Transfer pricing and intangibles : US and OECD arm's length distribution of operating profits from IP value chains. 9789087224943, 908722494X, 9789087224950, 9087224958, 9789087224967, 9087224966

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45 DOCTORAL SERIES

Transfer Pricing and Intangibles US and OECD Arm’s Length Distribution of Operating Profits from IP Value Chains

Oddleif Torvik is a tax lawyer with Advokatfirmaet Schjødt AS, one of Norway’s largest corporate law firms, where he advises primarily on transfer pricing and international tax issues. He also holds a position as Associate Professor at the Department of Accounting, Auditing and Law at the Norwegian School of Economics (NHH) in Bergen and is an affiliated member of the Norwegian Centre for Taxation (NoCeT) at NHH. He obtained his PhD at the Faculty of Law at the University of Bergen. His primary research interest lies in the field of transfer pricing.

The first part of the process determines the amount of superprofits allocable to a unique and valuable IP (royalty amount). The US and OECD transfer pricing methods that govern this determination are analysed, applying a distinction between unique and non-unique value chain contributions, and it is observed that the methodology has evolved significantly over the years, from primarily relying on imprecise third-party benchmarking to more substancebased approaches that seek to ensure results that adhere to the realistic alternatives of the controlled parties. The second part of the profit allocation process determines to which group entity, and thus indirectly also to which jurisdiction, the amount of IP superprofits will be allocated. The US and OECD intangible ownership provisions that govern this determination are analysed, applying an original analytical distinction between manufacturing and marketing IP. The analysis shows that, while both the US and OECD rules go a long way towards aligning the allocation of superprofits from R&D-based manufacturing IP with value creation, the allocation of superprofits from marketing IP still largely hinges on formal legal ownership and thus opens the opportunity for tax planning from multinationals and should be ripe for future reform. This book is suited for those that have an interest in transfer pricing analysis, e.g. students, lawyers, accountants and economists. The historical background of the current transfer pricing rules is explained, allowing for an “all-in-one” solution for catching up with the US and OECD transfer pricing development over the last decades.

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Transfer Pricing and Intangibles: US and OECD Arm’s Length Distribution of Operating Profits from IP Value Chains

The transfer pricing of intangibles (patents, trademarks, etc.) is an important issue in international tax law, because it determines how superprofits generated by multinationals through the exploitation of valuable intellectual property (IP) in their worldwide value chains are allocated among the jurisdictions in which they do business. For decades, multinationals have used IP transfer pricing to shift taxable profits out of high-tax jurisdictions, causing serious base erosion. Both the United States and the OECD seek to combat these practices through mandatory transfer pricing rules aimed at ensuring that IP superprofits are taxed where the intangible value was created. The profit allocation process prescribed by these rules is analysed in this text.

Oddleif Torvik

About the Author

Oddleif Torvik

Transfer Pricing and Intangibles US and OECD Arm’s Length Distribution of Operating Profits from IP Value Chains

About the Series True to its mission of disseminating knowledge of international taxation and promoting the study of taxation in general, IBFD has taken the initiative to make available to a wider audience a series of books based on doctoral research. The IBFD Doctoral Series accepts only contributions that enhance the international academic tax debate and meet the highest academic standards. In order to ensure top quality, every thesis published in the series underwent peer reviewing in line with the strictest selection standards.

Books published in the IBFD Doctoral Series should: • achieve particularly original research results • include a significantly innovative component • be based on a thorough knowledge of the existing literature on the topic(s) • have a particularly strong, longlasting impact on European and/or international tax law

IBFD DOCTORAL SERIES

45 02-11-18 14:53

Transfer Pricing and Intangibles

IBFD Doctoral Series Editor-in-Chief: Pasquale Pistone Managing Editor: Craig West True to its mission of disseminating knowledge of international taxation and promoting the study of taxation in general, IBFD has taken the initiative to make available to a wider audience a series of books based on doctoral research. The IBFD Doctoral Series accepts only contributions that enhance the in­ ternational academic tax debate and meet the highest academic standards. In order to ensure top quality, every thesis published in the series underwent peer reviewing in line with the strictest selection standards. Books published in the IBFD Doctoral Series should: – achieve particularly original research results; – include a significantly innovative component; –  be based on a thorough knowledge of the existing literature on the topic(s); – have a particularly strong, long-lasting impact on European and/or in­ ternational tax law. The IBFD Doctoral Series is indexed in Thomson Reuters’ Book Citation Index.

Transfer Pricing and Intangibles US and OECD arm’s length distribution of operating profits from IP value chains Oddleif Torvik

Thesis submitted to the University of Bergen in fulfilment of the requirements for the degree of Philosophiae Doctor (PhD) Degree awarded on 9 December 2016

Volume 45 IBFD Doctoral Series

IBFD Visitors’ address: Rietlandpark 301 1019 DW Amsterdam The Netherlands Postal address: P.O. Box 20237 1000 HE Amsterdam The Netherlands Telephone: 31-20-554 0100 Fax: 31-20-622 8658 www.ibfd.org © 2018 IBFD All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the written prior permission of the publisher. Applications for permission to reproduce all or part of this publication should be directed to: [email protected]. Disclaimer This publication has been carefully compiled by IBFD and/or its author, but no representation is made or warranty given (either express or implied) as to the completeness or accuracy of the information it contains. IBFD and/or the author are not liable for the information in this publication or any decision or consequence based on the use of it. IBFD and/or the author will not be liable for any direct or consequential damages arising from the use of the information contained in this publication. However, IBFD will be liable for damages that are the result of an intentional act (opzet) or gross negligence (grove schuld) on IBFD’s part. In no event shall IBFD’s total liability exceed the price of the ordered product. The information contained in this publication is not intended to be an advice on any particular matter. No subscriber or other reader should act on the basis of any matter contained in this publication without considering appropriate professional advice. The IBFD and/or the author cannot be held responsible for external content, broken links or risks within the external websites that are referenced as hyperlinks within this publication. Where photocopying of parts of this publication is permitted under article 16B of the 1912 Copyright Act jo. the Decree of 20 June 1974, Stb. 351, as amended by the Decree of 23 August 1985, Stb. 471, and article 17 of the 1912 Copyright Act, legally due fees must be paid to Stichting Reprorecht (P.O. Box 882, 1180 AW Amstelveen). Where the use of parts of this publication for the purpose of anthologies, readers and other compilations (article 16 of the 1912 Copyright Act) is concerned, one should address the publisher.

ISBN 978-90-8722-495-0 (print) ISBN 978-90-8722-497-4 (eBook, ePub); 978-90-8722-496-7 (eBook, PDF) ISSN 1570-7164 (print) NUR 826



Table of Contents Preface

xxvii

Abbreviations

xxxi Part 1

Chapter 1:

Research Questions, Methodology and Sources of Law

3

1.1. Introductory comments

3

1.2. Key terminology and contextualization

6

1.3. Research questions and structure

12

1.4. Methodology

16

1.5. The relevant OECD sources of law 1.5.1. Introduction 1.5.2. Article 9 of the OECD MTC 1.5.3. The OECD Commentaries on Article 9 and the OECD Transfer Pricing Guidelines 1.5.4. Article 7 of the OECD MTC 1.5.5. The OECD Commentaries on Article 7 and the 2010 OECD Report 1.5.6. Case law in connection with articles 9 and 7

22 22 23 24 28 29 30

1.6. The relevant US sources of law 1.6.1. Introduction 1.6.2. IRC section 482 1.6.3. The IRC section 482 US Treasury Regulations 1.6.4. Case law 1.6.5. The OECD TPG

30 30 31 33 35 36

1.7. A few words on the 2017 US tax reform

37

1.8. The relationship between the book and other transfer pricing literature

41

1.9. Reference register and source abbreviations

45

v

Table of Contents

Chapter 2:

Business and Tax Motivations for Intangible Value Chain Structures

47

2.1. Introduction

47

2.2. Horizontal and vertical FDI

48

2.3. To stay home (outsource) or to go out (FDI)?

50

2.4. The centralized principal model for profit allocation

52

2.5. IP regimes and the 2015 OECD nexus approach

54

Chapter 3:

Controlled Intangibles Transfers

63

3.1. Introduction

63

3.2. The US intangibles definition 3.2.1. Introduction 3.2.2. The pre-2018 version of the US IP definition 3.2.2.1. Introductory comments 3.2.2.2. The relationship between the 936 definition and ­profit ­allocation 3.2.2.3. Are goodwill, going concern value and workforce in place encompassed by the pre-2018 version of the 936 definition? 3.2.2.4. Is goodwill distinguishable from synergy value attributable to a group of identifiable 936-definition intangibles valued in the aggregate? 3.2.2.5. Concluding comments on the pre-2018 version of the US IP definition 3.2.3. The 2018 version of the US IP definition (the 2017 tax reform amendment)

64 64 65 65

3.3. The OECD intangibles concept

85

3.4. Useful distinctions on the intangibles concept 3.4.1. Introduction 3.4.2. Manufacturing and marketing intangibles 3.4.3. Unique and non-unique value chain contributions

88 88 88 90

vi

68 71 79 82 84



Table of Contents

3.5. Controlled intangibles transfers subject to transfer pricing under US law 3.5.1. The taxation of US inbound and outbound intangibles transfers 3.5.2. The context in which IRC section 367 applies: Non-recognition transactions 3.5.3. The historical background of IRC section 367 3.5.4. Current gain recognition under IRC section 367(a) 3.5.5. Deemed royalty inclusions under IRC section 367(d) 3.5.5.1. Historical background 3.5.5.2. The material content of IRC section 367(d): Sale of ­contingent payments 3.5.6. Income recognition under section 367(a) or (d) for intangible transfers? 3.5.7. The further relationship between profit allocation under sections 482 and 367 3.5.8. The relationship between profit allocation under the section 482 cost-sharing regulations and section 367(d)

95 95 97 98 99 104 104 105 108 109 112

3.6. Controlled intangibles transfers subject to transfer pricing under the OECD TPG

116

3.7. Concluding comments

117

Chapter 4:

Introduction to Part 2

119

Part 2 Chapter 5:

The Historical Development of ­ Profit-Based Transfer Pricing Methodology

125

5.1. Introduction

125

5.2. Development of the US PSM and the contract manufacturer theory through case law 5.2.1. Introduction 5.2.2. The 1968 regulations and their background 5.2.3. Three inbound cases: Nestlé, French and Ciba 5.2.3.1. Introduction

126 126 127 129 129

vii

Table of Contents

5.2.3.2. Nestlé (1963) 5.2.3.3. French (1963) 5.2.3.4. Ciba (1985) 5.2.4. Three outbound cases: Eli Lilly, Searle and Merck 5.2.4.1. Introduction 5.2.4.2. The historical tax treatment of investments in US ­possessions 5.2.4.3.  Eli Lilly (1985) 5.2.4.4. Searle (1987) 5.2.4.5. Merck (1991) 5.2.5. Four roundtrip cases: Bausch, Sundstrand, Perkin and Seagate 5.2.5.1. Introduction 5.2.5.2. Bausch (1989) 5.2.5.3. Sundstrand (1991) 5.2.5.4.  Perkin-Elmer (1993) 5.2.5.5. Seagate (1994) 5.2.6. Two cases on controlled services and sales contracts: DuPont (1979) and Hospital Corporation of America (1983)

130 131 135 136 136 137 137 142 143 145 145 146 148 149 150 152

5.3. US legislative and regulatory implementation of “profit-based” methods 5.3.1. Introduction 5.3.2. The 1986 tax reform 5.3.3. The 1988 White Paper 5.3.4. The 1994 US regulations

153 153 153 155 159

5.4. OECD implementation of “profit-based” transfer pricing methodology

161

Chapter 6:

Metaconcepts Underlying the US and OECD Profit Allocation Rules

165

6.1. Introduction

165

6.2. The relationship between operating profits and the transfer pricing methods 6.2.1. Introduction 6.2.2. The concept of operating profits 6.2.3. Delineating the components of operating profits

167 167 167 169

viii



Table of Contents

6.2.3.1. Sales 169 6.2.3.2. Costs of goods sold 170 6.2.3.3. Gross profit 170 6.2.3.4. Operating expenses 170 6.2.3.5. Net profit 171 6.2.4. Information on gross profits may be unavailable 172 6.2.5. Information on transaction-level profits may be unavailable173 6.3. The relationship between gross and net profit methods 174 6.3.1. Introduction 174 6.3.2. Common methodological traits among the gross and net profit methods 175 6.3.3. Relevant parameters under the gross and net profit methods and their impact on reliability 178 6.3.4. Are operating expenses relevant under the transactional pricing methods (CUT, resale and cost-plus)? 181 6.3.5. Are comparability adjustments under the gross profit methods more reliable than under the net profit methods? 184 6.4. Which transfer pricing method should govern the profit allocation among value chain inputs?

187

6.5. The arm’s length range 6.5.1. Introduction 6.5.2. The level of comparability required to include an uncontrolled transaction in the arm’s length range 6.5.3. On which point within the arm’s length range may a reassessment be based?

190 190

6.6. Comparability 6.6.1. Introductory comments 6.6.2. The standard of comparability 6.6.3. Does the degree to which comparability is required vary among the pricing methods? 6.6.4. The relationship between comparability and the rules for determining ownership of intra-group-developed intangibles

194 194 197

ix

191 194

198 199

Table of Contents

6.6.5. Comparability factors 6.6.5.1. Introduction 6.6.5.2. Contractual terms 6.6.5.2.1. Introduction 6.6.5.2.2. Comparability of contractual terms 6.6.5.2.3. Economic substance and non-recognition 6.6.5.3. Functions 6.6.5.4. Economic conditions 6.6.5.4.1. Introduction 6.6.5.4.2. Use of comparables from other markets 6.6.5.4.3. Location savings 6.6.5.4.4. Temporary pricing strategies 6.6.5.5. Risks 6.6.5.5.1. Introductory comments on risk 6.6.5.5.2. Contractual risk allocation among group entities 6.6.5.5.3. Risks affect pricing, not the other way around

200 200 201 201 201 202 207 208 208 209 209 210 211 211 213 217

6.7. The aggregation of controlled transactions 6.7.1. Introduction 6.7.2. The US regulations 6.7.3. The OECD TPG 6.7.4.  GlaxoSmithKline (Canada) 6.7.4.1. Introduction 6.7.4.2. The factual pattern 6.7.4.3. The 2008 Tax Court ruling 6.7.4.4. The 2012 Supreme Court ruling 6.7.4.5. Observations on the Supreme Court ruling

217 217 218 220 221 221 222 225 230 232

Chapter 7:

Direct Transaction-Based Allocation of Residual Profits to Unique and Valuable IP: The CUT Method

237

7.1. Introduction

237

7.2. The US CUT method 7.2.1. Introduction 7.2.2. The purported CUT pertains to a transfer of the same intangible as transferred in the controlled transaction

238 238

x

238



Table of Contents

7.2.3. The purported CUT pertains to a transfer of a different intangible than that transferred in the controlled transaction 7.2.3.1. Introduction 7.2.3.2. Direct assessment of profit potential 7.2.3.3. Indirect assessment of profit potential 7.2.3.4. Assessment of profit potential in other cases 7.2.4. There are no CUTs available 7.3. The OECD CUT method 7.3.1. Introduction 7.3.2. Comparability requirements for unique IP under the CUT method 7.3.3. Comparability adjustments for unique IP under the CUT method 7.3.4. Commercial databases 7.3.5. Concluding comments Chapter 8:

Indirect Profit-Based Allocation of Residual Profits for Unique and Valuable IP: The CPM (US) and TNMM (OECD)

239 239 241 241 242 246 247 247 248 249 250 251

253

8.1. Introduction

253

8.2. A lead-in to the methodology

254

8.3. The scope of application of the methodology

257

8.4. How operating profits may be allocated to the tested party under the methodology 8.4.1. Introduction 8.4.2. Selecting an appropriate profit level indicator 8.4.3. Extracting the profit level indicator data from comparable independent enterprises 8.4.4. Applying the extracted profit level indicator data to the tested party

264

8.5. Comparability under the CPM

265

8.6. Comparability under the TNMM 8.6.1. Introduction

267 267

xi

259 259 259 262

Table of Contents

8.6.2. The concept of blended profits illustrated by an example 268 8.6.3. The 1995 consensus text on the TNMM with respect to aggregation of transactions 273 8.6.4. The 2006 comparability report 277 8.6.5. The 2008 discussion draft 282 8.6.6. The final 2010 OECD TPG on the use of aggregated third-party profits as comparables 284 8.6.6.1. Introduction 284 8.6.6.2. The first norm: Aggregated third-party profits may be used as comparables as long as they are the result of “similar” third-party transactions 284 8.6.6.3. The second norm: Aggregated third-party profits may be used as comparables as long as they are not the result of “materially different” third-party transactions285 8.6.6.4. The third norm: Aggregated third-party profits may be used as comparables if the total functions performed by the third party are closely aligned with the functions ­performed by the tested party with respect to the ­controlled transaction 287 8.6.6.5. Harmonizing the three norms through interpretation 289 8.6.6.6. Conclusion 292 8.6.7. Applying the 2010 OECD TPG rule to the golf ball example294 8.7. Has the TNMM converged towards the 1988 White Paper BALRM?

295

8.8. Is reduced transactional comparability under the TNMM a significant problem?

297

8.9. Closing comments on comparability under the ­one-sided, profit-based methodology

299

Chapter 9:

Direct Profit-Based Allocation of Residual Profits to Unique and Valuable IP: The Profit Split Method

301

9.1. Introduction

301

9.2. The scope of application of the methodology

302

xii



Table of Contents

9.2.1. Introduction 9.2.2. The US PSM 9.2.3. The OECD PSM

302 302 304

9.3. How operating profits may be split under the methodology 9.3.1. Introduction 9.3.2. Profit split allocation patterns allowed under the US regulations 9.3.3. Profit split allocation patterns allowed under the OECD TPG

317

9.4. The PSM in valuation scenarios

320

9.5. The OECD PSM is limited to information known or reasonably foreseeable at the outset

323

Chapter 10: Location Savings, Local Market Characteristics and Synergies

311 311 311

327

10.1. Introduction

327

10.2. A lead-in to the topic: The incremental operating profits at stake

328

10.3. Which jurisdiction should be entitled to tax incremental operating profits: The basic arguments

330

10.4. What are location savings?

331

10.5. The allocation of cost savings 10.5.1. Introduction 10.5.2. Local comparables are available 10.5.3. Local comparables are unavailable

333 333 333 339

10.6. What are other LSAs?

341

10.7. The allocation of location rents 10.7.1. Introduction 10.7.2. Local comparables are available 10.7.3. Local comparables are unavailable

343 343 343 343

10.8. Synergies

344 xiii

Table of Contents

Chapter 11: Transfer Pricing of Intangibles in the Post-BEPS Era under the OECD TPG

347

11.1. Introduction

347

11.2. A transfer pricing paradigm under pressure

347

11.3. Shall something more now be allocated to source jurisdictions?350 11.4. The relative roles of the CUT method, TNMM and PSM for the transfer pricing of intangibles Chapter 12: Allocation of Residual Profits for Unique and Valuable IP Based on Unspecified Pricing Methods

355

359

12.1. Introductory comments

359

12.2. Unspecified methods under the US regulations

361

12.3. Unspecified methods under the OECD TPG

363

Chapter 13: Allocation of Residual Profits to Unique and Valuable IP through Valuation

367

13.1. Introduction

367

13.2. The valuation techniques accepted under the OECD TPG

369

13.3. The valuation parameters in DCF-based valuation 13.3.1. Introduction 13.3.2. The estimation of future operating profits 13.3.3. The estimation of useful life, growth rates and terminal value 13.3.4. The estimation of discount rates 13.3.5. What are the consequences of using unreliable valuation parameters?

xiv

371 371 371 372 375 376



Table of Contents

13.4. Allocation of the valuation amount among the controlled value chain contributions

376

13.5. The options realistically available as a restriction on the possible allocation outcomes

379

13.6. Is there a legal basis for applying a discount to the transfer price?

382

Chapter 14: Allocation of Residual Profits to Unique and Valuable IP through Cost-Sharing Structures

383

14.1. Introduction

383

14.2. Buy-in pricing under the US regulations 385 14.2.1. Introduction 385 14.2.2. The development of the US cost-sharing regulations 385 14.2.3. The 2007 Coordinated Issue Paper 389 14.2.4. Case law: Veritas (2009) 394 14.2.5. Case law: Amazon.com (2017) 401 14.2.6. Concluding comments on Veritas and Amazon.com 409 14.2.7. Key concepts under the current cost-sharing regulations412 14.2.7.1. Introduction 412 14.2.7.2. Cost-sharing transactions 412 14.2.7.3. RAB share 412 14.2.7.4. Non-overlapping (ownership) interests in intangibles d­ eveloped under the CSA 413 14.2.7.5. Platform contributions 414 14.2.8. The buy-in pricing methods 416 14.2.8.1. Introduction 416 14.2.8.2. The CUT method 417 14.2.8.3. The income method 418 14.2.8.4. The acquisition price method 425 14.2.8.5. The market capitalization method 426 14.2.8.6. The RPSM 427 14.2.8.7. Unspecified methods 430 14.3. Buy-in pricing under the OECD TPG

430

14.4. The relationship between US and OECD buy-in pricing

435

xv

Table of Contents

Chapter 15: Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

437

15.1. Introduction

437

15.2. A lead-in to compensating adjustments

438

15.3. Taxpayer-initiated adjustments under US law

443

15.4. Year-end adjustments under the OECD TPG

447

15.5. Year-end adjustments in the European Union

451

452 15.6. Case law: Vingcard (Norway, 2012) 15.6.1. Introduction 452 15.6.2. The factual pattern of the case 453 15.6.3. The comparables supporting the taxpayer profit allocation454 15.6.4. The contractual risk allocation 457 15.6.5. Concluding comments 459 15.7. Case law: ITCO (Italy, 2010)

460

15.8. Case law: H1 A/S (Denmark, 2010)

460

15.9. Case law: H1.1.1 A/S (Denmark, 2012)

461

15.10. The US GlaxoSmithKline settlement (2006)

462

Chapter 16: Periodic Adjustments of Controlled IP Transfer Pricing 16.1. Introduction

465 465

16.2. The development of the US periodic adjustment concept465 16.2.1. Introduction 465 16.2.2. The 1985 House Report and the 1988 White Paper 466 16.2.3. The relationship between the transfer pricing methods and the periodic adjustment provision in the White Paper 470

xvi



Table of Contents

16.2.4. Exceptions from the White Paper’s periodic adjustment provision 16.3. The US periodic adjustment provision 16.3.1. Introduction 16.3.2. The main rule: The profit allocation must be commensurate with income 16.3.3. Exceptions to the periodic adjustment rule 16.3.3.1. Introduction 16.3.3.2. First exception: Initial fixed pricing based on CUTs i­ nvolving the same intangible (“genuine” CUT exception) 16.3.3.3. Second exception: Initial fixed pricing based on CUTs i­ nvolving a comparable intangible (inexact CUT exception) 16.3.3.4. Third exception: Initial fixed pricing based on methods other than the CUT method 16.3.3.5. Fourth exception: Extraordinary events 16.3.4. Five-year cut-off rule 16.3.5. Concluding remarks on the exceptions

471 472 472 472 479 479 480 481 487 488 490 490

16.4. Periodic adjustments to lump-sum IP transfers under US law

491

16.5. The OECD periodic adjustment provision

493

16.6. Periodic adjustments of buy-in pricing under the US regulations 16.6.1. Introductory remarks 16.6.2. A periodic adjustment is triggered if the AERR is greater than the PRRR 16.6.3. Making a periodic adjustment: Applying the adjusted RPSM 16.6.4. The procedure for making a periodic adjustment to a buy-in payment illustrated 16.6.5. Exceptions to the periodic adjustment provision 16.6.5.1. Introduction 16.6.5.2. Exception: The initial buy-in pricing is based on a CUT involving the same platform contribution

xvii

503 503 504 507 508 514 514 514

Table of Contents

16.6.5.3. Exception: Extraordinary events 16.6.5.4. Exception: Reduced AERR does not cause a periodic trigger 16.6.5.5. Exception: Increased AERR does not cause a periodic trigger 16.6.5.6. Exception: Cut-off rule 16.7. Periodic adjustments of buy-in pricing under the OECD TPG Chapter 17: The Allocation of Residual Profits to a Permanent Establishment

514 515 516 517 517 519

17.1. Introduction

519

17.2. Historical background

520

17.3. The relationship between articles 7 and 9

522

17.4. The article 7 profit allocation system 17.4.1. Introduction 17.4.2. Assignment of assets, capital and risk to the PE 17.4.3. Assignment of transactions and dealings to the PE

523 523 524 528

17.5. Transfer pricing of the IP transactions and the dealings of a PE

529

17.6. Allocation of operating profits to a dependent agent PE 17.6.1. Introduction 17.6.2. A lead-in to the discussion 17.6.3. The OECD approach for allocating operating profits to a dependent agent PE 17.6.4. Is the dependent agent PE relevant? 17.7. The UN approach for allocating profits to a PE 17.7.1. Introduction 17.7.2. The allocation norm under article 7 of the 2011 UN MTC 17.7.3. The relationship between articles 7 and 9 of the UN MTC

xviii

532 532 533 535 537 543 543 544 547



Table of Contents

Chapter 18: Introduction to Part 3

549

Part 3 Chapter 19: The Evolution of the US and OECD Approaches to Intangible Ownership 19.1. Introduction

555 555

19.2. Determination of IP ownership under the 1968 US regulations 19.2.1. Introduction 19.2.2. The DA rule 19.2.3. The DA rule was geared towards, but not limited to, manufacturing IP 19.2.4. Was the DA rule limited to the development of entirely new IP? 19.2.5. Case law on the DA rule 19.2.5.1. Introduction 19.2.5.2.  GlaxoSmithKline Holdings v. CIR (2006) 19.2.5.2.1. Introductory comments 19.2.5.2.2. A lead-in to the case 19.2.5.2.3. The principal IRS argument that the US subsidiary was the developer 19.2.5.2.4. The secondary IRS argument that the US subsidiary was the assister 19.2.5.2.5. How would the case have been assessed under the DA rule? 19.2.5.3.  DHL Corporation v. CIR (1998) 19.3. Determination of IP ownership under the 1992 proposed and 1993 temporary US regulations 19.4. Determination of IP ownership under the 1994 final US regulations 19.4.1. Introduction 19.4.2. Reason 1 for replacing the DA rule: Criticism against its treatment of the legal owner 19.4.3. Reason 2 for replacing the DA rule: OECD conformity

xix

556 556 557 559 560 561 561 561 561 562 563 564 566 567 571 572 572 573 575

Table of Contents

19.4.4. The point of departure under the 1994 IP ownership rules: The legal owner (of IP subject to legal protection) and the developer (of IP not subject to legal protection) are entitled to residual profits 19.4.5. The first exception to the legal ownership rule: Economic substance 19.4.6. The second exception to the legal ownership rule: The multiple owners rule (1994 cheese examples) 19.4.7. Concluding remarks on the 1994 US approach to intangible ownership

584

19.5. Determination of IP ownership under the historical OECD TPG

585

Chapter 20: A Lead-In to the Determination of IP Ownership under the US Regulations and OECD TPG: A Story about Legal Ownership, Control and Economic Substance

577 580 581

589

20.1. Introduction

589

20.2. The US regulations 20.2.1. Introduction 20.2.2. Legal ownership 20.2.3. The treatment of licensees

590 590 590 591

20.3. The OECD TPG

596

20.4. The determination of ownership of intangibles not subject to legal protection

597

20.5. Ownership and economic substance

597

Chapter 21: The Distribution among Group Entities of Residual Profits Generated through Exploitation of Internally Developed Manufacturing IP under the US Regulations

607

21.1. Introduction

607

21.2. The value drivers in manufacturing IP development

608

xx



Table of Contents

21.3. The economic substance exception applied to manufacturing IP 21.3.1. Introduction 21.3.2. The economic substance exception should not replace the transfer pricing methods 21.3.3. Imputation of contingent payment terms: A lead-in 21.3.4. Imputation of contingent payment terms base example: Successful contract R&D arrangement with contingent profit split payment structure 21.3.5. Imputation of contingent payment terms example: Unsuccessful contract R&D arrangement with contingent profit split payment structure 21.3.6. Imputation of contingent payment terms example: Successful contract R&D arrangement with cost-plus-based contingent payment structure 21.3.7. Concluding remarks on the application of the economic substance exception to impute contingent payment terms 21.4. The US stance on contract R&D arrangements in light of the 2015 provisions on the arm’s length standard and best-method rule Chapter 22: The Distribution among Group Entities of Residual Profits Generated through Exploitation of Internally Developed Manufacturing IP under the OECD TPG

610 610 610 612 614 615 616 617

619

625

22.1. Introduction

625

22.2. A lead-in to the profit allocation problem for internally developed manufacturing IP

626

22.3. Profit allocation for IP development contributions: Functions628 22.3.1. Introduction 628 22.3.2. The “important functions” doctrine 629 22.3.3. Outsourcing: Contract R&D arrangements 630 22.3.3.1. Introduction 630

xxi

Table of Contents

22.3.3.2. The relationship between the 2015 OECD important-functions doctrine and the historical 2009 business ­restructuring and intra-group services guidance 22.3.3.3. The important-functions doctrine and contract R&D ­arrangements 22.3.3.4. Performance of important R&D functions through ­geographically dispersed employees

631 634 639

22.4. Profit allocation to IP development contributions: Funding640 22.4.1. Introduction 640 22.4.2. A lead-in to the issue 640 22.4.3. Control over financial risk 643 22.4.4. The point of departure for determining the riskadjusted rate of return 646 22.4.5. Uncontrolled transaction analogy for determining the risk-adjusted rate of return: Venture capital financing647 22.4.6. Do the OECD TPG examples contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? 652 22.4.7. Do the US CSA regulations contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? 655 22.4.8. Does the cost of capital contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? 658 22.4.9. Do the financing alternatives realistically available contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? 659 22.4.10. Does the financial risk assumed contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? 663 22.4.11. Concluding comments on IP development funding 667 22.5. Profit allocation for IP development contributions: Pre-existing unique IP 22.5.1. Introduction 22.5.2. The point of departure for pricing the contribution of the pre-existing IP

xxii

672 672 673



Table of Contents

22.5.3. The pre-existing IP is contributed by the same group entity that carries out the ongoing R&D functions675 22.5.4. The pre-existing IP is contributed by a group entity different from that which carries out the ongoing R&D functions 677 22.5.5. Concluding remarks on the contribution of ­ pre-existing IP to intangible development processes 679 Chapter 23: The Distribution among Group Entities of Residual Profits Generated through Exploitation of Internally Developed Marketing IP under the US Regulations

681

23.1. Introduction

681

23.2. A lead-in to the profit allocation problem for internally developed marketing IP

682

23.3. When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance? 23.3.1. Introduction 23.3.2. The wristwatch example: US distributor incurs incremental marketing expenditures to build local value of foreign-owned trademark 23.3.3. The athletic gear base example: US subsidiary incurs incremental marketing expenditures to build local value of foreign-owned trademark 23.3.4. The athletic gear example: The 2006 extension 23.3.5. Concurrent remuneration during the IP development phase as a safe harbour from the economic substance exception 23.3.6. A premise for triggering the economic substance exception: “Incremental” marketing expenditures 23.3.7. The economic substance exception should be relevant only for incoherent pricing structures 23.3.8. The economic substance exception is balanced relative to its 1994 predecessor 23.4. Remuneration of a US distribution entity when the economic substance exception is not triggered xxiii

684 684 684 685 686 687 688 691 694 696

Table of Contents

23.4.1. Introduction 23.4.2. Arm’s length marketing expenditures are incurred 23.4.3. Above-arm’s length marketing expenditures are incurred 23.4.3.1. Introduction 23.4.3.2. Scenario 1: The US subsidiary is deemed owner of a licence 23.4.3.3. Scenario 2: The US subsidiary is compensated under a separate service agreement 23.4.3.4. Scenario 3: The foreign legal owner is compensated ­under a separate service agreement 23.4.4. What is the appropriate transfer pricing methodology to remunerate an assister? 23.5. Concluding remarks Chapter 24: Distribution among Group Entities of Residual Profits Generated through Exploitation of Internally Developed Marketing IP under the OECD TPG

696 697 699 699 699 702 703 705 707

711

24.1. Introduction

711

24.2. The 2017 OECD TPG require differentiation of market-based super profits

712

24.3. Scenario 1: The local group distribution entity is reimbursed on a cost-plus basis

714

24.4. Scenario 2: The local group distribution entity bears an arm’s length level of marketing costs 24.4.1. The subsidiary must earn a normal market return throughout the IP development phase 24.4.2. The first twist: The duration of the distribution agreement is shortened; can residual profits then be allocated to the subsidiary? 24.4.3. The second twist: A royalty payment is introduced; can residual profits then be allocated to the subsidiary?

