resource development column, the costs for subscriber acquisition ($139 million) and the costs per new subscriber ($52) should be displayed. These costs include, for example, commissions that Sirius paid

69 70

Lev and Gu (2016), pp. 121–126. Lev and Gu (2016), pp. 133–142.

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to car manufacturers to incentivize the installation and activation of satellite radios (carrying Sirius) in new cars. In comparison to the annual subscription charges of about $180 million, new customers will cover the acquisition costs in approximately one year, showing the cost-benefit relation is adequate. In addition, the report section can contain sales and marketing expenses per subscriber ($2.8), which only marginally increased compared to the previous period and hence do not explain the mentioned subscriber rise. Instead, an increase in car sales benefited the customer acquisition of Sirius as the firm has agreements with car manufacturers to install a 6-month trial of Sirius service in new cars. This resulted in a new-car installation rate of 69% (to be reported in the resource deployment column). The conversion rate (subscribers who signed for a paid service after the trial period) was 45%. Moreover, the strategy of Sirius includes agreements with used-car sales representatives for installing Sirius software. As the rates are already relatively high or exhibit no change over recent periods, to achieve growth in subscribers is one of the biggest challenges Sirius faces. Growth can also stem from new products and services, which should also be reported in the resource deployment column. Even when the Sirius brand is well-known and established in the market, the firm must beware of competitive and disruption threats. In particular, the use of the Internet as an alternative to satellite radio and market-entry of successful companies like Apple and Google could jeopardize its business. These potential disruptions and competitors should be reported in the resource preservation column. To complete the Strategic Resources and Consequences Report, the firm should provide information about the value created. Lev and Gu (2016) propose calculating the total value created by operations ($230 million) by adding expensed investments to income from operations, subtracting capital expenditures, and costs of equity. In addition, Lev and Gu (2016) provide a new indicator: an estimation of the main strategic resource of Sirius—the lifetime value of its subscriber franchise. For an approximation, the monthly margin per subscriber is multiplied by the inverse of churn rate, which results in the lifetime value of one subscriber. This value is subsequently multiplied by the total number of subscribers, leading to the overall lifetime subscriber value ($8.38 billion). This value represents a considerable part of the market value of Sirius in 2013, roughly $20 billion, while the book value is only $3.2 billion. In summary, the exemplary Strategic Resources and Consequences Report for Sirius enables users to evaluate the firm holistically as it provides information that cannot be found in financial reports. In particular, information on the success of the firm’s strategy and its strategic resources allows investors to draw conclusions about the firm’s future prospects.

3.4

The Concept of Integrated Reporting

In recent years, firms have increasingly attempted to supplement their financial reporting with further nonfinancial data to improve decision-making for their

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stakeholders. These may include information about intangibles such as customer satisfaction, corporate reputation, and information about environmental issues. The concept of Integrated Reporting () was developed for this purpose, which is “a concise communication about how an organization’s strategy, governance, performance and prospects, in the context of its external environment, lead to the creation of value over the short, medium and long term”.71 In other words, the purpose of integrated reporting is to explain how a firm creates value over time, by showing a holistic picture of the firm’s resources and relationships (in the framework these are called “the capitals”). The capitals are divided into six categories:72 (a) Three categories that comprise a firm’s tangible resources: • Financial capital (the pool of funds available to a firm) • Manufactured capital (physical objects available for the production of goods or provision of services, such as buildings, equipment, and infrastructure) • Natural capital (renewable and nonrenewable environmental resources and processes such as air, water, and minerals) (b) Three categories that contain a firm’s intangible resources: • Intellectual capital (organizational, knowledge-based intangibles like intellectual property) • Human capital (employees’ competencies, capabilities, and experience) • Social and relationship capital (relationships within and between communities, groups of stakeholders, and other networks, as well as the ability to share information to enhance individual and collective well-being) An integrated report is based on the principle of integrated thinking, which means that financial and nonfinancial information should be connected. The six capitals represent the inputs to a firm’s business model, which are converted to outputs and outcomes by the firm’s business activities (value creation process). Hence, the interrelations and dependencies between the factors that affect the organization’s ability to create value should be shown.73 Integrated reporting entails several positive consequences for a firm. First, integrated reporting helps to reduce information asymmetry74 by signaling the quality of the firm, expanding the set of information the firm discloses, and reducing uncertainty with respect to the assessment of the firm’s performance.75 Thus, integrated

71

IIRC (2013), p. 7. IIRC (2013), pp. 11–12. 73 IIRC (2013), p. 16. 74 Barth et al. (2017), p. 10. 75 Zhou et al. (2017), p. 103. 72

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reporting leads to lower costs of capital.76 Second, integrated reporting has a beneficial impact on firm value and performance.77 Third, integrated reporting benefits the attraction and retention of long-term-oriented investors.78 To date in corporate practice, only a few companies provide comprehensive integrated reports (only 13% of DAX 30 companies in 2018; examples are BASF, Bayer, and SAP). However, integrated reporting with its embedded principle of integrated thinking is an evolving reporting trend. A benchmark survey of DAX 30 companies by PwC (2016) analyzed the extent to which the seven content elements of an integrated report, according to the International Integrated Reporting Council (IIRC) Framework (Paragraph 4.1) are contained in firms’ annual reporting. For the majority of content elements, firms have the potential to develop their reporting. Effective communication is currently provided to the following extents: organizational overview and external environment (30%), governance (6%), business model (13%), risks and opportunities (64%), strategy and resource allocation (44%), performance (20%), and outlook (20%).79 In summary, while financial reporting is highly regulated and established in corporate practice, integrated reporting is still an evolving model. However, the future development of external reporting will be a highly relevant topic in the coming years.

3.5

Connectivity of Financial and Nonfinancial Indicators as a Future Trend

The disclosure of financial and nonfinancial indicators, for example, in the concept of integrated reporting, enables stakeholders to assess in a holistic way a firm’s ability to create value. The principle of integrated thinking targets the connection between financial and nonfinancial indicators and revealing the underlying causeand-effect relationships. A prominent example of the corporate practice is by SAP SE, which has provided comprehensive integrated reports since 2012, with the purpose of presenting a holistic view of its performance. As recent developments for the corporate disclosures of intangibles are based on the notion that social, environmental, and economic performance is interrelated, SAP uses a cause-andeffect analysis to assess how a selection of nonfinancial indicators affect its operating profit. SAP draws on empirical research studies that provide evidence of the respective relationships; for example, the positive relationship between a firm’s social investment and employee engagement is based on a study from Müller et al. (2012). If possible, SAP also uses real data and techniques like linear regression analysis for 76

Zhou et al. (2017), pp. 103, 116. Lee and Yeo (2016), p. 1226. 78 Serafeim (2015), p. 40. 79 PwC (2016), p. 14. 77

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Growth Emp m loyee Employee Engagement (+) / (-)

Customer Loyalty

BHCI (+) (+) (+)

(+)

Profit f ability Profitability Emp m loyee Employee Retention

(+)

(+) (+)

(+)

Women in Management

GHG Footprint Footp t r

Total Energy Consumed

(+)

Social investment

Cap a ability t Capability Building

corp r orate objectives obj b ectives SAP‘s corporate

Economic indicators

m on operating profit f Impact

Social indicators

Environmental ind indicators (€ … M) Increase in Operating Operati Profit

for a change by 1 pp

Fig. 12 Connectivity between operating profit and other financial and nonfinancial indicators. (Adapted from SAP SE 2018b)

the assessment, in order to translate the cause-and-effect chains into a quantified impact on operating profit (see Fig. 12). A change of one percentage point in employee engagement, for example, would have an impact of €50–60 million on SAP’s operating profit.80 SAP’s primary financial objectives are profitability and growth (as indicators of actual performance), while its primary nonfinancial objectives are customer loyalty and employee engagement (as indicators of future performance). In addition, SAP integrates the following nonfinancial indicators into its analysis: Business Health

80

SAP SE (2018a), p. 216.

T. M. Fischer and K. T. Baumgartner

104

Growth Profi f tability t Profitability (+) (+)

Customer Loyalty

BHCI (+) (+) / (-) (+)

(+)

Emp m loyee Employee Retention

Employee Engagement

(+) / (-) (+) / (-)

(+)

GHG Footp t r Footprint

(+)

Total Energy Consumed

Women in Management

Social investment

Cap a ability t Capability Building

SAP‘s corp corporate r orate objectives obj b ectives

Economic indicators

Impact m on operating profit f

Social indicators

indicators Environmental indicato

Fig. 13 Connectivity of financial and nonfinancial indicators. (Adapted from SAP SE 2018b)

Culture Index (BHCI), which assesses the health of SAP’s culture and of its employees, employee retention, women in management, social investment, capability building, total energy consumed, and Greenhouse Gas (GHG) footprint. Fig. 13 shows how the corporate objective of employee engagement is connected with the other financial and nonfinancial indicators. SAP defines employee engagement as “the level of employee commitment, pride, loyalty, as well as the feeling of employees being advocates for their company.”81 First, this nonfinancial indicator can be linked with SAP’s financial objectives: Reciprocal relationships exist between employee engagement and with growth and

81

SAP SE (2018a), p. 217.

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profitability. Based on an analysis of real data, SAP can prove the positive impact that employee engagement has on revenue (related to the growth indicator) and operating profit (related to the profitability objective). In contrast, high operating profits can either positively or negatively drive employee engagement (depending on the background for the profit results achieved), while higher revenues increase employee pride and loyalty.82 Second, employee engagement has a positive impact on employee retention (based on an analysis of real data). The influence of employee engagement on the GHG footprint can be positive (engaged employees want to help SAP achieve its target of lowering GHG emissions) or negative (employee engagement could lead to more travel required for business, increasing GHG emissions). The effects are the same the other way around as the GHG footprint can have a positive or negative impact on employee engagement. In addition, employee engagement is positively influenced by the BHCI (based on an analysis of real data) and social investment as employees’ perception of their firm’s commitment to corporate social responsibility is positively linked with their own commitment to the company. Furthermore, employees’ commitment and loyalty to the firm are influenced by the firm’s capability of building them, meaning how much the firm develops its employees and supports their careers.83 With its connectivity model, SAP has established links between the various financial and nonfinancial indicators. By analysis and extension of its corporate disclosure, SAP has clarified that intangibles play a crucial role in its business strategy and are essential for its financial success. In addition, the connectivity of financial and nonfinancial indicators provides levers to develop further tools of business analytics for a comprehensive analysis of intellectual capital, based on big data in the future.84

3.6

Empirical Evidence Regarding the Reporting of Intangibles

A large number of studies, which mostly draw on annual reports as their data basis, have analyzed external intellectual capital (IC) reporting. Most of them use content analysis to identify the reporting practices of firms in various countries. An overview of chosen examples of intellectual capital reporting studies is presented in Table 2. One major finding is that relational capital is more frequently reported than structural capital and human capital.85 However, the studies also reveal differences among the surveyed countries. Possible reasons for these country-specific differences are not identified. Nevertheless, some studies have empirically investigated the 82

SAP SE (2018a), pp. 217–218. SAP SE (2018a), pp. 217–218. 84 See also Secundo et al. (2017). 85 See also Goebel (2015), p. 704. 83

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Table 2 Selected empirical studies on intellectual capital reporting in various countriesa Author (year) Sangiorgi and Siboni (2017)

Country/sample Italy/17 universities that published voluntary social reports

Wang et al. (2016)

China and India/20 IT companies listed on the Shenzhen or Shanghai stock exchanges and the 20 largest companies listed on the Indian stock market

Goebel (2015)

Germany/428 companies listed by the German stock exchange on December 30, 2010

De Silva et al. (2014)

New Zealand/5 knowledge-intensive companies and 5 product-based companies listed on the New Zealand stock exchange

Yi and Davey (2010)

China/49 dual-listed companies in mainland China

Vergauwen et al. (2007)

Sweden, Denmark, and UK/20 firms on the Stockholm stock exchange, 20 on the Copenhagen stock exchange, and 20 on the FTSE 100

Guthrie et al. (2006)

Australia and Hong Kong/50 listed companies in Australia and 100 companies in Hong Kong

Main results with regard to intangibles The biggest IC category disclosed was structural capital (82.34%), followed by knowledge transfer to the public (58.82%), services (52.94%), relational capital (52.21%), commercializing (51.47%), human capital (47.06%), education (45.88%), and research (40.34%). In China, external capital (e.g., stakeholder relationships) is the most frequently reported category, followed by human capital (e.g., employee satisfaction) and internal capital (e.g., corporate culture). In India, the most frequently disclosed category is also external capital, followed by internal capital and human capital. German companies mostly report structural capital (43.1%), followed by relational capital (36.9%) and human capital (20.0%). The most-reported intellectual capital category in 2010 was human capital (55%), followed by external capital (29%) and internal capital (16%). The knowledge-intensive companies provided a greater amount of intellectual capital reporting than traditional, product-based companies. Chinese companies most frequently reported external capital (46%), followed by internal capital (30%) and human capital (24%). The most frequently disclosed items were management processes (belonging to internal capital), employee (belonging to human capital), business partnerships, and brands/reputation (both belonging to external capital). Among the 60 firms analyzed, relational capital had the highest degree of disclosure (46%), while human and structural capital represented 32% and 22%, respectively. In Australia, external capital (49%) was reported most frequently, followed by internal capital (41%) and human capital (10%). In Hong Kong, (continued)

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Table 2 (continued) Author (year)

Country/sample

Vergauwen and van Alem (2005)

Netherlands, France, and Germany/ companies listed in the Dutch AEX, the French CAC 40, and the German XetraDAX

Speckbacher et al. (2004)

Germany and Austria/German DAX 30 and Austrian ATX 20 companies

Bozzolan et al. (2003)

Italy/30 organizations chosen from nonfinancial companies listed on the Italian stock exchange

Bontis (2003)

Canada/approximately 11,000 Canadian corporations contained in the database Compact D: Cancorp Plus

Main results with regard to intangibles external capital (37%) was also disclosed most frequently but followed by human capital (35%) and internal capital (28%). In total, the most frequently reported items were business collaborations (external capital) and management philosophy (internal capital). From the total set of 38 intellectual capital terms, 23 were actually found in annual reports. The three most popular search terms were information system, knowledge management, and intellectual property. The most-reported intellectual capital category was human capital (39.2%), followed by structural capital (36%) and relational capital (24.8%). Looking at the respective intangible values, network and information system (13.7%), training (11.5%), and customer satisfaction (10.6%) were the most reported items. Most of the reported information is related to external structure (relational capital 49%) and internal structure (structural capital 30%), while the remaining 21% concerned human capital. From a total set of 39 intellectual capital terms, only 8 terms were disclosed: intellectual property, knowledge management, human capital, employee value, employee productivity, Economic Value Added, intellectual capital, and intellectual assets.

a For further examples see: Yi and Davey (2010), pp. 330–332, Ramanauskaite and Laginauskaite (2014), pp. 140–144

impact of certain company criteria, like industry or size, on intellectual capital reporting. As regards industry, some differences seem to exist across the industry groups. As intellectual capital is particularly important in high-tech industries, the IT and healthcare sectors, for example, encourage the reporting of intellectual capital.86 This is consistent with Goebel (2015), who found that pharmaceutical and

86

Brüggen et al. (2009), p. 240.

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technology companies disclose more information about their intangible values than other industries. In general, firms in knowledge-intensive sectors tend to report more about their intellectual capital than firms in traditional sectors.87 With regard to size, Brüggen et al. (2009) and Goebel (2015), for example, report a positive impact of size on intellectual capital reporting. One explanation may be that the costs of producing information are more prohibitive for smaller firms than for larger ones. However, other empirical studies have not confirmed this relationship.88 Further factors that may influence reporting behavior include profitability,89 ownership structure,90 and national legislation or guidelines that foster intellectual capital reporting.91 Another important research area concerns the implications of intellectual capital reporting for firms. Boujelbene and Affes (2013) investigated the impact of intellectual capital disclosure on the costs of equity by analyzing the annual reports of French companies in the SBF 120 French index. Their findings confirmed the expected negative relationship. However, when looking at the three components of intellectual capital, only a negative impact on the costs of equity is validated for human capital and structural capital, but not for relational capital. These results are mainly in line with Mangena et al. (2010) who revealed a negative relationship between intellectual capital disclosure and the costs of equity for UK listed firms. Orens et al. (2009) also examined the impact of web-based intellectual capital reporting on the costs of finance and firm value across four European countries (Belgium, France, Germany, and the Netherlands). The study shows that greater intellectual capital disclosure is associated with lower information asymmetry, hence lower costs of equity and a lower rate of interest paid. Moreover, the amount of intellectual capital reporting has a positive impact on firm value, suggesting that firms can improve their value by reporting more about their intangible resources. In an analysis based on IT companies listed on NASDAQ, Garania and Dumay (2017) found that intellectual capital disclosure in initial public offering prospectuses has a positive impact on post-issue stock performance. In an analysis of companies listed on the Kuwait Stock Exchange, Alfraih (2017) revealed that intellectual capital reporting is positively associated with market value. These results were also confirmed by Gamerschlag (2013). His analysis of German companies listed on the DAX, MDAX, and SDAX showed that human capital information is relevant to valuation. Ellis and Seng (2015) found a positive relationship between intellectual capital disclosure and market value based on an analysis of companies listed on the New Zealand Stock Exchange. In an empirical study of a sample of listed companies from four different countries (Australia, Hong Kong, Singapore, and the UK), Vafaei et al. (2011) showed that intellectual capital reporting is positively associated with

87

Bozzolan et al. (2003), p. 550, Bukh et al. (2005), p. 717. E.g., Bukh et al. (2005), p. 726. 89 E.g., Cerbioni and Parbonetti (2007), pp. 807, 815. 90 E.g., Bukh et al. (2005), p. 726. 91 E.g., Vergauwen and van Alem (2005), p. 92. 88

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the market price in Britain and Hong Kong. The results for Australia and Singapore were not significant, leading to the conclusion that the relationship is likely affected by country-specific factors. Other examples that underpin the positive association of intellectual capital reporting and market value are the studies of Abdolomohammadi (2005) and Anam et al. (2011). However, there are also some studies that have failed to document a significant relationship between intellectual capital disclosure and market value.92 Overall, there seems to be strong evidence supporting the assumption that intellectual capital disclosure has the effect of reducing the costs of capital and increasing the market value. Further analysis would be helpful, for example, with regard to the impact of intellectual capital reporting on a firm’s financial performance.

4 Conclusion While traditional financial reporting has lost some of its relevance in the knowledgebased economy, intangible values and intellectual capital reporting have become critical success factors for firms. Stakeholders today expect reliable information regarding a firm’s intangible resources, in order to thoroughly assess the firm’s future value-creation potential. As intangibles represent important drivers of firm value, enhanced transparency is required, both internally and externally, to provide stakeholders with sufficient information for well-founded decision-making. By reducing information asymmetry between management and a firm’s stakeholders, intellectual capital reporting is likely to result in a reduction in the costs of capital and an increase in firm value. As illustrated by the example of SAP SE (see Sect. 3.5), big data and business analytics offer an opportunity for enhanced intellectual capital analysis and reporting. Data management and analytics such as regression analysis enable a firm to gain more insights into its intellectual capital and its relationship with financial performance and firm value.93 To date, no uniformly applied tool has been developed for the external reporting of intangibles in corporate practice. The concept of Integrated Reporting was developed to fill this gap and to provide—even if only applicable on a voluntary basis—guidelines for integrating financial and nonfinancial information and thus a holistic and concise presentation of a firm’s value creation.94 However, to achieve more uniformity and better comparability, additional legal regulations with respect to intellectual capital reporting are necessary in the future.

92

E.g., Ferraro and Veltri (2011). Secundo et al. (2017). 94 Abhayawansa (2014), p. 130, Zhou et al. (2017), pp. 94–95. 93

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Speckbacher, G., Güldenberg, S., & Ruthner, R. (2004). Externes Reporting über immaterielle Vermögenswerte. In P. Horváth & K. Möller (eds.), Intangibles in der Unternehmenssteuerung—Strategien und Instrumente zur Wertsteigerung des immateriellen Kapitals (pp. 435–453). München: Vahlen Verlag. Stern, H. J. (2007). Marktorientiertes Value Management. Wiley-VCH Verlag: Weinheim. Stern, J. M., Stewart, G. B., & Chew, D. H. (1995). The EVA Financial Management System. Journal of Applied Corporate Finance, 8(2), 32–46. Su, L., Swanson, S. R., Chinchanachokchai, S., Hsu, M. K., & Chen, X. (2016). Reputation and Intentions: The Role of Satisfaction, Identification, and Commitment. Journal of Business Research, 69(9), 3261–3269. Sveiby, K. E. (1997). The New Organizational Wealth—Managing & Measuring Knowledge-based Assets. San Francisco: Berrett-Koehler Publishers. The New York Times. (2013). Giving Viewers What They Want. Retrieved May 4, 2017, from http://www.nytimes.com/2013/02/25/business/media/for-house-of-cards-using-big-data-toguarantee-its-popularity.html. Vafaei, A., Taylor, D., & Ahmed, K. (2011). The Value Relevance of Intellectual Capital Disclosures. Journal of Intellectual Capital, 12(3), 407–429. Vergauwen, P., Bollen, L., & Oirbans, E. (2007). Intellectual Capital Disclosure and Intangible Value Drivers: an Empirical Study. Management Decision, 45(7), 1163–1180. Vergauwen, P. G. M. C., & van Alem, F. J. C. (2005). Annual Report IC Disclosures in the Netherlands, France and Germany. Journal of Intellectual Capital, 6(1), 89–104. Walsh, G., Mitchell, V.-W., Jackson, P. R., & Beatty, S. E. (2009). Examining the Antecedents and Consequences of Corporate Reputation: A Customer Perspective. British Journal of Management, 20(2), 187–203. Wang, Q., Sharma, U., & Davey, H. (2016). Intellectual Capital Disclosure by Chinese and Indian Information Technology Companies: A Comparative Analysis. Journal of Intellectual Capital, 17(3), 507–529. Working Group “Accounting and Reporting of Intangible Assets” (WGARI). (2004). Erfassung immaterieller Werte in der Unternehmensberichterstattung vor dem Hintergrund handelsrechtlicher Rechnungslegungsnormen. In P. Horváth & K. Möller (eds.), Intangibles in der Unternehmenssteuerung—Strategien und Instrumente zur Wertsteigerung des immateriellen Kapitals (pp. 221–250). München: Vahlen Verlag. Working Group “Accounting and Reporting of Intangible Assets” (WGARI). (2005). Corporate Reporting on Intangibles—A proposal from a German Background. In W. Ballwieser (ed.), Current Issues in Financial Reporting and Financial Statement Analysis (pp. 65–100). Schmalenbach Business Review, Special Issue 2/05, Düsseldorf. Wulf, I., & Rentzsch, N. (2013). Lageberichterstattung von immateriellen Werten insbesondere in KMU. In T. M. Fischer & I. Wulf (eds.), Wissensbilanzen im Mittelstand (pp. 37–58). Stuttgart: Schäffer-Poeschel Verlag. Yi, A., & Davey, H. (2010). Intellectual Capital Disclosure in Chinese (mainland) Companies. Journal of Intellectual Capital, 11(3), 326–347. Young, S. D., & O’Byrne, S. F. (2001). EVA and Value-Based Management—A Practical Guide to Implementation. New York: McGraw-Hill. Zhou, S., Simnett, R., & Green, W. (2017). Does Integrated Reporting Matter to the Capital Market? Abacus, 53(1), 94–132.

Intangibles in Different Industries Marc C. Hübscher and Niklas Martynkiewitz

What Will the Reader Learn? • Typical success factors within the industry • How intangibles are interpreted in different industries • How a value contribution in different industries is derived from existing PPA data

1 Introduction Intangible assets became increasingly important in international accounting at the beginning of the twenty-first century. With the what is known as Purchase Price Allocation (“PPA”), implemented by IFRS 3 and the SFAS 141 and 142, a framework was created that prohibits the reporting of differences between the purchase price (acquisition cost) and net book assets that include goodwill within the scope of capital consolidation. Rather, international accounting standards require for compliance with transparency that the reporting company explain the strategic considerations that led it to pay a higher price for the company than results from a pure consideration of the net book value. In essence, a PPA sets out why the reporting company was willing to pay a premium above the net book value at the time of the acquisition. Based on the published PPAs available in the years 2016 and 2017, we have conducted an empirical analysis that shows how differences between the purchase price and net book value are allocated to intangible assets and goodwill in different industries.

M. C. Hübscher · N. Martynkiewitz (*) Deloitte, Hamburg, Germany e-mail: [email protected]; [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_7

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In the following, we first introduce the theoretical principles of purchase price allocation following the guidance and principles set out in the IFRS. Then we discuss the value drivers of various industries in conceptual terms and provide an overview of the relationship between intangible assets and goodwill in these industries. Even though the applicability of a PPA for transfer pricing purposes is limited, due to differences in valuation paradigms,1 this chapter may help to understand the way value drivers and intangibles are seen by third-party market participants within different industries. Despite what is contained in this overview, a detailed analysis of the value drivers and intangibles is needed in each specific case.

2 Theoretical Background of the Purchase Price Allocation: A Brief Summary 2.1

General Remarks

In the following, we briefly explain what a PPA is and how it is implemented. We will focus on the International Financial Reporting Standards (IFRS). The objective of PPA is to improve the relevance, reliability, and comparability of the information that a reporting entity provides in its financial statements about a business combination and its effects. A business combination is defined as a transaction or other event in which an acquirer obtains control of one or more businesses. A business is an integrated set or bundle of activities and assets that is capable of being conducted and managed for the purpose of providing a return in the form of dividends, lower costs, or other economic benefits directly to investors or other owners, members, or participants. For each business combination, the acquirer has to apply the acquisition method. According to IFRS 3.5, the acquisition method requires the following steps: • Identifying the acquirer • Determining the acquisition date • Recognizing and measuring the identifiable assets acquired, the liabilities assumed, and any noncontrolling (minority) interest (hereinafter NCI) in the acquiree • Recognizing and measuring goodwill2 or a gain from a bargain purchase An asset is identifiable if it meets either the separability or contractual legal criterion (IFRS 3.A). All identifiable assets acquired and liabilities assumed are classified or designated as necessary in order to apply other IFRS. Any

1

See Chap. 10. Additionally, IFRS 3.19 allows an accounting policy choice, available on a transaction by transaction basis, to measure NCI either at fair value (sometimes called the full goodwill method), or the proportionate share of the NCI of identifiable net assets of the acquiree. 2

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Fig. 1 Fair value hierarchy

classifications or designations must be made in accordance with the contractual terms, economic conditions, acquirer’s operating or accounting policies, and other factors that exist at the acquisition date (IFRS 3.15). Identifiable assets and liabilities are measured by their fair value at the acquisition date with a limited number of specified exceptions (IFRS 3.18–20). There is no “reliable measurement” exception. Three widely used valuation techniques are the market approach, the cost approach, and the income approach (IFRS 13.62). To increase consistency and comparability in fair value measurements and the related disclosures, the IFRS established a fair value hierarchy that categorizes on three levels the inputs to the valuation techniques that are used to measure fair value. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (level 1 inputs) and the lowest priority to unobservable inputs (level 3 inputs) (Fig. 1). The acquirer also accounts for the potential tax effects of temporary differences and tax loss carryforwards of an acquiree that exist at the acquisition date or arise as a result of the acquisition. The acquirer has to recognize and measure a deferred tax asset, or a liability arising from the assets acquired and liabilities assumed in a business combination, in accordance with IAS 12 Income Taxes (IFRS 3.24–25). Consequently, goodwill is measured by finding: (a) The aggregate of: • The fair value of the consideration transferred at the acquisition date • The amount of any NCI • In a business combination achieved in stages, the fair value at the acquisition date of the acquirer’s previously held equity interest in the acquiree (b) The net of the amounts at the acquisition date of the identifiable assets acquired and the liabilities assumed, measured in accordance with IFRS 3.32 If the amount of (b) exceeds the amount of (a), the excess is recognized as a bargain purchase in profit or loss (IFRS 3.34) (Fig. 2).

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Fig. 2 From closing accounts to accounts including PPA

Fig. 3 Performing PPA

2.2

Process of a Purchase Price Allocation

The PPA process is comprised of four material steps (Fig. 3): Every PPA is based on understanding the transaction, meaning the transaction rationale of the acquirer. Therefore, the background and occasion of the transaction have to be discussed with the management of the companies involved. Furthermore, the business of the target company must be analyzed and a preliminary identification made of the material categories of assets and liabilities.

2.2.1

Identification

In order to gather information, interviews with the management of the acquiree should be conducted and due diligence documents evaluated. Based on this knowledge and their industry expertise, the PPA team next identifies the material tangible and intangible assets, liabilities and contingent liabilities that are either not capitalized at all or not with fair value in the balance sheet of the target.

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Valuation

After completion of the identification phase, the fair values of identified tangible and intangible assets, liabilities and contingent liabilities are calculated using the chosen valuation approaches. Considering deferred taxes and the purchase price, a goodwill value or gain from a bargain purchase is derived as a residuum.

2.2.3

Plausibility Check

Checking for plausibility includes verifying the business plan analysis and reasonableness of the results of the PPA, in terms of mathematical accuracy and business consistency.

2.3

Recognition of Intangible Assets

IAS 38.8 states that an intangible asset is an identifiable non-monetary asset without physical substance. An intangible asset is identifiable either when: • It is separable (capable of being separated and sold, transferred, licensed, rented, or exchanged, either individually or as part of a package) or from a related contract (IAS 38.12a) • 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 (IAS 38.12b) The inflows of cash or other assets generated by the underlying resource have to be controlled by the enterprise (IAS 38.13) and access of third parties to the benefits resulting from the assets is restricted. A necessary implied condition is thus the existence of future economic benefits, according to IAS 38.17. IAS 38 requires an enterprise to recognize an intangible asset, whether purchased or self-created (at cost), but only when it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise and the cost of the asset can be measured reliably (IAS 38.21). Figure 4 outlines the types of potential intangibles, based on the IAS definition, which may be identified during a PPA. Please note that this definition of intangibles differs from that used for transfer pricing purposes (see Chap. 1).

Fig. 4 Types of potential intangibles suited to PPA

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3 Empirical Study: Typical Value Drivers within Different Industries In our analysis of annual financial statements for the years 2016 and 2017, we have worked out how business combinations in the various sectors are actually recognized in practice for the application of the PPAs. Our main focus is on the question of how the purchase price is allocated to intangible assets and goodwill in general in the overall market and in particular for different industries.

3.1

Dataset

The basis of the data used consists of the 631 largest corporation transactions in 2016 and 2017, for which their accounting was in accordance with IFRS. As sufficient publicly available information was available for only about a third of the transactions, our adjusted population, therefore, includes 211 corporate transactions for both years (Fig. 5). Around 75% of the transactions of this adjusted population is for deal volumes of less than EUR 1 billion. In more than 40% of the transactions examined, the purchase price is below EUR 250 million. Our main focus is on the question of how the purchase price is allocated to intangible assets and goodwill in the overall market and in different industries.

Fig. 5 Transactions by equity values

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Fig. 6 Headquarters of acquiring companies in the evaluated transactions

The adjusted population comprises buyers from 29 different countries. The largest share is made up of purchasers from the United Kingdom and Germany, who completed around 37% of the transactions (Fig. 6).

3.2

Methods

Based on the published annual reports of the acquiring companies, asset-specific financial information was determined for the adjusted population of company transactions using the levels of analysis shown below (hereafter referred to as “aggregated analyses”): • Goodwill • Intangible assets • Other assets and assumed (contingent) liabilities The adjusted population comprised 211 company transactions. For 151 of these transactions, further detailed analyses could be carried out. This includes a detailed breakdown of the identified intangible assets into the following subcategories (hereafter referred to as “detailed analyses”):

Intangibles in Different Industries Fig. 7 Deriving purchase value

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Determination of share values as % Purchase consideration + Net financial liabilities + Interest-bearing liabilities + Pension provisions + Minority interests ./. Existing cash balance ./. Other liquid financial assets Total enterprise value thereof intangible assets as % thereof goodwill as % thereof other assets and liabilities as % + Fixed assets + Financial assets + Current assets + Deferred tax assets ./. Provisions ./. Liabilities ./. Deferred tax liabilities ./. Contingent liabilities ./. Net financial liabilities

• • • • •

Technology-related intangible assets Customer-related intangible assets Contract-related intangible assets Marketing-related intangible assets Other intangible assets

The percentage allocations of goodwill, intangible, and other assets, and assumed (contingent) liabilities are based on the total enterprise values of the acquired companies (Fig. 7). In order to be able to determine an undistorted total enterprise value for 100% of the allocations, the previously mentioned net financial liabilities include interestbearing liabilities as well as pension provisions and any minority interests, which are reduced by, for example, existing cash balances, other liquid financial assets, and assets held for sale. This approach was used for the analyses, both on the aggregated level and in the sector-specific observations. We have presented the following sectors separately in the analysis: • • • • •

Consumer Goods Life Sciences and Healthcare (LSHC) Technology, Media, and Telecommunications (TMT) Energy, Resources, and Industrials (ERI) Financial Services (FSI)

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Only for the “Financial Services” sector, we did deviate from the described procedure, for cases of banks and insurance companies. We prorated the financial assets and interest-bearing liabilities directly to operating activities. Thereby we took the implicit assumption that, provided there are no minority interests in excess of this to consider, the value of the company as a whole is equal to the value of the equity capital, i.e., the purchase price. With the exception of the Financial Services sector, in order to derive total enterprise values, we applied the purchase prices as the fair value of equity and increased these by the cumulative fair values of net financial liabilities.

3.3

General Results

In relation to the total enterprise value, the largest percentage is explained by the goodwill acquired in the course of acquisitions, which averages around 45% across all industries, as shown below. From the perspective of the market as a whole, a further share of around 36% of the total enterprise value of each acquired company is accounted for by identified intangible assets. Hence a residual share of just 19% remains for any other assets and assumed (contingent) liabilities. A slightly different view is shown in Fig. 8. As expected, the distributions that are determined deviate from the aggregated analysis and from the detailed analysis due to its having a different number of company transactions. Nevertheless, goodwill still accounts for the largest share of the total enterprise value at around 43%. The share of identified intangible assets in this reduced sample amounts to a comparable value of around 38%. With regard to the weighting of the individual categories of intangible assets, no clear trend could be identified across all sectors. However, customer-related intangible assets account for the largest share of total enterprise value at around 13%, followed by marketing- and technology-related assets with approximately 9% and 8%, respectively (Fig. 9). With regard to the remaining useful life of the individual intangible assets disclosed, we observe a very broad range on a case-by-case basis, ranging from one year to an infinite life, depending on the intangible asset. However, if we look at the medians of the respective minimum and maximum values, it can be observed that for marketing-related and customer-related intangible assets these lie within very comparable ranges of between 5 to 15 years and 6 to 15 years, respectively (Table 1). A comparable maximum term can also be observed in the median for contractrelated intangible assets. The remaining useful lives of technology-related intangible assets are shorter, with a median of 3–8 years, but in view of the comparatively long remaining useful life of these intangible assets, longer-term burdens on earnings can nevertheless be assumed. Considering the material significance of these intangible assets that was uncovered in the course of the purchase price allocation, corporate decision-makers

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Fig. 8 Breakdown of the assets across all sectors

should, therefore, take the expected value effects into account as early as possible, ideally in the initiation phase of the transaction.

3.4

Sectoral Results

In addition to the analysis of the overall market, an evaluation was also made for the sector-specific breakdown of tangible and intangible assets acquired and (contingent) liabilities assumed. The following sector classification was chosen to define the sectors considered separately: • • • • •

Consumer Goods Life Sciences and Healthcare (LSHC) Technology, Media, and Telecommunications (TMT) Energy, Resources, and Industrials (ERI) Financial Services (FSI)

Fig. 9 Intangible assets and categorization

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Intangibles in Different Industries Table 1 Remaining useful life with respect to classes of intangible assets

Intangible assets Technology-related Contract-related Customer-related Marketing-related

127 Remaining useful life (years) 3–8 2–17 6–15 5–15

Similar to the procedure used for the overall market, for the above five sectors we also made a distinction between transactions with usable reporting and those with categorized reporting. To round off the sector-specific analysis, we discuss the key value drivers of each sector.

3.4.1

Consumer Goods

The consumer industry includes the suppliers and providers of all types of consumer products, automotive, transportation, and hospitality as well as distributors such as wholesale and retailers. The performance of the consumer industry is largely determined by its ability to utilize marketing-related intangibles to consolidate its current customer base and to win new customers in a competitive market. The customer base, a key intangible success factor, is supported by an attractive product portfolio and the brand, which is an intangible itself. The visibility and popularity of the brand is primarily determined by the company’s marketing, which considers and guides the brand through constant changes. These changes are driven by changes in consumer needs such as the transformation to digitalized customers or the desire for sustainable and environmentally conscious consumption.3 Furthermore, the marketing of multinational enterprises in the consumer sector is challenged by demographic shifts and the consumption pattern. The increase in economic output in the emerging markets has also led to an expansion of the global middle class, resulting in greater diversification of consumer needs. Modern marketing must build a global brand for the international market while staying in touch with the local consumer. This trade-off between global and local is one reason why multinational companies are shifting marketing services to foreign subsidiaries, to be more responsive to local trends. Not least as great a challenge as marketing a global brand is content marketing across various channels such as print, internet, outdoor advertising, television, and social media. In particular, social media has become increasingly important in recent years. Platforms like Facebook, YouTube, and Instagram reach millions of people today and offer scope to implement the latest forms of marketing.4 Companies place and sell their products within 3

See Chatterjee et al. (2010). See Saravanakumar and Lakshmi (2012), Social Media Marketing. Life Science Journal 2012; 9 (4).

4

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these social networks and monitor their success through customer journey analyses that provide an overview of customers’ purchasing processes, or they even develop a new product together with customers. In general, marketing activities contribute a great deal to the value and visibility of a brand and therefore represent a key performance driver in the consumer industry. However, the success and responsivity of these marketing activities depend to a large extent on the structure of the supply chain. Only an integrated, highly efficient, and agile supply chain enables companies to react to market trends and reliably satisfy consumer tastes. Big data analytics, automated production, and digital performance management are key terms that symbolize a variety of new techniques that are used in the context of Supply Chain 4.0 and aim to increase the operational efficiency and agility in performance and order management, planning and physical flow management.5 Apart from the operational design of the supply chain, a superior supply chain strategy ensures long-term supply stability and high levels of customization and flexibility in response to external factors. For instance, volatile input costs and political instability can result in costly delivery failures. Hence, contractrelated intangible assets such as a broad network of producers and transport service providers secure sourcing flexibility. To sum up, following the realization that the success of a company depends to a large extent on its ability to expand and retain a customer base through active brand management, a tight integration of state-of-the-art marketing with modern, flexible, and responsive supply chains are nowadays considered essential for company success in the consumer industry. In the consumer sector, around 47% of the total enterprise value is attributed to acquired goodwill. Intangible assets account for a further 34%. Among the intangible assets, marketing-related assets account for the lion’s share with around 21%, followed by contract-related and customer-related intangible assets with around 8% and 5%, respectively. Technology-related assets are of only minor importance to this industry. The relatively high importance of brands (corporate and product brands) compared to other industries is also reflected in their remaining useful lives, the majority of which were assumed to be infinite in the transactions examined (Fig. 10).