719 719 724 726

24.5. Scenario 3: The local group distribution entity bears an above-arm’s length level of marketing costs 729 xxiv



Table of Contents

24.5.1. Introduction 729 24.5.2. The OECD TPG threshold for additional profit allocation to the source-state distribution subsidiary 729 24.5.3. The material content of the profit allocation 734 24.5.4. The profit allocation reservation 741 24.6. Concluding comments Chapter 25: The Allocation of Residual Profits from Unique and Valuable IP to Permanent Establishments

742 745

25.1. Introduction

745

25.2. Assigning economic ownership to internally developed manufacturing IP

745

25.3. Assigning economic ownership to internally developed marketing IP

747

25.4. Assigning economic ownership of acquired manufacturing IP

749

25.5. Assigning economic ownership of acquired marketing IP

750

25.6. The cliff effect under article 7 of the OECD MTC and the important-functions doctrine 25.6.1. Introduction 25.6.2.  Philip Morris (Italy, 2001) 25.6.3.  Rolls Royce (India, 2007) 25.6.4. Zimmer (France, 2010) 25.6.5. Dell (Norway, 2011) 25.6.6.  Boston Scientific (Italy, 2012) 25.6.7. Concluding comments

751 751 753 755 756 758 761 762

Chapter 26: Concluding Remarks

767

26.1. Introduction

767

26.2. The methodology for the transfer pricing of IP

767

26.3. Remuneration of IP development funding

768

xxv

Table of Contents

26.4. Allocation of profits for foreign-owned marketing IP 771 26.5. The identification of local marketing IP

773

26.6. Is the OECD arm’s length standard heading towards formulary apportionment?

773

References

777

xxvi

Preface The research project that resulted in this book commenced in September 2011, when the author began his studies for the PhD programme at the Faculty of Law of the University of Bergen (UiB). The project was made possible by financing provided through a PhD research scholar position at the Department of Accounting, Auditing and Law (IRRR) at the Norwegian School of Economics (NHH). The project was initially intended to be finalized in September 2015, when my position at NHH ended. As life would have it, however, this was around the time that the US tax authorities issued relevant new regulations and just before the OECD finalized its BEPS deliverables on transfer pricing of intangibles and related topics in October 2015. The author found withholding the thesis until he could fully incorporate these developments to be the only rational solution. The thesis was submitted for evaluation at the Faculty of Law at UiB on 3 May 2016 and was defended on 9 December 2016. This book is an updated, and somewhat edited, version of that thesis. The text takes into account material published before 31 March 2018 (the date on which the text was submitted for publication). The author’s research has benefited from the input of many. When he began working as a tax lawyer in Oslo after his studies in 2006, he found it inspiring to observe how those he worked under mastered the tax law discipline, including, in particular, tax lawyer and Professor Arvid Aage Skaar and tax lawyer Terje Hoffmann, both with Wiersholm then, and tax lawyers Christian Bruusgaard, Sverre Koch and Henning Naas, all with Thommessen then. In this sense, they have contributed to the author’s research, as there perhaps would be none without their inspiration. The author thanks the resources at IRRR, where he had his daily workplace throughout the project. He also thanks Professor Katarina Kaarbøe and Professor Guttorm Schjelderup at the Norwegian Centre for Taxation (NoCeT), for believing in the project and offering strong initial support; Professor Trond Bjørnenak, Professor Kjell Henry Knivsflå and Professor Frøystein Gjesdal for management accounting, valuation and transfer pricing discussions, respectively; Assistant Professor Dirk Schindler for insights on the economics of profit shifting; and PhD candidate Kjell Ove Røsok for financial accounting insights. The author also benefited from discussions with tax economists connected to, and from several interesting seminars arranged by, NoCeT. He thanks the European Association of Tax Law Professors (EATLP) and the International Fiscal Association (IFA) for allowing him to participate in the xxvii

Preface

2013 EATLP Poster Program for Doctoral Students in Lisbon and the 2014 IFA Mumbai Congress Poster programme, respectively, and would also like to thank everyone who engaged in discussions with him there. The author made several trips to the OECD in Paris throughout the project, participating in discussion draft consultations. He thanks those who shared their knowledge with him there, in particular Arthur Kristoffersen, Trude Sønvisen and Stig Sollund, with the Norwegian Ministry of Finance, and Matthew Wall, with MDW Consulting in Canada. The author also participated in several PhD seminars. At a 2012 seminar at BI Norwegian Business School in Oslo, Professor Ole Gjems-Onstad offered helpful comments at an early stage. At a 2013 seminar arranged by the Nordic Tax Research Council, the author learned from a lecture held by tax lawyer PhD Andreas Bullen. At a 2013 David Doublet seminar in Solstrand, Professor Ragna Aarli at UiB provided the author with helpful guidance. At a 2014 seminar at the Uppsala Center for Tax Law, the author benefitted tremendously from the vast international tax law insights of Professor Hugh J. Ault from Boston College Law School and from discussions with Professor Bertil Wiman and Associate Professor Jérôme Monsenego, both with Uppsala University. The author participated in several seminars arranged by the International Bureau of Fiscal Documentation (IBFD) in Amsterdam. He thanks those who engaged in discussions with him there, in particular Antonio Russo, with Baker & McKenzie, and Patrick Ellingsworth, trustee of IBFD. The author thanks NHH, NoCeT and the Meltzer Research Fund for financial contributions for making these research travels possible. Others that kindly offered him comments, practical help or other support during the project include Professor Richard T. Ainsworth with the Boston University School of Law; Lee Sheppard with Tax Analysts, whom he met at a seminar at NHH in the fall of 2012 and provided interesting comments on US transfer pricing law; tax lawyer Michael Lebovitz, with White & Case, for helpful comments on the US cost-sharing regulations at a 2012 seminar he attended in Amsterdam; tax lawyer Leif Drillestad, then with PwC, for interesting practical insights on transfer pricing; tax lawyer PhD Hugo P. Matre, with Schjødt, for initial talks in 2011; tax lawyer Christian Svensen, with Simonsen Vogt Wiig, for transfer pricing discussions; tax lawyer Kristine Ilstad, with DnB; tax lawyer Bjørn Christian Lilletvedt Tovsen, with Thommessen; Associate Professor Emeritus Arthur J. Brudvik, at NHH; and Susanne Tollefsen Log, with Skatt Vest. The author is grateful for the help he received from University Librarian Jørn Wangensten Ruud at UiB and University Librarian Fredrik Andersen Kavli at NHH. He also thanks the IBFD library staff for their help. He also thanks Administration Manager at IRRR, Maren Dale Raknes, who has xxviii

Preface

always been helpful, and Senior Consultant Mari Myren, then at UiB, for her kind assistance. He also thanks his fellow tax law PhD candidates for friendly discussions throughout the project. These are Tormod Torvanger, Henrik Skaar, Ingebjørg Vamråk, PhD Eivind Furuseth, Sarah Lindeberg and Blazej Kuzniacki. He also thanks Katriina Pankakoski, now with the Finnish Tax Administration, as well as his PhD candidate friends at NHH, in particular Øivind Schøyen and Martin Evanger. He thanks Julie Wille for proofreading the manuscript with impressive precision and haste. He thanks tax lawyer and Professor Jens Wittendorff, with EY and Aarhus University, for thorough, insightful and helpful comments and discussions in connection with the midway evaluation of this project. The person the author is most indebted to is his supervisor, Professor Frederik Zimmer, with the Faculty of Law at the University of Oslo. He contributed significantly during every stage of the project, offering immense help, always being kind, patient and elegant. It was a privilege to benefit from his teachings. He further thanks his mother, Ingvild, for her kind support throughout the entire project. He dedicates this work to his beloved daughter, Kamille: Denne boken er til deg, Kamille. Bestevenna for alltid. Oddleif Torvik Førde i Sogn og Fjordane, 31 March 2018 The author will be thankful for comments or questions on the book and can be contacted by email at [email protected].

xxix

Abbreviations 10th Cir. 11th Cir. 1st Cir. 2nd Cir. 3rd Cir. 4th Cir. 5th Cir. 6th Cir. 7th Cir. 8th Cir. 9th Cir. 2010 OECD Report AC ADR AERR A.F.T.R.2d AOA AOD APA ATB BALRM BC BEPS BIAC BRIC countries BTA CAPM

Tenth Circuit (US Court of Appeals) Eleventh Circuit (US Court of Appeals) First Circuit (US Court of Appeals) Second Circuit (US Court of Appeals) Third Circuit (US Court of Appeals) Fourth Circuit (US Court of Appeals) Fifth Circuit (US Court of Appeals) Sixth Circuit (US Court of Appeals) Seventh Circuit (US Court of Appeals) Eight Circuit (US Court of Appeals) Ninth Circuit (US Court of Appeals) 2010 OECD Report on the Attribution of Profits to Permanent Establishments EU Arbitration Convention Applicable discount rate (United States, cost sharing) Actually experienced return ratio (United States) American Federal Tax Reports, 2nd Series Authorized OECD approach Action on decision (United States, Internal R ­ evenue Service) Advance pricing agreement Active trade or business Basic arm’s length return method (United States) Basis for conclusions (International Financial Reporting Standards) Base erosion and profit shifting Business and Industry Advisory Committee to the OECD Brazil, Russia, India and China US Board of Tax Appeals Capital asset pricing model

xxxi

Abbreviations

CATM CB CBCR CBDT CBP CC CCA CCA CCA2 CCC CCCTB CCED.Mo. CCPA CD.Cal. CFA CFC CFO CFR CIP CIR CIT Cl. Ct. CMO COGS COI CPI CPM CRO CSA CUP CUT

Comparable adjustable transaction method (United States) Cumulative bulletin (United States) Country-by-country reporting Central Board of Direct Taxes (India) US Customs and Border Protection Cost centre Cost contribution arrangement (OECD) US Circuit Court of Appeals US Circuit Court of Appeals, Second Circuit Community Customs Code Common consolidated corporate tax base (European Union) US Circuit Court, Missouri, Eastern Division US Court of Customs and Patent Appeals US District Court, Central District of California Committee on Fiscal Affairs (OECD) Controlled foreign corporation Chief Financial Officer Code of Federal Regulations (United States) 2007 IRS Coordinated Issue Paper Commissioner of Internal Revenue (United States, Internal Revenue Service) Commissioner of Income Tax (India) US Claims Court Reporter Contract manufacturing organization Cost of goods sold Constructive operating income (United States) Comparable profit interval (United States) Comparable profits method (United States) Contract research organization Cost sharing agreement (United States) Comparable uncontrolled price Comparable uncontrolled transaction

xxxii

Abbreviations

CWI DA rule DCF DDIT D.Kan. D.Minn. D.N.J. EBIT EBITDA ECJ ECR EDNC EFTA ESO F.2d F.3d FASB FCA FCMU FDA FDI Fed. Reg. Fed. TD FIFO Fin. Treas. Reg. FRD FSA GAAP GATT GLAM GP

Commensurate with income Developer-assister rule Discounted cash flow Deputy Director of Income Tax (Indian tax authorities) US District Court, Kansas US District Court, Minnesota US District Court, New Jersey Earnings before interest and taxes Earnings before interest, tax, depreciation and amortization Court of Justice of the European Union European Court Reports US District Court, North Carolina, Eastern Division European Free Trade Area Employee stock option Federal Reporter 2nd (United States) Federal Reporter 3rd (United States) Financial Accounting Standards Board (United States) Federal Court of Appeal (Canada) Full cost mark-up US Food and Drug Administration Foreign direct investment Federal Register (United States) Federal Court, Trial Division (Canada)h First in, first out Final Treasury Regulations (United States) Federal rules decisions (United States) Field service advisory Generally Accepted Accounting Principles General Agreement on Tariffs and Trade Generic Legal Advice Memorandum (United States, Internal Revenue Service) General partner xxxiii

Abbreviations

GSMM GVC HMRC HR Conf. Rep. HR Rep. HTVI IAS IASB IBFD ICC IDA IFA IFRS IMC IP IPO IPR IRB IRC IRR IRS IRS RR IRS TD IT ITAT ITPL KERT LIFO LMSB LOC LoN LP

Gross services margin method (United States) Global value chain Her Majesty’s Revenue and Customs (United Kingdom) US House Conference Report US House Report Hard-to-value intangible International Accounting Standards International Accounting Standards Board International Bureau of Fiscal Documentation International Chamber of Commerce Intangible development activity International Fiscal Association International Financial Reporting Standards Incremental marketing costs Intangible property Initial public offering Intellectual property rights Internal Revenue Bulletin (United States) Internal Revenue Code (United States) Internal rate of return Internal Revenue Service (United States) IRS Revenue ruling (United States) IRS Treasury Decision (United States) Information technology Income Tax Appellate Tribunal (India) International transfer pricing legislation (Japan) Key entrepreneurial risk-taking Last in, first out Large and Mid-Size Business Division (United States, Internal Revenue Service) Local operating company League of Nations Limited partner

xxxiv

Abbreviations

LRD LSA M&A MAP MNE MTM N.D. Cal. N-GAAP NPV OECD OECD MTC OECD TPG OEEC OEM ORA P&L statement PC PCT PE PFA PLI PPA Prop. Treas. Regs. PRRR PSM Pub.L. PV

Low-risk distributor Location-specific advantage Mergers and acquisitions Mutual agreement procedure Multinational enterprise Matching transaction method (United States) US District Court, Northern California Norwegian Generally Accepted Accounting Principles Net present value Organisation for Economic Co-operation and Development OECD Model Tax Convention on Income and on Capital OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations Organisation for European Economic Co-operation Original equipment manufacturer Options realistically available Profit-and-loss statement (financial accounting) Profit centre Platform contribution transaction (United States, cost sharing) Permanent establishment Post-formation acquisition (United States, cost sharing) Profit level indicator Purchase price allocation (financial accounting) Proposed Treasury Regulations (United States) Periodic return ratio range (United States, cost sharing) Profit split method US Public Law Present value

xxxv

Abbreviations

PVI PVTP R&D RAB share RC RDD Rev. Proc. Rev. Rul. ROCE RPSM RT SCBM SCC S.Ct. S.D.Fla. S.D.Tex. SE SEC SEP SIC Code SpA SPF TAM Tax Ct. TCC TC Memo

Present value of investments (United States, cost sharing) Present value of total profits (United States, cost sharing) Research and development Reasonable anticipated benefits share (United States, cost sharing) Revenue centre OECD revised discussion draft on transfer pricing aspects of intangibles Revenue procedure (United States, Internal Revenue Service) IRS revenue ruling Return on capital employed Residual profit split model Reference transaction (United States, cost sharing) Simplified cost-based method Supreme Court of Canada Supreme Court of the United States US District Court, Southern District of Florida US District Court, Southern District of Texas, Hous­ ton Division Societas Europaea Securities and Exchange Commission (United States) Standard essential patent Standard Industrial Classification Code Società per Azioni (Italian corporate form used by public corporations) Significant people functions IRS National Office Technical Advice Memorandum US Tax Court Tax Court of Canada Tax Court Memorandum Decision (United States)

xxxvi

Abbreviations

TD Temp. Treas. Regs. TMTPR TNMM TPO Treas. Regs. True-up UN UNIDROIT UNM UN PMTP USCA VAT VC VCLT WACC WD Wash. WP6 WTO

Treasury Decisions (United States) Temporary Treasury Regulations (United States) Tax Management Transfer Pricing Report) Transactional net margin method (OECD) Transfer pricing operations, IRS Large Business and International Division Treasury Regulations (United States) Taxpayer-initiated compensating adjustment United Nations International Institute for the Unification of Private Law United Nations Practical Manual on Transfer Pri­ cing for Developing Countries United Nations Practical Manual on Transfer Pri­ cing for Developing Countries US Code Annotated Value added tax Venture capital 1969 Vienna Convention on the Law of Treaties Weighted average cost of capital US District Court, Western District of Washington Working Party No. 6 on the Taxation of Multinational Enterprises (OECD) World Trade Organization

xxxvii

Part 1

Chapter 1 Research Questions, Methodology and Sources of Law 1.1. Introductory comments Multinational enterprises are profitable. They make and sell products and services in multiple geographical markets. Behind the profits realized from selling a product in one particular jurisdiction may lie contributions from group companies resident in other countries or permanent establishments (PEs) of such companies in source jurisdictions. These different taxable entities within the multinational enterprise are all part of the same economic totality and do not have conflicting economic interests. Their contributions are priced, thereby effectively extracting profits from the jurisdiction where the product is sold. These controlled prices may deviate from those that would have been yielded by the normal supply-and-demand market mechanism that ensures balanced pricing among third parties with conflicting interests.1 Most jurisdictions have, for this reason, enacted mandatory profit allocation rules that govern how a multinational must distribute its profits among its entities and have entered into tax treaties, which, also via profit allocation rules, ensure that there is no double taxation on such profits.2 This book is a study of how the profits from multinationals’ sales of products and services based on unique intangibles (valuable patents, trademarks, etc.) are allocated among jurisdictions under two of the most significant and influential transfer pricing systems in the world:3 (i) the transfer pricing regime under US law under section 482 of the Internal Revenue Code (IRC); and (ii) the transfer pricing regime under articles 7 and 9 of tax treaties based on the OECD Model Tax Convention on Income and on Capital (OECD MTC). There are important interactions between the two regimes. First, both are based on the same meta-norm, i.e. the arm’s length standard, aimed 1. Or, as stated in Schön (2010a), at p. 236, “[B]etween independent taxpayers, transaction prices therefore truly allocate income.” 2. Schön (2010a), at p. 232, applies the terminology “transfer pricing control”, which conveys the purpose of such mandatory profit allocation rules well. 3. See Schoueri (2015) for principal reflections on the arm’s length principle. See Schön et al. (2011), at pp. 47-67, for an insightful overview of the concept of transfer pricing across different legal contexts.

3

Chapter 1 - Research Questions, Methodology and Sources of Law

at achieving parity in the taxation of related and unrelated enterprises.4 Second, the overarching legal structure of the systems is similar. The basic principle for profit allocation is expressed in a few sentences in IRC section 482 and articles 7 and 9 of the OECD MTC and elaborated in the comprehensive section 482 of the US Treasury Regulations and the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG). Third, even though the main principles for profit allocation under the two systems have remained intact since the first part of the 20th century, the more specific methodology that is decisive for the actual allocation of profits among jurisdictions is constantly evolving, with revisions typically aimed at avoiding base erosion and profit shifting (BEPS). Fourth, the systems are largely self-contained. Their allocation of intangible profits generally do not depend on underlying private law classifications. Fifth, there have historically been significant “spill-over” effects of the US regime on the OECD TPG. For instance, central TPG concepts, such as the transactional net margin method (TNMM) and the periodic adjustment authority, are more or less direct imports from US law. The division of taxing rights among jurisdictions under both systems is effectively carried out through these profit allocation rules. The United States will tax the amount of profits from controlled transactions calculated pursuant to section 482 of the US Treasury Regulations. Indirectly, these rules also determine the amount of profits that the residence jurisdiction of the other group entity involved in the controlled transaction may tax without resulting in double taxation, disregarding tax treaties. Similarly, under article 9(1) of the OECD MTC, the amount of business profits from controlled transactions calculated pursuant to the OECD TPG may be taxed by the residency jurisdiction of the relevant group entity, while the residence jurisdiction of the other group entity involved in the controlled transaction shall, in principle, exclude an identical amount from taxation under article 9(2), thereby avoiding economic double taxation.

4. See Brauner (2016), at p. 108, where a background is provided through these fitting words: “There is no inherent justification for treating related and unrelated transactions alike beyond simplistic symmetry. One could have perhaps made an efficiencybased justification for such symmetry in some circumstances; however, such a case has not been made, and the arm’s length transfer pricing rules hardly follow efficiency goals. Arm’s length, therefore, is not a principle; it is a standard. It serves as a basis for the specific rules that implement it and is justified by other principles. In the case of arm’s length, it is justified as a method for allocation of profits. Even we know that, historically, it was one of several standards that could be used for achieving the goals that underlie our tax systems. It is perhaps the most desirable standard, yet it is not a principle”.

4



Introductory comments

The same basic system, even though operationalized through a different legal mechanism,5 is put in place to govern the distribution of taxing rights to business profits among residence and source jurisdictions in the context of PEs under article 7(2) of the OECD MTC, according to which the profits allocated to the source jurisdiction pursuant to the OECD TPG and the 2010 OECD Report on the Attribution of Profits to Permanent Establishments (2010 OECD Report) shall be excluded from taxation in the residence jurisdiction through the provision of double taxation relief, thereby avoiding juridical double taxation. This book is an analysis of the following two research questions: (1) The primary question is how the taxing rights to operating profits from intangible value chains shall be allocated among jurisdictions under IRC section 482 in US law and articles 7 and 9 of tax treaties based on the OECD MTC. (2) The secondary question, which is dependent on the results from the analysis of the primary research question, is to provide a critical assessment of whether the current US and OECD profit allocation solutions are useful or if they ideally should be altered, and if so, to propose the relevant amendments. The author will further develop the research questions and outline the structure of the book in section 1.3., after introducing key terminology and providing necessary contextualization for the research questions in section 1.2. This book will not address possible alternatives to arm’s length transfer pricing, e.g. so-called “formulary apportionment” (distribution of worldwide operating profits based on predetermined allocation keys).6 Arm’s length transfer pricing is the international consensus for profit allocation. It does not seem realistic that this will change in the near future. Analytical efforts therefore seem better spent contributing to legal clarification of the current regime rather than discussing more loosely based notions of possi5. For a multinational’s tax planning purposes, an art. 9 allocation may yield a more favourable profit allocation, in the sense that double taxation relief is not contingent on the extent to which the profits are actually taxed in the other residence jurisdiction, much akin to the result of the exemption method under art. 7 (see art. 23A). This stands in contrast to an art. 7 allocation, where relief nowadays tends to be provided through the credit method (see art. 23B) and thus is contingent on the extent of taxation in the source state (of course, the exception method is still applied in some treaties). 6. For a recent overview of the features of formulary apportionment, see Andrus et al. (2017), at p. 96; and Pankiv (2017), at pp. 38-42. For further discussions on formu-

5

Chapter 1 - Research Questions, Methodology and Sources of Law

ble alternative allocation regimes. An analysis of the formulary apportionment alternative would also expand the scope of this book beyond what could be addressed within the time constraints of the research project.7 The book will nevertheless provide some limited comments on certain aspects of the relationship between arm’s length transfer pricing and formulary apportionment, as this is deemed to contribute to the analysis of the research questions.8

1.2. Key terminology and contextualization Operating profits are business profits before interest expenses and taxes, i.e. sales revenues minus the cost of goods sold and other operating expenses.9 The author’s analysis is limited to the allocation of operating profits generated through the sale of products or services based on unique intangibles, e.g. a pharmaceutical preparation manufactured on the basis of a patent and sold under a trademark. In the context of transfer pricing, operating profits are determined and benchmarked at the level of the value chain for a parlary apportionment (versus the arm’s length principle), see, e.g. Langbein (1986); Turro (1994); Lebowitz (1999); Kauder (1993); Hellerstein (1993); Sadiq (2001); Hamaekers (2001), at p. 38; Ackerman et al. (2002); McLure (2002); Vincent (2005), at p. 414 (on global profit splits); Hellerstein (2005a); Hellerstein (2005b); Hardy (2006); Benshalom (2007); Roin (2008); Benshalom (2009); Mayer (2009); Angus et al. (2010); Durst (2010); Morse (2010); Durst (2012a); Kroppen et al. (2011); Fleming et al. (2014); AviYonah (2015); White (2016), at p. 216; Lebowitz (2008); Luckhaupt et al. (2011), at pp. 100 and 107; Gresik (2011); Wilkie (2011), at p. 152; as well as the more sceptical view expressed in Burke (2011). On global tax reform, see Brauner (2003). See also recent reflections on the usefulness of the arm’s length principle in Biegalski (2010); and, in particular, Schoueri (2015). For a theoretical proposal to address intangible property (IP) profit shifting through cost sharing agreements by way of formulary apportionment pricing, see Benshalom (2007), at pp. 648 and 679. See Brauner (2008), at p. 160, on the use of a formulary apportionment approach to IP valuation. 7. For an interesting economic analysis of the relationship between the separate entity approach and formulary apportionment, see Altshuler et al. (2010), a study that also highlights some of the problems associated with formulary apportionment. 8. See the discussion in secs. 11.2. and 26.6. 9. This description will suffice for now. A more in-depth understanding of the concept is primarily necessary for the purpose of analysing the one-sided transfer pricing methods (the gross [resale price and cost plus] and net [comparable profits method (CPM)/transactional net margin method (TNMM)]) and for understanding the historical context in which the TNMM was introduced into the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG) in 1995, in particular the OECD arguments against the method. For a further analysis of the concept of operating profits, see section 6.2. It should be noted that operating profits do not reflect the costs of debt financing. The issue of intra-group debt financing will not be discussed in this book, as it falls outside the scope of the research questions. An important nuance here is that the profit allocation rules under art. 7 of the OECD

6



Key terminology and contextualization

ticular product or service (transactional level), not at the total level for all products and services sold by the relevant group entity (aggregated level). This is fundamentally due to the fact that intangibles are normally used in connection with the creation and sale of specific products or services and contribute to their profits (e.g. the patent for a blockbuster drug or the code for a best-selling software package).10 A value chain is a set of activities that an enterprise performs in order to deliver a valuable product or service to the market.11 As the author’s focus is on profits from products based on intangibles, he will refer to the relevant value chain as an “intangible value chain”. In order to deliver a product to the marketplace, a multinational will perform functions (research and development (R&D), manufacturing, sales, etc.) and apply tangible and intangible assets (plant and property, patents, trademarks, etc.). In doing so, it will incur expenses (for R&D, manufacturing, distribution and marketing, etc.), and thereby also financial risks. All functions performed, assets used and risks assumed along the value chain, from early-phase R&D to the sale of the final product to the end consumer, contribute to the value of the product (and thereby the operating profits derived from its sale) and are, in this sense, value chain contributions (or inputs). Value chain contributions are conducive to operating profits to varying degrees. Both the US and OECD rules rely on the fundamental distinction Model Tax Convention on Income and on capital (OECD MTC) allow the allocation of external interest expenses to the permanent establishment (PE) for the purpose of determining its operating profits. This is not a pricing issue, as the interest expenses are at arm’s length, but a matter of allowing for external financing of a PE for profit calculation purposes (see the comments in section 17.4.2). 10. For example, in Eli Lilly v. Commissioner of Internal Revenue (84 T.C. No. 65 [U.S. Tax Ct., 1985], affirmed in part, reversed in part by 856 F.2d 855 [7th Cir., 1988], the question was how to allocate the operating profits connected to a patent and a trademark employed in the value chain for the drug Darvon and Darvon-N. In both the US Glaxosmithkline settlement (see the analysis in sec. 19.2.5.2.) and the Canadian Supreme Court ruling in GlaxoSmithKline Inc. v. R. (2012 SCC 52 [2012], which affirmed 2010 CAF 201, F.C.A., [2010], which reversed 2008 TCC 324 [T.C.C., 2008]; see the analysis of 2012 SCC 52 in sec. 6.7.4.), the question was how to allocate operating profits from sales of the Zantac drug to the connected patents and trademarks. In Veritas Software Corporation & Subsidiaries v. CIR (133 T.C. No. 14 [U.S.Tax Ct. 2009], US Internal Revenue Service (IRS) nonacquiescence in AOD-2010-05; see the analysis of the ruling in sec. 14.2.4.), the question was how to allocate profits to the intangibles connected to a software package contributed to a cost sharing agreement (CSA). 11. The general concept was introduced by Porter (1985), but there has been a conscious focus on the structure of value chains in transfer pricing jurisprudence for far longer.

7

Chapter 1 - Research Questions, Methodology and Sources of Law

between unique (or non-routine) and non-unique (or routine) value chain contributions.12 This distinction is the heart of modern transfer pricing and will be a red thread throughout the different profit allocation contexts discussed in this book. The point of the distinction is that routine value chain inputs only contribute operating profits equal to normal market returns, while non-routine inputs (in practice, unique intangibles) may contribute above-normal returns, which are so-called “super profits”.13 Thus, there is a significant profit allocation “cliff effect” associated with the distinction. Routine contributions typically include contract manufacturing, distribution, marketing and sales functions. Due to their relatively generic nature, a range of enterprises will compete to offer these inputs, driving prices down to a level where there are no super profits, only normal market returns. In contrast, unique intangibles represent market imperfections. Their presence in a value chain may cause the supply-and-demand market mechanism to fail in setting a price that provides mutually beneficial outcomes for the contracting parties. An enterprise that owns unique intangibles may then reap super profits by exploiting them, as competitors will not have access to equivalent input factors. This exclusive market entry barrier position may be shielded by legal protection (patents, trademarks, etc.) or business secrets (e.g. the Coca-Cola recipe), effectively securing the enterprise in a monopoly position to sell certain products or services. This can normally be sustained only for so long due to time-limited legal protection or the emergence of new and superior products or services that render the unique intangibles economically obsolete. Super profits are known as “residual profits” in the transfer pricing jurisprudence of US law and the OECD MTC.14 These are the operating profits that are allocated to a group entity that is deemed to own a unique intangible after all other group entities that have contributed to the relevant value chain have been compensated with a separately determined normal market return for their routine contributions. In general, residual profits 12. See the US and OECD definitions in para. 6.17 OECD TPG; and US: Treasury Regulations (US Treas. Regs.) § 1.482-6(c)(3)(i)(B), and the analysis of the US and OECD concepts of unique and non-unique value chain contributions in section 3.4.3. 13. Pankiv (2017), at p. 198, touches on this. See also Roberge (2013), at p. 220. 14. Super profits go by different names, depending on the discipline in which the concept is referred to. Economists normally refer to it as an “economic rent”, meaning a profit in excess of the market return to the factors of production (labour and capital). Under perfect competition, this rent will be zero. Financial economists and accountants normally refer to super profits as the rate of return in excess of the capital requirement (risk-adjusted cost of capital), yielding a positive net present value for an investment.

8



Key terminology and contextualization

represent a significantly greater amount of operating profits than those allocated as normal market returns.15 Further, entitlement to residual profits is an ongoing interest in the operating profits generated by the intangible.16 Thus, a group entity entitled to residual profits will receive such allocation throughout the life of the intangible. Both the US and OECD rules have traditionally assumed that the operating profits remaining after all routine functions, assets and risks have been remunerated are due solely to the unique intangibles exploited in the value chain. The implication of this approach is that all remaining profits are classified as residual profits, and the right to tax this profit is allocated to the jurisdiction where the group entity that is assigned ownership (for transfer pricing purposes) of the unique intangibles is resident (or the source state in the case of a PE).17 Such an assumption is normally unrealistic. Parts of the remaining profits in an intangible value chain may be incremental profits due to location savings, local market characteristics and synergies. These profits are, in principle, distinguishable from those generated by unique intangibles.18 The new OECD rules seek to amend the historical flaw that the transfer pricing rules have not sufficiently distinguished operating profits in this manner.19 The larger the normal market return and incremental operating profits, the smaller the residual profits will be. The question of how the taxing rights to residual profits generated by unique intangibles are allocated among jurisdictions under US law and the OECD MTC will therefore not be possible to analyse without also addressing how normal market returns from the same intangible value chain are allocated among routine value chain contributions and how incremental operating profits due to cost savings, local market characteristics and synergies are allocated among the involved jurisdictions. This is because the residual profits, due to unique intangibles, 15. This line may be blurred in some scenarios. For instance, in the context of intangible development under the OECD TPG, the profits allocable to research and development (R&D) financing may become significant, resembling residual profits (as the author will revert to in sec. 22.4.). 16. This stands in contrast to a separate normal market return to routine value chain contributions. If no such contributions are rendered in a given income period, no compensation will be allocated. 17. See also Francescucci (2004a), at p. 72. 18. See, however, Kane (2014) for an interesting discussion of whether synergy value should be seen as an intangible. 19. See the analysis in ch. 10. See also Francescucci (2004a), at p. 72, for a discussion of the allocation of incremental profits (in the historical context of the 1995 OECD TPG).

9

Chapter 1 - Research Questions, Methodology and Sources of Law

are the operating profits that remain after these two groups of profits have been allocated. It has been claimed that the arm’s length principle is “flawed”, as it supposedly is unable to account for and allocate parts of the profits that big multinationals generally make, i.e. residual profits from unique intangible property (IP) and incremental profits from economies of scale and integration.20 The rationale is that multinationals are able to create such profits while unrelated parties are not. Thus, if the profits of a multinational are allocated among its group entities, and thus among jurisdictions, based on comparison (benchmarking) with the pricing applied between unrelated parties, the intra-group pricing will always “miss out” on the residual and incremental profits, as such profits do not exist among third parties. The author is sceptical as to whether the bulk of this criticism is indeed justified, taking into account the transfer pricing methodologies currently at offer under the US and OECD arm’s length regimes for allocating taxing rights to business profits.21 All benefits derived by multinationals due to their assets and organization (unique IP, integrated value chains, synergies, cost savings, etc.) materialize in profits through the sale of products and services to third parties in market jurisdictions where the multinational does business. The US and OECD transfer pricing methods will allocate all of these profits to the group entities that have contributed to the value chains through which the profits were created. The critics of the arm’s length principle claim – and rightfully so – that this allocation is difficult (if not impossible) to carry out if it is to be based on third-party comparables for the unique value chain contributions (unique IP), as such comparables simply do not exist. On this point, however, it is important to remember (as the critics not always do) that multinationals do not only use unique value chain inputs, but they also use a lot of generic (or routine) inputs, for which there indeed are thirdparty comparables available. Thus, the key is to recognize that allocation of profits from controlled transactions can then be based on benchmarking such routine value chain inputs, resulting in a normal market return profit allocation to the tested party and treating the remaining profit as a residual that either shall be allocated fully to the controlled party that contributes the unique value chain input (under the comparable profits method (CPM)/ 20. For an overview of the debate, see, in particular, Schön (2010a), at pp. 233-234; and Schoueri (2015), at p. 698. For further discussions, see, e.g. Durst (2010); Kobetsky (2008); Lebowitz (2008); and Francescucci (2004a); as well as much of the formulary apportionment discussions referred to in the works mentioned in supra n. 6. 21. The transfer pricing methods are analysed in part 2 of the book.

10



Key terminology and contextualization

TNMM) or be split among the controlled parties if they both contribute such unique inputs (profit split method).22 Both the normal return and residual profits will be effectively allocated among jurisdictions through the application of these transfer pricing methods that operationalize the arm’s length principle. None of the multinational’s profits will then be “missed”. This fact seems to be recognized by at least some now.23 My impression is that the critics that claim that the arm’s length principle is “flawed” may have based their reasoning on an inaccurate understanding (likely influenced by the historical dominance of the comparable uncontrolled transaction (CUT) method) of how the current transfer pricing methods actually work in practice. For instance, critics often focus solely on the CUT method without recognizing that other transfer pricing (the “profit-based”) methods in fact dominate the transfer pricing practices of both tax authorities and taxpayers worldwide nowadays. In order to facilitate a more nuanced debate, critics should, in the author’s view, take into account that the arm’s length principle does not equal the CUT-method, but encompasses also a range of other – and effective – pricing methodologies.24 In fact, the CUT method will only rarely be applicable at all to allocate profits from the typical IP-dominated value chains of multinationals.25 The key methods in practice are the CPM/TNMM and the profit split method,26 but the workings of these are seldom highlighted by critics. Further, in light of the fact that the 2017 OECD TPG contain elaborate provisions for allocating residual profits from unique IP27 and also address how incremental profits from cost savings, local market characteristics and synergies shall be distributed among jurisdictions,28 there should, in the author’s view, be little doubt that the arm’s length principle – as it today is operationalized through the methodology set out in the OECD TPG – actually does allocate such profits among jurisdictions and thus, in this sense at least, should not be regarded as “flawed”. 22. This approach is the core of the profit-based methodology paradigm introduced in the 1988 US White Paper; see the analysis in sec. 5.3.3. (with further references). 23. See Peng (2016), at p. 383 (see also p. 380) with respect to TNMM allocation, and p. 385 for profit-split-method allocation. See also Schoueri (2015), at p. 699. 24. The current US and OECD transfer pricing methodologies, as applied to IP value chains, are analysed in part 2 of the book. 25. See the analysis of the comparable uncontrolled transaction (CUT) method in ch. 7. 26. See the analyses in ch. 8 and ch. 9, respectively. 27. See the analysis of the 2017 OECD provisions for allocating residual profits from intra-group developed manufacturing and marketing IP in ch. 22 and ch. 24, respectively. 28. See the analysis of the OECD guidance in ch. 10.

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Chapter 1 - Research Questions, Methodology and Sources of Law

There is no doubt that the arm’s length principle can be criticized for a whole range of issues (e.g. ambiguous and often imprecise allocation rules, significant compliance costs due to documentation requirements, etc.), but the author does find it very difficult to see that the arm’s length principle is unable, as the critics claim, to allocate all of a multinational’s profits due to the absence of third-party comparables that reflect residual profits from unique IP and incremental profits from local market characteristics and synergies.

1.3. Research questions and structure The primary research question is how the taxing rights over operating profits from intangible value chains shall be allocated among jurisdictions under IRC section 482 in US law and Articles 7 and 9 of tax treaties based on the OECD MTC. Applied in the context of intangible value chains, the US and OECD profit allocation rules will generally be relevant in the exploitation phase of an intangible’s life. There will normally be no need to allocate profits before an intangible has been successfully developed and commercialized, as it will generate profits first when it is exploited through the sale of products and services.29 Prior to this phase, there will be no profits to allocate. The profit allocation assessment begins by splitting the total operating profits from the intangible value chain among the value chain contributions; in other words, among: (1) routine value chain contributions (manufacturing, distribution, etc.), which are assigned normal market return profits;30 (2) location savings, local market characteristics and synergies, which are assigned incremental profits; and (3) non-routine value chain contributions (i.e. unique intangibles), which are assigned the residual profits.

29. It may, however, be that an in-development intangible is transferred among group entities. An arm’s length charge for the transfer, in the absence of a CUT, will likely need to rely on a valuation in which one of the key parameters will be an estimate of the profits that can be generated through future exploitation of the intangible. See the analysis of the OECD guidance on IP valuation in ch. 13. 30. For the purpose of this overview, the author deems a separately determined riskadjusted rate of return to intangible-development-funding contributions (as discussed in sec. 22.4.) to be included in this category of profits.

12



Research questions and structure

This split is governed by the US and OECD transfer pricing methodologies,31 the analysis of which may be broken down into a range of different subquestions, depending on the context and specific methodology used. The purpose of the methodologies is twofold. First, they aim to split the total operating profits among the above three categories of value chain contributions. This is a question both of causality and value, i.e. the value chain inputs that have contributed to the total profits must be identified and the degree of profit contribution from each input must be determined (the amount of profits allocable to the input). Second, the methodologies aim to assign the categorized profits to the group entities (or headquarters or PE) that have contributed the relevant value chain inputs. The assignment will normally be straightforward for routine value chain contributions. For example, it will be causally clear which group entity has performed contract manufacturing or marketing functions. It may, however, be more complex to assign incremental operating profits due to cost savings, local market characteristics and synergies to a specific group entity, as the determination does not depend on causality, but rather on how third parties would have allocated the profits. For unique intangibles, the transfer pricing methodologies only determine the amount of residual profits to be allocated to a specific unique intangible. They do not provide a link between the determined residual profit amount and the group entity to which the amount is to be allocated. That task is left for the US and OECD intangible ownership provisions to deal with. These latter provisions connect the residual profits to specific group entities within the multinational. The basic principle underlying both the US and OECD intangible ownership provisions is that the residual profits generated in the exploitation phase shall be allocated among the group entities that participated in the creation of the intangible. This profit allocation shall be carried out in proportion to the relative values of the involved group entities’ routine and non-routine contributions in the development phase of the intangible’s life. Through this profit assignment to a specific group entity (or headquarters or PE), the residence (or source) jurisdiction of the relevant entity is allocated the right to tax the residual profits. In this way, taxing jurisdiction

31. For the purpose of this overview, the author uses the term “transfer pricing methodologies” broadly to not only encompass the pricing methods, but also the OECD profit allocation guidance on incremental profits from location savings, market characteristics and synergies.

13

Chapter 1 - Research Questions, Methodology and Sources of Law

over operating profits from intangible value chains is divided among the jurisdictions through which the multinational routes its value chains.32 The primary research question must therefore be answered through an analysis of the US and OECD transfer pricing and intangible ownership provisions relevant to intangible value chains, as these provisions in concert determine the profit allocation. The author seeks to illustrate this profit allocation process in figure 1.1. Figure 1.1

The total operating profits to be allocated

The allocation of the total operating profits among the value chain contributions is governed by the TP methods (and the provisions for location savings, location specific advantages and synergies)

The allocation of residual profits among group entities (that provided intangible development contributions) is governed by the intangibles ownership rules

Normal market return to non-unique value chain contributions

Operating profits from intangible value chain

Incremental operating profits to location savings, location specific advantages and synergies Residual profits to unique value chain contributions (unique IP)

Group entities

Value chain contributions

IP development contributions

Thus, the transfer pricing provisions determine the amount of profits that shall be assigned to an intangible, and the ownership provisions determine which group entity, and therefore which jurisdiction, the amount shall be assigned to. While the transfer pricing rules are mainly relevant in the exploitation phase of an intangible’s life, they are, however, also of relevance in the development phase. Group entities that contribute routine development inputs (e.g. laboratory equipment and research facilities) to the creation of an intangible but are not assigned entitlement to subsequent residual profits un32. See Schön (2010a), at p. 230, on the two-sided function of the arm’s length principle with respect to the allocation of taxing rights (income allocation first to persons and then jurisdictions). See also Schön (2010b) on the topic of the allocation of taxing rights.