3.4.2

Life Sciences and Healthcare (LSHC)

The Life Sciences and Healthcare sector comprises research-oriented fields such as pharmaceuticals, medical technology, and biotech as well as care-oriented specializations such as hospitals, care, and rehabilitation facilities. The development of the Life Sciences and Healthcare industry is heavily dependent on intangible assets. Apart from marketing-related intangible assets such as marketing-related and customer-related assets such as medical practices, hospitals, and nursing facilities,

5 See Ivanov et al. (2019). The impact of digital technology and Industry 4.0 on the ripple effect and supply chain risk analytics. International Journal of Production Research, 57(3), 829–846.

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Fig. 10 Relative significance of asset categories in the consumer sector

technology-related intangible assets like patents make a large contribution to the overall enterprise value. The current portfolio of drugs and therapies only remains profitable as long as these products are protected by patents or licenses. When the patent protection of a drug or therapy expires, competitors enter the market with generic products that are similar in composition to that of a product on the market that is registered as a trademark. The market entry of a generic drug is often associated with a drastic decrease in prices and sales.6 Hence, such patents and licenses can be considered the most valuable intangible asset for companies in the Life Sciences and Healthcare sector. The development of a particular drug can be divided into five phases.7 After drug approval by public health authorities like the Food and Drug Administration (FDA) in the USA and the European Medicines Agency (EMA) the sales increase gradually (pre-peak growth phase) until they reach a peak. After reaching their peak, sales usually remain constant with only minor fluctuations (plateau phase). The length of this phase depends on the duration of patent protection and the complexity of the drug. The formulation of some drugs is so complex that the expiration of a patent does not lead to an immediate decline in sales, because competitors are not able to offer a generic alternative quickly, due to the complex and costly development required. However, in most cases, the 6 7

See Drukarczyk and Ernst (2010). See US Food and Drug Administration (FDA) (2018b). The Drug Development Process.

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expiration of the patent leads to a decrease in sales following the market entry of alternative formulations or generics. According to the standard terms of patents in the USA and Europe, patents generally last for 20 years.8 However, this period is different from the period in which the drug has market exclusivity. The timeframe is often halved to 10 years by the extensive approval tests required by the FDA and EMEA. This result underlines the fact that companies in the Life Sciences and Healthcare industry cannot rely on their technology-related intangible assets, like patents, because they will expire at some point in time. Therefore, such companies find themselves in a situation in which they have to constantly “reproduce” intangible assets by investing in R&D. For this reason, expenditure in R&D is considered a key performance driver as it creates the basis for future patents and new products. However, this process is far from routine. Investments in R&D are associated with high risks of failure because drug approvals underly strict requirements. The drug approval cycle consists of three phases. Phase I focuses on the safety and pharmacology aspects and marks the start of clinical trials. Phase II studies evaluate the effectiveness of the compound, whereas in the Phase III studies physicians test the drug on a larger number of patients to see whether efficacy and safety can be confirmed by many different patients.9 Interactions with other drugs are also investigated in this final phase. According to Wong et al. (2019), only 13.8% of new drugs pass all three phases and obtain market approval.10 A wide product pipeline is another important key performance driver as it reflects the competitiveness of the company in the future. As the development of new drugs usually tsakes on average between 7 and 12 years,11 it is crucial for the company to have a large number of products at different development stages of the approval process, in order to secure the company’s earnings in the long run. When assessing the product pipeline, the number of products in Phase III is particularly important. The greater this number, the more likely it is that products will be ready for the market in the near future. Besides the time to market, the market potential with respect to therapeutic areas in the portfolio, such as oncology or diabetes, is also important for the overall profitability. A Deloitte UK study (2017) investigated the return of investment (ROI) of biopharma companies.12 The report shows that the costs to bring an asset to the market increased over the last decade from $1,188 billion in 2010 to $1,992 billion in 2017. The R&D return on investments decreased from 10.1% in 2010 to 3.2% in 2017. To sum up, companies in the Life Sciences and Healthcare industry are faced with an uncertain, costly, and time-consuming process of creating new long-term

8

See FDA and CDER SBIA Chronicles (2015). See US Food and Drug Administration (FDA) (2018a). 10 See Wong et al. (2019). 11 See Van Norman (2016). 12 See Steedman et al. (2018). 9

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intangible assets. The risky process of inventing new drugs and therapies is often supported by strategic alliances and partnerships. These strategic alliances range from simply structured licensing agreements to complex and long-term mergers and acquisitions. In general, the companies, academic institutions, and industry benefit from these alliances as a whole, as they often make the research process more costeffective and efficient. Strategic alliances have the advantage that the R&D risk is borne by several parties, which make failures less of a burden, but strategic alliances also bear the risk of an unintended transfer of technological knowledge. Such spillovers can jeopardize the success of the creation of new intangible assets in the form of new patents and products. Due to the high risks, rising R&D costs, and scarce resources, the networks between companies, academic institutions, and government organizations are also considered intangible assets essential for a company’s success. In the Life Sciences and Healthcare sector, intangible assets are comparatively important, accounting for around 52%. This is mainly due to the high proportion of technology-related intangible assets, which account for 27% of hidden reserves. These consist mainly of research and development projects and (un)patented technologies. In addition, the brand and existing customer relationships also play an important role. Considering the comparatively short remaining useful lives of technology-related assets, it can be concluded that purchase price allocations in the Life Sciences and Healthcare segment are expected to have both material effects on the balance sheet and effects on income, in the form of comparatively high depreciation and amortization of the acquired company, at least in the short and medium term. The high level of goodwill in this sector can largely be explained by the cautious valuation of products that are not yet fully developed so that a large part of future expectations is included in goodwill (Fig. 11).

3.4.3

Technology, Media, and Telecommunications (TMT)

The Technology, Media, and Telecommunications sector is a very dynamic industry consisting of technology companies that include internet services, e-commerce, and advertising as well as media companies such as publishing, television, and telecommunications companies. In addition to technology-related intangible assets, customer-related assets contribute in particular to the success of companies in this sector. For instance, telecommunications companies generate a large part of their revenues from monthly paid mobile and internet contracts. Furthermore, subscribers and advertising customers are key drivers for the business success of media service providers and the newspaper industry. While companies in the Consumer Goods industry mainly attract customers by building up a renowned and valuable brand, companies in the TMT sector catch customers’ attention by providing quality content and services. While subscriber models have the ability to “lock up” customers with long-term contracts for a certain

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Fig. 11 Relative significance of asset categories in the Life Sciences and Healthcare sector

time, they must remain attractive to retain these subscribers after the end of the contract period and to acquire new subscribers. For example, if we consider the “battle” among streaming portals such as Netflix, Amazon Prime, and the like, the business success of these companies depends strongly on their respective portfolio of movies and series. Exclusive rights to show a film or a series attract new subscribers and strengthen the existing customer base. Since these rights require very high payments to the author or copyright holder, streaming companies are increasingly investing in their own productions. In so doing, contract-related IPs like contracts with film production studios, actors, and directors are getting more and more important for streaming providers. Nonetheless, the services offered, in this case movies and series, are only as successful as they fulfill consumer preferences. Therefore, companies in the TMT sector in general, and streaming providers in particular, have to see themselves not only as simple providers of media but above all as data-collecting companies that process and analyze customer data with the help of algorithms and other big data technologies, in order to derive an innovative product portfolio that meets customer preferences. Strategies such as multi-channel digital marketing and flexible subscription pricing support the maintenance of customer relationships. From this point of view, the knowledge and methods of data analysis itself can be considered a value driver as the value of the data can only be as high as the underlying analysis technique allows. In this regard, Sridhar and Fang (2019) conclude that in the last

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decade marketing strategies have evolved rapidly toward the digital and data-rich.13 Furthermore, technology-related assets play an important role on the customer side as well. An appealing website design, an intuitive user interface with a lean process workflow, or a meaningful connection of different services of the same provider can increase customer usability and goes hand in hand with the actual service provided. Often these points can make a remarkable difference when it comes to competitive advantages even though they affect the business core services. In the TMT sector, customer-related intangible assets account for the lion’s share of the intangible assets identified, at around 43%. Taking a business model into account that is driven primarily by customer relationships with subscribers and advertising customers, this seems very understandable. Goodwill is of significant importance for technology, media, and telecommunications companies, accounting for around 58%. This implies that investors in companies in this sector have more than average growth expectations. In the LSHC and TMT sectors, their large proportions of goodwill tend to have a lower impact on earnings, but this is offset by higher risks from possible goodwill impairments. With regard to the effects on earnings that can be expected, it is hardly possible to make reliable statements, due to the wide range of customer terms, according to our evaluation, these are in the median range of 6–15 years. However, it should be noted that due to the comparably high proportion of goodwill there is a lower impact on future earnings, but this is associated with a higher risk of possible goodwill impairment (Fig. 12).

3.4.4

Energy, Resources, and Industrials (ERI)

The ERI sector comprises a broad range of companies from industrial product manufacturers, oil, gas, and chemical companies, to power producers and electricity grid operators. What companies in this sector have in common is that tangible assets account for a disproportionately large share of their value added. This follows mainly due to their highly technology-driven and especially capital and raw material-intensive production processes. Aluminum smelters, for example, are highly dependent on the functioning of their smelting plants, which is only guaranteed by a constant supply of aluminum ores and a stable supply of electricity. Therefore, competitive advantages are primarily achieved through an efficient design of the production process and along the supply chain and by economies of scale, which are reflected in low unit costs. Other important performance drivers are location factors, which can be divided into hard factors such as infrastructure, access, and costs of production and soft factors such as the economic climate and the availability of skilled workers. Location factors provide the economic framework for the customer-related and

13

See Sridhar and Fang (2019).

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Fig. 12 Relative significance of asset categories in the Technology, Media, and Telecommunications sector

contract-related assets described below, as they influence the proximity of customers, suppliers, and competitors and thus directly affect delivery costs and competitive intensity. This is particularly important for companies in the ERI sector, whose production facilities represent very inflexible assets, at least in the medium term. For example, power supply companies are severely restricted in their choice of location due to their lack of energy storage capabilities.14 Technology-related intangible assets such as patented or licensed manufacturing technologies support the production process and contribute to the performance of the company. However, this contribution is relatively low compared to the strong contribution of patents and licenses in the Life Sciences and Healthcare industry. More important intangible performance drivers for ERI are customer-related assets, such as the customer base, consisting of downstream suppliers or wholesalers, and in addition contract-related assets. Contract-related assets can occur in a variety of different ways for a company in the ERI sector. Firstly from long-term supply contracts with, for example, raw material suppliers and/or upstream manufacturers, which improves the long-term production and cost planning by ensuring the supply of raw materials or intermediate goods at fixed prices over a longer period. The determination of prices and quantities often takes place as part of annual 14

See Drukarczyk and Ernst (2010), p. 402.

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price negotiations between the supplier and intermediary manufacturer. Having a broad and reliable upstream contractual network reduces uncertainty and the risk of losses due to delivery failures and production stops and this can be regarded as an important competitive advantage and performance driver. Secondly from sales contracts on the demand side, for example, with downstream manufacturers, intermediaries, or grid operators who guarantee the acceptance of manufactured goods at fixed prices. Contracts on the demand side reduce uncertainties in the sale of goods and thus help, for example, with inventory planning and profit forecasting. The value of the contract network, both on the supply side and on the demand side, depends very much on the upstream and downstream competitive situation and the associated market power. Upstream contracts with suppliers of a key technology are regarded as particularly valuable. Another particularly valuable type of contract or license is one that includes a territorial or temporal exclusivity of use or provision of goods and services.15 Examples are the networks of electricity network operators or the transportation pipelines of petroleum and gas producers that are subject to strict government requirements. However, these contracts very often hold the potential for market exclusivity. This is because the high investment required makes market entry by more than one company neither profitable for the company nor desirable for the government. In the case of energy and utility companies or for manufacturing companies, the value shares allocated to residual goodwill (around 37%) and intangible assets (35%) are relatively low. In contrast, the share of other tangible assets and assumed (contingent) liabilities (around 37%) is well above the market average (around 19%). This can be explained by the fact that for the companies in the Energy, Resources, and Industrials Sector, tangible assets are key value drivers, particularly those for production facilities and networks. Contract-related assets account for the largest share of intangible assets (around 14%), most of which consist of purchase and offtake agreements. As intangible assets are of subordinate importance to this sector, only manageable effects from purchase price allocations in the annual company results may be expected when longer-term contracts are taken into account (Fig. 13).

3.4.5

Financial Services (FSI)

The Financial Services (FSI) sector is made up of the four subsectors that include banking and capital markets, insurance, investment management, and real estate.16 What these industries have in common is that a large part of each company’s success depends on maintaining and expanding its customer base. Similar to the consumer industry, the sales of services and goods generates revenues and profits, but unlike

15

See Drukarczyk and Ernst (2010), p. 402. See https://www2.deloitte.com/de/de/industries/financial-services.html?icid¼top_financial-ser vices [accessed: January 9, 2020].

16

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Fig. 13 Relative significance of asset categories in the Energy, Resources, and Industrials sector

the consumer industry, especially the fast-moving consumer goods sector, long-term customer relationships are, according to our analyses, even more important intangible assets than marketing-related assets, such as brands. On the customer side, the acquisition of services or the conclusion of contracts with companies in the FSI sector are usually characterized by a long-term and trustworthy relationship. According to our surveys, these customer relationships last an average of ten years, which is also attributable to the comparatively high switching costs, such as when changing bank accounts or the sunk costs that are abandoned when switching between occupational disability insurances. However, traditional financial services providers cannot rely on “locking their customer in” because the digitalization of business models and the market entry of new “fintechs” in the past few years has led to a reduction in switching costs, which has increased the mobility of customers.17 Companies in the FSI industry, therefore, have to convince with innovative portfolios of products and services to win new customers and to stabilize the existing customer base.18 This challenge is amplified by changing consumer demands. Digitalization, and in particular the emergence of online comparison portals, has led to greater market transparency and the opportunity for consumers to find out more about financial services themselves. For example, the 17 18

See Pousttchi and Dehnert (2018). See Domazet et al. (2010).

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majority of those interested in switching a bank account will now search for information online in addition to seeking local advice from a bank customer advisor and even assemble a service and product portfolio to suit their own preferences. Financial service companies have responded to this trend by developing their product portfolios in a modular way, enabling customers to meet their needs by creating individual portfolios. Wisskirchen et al. (2006) identified modular service offerings as one of “six imperatives” to win new customers in the banking sector.19 Another area that is increasingly involving customers personally in the company’s processes is customer service. Customer self-service options allow customers to perform certain services at any time, from any location and on any device, which satisfies customer needs for greater availability, time savings, anonymity, and ease of use.20 These services lead to higher perceived transparency on the customer side and at the same time to a reduction of costs on the company side, because customers actively maintain their own customer information, for example. On the marketing side, omnichannel management in particular is an important technique for reaching customers at any time across various channels and for offering them individual products with intensive use of customer information. This allows financial service providers to gain competitive advantages from data-based evaluations of monthly cash flows on bank accounts, which can be used to advise customers, such as about insurance or mobile phone contracts. In order to further meet the needs of digitalized customers and to face the rising cost pressures, contract-related IPs such as cooperations between traditional financial service companies and fintechs that are revolutionizing parts of the industry with new approaches, such as contactless payment, online platforms, and predictive analytics, are currently very valuable assets for financial service companies. However, in the long run, these companies can only survive the competition if they develop their own digitalization strategies and manage to build up their own “digital departments” that can develop and implement modern technologies like machine learning.21 In particular, methods based on the use of (big) data like forecasting, which supports the companies in making more accurate risk assessments or to manage their product and service portfolio more efficiently, are key performance drivers in the FSI sector. Purchase price allocations of corporate transactions in the financial services sector have the lowest impact on earnings in terms of value. Our surveys show that both the share of goodwill and the share of disclosed intangible assets are significantly below the overall market, at 29% and 26%, respectively. The largest share of the company’s total value, at around 45%, is accounted for by other assets and (contingent) liabilities, which mainly consist of credit volumes, securities, and trading assets or liabilities (Fig. 14).

19

See Wisskirchen et al. (2006). See Edmondson (2016). 21 See Gargiulo (2018). 20

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Fig. 14 Relative significance of asset categories in the Financial Services sector

With a share of 20% of the total enterprise value, customer relationships are the most important. In our opinion, this should also be seen in the context of existing longer-term client relationships in the financial services sector, which, based on our survey, average around 10 years. Consequently, the effects on earnings that result from a purchase price allocation should be below average in the Financial Services sector.

4 Final Remarks To assess fair market values of intangibles for transfer pricing purposes it is not only important to choose the appropriate valuation method and the sufficient documentation. It is also important to support the narratives and numbers as well as methods with a benchmarking of public reported fair values of intangibles. The result of an empirical analysis of reported fair values of intangibles, which we presented in this chapter, combined with a brief discussion of sector-specific value drivers should help the reader to perform own plausibility analysis to support fair market values of intangibles.

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Acknowledgements We highly appreciate the support of Jürgen Lang and Michael Konermann for providing some thoughts about PPA and the support of Data Collection and analysis for this chapter.

References Chatterjee, I., Küpper, J., Mariager, C., Moore, P., & Reis, S. (2010). The Decade Ahead: Trends that will Shape the Consumer Goods Industry. McKinsey & Company, 1(1), 1–18. Deloitte Centre for Health Solutions. (2017). A new future for R&D? Measuring the return from pharmaceutical innovation 2017. https://www2.deloitte.com/content/dam/Deloitte/uk/Docu ments/life-sciences-health-care/deloitte-uk-measuring-roi-pharma.pdf Domazet, I., Zubović, J., & Jeločnik, M. (2010). Development of Long-term Relationships with Clients in Financial Sector Companies as a Source of Competitive Advantage. Bulletin Universitǎţii Petrol-Gaze din Ploieşti, 62(2), 1–10. Drukarczyk, J., & Ernst, D. (2010). Branchenorientierte Unternehmensbewertung (3rd ed.). Munich: Vahlen. Edmondson, D. (2016). Is the Banking Customer Experience Really Being Served by Self-service Banking? Accenture Article. Retrieved January 09, 2020, from https://bankingblog.accenture. com/is-the-banking-customer-experience-really-being-served-by-self-service-banking FDA and CDER SBIA Chronicles. (2015). Patents and Exclusivity. FDA/CDER SBIA Chronicles, May 19. Gargiulo, D., Oguz. T., & Pinto, V. (2018), For US Banks: A Time for Transformation. McKinsey & Company. Retrieved January 13, 2020, from https://www.mckinsey.com/industries/financialservices/our-insights/for-us-banks-a-time-for-transformation# Ivanov, D., Dolgui, A., & Sokolov, B. (2019). The Impact of Digital Technology and Industry 4.0 on the Ripple Effect and Supply Chain Risk Analytics. International Journal of Production Research, 57(3), 829–846. Pousttchi, K., & Dehnert, M. (2018). Exploring the Digitalization Impact on Consumer DecisionMaking in Retail Banking. Electronic Markets, 28(3), 265–286. Saravanakumar, M., & Lakshmi, T. (2012). Social Media Marketing. Life Science Journal 2012, 9 (4), 4444–4451. Sridhar, S., & Fang, E. (2019). New Vistas for Marketing Strategy: Digital, Data-rich, and Developing Market (D3) Environments. Journal of the Academy of Marketing Science, 6(47), 977–985. Steedman, M., Stockbridge, M., Shah, S., Taylor, K., Korba, C., & Thaxter, M. (2018). A New Future for R&D? Measuring the Return from Pharmaceutical Innovation 2017. Deloitte. U. S. Food and Drug Administration (FDA). (2018a). Step 3: Clinical Research. Retrieved January 08, 2020, from https://www.fda.gov/patients/drug-development-process/step-3-clinicalresearch U. S. Food and Drug Administration (FDA). (2018b). The Drug Development Process. FDA, April 1. Retrieved March 03, 2020, from https://www.fda.gov/patients/learn-about-drug-and-deviceapprovals/drug-development-process Van Norman, G. A. (2016). Drugs, Devices, and the FDA: Part 1: An Overview of Approval Processes for Drugs. JACC: Basic to Translational Science, 1(3), 170–179. Wisskirchen, C., Vater, D., Wright, T., De Backer, P., & Detrick, C. (2006). The Customer-led Bank: Converting Customers from Defectors into Fans. Strategy & Leadership, 34(2), 10–20. Wong, C. H., Siah, K. W., & Lo, A. W. (2019). Estimation of Clinical Trial Success Rates and Related Parameters. Biostatistics, 20(2), 273–286.

The Miracle of Brand Value Creation: Where Does the Value Come From? Anton Nagatkin, Roman Kral, and Janine Stockmeier

What Will the Reader Learn? • How a DEMPE analysis for a brand can be performed • What constitutes brand value • What the key functions of a brand are

1 Introduction With the launch of the iPhone, announced in January 2007, Apple unilaterally created the smartphone industry, which led to the rise of Apple as one of the undisputed leaders in the technology industry. On August 8, 2018, Apple hit a market capitalization of $1 trillion, which made it the first company to quote above the “magical barrier” and became the most valuable company in the world. At roughly the same time, Interbrand (2018) valued the brand name “Apple” at $214.5 billion in its study “Best Global Brands 2018,” yielding for the brand a share of about 21.5% of the entire enterprise, making the brand the most valuable intangible asset owned by Apple, by far.1 This story about Apple illustrates that the topic of brands is of increasing relevance for both decision-makers of international enterprises and economic 1

Other values for the Apple brand were determined in comparable reports, e.g., Forbes. However, the value quoted remains within the available estimates. A. Nagatkin (*) Deloitte, Nuremberg, Germany e-mail: [email protected] R. Kral · J. Stockmeier Deloitte, Munich, Germany e-mail: [email protected]; [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_8

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research alike. But what are the factors that actually have an impact on the value of a brand? In this chapter, we examine this question from a functional point of view. We have identified three main functions of a brand that have an influence on the decision-making processes of customers. In particular, we discuss how these brand functions create value by having a positive effect on the purchasing decision of a customer for a certain product. If these brand functions are well established, they can contribute to higher sales volumes and/or premium prices for a product or service, thereby creating additional brand value. Hence, they also influence the price a third party would pay for brand licenses and purchases. In this respect, we would like to point out that this chapter only covers the qualitative aspects of brand value creation and does not discuss any quantitative brand valuation methods. It is important to take the market environment of a brand into account when analyzing its main functions and other value-creating factors. The following discussion focuses on the most relevant factors and examines their impact on both types, namely Business-to-Consumer (“B2C”) products and Business-to-Business (“B2B”) industrial goods. This differentiation is necessary and of special interest, as certain aspects in the processes of a purchasing decision differ between these types.2 Empirically, there is evidence that a highly recognizable brand plays a more important role in the purchasing decision in the B2C market. This statement is widely discussed, but brand significance does seem more controversial in the B2C market. Kotler and Pfoertsch (2007) state that branding is in fact relevant in the B2B market as well. IBM General Electric, Boeing, Siemens, and SAP serve as examples of some of the strongest B2B brands. Kotler also sees a broader audience for B2B brands than for B2C brands: “Another important aspect of B2B branding is that brands do not just reach your customers, but all stakeholders—investors, employees, partners, suppliers, regulators, and members of your local community.” Before discussing the differences between brand values in B2C and B2B markets, we first provide the relevant concepts and definitions in the following.

1.1

The Concept of Brands

According to Aaker (1991): “A brand is a distinguished name and/or symbol (such as a logo, trademark, or package design) intended to identify the goods or services of either one seller or a group of sellers, and to differentiate those goods or services from those of competitors. A brand thus signals to the customer the source of the product and protects both the customer and the producer from competitors who may attempt to provide products that appear to be identical.” As the difference between a brand and a trademark is rather of a legal nature, we will use both terms synonymously for the purpose of this assessment.

2

Backhaus and Voeth (1999).

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Brand Value Versus Brand Equity

In order to gain a better understanding of value-creating factors for brands, the terms brand equity and brand value need to be distinguished. While the determination of brand value from a company’s point of view mainly relies on financial figures, the determination of brand equity from the customer’s point of view mainly relates to the perception of a brand.3 This differentiation emphasizes the circumstances under which the value added by a brand can be analyzed from two different perspectives, namely the customer’s perspective and the company’s perspective.4 In this regard, it is important to note that brand equity significantly affects brand value, because the greater willingness of customers to pay a premium for a certain brand positively affects the financial outcomes of a company. Thus, this chapter investigates further the concept of brand equity and how it helps create brand value. As a next step, in order to understand why well-established brands might encourage customers to pay more for a branded product, it is important to understand first what functions brands might have and how these functions may contribute to the value of the brand by affecting the purchasing decision of customers.

1.3

Functions of Brands

According to Leek and Christodoulides (2012), functional and emotional qualities drive brand equity. The customer evaluates functionally the quality of the product or service, the price, the superior technology, the innovation and/or after-sales services, whereas emotional evaluations are driven by other factors: such as differentiation, promise, trust, credibility, reliability, and reputation of the product that spill over to the customer. Hence, when the functional qualities of two brands are equal, the customer will base his purchasing decision on emotional qualities, individually attributed to the two brands by the customer. In the following, we will describe the three major brand functions that influence the purchasing decision of a customer in a more detailed fashion.

1.3.1

Information Cost Reduction

Economically, a brand is valuable when customers are willing to pay more for the reduced information costs, i.e., they are willing to save their time in return for the price premium the brand demands. In the case of this function, brands act as a summary of information for the customer, especially in cases where brands are 3 4

Keller (1993). Leek and Christodoulides (2012).

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superficial, i.e., they are familiar and recognizable, providing associations with attributes that the brand stands for.5 Valuable brands can reduce the information costs in the customer’s purchasing decision process, especially when it comes to homogenous goods. Valuable brands can simplify or accelerate this process. That means that relying on a brand when making purchasing decisions for homogenous goods will involve lower costs, in terms of time and effort, than would be incurred by evaluating the individual product attributes.6 During the purchasing decision process, valuable brands can help expedite matters by giving the customers orientation with regard to attributes of the products that they associate with the brand, e.g., quality, service, and durability.

1.3.2

Risk Reduction

The second main function that affects the customer’s purchasing decision is that of risk reduction because choosing a brand can reduce the customer’s risk of making a wrong purchasing decision.7 The function of brands for risk reduction is highly connected with their function of information cost reduction and hence if wellestablished they positively influence the purchasing decision. One of the aspects a customer will incorporate into a purchasing decision is whether the products are of high quality and therefore unlikely to fail. Customers are rarely able to obtain all the relevant information about the quality of a product, e.g., regarding durability. As such, they might rely on certain indicators to make predictions about its potential quality. Typical indicators in this regard include the price, country of origin, and impression of the brand.8 From a customer’s point of view, it is rational to expect a product of a highly recognizable brand to be of high quality and the risk of making a wrong purchasing decision to be accordingly low. Companies generally make significant investments in establishing their brands and therefore have a strong intrinsic motivation to satisfy their customers’ expectations. Since any failure to do so might decrease the reputation of the brand and accordingly reduce the positive associations of risk reduction on the customer’s side. As a result, any decrease in reputation might reduce the brand premium that customers are willing to pay, which consequently reduces the profits the brand can generate, thus reducing its value.9

5

Loken and John (1993), Zeithaml (1988). Backhaus et al. (2011). 7 Caspar et al. (2002). 8 Agarwal ad Teas (2001). 9 Keller and Lehmann (2006). 6

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Table 1 Overview of the three functions of brands Function Information cost reduction Risk reduction Symbolic meaning

1.3.3

Description Brand reduces information costs in the purchase decision process by offering recognition and orientation among a variety of offers Brand reduces the customer’s subjective risk of making a wrong purchasing decision and creates trust Brand provides additional emotional and experience-related value to the customer, by contributing to self-expression and self-fulfillment

Symbolic Meaning

The term symbolic meaning refers to the circumstance in which brands can provide additional emotional and experience-related value to the customer.10 This additional value can either face outward or inward. The additional value faces outward when the brand enhances the self-expression of the buyer toward others, for example, with luxury clothing brands. By contrast, the additional value faces inward when the brand contributes to self-fulfillment and/or corresponds with the personal values of the buyer, i.e., the associations with a brand align with the mindset of the customer. For example, certain global brands might communicate that the owner of the brand has an open, liberal mindset and wants to show this to others.11 Table 1 below summarizes the main functions of a brand.

2 Definition and Differentiation between the B2C and B2B Market As indicated in the introduction, the relevance of a brand generally differs across product markets. Product markets can be divided into the consumer goods market (B2C) and the industrial goods market (B2B). Purchasing decisions differ in both these product markets.12 The obvious difference between these two markets lies in their target groups. In the B2C market, the target group affected by a brand is the end-consumer who buys a certain consumable good. Whereas in the B2B market, the target group are industrial or service companies and public sector organizations buying an investment or for materials or services to support production. The key differences between the B2C and the B2B market are summarized in Table 2.

10

Kemper (2000). Steenkamp (2014). 12 Backhaus and Voeth (1999). 11

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Table 2 Key differences between the B2C and the B2B markets Target group Relevant goods Business partners

B2C market End-consumer • •

Consumables Services

Consumers, distributors, retailers (Consumer trade)

B2B market Industrial or service companies and public sector organizations • Investment goods • Production materials • Commercial services Supply chain companies (Production trade)

While brands obviously have a significant influence on the decision-making process for consumer goods, a brand may be less relevant in the decision-making process for industrial materials.13 Apart from the diverse characteristics of the B2B and B2C markets, the relevance of a brand for the customer’s decision-making process also highly depends on the degree of individuality of the product. Generally, brands do not play a major role with products that require a high level of customization, as the functional characteristics of this type of product are the main criteria that influence the customer’s buying decision.14 However, commodity products that are more homogenous with regard to their characteristics and prices may achieve a competitive advantage from their brand. Therefore, especially in highly competitive commodity markets, the supplier may influence the customer’s decision by having a strong and stable brand. Hence, a brand can generate value for a company, provided it is able to influence the purchasing decision of the target group, i.e., when it is relevant for the purchasing-decision process of customers in either the B2C or B2B markets. As shown in the introduction brands play an important role, both from company and customer points of view. However, before focusing on the brand value drivers of the previously described brand functions, we first characterize the market conditions of the B2C and B2B markets.

2.1

Market Conditions in the B2C Business

In the B2C market, companies face the following conditions, among others:15 • Purchasing decisions are predominantly the individual decision of the end-consumer. • Market contacts are often anonymous. • Large offers often trigger a crowding out of the competition. • Mass production (Kemper 2000) and standardized solutions. 13

Caspar et al. (2002). Leek and Christodoulides (2012) 15 Caspar et al. (2002). 14

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More specifically, these days technical advantages can be copied faster than in the past. Many providers offer similar products and services and thereby become increasingly similar, leading to standardized solutions. This tendency is intensified by implementations of enforced standards (e.g., in the EU), which further drives standardization. Standardization forces providers to use alternative possibilities to differentiate, such as brand strategies. The number of possible suppliers is increasing, due to globalization, deregulation, and liberalization, particularly in attractive sectors. Also competitive behavior is shifting, due to increases in fixed costs in proportion to total costs. Both these developments lead to increased price pressure, as customers are not willing to pay a price premium for a product they can easily substitute with a product of another company. Moreover, the use of brand strategies in a targeted manner is increasingly recognized as a lever to control demand preferences. For the reasons stated above and also due to the growing use of modern information and communication technologies (e.g., online shops, etc.), the relationship between customers and companies tends to be less personal than it is in the B2B market. This results in a compulsion to create something other than a personal relationship between the customer and the company to support the purchasing decision. One way a company offering products can achieve this is by evoking a personal relationship between the customer and the product itself with the brand strategy.

2.2

Market Conditions in the B2B Business

Although amongst the most valuable brands one will find many B2C brands, there are also some well-known B2B brands, such as IBM, Intel, General Electric, Cisco, Oracle, and SAP.16 In the B2B market, companies normally face the following conditions: • • • • •

Organizational demand Rational decision-making processes Limited number of purchasers Highly customized products Supplier dependence on B2C demand

The B2B market conditions differ markedly from those of B2C, e.g., due to differences in the type of demand. Demand in the B2B business is rather organization oriented.17 In the B2B market, buyers make their purchasing decisions on behalf of an organization and not on behalf of themselves. Moreover, formal prescriptions need to be met within the B2B purchasing process. Thus, the demand in the B2B

16 17

Interbrand (2018). Caspar et al. (2002).

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business is considered as more rational, formal, and detached. Often, buying centers consist of a group of people involved in the purchasing process, who calmly make the purchasing decisions.18 That is why the decision process appears more objective and due to this organizational setup impulse buying rarely occurs in B2B.19 In most cases, there is only a limited number of purchasers with B2B. That is why in B2B markets the tendency is to focus on specific customers with specific needs and offerings in the B2B market are usually highly individualized and technically complex. It also explains why business relationships are more important in B2B than B2C, because B2B purchasers are usually closely bound to their supplier due to the complexity and level of customization of their needs. Finally, as part of supply chains for products or services intended for final customers, B2B demand largely depends on demand in the B2C market. In this event, the final product will carry the B2B product’s brand, resulting in what is called ingredient branding (see Sect. 3.2.3).

3 Brand Functions in the B2C and B2B Markets 3.1

Main Functions of a Brand in the Context of the B2C Market

In this section, we will examine the three major functions of a brand in the context of the B2C market and identify which departments of a company contribute to brand value creation.

3.1.1

Information Cost Reduction

The information cost reduction function plays a major role in the B2C market. With homogenous goods and little product differentiation, brands can reduce the cost of the decision process because they effectively bundle information. One example: the brands of one of Germany’s largest grocery stores REWE are “JA!” and “REWE’s feine Welt.” Both of these brands are associated with certain consumer expectations. For example, if customers choose to purchase affordable pasta they can expect that the products of “JA!” will be among the most cost-conscious alternatives with a fair quality. However, if someone is looking for higher quality products the brand “REWE’s feine Welt” is useful as it simplifies the decision process and saves the time of comparing them in detail with other products. This illustration serves as an example of the function of information cost reduction, which is of significant relevance in the decision-making process of everyday purchases like groceries 18 19

Backhaus and Voeth (1999). Kemper (2000).

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because brands provide information about the product in a bundled, efficient way without going into detail about the inherent qualities. For this reason, information cost reduction is an important function for the seller as well as for the consumer in the B2C market. It contributes to the brand value and may result in higher sales figures realized for a brand. The example provided above suggests that it is the product management department of a company that mainly establishes and controls this brand function. The marketing department supports the product management department in this regard, by creating and commercializing the brand through the respective advertising channels in the B2C market. Whether consumers expect high quality or budget product most likely does not depend on rational and objective parameters, rather on a general perception of the brand of the product, especially with regard to homogenous and relatively low-cost products. As product managers are responsible for the strategy, roadmap, and feature definition of a certain product (or group) they need to ensure that they set a product vision and differentiation strategy that delivers unique value, based on customer demands. This includes analyzing the respective market and competitive conditions. As it seems reasonable to assume that the perception of a product is highly influenced by external factors, such as advertising for the brand, the marketing department supports the product management department by mediating its vision and strategy to the customers in the market. Since marketing departments set up advertising campaigns to specifically communicate the attributes and characteristics that are wanted, they correspondingly determine how customers perceive the products of their brands by bundling and presenting the information.

3.1.2

Risk Reduction

As mentioned above, the risk reduction function also affects the purchasing decision-making process and is connected with the information cost reduction function. Accordingly, we observe the risk reduction function of brands in the B2C market on a daily basis. An instructive example is the slogan “Made in Germany” which is associated with high-quality products by customers worldwide.20 Many German companies in different industries directly or indirectly communicate this slogan, satisfying all the mentioned criteria of the risk reduction function. Instead of evaluating every detail of product quality, customers understand “Made in Germany” as a heuristic for their purchasing decision when considering valuable goods and simply trust that this slogan provides them the desired quality attributes. This example shows how brands can create value in the B2C market by reducing the risks of purchasing low-quality products without investing great effort in terms of evaluating all the different products in detail.

20

Damm (1993).

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In contrast to the subjective general perception of a brand and its corresponding function for reducing the information cost, the quality of a product is a more rational and objective feature from a customer’s point of view. Customers will choose branded products because they can rely on them, especially when dealing with durable or investment goods. Especially for R&D, the production and the quality assurance departments have to make sure that the products offered really are of high quality. If they succeed, consumers can rationally expect that the risk of buying a product with this brand is limited. In such cases, a brand with a well-established risk reduction function contributes to a higher brand value.

3.1.3

Symbolic Meaning

The symbolic meaning of brands is also of great significance in the B2C market. While the first two functions create a value by reducing information cost or perceived risk in the purchasing decision-making process, the symbolic meaning of a brand creates value for the customer, especially when using or wearing the product. In this sense, this function increases the perceived value of the product itself. For example, consumers might wear luxury brands or outdoor brands because they want to communicate that they belong to, or want to belong to, a certain group in society. This is the additional value known as outward facing. One example of additional value that is inward facing would be a preference for Italian coffee brands or the famous mocha coffee maker of Italian brand “Bialetti.” Consumers may find it attractive to purchase products of these Italian brands because they associate certain emotional experiences with them or they identify themselves with “the myth of foreign cultural origin.”21 In this context, a brand that is able to fulfill the symbolic meaning function may attract additional customers who identify themselves with specific cultural or grouprelated aspects. Therefore, the value creation coming from such a brand function may result in other customers also having specific consumer preferences and/or a greater willingness to pay for a certain product that incorporates the aspired symbolic meaning. It seems reasonable to assume that the sales and marketing department is the major party responsible when it comes to the symbolic meaning of brands because the way customers perceive a brand is generally subjective and most likely not based on a purely rational decision. Sales and marketing departments can define how customers perceive a brand and what attributes it conveys by creating specific advertisements, setting up sponsorships, and further marketing activities. The actions of the marketing department in trying to define and influence the perception of a brand therefore heavily affect the symbolic meaning of a brand.

21

Steenkamp (2014).