14



Research questions and structure

der the intangible ownership provisions are assigned a concurrent normal market return in the development phase for their contributions through the transfer pricing methods. Comparatively, the intangible ownership provisions (for the purpose of allocating residual profits in the exploitation phase of an intangible’s life) look towards which functions, assets and risks were contributed to the creation of the IP by the involved group entities in the development phase and allocate profit in a way much akin to the profit split methodology. Thus, there is an interplay between the transfer pricing and intangible ownership provisions in both the intangible development and exploitation phases. Nevertheless, as the focus of the US and OECD transfer pricing and intangible ownership provisions is on the remuneration of value chain contributions in the exploitation phase and intangible development contributions in the development phase, it is necessary to analyse the provisions separately, which the author does in parts 3 and 4 of this book, respectively.33 This basic structure of the book mirrors that of a practical transfer pricing analysis. The structure, however, departs from the chronology of section 482 of the US Treasury Regulations and the OECD TPG, where the intangible ownership issue is addressed before the transfer pricing issues. The author finds that the structure of this book is more appropriate for analytical purposes. It reflects the fact that the material content of the ownership rules has converged significantly with the transfer pricing methodologies34 and is best seen as a specific application of these. Thus, the structure of this book offers the benefit of seeing these applications in light of more general principles. It is also the author’s view that this makes the book easier to read, as it otherwise would have been necessary to refer to the transfer pricing analysis when analysing the intangible ownership provisions.35

33. The author refers to the introductions to parts 3 and 4 of this book for detailed outlines of the analysis in each respective part. 34. In particular, the profit split method, which is analysed in ch. 9. 35. As mentioned, group entities that contribute to the development of an intangible and are not compensated with residual profits shall be allocated a concurrent normal market return compensation for their efforts. In other words, such compensation will not be drawn from the operating profits generated through the exploitation of the intangible once fully developed. Thus, the compensation of such entities will, in principle, be triggered before the profit allocation issues discussed above in this section. This does not, however, apply for the remuneration of intangible development financing under the OECD TPG, which is linked to the profits generated through the exploitation of the developed intangible. This entails that, in practice, it will only be the remuneration of group entities that have rendered routine development contributions that shall be allocated compensation concurrently throughout the R&D phase. While it could be argued that it would be beneficial to discuss the remuneration of these entities before the main

15

Chapter 1 - Research Questions, Methodology and Sources of Law

The secondary research question, which is dependent on the results of the analysis of the primary research question, is to provide a critical assessment of whether the current US and OECD profit allocation solutions are useful or if they ideally should be altered, and if so, to propose relevant amendments. This is addressed throughout the book concurrently and in connection with the analysis of each sub-question under the primary research question. The author will introduce fundamental concepts in part 2 of the book. The topics discussed there are closely interwoven with the subsequent analysis of the profit allocation rules and form the platform for, and should be seen as an integrated part of, the analysis of the research questions. The author will outline the business and tax reasons for intangible value chains, with a focus on the concept of foreign direct investments and how they relate to super profits.36 He will also introduce the centralized principal model, which is commonly applied by multinationals for profit allocation purposes. A discussion of the 2015 OECD nexus approach for preferential taxation of super profits under IP regimes is also provided. Further, the author will discuss the types of controlled intangible transactions that are encompassed by the US and OECD profit allocation rules, as well as the US and OECD intangibles definitions.37

1.4. Methodology This book is a legal analysis carried out under the academic traditions of the discipline of law. The main object of legal research is text. The main research activity is interpretation. Hermeneutics is, broadly stated, the philosophy and methodology of text interpretation.38 Thus, legal research can be seen as a hermeneutical discipline.39 Its closest academic parallels are likely theology and the study of literature. Legal research may also be seen as a normative discipline.40 The researcher will not always be able to find a legal norm that exists independently of his own interpretative contribuallocation issues discussed above in this section, the author finds it to be a small sacrifice to delay the discussion of this issue in order to attain, in his view, an undoubtedly better overall structure of the book. 36. See ch. 2. 37. See ch. 3. 38. For a somewhat diverging definition, cf. Bernt & Doublet (1998), at p. 181. 39. For a fascinating hermeneutical perspective on legal research, see Bernt & Doublet (1998), at p. 178. See also Hoecke (2011), ch. 1, p. 4. 40. See Hoecke (2011), p. 10.

16

Methodology

tions. When there is more than one interpretation alternative available, the researcher may have to take a normative position based on his own discretionary balancing of conflicting interests. By doing so, the researcher will unavoidably contribute to the formation of the law. The notion that a legal researcher passively applies a set of tools (legal principles for interpretation) to given material (sources of law) and a solution (legal rule) just reveals itself, independently of the choices he makes throughout the interpretation process, is groundless. Legal research is not an empirical discipline.41 While sources of law in themselves (statutory texts, preparatory works, court rulings, etc.) clearly are empirically verifiable, their legal meaning is not. Legal research is, in the author’s view, a hermeneutical-normative discipline, the goal of which is to arrive at soundly founded interpretations of the relevant legal text. Empirical work may be useful in legal analysis as a supplementary element (e.g. to substantiate factual assertions, provide contextualization for legal discussions or indicate whether the law works as intended), but will generally have no place in the legal interpretation process as such. Legal analysis is, and should remain, an art of authoritative text interpretation, providing continuity to a tradition with historical roots dating back over 2 millennia to the Roman legal doctrine.42 An implication of this perspective is that legal research is not an academic discipline that yields objective answers. There may be no right or wrong answer as to how a legal text should be interpreted – or, put differently, it will normally not be feasible to verify in an objective manner whether the output of the legal analysis, i.e. the interpretation result, is “correct”.43 This stands in contrast to the natural sciences (biology, chemistry, physics, etc.) and formal sciences (mathematics, statistics, logic, etc.), where a research problem may be broken down into a research hypothesis capable of falsification, i.e. of being proven false. Philosopher of science Karl Popper regarded all theories without potential for falsification as non-scientific.44 The logical positivists supplemented the idea of falsification with the verifiability requirement, entailing that only theories that were verifiable 41. On the relationship between legal science and empirics, see, e.g. Burns et al. (2009), at p. 153; and Sandgren (1995), at p. 726. 42. On the Roman roots, see, e.g. Hoecke (2011), at p. 1; and Samuel (2003), at p. 25. 43. It will, however, likely be feasible to verify whether the interpretation itself is valid. This will be a question of whether the interpretation has respected the boundaries set by the governing hermeneutic interpretation principles. 44. Popper (1962).

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Chapter 1 - Research Questions, Methodology and Sources of Law

through empirical means, or logically necessary, should be considered scientific.45 Contrary to the view of Alf Ross that the principle of verification must apply also to legal research, in the sense that assertions in legal doctrine should be verified against the actions of the courts,46 the author finds that the notion of verification has no place in legal research.47 As there is no manner in which the interpretation of a legal text may be proven false or verified empirically or logically, there seems to be little sense in formulating research hypotheses in legal research. A more useful approach is to formulate relevant interpretation questions, which may serve as research questions.48 The author has acted in accordance with this logic and formulated the two research questions presented in section 1.1. In doing so, he recognized that there are no clear norms governing how such questions should be structured. The guiding parameters that he used are that the research questions should make sense and be highly relevant within the legal field to which the research pertains (i.e. international transfer pricing). The research questions are answered through legal analysis. With this, the author refers to: − an interpretation of the relevant sources of law aimed at delineating their meaning for the purpose of determining a legally binding rule through a harmonization of the source contributions, i.e. to find the law “as it is” (de lege lata approach); and − an assessment of whether the derived legally binding rule is useful as it is or if it should ideally be altered, and if so, proposals for the relevant amendments (de lege ferenda approach), i.e. to find the law “as it should be”. 45. See https://en.wikipedia.org/wiki/Logical_positivism#Verification (6 Oct. 2015). 46. Ross (1958), at p. 40. See also Samuel (2008), at p. 319. 47. It could be argued, however, that if the positions taken in legal research are not given any weight by the courts in their applications of the law, the positions would be of little value. Contrary, if they are taken into account by the courts, they thereby, in some sense at least, are “verified”. This argument, however, does not pertain to verifiability as the term is used in the natural and formal sciences. 48. There are nevertheless examples of research hypotheses being used in legal research of tax law issues, as done in Skaar (1991). If research hypotheses are used in legal research, it should, in the author’s view, be made clear that they should not be read as assertions that are capable of objective scientific falsification, but rather as a way to formulate the relevant interpretation questions. A hypothesis in this field of research does not seem to be anything other than an interpretation question “in disguise”, nor does it add anything (relative to an interpretation question), and it may provide a misleading impression (that the hypothesis is capable of scientific falsification). The author is therefore of the view that it could be for the better to just discard the notion of research hypotheses in the field of legal research altogether.

18

Methodology

The primary research question is answered through a de lege lata analysis of the current US and OECD profit allocation provisions, encompassing both the transfer pricing methodologies and the intangible ownership provisions. Such an analysis is, in the author’s view, relevant, as there is considerable ambiguity associated with these provisions, triggering a need for legal clarification. Also, many of the relevant provisions were introduced recently and have therefore not previously been thoroughly analysed for academic purposes.49 The author’s interpretations of the relevant texts are restrained by the fundamental legal interpretation principles that govern which sources of law are relevant, how interpretation arguments may be derived from them and how the arguments should be harmonized when they provide diverging directions for the interpretation. Application of these principles validates the author’s interpretations as legal research, distinguishable from text analyses carried out in other hermeneutical disciplines.50 The US rules are domestic tax law, while the OECD rules are international treaty law. The principles for interpretation of the two sets of rules have different legal foundations. US tax law shall be interpreted in accordance with the prevailing interpretation principles developed within this legal system for the particular field of tax law. The IRC is the primary source of law, as interpreted by the US Treasury Regulations and court decisions. The Supreme Court is the highest court in the United States,51 above the US courts of appeals52 and the trial courts.53 Decisions from the US Tax Court are generally deemed to have more weight than decisions from a trial court due to its technical expertise on tax law issues.54 The OECD MTC provisions shall be interpreted in accordance with the principles developed under international law, as codified in articles 31-33 of the 1969 Vienna Convention on the Law of Treaties (VCLT).55 Primary weight is placed on the wording 49. For a brief and recent overview of the 2015 OECD profit allocation rules, see Wittendorff (2016). See also Petruzzi (2016). For critical comments, see Avi-Yonah et al. (2017), at sec. 3.12 (The limits of Actions 8-10); and Musselli et al. (2017). 50. See also Bernt & Doublet (1998), at p. 205. 51. The US Supreme Court has its legal basis in art. III of the US Constitution. The federal court system is made up of 94 district-level trial courts and 13 courts of appeals that sit below the US Supreme Court. 52. These are 13 appellate courts that sit below the US Supreme Court. The 94 federal judicial districts are divided into 12 regional circuits, each with their own court of appeals. 53. The 94 districts (or trial courts) are called US District Courts. 54. The US Tax Court is established under art. I of the US Constitution. 55. See, in particular, Bullen (2010), at pp. 27-32 and pp. 42-53 on the application of the 1969 Vienna Convention on the Law of Treaties (VCLT) interpretation principles for the interpretation of the OECD MTC and the OECD TPG, respectively.

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Chapter 1 - Research Questions, Methodology and Sources of Law

of the relevant treaty provisions in light of their context and the purpose of the treaty. These formal points of departure, however, offer little in terms of useful guidance – or meaningful restrictions, for that matter – with regard to the interpretation process. The core principle for profit allocation in both regimes, i.e. the arm’s length principle, is (as touched upon in section 1.1.) expressed in a few sentences in the US IRC, section 482 and the OECD MTC, articles 7 and 9. The principle is developed and operationalized through comprehensive, detailed and often ambiguous provisions in the US Treasury Regulations and the OECD TPG in implementing the arm’s length metanorm for a wide range of different transfer pricing contexts. As the author will revert to in sections 1.5.6. and 1.6.4., case law may offer useful analogies but is rarely decisive for the interpretation process. The lion’s share of the interpretation problems raised in this book are resolved by way of interpreting the US Treasury Regulations or the OECD TPG, not the wording of IRC section 482 or articles 7 and 9 of the OECD MTC as such. The former secondary texts have their own distinct terminology, structure and inherent logic, making up complex micro legal systems. While the wording of their provisions often may yield little in the way of specific direction, a range of contextual, transfer pricing and economic arguments generally aid in the interpretation. Such arguments include: – internal consistency (within the US Treasury Regulations and the OECD TPG); – direction provided through examples (included in the US Treasury Regulations and the OECD TPG); – the core purpose behind the US and OECD profit allocation rules for IP that intangible profits should be allocated according to value creation; – the degree of correlation between the different interpretation alternatives and the fundamental transfer pricing principles deducted from the arm’s length metanorm, e.g. parity in the taxation of related and unrelated enterprises, the realistic alternatives available, etc.; and – fundamental economic reasoning, e.g. that routine and non-routine value chain contributions attract normal market returns and residual profits, respectively. The US and OECD profit allocation rules are constantly evolving. It is important to have a clear understanding of the material content of historical 20

Methodology

rules, as new rules are normally adopted to alter the profit allocation consequences of their predecessors. It will therefore often be relatively easy to identify the purpose of new rules, which may then aid in their interpretation. An understanding of the historical context of the current rules also facilitates a better understanding of development trends in transfer pricing jurisprudence. The historical rules are therefore analysed where the author finds them to be relevant. The secondary research question will be analysed using a de lege ferenda approach for the purpose of determining whether the law is as it should be. The relevance of such an analysis is accentuated by the likelihood that multinationals will continue to adapt to the US and OECD profit allocation rules, resulting in a potential for continued BEPS and a need to revise the current rules. Analytically founded suggestions for more useful profit allocation rules should therefore, in the author’s view, be relevant. Also, the OECD has not yet fully completed its BEPS Project revision of the transfer pricing guidance. The OECD work on significant topics, such as the application of the profit split method in the context of global value chains and the allocation of profits to R&D funding contributions, is ongoing.56 The viewpoints expressed in this book could be relevant for the ongoing OECD work. This book is not an interdisciplinary work. The author’s analysis of the research questions is based solely on a hermeneutical-normative legal methodology. No theoretical or empirical methodology from other academic disciplines is applied. This is not to say that an interdisciplinary approach would not possibly be fruitful; perhaps it would have been. Such an analysis, however, would raise principal methodological and practical issues and should likely be carried out in cooperation with researchers from other disciplines (e.g. economics, financial accounting and finance).57 Important transfer pricing research has been done within the field of economics in particular. The author will present an overview of some of the basic findings from this research in chapter 2. This will provide useful perspectives and facilitate the subsequent analysis through a framing of 56. See the analyses in ch. 9 and sec. 22.4. for the profit split method and R&D funding remuneration, respectively. 57. It would have been necessary to have separate parts on legal analysis and empirical work. One approach would, for instance, be that empirical data was presented after the legal interpretation of a provision to illustrate how multinationals actually have adapted to the rule. Whether such use of empirical data would add much value to the

21

Chapter 1 - Research Questions, Methodology and Sources of Law

the relevant legal issues in an economical and empirical context. It will also ground factual assertions that the author employs in his analysis (e.g. on the realistic alternatives to a controlled transaction) of empirical facts. On a related topic, the author would like to add that some of his discussions pertain to rules that govern somewhat technical financial concepts, such as transfer pricing valuation. It is necessary to have a basic understanding of these concepts in order to gauge how the law governing them should be read. The author will provide brief outlines of the underlying concepts where necessary.

1.5. The relevant OECD sources of law 1.5.1. Introduction The analysis of both research questions, with regard to the OECD MTC, depends on an interpretation of articles 7 and 9. Together, they govern the international allocation of business profits under OECD MTC-based treaties, eliminating double taxation. Their purpose, however, goes far beyond the mere avoidance of double taxation, as they are set in place to ensure that business profits are allocated pursuant to the specific arm’s length pattern,58 book is another question. This does not seem clear, given the considerable empirical work already done by the OECD on the extent of BEPS; see OECD, Measuring and Monitoring BEPS – Action 11: 2015 Final Report (OECD 2015), International Organizations’ Documentation IBFD. See also, somewhat in the opposite direction, Musselli et al. (2012); Musselli et al. (2013); and Hines (2014). 58. There is a clear distinction between profit allocation aimed solely at avoiding double taxation and that which is aimed at avoiding double taxation by way of an arm’s length profit allocation. The former is adhered to as long as the profit is not taxed in both jurisdictions, regardless of the underlying contributions of functions, assets and risks, for example, if 100% of the profits are allocated to one of the jurisdictions. The latter type of allocation is achieved if total profits are split among the involved jurisdictions pursuant to the OECD profit allocation rules. For example, this could be the case if the contract manufacturing performed by a group entity in jurisdiction 1 is responsible for 10% of the total operating profits while the patent and trademark owned by a group entity in jurisdiction 2 is responsible for 90% of the operating profits from the value chain and the allocation of income reflects this value contribution. Through the allocation of 10% to jurisdiction 1 and 90% to jurisdiction 2, double taxation will be avoided and the arm’s length standard adhered to. On a similar note, see Schön (2010a), at p. 232, where he points out that “this does not explain why it is exactly the comparison between a dependent and an independent enterprise which provides the standard benchmark for jurisdictional allocation. The same holds true when the arm’s length standard is regarded primarily as a means to administrate

22



The relevant OECD sources of law

i.e. as unrelated enterprises would have done under similar conditions. The author will tie some comments to the sources of law relevant to the interpretation of these provisions in sections 1.5.2.-1.5.6., beginning with article 9, as the OECD TPG were designed to elaborate on this provision.

1.5.2. Article 9 of the OECD MTC The allocation of operating profits among group entities resident in different jurisdictions is governed by article 9 of the OECD MTC. Article 9(1) expresses the arm’s length standard for profit allocation as follows: [C]onditions are made or imposed between the two enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.59

The question is how this standard should be understood in the context of controlled intangibles transfers.60 The language of article 9 offers little guidance. It should be seen as merely expressing the principle that profits should be allocated in a manner that reflects the allocation that would have been carried out among third parties with conflicting interests. The delineation of the further content of article 9 must therefore rely on other sources of law.

double taxation: while this requires the consent to apply one single standard by both countries, it is not self-evident that this measuring rod should be exactly the arm’s length standard”. On the status of the arm’s length principle in treaty law, see Lepard (1999/2000). 59. The system of art. 9 is that the profits allocable to a residence jurisdiction under art. 9(1) shall be excluded from taxation in the other residence jurisdiction under art. 9(2). This avoids economical double taxation and ensures that the profits are allocated among the residence jurisdictions pursuant to the arm’s length standard. With respect to the area of application of art. 9, see Dwarkasing (2011) and Rotondaro (2000) for an analysis of the concept of associated enterprises under art. 9 of the OECD MTC. 60. See Schön (2010a), at p. 231, for reflections on the origins of the OECD arm’s length standard as an allocation norm for attributing income to PEs, a norm which is now applied to allocate income among different group entities and has had immense “reverse” influence on the OECD PE allocation regime (for the TPG analogy approach taken by the Authorized OECD Approach doctrine, see the discussion in sec. 17.4.). On the interpretation of art. 9, see, e.g. Vogel et al. (1993); Wittendorff (2010a), at pp. 112-145; and Bullen (2011), at pp. 27-30, with further references. For interesting analysis of the arm’s length principle and EU law, see, in particular, Schön (2011a); and Almendral (2013).

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Chapter 1 - Research Questions, Methodology and Sources of Law

1.5.3. The OECD Commentaries on Article 9 and the OECD Transfer Pricing Guidelines The main sources of law for interpreting article 9 are the OECD commentaries.61 They do not contain any transfer pricing guidance in and of themselves, but effectively incorporate the TPG by way of reference.62 The TPG represent the OECD’s interpretation of the arm’s length principle, thereby expressing the consensus approach of the OECD member countries on the allocation of operating profits. This document enjoys an immense and unique position as the dominating source of law in international transfer pricing jurisprudence.63 Both tax authorities and multinationals follow the development of the TPG closely, often adapting their practices to new OECD positions even before these are finalized in a consensus text.64 The text is influential for the design and interpretation of domestic transfer pricing provisions worldwide, as well as for other model treaties, most notably the UN MTC.65 The TPG describe a transfer pricing system, with well-developed and detailed concepts. There is, in the author’s view, no room for illusions here: it will simply not be possible to carry out a complex profit allocation assessment in a uniform manner based on the arm’s length metanorm expressed in article 9(1) alone.66 This comprehensive document spans over 61. See Bullen (2011), at pp. 31-33 for a discussion of the status of the OECD Commentaries as a source of law. 62. Sec. 1 of the OECD Commentary on Article 9. For discussions pertaining to the status of the OECD TPG as a source of law for the interpretation of art. 9, as well as on the interpretation of the OECD TPG themselves, see Bullen (2011), at pp. 33-56. For a critical view on the (2010) OECD TPG, see Li (2011). For interesting de lege ferenda reflections on the OECD TPG, see Schön et al. (2011), in particular pp. 71-89 and 123136. For an informed historical discussion of why the OECD arm’s length regime has persisted, see Durst (2011), at p. 128. 63. See Rocha (2017), at p. 193, where it is stated that the 2017 IFA branch reports demonstrated that the OECD TPG comprise the most important transfer pricing standard for the IFA branches. For a thorough analysis of the influence of the OECD TPG on international tax law, see Calderón (2007). 64. The transfer pricing influence of the OECD should be seen in the broader context of the significant role that the organization plays in developing international tax rules. On this issue, see, in particular, Ault (2008). See also Ernick (2013). 65. See, e.g. Vega (2012). 66. For instance, it is self-evident that transfer pricing concepts, such as the TNMM, profit split method (PSM), intangible ownership and periodic adjustment, must be developed with detailed guidance in order to be applied in a uniform manner that avoids double taxation and reflects a third-party profit allocation pattern. It is therefore ironic that the OECD, in the historical Commentary on Article 9 of the draft 1963 OECD MTC, stated that “the Article seems to call for very little comment”.

24



The relevant OECD sources of law

a multitude of topics, ranging from general guidance on the arm’s length principle,67 the transfer pricing methods,68 comparability analysis,69 administrative procedures and documentation,70 as well as guidance tailored to specific types of controlled transactions, including intangibles,71 intragroup services,72 cost sharing agreements73 and business restructurings.74 The author will make two general observations of this document here and address more specific issues as they arise in later analysis. First, the arm’s length standard in article 9(1) will generally be met if the TPG are adhered to.75 It is difficult to imagine a realistic scenario in which there is direct conflict between the language of article 9 and the material content of the TPG. Nevertheless, it is not inconceivable that some of the solutions drawn up in the TPG would likely be difficult for third parties to accept.76 Even in these instances, however, it seems unrealistic to imagine that a convincing legal argument could be made that the positions taken in the TPG should be interpreted as conflicting with article 9 and that the latter should prevail.77 The reason for this is that article 9(1) only expresses a principle, while the more specific content of that principle is developed in the TPG and is subject to more or less constant changes. 67. OECD TPG, ch. 1. 68. OECD TPG, ch. 2. 69. OECD TPG, ch. 3. 70. OECD TPG, chs. 4-5. 71. OECD TPG, ch. 6. 72. OECD TPG, ch. 7. 73. OECD TPG, ch. 8. 74. OECD TPG, ch. 9. 75. See, however, Pankiv (2017), at p. 148, where it is asserted that “the transfer pricing analysis should not only be limited to the pricing of particular transactions and the methods provided by the OECD Guidelines, but should also take into account the financial or commercial conditions under which the transactions occur”. This assertion must be based on a shallow view of the transfer pricing methods, as the methods clearly do take into account relevant financial and commercial conditions. Thus, the “conflict” that the author seems to indicate between art. 9 and the OECD TPG is, in the author’s view, one that does not exist. 76. As the author will revert to at several points in this book, some of the positions taken in the OECD TPG do seem difficult to reconcile with third-party behaviour. For instance, the now historical 2009 guidance on contract R&D agreements in effect allocated residual profits in a manner that was not aligned with intangible value creation; see 2010 OECD TPG, at paras. 7.41 and 9.22-9.28; and the discussions in secs. 22.3.3.2., 25.2. and 22.4.2. of this book. 77. See, however, Musselli et al. (2017), at p. 341, where it seems to be argued that the new OECD approach to IP ownership in the context of intra-group contract R&D agreements (see the analysis in sec. 22.3.3.) could be contrary to the wording of art. 9 of the OECD MTC. The author does not find the argument convincing.

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Chapter 1 - Research Questions, Methodology and Sources of Law

Second, the TPG is a document that raises problematic interpretation issues. This is partly due to incoherence. Some of its positions, typically on controversial topics, are difficult to reconcile with each other. Much of the reason for this is to be found in the fact that the TPG is a “patchwork”, consisting of texts written at different times. The core foundation of the current TPG was largely put in place in connection with the revision of the 1979 OECD Report on Transfer Pricing and Multinational Enterprises (1979 OECD Report), which resulted in the 1995 TPG. Among the “big issues” at that time was the adoption of the profit-based transfer pricing methodology (the TNMM, profit split method and the periodic adjustment authority) as a reaction to section 482 of the 1994 US Treasury Regulations. In 2009, the (now previous generation of) business restructuring guidance was finalized, with important positions taken with regard to, for instance, the allocation of profits from contract R&D agreements. The 2015 implementation of the BEPS work introduced a range of new positions with regard to the allocation of residual profits.78 The composition of Working Party No. 6 of the OECD’s Committee on Fiscal Affairs was different in each of these revisions, as were the political and economic contexts in which the texts were written. For instance, the OECD took relatively conservative positions in the 1995 revision, offering taxpayers significant leeway in pricing their controlled transactions. The pre-financial crisis text on business restructurings, written a good 10 years after the 1995 text, addressed a specific type of controlled transaction, and its scope was therefore narrower than that of the general 1995 revision. While geared towards curtailing profit shifting, it still contained a range of MNE-friendly positions relevant to the transfer pricing of intangibles (the text came perhaps a little late, as many multinationals by that time had already restructured their operations to accommodate a tax-efficient structure). The 2015 BEPS text was written in the post-financial crisis climate, with public financing in most OECD jurisdictions declining and on the basis of a broad political consensus that the transfer pricing rules were ripe for a major revision aimed at preventing widespread base erosion. As the author will revert to at relevant points in the book, the positions taken in these three major revisions are not always easily reconcilable.

78. For informed overviews of the BEPS Project, see, in particular, Christians et al. (2017), at pp. 36 and 46 with respect to transfer pricing; as well as Brauner (2014a); Andrus et al. (2017), at p. 89; Ernick (2011); Wilkie (2014b); and Brauner (2014b). On changes to the OECD profit allocation rules for residual profits from manufacturing (R&D-based) intangibles in particular, see Musselli et al. (2017).

26



The relevant OECD sources of law

Adding to this that the key controversial issues in each of the three revisions were problematic to achieve clear consensus on,79 resulting in relatively ambiguous language, one is faced with a document that is not straightforward for interpretation. In some scenarios, ambiguous text may conceal a lack of real consensus on a contentious issue. In these cases, it may be that the examples included in the TPG, the relationship between the relevant language and other parts of the TPG, “preparatory works” (i.e. discussion papers issued prior to the enactment of the final text), fundamental transfer pricing principles, basic economic reasoning, etc. may contribute to the interpretation.80 The OECD BEPS Project resulted in the finalization of the following guidance (relevant to the analysis in this book) in October 2015: 81 − revisions to section D of chapter I of the OECD TPG on, inter alia, controlled risk allocations (resulting in new paragraphs 1.33-1.173); − revisions to chapter VI of the OECD TPG on intangibles (resulting in new paragraphs 6.1-6.212), including a new annex to the chapter illustrating the intangibles guidance (resulting in new paragraphs 1-111); − revisions to chapter VII of the OECD TPG on intra-group services (resulting in new paragraphs 7.1-7.65); and − revisions to chapter VIII of the OECD TPG on cost contribution arrangements (paragraphs 8.1-8.53), including a new annex to the chapter illustrating the cost-sharing guidance (resulting in new paragraphs 1-22). These 2015 texts represented the consensus view of the OECD member countries at the time at which they were issued82 and were formally approved by the OECD Council for incorporation into the OECD TPG in May 2016.83 In June 2016, the OECD issued a revised version of the business restructuring guidance in chapter 9 of the OECD TPG under the label 79. Relevant examples include the implementation of the TNMM and the periodic adjustment authority in the 1995 revision, the treatment of contract R&D agreements in the 2009 revision and the allocation of intangible profits pursuant to the concept of important functions in the 2015 revision. 80. See Bullen (2011), at pp. 50-53, for a discussion of the significance of other OECD publications addressing the interpretation and application of the arm’s length principle as sources of law. 81. The texts are printed in the OECD, Aligning Transfer Pricing Outcomes with Value Creation – Actions 8-10: 2015 Final Report (OECD 2015), International Organizations’ Documentation IBFD. 82. Id., at p. 10. 83. See http://www.oecd.org/ctp/transfer-pricing/oecd-council-approves-incorpora​ tion-of-beps-amendments-into-the-transfer-pricing-guidelines-for-multinational-en​ terprises-and-tax-administrations.htm (accessed 15 June 2016).

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Chapter 1 - Research Questions, Methodology and Sources of Law

“conforming amendments”, which removed the sections of the 2009 text on business restructuring that were deemed incompatible with the profit allocation positions taken in the above 2015 texts.84 The revised chapter 9 was approved by the OECD Council in April 2017. In June 2017, the OECD released the 2017 edition of the OECD TPG, which incorporated these revisions to the 2010 OECD TPG.85 References throughout the book to the OECD TPG are references to the current 2017 version. The author will specifically state when he refers to the historical 1995 or 2010 versions of the OECD TPG. Further, the OECD has now issued discussion drafts containing new guidance for the profit split pricing method, as well as for the attribution of profits to PEs. While these drafts have not yet resulted in consensus texts that have been approved by the OECD Council, they are, at the time of writing, well developed, and there will likely be no major changes in the final consensus texts. The author therefore assumes that his discussions on the drafts will be relevant also after the consensus texts have been issued and approved by the OECD Council.

1.5.4. Article 7 of the OECD MTC The allocation of operating profits among the headquarters of an enterprise in its residence jurisdiction and a PE in a source jurisdiction is governed by article 7 of the OECD MTC. Article 7(2) expresses the arm’s length standard in the PE context and states that the profits allocable to a PE are: [profits that] it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.86 84. See http://www.oecd.org/ctp/transfer-pricing/public-review-sought-of-beps-con​ forming-changes-to-chapter-ix-of-the-oecd-transfer-pricing-guidelines.htm (accessed 4 July 2016). 85. See http://www.oecd.org/ctp/transfer-pricing/oecd-releases-latest-updates-to-thetransfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations.htm (accessed 10 July 2017). 86. The system of art. 7 is that the profits that are allocable to the source jurisdiction under art. 7(2) shall be excluded from taxation in the residence jurisdiction under art. 7(3) through double taxation relief, avoiding juridical double taxation. Relief is provided in the form of exclusion of income under the exception method in the OECD

28



The relevant OECD sources of law

The question is how the arm’s length standard in article 7(2) shall be understood in the context of controlled intangibles transfers. The language of the provision is from 2010 and reflects the essential building blocks of modern transfer pricing jurisprudence through its reference to functions, assets and risks, in contrast to the old-fashioned and obtuse language of article 9. Nevertheless, there is realistically little concrete guidance that can be deduced from the language of article 7(2). The delineation of its further content must therefore rely on other sources of law.

1.5.5. The OECD Commentaries on Article 7 and the 2010 OECD Report The main sources of law for interpreting article 7(2) are the OECD Commentaries.87 These largely contain a summary of the 2010 OECD Report. The Report is a significant document and was a long time coming.88 There are some points that should be noted with respect to the 2010 OECD Report as a source of law for interpreting article 7(2). First, its basic approach is to apply the OECD TPG analogically to allocate operating profits to a PE. This means that the new 2015 text on intangibles in the OECD TPG is directly relevant for the interpretation of article 7(2). Second, most of the 2010 OECD Report pertains to the allocation of profits in three specific sectors: (i) banking; (ii) global trading; and (iii) insurance. The incurring of financial risk is the hallmark of these sectors, driving profits. This has also influenced the content of the allocation rules that apply to other sectors. These latter rules are the ones that are relevant for the purposes of this book, as they govern the allocation of residual profits from unique intangibles in the PE context, together with the OECD TPG. The 2010 OECD Report was written in the same pre-financial crisis environment as the 2009 (previous generation) business restructuring guidance of the OECD TPG. The new 2017 OECD TPG on intangibles tones down the importance of financial risk for the purpose of allocating residual profits, MTC, art. 23A or under the credit method in the OECD MTC, art. 23B. Thus, art. 7 determines the maximum amount of profit allocable to the source jurisdiction, as well as the maximum amount of profits for which the residence jurisdiction must provide double taxation relief. 87. For a general discussion of the relevance of the OECD commentaries, see, e.g. Wittendorff (2010a), at pp. 122-131, with further references. 88. It essentially reiterates the positions taken in the 2008 OECD Report on the Attribution of Profits to Permanent Establishments.

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Chapter 1 - Research Questions, Methodology and Sources of Law

triggering tension regarding the 2010 OECD Report. The author will revert to these interpretation issues in his later analysis of the allocation of profits under article 7.

1.5.6. Case law in connection with articles 9 and 7 There is some relevant case law from various countries with regard to articles 9 and 7 that will be touched upon in this analysis.89 Examples include cases on the allocation of profits to asserted commissionaire PEs, as well as on the application of the TNMM in the context of taxpayer-initiated compensating adjustments. These cases were decided by domestic courts for the purpose of determining domestic tax obligations but contain viewpoints on articles 7 or 9 that arguably may be relevant to the interpretation of these articles.90 These cases are, however, pronouncedly fact-driven and therefore normally readily distinguishable from similar matters. They may therefore mostly be used as illustrations of practical profit allocation scenarios. Another point is that this case law generally trails behind the rapidly evolving profit allocation rules. Some of the problems at issue are no longer directly relevant in light of the 2015 revision of the OECD TPG.91

1.6. The relevant US sources of law 1.6.1. Introduction The analysis of both research questions, with respect to US law, depends on an interpretation of IRC section 482. The author will tie some comments to the sources of law relevant to this in sections 1.6.2.-1.6.5.

89. For a general discussion on the relevance of case law pertaining to art. 9, see Wittendorff (2010a), at pp. 143-145, with further references. See also Bullen (2011), at pp. 64-66, for a discussion on the role of domestic law for the interpretation of art. 9. For a comprehensive comparative discussion of transfer pricing case law, see Roin (2011). 90. See Bullen (2011), at p. 12 on the principle of common interpretation. 91. It has been argued that it is a problem that the material content of the arm’s length standard has not been subject to more delineation through case law; see Schoueri (2015), at p. 699; and Baistrocchi (2006), at p. 949. The author does not share this concern, as it is difficult for case law to contribute significantly to the clarification of the content of the arm’s length standard due to the fact-sensitive nature of transfer pricing cases. Clarification should, first and foremost, be done through the OECD TPG, legal literature and transfer pricing practice.