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Table 3 Brand value creation within the B2C market

Function Information cost reduction Risk reduction Symbolic meaning

Corporate departments responsible for brand value creation Product management Marketing department R&D department Production and quality assurance Marketing department

Example Especially for homogenous goods: Germany’s grocery store REWE with brands “JA!” and “REWE’s feine Welt” Quality products with the slogan “Made in Germany” Italian coffee brand “Bialetti”

An overview of the corporate departments that are primarily responsible for brand value creation in B2C and the examples described are summarized in Table 3.

3.2

Main Functions of a Brand in the Context of the B2B Market

At first sight, branding may not appear to play as important a role in B2B as it does in B2C. Marketing has focused its research on B2C and thus has neglected the role of brands in the industrial materials business for a long time. However, due to the increasing homogeneity of products and services, increasing price pressure and complexity, as well as increasing digitalization that removes the necessity for personal relationships by its anonymity, brands may be able to counteract this development by creating relationships, stability, and reliability,22 even with B2B. For that reason, we can conclude that brands are also a matter for the B2B segment.23 However, the value drivers in B2B likely differ from the value drivers of B2C due to the differences in their types of demand. We next examine the three major functions of a brand as they relate to the B2B market and identify which departments of a company mainly contribute to brand value creation by using the examples in the previous section.

3.2.1

Information Cost Reduction

Contrary to B2C, experts have often argued that due to the rather organizational demand in B2B, product characteristics such as quality play a key role when

22 23

Caspar et al. (2002). Kotler and Pfoertsch (2007).

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purchasing a product or service. Hence, the functional qualities appear to be crucial factors for the buying decision in the B2B market. Given the organizational purchasing processes within B2B, a brand is able to enhance information efficiency. By bearing certain information, a B2B brand may facilitate communication with the various members of a buying center and reduce the efforts involved in the decision-making process.24 In addition, the brand provides orientation among different offerings and enhances the ability to recognize a particular product or service.25 One example of this function in the B2B business is the brand DHL that generally stands for a reliable logistics company. The brand fulfills the information cost reduction function because the business customer can expect the logistics company to perform the required services in the logistics sector without spending much time and effort researching this. In addition, the DHL brand represents a strong international logistics network. DHL ensures reliable project management, technical innovation, and renders services worldwide. The brand can, therefore, serve as a simplification or acceleration of the decision-making process for potential business clients. By means of reduced information costs for the business customer, DHL is able to obtain a higher market share compared to what it would have without its strong brand. For DHL’s brand, its strengths seem to stem mainly from the business development department, who are responsible for identifying, developing, and implementing growth strategies within the company. For all technological aspects, especially in relation to project management and innovation, the IT and R&D departments may be involved in developing new services, products, and processes, or to improve existing ones.

3.2.2

Risk Reduction

A B2B brand’s other major function is to reduce the customer´s exposure to risk. Buying a product or service of a certain brand that carries a high reputation reduces the purchasing risk and provides a degree of security to the organization’s purchaser. It will be easier to justify his or her purchasing decision, according to the slogan: “Nobody ever got fired for buying an IBM.”26 SAP may serve as a descriptive example of a B2B brand that fulfills the risk reduction function in the perception of potential customers. If a company considers purchasing IT solutions, it can expect the risk of SAP failing as a competent service provider to be relatively low. In addition, SAP provides innovative solutions for all kinds of industries and acts globally, ensuring customers that SAP offers stable and durable services of high quality. Thus, within the IT services market, the brand SAP

24

Caspar et al. (2002). Hague and Jackson (1994), Henning-Bodewig and Kur (1990). 26 De Chernatony and Dall’Olmo Riley (1998). 25

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stands for reliable IT solutions. As such, SAP should be able to achieve a higher market share by means of the risk reduction function of its brand. The company may also be able to charge higher prices for the services they provide as customers will have a greater willingness to pay a price premium for the expected reliability and quality of the product. At the company level, it is mainly the R&D department that is responsible for the development of innovative technological solutions for the customer. In addition, the customer support and the appropriate quality assurance play further important roles in achieving the perceived risk reduction of the customers, as customers know that sufficient assistance will be provided in case any issue with the product or service should arise. Hence, the brand may be associated with trust, since it promises longlasting good performance and the customer believes the brand promise will be fulfilled.27 Another important aspect connected with the risk reduction function is business relationships. Unlike B2C, the purchasing process in B2B strongly depends on relationships.28 In many cases, the relationship between the sellers of a product or service and the buyers in the B2B market persist over several years. In practice, the (key) account management or sales department of a company is responsible for establishing and maintaining the relationship with their customers. A key account manager with a strong and loyal customer base adds significant value to the company and consequently to brand value creation.

3.2.3

Symbolic Meaning

The symbolic value in B2B clearly differs from B2C, because the sphere of influence of the symbolic meaning of a brand is larger in B2B.29 This is because the brand may not only convey a symbolic benefit to the purchasing organization, but also to its employees and to end-consumers. A brand may bear a symbolic meaning to the purchasing organization by representing entrepreneurial success. The purchasing organization’s employees may enhance their social status, for instance, with high-quality company cars. Moreover, a brand may entail a marketing benefit to the purchasing entity by a transfer of the reputation of the supplier’s products or services that are afterward incorporated into the final products or services. With what is called ingredient branding, B2B products that are perceived to have a good image are incorporated into final products. The use of Intel processors that transfer a positive brand image to the final product serves as a good example of this point. On the strength of which the

27

Mudambi (2002). Kuhn et al. (2008), Hakansson (1982), Leek and Christodoulides (2012). 29 Caspar et al. (2002). 28

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Table 4 Departments responsible for B2B brand value creation Function Information cost reduction

Risk reduction

Symbolic meaning

Corporate departments responsible for brand value creation R&D department IT department Business development department Project management R&D department Quality assurance Due to the significance of business relations: (Key) Account management and customer support Product management Marketing department Procurement Quality assurance

company selling the final product may be able to include a price premium and increase its corporate image.30 With respect to ingredient branding and the related symbolic meaning of brands, it is reasonable to assume that the company’s product management, in combination with its procurement and quality departments, play a significant role. As the related B2B product or services are also included in the respective advertising campaigns, the marketing department assumes a supporting function in establishing brand value by leveraging symbolic meaning. A summary of the corporate departments that are responsible for the brand value creation within the B2B segment is provided in Table 4.

3.3

The Role of the Marketing Department in the B2C and B2B Markets

As may be inferred from previous chapters, the marketing department (in cooperation with the product management) plays a central role with respect to brand value creation, both for B2C and B2B. For all the brand functions the marketing department assumes at least a supporting role for the corporate departments that are responsible or even bears full responsibility for the strengthening of certain brand functions. Hence, the marketing department helps to create a strong brand and consistently adds brand value by implementing a brand strategy that promotes the three brand functions as defined in Sect. 1.3. One of the main purposes of marketing is to differentiate a brand from the competitor’s brands, create brand awareness of the customers, positively influence their attitude toward the brand, and achieve the desired customer action. Customer actions range from purchasing, repurchasing, paying a premium, and endorsing the 30

Venkatesh and Mahajan (1997).

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product to others. Thus, the marketing department is able to enhance the relevance of the brand by influencing the perceived necessity of a brand to satisfy customers’ needs. Typical tools to strengthen brand relevance are individual advertising and price setting approaches, i.e., increasing accessibility to the brand by decreasing prices or by offering price promotions. In addition, a continuous stream of new product launches may be another way of keeping the brand relevant in a fast-paced environment.31 The marketing department is able to enhance the market value of a brand by fostering what is termed a customer’s brand esteem. However, it is only possible for the marketing department to create brand esteem when the customers recognize the brand’s identity. Thus, brand esteem may be fostered by improving the actual quality of the products or services. The marketing department can then stress the quality of the product or service in its marketing activities. Considering all these aspects, it can be concluded that the overall goal of the marketing department is to create a particular image of a brand for the customer by emphasizing the various brand functions of a product or service as part of its brand strategy. The brand image that may be influenced by the marketing department by the previously mentioned activities that affect the attitude of the customer toward the brand and may then stimulate customer action.32

4 Transfer Pricing Aspects of Brand Value Creation In the context of the Base Erosion and Profit Shifting (“BEPS”) project, the OECD designed what is called the DEMPE analysis approach33 in order to determine the economic ownership of and appropriate remuneration for intangible assets. DEMPE stands for Development, Enhancement, Maintenance, Protection, and Exploitation, which have been identified by the OECD as the key functions to be analyzed in cases where entitlement to returns related to intangible assets has to be determined. In particular, according to Chapter VI of the OECD Transfer Pricing Guidelines, entities of a multinational company that perform DEMPE functions in terms of an intangible asset to a significant extent should be entitled to a return for the intangible. As outlined in Chap. 2, the DEMPE functions are not allotted to entities that only assume execution of the functions, but focuses on control of the functions and the associated bearing of risks.34 For example, if the brand’s character is designed by an advertising design company, this does not imply that the advertising company is the

31

Steenkamp (2017). Esch et al. (2014). 33 Chapter VI of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations dated July 2017 (hereafter referred to as “OECD Transfer Pricing Guidelines”). 34 See OECD Transfer Pricing Guidelines 2017, Chapter VI (B)(2.1). Such separation of performance and control is often observed in corporate processes. 32

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economic owner of the brand. The principal clearly has the power of decision and the final say on the brand character and is typically the economic (and legal) owner of the brand. The OECD Transfer Pricing Guidelines explicitly consider the DEMPE analysis approach as suitable for trademarks, trade names, and brands.35

4.1

DEMPE Functions

This section outlines further details on the DEMPE functions as they apply for brand, trademarks, and tradename analyses. Despite general guidance, a detailed analysis should be performed for every brand.

4.1.1

Development

Typical development activities for brands include the development of brand strategy (such as the definition of whether the brand should be advertised as a highly priced premium brand), the specification of group-wide principles for corporate design, advertising and sponsoring, the selection of the core advertising message and strategic implementation steps. Further development activities are developing and specifying group-wide principles for digital marketing and communications, brand architecture, and presentation of the brand and the principles governing website standards and structure.36

4.1.2

Enhancement

Typical enhancement activities for brands are the custom specifications of groupwide principles for corporate design, including the design of the brand character, writing styles, the selection of group-wide principles for advertising and sponsoring for local market purposes, and the improvement of strategic implementation steps. For example, elaborating whether a brand strategy is still applicable after a merger with another company can also be considered brand enhancement.37

4.1.3

Maintenance

The maintenance of brands may be considered as the operational execution of the specifications and guidelines that result from the development and enhancement

35

See OECD Transfer Pricing Guidelines 2017, Chapter VI (B)(4.1). See OECD Transfer Pricing Guidelines 2017, Chapter VI (B)(4.1) and examples 8–13. 37 See OECD Transfer Pricing Guidelines 2017, Chapter VI (B)(4.1) and examples 8–13. 36

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activities. This includes activities such as the continuous updating of advertising campaigns and merchandising articles, but also the revision of strategic branding activities. Further, this function includes the execution of sponsorships and the revision of sponsorship engagements. Further brand maintenance activities can include, for instance, the management of marketing budgets as well as the operational (local) implementation of marketing and brand strategies.38

4.1.4

Protection

The protection of a brand or trademark includes all activities that (legally) enforce the owner’s exclusive exploitation rights of the brand. Typical protection activities are legal and operational brand controlling, the registration of new brands and trademarks, the renewal and extension of existing brand registrations with patent offices, and other activities related to the legal enforcement of brand protection including the detection and pursuance of trademark infringements.39

4.1.5

Exploitation

The exploitation of an intangible asset can be defined as the ability to earn profits from using it. The exploitation has a special role among the DEMPE functions. While it is intuitively comprehensive that the performance and control of the DEMPE functions should be connected to economic ownership of the brand and should as a consequence be appropriately remunerated, this relation may not be as clear for the exploitation of a brand. Strictly speaking, the exploitation right should follow from DEMP activities, i.e., entities within a multinational company that perform DEMP functions shall have rights to exploit the intangible they created or alternatively receive a compensation for their DEMP activities. Irrespective of the above argument, the OECD regards exploitation as a key function for intangible assets.40 Typical functions related to the exploitation of a brand include the use of the brand for products and services within its defined scope of protection, the ability to exploit the brand, or the (sub)licensing of brand rights. Table 5 outlines possible DEMPE (sub)functions with respect to brands.

38

See OECD Transfer Pricing Guidelines 2017, Chapter VI (B)(4.1) and examples 8–13. See OECD Transfer Pricing Guidelines 2017, Chapter VI (B)(1). 40 Cf. OECD Transfer Pricing Guidelines 2017, Chapter VI Section A.1.. 39

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Table 5 Summary of DEMPE functions with respect to brands Development

Enhancement

Maintenance

Protection

Exploitation

4.2

• Development of brand strategy (e.g., defining the brand’s position) • Development of the brand’s logo and corporate identity (e.g., brand presentation, specification of group-wide principles for corporate design, design of brand character) • Development of marketing concepts (direct and online) for brand communication (e.g., selection of the core advertising message and strategic implementation steps) • Definition and development of guidelines for brand usage • Development of local advertising campaigns • Management and administration of a global marketing budget • Market research (brand perception and customer behavior) • Customization of the specification of group-wide principles for corporate design • Adjustments to the brand logo and corporate identity • Adjustment of product and service portfolio, regional presence based on market research • Selection of group-wide principles for advertising and sponsoring for local purposes • Improvement of strategic implementation steps • Implementation and local adaption of a globally developed marketing strategy • Execution and revision of local marketing activities (trade fairs, brochures, etc.) • Management and administration of a local marketing budget • Execution of local sales and distribution activities • Execution and implementation of strategic branding activities • Execution and implementation of global quality standards for products and services • Controlling of local execution, administration and implementation activities • Legal and operational brand controlling • Registration of new brand(s) in new markets • Renewal and extension of existing brand registrations with patent offices • Detection and pursuance of trademark infringements • Legal enforcement of brand protection, including dealing with possible infringements • Enforcement and controlling of global and regional quality standards, and compliance with brand guidelines • Defining the protection strategy • Utilization of the brand for products and services within the defined scope of protection • Ability to exploit the brand or to (sub)license brand rights

Brand Value Creation and the DEMPE Analysis

In the sections above, we described that the marketing department plays a central role with respect to brand value creation by strengthening the three main brand functions. Other corporate departments also contribute to this process, e.g., product management, project management, R&D, and quality assurance. Therefore, the

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Fig. 1 Interdependence of brand value creation and remuneration

question arises whether it would be reasonable to take into account these departments and their contribution to brand value creation when performing a brand DEMPE analysis. The answer to this question, however, may only be given on a case-by-case basis as it has a significant effect on the allocation of economic ownership of a brand and the appropriate remuneration for intragroup transactions concerning brands. In some cases, it may be appropriate to remunerate only the corporate entity that performs marketing-related DEMPE functions. In other cases, where a contribution to brand value creation by departments other than marketing can be objectively justified, it may be reasonable to attribute them at least parts of the DEMPE functions. In this context, it also needs to be considered whether departments such as R&D, product management, or project management may have already received a remuneration for their overall contribution to the value chain within the group. It should be avoided that the same activity is remunerated twice. Figure 1 summarizes the interdependence of brand value creation and remuneration with respect to brand intangibles.

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5 Conclusions In the introduction to this chapter we provided some relevant brand concepts and definitions, but the main part of the discussion focused on brand value drivers from a functional point of view. In general, we identified three important functions of a brand in B2B and B2C: information cost reduction, risk reduction, and symbolic meaning. These functions have a positive influence on the purchasing decision of customers, either by reducing risks and decision-related costs or by the additional perceived value of the product itself from its symbolic meaning. In conclusion, the better a brand is able to fulfill these functions, the higher its value becomes. In the next step, we analyzed which corporate departments influence these brand functions and contribute to brand value creation. For all the brand functions, the marketing department assumes at least a supporting role for the corporate departments responsible or even bears the full responsibility for strengthening a particular brand function. Hence, the marketing department helps to create a strong brand and consistently adds brand value by implementing a brand strategy that relies on the three brand functions. In addition, other corporate departments also contribute to this process, e.g., product management, project management, R&D, and quality assurance. For a better understanding of brand value creation and its remuneration in brandrelated intragroup transactions, analysis of the DEMPE functions provided another helpful framework. DEMPE stands for Development, Enhancement, Maintenance, Protection, and Exploitation, which have been identified by the OECD as key functions to be analyzed in cases where the entitlement to returns related to intangible assets has to be determined. However, the answer to the question of whether to consider the brand value contribution of departments other than marketing when performing a brand DEMPE analysis may only be decided on a case-by-case basis.

6 Practical Questions for Assessing the Relevance of Brands and their Creation In the following, we present some example questions that may help transfer pricing professionals to better understand the value of a brand and to decide which divisions within a company actually contribute to brand value creation: • How relevant is the brand for the purchasing decision of the customer? • What attributes do customers associate directly with the brand? What does the brand stand for? • How popular is the brand compared to the brands of competitors in its market? • Do customers of a branded product face high risks should the product fail (destruction of machines, failure of production, loss of reputation, etc.)?

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• Why is there a positive perception of the brand on the market? Does the brand have a strong symbolic meaning (e.g., in the fashion sector) or does it convey particular product attributes such as quality? • Is the brand well-known and popular, or is the brand well-known but disliked, among the relevant target group? • Are the products themselves trademarked? Is the packaging trademarked? • Are the brands consistently registered in all countries where the group’s companies are active? • Which department makes the important decisions with regard to brand value creation and which department bears the corresponding risks? Who is responsible for logos, slogans, corporate design, etc.? • How relevant is the brand of a product relative to the technology and quality incorporated in that product? • What is the connection between brand value and the sales department? How does the sales team influence brand value creation? • Is the brand positioned differently in different markets? If so, which department makes the decision? • Does the brand require high local adaption costs or can the brand be used in the same guise globally? • What specific market conditions of B2C and B2B markets need to be considered with regard to a particular product? • Hypothetical question: Assuming you would take over a company, what value would you attribute to the company’s brand? Does an external brand valuation exist? • Hypothetical question: Assuming you had to replace the brand with a completely unknown new generic brand in 2 months, what would you be willing to pay to prevent this?

References Aaker, D. A. (1991). Managing Brand Equity: Capitalizing on the Value of a Brand Name (pp. 35–37). New York: Free Press, 28(1). Agarwal, S., & Teas, R. (2001). Perceived Value: Mediating Role of Perceived Risk. Journal of Marketing Theory and Practice, 9(4), 1–14. Backhaus, K., Steiner, M., & Lügger, K. (2011). To Invest, or Not to Invest, in Brands? Drivers of Brand Relevance in B2B Markets. Industrial Marketing Management, 40(7), 1082–1092. Backhaus, K., & Voeth, M. (1999). Industriegütermarketing. München: Vahlen. Caspar, M., Hecker, A., & Sabel, T. (2002). Markenrelevanz in der Unternehmensführung— Messung, Erklärung und empirische Befunde für B2B-Märkte. Münster: Marketing Centrum. Damm, C. (1993). Marke, Markt, Marketing. Strategien für Investitionsgütermärkte–Antworten auf neue Herausforderungen. Landsberg/Lech: Verl. Moderne Industrie De Chernatony, L., & Dall’Olmo Riley, F. (1998). Defining a “brand”: Beyond the Literature with Experts’ Interpretations. Journal of Marketing Management, 14(5), 417–443.

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Esch, F. R., Tomczak, T., Kernstock, J., Langner, T., & Redler, J. (2014). Corporate Brand Management: Marken als Anker strategischer Führung von Unternehmen (pp. 61–128). Wiesbaden: Springer Gabler. Hague, P. N., & Jackson, P. (1994). The Power of Industrial Brands: An Effective Route to Competitive Advantage. London: McGraw-Hill. Hakansson, H. (1982). An Interaction Approach. International Marketing and Purchasing of Industrial Goods: An Interaction Approach (pp. 10–27). Chichester: John Wiley & Sons. Henning-Bodewig, & Kur. (1990). Marke und Verbraucher-Bericht über ein Projekt und seine Ergebnisse. Wettbewerb in Recht und Praxis, 7/8, 453–459. Interbrand. (2018). Activating Brave—Best Global Brands 2018. Retrieved February 27, 2019, from https://www.interbrand.com/wp-content/uploads/2018/10/Interbrand_Best_Global_ Brands_2018.pdf. Keller, K. L. (1993). Conceptualizing, Measuring, and Managing Customer-based Brand Equity. Journal of Marketing, 57(1), 1–22. Keller, K. L., & Lehmann, D. R. (2006). Brands and Branding: Research Findings and Future Priorities. Marketing Science, 25(6), 740–759. Kemper, A. C. (2000). Strategische Markenpolitik im Investitionsgüterbereich. Cologne: Joseph Eul. Kotler, P., & Pfoertsch, W. (2007). Being Known or Being One of Many: the Need for Brand Management for Business-to-Business (B2B) Companies. Journal of Business & Industrial Marketing, 22(6), 357–362. Kuhn, K. A., Alpert, F., & Pope, N. (2008). An Application of Keller’s Brand Equity Model in a B2B Context. Qualitative Market Research: An International Journal, 11(1), 40–58. Leek, S., & Christodoulides, G. (2012). A Framework of Brand Value in B2B Markets: The Contributing Role of Functional and Emotional Components. Industrial Marketing Management, 41(1), 106–114. Loken, B., & John, D. R. (1993). Diluting Brand Beliefs: When do Brand Extensions have a Negative Impact? Journal of Marketing, 57(3), 71–84. Mudambi, S. (2002). Branding Importance in Business-to-Business markets: Three Buyer Clusters. Industrial Marketing Management, 31(6), 525–533. OECD. (2017). Transfer Pricing Guidelines. Paris: OECD Publishing. Steenkamp, J. B. (2014). How Global Brands Create Firm Value: The 4V Model. International Marketing Review, 31(1), 5–29. Steenkamp, J. B. (2017). Global Brand Strategy: World-wise Marketing in the Age of Branding. Berlin: Springer. Venkatesh, R., & Mahajan, V. (1997). Products with Branded Components: An Approach for Premium Pricing and Partner Selection. Marketing Science, 16(2), 146–165. Zeithaml, V. A. (1988). Consumer perceptions of price, quality, and value: a means-end model and synthesis of evidence. Journal of Marketing, 52(3), 2–22.

Valuation: Understanding, Assessing, and Documenting Marc C. Hübscher and Björn Heidecke

What Will the Reader Learn? • Understand what “valuation” means • Assessment criteria of a good valuation • What documentation is required by the OECD

1 Introduction “Valuation means comparing,”1 to put a complex topic in a nutshell. In fact, this definition gets to the heart of the matter, as the valuation of companies, or of assets as a whole, always involves considering comparatives. Valuation is also a measuring process because in so doing an empirical relation (e.g., an intangible value) is assigned a numerical relation (e.g., a monetary unit). Valuations, in state-of-the-art international valuation theory and practice, are ways to determine the value of an asset. This value is also referred to as the present value of future profits. The Discounted Cash Flow (DCF) approach and its various methods are generally accepted in international theory and practice for determining this value of future success.2,3

1

See Moxter (1983). See Ballwieser (2011), Brealey and Myers (2003), Diedrich and Dierkes (2015). 3 In this section, we primarily deal with income-based methods within the framework of valuation theory, knowing full well that in principle other valuation methods are also available. However, we also believe that the considerations presented here can be applied to all other valuation methods. 2

M. C. Hübscher · B. Heidecke (*) Deloitte GmbH, Hamburg, Germany e-mail: [email protected]; [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_9

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The basic idea behind DCF requires a forecast of excess cash flows over a certain planning period, which is discounted at a certain point in time (valuation date) with a reasonable risk return for the respective asset. In essence, any valuation of assets, whether of companies or shares in companies, tangible or intangible assets, involves discussion of the reasonable numerator and denominator. The reasonable numerator includes the projected excess cash inflows or outflows (referred to here as simply free cash flows) that are attributable to the use of the asset. The reasonable denominator represents the risk-adjusted expected return that is associated with the asset. But how do we arrive at these values, i.e., free cash flows and risk returns that can be described as reasonable? In the following, we will examine this crucial question in more detail. We will explain our thesis, which we share with Damodaran,4 that a good valuation is only given if two different ways of working are combined in a constructive manner. By these two ways of working we mean: First, a kind of handicraft, namely the derivation of intersubjectively verifiable cash flows (numerator) and a quasitechnical clean and comprehensible derivation of a reasonable risk return (denominator). Second, a kind of artwork that provides us with stories (narratives) with which the reasonableness of cash flows and returns is established by an intersubjective process of understanding.5 Keeping what makes a “good valuation” in mind, the question now arises: What actually is a valuation of assets? Is it a science, a craft, or a virtuoso performance? Damodaran designates “valuation as a bridge,”6 which forms a link between narratives and numbers. In principle, it is irrelevant whether a practitioner sees his work as a craft, as a quantitative science of numerical calculation, or as the arts and craft of storytelling. All these elements are included in every valuation, be they good, bad, or even wrong. It is the quality of the two ways of working that determines what we ultimately wish to label a good valuation. In short: every valuation needs a number cruncher, but only the storyteller can turn a valuation into a good valuation. In the following, we first examine what constitutes the reasonableness of valuation results in theory and practice. In particular, we look at the dominance of quantitative, analytical methods in valuation theory, then highlight the power of narratives from a more practical perspective. Using this as a basis, as the next step we present a framework that allows us to make a normative distinction between a good and not so good valuation.

4

Damodaran (2017), pp. 1ff. See Reckling (2002). 6 Damodaran (2017), p. 5. 5

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2 Toward a Good Valuation 2.1

The Reasonableness of Valuation Results

As already indicated, asset valuations are often carried out using an income-based method, which is based on the calculation of net present value.7 It is therefore a matter of discounting expected future free cash flows attributable to an asset using a reasonable capitalization rate that adequately reflects the risk assumed with the asset at the time of investment. Both the numerator and denominator must be reasonable, but reasonableness is neither in valuation theory and practice nor for practitioners an adequately defined concept. Reasonableness can therefore only arise in the (always communicative) process of mutual understanding,8 without implying that everything is arbitrary. So how can we ensure reasonableness in the numerator and denominator? In business valuation theory and practice, formal, analytical provisions of the capitalization rate and general, deductive provisions of free cash flows have prevailed.9 This is discussed in the subsection below. It does not, however, say anything about the reasonableness of the level of free cash flow, and not much has been said so far about the actual comparability of similar capital market companies. It is already obvious that there is a need for a further element, which we have introduced above as the narrative method.

2.2

The Dominance of Calculation Work

The company valuation theory has so far mainly dealt with the structure of deriving free cash flows and the derivation of the capitalization rate. In terms of deriving the free cash flows, however, no serious textbook on corporate valuation and valuation theory omits to describe the structure of a cash flow statement in order to show how, in the common application of an indirect derivation of cash flow,10 adjustments have to be systematically made in order to convert earnings before interest and tax (EBIT) to free cash flows. Both cash changes in the balance sheet and valuation-related adjustments play a role here, depending on the respective valuation method, for example, when it is necessary to take a tax shield into account. In the application of an income-based method, great importance is often attached to the derivation of the capitalization rate, which is normally carried out by applying 7

See Ballwieser (2011), Peemöller (2014), Diedrich and Dierkes (2015). See Reckling (2002), pp. 247ff. 9 See Ballwieser (2011), Drukarczyk and Schüler (2009), Diedrich and Dierkes (2015). 10 To distinguish between direct and indirect derivation of cash flows, see Ballwieser (2011), Peemöller (2014). 8

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the capital asset pricing model (CAPM). A non-exhaustive list of issues that are sometimes controversially discussed in this regard,11 in valuation theory and practice as well as in case law, are:12 • Derivation of the market risk premium13 • Composition of the peer group • Parameters for the analytical derivation of the company-specific risk factor (beta factor) • Consideration of the capital structure risk14 • Consideration of other risk premiums15 • Determination of capital costs of insolvent companies16 It should also be mentioned that, in the phase of low interest rates that has now been going on for some time, the basic assumptions of CAPM, rooted in capital market theory, are sometimes called to question.17 For our purposes, we can summarize that from the perspective of valuation theory we will essentially discuss firstly consideration for a structural determination of free cash flows and then the valuation parameters in the form of quantitative modeling and calculation. The business management research on company valuation follows a tradition of the formation of theories based on the natural sciences, which is essentially characterized by nomological deduction, quantitative modeling, and a data-oriented focus. It thus follows a close tradition with economics, which is sometimes referred to as the “mathematization of the social sciences.”18 The exclusively quantitative theoretical basis in economics and a focus on numbers in practice should underline the probity of evaluation work. With a modern, positivist understanding of the acquisition of knowledge, models and numbers are paramount, as they are regarded as precise and objective. In addition, in the practice numbers have the functional concept of oversight, which is in keeping with the principle “you get what you measure.”19 For some time now, there is ever more comprehensive literature that criticizes or radically questions the purely scientific understanding of economics.20 But we will not be going into this in the following. Rather, we are convinced that an extensive examination of models, parameters, and quantitative methods is necessary in order to arrive at reasonable asset valuations.

11

For topics relevant to valuation in case law, see Ruthardt and Hachmeister (2016). See e.g. Dörschell et al. (2010). 13 See Castedello et al. (2018). 14 See Modigliani and Miller (1958), Diedrich and Dierkes (2015). 15 See Ruthardt and Hachmeister (2014). 16 See Lodowicks (2007). 17 See Stahl (2016), pp. 13–24. 18 See Hodgson (1999). 19 See Damodaran (2017), pp. 36ff. 20 See Hodgson (1999). 12

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However, we should also be aware of the limitations of such and look for working methods that offer complementary support for the reasonableness of valuation. For example, we see that structural knowledge of the cash flow calculation provides no indication of the level of free cash flows that may be considered reasonable. For this, we need qualitative elements. This takes a step further toward questioning the objectivity of data and facts. For example, we can easily imagine that there is a stone on the road that could cause us harm. However, even macroeconomics cannot help us with realizing this. We only regard changes to GDP from one year to the next as a material fact, because at some point it was conveyed in a communicative way as a socially effective fact.21 We can see in the examples above a need for a complementary view, which we refer to as narratives in the following.

2.3

The Power of Narratives

The scientific examination of language, communication, narratives and, not least, stories is still quite young.22 For the scientific world view of economists, it has not played a role, simply because the self-image of economists was and still is characterized by scientific reductions, in order to arrive at quasi-laws that are similar to those of the natural sciences.23 This applies to the mainstream of economics, although some economists have long since pointed out the social embeddedness of the economy.24 Not only the US economists of the old institutional order have indicated this,25 even Keynes in his grand theory pointed out the importance of the “spirits of life” to show that rational calculations are not the only factors for economic and entrepreneurial growth (and downturns).26 Nonetheless, these observations did not lead him to systematically expound the potency of spirits of life in his General Theory; to a certain extent, the quantitative logic of economics had the upper hand. One systematic reference to narratives in economics is given by McCloskey, who in “The Rhetoric of Economics” systematically examined where and how economic statements have a rhetorical effect on the economy, politics, and society.27 This study can certainly be interpreted as a systematic attempt to show how economic

21

About the underlying social-ontological concept see Searle (2011). See Männel (2002), Kabalak et al. (2008), Akerlof and Shiller (2009, 2015), Priddat (2015), Beckert (2018), Shiller (2019). 23 See Albert (1967). 24 See Granovetter (1985). 25 See Commons ([1934] 1990), Veblen ([1899] 1997). 26 See Keynes ([1936] 2000). 27 See McCloskey (1985) 22

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analyses and statements are interspersed with narratives or are themselves to be understood as narratives. The findings of behavioral economics in recent years28 have led, among other things, to the systematic consideration of the socio-psychological effects of narratives in the development of economic theory.29 Nevertheless, it is still the case that the positivist understanding of science in mainstream economics prohibits dealing with the hermeneutic intersubjective perspective of narratives; this also applies to business research on the valuation of assets. The two Nobel Prize winners for economics, Akerlof and Shiller, summed up this basic problem quite vividly. It is generally considered unprofessional for economists to base their analyses on stories. On the contrary, we are supposed to stick to the quantitative facts and theory—a theory that is based on optimization, especially optimization of economic variables (. . .) There is good reason to be careful about the use of stories. The news media are, after all, in the business of creating stories that people would like to hear (. . .) Thus economists are rightly wary of stories and of the reality they seek to define. But what if the stories themselves move markets? What if these stories of over-explanation have real effects? What if they themselves are a real part of how the economy functions? Then economists have gone overboard. The stories no longer merely explain the facts; they are the facts.30

When we speak of the power of narratives, then we do not mean qualitative studies, which by means of benchmarking,31 again based on data, produces reasonableness relative to comparative data. Rather we mean a peculiar connection in the social sciences, to which economics also belongs: narratives and numbers (or models) are not in opposition, instead narratives support the meaning-generating content of numbers. We believe instead, and this is entirely in line with the point made by Akerlof and Shiller (2009) that facts in the form of data and models are recursively and constitutively related to narratives (see Fig. 1).32 In this context, Shiller has recently expounded “narrative economics.”33 The connection between facts and narratives, which we will pursue in the following, follows Shiller’s idea that there is a reciprocal relationship between facts and narratives, and that this is also true in an epistemic sense: Though modern economists tend to be very attentive to causality, as a general rule they do not attach any causal significance to the invention of new narratives. I want to argue here not only that causality exists, but also that it goes both ways: new contagious narratives cause economic events, and economic events cause changed narratives.34

28

See e.g. Kahneman (2011), Thaler (2018). See Akerlof and Shiller (2009), pp. 11ff, Akerlof and Kranton (2011). 30 Akerlof and Shiller (2009), p. 54. 31 See Camp (1995) 32 For more information about the theoretical concept of recursion, refer to Ortmann (1995). 33 Shiller (2019). 34 Shiller (2019), p. 71. 29

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Fig. 1 Recursive relationship between numbers and narratives. (Own source)

2.4

Appropriate Valuation: A Framework

As discussed in the previous section, stories or narratives sometimes have a very powerful function in business practice. Naturally, what Shiller and Shiller/Akerlof, for example, worked out in relation to macroeconomic developments also has an effect on valuations of intangibles. Damodaran in particular recognized and structured the connection between numbers and narratives.35 From the core considerations of Damodaran we understand the relation between numbers and narratives with respect to the valuation of intangibles to mean that a “good” valuation is only the case when the calculation is carried out correctly, using an appropriate method, and the expectations associated with the asset are described in an appropriate story (see Fig. 2). Measured against these criteria of numbers and narratives, we can state that: • A poor valuation exists when either the arithmetic part is incomplete or completely wrong, or a good and plausible story has not been developed; while • A good valuation only exists when the numbers are robust, the calculation is appropriate and correct, and the story of the valuation of the intangibles is appropriate, likely, and plausible. The criteria of numbers and narratives can now be applied to the numerator (cash flow) and to the denominator (discount rate) as explained above. Figure 3 gives practical examples of numbers and narratives in the context of yield-based valuations.

35

Damodaran (2017).

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Fig. 2 Assessing a valuation from narratives and numbers. (Own source)

Provided the method has been applied mathematically correct, the model is consistent in itself and theoretically founded, speaking in favor of a good expression of the numbers. The narrative for this is the explanation related to the business and comparable companies as well as the economic framework such as the national economy, but also to the underlying theory of the model. For a cash flow plan, for example, this means that a projection such as “2% growth in the next 5 years” is qualitatively justified by a narrative. The narrative’s form will be specified in the following. Storytelling for literary and business purposes are quite different. While the storytelling in literature thrives on creativity, emotionality, and the ability to embed a story in the narrative, the criteria of a business story must have a strong link to economic reality.36 According to Damodaran, to develop a good story requires evaluating the following aspects: A business story should be (1) simple, (2) credible, (3) authentic, and last but not least (4) emotional.37 All good business stories must describe the

36 37

Damodaran (2017), pp. 27–28. Damodaran (2017), p. 34.

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Fig. 3 Examples of narratives and numbers. (Own source)

company, the market, and the competition as well as the framework conditions, whether big or small, established or disruptive/innovative, or whether a finite or infinite story is told. Stories should always contain statements about the potential for growth.38 There can be any number of business stories. Damodaran gave seven examples of classic business stories,39 which we have arranged according to market and company perspectives in the illustrations that follow. Such considerations can also be applied to the narrative when assessing intangibles (Fig. 4). With regard to the differences between the market and company, seven types of business story can be distinguished as follows: • The low-cost player: companies with a strategic focus on cost advantages. • The better mousetrap: companies that differentiate themselves by the way they deliver existing products or services. • The bully: companies that are clearly market leaders in terms of market shares, brand, and reputation. • The underdog: companies that want to challenge the market leader(s) in an existing market by achieving cost advantages.

38 39

Damodaran (2017), pp. 70–91. Damodaran (2017), p. 31.

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Fig. 4 Types of classic business stories. (Own source)

• The disruptor: companies that transform existing business models by finding new ways to deliver either existing or more attractive products and services. • The eureka moment: companies that transform existing needs into new requirements and develop ways and production methods to satisfy these needs. • The missionary: companies that define themselves and their operational activities from their own mission, and for who realization of their mission has a higher strategic value than purely making money. Although not exhaustive, this taxonomy of various business stories shows the fundamental openness of storytelling, which is not arbitrary. The criterion by which every business story will be measured is its credibility. To judge the credibility Damodaran considers three aspects, which he calls the three Ps: Possible, Plausible, Probable:40 • Possible is a business story where it is presented within the framework of a peer group and conviction is shared that implementation of this business intention can really happen, without knowing how this implementation will look in precise detail. • Plausible is a business story where either comparisons can be made with other valuation objects that have implemented something that is equal, similar or fundamentally comparable, or reference projects can be cited from the past of 40

Damodaran (2017), pp. 92–109.

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the valuation object under consideration that has transferred a business story from mere possibility to successful implementation. • Probable is a business story where the positively assessed possibility and plausibility can be transferred into a concrete business case. This test therefore mainly comprises the ability to quantify an interesting business intention by presenting estimates in the form of market developments, sales opportunities, and costs in concrete terms in expected values. Certainly, the definitions of these three P-questions are not without overlaps and have an analytical character in their first approximation. As well the basic quality and attractiveness of a business story is not dependent on whether the P-questions can be answered separately and fully convincingly. Rather, the P-questions are a “continuum of skepticism,”41 which can be used to assess the probability of occurrence and success of a business story. For the valuation of intangibles, it is advisable to check whether the narrative described, on which the valuation is based and which is reflected in model selection and model assumptions, is plausible, possible, and probable. This review will often be done ex negativo, by first showing what is implausible, impossible, and improbable.42 Only by testing appropriateness this way can the business story be assessed and a basis for a good valuation be laid.