30



The relevant US sources of law

1.6.2. IRC section 482 IRC section 482 governs the allocation of operating profits among related parties under US law.92 It reads as follows: In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. For purposes of this section, the Secretary shall require the valuation of transfers of intangible property (including intangible property transferred with other property or services) on an aggregate basis or the valuation of such a transfer on the basis of the realistic alternatives to such a transfer, if the Secretary determines that such basis is the most reliable means of valuation of such transfers.93

Unaltered since its introduction in 1928, the first sentence provides the IRS with the authority to reallocate income among related parties if necessary to prevent “evasion of taxes or clearly to reflect the income”.94 The language does not indicate the profit allocation standard to be applied to reallocate income, but the regulations in section 482 of the IRC clarify that “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer”.95 This arm’s length standard is, as the point of departure, met if the controlled pricing adheres to the profit allocation rules in the IRC section 482 regulations. This will, for instance, be the case if its results are consistent 92. For an introduction to the Internal Revenue Code (IRC), sec. 482, see, e.g. Wittendorff (2010a), at pp. 24-25 and 55-56; and Levey et al. (2010), at pp. 6-14. 93. On the control criterion of IRC sec. 482, see Gazur (1994). 94. Sec. 45 of US: Revenue Act of 1928 (45 Stat. 806). On the development of IRC sec. 482 from being an anti-abuse rule to becoming the basis for the current and comprehensive US transfer pricing regime, see Brauner (2017), at sec. 2.3. 95. Treas. Regs. § 1.482-1(b)(1). The US arm’s length standard concept has its historical roots in US: War Revenue Act of 1917, ch. 63, 40 Stat. 300 (1917), pursuant to the regulations of which (Regulation 41, arts. 77-78 (T.D. 2694, 20 Treas. Dec. Int. Rev. 294, 321 [1918])) the Commissioner was granted the authority to require related companies to file consolidated returns when “necessary to more equitably determine the invested capital or taxable income”. Some years later, in 1921, new legislation was

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Chapter 1 - Research Questions, Methodology and Sources of Law

with those that would have been realized if uncontrolled taxpayers had engaged in the same or a comparable transaction under the same or comparable circumstances.96 While the regulations are clarifying in linking the reallocation authority in IRC section 482 to the arm’s length standard, their reference to uncontrolled transactions provides a somewhat misleading impression of the material content of their current profit allocation rules for profits from intangibles. As the author will revert to in detail later in the book (in particular, in chapters 8, 9 and 14), the reality is that the allocation of intangible profits under IRC section 482, to a considerable degree, does not rely directly on uncontrolled transactions, but rather on indirect methods (the one-sided transfer pricing methods, in particular the comparable profits method), subjective assessments (the residual profit split method) or the application of valuation techniques premised on the best realistic alternatives to the controlled transaction (e.g. the income method under the IRC section 482 cost-sharing regulations). Further, the second sentence contains the so-called “commensurate with income standard” for intangibles, which was added to the IRC in 1986.97 It has two sides: (i) that the profits from controlled multi-period intangibles transactions must be allocated pursuant to the relative values of the con-

enacted by Congress, allowing the government to require consolidated accounting from groups “for the purpose of making an accurate distribution or apportionment of gains, profits, income deductions, or capital between or among such related trades or business” (US: Revenue Act of 1921, ch. 136, s. 240(d), 42 Stat. 260 (1921), re-enacted in US: Revenue Act of 1924, ch. 234, s. 240(d), 43 Stat. 288 (1924); and US: Revenue Act of 1926, ch. 27, s. 240 (f), 44 Stat. 46 (1926)). In 1928, this provision was replaced by sec. 45 on the allocation of income and deductions (based on sec. 240(f) of the 1926 Revenue Act) in the Revenue Act of 1928, ch. 852, s. 45, 45 Stat. 806 (1928). The wording of this provision equals the first sentence of the current IRC sec. 482. The 1928 provision was, in 1934, supplemented by regulations applying the arm’s length standard (Reg. 86, art. 45 (1935)). The whole regulation is quoted in Essex Broadcasters, Inc. v. CIR, 2 T.C. 523 [Tax Ct., 1943]). These prevailed for almost 35 years, until the 1968 regulations were issued. The tax code provisions were re-codified in 1939 as the Internal Revenue Code of 1939. 15 years later, the Internal Revenue Code of 1954 was enacted in the form of a separate code by the Act 16 August 1954, ch. 736, 68A Stat. 1, changing the lettering and numbering of subtitles, sections, etc. of the 1939 Revenue Code. Several provisions of the Revenue Code were revised in a tax reform in 1976 (4 October 1976, Pub.L. 94-455, Title XIX, § 1906(b)(13)(A), 90 Stat. 1834). The Tax Reform Act of 1986 changed the name of the 1954 Revenue Code to the Internal Revenue Code of 1986. See, e.g. Avi-Yonah (1995); and Avi-Yonah (2012) for historical walk-throughs of the development of the US IRC. The last sentence of the provision was added in 2017, Pub. L. 115–97, title I, §  14221(b)(2), Dec. 22, 2017, 131 Stat. 2219. 96. Treas. Regs. § 1.482-1(b)(1). 97. US: Tax Reform Act of 1986, Pub. L. No. 99-514, Sec. 1231(e)(1), 100 Stat. 2085, 2562-63 (1986).

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trolled value chain contributions in each income year; 98 and (ii) that the controlled ex ante pricing may be adjusted in light of ex post profits, within certain limits.99 The author will revert to the applications of the commensurate with income standard in detail later in the book (in particular, in chapters 8, 9 and 16).100 The third sentence of section 482 of the IRC was added in the 2017 US tax reform and codifies the aggregated valuation approach based on the realistic alternatives of the controlled parties, which the IRS has gradually developed in practice over the last decades.101

1.6.3. The IRC section 482 US Treasury Regulations The detailed provisions of the US Treasury Regulations represent the IRS interpretations of IRC section 482.102 The US Treasury Regulations are, in practice, the most significant sources of law for the interpretation of section 482 of the IRC. Their interpretation will play a key role in the author’s analysis. The US Treasury Regulations are generally treated as authoritative. The Supreme Court of the United States has established a high threshold for disregarding the Treasury Regulations. As long as Congress, through the wording of the relevant IRC provision, cannot be deemed to have spoken directly in respect of the precise tax question at issue (which likely will be extremely rare in transfer pricing cases due to the brief and ambiguous wording of IRC section 482) and the regulations thus fill a gap left by the statues, a court may not substitute its own construction for the reasonable interpretation of an agency.103 98. This result normally follows directly from a faithful application of the relevant pricing method (in practice, either the CPM or PSM). 99. This is, in some contexts, a necessary consequence of the first point. 100. It should, however, already at this stage be recognized that the standard is effectively incorporated into the CPM and PSM, as these methods allocate actual profits. 101. See the discussions in secs. 1.7. and 3.2. of this book, with further references. 102. For a thorough analysis of the historical development of the US regulations, see, in particular, Culbertson et al. (2003). 103. See Mayo Found. v. US, 562 US (2011), in which the Supreme Court applied the so-called “Chevron doctrine”; see Chevron USA Inc. v. Natural Resources Defence Council Inc., 467 US 837. See White (2016), at pp. 214-215, for comments. See also Altera Corp. & Subsidiaries v. CIR (145 TC No. 3, currently on appeal to the Ninth Circuit), where the Tax Court held that the Treasury had not engaged in reasoned decision-making with the result that the sec. 482 (2003 cost sharing) regulations at issue were found to be “arbitrary and capricious and therefore invalid”. See Kantowitz (2018)

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The core framework of the current US Treasury Regulations was established in 1994, when new regulations were issued to replace the 1968 predecessor regulations.104 A significant driving force behind the 1994 regulations was to better address the allocation of residual profits from unique intangibles.105 Key concepts of the 1994 regulations included the operationalization of the commensurate-with-income standard, as manifested in the new transfer pricing methods (i.e. the CPM and profit split method) and the periodic adjustment authority. The regulations have been amended several times since then, most notably through the potent 2009 cost sharing regulations and the 2015 regulations clarifying the application of the arm’s length standard and the best-method rule. The basic structure of the Treasury Regulations is as follows: (1) the first part deals with general transfer pricing issues (the arm’s length standard, the best-method rule, comparability, etc.);106 (2) the second part discusses the allocation of profits in specific situations (e.g. loans);107 (3) the third part discusses the allocation of profits for tangibles;108 (4) the fourth part contains a general discussion of the allocation of profits for intangibles;109

for comments on Altera. Without going into depth on the Altera ruling, the issue of whether the applicable cost sharing regulations (which required stock-based compensation to be treated as a cost and shared among the CSA participants) were compliant with the arm’s length standard in IRC sec. 482 was, in effect, treated as a question of whether it could be documented (by the IRS) that third parties – in so-called “comparable” CSAs – also shared such equity-based compensation costs. The author finds this entire reasoning puzzling, as it must be regarded as rather obvious that the typical IP-tax-planning CSAs, which have been so popular among US-based multinationals, in fact have no real third-party comparables (see fn. 1986, as well as fn. 1294 of the Xilinx ruling on the Xilinx ruling). It was thus not possible for the IRS to offer any such third-party evidence. However – as always in transfer pricing – the lack of third-party comparables cannot entail that the profits from controlled transactions should not be allocated among group entities in an arm’s length manner (based on, e.g. the realistic alternatives of the parties). 104. The US section 482 regulations have developed as follows: the 1968 regulations were published in the Federal Register (33 FR 5848) on 16 April 1968. Subsequent revisions and updates of the transfer pricing regulations were published in the Federal Register on 8 July 1994 (59 FR 34971), 20 December 1995 (60 FR 65553), 13 May 1996 (61 FR 21955), 26 August 2003 (68 FR 51171), 4 August 2009 (74 FR 38830), 22 December 2011 (76 FR 80082) and 27 August 2013 (78 FR 52854). 105. See US: Notice 88-123 (White Paper). 106. Treas. Regs. § 1.482-1. 107. Treas. Regs. § 1.482-2. 108. Treas. Regs. § 1.482-3. 109. Treas. Regs. § 1.482-4.

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(5) the fifth part discusses the CPM;110 (6) the sixth part discusses the profit split method;111 (7) the seventh part discusses the allocation of profits for cost sharing agreements;112 (8) the eight part contains examples of the best-method rule;113 and (9) the ninth (and last) part discusses the allocation of profits for intragroup services.114 Apart from the second and third parts, all of these provisions are relevant for the analysis of the research questions. When the author refers to the US Treasury Regulations, he refers to the current regulations unless otherwise specifically stated. As he will refer to a range of historical US regulations throughout the book (including proposed, temporary and final regulations from all relevant revision rounds), he has included detailed references to these texts in the References.115

1.6.4. Case law There is relatively comprehensive case law from US courts on the allocation of intangible profits under section 482 of the Treasury Regulations. Most is decided by the US Tax Court. Some cases are appealed, but the lion’s share is not, due to the significant costs and time required to litigate comprehensive transfer pricing cases and the inherent unpredictability of outcomes caused by their fact-sensitive nature.116 The author is not aware of any rulings by the US Supreme Court on the core profit allocation rules analysed in this book. This case law is generally binding on both taxpayers and the IRS with regard to the interpretation of IRC section 482, absent of changes in the law or regulations.117 Due to the fact-driven nature of these cases, however, it is often possible to distinguish the facts of a pending case from those of

110. Treas. Regs. § 1.482-5. 111. Treas. Regs. § 1.482-6. 112. Treas. Regs. § 1.482-7. 113. Treas. Regs. § 1.482-8. 114. Treas. Regs. § 1.482-9. 115. See p. 777 et seq. 116. For critical reflections on the lack of ability of transfer pricing case law to provide guidance for future cases, see Baistrocchi (2004a); and Baistrocchi (2006). 117. Andrus et al. (2012), at p. 4.

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a court case. The general impression in the literature is that transfer pricing case law now plays a less important role in relation to the US Treasury Regulations than historically has been the case, due to the comprehensive and up-to-date nature of the Regulations.118 Further, case law generally trails behind the development of the regulations. For instance, a reassessment may uncover shortcomings in the regulations, leading the IRS to revise them. A subsequent court ruling on the reassessment will then not be directly relevant for new cases, but may provide some analogical value. This was the situation in Veritas119 and the recent Amazon.com case120 pertaining to the determination of a buy-in amount under the predecessor of the current cost sharing regulations. The IRS argued that a so-called “income method”, which was first codified in the new 2009 regulations, should be applied. Even if the IRS argument only had limited support in the then-applicable 1995 regulations, its material content is similar to that of the current income method. Thus, even if the matter at issue was governed by the previous cost-sharing regulations, the rulings contributed to the interpretation of the current rules. Also, the amounts involved in some cases may justify litigation for the IRS even if the ruling will have no precedent value for future cases. This was the case in Amazon.com, argued before the Tax Court in 2017, essentially retrying Veritas.

1.6.5. The OECD TPG US transfer pricing assessments are founded in section 482 of the IRC, its regulations and case law. The IRS is nevertheless of the opinion that US transfer pricing law is generally aligned with the OECD TPG.121 The IRS competent authority accepts the OECD TPG as a basis for dispute resolution under treaty mutual agreement provisions.122 Historically, the perception has been that the material transfer pricing positions taken in the US Treasury Regulations differ from those of the OECD TPG with respect to intangibles, intra-group services and cost sharing arrangements.123 As 118. Id. See also Wittendorff (2010a), at p. 23. 119. Veritas Software Corporation & Subsidiaries v. CIR, 133 T.C. No. 14 (Tax Ct., 2009), IRS nonacquiescence in AOD-2010-05, 12 Nov. 2010. The ruling is analysed in sec. 14.2.4. of this book. 120. 148 TC No. 8; see the analysis in sec. 14.2.5. of this book. 121. See Bullen (2011), at pp. 40-41; and Wittendorff (2010a), at p. 28 on this topic. 122. See US: Rev. Proc. 2006-54. 123. Andrus et al. (2012), at p. 4. The US regulations have no direct parallel to OECD TPG ch. 9 on business restructurings.

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A few words on the 2017 US tax reform

the author will revert to in detail later throughout the book, there are now pronounced similarities between the systems. In any case, the OECD TPG will generally not be directly relevant for the interpretation of IRC section 482. Apart from the obvious fact that the interpretation of domestic law principally depend on domestic sources of law (in this case, the regulations in IRC section 482 and case law), it should be recognized that the design of the OECD TPG differs from that of the regulations. The OECD TPG often contain rather brief and ambiguous comments on specific transfer pricing issues, while the regulations generally offer comprehensive, detailed and instructive guidance with elaborate numerical examples. It should, however, be noted that the 2017 OECD TPG go significantly in the direction of the US Treasury Regulations in this respect. The current OECD TPG on intangibles now offer comprehensive examples, clearly inspired by the US Treasury Regulations. Nevertheless, due to the general difference in design, it may be difficult in practice to derive meaningful interpretation contributions from the OECD TPG. There are also notable material differences in the approaches of the two regimes to particular transfer pricing issues, which may render the OECD TPG unfit to contribute to the interpretation of IRC section 482.124 In the unlikely case that it should be possible to identify a direct conflict between the US Treasury Regulations and the OECD TPG, the former will of course prevail for the purpose of interpreting domestic US tax law.

1.7. A few words on the 2017 US tax reform The US enacted a comprehensive federal tax reform in the end of December 2017 through the Tax Cuts and Jobs Act.125 As this reform came just before this manuscript was to be delivered for publication, there was no time for a thorough analysis. A basic overview of the significance of the reform for the discussions contained in this book is, however, provided below. In general, the 2017 US tax reform introduced only two, but powerful, direct amendments to the US transfer pricing rules.126 124. An example includes the US and OECD approaches to the allocation of profits from internally developed manufacturing of IP in general, as analysed in chs. 21 and 22, respectively, and the approaches to the remuneration of R&D-funding contributions in particular (see sec. 22.4.7.). 125. US: Pub. L. No. 115-97, 22 Dec. 2017. The provisions discussed below in this section will have effect from and including 2018. 126. See the description in the proposal JCX-51-17, at pp. 236-237.

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First, the intangibles definition referred to in IRC section 482 (and section 367) has been changed so that it now also encompasses residual intangibles (goodwill, going concern value and workforce in place).127 This revision is significant and will bring an end to years of controversy pertaining to the interpretation of the previous version of the definition (see the discussion in section 3.2.). Second, a new sentence has been incorporated into section 482 of the IRC clarifying that the IRS may, going forward, base its transfer pricing assessments on aggregated valuations and on the realistic alternatives principle. This amendment is closely linked to the IP definition revision and is also significant. As the author will revert to in detail later in the book, the IRS has already based significant reassessments on this aggregated valuation approach, but has done so without a clear basis in IRC section 482 or the US Treasury Regulations and has lost repeatedly in court.128 These two legislative amendments entail that the US IRC now has “caught up” with the transfer pricing doctrine developed by the IRS through practice and ensure that the IRS going forward will have a crystal clear basis in the law on which to further develop its CPM (see the discussion in chapter 8) and income method-based (see section 14.2.8.3.) aggregated valuation approach. In particular, the legislative codification of the realistic alternatives pricing principle will likely lead to further refinement of the IRS valuation approach through future regulations. Until such regulations are issued, there will be a solid basis in the current regulations for ascertaining the material content of the aggregated valuation approach based on the realistic alternatives of the controlled parties.129 These two 2017 amendments to the law should be seen as nothing less than a true victory for the IRS and a recognition of the work that it has performed for decades with regard to advancing transfer pricing doctrine in general, and IP valuation doctrine in particular. Further, in addition to these two direct amendments to US transfer pricing law, the 2017 tax reform also introduced three sets of rules (FDII, GILTI and BEAT, as discussed below) that, in practice, will be highly significant 127. See IRC sec. 936(h)(3)(B)(2)(vi) and (vii). 128. See the analysis of the Veritas and Amazon.com rulings in secs. 14.2.4. and 14.2.5., respectively. 129. See the discussion in sec. 6.7.2. on the 2015 expansion of the US aggregation provisions; sec. 14.2.3. on the 2007 IRS Coordinated Issue Paper (CIP) valuation approach; sec. 14.2.8.3. on the income method; and secs. 14.2.4. and 14.2.5. of the Veritas and Amazon.com Tax Court rulings, respectively.

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A few words on the 2017 US tax reform

with respect to US taxation of multinationals, but are not transfer pricing rules as such. These new rules do not determine how profits from intragroup transactions shall be calculated and allocated among group entities (transfer pricing), but pertain to how certain items of income shall be taxed in the United States. These rules come in addition to the US transfer pricing regime and have important interactions with the regime, as the income calculated under these three new sets of rules can be influenced by transfer pricing. The author will provide a brief overview of these additional three sets of rules. First, the 2017 US tax reform introduced what in effect can be seen as a preferential regime for IP income derived from export activities (i.e. for non-US IP income) through the special deduction set out in section 250 of the IRC for foreign-derived intangible income (FDII).130 This provision entails, in a somewhat simplified manner, that excess IP returns (above a normal market return) earned directly by a US corporation from its foreign sales (including licensing of IP) can be deducted from its US income.131 Under the provision, 37.5% of the IP income may be deducted, resulting in effective US taxation of the foreign-source IP income of only 13.125%.132 This US IP box provision will likely encompass IP income from both manufacturing intangibles that have been developed through R&D carried out abroad as well as from marketing intangibles and may therefore arguably be in conflict with the OECD’s modified nexus approach for IP regimes (discussed in section 2.5.).133 Second, the tax reform introduced an add-on to the existing US controlled foreign corporation (CFC) rules (the subpart F rules) in IRC section 951A, which requires current-year inclusion of global intangible low-taxed in-

130. See the description in the proposal JCX-51-17, at p. 229. 131. See IRC sec. 250(b) on foreign-derived intangible income. 132. Which is the ordinary tax rate of 21% multiplied by the remaining part of the IP income (1-0.375). The deduction will be phased down from 37.5% to 21.875% from and including 2026, which will entail an effective tax rate of 16.4%. 133. It should be noted that “excess IP returns” under the new provision are not the same as residual profits from unique and valuable IP in a transfer pricing context. “Excess IP returns” may encompass also a range of other income items, as the profits, somewhat simplified, can be said to be determined as income minus a normal market return on tangible assets. The amount of income subject to the foreign-derived intangible income (FDII) provision can be influenced through transfer pricing (e.g. through increasing the royalty rate on IP licensing from a US parent to the controlled foreign corporation (CFC) in question or through charging for services (from the United States) through a transfer pricing method that includes a profit margin (as opposed to the services cost method, or SCM), thereby reducing the profits of the CFC).

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come (GILTI) by US shareholders.134 GILTI entails (somewhat simplified) excess foreign IP returns above a normal market return.135 This rule ensures that US tax on such IP income cannot be deferred until the profits are distributed to the US shareholder (but must be taxed on a current basis). As opposed to the FDII rule described above, which applies to foreign IP income earned directly by a US company, the GILTI-rule applies to foreign IP income earned through a CFC. GILTI is subject to tax at the ordinary US rate of 21%, but in the period of 2018-2025, a 50% GILTI deduction is allowed, making the effective tax rate on such income 10.5%.136 This GILTI rule results in a US CFC regime that is likely more burdensome than the CFC rules of the key trading partners of the United States and thus represents a comparative disadvantage for US investors. Third, the tax reform introduced a tax on “base erosion payments” carried out by large corporate taxpayers,137 i.e. the so-called “base erosion and anti-abuse tax” (BEAT) in IRC section 59A.138 The stated purpose of this tax is to level the playing field between US and foreign-headquartered parent companies.139 The provision effectively denies deductions for a portion of outbound payments (including amounts paid for the acquisition of depreciable property) made to foreign related entities for which US deductions are available.140 The BEAT rule is a significant provision, both with 134. See the description in the proposal JCX-51-17, at p. 227. This add-on was necessary in order for the CFC rules to catch active global intangible low-taxed income (GILTI) (as opposed to the passive income otherwise encompassed by the Subpart F CFC rules). See also initial reflections on ambiguous aspects of the GILTI provisions in Stevens et al. (2018). 135. IRC sec. 951A(b)(1). This provision encompasses more income than what is normally deemed to be IP income in a transfer pricing context (residual profits). The amount of income subject to the GILTI provision can be influenced through transfer pricing arrangements with other group entities. 136. IRC sec. 250(a)(1)(B). 137. The provision applies to domestic US companies that are not taxed on a flowthrough basis, that are part of a group with a minimum of USD 500 million in revenues and that have a “base erosion percentage” (essentially, the aggregate amount of base erosion tax benefits divided by the aggregate amount of total deductions for the taxpayer) of a minimum of 3%. 138. See the description in the proposal JCX-51-17, at p. 242. It can also be noted (as a side matter) that the new 2016 US Model Tax Convention denies treaty benefits for deductible related-party payments of mobile income in cases where the receiving beneficial owner pays little or no tax on the income due to a “special tax regime”. See Brauner (2017), at sec. 2.2.1.2 on this issue. 139. See the report entitled Unified framework for fixing our broken tax code, released by Republican leadership, dated 27 September 2017, at p. 9. 140. Important exceptions to the base erosion and anti-abuse tax (BEAT) provision are available for payments of: (i) amounts for services that qualify for pricing under the services cost method of the US IRC sec. 482 regulations and that reflect the total

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The relationship between the book and other transfer pricing literature

regard to its high degree of complexity and potential positive US revenue effect. It is also controversial. As it denies deductions for payments made to foreign entities where similar payments made to similarly situated domestic US entities would remain fully deductible, it will be problematic in the context of tax treaty non-discrimination provisions. The rule may also be in conflict with the World Trade Organization trade law obligations of the United States.

1.8. The relationship between the book and other transfer pricing literature The legal analysis in this book is based on interpretations of the primary legal sources.141 Transfer pricing literature is referred to where it provides meaningful contributions to these interpretations. The author’s experience is that while there certainly is a significant body of international literature on general transfer pricing issues with regard to US and OECD law,142 the literature is, unfortunately, a bit more limited when it comes to the specific problems analysed in this book, i.e. the profit allocation sides of the US and OECD transfer pricing provisions for IP in particular.143 With regard to books that, in whole or in part, deal with transfer pricing of intangibles under US and OECD law, the author’s experience is that these are generally limited to high-level discussions of (now) mostly historical US and OECD provisions. These books therefore provide somewhat modcost of the services without any mark-up; and (ii) qualified derivative payments for taxpayers that annually recognize ordinary gains or losses on such instruments (subject to exceptions). Further, costs of goods sold seem to fall outside the scope of the BEAT provision. Transfer pricing arrangements may affect the BEAT, in particular the choice of pricing methods to remunerate services; e.g. if more than one method (including the SCM) can be used to price a particular service, it could be strategic to choose the SCM in order to fall under the exception. 141. I.e. IRC sec. 482 and the accompanying Treasury Regulations with respect to the United States, and articles 9 and 7 of the OECD MTC, the OECD Commentaries and the OECD TPG with respect to OECD law. 142. E.g. literature covering discussions of the arm’s length principle versus formulary apportionment, intra-group financing, mutual agreement procedure issues, advance pricing agreement issues, documentation issues, general reflections on transfer pricing methodology, etc. 143. In other words, the analysis of how these transfer pricing provisions dictate how the total profits from an intangible value chain must be split into normal return profits, incremental operating profits from local cost savings, market conditions and synergies and residual profits from unique intangibles and allocated among the group entities that contribute the relevant value chain inputs.

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est contributions to a more detailed analysis of the current US and OECD provisions. For instance, Markham’s 2005 book takes a broad approach to the subject matter,144 as does the book written by Levey and Wrappe.145 Wittendorff’s book touches on a range of relevant issues but does not go into depth on profit allocation problems for IP.146 The book written by Boos is primarily an economic analysis.147 The 2007 IFA report on transfer pricing of IP has been useful, but offers only high-level discussions. These publications are now partly outdated.148 There are also “practical manuals” on transfer pricing of IP, but these are typically high-level overviews produced by big audit firms and are not written as academic analyses. With regard to articles, the author has, through extensive searches of, among others, the IBFD, Tax Notes International and BNA Transfer Pricing archives, identified a wide range of highly relevant publications on transfer pricing of IP that are referred to in his discussions. It is the author’s assertion that he has identified and referred to the most significant contributions in international (English) legal literature that deals with the profit allocation sides of the US and OECD transfer pricing provisions for IP. Nevertheless, it must be said that the amount of relevant literature that he has identified is more sparse than one could expect. He attributes this to two factors. First, there has been a historically unprecedented and anti-BEPS-driven development in US and OECD transfer pricing law in recent years, which has resulted in significant revisions of the law, altering historical profit allocation positions.149 With regard to the United States, the final versions of

144. Markham (2005). In addition to the transfer pricing of intangibles, Markham’s book also deals with a range of additional issues, such as documentation requirements, APAs and formulary apportionment. 145. Levey et al. (2010). 146. Wittendorff (2010a). 147. Boos (2003). 148. IFA (2007). 149. See, for instance, Wittendorff (2016), at p. 331, where it is stated that “its final report on BEPS actions 8-10 … involves significant changes to the OECD’s transfer pricing guidelines and the birth of a new arm’s-length principle that replaces the traditional principle adopted by the League of Nations in 1933”. See also Lang et al. (2016), preamble, where it is stated that “the work of the OECD on Transfer Pricing, Allocation of Risk and Recharacterization (Actions 8, 9 and 10 of the BEPS Action Plan) has developed proposals for a substantial revision of the OECD Transfer Pricing Guidelines with regard to a number of closely related topics which are ‘at the heart of the arm’s length principle’”. See also, in this direction, Pankiv (2017), at pp. 209-210.

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(i) the intra-group service regulations were issued in 2009;150 (ii) the cost sharing regulations were issued in 2011;151 and (iii) the new regulations on outbound transactions and coordination with the best-method rule were issued in 2015 (finalized in 2016). The December 2017 tax reform has also had an impact on US profit allocation through codification in IRC section 482 of the aggregated valuation principle based on the best realistic alternatives of the controlled parties (as well as amending the US IP definition for transfer pricing purposes).152 With respect to the OECD, the 2017 TPG contain revised language on key profit allocation aspects through new chapters on intangibles, intra-group services, cost sharing arrangements and business restructurings. Important parts of chapter I of the OECD TPG (on allocation of risk, local market conditions, etc.) have also been significantly revised. As the material differences between the 1995/2010 OECD TPG and 2017 OECD TPG provisions on many points run deep with respect to profit allocation for controlled IP transfers, legal literature analysing the historical 1995/2010 OECD TPG is not always capable of providing meaningful contributions to the interpretation of the current 2017 IP profit allocation provisions. Certain aspects of the 2017 OECD TPG rules do not even have any direct parallels in the 1995/2010 versions of the OECD TPG, thereby rendering legal literature that analyses the latter provisions unable to provide any clear contributions to the author’s interpretation of the relevant OECD provisions. This is the case, for instance, with respect to the new guidance on profit allocation to R&D funding,153 IP valuation,154 local cost savings and market conditions and synergies,155 application of the transfer pricing methods in the context of intangibles,156 periodic adjustments (the guidance for which is now linked to the new language on valuation and hard-to-value intangibles) 157 and guidance directly aimed at restricting profit allocation alternatives for cost sharing arrangements.158 It can also be mentioned that, as a first for the OECD TPG (and clearly inspired by the US regulatory style), the OECD has provided a range of detailed examples delineating the 150. These regulations contain key provisions for determining IP ownership under US transfer pricing law; see the analyses in ch. 21 and ch. 23. 151. See the analysis of the current US cost sharing regulations in sec. 14.2. 152. See IRC sec. 482, at fn. 129 on aggregated valuation and the discussion in sec. 3.2. of the revised US IP definition. 153. See the discussion in sec. 22.4. 154. See the discussion in ch. 13. 155. See ch. 10. 156. See ch. 11. 157. See sec. 16.5. 158. See sec. 14.3.

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more specific content of the 2017 profit allocation rules applied to intangible value chains. Parts of the OECD revision work is also still ongoing, e.g. the revision of the profit split method guidance.159 This book is likely among the first academic legal texts that analyse these new provisions in depth. Second, this thesis takes a (somewhat at least) original analytical approach. First, the author places his profit allocation analysis into a general framework, where he establishes a link between the concepts of unique (or nonroutine) and non-unique (or routine) value chain contributions on the one side,160 and the allocation of residual profits and normal market returns on the other side.161 This link grounds his analysis of the profit allocation consequences of the US and OECD transfer pricing provisions in economic concepts and reality and is used as a red thread throughout the entire book. Also, he places his analysis of the US and OECD IP ownership provisions into a more specific framework that distinguishes between manufacturing and marketing IP.162 He does so because there are important differences between these groups of IP that significantly affect how they should be analysed for transfer pricing purposes. This book also identifies and analyses the link between profit allocation under cost sharing provisions and the IP ownership rules.163 It is the author’s view that both frameworks have clear analytical value, and he is not familiar with any prior legal literature applying similar frameworks in this comprehensive manner. This book also offers some new perspectives on the historical US and OECD rules. First, the author provides a relatively detailed analysis of the profit allocation sides of the historical rules in order to gauge how the provisions dictated that intangible profits should be allocated among jurisdictions, thus enabling meaningful comparisons with the profit allocation positions taken in the current US and OECD rules. This historical analysis deepens the understanding of the context in which the current rules were introduced and contributes to their interpretation. It is also the author’s impression that several of the discussions in this thesis of “old” (but still current) US and OECD rules should be able to contribute to new insights. An example is his in-depth analysis of the OECD transfer pricing comparability requirements with respect to whether third-party “blended” profit 159. 160. 161. 162. 163.

See the discussion in ch. 9. On this classification, see sec. 3.4.3. See the discussions in secs. 1.2.-1.3. On this classification, see sec. 3.4.2. and the analysis in ch. 20. See sec. 20.5.

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Reference register and source abbreviations

data is legally acceptable for the purpose of benchmarking controlled profit allocations under the one-sided transfer pricing methods.164 the author is not familiar with any similar analyses in other legal literature.

1.9. Reference register and source abbreviations Throughout the book, the author applies abbreviations for the most frequently used legal sources (OECD TPG, US regulations, etc.) in order to avoid unnecessary repetition. This should be particularly useful with respect to the many different versions of the US regulations referred to in the book.

164. See sec. 8.6.

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Chapter 2 Business and Tax Motivations for Intangible Value Chain Structures 2.1. Introduction The research questions analysed in this book would not have been relevant had enterprises not engaged in foreign direct investment (FDI). The OECD defines FDI as a “category of cross-border investment made by a resident in one economy (the direct investor) with the objective of establishing a lasting interest in an enterprise (the direct investment enterprise) that is resident in an economy other than that of the direct investor”.165 A multinational is characterized by having activities that are geographically dispersed throughout different countries and internalized, as opposed to being outsourced to local third parties.166 It is the internalization of activities (i.e. FDI) that triggers the need for transfer pricing rules, as the allocation of operating profits among jurisdictions would be governed by the supply-and-demand market force – and thus be at arm’s length – if enterprises, instead of carrying out FDI, had chosen to outsource foreign activities to local third parties with conflicting economic interests. In this chapter, the author will provide an overview of the economic findings as to which factors are relevant when an enterprise decides whether to organize its business operations in another country through FDI or thirdparty outsourcing167 – in other words, why an enterprise may choose to become a multinational. These findings are relevant to the later analysis of the profit allocation rules, as the alternative of third-party outsourcing is 165. OECD Benchmark Definition of Foreign Direct Investment (4th ed., 2008), para. 11. 166. A seminal, economical, analytical framework for understanding this second aspect is the so-called “OLI-framework”, which states that an enterprise will decide to invest abroad if it (i) has market power given by the ownership of products or production processes (O); (ii) has a location advantage in locating its plant to a foreign, rather than its home, country (L); and (iii) has an advantage from internalizing its foreign activities in fully owned subsidiaries rather than carrying them out through third-party arm’s length market transactions (I). See Dunning (1977). 167. These discussions are based on findings referred in Navaretti et al. (2004), at pp. 23-48; and Dunning et al. (2008), at pp. 116-144.

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a recurring argument in transfer pricing discussions. Horizontal and vertical FDI are discussed in section 2.2. The trade-offs present in the choice between FDI and outsourcing are discussed in section 2.3. After having discussed the business reasons for why multinationals organize themselves as they do, the author turns to a discussion of how large, intangible property (IP)-driven multinationals typically structure their value chains for tax purposes. The so-called “centralized principal model” is introduced in section 2.4. The author will refer actively to this model throughout the book in his analysis of the US and OECD profit allocation provisions. The chapter will end with a discussion of the new OECD approach towards IP regimes – the so-called “modified nexus approach” – in section 2.5. The OECD IP regime rules have an interesting relationship to the 2017 OECD TPG on IP ownership (which are analysed in part 3 of the book), and thus form a valuable backdrop for the later discussions.

2.2. Horizontal and vertical FDI The main motives for FDI are access to foreign markets and the reduction of manufacturing costs. A local presence avoids transportation costs and trade barriers that might be incurred through imports, and it better enables the enterprise to tailor its products to local preferences and to respond to changes in local market conditions. It may also affect the interaction with local competitors.168 The costs of primary inputs vary across locations, and access to low-cost inputs is a significant reason as to why an enterprise may choose to geographically disperse its business activities.169

168. The equilibrium prices and sales volumes of firms typically depend on the marginal costs of all firms supplying the market. An enterprise that supplies the market through a local presence will save on trade costs relative to the costs that it would have incurred through imports, thus reducing the marginal cost of supplying the market. The firm with the lower marginal cost may expand, and the sales volumes and prices of competing firms may be reduced. 169. However, this argument is not absolute. First, the factor prices must be adjusted for the quality of the factor input. Empirical evidence shows that foreign direct investment (FDI) seldom goes to the lowest-wage economies, but instead goes to countries where labour with basic education is available. Research and development (R&D)-intensive activities will generally take place in countries where scientists are relatively abundant. Factor costs will be relatively more important for earlier stages of the value chain.

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Horizontal and vertical FDI

Geographical dispersion, however, gives rise to costs in the form of forgone economies of scale. An enterprise that carries out an integrated production process in its home country will have to duplicate its activities if it expands its operations to other countries. It will, logically, not choose to duplicate its entire activities in another country if it owns “firm-level” intangibles (patents, trademarks, know-how, goodwill, etc.) that generate firm-level increasing returns to scale. Once developed, they can be spread throughout the organization at no cost, i.e. without being duplicated. Thus, an enterprise will only duplicate specific business activities, such as manufacturing and sales. This is horizontal FDI, where the same stage of the value chain is duplicated in two or more countries.170 Some economies of scale will then be relinquished, but these are tied to particular levels in the value chain – so-called “plant-level economies of scale” – as opposed to firm-level. FDI is likely to occur when there are high firm-scale economies combined with relatively low plant-scale economies. The main economic trade-off in horizontal FDI is increased sales versus foregone economies of scale. Horizontal FDI is likely to be drawn to locations with good market access and where sales are large enough to cover plant-level fixed costs, and are likely to occur when there are high transportation costs associated with the final goods. Enterprises can alternatively split their value chains across countries with so-called “vertical FDI”;171 e.g. production of a specific component is placed in a foreign subsidiary. This results in a loss of economies of integration, giving rise to trade costs (freight expenses, import duties, etc.).172 The main economic trade-off in vertical FDI is lower input costs versus increased trade costs. Vertical FDI will be drawn to locations with lower factor costs and efficient transportation and trade links and is expected to occur when trade and disintegration costs are low.

170. On this topic, see also Boos (2003), at pp. 40-41; Brauner (2008), at p. 92; and Schön (2010a), at p. 228. 171. There is not always a bright line between horizontal and vertical FDI. For instance, a typical horizontal FDI (e.g. assembly plant duplication) will result in loss of economies of scale. However, if parts must be shipped to the plant, there will also be disintegration costs. Further, if a vertical FDI does not involve 100% of the production of the relevant component, there will be some degree of duplication. 172. Trade costs may be substantial, for instance, with freight charges ranging from 5-28%.

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Chapter 2 - Business and Tax Motivations for Intangible Value Chain Structures

2.3. To stay home (outsource) or to go out (FDI)? The question in this section is that of what influences an enterprise’s decision to internalize its geographically dispersed business activities through horizontal or vertical FDI as opposed to outsourcing them to local third parties. In other words, why do enterprises become multinationals?173 Internalization of business activities entails a cost penalty, as the enterprise alternatively could have contracted with the lowest-cost local third-party supplier to perform the relevant activities.174 Local third parties would likely possess better information on regional conditions (labour skills, product demand and administrative procedures), be capable of producing more cheaply, have specialized expertise within the relevant activity and have significant plant-level economies of scale, in the sense that expanding its production would come at a lower cost than setting up a new plant owned by the multinational. If the enterprise alternatively was to outsource its business activities to local third parties, this could trigger three types of costs. First, potential costs from what economists refer to as incomplete contracts and specialized investments, i.e. the so-called “hold-up problem”.175 The logic is that the local third-party supplier may fear that, after having made the necessary investments to produce inputs for the multinational, it may be denied payments due to some contingency, resulting in a renegotiation scenario. If its investment is specific to the relationship with the multinational and has no alternative use, its bargaining position will be weak. The point is that this fear may lead the third party to invest in a sub-optimal manner ex ante, which causes inefficiency that reduces the multinational’s return from outsourcing. Second, there are potential costs resulting from the depreciation of firm-specific assets.176 If the knowledge embodied in intangibles that are exploited in local production is vulnerable to appropriation, an unrelated licensee may choose to compete with the multinational after having gained access to the information and experience in applying it.177 This problem is pronounced for manufacturing intangibles (e.g. technical know-how), but 173. On this topic, see, in particular, Francescucci (2004a), at p. 57. On multinational enterprise (MNE) value chains, see also Roberge (2013), at p. 225. 174. See Navaretti et al. (2004), at p. 35. 175. See Navaretti et al. (2004), at p. 36; and Schmitz (2001). 176. See Navaretti et al. (2004), at p. 37. 177. To prevent this, the multinational has two alternatives: it can either (i) share some of its super profits with the licensee by charging a low royalty rate; or (ii) keep its activities internal through FDI instead of outsourcing.

50



To stay home (outsource) or to go out (FDI)?

also relevant for marketing intangibles (e.g. trademarks).178 Third, there may be informational asymmetries due to the geographical distance between the head office of the multinational and local third parties, giving rise to agency costs connected to monitoring and motivating the employees of the local parties, as their actions cannot be perfectly observed.179 The enterprise may avoid these three types of costs if it instead structures its foreign business through FDI. In conclusion, and particularly relevant for the purposes of this book, an enterprise will risk reducing the value of its unique intangibles if it outsources its activities to third parties, regardless of whether the outsourcing is horizontal or vertical. The local third parties may appropriate the knowledge embodied in manufacturing intangibles and start to compete (imitation problem) or dilute the value of marketing intangibles (free riding).180 If the enterprise in light of this chooses FDI, the major costs it will incur will be due to it not using the comparative advantages of a local specialized agent (input supplier, assembler or distributor), resulting in an increase in the average costs for supplying the final product.181 Thus, multinationals that choose FDI are likely to own unique and valuable intangibles, from which firm-level economies of scale originate, i.e. that generate residual profits.182 Further, a key reason as to why enterprises choose to carry out FDI is to control and protect such intangibles, which constitute their competitive advantages.183 The implication of the above is that there are pronounced business reasons as to why an enterprise should choose to become a multinational, apart from tax planning. This is an important recognition in the current BEPS 178. A multinational may incur costs in the latter context if the foreign licensee lacks sufficient incentives to maintain the multinational’s goodwill. The licensee will become a “free rider” if it reaps the benefits of the multinational’s trademarks without contributing to the maintenance of its value. Again, the multinational is faced with the same two alternatives: either (i) share some of its super profits with the unrelated licensee; or (ii) internalize local activities through FDI. 179. See Navaretti et al. (2004), at p. 38. 180. In this direction, see also Schön (2010a), at p. 246; and Parekh (2015), at p. 302. On the economics of franchising, see Blair et al. (2005). 181. Establishing a subsidiary will also entail fixed costs, which can be avoided through third-party outsourcing. 182. See also, in this direction, Purnell (1992); and Mogle (2001). 183. It should also be noted that some of the largest multinationals are extractive companies (oil, gas and other natural resources) and carry out FDI to benefit from locational advantages. They must go where the resources are geographically located. They reap super profits due to their monopolistic access to resources, not due to their intangibles.

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Chapter 2 - Business and Tax Motivations for Intangible Value Chain Structures

climate. Tax incentives are important, but their significance should not be exaggerated. The costs and benefits of FDI discussed above are, however, only relevant where the enterprise actually carries out substantive operational value chain activities abroad. Conversely, if a multinational simply establishes a foreign “post box” entity without business substance (e.g. to hold legal ownership of group intangibles), and perhaps even “cash box” entities (e.g. for research and development (R&D) financing purposes), the costs and benefits discussed above are not really relevant. In these highly practical scenarios, it is, in the author’s view, realistic to assume that the structure of the value chain is tax motivated.

2.4. The centralized principal model for profit allocation It should generally be assumed that multinationals, as rational economic actors, seek to minimize their global effective tax rates.184 They may do so by allocating their operating profits to jurisdictions where the profits will be subject to the least amount of taxation. A model for attaining this result is the so-called “centralized principal model”, which has been popular at least since the wave of international business restructurings began in the mid-1990s.185 The author will refer to the model throughout the book.

184. Empirical evidence supports this assumption; see, in particular, OECD, Measuring and Monitoring BEPS – Action 11: 2015 Final Report (OECD 2015), International Organizations’ Documentation IBFD. See also, e.g. Bauer et al. (2013). 185. See also the discussion of the principal model in the 2010 Joint Committee on Taxation Report, JCX-37-10, at pp. 16-17, which finds that US taxpayers, already prior to the 1986 tax reform, were engaged in business restructurings aimed at foreign, centralized ownership of intangible property (IP), typically trough cost sharing arrangements (CSAs). See also Brauner (2014a), at p. 97; Zollo (2011), at p. 776; Benshalom (2013), at p. 445; Pankiv (2016), at p. 470, Schön (2014), at p. 4; and Fedusiv (2016), at p. 483 on the centralization of IP rights; as well as Wu (2005); Huibregtse et al. (2011); Zammit (2015), at p. 542; Wilkie (2016), at p. 66; and Pankiv (2017), at p. 158. See Musselli et al. (2008a); and Musselli et al. (2008b) on risk-stripping of local entities; as well as Bullen (2010), at p. 624. For further information on business restructurings, see Lemein (2005); Hill et al. (2007); Hill et al. (2008); Schatan (2008); Ihli (2008); Bakker (2009); Morgan et al. (2009); Ainsworth et al. (2010); Ainsworth et al. (2011); IFA (2011); Andrew et al. (2012); and Chakravarty et al. (2013). On centralized “hub” structures, see Bilaney (2017). From the German perspective, see Beck (2008). With respect to tax structures from a US perspective, see, in particular, Kleinbard (2011); Kleinbard (2012a); Kleinbard (2012b); as well as Eden (1998). On value chain structuring, see Brem et al. (2005). On the relationship between IP holding structures and intellectual property rights (IPR) law, see, e.g. Cowan et al. (2013); and Quiquerez (2013). For an interdisciplinary analysis of firm theory and international tax law, see

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The centralized principal model for profit allocation

The model is important for understanding the BEPS challenges underlying the design of the current US and OECD profit allocation rules, in particular with respect to outbound transfers of R&D-based intangibles developed in high-tax jurisdictions. It may be illustrated as shown in figure 2.1. Figure 2.1 Normal return remuneration (cost+resale/TNMM basis) Routine entity (manufacturing, distribution, etc.)

Extraction of residual profits from source through transfer pricing Extraction of residual profits from source through transfer pricing Routine entity

(manufacturing, distribution, etc.)

Routine entity (manufacturing, distribution, etc.)

Intangible ownership

Routine entity (manufacturing, distribution, etc.)

Routine entity (manufacturing, distribution, etc.)

Routine entity (manufacturing, distribution, etc.)

Principal

Routine entity (manufacturing, distribution, etc.)

Routine entity (manufacturing, distribution, etc.)

Residual profits

Routine entity (manufacturing, distribution, etc.)

Routine entity (manufacturing, distribution, etc.)

Normal return remuneration (cost+resale/TNMM basis)

Figure 2.1 shows a group structure where the unique intangibles, entitled to the residual profits, are assigned to a single, centralized group entity (the principal), normally resident in a jurisdiction with no or low tax on IP income. All other group entities, including manufacturing, R&D and distribution entities are treated as routine value chain input providers, remunerated with a normal market return. In other words, all residual profits are extracted from the jurisdictions where R&D, manufacturing and sales take place and injected into the residence jurisdiction of the principal. The profit allocation profile of the model will only be compatible with the US and OECD profit allocation provisions (and thus only yield the desired allocation result for the multinational) if there are no unique intangibles outside of the principal jurisdiction, as the other group (routine) entities may then be remunerated as the tested party under a one-sided method (cost-plus, resale price or transactional net margin method (TNMM)) with a normal market return.186 Tavares (2016). For IP value chains and the relationship with cost sharing, see Benshalom (2007), at p. 646. For an analysis of Apple’s tax structure and comments on non-taxation, see Ting (2014). 186. An issue here is the extent to which operating profits can be extracted from local taxation in source countries through the application of the one-sided transfer pricing

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Chapter 2 - Business and Tax Motivations for Intangible Value Chain Structures

This extraction of residual profits to a low-tax principal jurisdiction is only possible to achieve if multinationals are able to migrate the unique intangibles responsible for the residual profits from the high-tax jurisdictions where they were created without triggering taxation of their full values.187 If done successfully, (at least parts of) the residual profits will be allocated pursuant to the multinational’s choice as opposed to where the intangible value was created. As will be discussed extensively later in the book, the current US and OECD rules seek to prevent this practice, an ambition that lies at the core of the new US cost-sharing regulations and the 2017 OECD Transfer Pricing Guidelines (TPG) on intangible ownership.

2.5. IP regimes and the 2015 OECD nexus approach The US and OECD profit allocation provisions analysed in this book fundamentally seek to allocate residual profits from unique intangibles to the jurisdictions where the intangible value was created. They say nothing about whether the profits in the end actually should be taxed, but only which jurisdiction is entitled to tax. Jurisdictions are provided with a piece of the cake, but are not required to actually eat it. These transfer pricing provisions are continually revised to prevent BEPS caused by the tax practices of multinationals and have, in recent years, been supplemented by a widespread introduction of thin capitalization rules in the domestic laws of

methods, e.g. the transactional net margin method (TNMM). In other words, how low can the “normal market return” profit allocation to source states can be set, indirectly determining the size of the residual profits to be extracted from source? This problem encompasses several key transfer pricing issues, such as the identification of local marketing intangibles and the allocation of incremental operating profits due to local market characteristics, cost savings and synergies, which the author will revert to later in the book: see, in particular, ch. 23 and ch. 24 with respect to the treatment of internally developed marketing IP under US law and the OECD TPG, respectively; and ch. 10 on the allocation of profits from local market characteristics, cost savings and synergies under the OECD TPG. 187. See, e.g. Ballentine (2016), where buy-in pricing under the 1995 US CSA regulations is attributed blame for much of the migration of US developed R&D-based IP at low prices, resulting in non-arm’s length profit allocations (on this, see also fn. 1276). See Pankiv (2016), at p. 470, where a “freeze” strategy is suggested as a migration technique, pursuant to which existing IP is licensed to the centralized IP company while the future IP is developed at the level of the IP company. In the author’s view, this technique will be more difficult to apply under the important functions doctrine of the 2017 OECD TPG (see the discussion in sec. 22.3.3.3.) than what was the case under the 1995/2010 TPG.

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IP regimes and the 2015 OECD nexus approach

many jurisdictions, limiting interest deductibility on multinationals’ intragroup (and in some cases, also external) debt.188 A range of jurisdictions have, parallel to this development, introduced preferential tax regimes for IP profits, ensuring that residual profits are either taxed at very low rates or not at all (often called “IP boxes”, “patent boxes”, etc.).189 Thus, even though the transfer pricing and thin capitalization rules provide a jurisdiction with cake, it may, pursuant to its IP regime, refuse to eat it. The aim of such regimes is to attract foreign-based multinationals with the hope that they will bring some of their economic activities with them or at least use local services (legal and tax, accounting, financing, etc.). There is tax competition among jurisdictions to offer the most attractive IP regimes with the lowest tax rates. If this “race to the bottom” were to continue without restrictions, one could, in theory, end up with residual profits not being taxed at all. The OECD does not advocate the harmonization of income taxes or tax rates within or outside the OECD. It accepts non-distortive tax competition.190 Tax competition for geographically mobile activities (e.g. IP-driven value chains), however, may result in an unfair eroding of the tax base of other countries (i.e. where the intangible value was created), distort the location of capital and functions and shift parts of the tax burden to less mobile tax bases, including labour, property and consumption.191 This particular form of tax competition is deemed undesirable by the OECD.

188. See IFA (2012) for an overview. Some jurisdictions limit interest deductions by setting an allowable debt-to-equity ratio (e.g. 2:1 in Italy’s prior thin capitalization regime, 5:1 in Belgium and 3:1 in several jurisdictions), while others limit interest deductions by reference to the earnings of the issuer; e.g. Germany’s “interest deduction ceiling” rule limits interest deductions to 30% of the EBITDA of the issuer, Italy limits deduction for net interest expenses to 30% of the EBITDA of the issuer, Spain and Norway adopted similar approaches in 2012 and 2014 respectively and the United States has thin capitalization rules as a part of their “earnings stripping” provisions; the allowable interest deduction is calculated by reference to net interest expense to income. 189. For example, the Netherlands (5% taxation of intangible income), Belgium (6.8%), Luxembourg (5.72%), Switzerland (8.4%-12%), Ireland (2.5%-12.5%), Malta (0%-10%), Hungary (5%-9.5%), Cyprus (2%), France (15%) and the United Kingdom (10%). See also fn. 1934. 190. OECD, Harmful Tax Competition: An emerging global issue, paras. 26-27 and 41 (OECD 1998) [hereinafter the 1998 Report]; and OECD, Agreement on a Modified Nexus Approach for IP Regimes – Action 5: 2015 Final Report, para. 3 (OECD 2015), International Organizations’ Documentation IBFD [hereinafter BEPS Action 5: 2015 Final Report]. 191. BEPS Action 5: 2015 Final Report, at para. 3.

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Chapter 2 - Business and Tax Motivations for Intangible Value Chain Structures

The 1998 OECD Report on Harmful Tax Competition introduced four key factors to determine whether a preferential tax regime was potentially harmful,192 requiring that (i) no or low effective tax rates are imposed on income from geographically mobile activities;193 (ii) the regime is ring-fenced from the domestic economy;194 (iii) the regime lacks transparency;195 and (iv) the regime has no effective exchange of information.196 In determining whether these criteria are fulfilled, it should, inter alia,197 be taken into account whether the regime encourages operations or arrangements that are purely tax-driven and involve no substantial activities.198 The report offers little guidance as to how this latter factor is to be applied.199 Action 5 of the 2013 OECD BEPS Action Plan called for a revision of the guidance on substantial activity for IP regimes in order to better align taxation with substance to avoid artificial shifting of profits out of jurisdictions where value is created.200 This resulted in the 2015 nexus approach consensus among OECD member countries and the G20 countries for the determination of whether there are substantial activities.201 The nexus approach represents a balancing of the conflicting acknowledgements that preferential IP regimes inherently trigger BEPS concerns, but also that IP-intensive enterprises facilitate economic growth and employ192. OECD, Report on Harmful Tax Competition (OECD 1998) [hereinafter 1998 OECD Report]. 193. 1998 OECD Report, para. 61. 194. 1998 OECD Report, para. 62. 195. 1998 OECD Report, para. 63. 196. 1998 OECD Report, para. 64. 197. The OECD 1998 Report lists eight additional factors in paras. 68-79. These are: (i) an artificial definition of the tax base; (ii) failure to adhere to international transfer pricing principles; (iii) foreign-source income being exempt from residence country taxation; (iv) negotiable tax rate or tax base; (v) existence of secrecy provisions; (vi) access to a wide network of tax treaties; (vii) the regime being promoted as a tax minimization vehicle; and (viii) the regime encouraging operations or arrangements that are purely tax-driven and involve no substantial activities. 198. For retrospective comments on the 1998 OECD Report, see Avi-Yonah (2009b). 199. BEPS Action 5: 2015 Final Report, at para. 24. 200. See OECD, Action Plan on Base Erosion and Profit Shifting, p. 13 (OECD 2013), International Organizations’ Documentation IBFD [hereinafter BEPS Action Plan]. 201. BEPS Action 5: 2015 Final Report, at para. 28. The nexus approach is inspired by R&D credits and similar “front-end” tax regimes to incentivize R&D. The OECD also considered two alternative approaches, namely (i) the value creation approach; and (ii) the transfer pricing approach, but these did not gain consensus support (para. 27). No new entrants are permitted in any existing IP regime that is not consistent with the nexus approach as of 30 June 2016. For an interesting analysis of the OECD nexus approach geared towards the relationship with EU law, see Faulhaber (2017). See also Zammit (2015), at p. 545, with respect to the EU State aid aspect of IP regimes.

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IP regimes and the 2015 OECD nexus approach

ment and that jurisdictions should remain free to offer tax incentives for R&D, provided that such incentives do not entail harmful effects for other countries.202 The aim is to ensure that the tax competition with respect to IP regimes is non-distortive. The nexus approach establishes the outer boundaries for the permissible material content of IP regimes. It says that a preferential IP regime may give favourable tax treatment to the income from an intangible in proportion to the extent to which the taxpayer itself has incurred R&D expenses to develop it in the jurisdiction where the IP regime is located. The logic is that the taxpayer’s R&D expenditures indicate to which extent it carries out substantial activities adding real value in the IP regime jurisdiction. Thus, R&D expenditures are used as a proxy for substantial activities. If the taxpayer,203 for instance, has only one intangible and has itself incurred all of the expenses to develop it, an IP regime is allowed to bestow favourable treatment on the entire IP income.204 If the taxpayer instead has acquired the intangible or outsourced its development to related parties, a portion of the IP income will be denied favourable treatment.205 The intention is to prevent capital contributions or related-party R&D funding from qualifying for benefits under an IP regime, as such expenses are not deemed to be indicative of substantial activity. The nexus approach is a fraction (nexus ratio) that, when multiplied with the relevant IP profits,206 yields the amount of profits that may be encompassed by the IP regime, as follows:207 a+b a+b+c+d

202. See BEPS Action 5: 2015 Final Report, at para. 26. There is an interesting economic study on the impact of corporate taxes on R&D and patent holdings; see Riedel et al. (2015). 203. Qualifying taxpayers include resident companies, domestic permanent establishments (PEs) and foreign PEs of resident companies that are subject to tax in the jurisdiction providing benefits. See BEPS Action 5: 2015 Final Report, at para. 33. 204. BEPS Action 5: 2015 Final Report, at para. 30. 205. BEPS Action 5: 2015 Final Report, at para. 44. 206. The income to be included is limited to income derived from the IP asset (royalties, capital gains and embedded IP income from the sale of products or the use of processes directly related to the IP asset). Thus, other income that is unrelated to IP must be excluded (e.g. manufacturing and marketing returns.) The OECD suggests that separation could be based on transfer pricing principles. 207. BEPS Action 5: 2015 Final Report, at para. 43.

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The elements in the numerator are jointly referred to as “qualifying expenditures”.208 They are: (a) R&D expenditures incurred by the taxpayer itself. These must be directly connected to the IP asset and incurred for the purpose of actual R&D activities; 209 and (b) expenditures for unrelated-party outsourcing. Taxpayers that engage in such outsourcing must nevertheless carry out substantial activities themselves. The OECD rejects the notion that it will be realistic for an enterprise to outsource its core R&D to unrelated parties, as that would entail the relinquishment of a competitive advantage (information and value inherent in R&D).210 Ergo, allowing only third-party outsourcing expenditures as qualifying expenditures ensures that only income derived from substantive R&D activities carried out by the taxpayer itself will be entitled to favourable treatment under an IP regime. The elements in the denominator are jointly referred to as “overall expenditures”. In addition to elements (a) and (b), this includes: (c) the acquisition costs for IP purchased from unrelated and related parties; 211 and (d) the expenditures for related-party outsourcing. Income from acquired IP and from IP developed by a related party is excluded from favourable treatment because the taxpayer has not carried out the R&D itself. This is necessary in order to prevent distortive effects from an IP regime. It will therefore, for instance, not be possible to “sell in” IP to a

208. Jurisdictions are allowed to permit taxpayers to apply a 30% “uplift” to qualifying expenditures; see BEPS Action 5: 2015 Final Report, at para. 40. The uplift may, however, only increase the qualifying expenses to the extent that the taxpayer has acquisition or related-party R&D-outsourcing expenditures (the increased amount of expenditures due to the uplift may not exceed these costs). The point of this uplift is simply to not penalize taxpayers too much for acquiring IP or outsourcing R&D activities to related parties. The uplift option has been necessary in order to achieve a consensus of the nexus approach. The overall picture is then that the nexus approach ensures that taxpayers only receive benefits if they themselves undertook R&D activities and at the same time acknowledges that taxpayers that acquired IP or outsourced a portion of the R&D to a related party may still be responsible for much of the value creation that contributed to the intangible income. See the comments on this conflicting logic below in this section. 209. Interest expenses, building costs, acquisition costs or any costs that cannot be directly linked to a specific IP asset are excluded. 210. BEPS Action 5: 2015 Final Report, at para. 50. 211. R&D expenses connected to an acquired IP asset that is carried out subsequent to the acquisition are deemed ordinary R&D expenses and are thus encompassed by (a); see BEPS Action 5: 2015 Final Report, at para. 52.

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central group IP-holding entity,212 regardless of whether the consideration is at arm’s length, or to use a group “cash box” entity to fund R&D and at the same time achieve favourable treatment of the subsequent income from the acquired or group-developed IP. It can be observed that the only way in which the nexus ratio – and thereby the proportion of IP income entitled to favourable treatment – can be decreased from 100% is if the taxpayer acquires the IP or outsources the R&D to related parties. A key feature of this OECD approach to IP regimes is the restriction that they may only encompass income from patents and functionally equivalent intangibles (qualifying IP assets).213 Preferential IP regimes that grant benefits to income from other assets will not be deemed to meet the substantial activity requirement and are thus not allowed. This significant restriction entails that the super profits from a wide range of practically important unique intangibles (marketing intangibles, e.g. trademarks), goodwill, know-how, workforce in place, etc.) can never be subject to favourable tax treatment under a preferential IP regime, but must be taxed in the ordinary tax regime of the relevant jurisdiction.214 The potential “race to the bottom” in the form of preferential IP regimes will therefore be limited to the profits from a highly significant, but ultimately narrow, group of intangibles. This is aligned with the view that IP regimes may be used to incentivize R&D activities, a goal that is not realized if the IP regime includes intangibles that are not based on R&D. One of the cornerstones of the 2017 OECD TPG on intangible ownership is to ensure that residual profits from R&D-based intangibles are allocated to the jurisdictions where the intangible value was created. The OECD position on preferential IP regimes allows beneficial tax treatment of profits from exactly this group of intangibles. As the author will revert to in detail,215 the ownership guidance allows, to a certain extent, residual profits 212. There is an incentive to undervalue controlled transfers of IP to a group holding entity resident in a jurisdiction with an IP regime in order to maximize the proportion of qualifying expenditures. Tax authorities should review such pricing critically. 213. Such assets must be both legally protected and subject to similar approval and registration processes where such processes are relevant. These assets include (i) patents, defined broadly; (ii) copyrighted software; and (iii) in certain circumstances, other IP assets that are non-obvious, useful and novel. 214. BEPS Action 5: 2015 Final Report, at para. 38. 215. See ch. 22 on the allocation of profits from internally developed manufacturing IP under the OECD TPG.

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to be allocated to a group entity that has outsourced its R&D to related entities, as long as it remains in control of important R&D functions.216 The nexus approach, however, excludes the profits yielded by intangibles developed under such controlled agreements from preferential taxation, regardless of whether the outsourcing entity is in control. Thus, there is a “conflict” of logic behind the OECD approach to intangible ownership and preferential IP regimes.217 While the ownership guidance asserts that the outsourcing entity is indeed the entity that creates the intangible value and therefore entitled to the residual profits, as long as it remains in control of the related-party outsourced functions,218 the nexus approach rejects the same logic under the view that third parties simply would not outsource any “core R&D”.219 This conflict resulted in the compromise that the taxpayer, pursuant to the nexus approach, nevertheless is entitled to an “uplift” of expenses in the calculation of the nexus ratio.220 The taxpayer is treated as if parts of its income from (acquired IP and) IP created through related-party R&D qualify for preferential treatment. The end result is that the lion’s share of residual profits generated by an intangible created through related-party R&D outsourcing allocated to a group entity pursuant to the ownership guidance will be excluded from beneficial treatment under a preferential IP regime and must therefore be taxed in the ordinary tax regime in the jurisdiction where the ownership entity is resident. A smaller portion of these residual profits, however, may nevertheless be included in the preferential IP regime due to the “uplift”. The end rationale behind the nexus approach is therefore a hybrid between the reasoning applied in the ownership guidance and the core idea behind the nexus approach that the qualifying entity itself must carry out substantial activities in the IP-regime jurisdiction.

216. See the analysis of the OECD important functions doctrine in sec. 22.3.2. 217. Of course, the OECD intangible ownership rules pertain to the allocation of residual profits to jurisdictions (how the cake is split), while the OECD nexus approach deals with the question of whether a jurisdiction may establish a preferential regime for the taxation of the residual profits (whether the piece of cake must be eaten). The “conflict” of logic pertains to the disparate views taken by these two sets of rules with respect to the underlying factual (or casual) relationship between related-party outsourcing and intangible value creation. Even though the two sets of rules deal with different issues, there does not seem to be any convincing reason as to why they should have conflicting views on the same underlying causal relationships. 218. OECD TPG, at paras. 6.56 and 6.58. 219. BEPS Action 5: 2015 Final Report, at para. 50. 220. See the ambiguous justification for the uplift in BEPS Action 5: 2015 Final Report, at para. 41. See also the author’s comments in fn. 208.

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The author will add that there seems to be potential for practical challenges in implementing the nexus approach.221 It remains to be seen whether it is viable. In conclusion, the nexus approach allows preferential treatment of IP income where real R&D activities are performed within the relevant jurisdiction. It will likely become onerous for multinationals to locate suitable “principal jurisdictions” that can be used as the residence jurisdiction for group IP-holding companies for R&D-based intangibles.222 This, in concert with the 2017 OECD TPG on intangible ownership and transfer pricing of intangibles, will likely make it more difficult for multinationals to attain low effective tax rates through structuring their value chains in models akin to the centralized principal model. Further, the 2017 OECD TPG on intangible ownership and transfer pricing of intangibles will allocate super profits to the jurisdiction(s) where the intangible value was created. These jurisdictions are, under the nexus approach, allowed to have IP regimes for only a narrow group of R&D-based intangibles. With respect to the profits from such intangibles, these jurisdictions may, in theory, lower the rate of taxation to 0%. The super profits from all other types of unique intangibles, however, must be taxed in the ordinary tax regimes of these jurisdictions. Thus, for the latter category of super profits, it seems unlikely that the rate of taxation will end up being anywhere near as low as the IP regime rate. It therefore seems likely that a significant portion of the total super profits generated through the intangible value chains of multinationals in the future will be taxed effectively where the intangible value is created. The severe restrictions on IP regimes imposed by the nexus approach may, however, incentivize jurisdictions to drop IP regimes and instead go for ordinary tax regimes with relatively low tax rates on all business income, akin to that of Ireland. 221. Among the challenges is that qualifying expenditures are to be included in the nexus ratio calculation at the time at which they occur; see BEPS Action 5: 2015 Final Report, at para. 45. The expenses must be treated cumulatively, which may be difficult to keep track of. It may also be challenging to track the relationship between expenses and the relevant intangible (or derivative product) (see para. 55, and to determine the scope of expenses to be included in the calculation, with respect to unsuccessful products when a portfolio approach is appropriate to apply (see para. 44). 222. See BEPS Action 5: 2015 Final Report, at p. 63, where there is a table listing the IP regimes of 16 countries (Belgium, China, Colombia, France, Hungary, Israel, Italy, Luxembourg, the Netherlands, Portugal, Spain, Spain – Basque Country, Spain – Navarra, Switzerland – Canton of Nidwalden, Turkey and the United Kingdom). These regimes do not fulfil the nexus approach requirements. The respective countries are now in the process of reviewing their regimes for the purpose of complying with the nexus approach.

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Chapter 3 Controlled Intangibles Transfers 3.1. Introduction The arm’s length transfer pricing standard seeks to ensure parity in the taxation of related and unrelated parties. If rights to an intangible are transferred among group entities and third parties would be willing to pay for such rights, arm’s length compensation must be rendered from the receiving to the transferring group entity to comply with the standard. It may, however, be that a jurisdiction exempts certain controlled intangible transfers from taxation to promote other policies than transfer pricing. Taking into account that intra-group intangible transfers may be carried out in different legal forms, spanning contracts such as licence agreements, cost sharing agreements and business transfer agreements (where the assets transferred include intangibles), it may be that there are direct exemptions for specific IP transfers that supersede the transfer pricing requirement, for instance, in connection with business reorganizations. Further, IP transfers may pertain to a wide variety of different types of intangibles, such as patents, trademarks, know-how, customer lists, workforce in place and goodwill. There may be indirect transfer pricing exemptions in the form of provisions that limit the scope of application of the transfer pricing methodology (the transfer pricing methods and the intangible ownership provisions), typically by way of linking the methodology to a definition that sets out which intangibles are subject to a transfer pricing charge.223 Tax exemptions for intra-group asset transfers in general, and for valuable intangibles in particular, represent roadblocks on the way to arm’s length pricing. This blocking effect comes into play if the transfer pricing methodology requires arm’s length compensation for an IP transfer but the transfer nevertheless goes tax-free under direct or indirect exemptions. This may create incentive effects with respect to the classification and valuation of intangibles. If some types of intangibles and forms of IP transfers are exempt from transfer pricing, there will be pressure from taxpayers to classify transferred intangibles as tax-exempt and maximize their value, as 223. Most jurisdictions (with the apparent exceptions of China, India, Malaysia, South Africa and the United States) do not have a definition of intangibles tailored for transfer pricing purposes; see Rocha (2017), at p. 212.

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well as to minimize the value of taxable intangible transfers. Thus, there will not only be a lack of arm’s length pricing for the exempt intangibles; taxpayers may also be enticed to misclassify taxable intangibles as nontaxable, thereby also preventing arm’s length pricing of what, in reality, is taxable intangible value. Direct and indirect exemptions from transfer pricing for IP transfers give rise to lack of neutrality and depart fundamentally from the arm’s length transfer pricing standard. For the standard to work fully, there must be absolute neutrality: all intangibles transfers, irrespective of the type of intangible transferred and the legal form in which the transfer occurred, must be subject to transfer pricing. The purpose of this chapter is to explore the extent to which the US and OECD transfer pricing systems are limited by intangibles definitions that set out the types of intangibles encompassed by the transfer pricing rules, as well as provisions that regulate the tax treatment of specific transaction types through which intangibles are transferred. The main focus will be put on the US rules, as these are the most problematic and have raised significant issues in practice. This approach is also useful with respect to highlighting the differences between the US and OECD solutions. The author discusses the US and OECD transfer pricing definitions of intangibles in sections 3.2. and 3.3., respectively. Categorizations of intangibles that are useful for the later analysis of the US and OECD transfer pricing methodology are discussed in section 3.4. The US and OECD rules for specific controlled intangible transaction types are discussed in sections 3.5. and 3.6., respectively, before concluding comments are provided in section 3.7.

3.2. The US intangibles definition 3.2.1. Introduction The definition of intangibles that is applied for US transfer pricing purposes is contained in US Internal Revenue Code (IRC) section 936, which governs Puerto Rico and possession tax credit (the section 936 definition).224 The commensurate-with-income standard in IRC section 482 and section 367(d) refers to this definition. 224. IRC sec. 936(h)(3)(B).

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An important issue is that the section 936 definition was amended in the December 2017 US tax reform.225 The amendment does not change the overall structure or content of the provision, but expands it to encompass more intangible value. The amendment can be regarded as an add-on to the pre-2018 version of the intangible property (IP) definition. The amendment has effect from and including the income year 2018. Thus, all US intragroup IP transfers carried out up to and including 2017 will be assessed under the pre-2018 version of the definition, while all transfers carried out after 2017 will be assessed under the new 2018 version. The pre-2018 version has caused significant interpretation problems in practice and has been – and currently is – a challenging issue in some of the most notable transfer pricing cases in US history, e.g. the 2009 Veritas and 2017 Amazon.com Tax Court cases (the latter of which is now appealed to the Ninth Circuit).226 It must be acknowledged that interpretation of the pre-2018 version of the US IP definition will continue to be highly relevant in US transfer pricing practice for years to come until all pre-2018 intra-group IP transfers have been assessed and finalized. As an example of the considerable lag in the treatment of transfer pricing cases, it can be mentioned that the 2017 Amazon.com case pertains to the income years 2005-2006. Due to the relevance of the pre-2018 version of the US IP definition for years going forward, the author will provide an analysis of its interpretation in section 3.2.2. This analysis will also serve as a discussion of the historical development of the US IP definition, as well as a contextualization of how the IP definition relates to the overall US IRC section 482 transfer pricing framework. The amendments made to the IP definition in the 2017 tax reform will be discussed thereafter, in section 3.2.3.

3.2.2. The pre-2018 version of the US IP definition 3.2.2.1. Introductory comments The section 936 definition contains 28 specific intangible items across five categories: “(i) patent, invention, formula, process, design, pattern, or know-how; (ii) copyright, literary, musical, or artistic composition; (iii) trademark, trade name, or brand name; (iv) franchise, license, or contract; 225. The content of the amendment was in line with earlier proposals for revision of the sec. 936 definition. On this, see Brauner (2017), at sec. 2.3.1.2. 226. See the analyses of the rulings in secs. 14.2.4. and 14.2.5., respectively.

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(v) method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data”.227 In addition to the positively listed items, the pre-2018 version of the definition also encompasses “any similar item”. Each item must have “substantial value independent of the services of any individual”. The listed items are not defined or further elaborated on in IRC section 936. The common and ordinary use of the terms must therefore apply.228 The definition provides historical continuity. It is virtually identical to the intangibles definition in the 1968 version of the IRC section 482 regulations.229 The current section 482 regulations also contain a definition of intangibles, which lists the same items as the section 936 definition.230 The section 936 definition was introduced as part of the Tax Equity and Fiscal Responsibility Act of 1982231 to ensure that intangibles that gave rise to US tax deductions for research and development (R&D) expenses during their development phases could not be transferred out of the US after the development had been completed without triggering a tax charge.232 The legislative motivation was thus to match income and deductions in the United States for the same intangible. There is a tension between this matching purpose and the broad design of the section 936 definition. The creation of R&D-based intangibles (e.g. patents) will normally entail US tax deductions for R&D expenses throughout the development phase. However, it may be challenging to distinguish between development and exploitation for some marketing intangibles (e.g. customer lists and trademarks). If it is not possible to identify a link between the development phase of US tax deductions and the subsequent 227. The US Internal Revenue Service (IRS) has made clear that contractual rights to use intangible assets, e.g. a licence agreement, are themselves intangibles; see Treas. Regs. § 1.482-4(f)(3) and the discussion in sec. 20.2.3. 228. See Amoco Production Co. v. Southern Ute Indian Tribe, 119 S.Ct. 1719 (1999). 229. 33 FR 5848, § 1.482-2(d)(3). The 1968 definition contains 27 of the 28 specific intangibles listed in the sec. 936 definition (it does not contain the item “know-how”), spread across the same five categories. 230. Treas. Regs. § 1.482-4(b). The current definition first surfaced in proposed form in the 1992 regulations, 57 FR 3571-01, § 1.482-2(d)(1)(ii)(A)(8) without – as far as the author can see – any specific justification. The 1992 definition contained the add-on “any interests in any such items”, which was removed in the temporary regulations version; see 58 FR 5263-02, § 1.482-4T(b). On this, see also Odintz et al. (2017), at sec. 2.2.1.3. 231. 96 Stat. 324 (1982), at sec. 213. 232. On the Congressional motivation, see S. Rep. No. 494, 97th Cong., 2d Sess., vol. 1, at pp. 158-159 (1982). For a historical discussion, see Driscoll (1988), at pp. 166-168.