2.5

Connection to Conventional Quality Criteria of an Assessment

The quality of an assessment, and therefore of a valuation, is usually checked against three criteria: objectivity, validity, and reliability.43 Objectivity indicates how independent the result of the valuation is from the person doing the valuation. Reliability shows how mathematically correct the value that was determined is, or more generally, how reliable the measurement method is. The validity points out whether what the assessment purports to assess was actually assessed. Consequently, what we explained about narratives and numbers must now be placed in the context of the quality criteria of an assessment. Working solid with the numbers, i.e., the computational level, increases reliability. The choice of the model itself and the underlying paradigms and theoretical background influences the result of the assessment and the question of whether the subject of the assessment was actually assessed. For example, if the value of an intangible is determined using a cost-based approach, it can be calculated correctly

41

Damodaran (2017), p. 95. See Damodaran (2017), pp. 94–106. 43 See about Jongebloed in: Bank (2005), p. 337. 42

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(high reliability). Nevertheless, the intangible’s value is not necessarily related to the model applied. Rather, to achieve a high degree of validity, it would have to be justified why the cost-based approach also correctly assesses the value of the intangible. This kind of theoretical explanation is found in the narrative, i.e., the superordinate qualitative choice of method, linking it to the concrete facts. Furthermore, the narrative increases the acceptance of the underlying assumptions. Hence, a good narrative for the selection of the valuation method and the parameters increases the validity. Supplementing this is objectivity: The narrative and numbers should be well documented to make the technical evaluation (numbers) and the underlying story (the facts of the case and choice of method) sufficiently verifiable and objectively independent of the person doing the valuation. The documentation can then be the subject of discourse within the company, with the consultant as well as with the tax authorities. In fact, the OECD requires that the valuation be documented along with numbers and narrative, as the next section shows. This shows that a good valuation should also be well documented.

3 Documenting the Valuation for Transfer Pricing Purposes The OECD calls for what is termed a three-tiered approach, consisting of Local File, Master File, and Country-by-Country Reporting. Explanations for intangibles are provided, especially within the framework of the Master File and the Local File. This chapter outlines the documentation of intangibles in the OECD concept.

3.1

Intangibles in OECD Country-by-Country Reporting

At present no information needs to be disclosed on intangibles in Country-byCountry Reporting. However, a recent paper published by the OECD indicates that this may change. In a public consultation draft dated February 2020, they asked for feedback on whether within the respective tables R&D expenditures, related party royalty income, and related party royalty expenses should be added.44 The further process of amending the Country-by-Country Reporting will show how this will be embedded in the Country-by-Country Reporting requirements.

44 See OECD (2017), Public consultation document: Review of Country-by-Country Reporting (BEPS Action 13), recital 109, 14.1, 14.2, and 14.3.

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Intangibles in the OECD Master File Concept

The taxpayer is obliged to document various statements on intangible assets In the Masterfile.45 These explanations show that a comprehensive overview of intangibles and their classification in the value chain must be provided: • A general description of the MNE’s overall strategy for the development, ownership, and its exploitation of intangibles, including the location of principal R&D facilities and the location of R&D management. • A list of the MNE’s intangibles, or groups of intangibles, that are important for transfer pricing purposes, and which entities legally own them. • A list of important agreements among identified associated enterprises that are related to the intangibles, including cost contribution arrangements, principal research service agreements, and license agreements. • A general description of the MNE’s transfer pricing policies related to R&D and intangibles. • A general description of any important transfers of interest in intangibles among associated enterprises during the fiscal year concerned, including the entities, countries, and compensation involved.

3.3

Intangibles in the OECD Local File Concept

In the Local File scope, the following information must be provided for each major transaction with related parties, also including the sales and licenses of intangibles:46 • A description of transactions and the context in which such transactions took place. • The amount of intragroup payments and receipts that involved the local entity, broken down by tax jurisdiction of the foreign payer or recipient. • An identification of associated enterprises involved in each category of controlled transactions, and the relationships among them. • Copies of all agreements. • A detailed comparability and functional analysis of the taxpayer and any relevant associated enterprises, including any changes compared to prior years. • An indication of the most appropriate transfer pricing method and the reasons for choosing that method. • An indication of which associated enterprise is selected as the tested party, if applicable, and an explanation of the reasons for this selection. • A summary of the important assumptions made in applying the transfer pricing methodology. 45 46

See OECD (2017), Transfer Pricing Guidelines, 5.18ff and Appendix I to Chapter V. See OECD (2017), Transfer Pricing Guidelines, 5.22ff and Appendix II to Chapter V.

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• If relevant, an explanation of the reasons for performing a multi-year analysis. • A list and description of selected comparable uncontrolled transactions (internal or external), if any, and information on relevant financial indicators for independent enterprises relied on in the transfer pricing analysis, including a description of the method used for comparable searches and the source of such information. • A description of any comparability adjustments performed, and an indication of whether these adjustments were made to the results of the tested party and/or the comparable uncontrolled transactions. • A description of the reasons for concluding that the transactions were priced on an arm’s length basis for applying the selected transfer pricing method. • A summary of financial information used in applying the transfer pricing methodology. • A copy of existing unilateral and bilateral/multilateral APAs and any other tax rulings to which the local tax jurisdiction is not a party, but which are related to controlled transactions. The explanations, therefore, require a comprehensive description of the transactions with intangibles together with the selected methods and parameters, and their application. Whether intended or not, the language of the OECD brings together the concept of narratives and numbers and requires both the narrative, in terms of the functional and risk analysis, the economic environment, the description of the underlying parameters and the method selection, and the numbers, in terms of the calculation itself and the link to the financials.

4 Conclusion This chapter describes the valuation of intangibles in what we wish to summarize as the 3N approach. In addition to a brief introduction to valuation theory, which in the mainstream focuses on numbers and models, we have chosen an interpretative approach that emphasizes the practical, socioeconomic impact of narratives that is increasingly finding its way into discourse on economic theory. This connection between the recursive relationship of numbers and narratives, which is particularly emphasized by Damodaran in terms of economic valuation theory, is then elaborated as a position that is guided by the thesis that we can always speak of a “good valuation” when two of the Ns—numbers and narratives—are balanced and considered in detail. Furthermore, we elaborated on how a good set of documentation (or “notes” for our third N) is also necessary for a good valuation, promoting objectivity of the valuation by improving its transparency. In our view, a “good valuation” therefore exists when the three Ns are considered in the valuation. N—Narratives: Every valuation of intangibles is based on a narrative. To narrate explicitly and test it is an essential step in performing the technical-functional

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evaluation. In the narrative, the theoretical regression of the valuation model is also carried out, by which the empirical relative is transferred to the numerical relative. N—Numbers: The narratives are concretized by deriving or developing fact-based expectation values (numbers) that are processed appropriately for the valuation model, i.e., calculated in a technically correct manner. N—Notes: In order to successfully complete a valuation for transfer pricing purposes, it is necessary to document the valuation results in detail, using the narratives and numbers and in particular to link these two requirements recursively. Only when a valuation of intangibles is reliable and valid, and its numbers are consistent with the narrative, and this is properly documented, can one speak of a good valuation. Linking this back to the narratives and numbers, the documentation—also known as notes—adds our third N. Hence a good valuation considers numbers, narratives, and notes. In valuation assessment criteria parlance: working solid with the numbers increases reliability, providing a good narrative for the selection of the valuation method and the parameters increase the validity and understandable notes (good documentation) increases the objectivity.

References Akerlof, G. A., & Shiller, R. J. (2009). Animal Spirits. How Human Psychology Drives The Econnomy And Why It Matter For Global Capitalism. Oxford: Princeton. Akerlof, G. A., & Shiller, R. J. (2015). Phishing For Phool: The Economy of Manipulation & Deception. Oxford: Princeton. Akerlof, G. A., & Kranton, R. E. (2011). Identity Economics. Warum wir ganz anders ticken, als die meisten Ökonomen denken. München: Carl Hanser. Albert, H. (1967). Marktsoziologie und Entscheidungslogik: Ökonomische Probleme in soziologischer Perspektive. München: Luchterhand, cop. Ballwieser, W. (Unternehmensbewertung, 2011). Unternehmensbewertung—Prozess, Methoden und Probleme (3. Auflage). Stuttgart: Schäffer-Poeschel Beckert, J. (2018). Imaginierte Zukunft. Fiktionale Erwartungen und die Dynamik des Kapitalismus. Berlin: Suhrkamp Verlag. Brealey, R., & Myers, S. (Principles, 2003). Principles of Corporate Finance (7. Auflage). New York City: McGraw-Hill Education. Camp, R. C. (1995). Business Process Benchmarking: Finding and Implementing Best Practices. Milwaukee: ASQC Quality Press. Castedello, M., Jonas, M., Schieszl, S., & Lenckner, C. (2018). Die Marktrisikoprämie im Niedrigzinsumfeld, in: WPg 13/2018, S. 806–825. Commons, J. R. ([1934] 1990). Institutional Economics: Its Place in Political Economy. Madison: Routledge. Damodaran, A. (2017). Narrative And Numbers. The Value Of Stories In Business. New York: Columbia University Press. Diedrich, R., & Dierkes, S. (2015). Kapitalmarktorientierte Unternehmensbewertung. Stuttgart: Kohlhammer Verlag.

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Dörschell, A., Franken, L., & Schulte, J. (Kapitalkosten, 2010). Kapitalkosten 2010 für die Unternehmensbewertung—Branchenanalysen für Betafaktoren, Fremdkapitalkosten und Verschuldungsgrade. Düsseldorf: IDW-Verlag Drukarczyk, J., & Schüler, A. (Unternehmensbewertung, 2009). Unternehmensbewertung (6. Auflage). München: Franz Vahlen. Granovetter, M. (1985). Economic Action and Social Structure. The Problem of Embeddedness. American Journal of Sociology, 91(3), 483–510. Hodgson, G. H. (1999). Evolution and Institutions: On Evolutionary Economics and the Evolution of Economics. Cheltenham: Edward Elgar. Jongebloed, H.-C. (2005). Die Messung schulischer und betrieblicher Leistungen in bildungsökonomisch-modellhafter Sicht. In V. Bank (Ed.), Vom Wert der Bildung: Bildungsökonomie in wirtschaftspädagogischer Perspektive neu gedacht. Haupt. Kabalak, A., Priddat, B. P., & Smirnova, E. (Eds.). (2008). Ökonomie, Sprache, Kommunikation. Neuere Einsichten zur Ökonomie. Marburg: Metropolis. Kahneman, D. (2011). Schnelles Denken, langsames Denken. München: Siedler. Keynes, J. M. ([1936] 2000). Allgemeine Theorie der Beschäftigung, des Zinses und des Geldes. Berlin: Duncker & Humblot GmbH. Lodowicks, A. (2007). Riskantes Fremdkapital in der Unternehmensbewertung: Bewertung von Insolvenzkosten auf Basis der Discounted-Cashflow-Theorie. Wiesbaden: Deutscher Universitäts-Verlag. Männel, B. (2002). Sprache und Ökonomie. Über die Bedeutung sprachlicher Prozesse für ökonomische Prozesse. Marburg: Metropolis. McCloskey, D. N. (1985). The Rhetoric of Economics. Madison: University of Wisconsin Press. Modigliani, F., & Miller, M. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review, 48, 261–297. Moxter, A. (1983). Grundsätze ordnungsmäßiger Unternehmensbewertung (2. Aufl.). Wiesbaden: Wiesbaden Gabler Verlag. OECD Transfer Pricing Guidelines. (2017). OECD Transfer Pricing Guidelines for Multinational ENTERPRISES and Tax Administrations. Paris: OECD Publishing. Ortmann, G. (1995). Formen der Produktion. Organisation und Rekursivität. Opladen: Westdeutscher Verlag. Peemöller, V. H. (Ed.). (2014). Praxishandbuch der Unternehmensbewertung. 6. vollständig aktualisierte und überarbeitete Auflage. Herne: NWB. Priddat, B. P. (2015). Economics of persuasion. Ökonomie zwischen Markt, Kommunikation und Überredung. Marburg: Metropolis. Reckling, F. (2002). Interpretative Handlungsrationalität. Intersubjektivität als ökonomisches Problem und die Ressourcen der Hermeneutik. Marburg: Metropolis. Ruthardt, F., & Hachmeister, D. (2014). Unternehmensbewertung in den USA, in: WPg, 67. Jg. (2014), S. 428–438. Ruthardt, F., & Hachmeister, D. (2016). Unternehmensbewertung im Spiegel der neueren gesellschaftsrechtlichen Rechtsprechung—Entwicklungen in den Jahren 2014 und 2015, in: WPg, 69. Jg. (2016), S. 687–693. Searle, J. R. (2011). Making the Social World: The Structure of Human Civilization. Oxford: Oxford University Press. Shiller, R. J. (2019). Narrative Economics. How Stories Go Viral & Drive Major Economic Events. Oxford: Princeton University Press. Stahl, R. (2016). Capital Asset Pricing Model und Alternativkalküle. Analyse in der Unternehmensbewertung mit empirischem Bezug auf die DAX-Werte. Berlin: Springer. Thaler, R. H. (2018). Misbehaving. Was uns die Verhaltensökonomik über unsere Entscheidungen verrät. München: Siedler. Veblen, T. ([1899] 1997). Theorie der feinen Leute. Eine ökonomische Untersuchung der Institutionen. Frankfurt/M: Fischer-Taschenbuch-Verl.

Part II

Finding the Arm’s Length Price for Intangibles

Structuring a License System Tim Eggebrecht, Markus Kircher, and Julia Kaiser

What Will the Reader Learn? • • • •

Differences between a fixed and flexible license model Parameters to be considered when structuring a license system How to determine an arm’s length license rate Empirical evidence on license arrangements between third parties

1 Introduction This chapter aims to provide an overview of how to structure a license system and what elements can be typically observed in practice. When setting up a license system, one should clearly define the contractual terms, especially the subject of the license and the license fee mechanism (Fig. 1). License agreements between third parties are generally very detailed. This chapter will provide a comprehensive overview of the main aspects that should be addressed in a license contract from a transfer pricing viewpoint. However, it will not cover all the potential aspects addressed in contracts between third parties. All elements agreed between the parties should be set out in a written contract. Due to the special nature of intangibles (“IP”), tax authorities of some jurisdictions require a written contract as the basis for license fee payments. Otherwise, they may partly or fully deny the deductibility of license payments. In addition, third parties are likely to desire a written contract for licensing activities, to ensure some certainty in the business relationship between the parties. A written contract is therefore recommended from a transfer pricing perspective.

T. Eggebrecht · M. Kircher (*) · J. Kaiser Deloitte, Frankfurt, Germany e-mail: [email protected]; [email protected]; [email protected] © Springer Nature Switzerland AG 2021 B. Heidecke et al. (eds.), Intangibles in the World of Transfer Pricing, https://doi.org/10.1007/978-3-319-73332-6_10

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Fig. 1 Main aspects of a license contract

The subject of the license should be clearly defined so that it complies with the arm’s length principle, as a sufficiently concrete definition is seen as an important element of (license) contracts between unrelated parties.1 In addition, a prudent and diligent business manager is only able to evaluate the suitability of a license scheme if the subject of the license is clearly defined. The following questions are relevant when defining the subject: what elements can be considered as IP; what exactly is the IP to be licensed; who is the legal and economic owner and is able to provide a license for the IP? As these questions are covered in other parts of this book, we will not address them in this chapter, but instead, refer to the other chapters. In the following, it is assumed that the subject of the license is clearly defined. As there are various methods available for structuring a license fee system and determining an arm’s length license rate, these aspects will be explored in more detail in Sects. 2 and 3. In the last section of this chapter, we provide some empirical observations on commonly used contract terms, in particular, the license fee mechanism and the license rate applied.

2 Structuring a License Fee System 2.1

License Mechanism

The fundamental mechanisms of a license fee system are manifold. In principle, the license mechanism agreed has to reflect both the perspective of the licensor, to generate for him an appropriate compensation for the provision of IP, and the perspective of the licensee, allowing him to earn adequate profits for his business activities. It must include appropriate returns for the risks borne and the assets utilized when developing, enhancing, and maintaining the IP. Also the administrative burdens and economic incentives for both sides should be considered when deciding on the license mechanism. Remuneration for providing licensed IP can be a fixed license amount, as a fixed payment for a certain period of time, or just a one-time payment, typically paid upfront. With such a system the parties reduce the administrative burden See FG München (16.07.2002), 6 K 1910/98; see also Blümich and Rengers (2010), KStG §8 margin note 551

1

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significantly. Along with this advantage comes the detriment that the license fee paid is not linked and may not reflect the actual business evolution of the licensed IP, which may significantly deviate from previous expectations. Hence the missing linkage would be a disadvantage for one of the parties and this is a reason why such systems are rarely seen in practice.2 With respect to license fee systems between related parties, the tax authorities and legislation partly address this aspect. The OECD assumes that with respect to transactions involving significant intangibles (such as typical license transactions) the unrelated parties would agree upon a price adjustment clause to account for the inherent uncertainty, for example, in cases where pricing is based only on the benefit.3,4 In this regard, a one-time payment would need to be scaled pro-rata for future periods on the level of the licensee, which adds additional complexity. The more frequently used alternative is a flexible license that depends to some extent on economic success with the licensed IP. For example, this can be achieved by applying a fixed license rate to a specified license base, which reflects the success of the business. This license mechanism is most commonly seen. However, it is also possible to apply declining or increasing license rates or license rates that depend on certain levels of sales or profits (“Staffellizenz” in German).5 In principle, the business risk with the licensed IP (i.e., the risk that the IP can be beneficially commercialized to generate profits) is shared between the licensee and the licensor in any of these mechanisms. As the license fee paid is linked to the economic success of the licensed IP, such mechanisms would be in the interest of the licensee. Perhaps also in the interest of the licensor, because acceptance of the license agreement and the incentive to license the IP would be higher—in particular when the business risk (uncertainty) associated with the licensed IP is significant. In addition, a flexible license allows for upside potential for the licensor, in case the business of the licensee develops better than expected. The trade-off between administrative burden, the interest of the licensor to exploit the IP to the greatest extent and the economic perspective of the licensee has also to be considered in flexible license mechanisms. Therefore, in addition to the above, mainly the following options for a flexible license mechanism could be applied: • Profit participating license: In a business with high risk (where profits expected are highly variable), it may make sense to pay a license fee only if a profit is made or when the profit exceeds a certain level. A rationale for such a mechanism would be that the licensed IP may not have created positive economic effects when the profit is low or the business is in a loss situation.

2

See Groß and Rohrer (2012), chapter A.I.3. See OECD (2017), chapter VI, D.3, 6.183. 4 In German TP regulations, for instance, §1 (3) (11) of the Foreign Tax Act (AStG) assumes that unrelated parties would agree a price adjustment clause that considers the inherent uncertainty. 5 See Engler and Gotsis (2015), chapter O.VIII.4 Arten von Lizenzgebühren. 3

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Fig. 2 Floor cap mechanism

While the aforementioned is an example of a pure floor mechanism, what is known as a “floor cap mechanism” defines a particular range of profit margins (between the floor and the cap) in which a predefined license rate has to be paid. For instance, the license rate would increase if the profit margin achieved by the licensee is above the “cap” in order to allocate some of the “excess” profit to the licensor. The floors and caps in such cases are determined from a functional and risk profile of the licensee and hence the range should reflect the character of the licensee (e.g., routine or hybrid entity). Examples of different floors and caps based on a functional and risk profile are shown in Fig. 2. • License holiday: Alternatively, the parties may agree that actual license payments start only when (i) a certain level of calculated license payments is surpassed, or (ii) a certain period of time has elapsed. The rationale for this is that the IP may not create its full potential right from the start of the license period. A license holiday also allows the licensee to invest in further market development. As the options above tend to focus on adapting the license mechanism to the needs of the licensee, the following focusses on the interests of the licensor. Even in cases of flexible license schemes, a one-time payment may be agreed upon. This helps the licensor cover some of his costs for developing the IP from the start of the licensing period and therefore reduce the uncertainty on his side. However, this does effectively push more of the economic risks associated with the use of the IP onto the licensee. In contrast to pure licensing models, a franchise model usually combines the licensing of IP with the provision of services by the franchise provider to the franchisee. The remuneration in a franchise model, therefore, includes a license fee component and a charge for the provision of services.