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exploitation phase of income for marketing intangibles, it is, in principle, not clear that such intangibles should be encompassed by the definition, as they may not facilitate the matching of US income and deductions. The author will not discuss each of the listed items in the 936 definition separately.233 Such general discussions would not facilitate the later analysis of the profit allocation rules. The reason for this is that the section 936 definition does not inform about the profit allocation that follows from applying the transfer pricing methods; it may only restrict this allocation. The question with respect to the intangibles definition is simply whether the transferred intangible falls within the definition. If so, it must be priced (and vice versa), as IRC section 482 links its arm’s length transfer pricing requirement for intangibles to the 936 definition. If the intangible is a patent, for instance, it will fall within the definition and must therefore be subject to a charge upon transfer. The more particular legal aspects of the patent will be highly relevant when it later comes to how much should be charged for its transfer. For instance, the remaining duration of legal protection may inform the amount of future profits can be expected from the patent, and may affect the choice of comparables and comparability adjustments under the comparable uncontrolled transaction (CUT) method. However, such discussions belong under the analysis of the transfer pricing methods, not the 936 intangibles definition. Bluntly put, the question under the transfer pricing methods regards the extent to which an intangible transfer should be priced, while the question under the 936 definition is simply whether the transfer should be priced. This is not to say that there has not been controversy surrounding the interpretation of the pre-2018 version of the 936 definition. The interpretation issues have not, however, pertained to the particular legal aspects of the listed 936 intangibles, but rather to whether goodwill, going concern value 233. For discussions of sec. 936 intangibles, the author refers to Andrus (2007), at pp. 632-634; and Wittendorff (2010a), at pp. 596-610. See also DHL Corp. v. CIR, T.C. Memo. 1998-461 (Tax Ct., 1998), affirmed in part, reversed in part by 285 F.3d 1210 (9th Cir., 2002), where the infrastructure and operating know-how of affiliates in a package delivery business were deemed to be intangibles. In Hospital Corporation of America v. CIR, 81 T.C. No. 31 (Tax Ct., 1983), nonacquiescence recommended by AOD- 1987-22 (IRS AOD, 1987) and Nonacq. 1987 WL 857897 (IRS ACQ, 1987), the court found that the mere opportunity to enter into a contract did not constitute a sec. 936 intangible. In Merck & Co., Inc. v. U.S., 24 Cl.Ct. 73 (Cl. Ct., 1991), it was found that the power to determine which entity in a controlled group will earn income does not qualify as a sec. 936 intangible. In line with the views expressed in these cases, see also the 2009 OECD guidance on business restructurings in the 2010 OECD TPG, at para. 9.65.

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and workforce in place are encompassed by the definition, and thereby also the commensurate-with-income standard in IRC sections 482 and 367(d), even though they are not positively listed in the definition. This latter interpretation problem illustrates how the US intangibles definition may serve as a roadblock for arm’s length pricing. The author analyses the issue in section 3.2.2.3. In order to properly frame the discussion, however, he will first further elaborate on the relationship between the 936 definition and profit allocation in section 3.2.2.2.

3.2.2.2. The relationship between the 936 definition and ­profit ­allocation The 936 definition is, in principle, decisive as to which controlled inbound and outbound intangible transfers are subject to a tax charge under US transfer pricing law. The reason for this is that, as mentioned in section 3.2.1., both IRC section 482 and 367 refer to the definition. Arm’s length compensation for intra-group intangibles transfers therefore cannot contain compensation for any elements that do not qualify as intangibles under the definition. Say, for instance, that five different intangibles are transferred intragroup together as a package. Assume that the true market value of each individual intangible is 10, but that the package as a whole – determined in the aggregate under an applicable transfer pricing method – has an arm’s length value of 60. If the taxpayer prices the transfer at 50, the tax authorities may only reassess the pricing to 60 if the residual value of 10 (typically goodwill) qualifies as an intangible under the section 936 definition. Thus, even though the transfer pricing methods may say that the arm’s length value indeed should be 60, the definition may restrict the pricing outcome to 50, given that the 10 in goodwill does not meet the definition. This restrictive roadblock effect of the intangibles definition has been a problem for the US tax authorities, particularly in two contexts. First, problems in this regard have occurred in cost sharing transactions in which a US group entity makes existing intangibles together with the experience and skills of an existing team of researchers (workforce in place) available to a foreign group entity for the purpose of further development of the existing intangible. In these cases, the value of the package of resources made available by the US entity may far exceed the value of the

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existing intangible. Nevertheless, in order for IRC sections 482 and 367 to capture the exceeding value (workforce in place), the intangible must, in principle, qualify as an intangible under the section 936 definition. The US Internal Revenue Service (IRS) has asserted that workforce in place is an intangible under the pre-2018 version of the 936 definition and thus taxable when transferred in a section 367 or 482 transaction.234 In the 2009 Veritas ruling, however, the US Tax Court rejected the notion that workforce in place was a compensable intangible in the context of a cost sharing arrangement (CSA) under the previous generation of cost sharing regulations.235 Essentially, the same position was taken in the 2017 Amazon.com.236 As the author will come back to, the IRS, in the current 2009 cost sharing regulations and the 2016 section 367 regulations, has, to some extent, “bypassed” the 936 definition. The cost sharing regulations require valuation of items such as workforce in place, while the relevance of the 936 definition in the context of section 367 now has been removed. The result is that residual value elements, such as workforce in place, in practice will be taxed under the current regulations. Second, the roadblock effect has been a problem in the context of so-called “936 exits”, where US-based multinationals with business operations in Puerto Rico that have benefited from the section 936 tax credit (subject to a 10-year phase-out) reorganize the operations into a controlled foreign corporation (CFC) for US tax purposes, effectively to replace the section 936

234. The IRS position may be influenced by Ithaca Industries Inc. v. CIR (97 T.C. No. 16 [Tax Ct., 1991], affirmed by 17 F.3d 684 [4th Cir., 1994], certiorari denied by 513 U.S. 821 [1994]), in which the court found that workforce in place was an intangible under pre-IRC sec. 197 tax law. See also the 1996 IRS issue paper on the amortization of assembled workforces (96 TNT 49-27), which explained that the factsensitive approach of the US Supreme Court in Newark Morning Ledger Co. v. US (734 F.Supp. 176 [D.N.J., 1990], reversed by 945 F.2d 555 [3rd Cir., 1991], reversed by 507 U.S. 546 [1993]; see the comments in sec. 3.2.2.4. of this chapter) and Ithaca Industries, Inc. v. CIR (97 T.C. No. 16 [Tax Ct., 1991], affirmed by 17 F.3d 684 [4th Cir., 1994], certiorari denied by 513 U.S. 821 [1994]) rendered inappropriate the prior IRS rejection of workforce in place as non-amortizable, reversing the IRS position taken in a 1991 issue paper (91 TNT 90-35) that workforce in place was part of going concern value. Further, with respect to goodwill, the IRS has seemingly indirectly admitted that it is not encompassed by the sec. 936 definition, as the 1992 proposed regulations (58 FR 5310, 5312) asked for comments on whether the definition should be expanded to also encompass goodwill. On this point, see also Odintz et al. (2017), at sec. 2.2.2.2. 235. 133 T.C. No. 14 (U.S. Tax Ct. 2009, IRS nonacquiescence in AOD-2010-05); see footnote 31 in the ruling, as well as the author’s analysis of the ruling in sec. 14.2.4. See also Zollo (2010), at p. 73. 236. 148 TC No. 8.

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tax credit with deferral benefits under the subpart F rules.237 In these conversions, the Puerto Rican business operations are contributed to a CFC in exchange for shares in the CFC or reincorporated as CFCs in non-taxable reorganizations.238 The transfer pricing issue in 936 exit cases is the determination of the arm’s length compensation required to be paid by the CFC for the transferred assets.239 Taxpayers have generally structured these conversions to fall within the so-called active trade or business (ATB) exception in section 367 (which is discussed in section 3.5.4.). A key design of these structures is to classify the transferred intangibles as goodwill or going concern value under the assertion that such items do not qualify as 936 intangibles in order to escape US taxation. The 936 exit cases have provided the IRS with an opportunity to relitigate some of the same pricing issues tried in Veritas outside of the CSA context. The core of the IRS argument in these cases is that in the end, the CFC should only earn a routine return on its activities, akin to the profit allocation under the comparable profits method (CPM), with the residual profits allocable to the US transferor under IRC section 482 or 367(d).240 So far, the IRS has been unsuccessful in this litigation. The 2016 Tax Court ruling in Medtronic v. CIR rejected the IRS claim that the Puerto Rican possessions company had transferred intangibles to the CFC in the conversion.241 The 2017 Tax Court ruling in Eaton Corp v. CIR rejected the assertion 237. See the 2007 Industry Director Directive No. 1 on section 936 Exit Strategies (LMSB-04-01-07-002) and audit guidelines on exit strategies (Notice 2005-21). The 2007 directive supplements the IRS position on aggregated valuation of cost-sharing contributions under the pre-2009 regulations, as described in the 2007 Coordinated Issue Paper, which provides guidance on buy-in issues (LMSB-04-0907-62, since withdrawn). A second directive was issued in 2008 (LMSB-04-0108-001), emphasizing that intangible transfers in sec. 936 exits may be taxable under sec. 367(d) and that workforce in place should not be treated as part of foreign goodwill or going concern value. 238. See IRC sec. 368(a)(1)(F). 239. As taxpayers may claim foreign tax credit for Puerto Rican withholding tax on royalties, the IRS reassessments are generally based on price adjustments on goods. 240. This stand is similar to the contract manufacturer theory professed by the IRS in the 1970s and 1980s (see the analyses of Bausch & Lomb Inc. v. CIR., 92 T.C. No. 33 [Tax Ct., 1989], affirmed by 933 F.2d 1084 [2nd Cir., 1991] and Sundstrand Corp. v. CIR, 96 T.C. 226 [Tax Ct., 1991] in secs. 5.2.5.2. and 5.2.5.3., respectively). Earlier case law is, however, distinguished due to the elevated position that the realistically available alternatives principle has gained in pricing methodology under the current regulations, as well as the commensurate-with-income standard. 241. T.C. Memo. 2016-112. See Gupta (2016) for comments in relation to the IRS’s attempt to apply the commensurate-with-income standard in the case.

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that US intangibles had been transferred to two Cayman Islands-registered group entities with branch operations in Puerto Rico, in spite of the fact that the two foreign entities earned super profits that indicated ownership of unique intangibles (as opposed to mere licensing positions that should earn only a normal CPM market return).242 It remains to be seen whether the IRS will convince the court in other pending 936 exit cases.243 The IRS’s concern is that taxpayers have not been sufficiently thorough in identifying and valuing all section 936 intangibles transferred to foreign corporations in section 367 transactions. The same concern applies for CSA transactions under the pre-2009 cost sharing regulations. This is the reason why the current cost sharing regulations require buy-in payments for all intangible development contributions, including workforce in place. These concerns are closely connected to the IRS’s dissatisfaction with the “bottom-up” valuation approaches normally taken by taxpayers, under which transferred intangibles are valued separately. This stands in contrast to the “top-down” approach adopted by the IRS (codified in the last sentence of IRC section 482 in the 2017 tax reform),244 pursuant to which transferred assets shall be valued in the aggregate and may include a residual amount (goodwill, going concern value and workforce in place).245

3.2.2.3. Are goodwill, going concern value and workforce in place encompassed by the pre-2018 version of the 936 definition? Rights in intangibles are often transferred intra-group on a stand-alone basis, e.g. licensing or sales transactions pertaining to a specific patent or 242. TC Memo 2017-147. 243. Other sec. 936 exit cases include Eaton Corp. v. CIR (Tax Court Docket No. 5576-12); Boston Scientific Corporation v. CIR (Tax Court Docket No. 26876-11); Guidant LLC v. CIR (Tax Court Docket No. 5989-11); Cardiac Pacemakers, Inc. v. CIR (Tax Court Docket No. 5990-11); and Medtronic, Inc. v. CIR (Tax Court Docket No. 6944-11). 244. As a way of background, see JCX-51-17, at p. 236. 245. The IRS valuation approach is described in the 2007 CIP (LMSB-04-0907-62). The CIP was withdrawn, but the IRS nevertheless remained dedicated to the described valuation approach for pre-2009 cases (as amply illustrated in Veritas v. CIR (133 TC No. 14) and Amazon.com Inc. v. CIR (148 TC No. 8)) and as codified in the new 2015 regulations clarifying the coordination of the application of the arm’s length standard and the best-method rule under IRC sec. 482 with other IRC provision 80 FR 55538-01 (see, in particular, § 1.482-1T(a)(i)(A)), requiring that all value provided in controlled transactions be compensated at arm’s length, and § 1.482-1T(a)(i)(B) on aggregation, requiring that the combined effect of two or more transactions (including under multiple IRC or regulations provisions) must be considered if that would yield a more reliable arm’s length profit allocation).

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trademark. In these cases, it will normally be clear that the transferred intangible is encompassed by the 936 definition and therefore available for an arm’s length charge under IRC section 482 or 367(d). In some cases, however, it may be that intangibles are transferred as part of a larger package of assets. Practical examples include the transfer of ongoing R&D, patents and workforce in place as contributions to a section 482 cost sharing agreement, or intangibles transferred as part of a larger section 367 business restructuring. In these cases, the pricing should be founded on an aggregated valuation of the entire package of transferred assets on a going concern basis.246 This may yield a higher price than the sum of the individual asset values transferred, resulting in a residual amount. The residual may be caused by a range of conditions, such as the utility to the buyer of integrating the purchased asset package into his existing business, economies of scale of using the assets as a group, or customer preferences that can be exploited only if the assets are used together. The residual will typically be classified either as goodwill, going concern value or the value of a workforce in place. The treatment of such residuals in US outbound transfers has been subject to considerable debate.247 Multinationals have historically claimed that the residual falls outside the pre-2018 version of the 936 definition, thus escaping a tax charge under IRC section 482 or 367, while the IRS has asserted that the value should be allocated to one of the specified section 936 intangibles, and therefore subject to tax.248 The point of departure is that goodwill, going concern value and workforce in place are not listed in the pre-2018 version of the 936 definition as separate items. The US tax code recognized goodwill, going concern value and workforce in place as concepts for other tax purposes (such as depreciation) long before the 936 definition was introduced.249 The absence 246. See, in particular, the author’s comments on the 2015 revisions of the regulations clarifying the interaction between the arm’s length standard and the best-method rule with other IRC provisions (80 FR 55538-01) in sec. 6.4. The application of aggregated DCF valuations has also been debated in the context of CSAs; see the analyses of the 2007 CIP (LMSB-04-0907-62) in sec. 14.2.3. and the income method in sec. 14.2.8.3. 247. See, e.g. Zollo (2010). 248. See the author’s comments on the 2015 revision of the IRC sec. 367 regulations in sec. 3.5.4. 249. See, e.g. Metropolitan Nat. Bank v. St. Louis Dispatch Co., 36 F. 722 (C.C.E.D.Mo., 1888), affirmed by 149 U.S. 436 (S.Ct., 1893), where goodwill is described as an intangible of an ongoing publishing business; and U.S. Indus. Alcohol Co. (West Virginia) v. C.I.R., 42 B.T.A. 1323 (B.T.A., 1940), affirmed in part, reversed in part by 137 F.2d 511

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of these items as positively listed intangibles in the pre-2018 version of the 936 definition may thus be read as an indication that Congress did not intend to tax the value transferred through their migration. Also, Congress has amended section 367(d) on two occasions since the 1993 enactment of the depreciation provision in section 197 (which encompasses goodwill) 250 without changing the reference to the 936 definition or the definition itself.251 These arguments carry some persuasive power, but it still cannot be ruled out that the pre-2018 version of the 936 definition encompasses goodwill, going concern value and workforce in place, as it includes intangibles “similar” to the ones listed. The question is therefore whether these residual intangible values can be seen as “any similar item”. As the 28 items listed in the 936 definition span a wide range of different types of intangibles, it is unclear which specific intangible features should be guiding for the “similar” determination.252 It has been argued in the literature that the listed items share two main aspects, i.e. they are susceptible to (i) separate valuation; and (ii) transfer.253 The author agrees, in principle, with this interpretation. The question is whether goodwill, going concern value and workforce in place can be transferred and valued separately. For the purpose of this discussion, the author will refer to going concern value and workforce in place as “goodwill”, as these three items in practice may be comprehensively difficult to separate from each other. The author therefore sees no convincing reason as to why they should be treated separately for the purpose of discussing whether they are encompassed by the pre-2018 version of the 936 definition.254

(C.C.A.2, 1943), where going concern value is described as the value of the ability to operate a business without interruption. See also IRC sec. 993(c)(2)(B); and the former IRC sec. 927(a)(2)(B), which was repealed in 2000 (Pub.L. 106-519, § 2). See Zollo (2010), at p. 73. 250. Treas. Regs. § 1.197-2(b)(1) defines goodwill as the “value of a trade or business attributable to the expectancy of continued customer patronage”. 251. Zollo (2010), at p. 73. However, it should be noted, as discussed in sec. 3.5.4., that the 2015 revision of the IRC sec. 367 regulations has removed the relevance of the sec. 936 definition in the context of IRC sec. 367 transfers. 252. Zollo (2010) argues that, due to the positive nature of the list of specified items in the sec. 936 definition, any expansion of the list based on similarity to the items listed should be narrow, with the burden being on the party advocating the expansion to demonstrate that the expansion is correct, with reference to US v. Merrill, 258 F.R.D. 302 (E.D.N.C., 2009), in which the position was that a catch-all provision should be read narrowly. See also Sinclair (1985). 253. See Blessing (2010a), Part D, 2, a). 254. The long-standing position of the IRS to consider workforce in place as part of the going concern value of a business was withdrawn in the 2007 Industry Director Di-

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The primary issue is whether goodwill should be understood to have a substantive meaning,255 aligned with the “continued customer patronage”, meaning developed through case law for depreciation purposes.256 If so, goodwill will at least not necessarily fall outside the scope of the pre-2018 version of the 936 definition, as it may be possible to value and transfer on a separate basis, and could therefore, in principle, be deemed “similar” to, for instance, customer lists or trade names, as opposed to simply being the residual value that surfaces when the total value of the transferred assets is larger than the aggregated sum of the single asset values. If goodwill is understood as a residual value, it will fall outside the scope of the pre-2018 version of the 936 definition, as it will not be susceptible to separate valuation and transfer. A residual is, by its very nature, an amount that cannot be allocated to any of the positively listed intangibles, and is therefore a negatively-defined concept. The narrow, substantive IRC section 197 meaning of goodwill developed for depreciation purposes would not promote the purpose of IRC sections 482 and 367,257 as it would likely restrict the potentially encompassed value of goodwill to a lesser amount than would typically be included in a residual goodwill value. This may conflict with the arm’s length allocation of operating profits under both provisions, as operationalized in the transfer pricing methods of the section 482 regulations. It is an undisputable fact

rective No. 1 on Section 936 Exit Strategies (LMSB-04-01-07-002). See also the 2005 audit guidelines on sec. 936 exits in Notice 2005-21. 255. See, e.g. Newark Morning Ledger Co. v. US, 734 F.Supp. 176 (D.N.J., 1990), reversed by 945 F.2d 555 (3rd Cir., 1991), reversed by 507 U.S. 546 (1993) (discussed below in this section). 256. Early depreciation cases on this issue include Northern Natural Gas Co. v. U.S., 470 F.2d 1107 (8th Cir., 1973), certiorari denied by 412 U.S. 939 (S.Ct., 1973); Black Industries v. CIR, 38 T.C.M. 242 (Tax Ct., 1979); Philip Morris Inc. v. CIR, 96 T.C. No. 23 (Tax Ct., 1991), affirmed by 970 F.2d 897 (2nd Cir., 1992); and VGS Corp. v. CIR, 68 T.C. 563 (Tax Ct., 1977), acquiescence recommended by AOD-1978-186 (IRS AOD, 1978) and acq. in 1979 WL 194041 (IRS ACQ, 1979). 257. The 1993 enactment of IRC sec. 197 (as part of the Omnibus Budget Reconciliation Act of 1993 Pub. L. No. 103-66, § 13261[g], 107 Stat. 312 [1993]) made the distinction between goodwill, going concern value and workforce in place and other identifiable intangibles, which is irrelevant for depreciation purposes, as both groups of intangibles (i.e.(i) residual” intangibles (negatively defined IP such as goodwill, going concern value and workforce in place); and (ii) identifiable intangibles (positively defined intangibles, such as patents, trademarks, etc.) now are depreciable. IRC sec. 197 was enacted to end the stream of disputes pertaining to whether acquired intangibles could be depreciated. The categories of intangibles qualifying for depreciation were significantly expanded, but all intangibles (including short-lived) now had to be depreciated over 15 years. Prior to the enactment, intangibles could be depreciated over the period of their useful lives.

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that third-party business acquisitions often result in purchase price allocations where considerable parts of the total purchase price are allocated to goodwill. In these third-party contexts, goodwill is the residual value above the sum of the values of the transferred assets. The author sees no sensible reason as to why goodwill should not have a residual meaning also in the context of transfer pricing, where the overarching purpose of the section 482 system is to provide parity in the taxation of related and unrelated parties. This chain of reasoning, where the substantive meaning of goodwill is rejected based on its lack of usefulness in the specific legal context, is aligned with the methodological approach taken by the US Supreme Court in the 1993 Supreme Court ruling in Newark Morning Ledger Co. v. US (Newark).258 At issue was whether parts of the purchase price paid for the shares in a newspaper publishing company could be allocated to the list of paid subscribers in the purchased company and depreciated by the purchasing taxpayer on a straight-line basis.259 The majority of the Newark court found the pre-section 197 substantive definition of goodwill as the “expectancy of continued patronage” to be of little value for a taxpayer trying to evaluate whether his intangibles qualify for depreciation deductions260 and concluded that the value of the customer lists over time diminished and that these costs should be matched against income. Also, while there are no general legislative or regulatory clarifications of what is included in goodwill in the context of section 482 or 367, for the specific context of section 367(d) transactions, foreign goodwill or going concern value is defined as “the residual value of a business operation conducted outside of the United States after all other tangible and intangible assets have been identified and valued”.261

258. Newark Morning Ledger Co. v. US, 734 F.Supp. 176 (D.N.J., 1990), reversed by 945 F.2d 555 (3rd Cir., 1991), reversed by 507 U.S. 546 (1993). 259. IRC sec. 167(a) allows “as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)”. The regulations allowed depreciation of intangibles if they were used in the business for only a limited period (see Treas. Regs. § 1.167(a)-(3)). Depreciation was not available for goodwill. The IRS, since 1927, had consistently held that goodwill was nondepreciable; see the 1927 IRS Treasury Decision on the amendment of Art. 163 of Regulations 45 (1920 edition) in T.D. 4055 (IRS TD). 260. See Boe v. CIR, 35 T.C. 720 (Tax Ct., 1961), affirmed by 307 F.2d 339 (9th Cir., 1962). 261. Treas. Regs. § 1.367(a)-1T(d)(5)(iii). The value of the right to use a corporate name outside of the United States has, in practice, been treated as foreign goodwill and going concern value. The definition is now irrelevant, due to the elimination of

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The author cannot see any clear reason as to why the basic understanding of the notion of goodwill as a residual value should not also be applicable in a general interpretation of the pre-2018 version of the 936 definition. In light of the above, he concludes that goodwill should be seen as the residual value that remains after all other identifiable section 936 intangibles have been allocated at arm’s length values. Goodwill falls outside the scope of the pre-2018 version of the 936 definition.262 As mentioned, this roadblock effect of the US intangibles definition has been problematic for the IRS in the context of CSAs and outbound business transfers under section 367. With respect to CSAs, the 2009 cost sharing regulations effectively override the pre-2018 version of the 936 definition’s exclusion of workforce in place through its “platform contributions” concept for the determination of the tax charge (buy-in amount).263 These platform contributions are contributions of “any resource, capability, or right … that is reasonably anticipated to contribute to developing cost shared intangibles”, for which an arm’s length consideration must be charged. The regulations clarify that making available “the expertise and existing integration of [a] research team is a unique resource or capability”.264 Thus, the regulations effectively require compensation for outbound transfers of workforce in place, even though such intangibles are not encompassed by the pre-2018 version of the 936 definition. In defence of this regulatory “override” of the IRC, it can be argued that it is necessary to secure an arm’s length profit allocation through the calculation of the buythe foreign goodwill exception in the 2015 revision of the sec. 367 regulations; see the discussions in secs. 3.5.4. and 3.5.5. 262. Some commentators have concluded otherwise; see, e.g. Bowen (2008); and Zollo (2010). Others, however, have concluded that foreign goodwill and going concern value (in the context of IRC sec. 367) fall within IRC sec. 936(h)(3)(B) property and are therefore subject to IRC sec. 367(d), not IRC sec. 367(a); see Collins et al. (2013). Recently issued regulations clarify that all property is subject either to IRC sec. 367(d) or IRC sect. 367(a); see Treas. Regs. § 1.367(a)-7(f)(10) and (11). See also the 2013 regulations on certain outbound property transfers by domestic corporations and certain stock distributions by domestic corporations (78 FR 17024-01). 263. See Treas. Regs. § 1.482-7(c)(1). Goodwill and going concern value are seldom or never relevant in the context of a cost-sharing agreement because only resources that contribute to the development of a particular joint R&D effort are priced through buyins. The relevant “residual” in cost-sharing agreements is therefore captured through the inclusion of the requirement to price workforce in place. Of course, workforce in place may be difficult to separate from goodwill and going concern value. 264. Treas. Regs. § 1.482-7(c)(5), Example 2.

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in amount.265 The arm’s length charge requirement is embodied in IRC section 482 (and, by reference, also section 367), and is therefore of equal legal rank as the 936 definition. It may therefore be asserted that the position of the regulations is loyal to the overarching legislative policy intention in that the allocation of profits among related parties should mirror that between unrelated parties, and that the regulations have done little more than harmonize two fundamentally conflicting provisions of the IRC. Second, the IRS has “overridden” the pre-2018 version of the 936 definition in the context of tax-free non-recognition transactions carried out under IRC section 367. Such business transfers are typically valued as a going concern through a discounted cash flow (DCF) valuation, and therefore often result in goodwill. Under the pre-September 2015 version of the IRC section 367 regulations, the transfer of foreign goodwill and going concern value could be carried out tax-free.266 The foreign goodwill exception is now removed from the section 367 regulations. Outbound transfers of such residual intangible value will thus now be taxed in spite of section 367(d) being limited to 936-definition intangibles and of the historical legislative intention for section 367(a) to permit tax-free conversion of a foreign branch.267 Even though goodwill transfers now will be taxed under the current regulations, the author finds the exclusion of goodwill from the pre-2018 version of the 936 definition to be a comprehensively unsatisfactory solution in principle. First, the development of US goodwill will likely have resulted in concurrent US tax deductions in the form of normal business costs (e.g. salaries, customer support and marketing campaigns). While it has been asserted that goodwill is not an asset that gives rise to US tax deductions prior to an outbound 265. This is also the IRS’s rationale. The preamble to the final 2011 cost-sharing regulations (76 FR 80082-01) states that “these regulations do not turn on whether a given transaction in connection with a CSA involves intangible property within the meaning of section 936(h)(3)(B), or whether such item has been transferred, licensed, or retained. Rather, if a controlled participant devotes, in whole or part, any existing resource, capability, or right to intangible development for the benefit of another controlled participant, whether by transfer or license to the other controlled participant, or by leveraging such resource, capability, or right within the context of the CSA, then the regulations require an arm’s length charge for such platform contribution, in addition to the funding of intangible development costs”. 266. In the author’s view, this was more than was intended. The development expenses for US goodwill and going concern value will likely have been deducted against current US income. Thus, a tax-free transfer will result in a mismatch in the allocation of expenses and income connected to the goodwill in the United States. 267. See H.R. Rep. No. 98-432, Pt. 2 (1984), at p. 1320.

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transfer,268 it is the author’s view that the residual connected to outbound transfers of US-developed intangibles should be seen as an asset, the development costs of which have been subject to deduction in the United States in the form of ordinary business costs. Goodwill is closely connected to, and often virtually inseparable from, a range of the intangibles positively listed in the 936 definition, such as trademarks, trade names and customer lists. This is amply illustrated by the pre-section 197 depreciation cases. The author would assert that if goodwill does not give rise to US tax deductions, neither do these intangibles. To the extent that his observation is justified, US matching of deductions and income will not be achieved if outbound transfers of goodwill are not encompassed by the 936 definition, contrary to its purpose. Second, a fundamental problem with the exclusion of goodwill from the pre-2018 version of the 936 definition – and therefore, in principle, from the commensurate-with-income standard in IRC sections 482 and 367 – is that it conflicts with the requirement that there shall be an arm’s length profit allocation among the related US transferor and the foreign group entity transferee. As third parties clearly pay for goodwill, it seems inappropriate that the same should not apply to related parties under the arm’s length standard. Third, the exclusion of goodwill from the pre-2018 version of the 936 definition introduces significant potential for controversy with respect to classification and valuation of intangible value, resembling the pre-section 197 depreciation disputes, as well as the historical principal purpose standard litigation under IRC section 367. Recent taxpayer applications of section 367 have amply underlined this point (see the discussion in section 3.5.4.). In light of the above, the author finds that the exclusion of goodwill (including going concern value and workforce in place) from the pre-2018 version of the 936 definition is a serious impediment to the US transfer pricing system, facilitating base erosion. The Obama administration suggested, in its budget proposals, to include these items.269 The proposal stated that to “prevent inappropriate shifting 268. Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984 (1984 Blue Book), at pp. 428-434. See also Aksakal et al. (2013), at p. 11; and Blessing (2010a), Part D, 2, a). 269. US Department of the Treasury, General explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (FY 2010 Greenbook), at p. 32. See also JCX-3710, FY 2014 Greenbook, at p. 49, which contains a proposal to tax currently excess returns associated with transfers of intangibles offshore; and p. 51, which contains a proposal to limit shifting of income through IP transfers.

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of income outside the United States … would clarify the definition of intangible property for purposes of sections 367(d) and 482 to include workforce in place, goodwill and going concern value”. The proposal is angled from the perspective that the revision will only clarify existing law, not change it. This is important for the IRS, as it then would be possible to tax outbound transfers of residual values carried out in income periods prior to the revision. This would go a long way towards reversing the effects of the 2009 ruling in Veritas and the 2017 ruling in Amazon.com, where the Tax Court rejected the assertion that residual intangible value (workforce in place, goodwill and going concern value) was a taxable intangible under the pre-2018 version of the 936 definition.270 It is the author’s view that a revision of the pre-2018 version of the 936 definition to also include residual intangibles clearly should be seen as a change to the law, not a clarification. The amendment will therefore not be relevant for past income periods.271 Nevertheless, in light of the fact that the 2009 cost sharing regulations and the 2016 revision of the 367 regulations effectively render the pre-2018 version of the 936 definition largely irrelevant in CSA and IRC section 367 transactions, respectively, it must be admitted that an amendment, in practice, will be a de facto clarification of the law as it now exists in the mentioned regulations. More precisely, the IRC will then have “caught up” with the IRS override in the CSA and section 367 regulations.

3.2.2.4. Is goodwill distinguishable from synergy value attributable to a group of identifiable 936-definition intangibles valued in the aggregate? In section 3.2.2.3., the author concluded that goodwill, arising from an aggregated valuation of intangibles transferred either as a package or as part of a larger business transfer, should be understood as a residual value that falls outside the scope of the pre-2018 version of the 936 definition. Taxpayers thus have an incentive to allocate a minimum amount of the total transaction value to specified section 936 intangibles and a maximum amount to goodwill, and the other way around for the IRS. 270. Veritas Software Corporation & Subsidiaries v. CIR (133 T.C. No. 14 [U.S.Tax Ct. 2009], IRS nonacquiescence in AOD-2010-05; see the author’s analysis of the ruling in sec. 14.2.4.), footnote 31 of the ruling. 271. It is clear that the 2017 tax reform amendment of the sec. 936 definition (discussed in sec. 3.2.3.) has effect only from and including 2018; see JCX-51-17, at p. 237; and Pub. L. 115–97, title I, §  14221(c).

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Likely in an effort to circumvent taxpayer goodwill classification and valuation, the IRS, in a Technical Advice Memorandum (TAM), concluded that the residual value that is the difference between the total value of a group of contracts when valued in the aggregate and the sum of the value of each individual contract should not be seen as goodwill, but rather as a synergistic value allocable to the specified 936-definition intangibles (the portfolio of contracts).272 The author will tie some comments to this issue, as the problem is relevant to more general interpretations of the 936 definition. The taxpayer valuation in the specific case addressed by the TAM allocated 97% of the total value to goodwill based on the assertion that each contract by itself purportedly had little value. Any incremental value on top of the sum of the individual contract values was not due to the contracts, but to the relationship between the distribution agents, constituting goodwill or, alternatively, going concern value. The reasoning behind the opposing IRS “synergy” view was that the transferred contracts (i) prior to the transfer were used by a single entity as an integrated network; (ii) were transferred as a single network to a single legal entity; (iii) would, at arm’s length, be valued as an integrated whole; and (iv) were used as a single, integrated asset. The IRS claimed support for its view in pre-section 197 depreciation case law. For instance,273 in Computing and Software, Inc. v. CIR,274 the taxpayer acquired the assets of three credit-reporting companies, including files with credit information. Depreciation deductions for the files were 272. See the technical advice memorandum in TAM 200907024, the factual pattern of which is akin to that in First Data Corp. v. CIR (Tax Court Docket No. 007042-09 [T.C. petition filed 20 Mar. 2009, case settled]), where the taxpayer argued that the IRS was wrong in deeming a network of foreign agent relationships as specified intangibles separate from goodwill and going concern value. The taxpayer argument was that the network had been aggregated into an ongoing business separate and distinct from the value of the contracts themselves and that the value attributable to the network was foreign goodwill or going concern value not subject to IRC sec. 367(d). 273. The IRS also claimed support in Kraft Foods Company v. CIR, 21 TC 513 (Tax Ct., 1954), where the Tax Court held that a group of 31 related patents should have been valued as a group for depreciation purposes. The case is, in the author’s view, unsuitable to serve as an argument for classifying a residual value as “synergy” added to the sum of the individual values of transferred specified intangibles, as the patents in the case were not susceptible to stand-alone valuation. Further, the IRS claimed support in Massey-Ferguson, Inc. v. CIR, 59 T.C. 220 (Tax Ct., 1972), acq., 1973 WL 157476 (IRS ACQ, 1973), a case that did not pertain to the classification of a residual value, but rather to the treatment of a group of distribution contracts as a single “system” intangible with respect to the issue of whether the taxpayer was entitled to deductions for abandonment loss of the distribution contracts in the year in which the last contract expired. The relevance of the case is therefore, in the author’s view, severely limited. 274. 64 T.C. 223 (Tax Ct., 1975), acq., 1976 WL 175506 (IRS ACQ, 1976).

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claimed based on an allocation of a substantial part of each purchase price to their cost basis. The court agreed with this allocation, as it found that the value allocated to the files was separable from the goodwill and going concern value of the acquired businesses. Each individual credit file was of little value. This case, is in the author’s view, is a rather good argument for classifying a residual value as an enhanced synergy value, as the issue in the case is analogous to the classification problem under the 936 definition. Further, the IRS found that the mismatch result of the taxpayer treatment, i.e. that 97% of the transferred value escaped US taxation through classification as goodwill, was contrary to the policy intention of IRC section 367(d). The significance of this purpose is pronounced here, as the link between current US deductions and the development of the distribution contracts will likely in general be clearer than for goodwill. The author nevertheless finds the IRS’s arguments flawed. The taxpayer business valuation resulted in a large goodwill value, but similar purchase price allocations are not unusual among third parties. Also, the IRS did not seem to dispute that the value of the individual contracts was modest. In this lies a crucial implication: that goodwill is the residual value above the sum of the individual asset values transferred. Thus, when the IRS characterized the residual value in this case as synergy value attributable to the portfolio of contracts, this violated the core system of the 936 definition, which is to only include positively defined intangibles. Goodwill is a negatively defined intangible. It is, per definition, the amount that cannot be allocated to specified 936 intangibles. The logical flaw in the IRS’s argument is precisely that it was possible to ascertain the value of each individual contract. Had this not been the case and the contracts could only be valued as a whole, the situation would have been different. It should then, in the author’s view, be possible to allocate the entire synergy value to the portfolio of contracts, provided that this value indeed was determined to stem from the contracts as opposed to general goodwill. Such an allocation would not violate the system of the 936 definition and would be more aligned with the pre-section 197 depreciation case law. The fact that, inter alia, the contracts prior to transfer were used by a single entity as an integrated network are only arguments as to why the business transfer should be valued in the aggregate. They provide no direction with respect to whether the residual amount resulting from such a valuation should be classified as a synergy value or goodwill. The IRS’s interpreta81

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tion is illustrative of the intricate and rather artificial constructions that may arise when taxpayers and the IRS have such pronouncedly different incentives to classify residual values, in particular for customer-based intangibles that are difficult to distinguish from goodwill.275 In conclusion, there is, in the author’s view, no legal basis to classify a residual amount from an aggregated valuation of intangibles as a synergy value.276 The residual amount is, by definition, goodwill, and thus falls outside the pre-2018 version of the 936 definition.277

3.2.2.5. Concluding comments on the pre-2018 version of the US IP definition Residual intangibles fall outside the pre-2018 version of the 936 definition. Thus, when goodwill, going concern value or workforce in place is transferred outbound, there is, in principle, no requirement under the commensurate-with-income standard in IRC section 482 or 367(d) for a tax charge. This is detrimental to an arm’s length profit allocation among related parties under US law, as the transfer of such values undoubtedly would be compensated by third parties. There is a basic conflict between 275. See also, in this direction, Aksakal et al. (2013), who admits that, in cases in which grouped intangibles are transferred along with significant tangible or business assets, there will be tension between valuing the separate sec. 936 intangibles in the aggregate and the policy intention to exclude foreign goodwill or going concern value from IRC sec. 367(d). 276. See, conversely, Aksakal (2013), at p. 11. The argument is that excluding going concern value from the value of a collection of intangibles is not consistent with the purpose of IRC sec. 367(d) to the extent that the underlying intangibles themselves give rise to mismatches and that it would be inappropriate to treat the value attributable to the combination of intangibles differently than the intangibles themselves. It could perhaps be claimed that Veritas (133 T.C. No. 14), where the court found that the valuation of pre-existing software should focus on the software itself and not on synergies between the software and other assets (separate valuation approach), stands in contrast to this aggregated valuation approach. In the author’s view, that is not the case, as the issue at hand is the classification of the residual value that results from a valuation as either an add-on value to identifiable sec. 936 intangibles (synergy) or as goodwill, going concern value or workforce in place. 277. Veritas dealt with the aggregated going concern valuation of a buy-in payment; see the analysis in sec. 14.2.4. The classification of the residual as a specified intangible or as goodwill was not an issue in Veritas. Nevertheless, the court noted that the IRS valuation took into account the value of a workforce in place (described as “access to research and development team” and “access to marketing team”) when calculating the buy-in amount and that workforce in place did not qualify as a sec. 936 intangible (see footnote 31 of the ruling). Had the IRS valuation approach been accepted by the court, this classification issue would likely have been brought to the forefront.