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185

License Fee

In the case of a flexible license system, the basis for calculating the license fee (the license base) should reflect the expected economic success of the business from using the licensed IP and consider the administrative burden. Two alternatives are generally possible: the license base can be according to sales or profits.6 Depending on the functional and risk profiles of the parties, as well as the economic environment, either may present the best alternative. Economic success is best measured by the profit generated by the licensed IP. The profit would, therefore, be a good base from the perspective of the licensee paying the license. A profit-based license may be based on gross profit or net profit (the latter determined by excluding certain operating costs other than the cost of sales), which may be defined, for example, as EBITDA, EBIT, or EBT. However, the profit determined depends on the accounting standards applied by the licensee and may also be affected by other factors that are not related to the use of IP, e.g., the costs incurred by the licensee. These factors are somewhat detrimental to the licensor; for instance, using the profit as the license base does not provide an incentive for the licensee to structure his business as efficiently as possible and this potentially reduces the license fee paid. The licensee’s sales are relatively simpler to observe and it creates a rather less administrative burden. Sales figures are also less affected by the accounting standards applied by the licensee. As the cost structure on the side of the licensee is not considered, using sales as the license base creates an added incentive for the licensee to organize his business efficiently. Due to these advantages, sales figures are used as the license base in most cases. We will, therefore, focus on sales-based licenses for the remainder of this chapter. When choosing sales as the license base, either total sales, including intercompany sales, or third-party sales may be considered. As the economic success of a business, from a group’s perspective, is ultimately determined by its sales to third parties, external sales figures should be used as the basis for calculating license fees. However, a lower rate that is applied to all steps of the value chain has also advantages, such as reducing the administrative burden. Applying the license rate only to the value-added and not to the full amount in each value step is in line with the net VAT system currently applied across Europe.7 Although a VAT system based on the gross amount was also applied in the past.8 In fact, the parties should agree on whether the license should be based on net or gross sales and whether discounts, year-end adjustments, bonuses, and delivery costs should be considered when calculating sales figures. The license rate applied to the license base determines the actual license fee. It should be chosen such that the license fee reflects the value of the licensed IP. The 6

See Engler and Gotsis (2015), chapter O.VIII.4 Arten von Lizenzgebühren. Known as “Allphasen-Nettoumsatzsteuer”. 8 Known as “Allphasen-Bruttoumsatzsteuer” applied in Germany until 1967. 7

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section “determination of license rate” sheds some light on useful methods and approaches for finding an appropriate license rate.

2.3

License Terms

Besides deciding on the fundamental license mechanism, and the license base and rate, several other aspects—some of which are outlined in the following—may be relevant to the parties. These aspects should be included in the license agreement as they can have a significant effect on the value of the licensed IP, the possibility to exploit the IP, and therefore the license fee. Term: The license contract shall be agreed for a specified period as this gives both sides certainty regardless of the business relationship between them. The term of the license agreement should not exceed the useful life of the licensed IP, because third parties would not be willing to pay for an asset when it no longer creates any value. The contract shall also include termination options with an arm’s length termination period. Exclusivity:9 The license agreement should specify the exclusivity of the license. The licensee may have the exclusive right to use the licensed intangible, i.e., to the exclusion of the licensor (exclusive license). Alternatively, the licensee may have the exclusive right to use the license as well as the licensor (sole license), or there can be no exclusivity, which means that the licensee may be one of several licensees (nonexclusive license). Sublicense:10 It should be made clear between the parties whether the licensed IP can be sublicensed by the licensee. Such provision would give control to the licensee over the IP. It also affects the chosen level of the license fee as the value of the licensed IP depends, among other aspects, on the right to sublicense or not. Alternatively, the parties could agree upon an additional license fee in cases where the licensee sublicenses the IP. Territory: In principle, the territory is limited that for which the IP rights are protected. However, it may be further restricted to certain countries, giving the licensor the opportunity to provide separate licenses for the respective territories.11 Monitoring and adjustment mechanism: The business using the licensed IP may develop very differently from that expected by the parties. The parties may, therefore, wish to implement monitoring and adjustment procedures (e.g., with a price adjustment clause, as discussed above). From a practical administrative perspective, to limit adjustments to significant cases the license rate should only be adjusted when the deviations exceed a

9

See Engler and Gotsis (2015), chapter O.VIII.3(e) Persönliche Beschränkung. See Groß and Rohrer (2012), chapter A.I.19.2. 11 See Nack and Noerr (2019), 12.2.1 Lizenzvertrag ausschließliche Lizenz, Anmerkungen, margin notes 4 and 5. 10

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predefined threshold. This predefined threshold should be specified in the license agreement and substantiated in the transfer pricing documentation. Since there is an international tendency toward the price-setting rather than the outcome-testing approach, we recommend limiting ex-post adjustments to cases in which unrelated parties would also consider such adjustments. In any case, careful documentation is paramount, to substantiate the arm’s length nature of the adjustment. This is particularly the case for sales-based license fees, as tax authorities are very likely to scrutinize ex-post adjustments of the license fee after the sales function has been performed and the sales generated. The underlying assumption of the tax authorities is that a third party would not agree to an ex-post adjustment after he has performed all his functions and borne the risk as agreed in the contractual framework. In any case, the adjustment mechanism should be clearly defined and agreed in advance by the parties in the license agreement. Improvement of licensed IP: In certain cases, the licensee may perform additional research and/or development activities to improve, adapt, or amend the licensed IP. The parties should find an agreement on whether such activities are permitted and who becomes the owner of further developed IP. If the R&D activities of the licensee lead to improved IP (in contrast to additional or new IP), it is often agreed that improvements will be to the benefit of the licensor and enter into his IP. In that case, remuneration for the R&D activities of the licensee may be agreed (if they lead to valuable improvements). Alternatively, such activities should be considered when determining the license rate. Aggregation level: Group companies commonly provide a license to more than one related entity.12 In case the functions performed by the licensees vary to some extent or there are regional differences, the license rate applied should take this into account. The license may also include a bundle of IP. The bundled IP should be clearly identified because a third party would very likely not pay for something that is not clearly defined or identifiable.13 The application of such differentiated license rates should increase the local acceptance when the profitability of the individual licensee differs from the average profitability. However, maintaining a license system with disaggregated license rates implies a large operational burden. When the differences in the functions performed by the individual licensees theoretically justify only minor differences in the license rate, reference to an arm’s length range of license rates (supported by a benchmarking study, for example) might help to identify a uniform rate for all licensees and, consequently, reduce the administrative burden significantly. Single versus multi-year approach: The applicable license rate (and update of this license rate) can either be calculated based on financial data or projections of one

12

See Grützner and Jakob (2015). The decision of the Fiscal Court of Münster regarding clear definition and identification of the licensed IP (as mentioned above) also applies to IP bundles.

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year or based on the financial data or projections of more than one year (multi-year approach; rolling license). The advantage of a multi-year approach is profitability fluctuations are smoothed out when a profit-based license fee is applied. However, from an administrative perspective, there is a disadvantage that the operational implementation can be very complex and burdensome. Furthermore, whether this approach would be accepted by all tax authorities is questionable. As an alternative, the parties may consider applying a license mechanism, where the level of the license fee depends on the actual profit level or the actual sales revenue achieved (e.g., via a sliding scale license fee, known as “Staffellizenz” in German).

3 Determination of License Rate The license rate should be determined based on the specific economic and legal conditions at hand. The subsections that follow shed some light on how an arm’s length license may be determined.

3.1

Applicable Transfer Pricing Methods

In principle, the CUP method, resale price method, cost-plus method, or profit-based methods may be used to determine the license rate. CUP method: The CUP method is one of the methods preferred by the OECD and most tax authorities. In case a license is provided to a third party, this may serve as an internal CUP if the licensed IP and the conditions under which the license is provided are comparable with the license provided to the related party. However, based on our experience, in most cases, an internal CUP is not available, because valuable IP is rarely licensed to third parties. Therefore, in almost all cases in which the CUP method is applied, an external CUP is used to determine an arm’s length license rate. When searching for a comparable external CUP, one should consider the aspects that significantly affect the value of the IP. These are mainly the comparability of the licensed IP and the compatibility of the industry in which the license is provided because both aspects have a significant effect on the value of the licensed IP.14 In principle, various sources may be used to search for an external CUP, such as databases and published studies. Further details in this regard are provided in the subsections that follow. Resale price method: On rare occasions, such as when the licensee sublicenses the licensed IP to third parties (e.g., one group entity is responsible for managing license activities), the resale price method could be applied to determine an arm’s length

14

See Engler and Gotsis (2015), chapter O.VIII.6 b), note 551 ff.

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license rate.15 The license rate may then be determined based on the revenue earned for onward licensing of the IP, deducting a certain margin. This margin should cover the costs of the licensee plus a profit element, determined using the cost-plus method. Cost-plus method: The cost-plus method should only be used for determining an arm’s length license rate when a clear link exists between the cost of developing the IP and its value.16 As the value of the IP is usually determined by other factors than cost, the cost-plus method is not applicable in most cases. However, this method may be used to determine a minimum license rate, because a licensor will try to cover his costs for developing the IP. Profit based methods: To avoid the restrictions of the methods described above, profit-based methods are preferred by the OECD for determining an arm’s length license rate. Given the general preference of the OECD for the CUP method, profitbased methods should theoretically be applied only as a secondary approach. However, due to the limitations of data availability, profit-based methods are often used, considering profit expectations as well as development costs.

3.2 3.2.1

External CUP Approaches Benchmark Study

The most common approach to identify an external CUP is to perform a benchmark study. There are databases—such as RoyaltyStat, RoyaltySource®, ktMINE, or FranchiseHelp—that can be used for such a database search. The databases collect information about third-party license agreements between unrelated parties.17 Due to the disclosure requirements in the USA, the databases mainly include US agreements. In most cases, the databases offer the possibility to view the license agreements. Therefore, not only information on the license rates are provided, but also more detailed information about the license subject, license base, and other conditions and these can be used to identify the license agreements that are comparable to the case in hand. Database studies are often used to determine an arm’s length license rate and are in line with the CUP method that is preferred by most tax authorities and the OECD. However, we notice that database studies are more and more often scrutinized by tax authorities, who frequently criticize the comparability of the license agreements identified. For a reliable database study and to be able to defend the results of the database study against claims from tax authorities, a detailed and thorough comparability analysis is therefore essential. It should also be assessed to what extent a comparability factor actually affects the license. It is often argued that the underlying

15

See Engler and Gotsis (2015), chapter O.VIII.6 c), note 611 ff. See Engler and Gotsis (2015), chapter O.VIII.6 d), notes 614 ff. 17 See Engler and Gotsis (2015), chapter H.IV.6 a) Comparables 16

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intangibles are not comparable. However, evidence is found that the license rate is less affected by the intangible that is licensed, rather by factors such as the duration of the agreement or exclusivity. We further recommend applying additional and corroborative analyses, with reference to the profit expectations, to confirm the applied license rate.

3.2.2

Markables Database Search

An alternative approach to determine arm’s length trademark license fees is to use the “Markables” database. This database contains a number of brand valuations (trademarks) sorted by industry. The valuations are mainly based on purchase price allocations (PPAs) or similar transactions between third parties from publicly available data sources. Implied license rates are calculated based on the information available (e.g., the value of the transferred brand and relevant sales volumes) with some assumptions (e.g., with respect to growth rates, discount rates, etc.). The rates are calculated for different scenarios—a cautious, optimistic, and medium scenario—which are based on various assumptions regarding growth rates and discount rates, among others. The database can thus be used to search for transactions in a comparable industry and, based on the implied license rates, to identify a range of comparable license rates for optimistic, pessimistic, and average scenarios.

3.2.3

Case Law

Judgments and rulings may also provide hints for finding an arm’s length license rate. Examples are outlined in the country chapter. For example, with regard to trademark licenses the Fiscal Court of Münster, Germany came to the conclusion that a license rate of 1% of the sales volume is appropriate for the use of a trademark.18 The calculation is based on the arm’s length principle, in other words, what an unrelated third party would have paid for the provision of the trademark (FG Münster, February 14, 2014, 4 K 1053/11 E, note 57). Rulings like this are decisions on single, specific cases. However, we recommend further substantiation of the license rate by performing additional analyses (e.g., literature research or a hypothetical arm’s length analysis). License rates may be found in judgments from infringement proceedings or those related to employee inventions. For example, for Germany such judgments are published by the German Patent and Trademark Office (Deutsches Patent und Markenamt “DPMA”); for international cases, information from the World Intellectual Property Organization (WIPO) can be used. Also, Google’s patents database, which has been published recently, gives some evidence of license agreements.

18

See FG Münster (14.02.2014), 4 K 1053/11 E.

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However, it should be noted that judgments from infringement proceedings relate to compensation for violating IP rights. These judgments can be used as a source to identify an arm’s length license rate, but one must bear in mind that judgment rulings may include a penalty, implying that the license rate from an infringement ruling could be higher than a license rate negotiated between unrelated parties. Nevertheless, in cases of infringement law in Germany what is known as “license analogy” is one of the methods used to identify the compensation to be paid to the IP owner by the person who has violated the owner’s IP rights. Following the license analogy, the IP owner can claim compensation of license fee amount that the person violating the IP right would have paid if he had entered into a license agreement. As well, court decisions on the remuneration for employee inventions may be somewhat less than an arm’s length license rate.

3.2.4

Literature

In the literature, overviews of license rates applied are available in certain cases, in particular for intangibles related to production functions.19 Such license rates are usually provided based on industries and/or product groups. As the overviews do not contain further information about the relevant facts and conditions under which the license was provided (other than the industry or product group), license rates identified this way may be used as a starting point to determine a license rate, but should be further substantiated; otherwise, the comparability of the license rates identified for the actual case in hand may be scrutinized and found questionable by tax authorities.

3.3 3.3.1

Approaches Relying on Profit-based Methods Hypothetical Arm’s Length Test

Basically, the hypothetical arm’s length test is a two-sided approach and a specific interpretation of the profit split method, applying the concept of “options realistically available” to the parties that are involved in the transfer of anything of value (in particular intangible property). It can be assumed that independent enterprises would compare transactions to the other options realistically available and would only enter into transactions if there were no attractive alternatives for meeting their commercial objectives.20 This approach basically simulates a process of bargaining between the licensor and the licensee.

19 20

e.g. Groß and Rohrer (2015). OECD (2017), chapter IX, B.3, 9.27.

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Based on the economic interests of both sides, it is necessary to determine both a minimum license fee for the licensor (the lowest price for which he is still willing to enter into a license agreement) and a maximum license fee for the licensee (the highest price for which he is willing to enter into the license agreement), considering all the relevant conditions and circumstances If the minimum license fee for the licensor is below the maximum license fee for the licensee, the two prices form a range of arm’s length license fees. The German transfer pricing regulations then assume that the arithmetic mean of the minimum and the maximum license fees is the license fee on which the two parties would agree upon. However, the taxpayer could choose any license fee within the range, provided he can substantiate his choice and provide arguments why this specific rate is the right one to choose. It should be noted that this analysis can also be used to argue that the provision of the license is, or at least was expected, to be beneficial for both parties when setting up the license agreement.

3.3.2

Profit Split and Residual Profit Split Methods

The license fee could be also determined using the profit split method. Using this method, an arm’s length profit split key has to be identified. This can be achieved by either analyzing a hypothetical bargaining situation between the licensor and the licensee (a hypothetical arm’s length analysis) or by relying on a database study. The profit split key that is identified would be applied to the expected profit, in order to determine an arm’s length license fee. If certain functions are also performed routinely, the procedure described above can be amended so that all routine functions are remunerated in a first step and the remaining profit is split between the licensor and the licensee in a second step. The first step would require identifying appropriate remunerations for the routine functions, which can often be achieved by relying on database searches.

3.3.3

Rule of Thumb

According to the German Administrative Principles of 1983, a prudent and diligent business manager would only be willing to pay for a license when he can earn an appropriate profit from the licensed product.21 The so-termed “Knoppe formula” is based on a similar logic. According to this formula, a licensee is likely to accept a license fee that amounts to 25–33% of the profit achieved by the licensee from using the licensed IP (before considering the license payment).22

21

See Verwaltungsgrundsätze (1983), 5.2. Ableitung der Fremdpreise, No. 5.23. See Knoppe (1972), Engler and Gotsis (2015), chapter O.VIII.6(e)(bb) Knoppe-Formel und andere Pauschalregeln. 22

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In English-speaking countries, a similar rule of thumb is known as the “25 per cent rule,” under which, as its name suggests, up to 25% of the profit may be paid as license fee.23 Further, US tax authorities often state that a licensee would only pay for the licensed IP if he would achieve profits that are commensurate with income generated from the IP over the medium term. However, such rules of thumb are nowadays rejected by many tax authorities as well as by the OECD. Tax authorities and the OECD prefer a thorough analysis, based on the profit split method and the expectations of the licensor and licensee with regard to the profit generated from the licensed IP.24

4 Empirical Observations The previous sections outline how a license system can be set up and discuss how the license fee can be determined. This section provides insights from empirical observations. In the subsections that follow we present: (i) insights from a database analysis, (ii) insights from license contracts we analyzed in recent license rate benchmarking studies, and (iii) insights based on our professional experience in supporting various clients in setting up license transactions.

4.1

Database Analysis

We used the RoyaltyStat database to analyze license agreements in order to find empirical evidence with regard to the structure and content of license systems. Our aim was to find license structures that are typically used in practice between unrelated parties. The RoyaltyStat database is an online directory that contains details of over 20,000 agreements compiled from the US Securities and Exchange Commission (SEC) Edgar Archive. This database permits the identification of agreements based on their business activity codes, types of agreement, territory, licensor and licensee names, and text keywords. The search engine for the database can filter agreements based on specified criteria. The agreements that were available in RoyaltyStat© License Agreement Search (1999–2019) amounted to 21,179 when excluding agreements between related parties. In order to find license structures commonly used in practice, we searched for various royalty bases and royalty rate ranges in the database. Table 1 shows the number of license agreements in RoyaltyStat that included either trademark or technology related licenses.

23 24

See Nestler (2013). OECD (2017), chapter II, A, 2.10; chapter VI, D.2.6, 6.144.

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Table 1 Number of license agreements Agreement type Trademark, trade name Patent, technology, know-how, research Total

No. of agreements 7,334 10,930 18,264

Table 2 Results of the database analysis Royalty rate Royalty based on Financials Net sales Net profit Operating profit COGS Value added Quota Per unit Per user Per ton Per copy Per pound

13,914 13,380 260 186 82 6 1,194 989 94 42 35 34

92% 89% 2% 1% 1% 0% 8% 7% 1% 0% 0% 0%