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the arm’s length transfer pricing requirement and the fact that the two key IRC provisions that govern related-party profit allocation, i.e. sections 482 and 367(d), are contingent on the 936 definition. The author applauds the IRS for alleviating the negative consequences of this contradictory legislation in the context of CSAs through the 2009 requirement to compensate platform contributions (and thereby also the value of workforce in place). Further, the DCF-based aggregated costsharing transfer pricing methods are influential in determining the pricing of other section 482 valuation-based transactions through the application of unspecified methods. Thus, the cost sharing regulations, in practice, ensure that the relevant residual intangibles in the context of section 482 transfers are taken into account and compensated. This IRS “vigilantism” has also fixed the problem with respect to section 367(d) transfers. The 2015 narrowing of the scope of the section 367(a) ATB exception and the removal of the foreign goodwill exception (see the discussion in section 3.5.4.) has ensured that transfers of residual intangibles in the context of outbound business transfers must now be compensated at arm’s length. It is a problem that these regulations conflict with the pre-2018 version of the 936 definition. They represent the IRS’s interpretation of the IRC. Taxpayers could challenge the validity of the 2009 cost sharing regulations and the 2015 revision of the section 367 regulations before the courts, based on the assertion that they require compensation that is irreconcilable with the pre-2018 version of the 936 definition referred to in the commensuratewith-income standard in IRC section 482 and the first sentence of IRC section 367(d). The courts would then need to harmonize the IRC section 482 arm’s length profit allocation requirement with the 936 definition. In the author’s view, the arm’s length requirement should prevail, as there otherwise would be a significant disparity between the taxation of related and unrelated parties, which seems comprehensively unlikely to have been intended by Congress. The compensation of intangible value transferred intra-group prior to 2018 hinges on the legal formality that the pre-2018 version of the 936 definition must be met, when the focus instead should have been on whether a transfer of intangible value has occurred that third parties would have required compensation for. It is unfortunate that the material profit allocation provisions alone, in the form of the US transfer pricing methods and intangible ownership rules, do not fully govern the allocation of operating profits among related parties, but are cluttered by the constraints of the rather arbitrary 936 definition.

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The above discussions pertaining to the exclusion of residual intangibles under the pre-2018 version of the US IP definition will not be relevant for intragroup IP transfers carried out from and including 2018, as the law has now been amended (see the discussion in section 3.2.3.). As mentioned in section 3.2.1., however, the reality is that this problem will continue to be relevant for years to come, until the assessment of all pre-2018 controlled IP transactions have been carried out and finalized. Depending on the outcome of the Ninth Circuit’s review of the 2017 Tax Court ruling in Amazon.com, there may be more cases on pre-2018 valuations of outbound IP transfers in which interpretation of the pre-2018 version of the IP definition may become a key issue.

3.2.3. The 2018 version of the US IP definition (the 2017 tax reform amendment) The 2017 US tax reform finally amended the 936 definition to include residual intangibles. As mentioned in section 3.2.1., the amendment should best be seen as an add-on to the pre-2018 version of the definition, as the revision “does not modify the basic approach of the existing transfer pricing rules with regard to income from intangible property”.278 The amendment leaves clauses (i)-(v) of the pre-2018 version of the 936 definition (which lists the 28 specific IP items) untouched,279 but replaces clause (vi) with the following: (vi) any goodwill, going concern value, or workforce in place (including its composition and terms and conditions (contractual or otherwise) of its employment); or (vii) any other item the value or potential value of which is not attributable to tangible property or the services of any individual.

The targeted inclusion of residual intangibles in the new clause (vi) brings an effective end to the long-running discussions with respect to whether the 936 definition encompasses residual intangible value in the form of goodwill, going concern value and workforce in place. Intra-group transfers of such value may now, from and including 2018, be taxed under IRC sections 367 and 482, with a clear basis in the law. The revision goes further, however, by also including other items of value that are not attributable to either tangibles or services. Residual value (i.e. the total value of the transfer minus the value of tangibles and services) 278. JCX-51-17, at p. 236. 279. This part of the provision is quoted above under sec. 3.2.2.1.

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is, in other words, regarded as value from IP. On this point, the revised US IP definition is similar to the OECD definition (see the discussion in section 3.3.). An interesting aspect of this new clause is that it simply refers to “value” without requiring that this value stems from something that can be owned or controlled by the transferring group entity, nor that the value is something that can be benchmarked against comparable uncontrolled transactions (CUTs). The fact that the provision shall be interpreted in this manner must be regarded as relatively certain, in light of the 2017 codification of the aggregated valuation and realistic alternatives principles in the last sentence of IRC section 482.280 Thus, any intragroup transfer of value that is not value from tangibles or services will be encompassed by the commensurate-with-income standard and subject to aggregated pricing. Going forward, this legislative development will likely entail that disagreements between the IRS and taxpayers with respect to intra-group IP transfers will go from the traditional classification debates (discussed in section 3.5.4.) to more pure valuation debates, as there will no longer be any question as to whether the IP must be priced. The only issue will be the correct valuation of the IP transfer pricing charge. When viewed together with the codification in IRC section 482 of the IRS’s aggregated valuation approach based on the realistic-alternatives pricing principle, it is difficult to imagine that the IRS in the future will face defeat akin to that which it incurred in the Tax Court rulings in Veritas and Amazon.com.

3.3. The OECD intangibles concept Paragraph 6.6 of the 2017 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG) defines an intangible negatively, as follows: [S]omething which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.

The broad design of this definition is intended to ensure arm’s length profit allocation in intra-group intangibles transactions, as well as to avoid the typical problems associated with defining intangibles for transfer pricing

280. See JCX-51-17, at p. 237, for background on the codification.

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purposes, in particular misclassification.281 The definition encompasses all intangibles relevant for transfer pricing. This includes patents,282 know-how and trade secrets,283 trademarks and trade names,284 rights under contracts and government licences285 and (other) licences.286 Residual intangible values, such as goodwill, going concern value and workforce in place, are also encompassed, even though such items cannot be transferred or valued separately.287 Further, the definition is disconnected from the concept of royalties under article 12 of the OECD Model Tax Convention on Income and on Capital (OECD MTC).288 An intra-group transfer of, for instance, goodwill or going concern value may require arm’s length compensation for transfer pricing purposes that is nevertheless not regarded as a royalty under article 12 of the OECD MTC. The definition is also not linked to financial accounting classifications.289 For instance, even if the R&D costs connected to a particular intangible are expensed for financial accounting purposes and therefore not recognized as a balance sheet item, the resulting intangible may be compensable for transfer pricing purposes. The most important aspect of the OECD intangibles definition is that it does not impose any restrictions on the profit allocation that follows from applying the OECD transfer pricing methodology and the intangible ownership rules (analysed in parts 3 and 4 of the book, respectively). Thus, as opposed to the pre-2018 version of the US definition, it has no roadblock effect on transfer pricing. This is made clear in paragraph 6.2 of the OECD TPG, which states that “[t]o the extent that an item or activity conveys economic value, it should be taken into account in the determination of arm’s length prices whether or not it constitutes an intangible within the meaning of paragraph 6.6”.290 281. See also OECD TPG, at para. 6.5. See the discussion in sec. 3.5.4. for examples of misclassification under the US regime. On the OECD IP concept, see also Wilkie (2016), at p. 76. See also Brauner (2016), at p. 105, who notes that the IP definition pertains to the scope of the OECD IP transfer pricing definitions, but also admits that the definition does not seem to exclude much in practice. 282. OECD TPG, at para. 6.19. 283. OECD TPG, at para. 6.20. 284. OECD TPG, at paras. 6.21-6.22. 285. OECD TPG, at para. 6.24. These must be distinguished from company registration obligations, which do not qualify as intangibles under the OECD definition. 286. OECD TPG, at para. 6.26. 287. OECD TPG, at paras. 6.28 and 1.156. 288. OECD TPG, at para. 6.13. 289. OECD TPG, at para. 6.7. 290. OECD TPG, at para. 6.2.

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Thus, the reality is that the definition merely serves as a reference to the underlying profit allocation rules that operationalize the arm’s length principle, i.e. the intangible ownership rules and the transfer pricing methods. If these profit allocation rules identify an intangible item that must be compensated to ensure arm’s length profit distribution, the definition will never intervene. This approach removes any distortion effects that could be caused by legal formalities. The broad OECD definition is combined with the requirement that taxpayers and tax authorities must clearly identify the intangibles that purportedly are transferred and compensable.291 If there is an intangible that is difficult to classify (e.g. local marketing know-how), taxpayers or tax authorities could simply “default” to a goodwill classification. As both know-how and goodwill are encompassed by the definition and, even more importantly, would be compensated if transferred between independent parties, such classification issues will not impact profit allocation. The identification requirement may, however, serve to protect taxpayers from reassessments based on loosely founded claims that vague intangibles have been transferred, such as local marketing intangibles, without further justification. The OECD intangibles concept must be distinguished from local market characteristics (e.g., cost savings and local purchasing power) and group synergies.292 Such characteristics and synergies may – similarly to unique intangibles – create incremental profits. However, such characteristics and synergies are not intangibles and cannot be owned by any particular group entity. Thus, for profit allocation purposes, the incremental operating profits from such characteristics and synergies must be kept separate from residual profits generated by unique intangibles and then allocated based on other principles than those that govern the allocation of residual profits from unique intangibles. This “segregation” of profits yields an important result: incremental profits that are caused by local market characteristics and group synergies cannot automatically be allocated to the group entity that owns unique intangibles. This is a new and important recognition by the OECD that, at least in principle, should affect international profit allocation. The reason for this is that, under past transfer pricing practices (often based on the TNMM), incremental operating profits from local market characteristics and synergies, more or less automatically, have been “blended” with the residual 291. OECD TPG, at para. 6.12. 292. OECD TPG, at paras. 6.9, 6.30 and 6.31.

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profits generated by unique intangibles and then allocated to the foreign principal group entity that held ownership of the unique intangibles. This ownership entity – and thereby, its residence jurisdiction – thus received more profits than it was entitled to in reality. The source jurisdictions, where the incremental profits arose due to local market characteristics, received correspondingly less profits. This “blending” of profits was made possible due to a lack of a more developed profit allocation doctrine. The historical practice has been a major concern for source jurisdictions. The new OECD rules on local market characteristics and synergies are a step in the right direction towards addressing this concern.293

3.4. Useful distinctions on the intangibles concept 3.4.1. Introduction Above, the author discussed whether and how the US and OECD IP definitions may restrict arm’s length profit allocation. In this section, the author will turn the perspective and briefly draw some useful distinctions with respect to the concept of intangibles that may facilitate the application of the US and OECD transfer pricing methodologies.

3.4.2. Manufacturing and marketing intangibles The distinction between manufacturing (or trade) and marketing intangibles represents established transfer pricing terminology.294 There is no legal importance attached to the use of these labels under US law or the OECD TPG.295 However, due to their ability to convey relevant transfer pricing differences among groups of intangibles, the author will employ them extensively in his later discussions throughout the book.296 The distinction is also used to structure his analysis of the intangible ownership

293. See further analysis of this topic in ch. 10. 294. See, e.g. Vann (2003), at p. 154. See also Lagarden (2014), at p. 334, for a broader analysis on the classification of intangibles. On the categorization of IP, see also Wilkie (2016), at p. 76. 295. OECD TPG, at para. 6.15. 296. Further, the term “hard intangibles” is sometimes used to refer to the most typical intangibles in the context of transfer pricing, such as patents, trademarks and knowhow, while the term “soft intangibles” is used for goodwill, going concern value and workforce in place. The author does not find this terminology particularly useful and will not employ it often in this book.

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provisions in part 3 of the book. The author is not aware of any prior legal analysis that has used this framework to analyse the US and OECD IP ownership provisions. Manufacturing intangibles include patents, know-how and similar technical knowledge that is used in the process of producing goods or services.297 Marketing intangibles encompass trademarks, trade names, customer lists, etc. that are used in the distribution and sale of products and services.298 There are relevant differences between these two groups of intangibles.299 Manufacturing intangibles tend to be developed through risky, expensive and often lengthy R&D, reliant on the talents of skilled researchers, and are typically performed at R&D facilities located in only one or a few jurisdictions. The value of marketing intangibles tends to be mainly driven by the amount of expenses incurred to create and carry out, for example, marketing campaigns. Successful development of a marketing intangible is also normally (to some extent at least) contingent on the quality of the underlying product being marketed, and therefore also on the manufacturing intangible that the product is based on. Marketing strategies and designs tend to be developed at a centralized level within the group, but the value of a marketing intangible must be developed in each market in which the product is sold. Thus, as opposed to manufacturing intangibles, marketing intangible development will not be contained within a few jurisdictions, but will rather be carried out in all jurisdictions where the product is marketed and sold. Another relevant difference is that it will, as touched upon above, normally be straightforward to distinguish between the development and exploitation of a manufacturing intangible, while this is often not true for market297. The OECD TPG glossary defines “manufacturing intangibles” (there denoted as “trade intangibles”) negatively, as commercial intangibles other than marketing intangibles. 298. The OECD TPG glossary defines “marketing intangibles” as intangibles within the meaning of “intangibles” in para. 6.6, which relate to marketing activities, aid in the commercial exploitation of a product or service and/or have an important promotional value for the product concerned. Depending on the context, marketing intangibles may include trademarks, trade names, customer lists, customer relationships and proprietary market and customer data that is used or aids in marketing and selling goods or services to customers. On marketing intangibles, see, in particular, Roberge (2013), at p. 213; and Levey et al. (2006). 299. See, e.g. the informed discussion in Brauner (2014a), at p. 100, where he criticizes the OECD for (in the run-up to the 2017 OECD TPG) not putting enough effort into distinguishing between different groups of IP based on how the value of the respective IP is created.

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ing intangibles.300 For instance, a marketing campaign will build the value of the trademark being marketed while at the same time exploiting it for the purpose of attaining sales. Further, marketing intangibles may, in some cases, be difficult to distinguish from residual intangibles (e.g. goodwill, going concern value and workforce in place) and local market characteristics (e.g. local customer preferences). Certain manufacturing intangibles, such as know-how, may be difficult to distinguish from the services of, for example, technical personnel.

3.4.3. Unique and non-unique value chain contributions Another useful distinction, which both the US and OECD transfer pricing rules fundamentally rely on, is between unique (non-routine) and nonunique (routine) value chain contributions. Routine contributions will typically be generic and relatively straightforward functions (e.g. contract manufacturing, distribution and marketing), but may also be intangibles. Such routine IP encompasses widely available technology, production, programming and marketing know-how, etc. Competition among enterprises that all have access to such technology will drive prices down to a level at which routine intangibles only will be capable of generating normal market returns. Thus, a group entity that contributes a routine intangible to the value chain only contributes to a normal return. Arm’s length compensation to this entity will therefore also be limited to a normal return. In contrast, an enterprise that owns unique intangibles may reap super profits by exploiting them, because competing enterprises will not have access to equivalent input factors. Therefore, an entity that contributes a unique intangible to the value chain may contribute to the creation of residual profits. This will, however, only be the case if the unique intangible actually has contributed to such residual profits. This will not always be the case, as not all unique intangibles are commercially successful.301 Provided that there is causality between the unique intangible and residual profits, arm’s length compensation to the group entity that contributed the unique intangible to the value chain must include the residual profits. 300. On this issue, see, in particular, Roberge (2013), at p. 212. 301. On this point, see also Lagarden (2014), at p. 334.

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Even though the US and OECD transfer pricing methodologies provide a lot of leeway to adjust profit margins, it can be said that residual profits in general represent a significantly greater amount of operating profits than normal market returns. This means that the distinction has a significant impact on international profit allocation. A group entity that is deemed to contribute a unique intangible to the value chain may receive “big” profits, while a group entity that contributes a routine intangible will only receive “small” profits. This impact may be described as a threshold or “cliff” effect, as the issue of whether a group entity shall be allocated residual profits depends on whether it contributes unique intangibles to the value chain. The distinction is therefore capable of providing clear direction with respect to how profits shall be allocated among the entities within a multinational, and thus lies at the heart of modern transfer pricing. The distinction comes into play in two main settings. The first setting is the process of allocating profits between group entities that contribute different value chain inputs. The distinction has direct effect on the choice of transfer pricing method to be applied. As the author will come back to in more detail (see sections 8.3. and 9.2.), the one-sided methods (the resale price and cost plus methods, as well as the TNMM) can directly only be used to price non-unique contributions,302 leaving only the CUT method and the profit split method as available methodologies to directly price unique contributions. A basic example of the cliff effect in this setting is as follows: A subsidiary in France sells a pharmaceutical product that generates 1,000 in profits. The subsidiary provides local manufacturing, distribution and sales functions. The product is produced under a patent that is licensed from the UK parent. The unique value chain contribution is the UK patent, while the non-unique contributions are the French manufacturing, distribution and sales functions. Let us say that, based on, for instance, the cost plus method, the profits attributable to the non-unique contributions are 200. The remaining 800 are super profits caused by the unique value chain contribution, i.e. the UK 302. See the Canadian Tax Court ruling in Alberta Printed Circuits Ltd. v. The Queen (2011 TCC 232), where the Court rejected a reassessment by the Canadian tax authorities denying deductions claimed by a Canadian company for royalty payments made to its subsidiary in Barbados based on the view that the Barbados subsidiary was a routine entity that did not own any unique and valuable IP and thus could be allocated profits based on the transactional net margin method (TNMM). See also infra n. 917 on this case.

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patent. As the French subsidiary is deemed to contribute only routine value chain contributions, the profits allocable to it are limited to a normal market return. The 800 are extracted from taxation in France and allocable to the United Kingdom, thereby creating a “cliff” compared to the relatively small profits allocable to France. The second setting in which the distinction comes into play is in the determination of intangible ownership, i.e. the process of allocating the residual profits between group entities that contributed to the development of the relevant unique intangible from which the residual profits stem. The provision of relatively unique and high-skill R&D functions, as opposed to more generic and administrative functions, is generally determinative as to which group entity shall be assigned the right to residual profits from an intangible that it has contributed to the development of under the OECD regime, as well as under the transfer pricing methods of the US cost-sharing regulations, in particular, the income method.303 Imagine that the UK patent in the above example was developed by R&D staff of a Norwegian subsidiary. The development process was, however, financed by the UK parent. As the author will revert to in detail later in the book (see section 22.3.2.), the OECD intangible ownership provisions will allocate the bulk of the residual profits to the group entity that provided the most unique and valuable R&D inputs, which, in this example, was the Norwegian subsidiary. The idea is that such inputs are relatively more important for the creation of intangible value than more generic functions and inputs, and thus should attract relatively more profits. The potentially significant difference in profit allocation, depending on whether the relevant value chain contribution is deemed to be unique or non-unique, triggers the question of what constitutes unique contributions entitled to residual profits versus non-unique contributions only entitled to normal market returns. The US profit split method regulations define a non-routine contribution negatively, as “a contribution that is not accounted for as a routine contribution”.304 A routine contribution, on the other hand, is described by focusing on the normal market return profits allocable to it, which will not include residual profits. 303. Treas. Regs. § 1.482-7(g)(4). Relatively unique and high-level R&D functions are often provided in combination with the contribution of a pre-existing unique intangible to the CSA for the purpose of further research. 304. Treas. Regs. § 1.482-6(c)(3)(i)(B).

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The 2017 OECD TPG define “unique and valuable intangibles” as those “(i) that are not comparable to intangibles used by or available to parties to potentially comparable transactions, and (ii) whose use in business operations (e.g. manufacturing, provision of services, marketing, sales or administration) is expected to yield greater future economic benefits than would be expected in the absence of the intangible”.305 Similarly to US law, this OECD definition is closely linked to the scope of application for the profit split method. The definition requirement that there is no comparable intangible will render the CUT method unavailable to allocate residual profits, leaving the profit split method as the only available methodology capable of directly allocating residual profits. The link between the distinction and the profit split method is further underlined by the fact that the OECD introduced this definition alongside its new 2017 preference for the profit split method as the go-to method for allocating residual profits.306 Both the US and OECD definitions point towards the same, but they start at opposite ends. The US definition indirectly describes unique contributions as those that are able to generate residual profits. The OECD definition describes unique intangibles as those that are not available to competitors and therefore generate higher profits. The core point is the same under both US and OECD law: in order for an intangible to be entitled to residual profits, (i) it must be unavailable for competing enterprises; and (ii) there must be either actual or likely causality between the intangible and the creation of residual profits, as not all exclusive intangibles generate residual profits; only those that are commercially successful do. Only intangibles that satisfy both (i) and (ii) should be seen as unique value chain contributions under US and OECD law. The border between routine and non-routine contributions will, in most cases, likely be clear, as it was in the above example with the UK patent. Other cases may be less clear. These have the potential to generate significant controversy. The stakes are high; the issue is whether a jurisdiction is entitled to tax residual profits or not. 305. OECD TPG, at para. 6.17. The second part of the definition contains a nonsensical statement, as the operating profits of any business will be less if one removes a business asset and its associated profits. The point must rather be that the business profits would be less if the intangible instead had also been available to competitors. These competitors could then offer the same products, resulting in price competition, driving down prices and eliminating the residual profits. 306. OECD TPG, at paras. 6.138, 6.145 and 6.146.

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Imagine, for instance, that the French subsidiary in the example above over time has developed a valuable network of customers and a strong reputation for delivering quality products. These factors are no doubt exclusive to the French subsidiary, and it does not seem unreasonable to assume that they may have contributed to the residual profits from local sales of the product. French tax authorities may then argue that the marketing network and reputation of the subsidiary should be seen as unique intangibles and then apply the profit split method to split the residual profits of 800 between the UK patent and the French marketing contributions. Say, for the sake of simplicity, that the split is set at 50/50. Because a unique value chain contribution has been identified on the side of the French subsidiary, it will go from receiving only 200 in profit as compensation for its routine contributions to receiving a profit of 600, which also compensates it for its unique marketing intangibles. The UK tax authorities may oppose this and assert that the patent is the only unique value chain contribution and claim taxing rights over the entire residual profits of 800. Given the potentially significant profit allocation effect of identifying unique value chain contributions, it is decisive that the functional and factual analysis of value chain contributions is carried out in a prudent and thorough manner. On the one side, there must be a relatively high threshold for classifying a value chain contribution as non-routine, as the economic rationale underlying the transfer pricing methodology is that such contributions represent monopoly positions that enable the owner to accrue super profits. The widespread application of the one-sided transfer pricing methods, however – which are fundamentally based on the tested party only contributing routine inputs – seems to indicate that transfer pricing practice has adopted a too-narrow definition of non-routine contributions.307 The author’s impression of the US and OECD rules is that the “unique intangible” threshold – and thereby also the threshold for attracting residual profits – is, in practice, set too high, in particular in the context of recognizing local marketing intangibles. Given the profound significance of the distinction between unique and nonunique value chain contributions, it is rather striking that it has not been developed further in US and OECD law. Both systems have instead put effort 307. It can, however, be observed that the 2009 US service regulations stretch the non-routine input concept far, as the mere obligation to perform under a service agreement qualifies; see Treas. Regs. § 1.482-9(g)(2), Example 2. This regulatory position (which, in the author’s view, is too relaxed with respect to what can qualify as unique) can be seen as a reaction to current transfer pricing practices (which, in the author’s view, are too restrictive with respect to what can qualify as unique).

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into simply defining what intangibles are. However, the simple fact that an intangible is present in the value chain says very little about how transfer pricing should be carried out. The truly relevant question is whether that intangible qualifies as a unique value chain contribution or not, because it will be decisive for the allocation of residual profits. Further work should be done within the two regimes to develop the distinction.

3.5. Controlled intangibles transfers subject to transfer pricing under US law 3.5.1. The taxation of US inbound and outbound intangibles transfers US inbound intangibles transfers occur when a foreign group entity owns an intangible and transfers rights to exploit it in the United States to a local group entity. This may be relevant for both manufacturing and marketing intangibles, such as patents and trademarks, respectively.308 The allocation of profits from inbound transfers is governed solely by IRC section 482. The allocation of profits from outbound transfers of US-developed intangibles may be governed by either IRC section 482 or 367, depending on the circumstances. A US taxpayer can transfer intangibles to a foreign related entity in five main ways: (1) through a sale; (2) through a licence agreement;309 308. Particularly, inbound transfers of marketing intangibles have caused challenging allocation issues, for instance, where a local US entity incurs substantial marketing costs to build the local value of a foreign-owned trademark. The question in these cases is whether the US entity should be allocated residual profits from the intangible due to its development contribution to the local value of the trademark. The author will discuss the US profit allocation rules in ch. 23. 309. The distinction between a sale and a licensing transaction lies in whether the transferor has transferred all substantial rights to the intangible and may affect the character of the income (e.g. capital or ordinary income), the source of the income (US or foreign), “basketing” for foreign tax credit purposes of the transferor’s gain (active or passive income) and the recovery of the transferee’s costs. On the distinction, see Treas. Regs. § 1.1235-1(a), pertaining to the determination of capital gains and losses with respect to the sale or exchange of patents. See also Waterman v. McKenzie, 29 F. 316 (1886), affirmed by 138 U.S. 252 (1891); Hooker Chem. & Plastics Corp. v. US, 1978 WL 21534 (Ct.Cl. Trial Div., 1978), affirmed by 219 Ct.Cl. 161 (Ct.Cl., 1979), supplemented by 221 Ct.Cl. 988 (Ct.Cl., 1979); and Bell Intercontinental Corp. v. US, 1967 WL 156523 (Ct.Cl., 1967), report and recommendation adopted by 180 Ct.Cl. 1071 (Ct. Cl., 1967). See also Zollo (2011), at p. 768.

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(3) through a CSA; (4) through a contribution of capital; or (5) through a reorganization. Transaction types (1)-(3) are governed by IRC section 482, while transaction types (4)-(5) are governed by section 367. Transactions carried out under section 367 pertain to the transfer of an ongoing business in exchange for stock or securities in the foreign transferee, organized as a non-recognition (tax-free) transaction. Here, intangibles are transferred as part of a larger business transfer, in contrast to the typical section 482 transaction types (1)-(3). Both IRC sections 482 and 367 seek to ensure that intangible value developed in the United States is not migrated without taxation. The US transferor will normally have deducted development-phase R&D expenses in the United States. Taxation of the full value of the intangible when transferred abroad is therefore necessary to match income and deductions connected to the same intangible in the United States. It is up to the taxpayer to choose whether to structure a transaction as a section 482 or section 367 transfer. Section 482 will likely be the natural choice when only intangibles are transferred, while section 367 will be chosen when there is a business transfer that includes intangibles. The author will discuss transaction types (1)-(3) (licence, sale and CSAs) in connection with his analysis of the US and OECD transfer pricing methodologies in part 2 of the book. Focus in sections 3.5.2.-3.5.8. will be on section 367 transaction types (4)-(5). Section 367 has important interactions with section 482. If taxation is triggered under section 367, the value of the transferred intangibles must be calculated pursuant to the material profit allocation rules under section 482. Thus, the section 482 transfer pricing methodology that is analysed in part 2 of the book also governs profit allocation under section 367. The aim of the discussions in this chapter on section 367 is to contextualize how this provision fits into the larger section 482-driven US framework for related outbound IP transfers and to pinpoint the most significant nuances of the relationship between sections 482 and 367.

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3.5.2. The context in which IRC section 367 applies: Non-recognition transactions The federal US tax code affords non-recognition treatment for certain transactions (including business reorganization asset transfers).310 A transfer that qualifies under a non-recognition provision generally entitles the transferee to earn the income associated with the transferred property. Non-recognition transactions that are carried out among related parties will trigger a conflict between section 482 – which requires arm’s length profit allocation when value is transferred among related parties – and the tax-free treatment granted under the non-recognition provision applied to the transaction. The IRS has, in general, reserved the right to perform section 482 reallocations notwithstanding the application of non-recognition provisions.311 The section 482 regulations indicate a rather narrow window for applying section 482 in the context of non-recognition transfers.312 This reflects the fact that the IRS has only been successful in reallocating income by overriding non-recognition provisions when the transferred property was disposed of by the transferee quickly after the contribution. In more sophisticated cases, when the transferee has used the transferred intangible in its business to generate profits, the IRS has lost. The prime example of this is Eli Lilly v. CIR, where the Tax Court found that the residual profits earned by a Puerto Rican subsidiary from exploiting a USdeveloped patent transferred to it in a section 351 non-recognition transaction could not be reallocated to the US parent under section 482.313

310. On US non-recognition treatment of corporate reorganizations in general, see, in particular, Brauner (2004). 311. Treas. Regs. § 1.482-1(f)(1)(iii). 312. See the example in Treas. Regs. § 1.482-1(f)(1)(iii), pertaining to a tax-free transfer of shares to a subsidiary in exchange for capital stock, which sells the shares to a third party the year after, realizing a loss. The regulations state, with reference to National Securities Corp. v. CIR, 46 B.T.A. 562 (B.T.A., 1942), affirmed by 137 F.2d 600 (C.C.A.3, 1943), certiorari denied by 320 U.S. 794 (S.Ct., 1943), that the IRS may disallow the loss on the basis that it was incurred by the transferor. See also Southern Bancorporation v. CIR, 67 T.C. 1022 (Tax Ct., 1977); and Northwestern Nat. Bank of Minneapolis v. U.S., 1976 WL 1016, (D.Minn. 1976), affirmed by 556 F.2d 889 (8th Cir., 1977). Similarly, in Bank of America v. U.S., 1978 WL 1257 (N.D. Cal., 1979), the court found that the IRS could not apply sec. 482 to disregard the tax consequences of a transaction governed by the former sec. 311. 313. 84 TC No. 65. The intangible transfer in Lilly occurred prior to the enactment of sec. 367(d). See the analysis of the case in sec. 5.2.4.3.

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In the context of section 367 transactions, however, non-recognition treatment that follows from other sections of the IRC (typically, IRC sections 351 and 361) is overridden, unless an exception is applicable. In other words, section 367 in itself ensures that a non-taxable transaction becomes taxable.

3.5.3. The historical background of IRC section 367 The predecessors of the current IRC section 367 were section 112(k) of the Revenue Act of 1932 and section 367 of the Internal Revenue Code of 1954.314 The motivation behind the introduction of the 1932 provision was to close a “serious loophole for avoidance of taxes”, i.e. that a US transferor could transfer appreciated property to a foreign subsidiary in a reorganization under section 351 without triggering taxes and then defer or avoid tax upon the subsequent sale of the transferred property by the foreign subsidiary.315 The 1932 provision and the subsequent 1954 section 367 determined that a section 351 or 332 exchange would be immediately taxable unless it was established that the exchange was not in pursuance of a plan having the avoidance of tax as one of its principal purposes (the principal purpose standard).316 A transfer of assets used in an active foreign trade or business was generally not deemed to have tax avoidance as its principal purpose, as opposed to transfers of passive income generating intangibles or intangibles relating to income from the manufacture or sale of goods in the United States (roundtrip transactions). Congress observed that the principal purpose standard was interpreted narrowly by courts and difficult to administer.317 314. Revenue Act of 1932, Pub. L. No. 72-154, 46 Stat. 169, § 112(k). The initial focus of the rule was to trigger tax on built-in gains. 315. H.R. Rep. No. 708, 72d Cong., 2nd Sess. (1932), 1939-1 (Part 2) C.B. 471. 316. There was comprehensive IRS ruling practice on this standard. See the IRS ruling guidelines, originally set out in Revenue Procedure 68-23. See also Rev. Proc. 7529; Rev. Proc. 76-20; Rev. Proc. 77-17; Rev. Proc. 80-14; and Rev. Rul. 2003-99. 317. In the early 1980s, the IRS was faced with two significant Tax Court reversals of its interpretation of the principal purpose standard, with the result that high-value intangibles were migrated without taxation. The first case, Dittler Brothers, Inc. v. CIR, 72 T.C. 896 (Tax Ct., 1979), affirmed by 642 F.2d 1211 (5th Cir.(Ga.), 1981), pertained to the transfer of scratch-off lottery ticket technology to a foreign joint venture. The Tax Court rejected the IRS assertion that there was a tax avoidance purpose because the technology was to be used in mainly passive activities of the foreign joint venture, with the result that the transfer qualified for tax-free non-recognition treatment. In the second case, Hershey Foods Corp. v. CIR, 76 T.C. 312 (Tax Ct., 1981), declined to follow by Private Letter Ruling (IRS PLR, 1982), 1982 WL 204647, the taxpayer wanted

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The standard was replaced in 1984 with the section 367(a)(1) requirement that gains be recognized on any transfer by a US taxpayer to a foreign corporation otherwise qualifying for tax-free treatment, unless an exception applies. While the current version of section 367 contains exceptions to the nonrecognition override, these do not apply for transfers of intangibles. Thus, tax will now always be triggered when intangibles are migrated as part of a section 367 transaction. The question now is only with regard to how the income from the intangibles transfer shall be recognized. The answer to this depends on whether section 367(a) or (d) shall be applied. The author discusses these provisions in the following two sections (3.5.4.3.5.5.).

3.5.4. Current gain recognition under IRC section 367(a) When property is transferred outbound from a US taxpayer to a foreign corporation in the form of a non-recognition exchange described in sections 332, 351 (incorporation transfers), 354, 356 or 361 (reorganization transfers),318 IRC section 367(a)(1) requires that the gain realized is subject to immediate recognition and taxation for the US transferor.319 There are some important exceptions from this non-recognition override. Particularly relevant for the purposes of this book is an exception pertaining to transfers of property to a foreign corporation for use in the active conduct of a trade or business outside the United States, i.e. the mentioned ATB exception (the predecessor of which was the principal purpose stand-

to incorporate the assets of two Canadian branches, one of which was loss-making, at a time when it could be expected to become profitable. The Tax Court found that IRC sec. 367 was not intended to recapture past losses when a branch is incorporated in a foreign country. 318. The non-recognition rules apply only to the transfer of property. See, e.g. E.I. Du Pont de Nemours and Co. v. US, 296 F.Supp. 823, (D.Del., 1969), affirmed in part, reversed in part by 432 F.2d 1052 (3rd Cir., 1970), where the court observed that US tax law contains a “generous definition of property” for sec. 351 purposes. See also Hospital Corp. of America v. CIR, 81 T.C. No. 31 (Tax Ct., 1983), nonacquiescence recommended by AOD- 1987-22 (IRS AOD, 1987) and Nonacq. 1987 WL 857897 (IRS ACQ, 1987), where the rendering of negotiation and other support pertaining to a business opportunity was deemed to be a service and not a transfer of property under sec. 351. 319. IRC sec. 367(a)(1); and Treas. Regs. § 1.367(a)-1T(b)(1). Taxation is a consequence of the foreign corporation not being considered a corporation.

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ard, referred to in section 3.5.3.).320 Outbound transfers of property that qualify for this exception are tax free, i.e. the non-recognition treatment for these transfers is not overridden. Until autumn 2015, the ATB exception was designed so that it encompassed all types of property unless specifically excluded.321 Section 936 intangibles were excluded, and thus taxable. This meant that intangibles that were not encompassed by the pre-2018 version of the section 936 definition fell within the wording of the ATB exception in IRC section 367(a) (3)(A) as “property transferred to a foreign corporation”, and could thus be migrated without triggering taxation. The legislative history behind the ATB exception documents that the original intention was to facilitate tax-free conversion of an active foreign business from branch to subsidiary form.322 Foreign goodwill and going concern value transferred in such conversions was seen as the result of genuine non-US development activities. Non-taxation of these items was therefore not deemed to have any potential for abuse of the US tax system. This point was highlighted by Congress in the 1984 revision of section 367:323 “The committee does not anticipate that the transfer of goodwill or going concern value developed by a foreign branch to a newly organized foreign corporation will result in abuse of the U.S. tax system.”324 Congress envisioned that the transfer of foreign goodwill or going concern value would be assessed under the ATB exception, as opposed to a separate 320. IRC sec. 367(a)(3)(A); and Treas. Regs. § 1.367(a)-2T(a)(1). US taxpayers may structure their foreign active business operations in branch form or through deferral vehicles (controlled foreign corporations, CFCs). The trade-off is that deferral of US tax may be achieved through the use of deferral vehicles, but not if the branch form is chosen. On the other side, the losses of a foreign branch may be offset against US income, as opposed to the losses incurred in a CFC. The active foreign trade exception lies at the cross-section of these two regimes, governing incorporations of active foreign branches and transfers of other active foreign business assets to deferral vehicles. US outbound transfers to a foreign branch of a US enterprise is not taxable; see IRC secs. 351 and 367(b). The branch will remain subject to current US taxation, entitled to credit for foreign income taxes paid; see IRC sec. 901. However, the transfer of an active foreign business to a foreign parent corporation is a fully taxable transaction; see IRC secs. 311(b) and 367(e)(2). 321. This exclusion was operationalized through the so-called “tainted asset rule” in IRC sec. 367(a)(3)(B)), which encompassed, in addition to sec. 936(h)(3)(B) intangibles, outbound transfers of inventory, copyrights, accounts receivable, foreign currency and property of which the transferor was the lessor at the time of transfer. 322. See Zollo (2010), at p. 73. 323. On this, see, in particular, Driscoll (1988), at p. 171. 324. H.R. Rep. No. 98-432 (1984), Pt. 2, at pp. 1317-1319.

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rule for intangibles. The Treasury Department and the IRS followed up on this and released temporary section 367 regulations in 1986.325 These stated, in line with the Congressional intention, that the “transfer of foreign goodwill or going concern value” was exempt from section 367(d) and thus fell under the ATB exception (given that foreign goodwill was not a section 936 intangible), with the result being that such transfers would not be subject to tax.326 This regulatory interpretation would give rise to abusive classification and valuation practice where multinationals asserted that US outbound transfers of intangible value (i) should not be classified as 936 intangibles, but rather as foreign goodwill or going concern value qualifying under the ATB exception; and (ii) minimized the value of the transferred 936 intangibles for which income inclusion was required and maximized the value of the foreign goodwill exempt from tax. This practice relied on creative interpretations of foreign goodwill, where it was even argued that US marketing activities and value from business operated by US employees where income was earned remotely from foreign customers should be seen as foreign goodwill.327 Such interpretations were combined with unreliable valuation approaches, using standalone item-byitem valuations, even where aggregated valuations of the entire package of transferred assets would yield more reliable value estimates. These practices became more widespread and aggressive over time, as taxpayer incentives for structuring US outbound intangibles transfers in the form of section 367 (as opposed to section 482) transfers grew. Such incentives included the 1997 removal of the treatment of section 367(d) deemed royalties as US income in relation to the foreign tax credit limitation,328 the combined effect of the 1996 “check-the-box” regulations and the 2005 sub325. TD 8087, 51 FR 17936. 326. Treas. Regs. § 1.367(d)-1T(b). See the definition of foreign goodwill/going concern value in Treas. Regs. § 1.367(a)-1T(d)(5)(iii). 327. See Zollo (2010), at p. 84, on the IRS position that taxpayer classifications of foreign goodwill could also encompass “US goodwill”. Zollo is critical of the IRS position on the basis that foreign goodwill was defined in the regulations as a residual amount of the value of the foreign business, implying that the entire residual should be deemed foreign. 328. Taxpayer Relief Act of 1997, Public Law 105-34, 111 Stat. 788. The 1997 amendment to sec. 367(d)(2)(C) secured that deemed royalty amounts received under sec. 367(d) are treated as ordinary income that is sourced in the same manner as royalties, and therefore potentially as from sources outside of the United States. Prior to 1997, deemed royalties received under sec. 367(d) were seen as income from US sources (and thus not eligible for credit).

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part F “look-thru” rule, making it easier to move funds earned in a foreign group entity intra-group without incurring US tax and for foreign group entities to license intangibles intra-group without triggering subpart F income.329 The likely strongest taxpayer incentive to structure transactions under section 367 came in 2009, when the new temporary cost-sharing regulations significantly strengthened the valuation methods under IRC section 482 for buy-in transactions, ensuring “full value” taxation of intangibles transferred abroad through CSAs.330 This development occurred over decades in which the importance and value of intangible assets for the businesses of large multinationals had just increased.331 The result of these practices was that significant US-developed intangibles were not taxed at their full value – or even escaped taxation altogether – when transferred within the group to a foreign jurisdiction. The IRS issued new proposed section 367 regulations in September 2015 to put an end to these BEPS practices.332 These regulations were finalized in December 2016.333 The revised ATB exception is significantly narrowed and represents a clear departure from previous, 3-decades-long practice. The ATB exception now only applies to positively listed (so-called “eligible”) property. The list of eligible property encompasses tangible property, working interests in oil and gas property and certain financial assets.334 Intangibles do not qualify as eligible property. 329. For the “check-the-box” regulations of § 301.7701–3 TD 8697 (61 FR 66584), see TD 8697 (61 FR 66584). For the subpart F “look-thru” rule, see sec. 954(c)(6) of the Tax Increase Prevention and Reconciliation Act of 2005, Public Law 109-222, 120 Stat. 345. 330. TD 9441 (74 FR 340), finalized in TD 9568 (76 FR 80082). It was, in particular, the introduction by these regulations of the income method to value buy-ins that discouraged taxpayers from structuring outbound IP transfers under sec. 482. See the analysis of the income method in sec. 14.2.8.3. 331. See the discussion in the preamble to the 2016 regulations, TD 9803. 332. The revision was made effective immediately, in proposed form, without allowing for notice and comment before making the rule change; see 80 FR 55568-01. This is unusual and emphasizes the urgent need to address the profit shifting practices of multinationals under IRC sec. 367(a) and (d). It should be noted that the 2015 revision of the active trade or business (ATB) exception also intended to make the information more easily accessible. The text of the pre-2015 ATB exception was scattered through a range of different regulations (Treas. Regs. § 1.367(a)-2; § 1.367(a)-2T; § 1.367(a)-4; § 1.367(a)-4T; § 1.367(a)-5; and § 1.367(a)-5T). The revised 2015 exception combines these regulations into a single provision, i.e. Treas. Regs. § 1.367(a)-2, published in 80 FR 55568-01. The revised provision does not include the depreciation loss recapture rule, which is now moved from § 1.367(a)-4T to 1.367(a)-4) (see 80 FR 55568-01). 333. TD 9803. 334. Treas. Regs. § 1.367(a)-2(c) (see 80 FR 55568-01) lists four categories of ineligible property. These are (i) inventory; (ii) instalment obligations, etc.; (iii) foreign currency, etc.; and (iv) certain leased tangible property.

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The exception for foreign goodwill and going concern value was removed.335 The IRS assessed whether it could be retained in a modified form that ensured that it would not be abused. Both the definition of a foreign branch and a “cap” on the foreign goodwill that could be exempted was considered,336 but the IRS ultimately found that such a modified exemption would be difficult to administer. The scrapping of the foreign goodwill exception was a controversial move by the IRS,337 as Congress clearly envisioned in 1984 that there should be an exception for the transfer of foreign goodwill and going concern value.338 The author nevertheless finds the IRS reasoning for the removal convincing. In 1984, when the ATB exception was introduced – coming from a situation with severe difficulties in administering the principal purpose standard – it was clearly also the congressional intent that (i) the foreign goodwill exception should not entail abusive profit shifting practices; and (ii) outbound transfers of US-developed 936 intangibles should be taxable. Given the aggressive taxpayer practices of classifying outbound transfers of (what in reality, in many cases, must have been 936) intangibles as foreign goodwill and maximizing the value of such wrongly classified intangibles at the expense of 936 intangibles transferred in the same business transfer using standalone item-by-item valuations, it is indeed difficult to see how the exception for foreign goodwill could be upheld while at the same time protecting the integrity of the federal US tax system.339 Even though the 2015 revision of the ATB exception certainly came abruptly, it was, in the author’s view, a necessary modification of the section 367 regulations. It will undoubtedly facilitate arm’s length profit allocations in the context of controlled intangibles transfers going forward. Thus, under the current regulations (as revised in 2015 and finalized in 2016), all outbound transfers of intangibles under IRC section 367 – including foreign goodwill and going concern value – will be taxable for the US transferor. The intangibles transfers shall be valued using the transfer pri­ 335. Thus, outbound transfers of foreign goodwill or going concern value are subject to either current gain recognition under IRC sec. 367(a) or gain deferral under sec. 367(d), but are nevertheless taxable. 336. See Velarde (2015). 337. The removal of the foreign goodwill exception was met with considerable criticism from taxpayers. The IRS discussed the objections thoroughly in the preamble to the final regulations, but upheld its position. 338. See H.R. Rep. No. 98-432, Pt. 2 (1984), at p. 1320. 339. Reinstatement of an exception for active trade or business is, however, now under consideration with respect to cases that pose little risk for abuse and administrative challenges; see TNT Doc-2017-72131. See also JCX-51-17, at p. 195.

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cing methodology under IRC section 482 so that the full value is captured under US taxation. However, the current gain recognition treatment under section 367(a) cannot be applied to transfers of 936 intangibles,340 as such intangibles must be taken into account under section 367(d) and its commensurate-with-income deemed royalty construction (discussed in section 3.5.5.). The scope of application for section 367(a), in the context of intangibles transfers, is therefore narrow. Only non-936 intangibles can now be treated to immediate gain recognition under section 367(a). However, as the author will elaborate on in section 3.5.5., taxpayers are now given the choice to elect treatment under section 367(d) for such non-936 intangibles.

3.5.5. Deemed royalty inclusions under IRC section 367(d) 3.5.5.1. Historical background In the 1970s and early 1980s, US pharmaceutical companies had a practice of transferring ownership of US-developed, high-profit-potential manufacturing intangibles to Puerto Rico as well as other US possessions through non-recognition transactions, often at the point in time when the intangibles were expected to become profitable. This was profit shifting, as the subsequent profits generated by the intangibles would then not be allocated to the United States, in spite of the fact that US tax deductions had been claimed for R&D expenses throughout the development phase. IRC section 936(h) was introduced in 1982 as a reaction to these practices, requiring US shareholders of possession companies to include in their current income the profits generated by the intangibles owned by the possession companies.341 Congress acknowledged that some multinationals would, as a result, transfer intangibles from Puerto Rico to foreign jurisdictions. This was the background for the 1982 introduction of the initial version of section 367(d), which deemed intangibles transfers from a possession corporation to a foreign corporation as having tax avoidance as the principal purpose and being thus ineligible for non-recognition treatment under section 367. This first version of section 367(d) required recognition of the full realized gain at the time of the transfer.342

340. Treas. Regs. § 1.367(a)-(1), in 80 FR 55568-01. 341. See the Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. No. 97-248, 96 Stat. 324 (1982). 342. See Driscoll (1988), at p. 177.

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Section 367(d) was amended in 1984 to apply more generally to outbound intangible transfers. Even though it no longer applied solely to possession corporations, the provision retained its original cross-reference to the 936 intangibles definition. The requirement for current and definitive recognition of gains at the time of transfer was replaced with a deemed royalty construction, aimed at better reflecting the actual profits generated by the transferred intangible. In 1986, the first IRS interpretation of section 367(d) was released in the form of the temporary IRC section 367(d) regulations.343 That same year also saw the incorporation of the new IRC section 482 commensurate-withincome standard into IRC section 367(d).344 In 2010, the IRS announced a project to revise the 1986 temporary section 367(d) regulations,345 which resulted in the 2015 proposed regulations (finalized in 2016).346

3.5.5.2. The material content of IRC section 367(d): Sale of ­contingent payments The system under the section 367 regulations is that transfers of 936 intangibles must be subject to deemed royalty recognition under section 367(d) (a so-called “transfer pursuant to a sale of contingent payments”), and thereby the commensurate-with-income standard. There are four main scenarios for the application of section 367(d): (1) Intangible transfers to a foreign corporation under section 351 or 361: The US transferor will, in these cases, be treated as having transferred the intangible in exchange for annual royalty payments, contingent on the productivity or use of the property, subject to the commensuratewith-income standard.347 (2) Subsequent disposal by the foreign transferee of the intangible to a third party: The US transferor must, in these cases, recognize any gain 343. See 51 Fed. Reg. 17936-01. 344. Tax Reform Act of 1986, Pub. L. No. 99-514, 100 Stat. 2085 (1986), at sec. 1231(e)(1). 345. For informed recommendations pertaining to the regulation project, see Blessing (2010a). 346. 80 FR 55568 (proposed 2015 regulations); and TD 9803 (final 2016 regulations). 347. Treas. Regs. § 1.367(d)-1T(c). The initial version of IRC sec. 367(d), as proposed by the House Committee on Ways and Means, described the IRC sec. 367(d) payments as an exclusive licensing agreement. The Senate version, as adopted in the final legislation, used the contingent sale approach.

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that comes from deducting its former adjusted tax basis for the intangible from the value of the intangible as of the date of the transferee’s disposition.348 (3) Subsequent transfers of the stock of the foreign transferee corporation to a related US person:349 The new related US stock owner will, in these cases, be treated as having received a proportional right to the annual royalty payments that otherwise would have accrued to the US transferor.350 (4) Subsequent transfers of the stock of the foreign transferee corporation to a third party: The US transferor will, in these cases, be treated as having sold the intangible and must recognize any gain that comes from deducting its former adjusted tax basis for the intangible from the value of the intangible at the date of the stock disposition.351 The author will focus on the first scenario, as this is the scenario that is relevant for direct transfers of intangibles out of the United States (as part of a larger business transfer). In this scenario, the US transferor is, under section 367(d), treated as having sold the intangible in exchange for payments contingent upon the productivity, use or disposition of the intangible for amounts that would have been received annually in the form of such payments over the useful life of the intangible.352 Thus, section 367(d) sees the intangible transfer as separate from the larger business transfer of which it is a part. The sale for contingent consideration approach (1) entails that the income is deferred over the life of the intangible, and the contingent amount of gain is taxable as ordinary income. The useful life of the intangible – and thus the period of the potential income stream – was set to 20 years under 348. Treas. Regs. § 1.367(d)-1T(f)(1). 349. If the related entity that acquires the stock is foreign, the US transferor will continue to include in its income the annual deemed payments under IRC sec. 367(d) as if the subsequent stock disposition had not occurred. 350. Treas. Regs. § 1.367(d)-1T(e). 351. Treas. Regs. § 1.367(d)-1T(d). The calculation will be reduced by the gain that the US transferor has recognized with respect to the deemed sale of the intangible under IRC sec. 367(d). 352. IRC sec. 367(d)(2)(A). A US taxpayer may, as the point of departure, transfer intangibles to a foreign partnership without recognizing gains on the transfer (see IRC sec. 721). The US transferor will, however, be subject to tax on its share of the partnership’s income subsequent to the transfer (see IRC secs. 701 and 702). Regulations were issued in February 2017 that extend the deemed sale treatment to transfers to foreign partnerships under IRC sec. 367(d)(3); see TD 9814.

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the 1986 regulations.353 The revised 2015 regulations broadened the rule to encompass the entire period during which the exploitation of the intangible was reasonably anticipated to occur, including the use of the intangible for the purpose of further R&D, as well as the use in subsequently developed intangibles akin to CSAs.354 The 20-year limitation was removed due to the concern that it could result in less than all of the income from the transferred intangible being recognized as income by the US transferor. This 2015 rule was criticized by taxpayers for being difficult to administer. The IRS therefore modified the rule in the final 2016 regulations so that taxpayers may, in the year of the transfer, choose to take into account deemed royalties under section 367(d) for only 20 years.355 However, this modification was combined with the requirement that the 20-year limitation should not affect the present value of all amounts included by the taxpayer under section 367(d). The result is essentially that the “full value” of the intangible (as captured by the 2015 rule) can now be spread over “only” 20 years, should the taxpayer choose the 20-year limitation. While this modified rule will also undoubtedly be challenging to administer, it seems necessary to capture the entire income from long-lived intangibles. It has been asserted that the purpose of section 367(d) is merely to “claw back” the US tax advantages gained through deducting R&D costs related to the transferred assets or from operating in branch form, as opposed to establishing a general exit tax on US persons that incorporate their foreign branch operations or transfer foreign business assets outbound.356 The author finds this assertion comprehensively difficult to reconcile with the methodology for calculating income under section 367(d), which is a construction for deemed royalty inclusion based on the section 482 commensurate-with-income standard, designed to capture the actual income generated through exploitation of the transferred intangibles, unrelated to development phase costs. Nevertheless, the literature argues that this is not incompatible with a mere claw-back intention, as the commensurate-with-income standard purportedly may better address mismatch concerns due to the difficulty in iden353. The 20-year rule was found in Treas. Regs. § 1.367(d)-1T(c)(3). 354. This is consistent with the cost-sharing regulations; see Treas. Regs. § 1.482-7(g) (2)(ii)(A) and § 1.482-7(g)(4)(viii), Examples 1 and 7. 355. From and including the first year in which the US transferor takes into account such income. 356. Aksakal et al. (2013), at p. 13.

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tifying R&D costs for those specific intangibles that are successfully developed.357 While the author finds this argument somewhat alluring, it is not convincing. Section 367(d) goes further than simply clawing back US R&D deductions; it captures the entire intangible value transferred.

3.5.6. Income recognition under section 367(a) or (d) for intangible transfers? The US transferor may now apply IRC section 367(d) to a transfer of intangibles that otherwise would be subject to IRC section 367(a).358 The taxpayer is, in other words, given a choice between immediate income recognition under section 367(a) and deferred income recognition under section 367(d). This is new, as non-936 intangibles could not be assessed under section 367(d) under the previous regulations. To implement this taxpayer choice (as well as the removal of the foreign goodwill exception), the definition of intangibles that applies for the purpose of section 367(a) and (d) was revised in 2015. The new definition encompasses both 936 intangibles and property to which a US person applies IRC section 367(d) in lieu of applying IRC section 367(a).359 The IRS reasoning for this election is that it does not have the authority to force taxpayers to apply IRC section 367(d) (and thereby the commensurate-with-income standard) to intangibles that fall outside the 936 definition. In connection with the finalization of the 2016 regulations, taxpayers requested that the regulations provide certainty that taxpayers would be permitted to treat goodwill and going concern value as non-936 intangibles, subject to section 367(a) and not 367(d). The IRS refused to take a clear position on this issue. The answer is, in the author’s view, clear. Section 367(d) applies only to 936 intangibles. Residual intangible value, such as, inter alia, foreign goodwill and going concern value, is not encompassed by the pre-2018 version of the 936 definition. There is no legal basis for objecting to taxpayer treatment of non-936 intangibles under section 367(a). 357. Ibid., at p. 14. 358. Treas. Regs. § 1.367(a)-1(b)(5), in 80 FR 55568-01. The IRC sec. 367(d) treatment must be applied consistently for all controlled transfers with respect to such items of property. 359. Treas. Regs. § 1.367(a)-1(d)(5), in 80 FR 55568-01. A similar definition will be used for the purpose of implementing Notice 2012-39 (IRB 2012-31) on outbound transfers of intangibles in certain asset reorganizations. Odintz et al. (2017), at sec. 2.2.2.2, are under the impression that the definition may exceed the IRS’s authority, as it may require compensation for intangible items that fall outside the sec. 936 definition.

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Whether taxpayers will choose income recognition under section 367(a) or (d) will likely depend on the circumstances. The entire value of the residual intangible must be recognized immediately upon transfer under section 367(a). A valuation must be performed to estimate this value, based on the probable future income generated by the intangible. This may lead to high values and corresponding high immediate taxation. The IRS will likely take a critical view towards taxpayer valuations. An upside for taxpayers will be that the income recognition under section 367(a) is a one-off event with no future follow-up obligations. Section 367(d), on the other hand, offers taxpayers a significant deferral benefit, entailing a lower present value of the tax obligation as compared to the situation under section 367(a). However, the commensurate-with-income standard applies under section 367(d), requiring that the income recognized must correspond to the actual income generated by the intangible over the 20-year period, triggering risk of subsequent periodic adjustments.360 As taxpayers must report income over the 20-year period, section 367(d) also entails considerable follow-up obligations subsequent to the transfer.

3.5.7. The further relationship between profit allocation under sections 482 and 367 The material content of the profit allocation rules used to determine the amount of taxable income for all outbound intangible transaction types are, in principle, the same under US law, regardless of whether the transfer is structured as an actual sale, licence or CSA directly subject to section 482, or as a section 351 or 361 exchange subject to section 367. Thus, the fair market value necessary to calculate any gain under section 367(a), as well as the determination of the annual deemed royalty amounts under section 367(d), relies on the transfer pricing methods under section 482.361 This “catch all” application of the arm’s length standard is further accentuated by the 2015 regulations clarifying the application of the arm’s length standard and the best-method rule with other IRC provisions (including IRC section 367), where the overarching principle is that arm’s length compensation must be provided for all intra-group value transfers independent of the form or character of the controlled transaction.362 There are, however, 360. See ch. 16 for a discussion of the US periodic adjustment authority. 361. See Treas. Regs. § 1.367(d)-1T(c)(1) for royalty payments and § 1.367(d)-1T(g)(5) with respect to the determination of the fair market value of the transferred intangible. 362. Treas. Regs. § 1.482-1T(f)(2)(i)(A).

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some nuances with respect to the application of the section 482 profit allocation rules in the context of section 367, which deserve to be mentioned. First, the form of payment rules are flexible under section 482, allowing royalty, lump sum, instalment and contingent payments. In contrast, section 367(d) restricts the form of payment to periodic deemed royalty payments over a 20-year period (reflecting in total the full value of the intangible) or to immediate recognition of the entire gain if the intangible is transferred out of the group. These differences do not affect the profit allocation as such (i.e. the amount of income to be recognized), but only how and when this amount shall be recognized. The deemed royalty under section 367(d) will, as mentioned, give the taxpayer a beneficial present value effect. Under section 482, it must be assumed that the taxpayer will often opt for deferred treatment in the form of royalty, instalment or contingent payments. This will “smooth the difference” between the form-of-payment rules of sections 482 and 367(d) in practice. Second, none of the section 482 exemptions from the periodic adjustment authority under the commensurate-with-income standard are specifically mentioned in the section 367(d) regulations.363 It has been questioned whether they are applicable under section 367(d).364 The asserted relevance of the question is due to the observation that the US transferor remains taxable on the appreciated value if he disposes of the intangible, regardless of whether the gain is due to factors that could not reasonably have been anticipated at the time of the transfer. The author doubts whether the question is justified. The deemed section 367 considerations are treated as royalty-like contingent payments based on actual profits, typically determined either through the CPM or the profit split method.365 The recognized income will not be restricted to the profits that were possible to estimate at the time of transfer. The exceptions to the commensurate-with-income standard, which generally turn on the degree of discrepancy between the profits that could reasonably be estimated at the time of the transfer and the subsequent actual profits,366 are therefore not meaningful 363. For an analysis of the US periodic adjustment authority, see sec. 16.3. 364. See Blessing (2010a), Part D, 1, a). 365. It has been suggested that the “contingent upon the productivity” language appearing in the original statute in 1982 and 1984 was rendered duplicative, or at least unnecessary, when the commensurate-with-income standard was added to IRC secs. 367(d) and 482 in 1986. 366. See the analysis of the exceptions from the US periodic adjustment authority in sec. 16.3.3.

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in the context of section 367. Had section 367 instead prescribed a gain calculation based on the estimated value of the intangible at the time of transfer and the subsequent actual profits had indicated that the transfer price was set too low, the periodic adjustment authority could have been applied in a sensible way. That, however, is not the case. The author therefore fails to see that the exceptions to the standard are relevant in the context of section 367(d). Third, there are some nuances between section 482 and section 367(d) with respect to basis recovery. Under section 482, the basis will be deductible against the amount realized upon disposition.367 The deemed royalty construction under section 367(d) does not allow the US transferor to deduct his basis in the transferred intangible,368 as the full amount of the deemed payment received must be included in the gross income.369 Thus, if the taxpayer has a basis in the transferred intangible, the result of the section 367(d) deemed sale construction will be less favourable than a section 482 sale. The author does not find any indications in the legislative history that this inconsistency was intended.370 He cannot see any good reason as to why the transferor should not be able to recover his basis over the useful life of the intangible. Fourth, section 367(d) gains are not subject to section 453A interest charges, resulting in a potential deferral benefit under section 367(d) compared to the treatment under section 482. Fifth, as touched upon above, prior to 1997, there was a disadvantage connected to section 367(d) transactions (compared to licence transactions under section 482) in the sense that the deemed royalty inclusions were ineligible for foreign tax credits under the then-current sourcing rule. The 1997 revision removed the requirement to treat the deemed royalty income as US-source income.371 The royalty is now considered foreign-source to the extent that an actual payment made by the foreign corporation under 367. IRC sec. 1001(a). This is subject to the instalment method rule in IRC sec. 453, under which the income recognized for any taxable year from a disposition is the proportion of the payments received in that year that the gross profit bears to the total contract price; see IRC sec. 453(c). 368. The only circumstances in which the transferor recovers his original basis in the intangible are where (i) he disposes of his stock in the transferee corporation to a third party (Treas. Regs. § 1.367(d)-1T(d)(1)); and (ii) the transferee corporation disposes of the transferred intangible to a third party (Treas. Regs. § 1.367(d)-1T(f)(1)(i)). 369. Treas. Regs. § 1.367(d)-1T(c). 370. See also Blessing (2010a), at part D, 4, b). 371. See the Taxpayer Relief Act of 1997 (P.L. 105-34), which amended subparagraph (c) of IRC sec. 367(d)(2) to read as follows: “[…] any amount included in gross income by reason of this subsection shall be treated as ordinary income.”

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a licence or sale agreement would be treated as foreign-source income.372 Prior to this amendment, taxpayers generally chose section 482 licence structures over outbound section 367(d) transfers.373 The main problem for taxpayers with section 367(d) transactions is the likelihood that the deemed royalty payments will not be deductible under the domestic law of the foreign jurisdiction. The author sees this as more of a consequence of the relevant domestic law than a necessary feature of section 367(d). In light of the above, it should be acknowledged that the most important differences between the tax treatment of intangible transactions governed by sections 482 and 367 lie not in the profit allocation rules themselves, but rather in subordinate consequences pertaining to the treatment of the recognized income, in particular the differences in basis deductibility when calculating US income and the probable lack of local deductibility for deemed section 367 royalty inclusions when calculating foreign income. These differences may, seen in isolation, incentivize taxpayers to structure intangibles transfers as section 482 transactions, i.e. as a licence, sale or CSA. As discussed above (in section 3.5.4.), however, there has been a trend towards structuring outbound intangibles transactions as section 367 transfers, geared at classifying the transferred intangibles as residual intangible value (goodwill) to escape taxation under the ATB exception. Now, subsequent to the 2016 narrowing of the ATB exception and the removal of the foreign goodwill exception, it remains to be seen whether multinationals will retain their historical interest in migrating US intangibles by way of section 367.

3.5.8. The relationship between profit allocation under the section 482 cost-sharing regulations and section 367(d) 374 Qualified CSAs have historically been popular legal vehicles for migrating valuable US-developed intangibles using “below full value” buy-in valuations, thereby escaping US taxation on significant parts of the true intan372. IRC sec. 367(d)(2)(C); see also ibid. 373. In terms of the context of this revision, the pre-1997 rule was intended to discourage outbound intangible transfers, but the enhanced information reporting requirements included in the Taxpayer Relief Act of 1997 made it unnecessary to uphold this rule. See the discussion in Congressional Record (107th Congress), V. 147, P.T. 20, 19 Dec. 2001-3 Jan. 2002. 374. It should be noted that the author’s comments in this section refer to the terminology of the US cost-sharing regulations in Treas. Regs. § 1.482-7. He refers to his analysis in sec. 14.2.7. (with further references) for an elaboration of these concepts.

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gible value. The current 2009 section 482 cost-sharing regulations,375 with their highly developed pricing methods, based on the realistic alternatives available to the controlled parties, seem to be effective in curtailing these practices.376 As a result, US-based multinationals– at least until September 2015, when the new proposed section 367 regulations were issued – have seemed to focus their efforts on migration of US-developed intangibles through, inter alia, section 367 transactions in an attempt to avoid the valuation principles of the CSA regulations.377 Put plainly, the CSA pricing methodology, where the go-to methods (the income method and the RPSM) rely on aggregated DCF valuations, will generally yield a higher price for a transferred group of intangibles than stand-alone pricing of each transferred intangible based on the ordinary specified pricing methods (which undoubtedly apply under section 367(d)). Thus, in theory, it could be possible for a multinational to attain a “valuation rebate” by avoiding the CSA pricing methodology through a section 367(d) transfer.378 The author will analyse the CSA pricing methods later in the book.379 The question at this point is whether they are applicable to value section 367(d) intangibles transfers that are connected or similar to a CSA. This is relevant when intangibles are transferred for the purpose of serving as the basis for further research, e.g. when a US multinational transfers its R&D branch to a foreign corporation or transfers its intangibles in a section 367(d) transfer to subsequently use them as platform contributions via the foreign transferee to a CSA. The economic substance of such transactions may lie closely to that of CSAs, in the sense that ownership to – and thus entitlement to residual profits from – US-developed intangibles are migrated to foreign group entities. It is clear that a section 367(d) intangibles transfer as such is not a CSA and that the pricing methods of the CSA regulations therefore cannot be used (section 367(d) intangibles transfers fall outside the scope of the CSA regulations).380 The issue is whether the CSA pricing methods may be applied analogically.

375. Treas. Regs. § 1.482-7. 376. See Sheppard (2011), who assumes that CSAs are no longer being used for profit shifting purposes due to the new rules. 377. Another popular migration method is the contribution of intangibles to partnerships with foreign related entitles as partners; see the comments infra n. 388 and n. 390. 378. See also Reams et al. (2005), at sec. V. 379. See ch. 14 on CSAs. 380. The IRC sec. 367(a) regulations state that “a person’s entering into a cost-sharing arrangement under § 1.482-7 or acquiring rights to intangible property under such an

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The regulations were clarified on relevant points in September 2015, when the IRS and the Treasury, concurrently with the issuance of the new section 367 regulations, issued new temporary and final regulations clarifying the application of the arm’s length standard and the best-method rule under section 482.381 Particularly relevant in the current context is the requirement that all value provided in controlled transactions must be compensated at arm’s length without regard to the form or character of the transaction.382 For this purpose, the entire arrangement must be considered, as determined by the contractual terms, whether written or imputed in accordance with the economic substance of the arrangement. Further, there is a new requirement for a coordinated best-method analysis of two or more controlled transactions to which one or more provisions of the IRC or regulations apply. The point is to ensure that that the overall value transferred, including any synergies, is properly taken into account.383 The new 2015 rules target, inter alia, speculative controlled transactions that seek to reduce the arm’s length compensation amount through the use of section 482 and section 367 to different parts of what is, in economic substance, the same transaction. A key point of these new rules is that outbound section 367 transfers of limited rights in US-developed intangibles combined with a subsequent R&D arrangement between the US and foreign group entities (e.g. contract R&D) – where the substance of the entire set of transactions resembles a CSA – must be valued in the aggregate based on the best realistic alternatives of the controlled parties so that all value transferred is reflected in the consideration (as opposed to separate pricing of the IP transfer and the subsequent R&D arrangement), regardless of the legal form.384 A notable aspect of the 2015 rules is that they only address the requirement for arm’s length pricing as such and not the particular pricing methodology that should be applied. The CSA pricing methods should be applied to determine the valuation of section 367(d) transactions, where their economic substance is akin to CSAs. arrangement shall not be considered a transfer of property described in section 367(a) (1)”; see Treas. Regs. § 1.367(a)-1(d)(3). It follows from the cost-sharing regulations that shares in the transferee cannot be used as a buy-in payment. 381. 80 FR 55538-01. See the author’s comments on these provisions in the context of (i) the best-method rule in sec. 6.4.; (ii) aggregated valuation in sec. 6.7.2.; and (iii) intra-group R&D services (contract R&D arrangements) in sec. 21.4. 382. Treas. Regs. § 1.482-1T(a)(i)(A), as added by 80 FR 55538-01. 383. Treas. Regs. § 1.482-1T(a)(i)(C), as added by 80 FR 55538-01. 384. See Treas. Regs. § 1.482-1T(a)(i)(E), Examples 6, 7 and 8.

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Nevertheless, it is a problem that valuations under IRC section 367(d) in principle should be restricted to taking into account only section 936 intangibles.385 For US intra-group IP transactions carried out before 2018 and thus assessed under the pre-2018 version of the US IP definition, this will typically exclude residual intangibles, such as workforce in place, which tends to be a part of the intangible value transferred through CSA transactions. However, the new 2015 section 367 regulations, which narrowed the application of the ATB exception and removed the foreign goodwill exception, effectively “override” the section 936 definition restriction in the sense that all intangible transfers under section 367 now are taxable either on a current gain recognition basis under section 367(a) or on a deferred deemed royalty basis under section 367(d), leaving residual intangibles open for taxation in the context of section 367 transfers. Likewise, the 2009 cost-sharing regulations circumvent the section 936 definition restriction in the context of CSAs through the design of the calculation of the buy-in amount. Nevertheless, the author finds that an analogical application of the CSA pricing methodology will likely be the only option that will yield an arm’s length profit allocation in transactions combining sections 482 and 367. These methods are specifically designed to capture the value transferred when intangibles are made available to related parties for the purpose of further research. Also, the income method,386 the hallmark of which is to allocate the entire residual profits to the US transferor, will, in the author’s view, generally provide the most reliable profit allocation result in these cases, as the non-routine development contributions come from the US entity alone. There is also a clear link between the emphasis of the realistic alternatives available for pricing purposes in the new 2015 regulations on the application of the arm’s length standard and the income method of the 2009 costsharing regulations.387 This also aligns with the recent IRS approach to the valuation of transfers of US-developed intangibles by a US partner to 385. See the discussion of the US intangibles definition applicable under IRC secs. 482 and 367 in sec. 3.2. 386. Treas. Regs. § 1.482-7(g)(4). See the analysis in sec. 14.2.8.3. 387. The author’s view correlates with that of the IRS; see IRB 2012-12. Further, the preamble to the final cost-sharing regulations envisions that the aggregated valuation approach of the buy-in pricing methods should be applied to reflect the “combined effect of multiple contributions”, including controlled transactions “outside of the CSA (for example, make-or-sell licenses, or intangible transfers governed by section 367(d))”, if an aggregated valuation would yield the most reliable measure of an arm’s length result. See 76 FR 80082-01, Explanation of provisions, sec. A.

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a partnership with foreign controlled partners (an alternative tax planning approach to section 367 transfers that is currently popular among US-based multinationals), which is linked to the CSA methodology, in particular, the income method.388 New regulations were issued in 2017 on transfers of certain property by US persons to partnerships with related foreign partners.389 The IRS is of the view that section 482 applies to controlled transactions that fall under the new regulations, and will likely apply the income method valuation approach for such transfers.390 In light of the above, the author concludes that the CSA pricing methods should be applicable by analogy to pricing section 367(d) transfers if the economic substance of the controlled transaction is akin to that of a CSA. This conclusion is strengthened by the 2017 tax reform codification (contained in the last sentence of IRC section 482) of the aggregated valuation approach based on the best realistic alternatives of the controlled parties.391

3.6. Controlled intangibles transfers subject to transfer pricing under the OECD TPG The transfer pricing methods and the intangible ownership rules set out in the 2017 OECD TPG will allocate profits to any group entity that, in controlled transactions, has contributed functions, assets or risks to the development, enhancement, maintenance, protection or exploitation (DEMPE) of intangibles.392 These OECD allocation rules are triggered if intangible value is transferred intra-group, regardless of how the transfer was structured contractually. Thus, the same material allocation norms govern profit allocation in:393 − transactions in which an intangible is sold;394 − transactions in which an intangible is licensed;395

388. This overrides the non-recognition provision in IRC sec. 721; see 2015-34 I.R.B. 210. See also the comments in 2014-42 I.R.B. 712 on inversions and related transactions. 389. TD 9814. 390. See the preamble to TD 9814. See also IRB 2015-34; Tax Notes Intl., 24 Aug. 2015, at p. 646; Tax Notes Intl., 14 Sept. 2015, at p. 942; and Sheppard (2015). 391. As a way of background for the codification, see JCX-51-17, at pp. 236-237. 392. OECD TPG, at para. 6.75. 393. See Lagarden (2014), at p. 333, for a discussion of different types of IP transactions. 394. OECD TPG, at paras. 6.88-6.91. 395. Ibid.

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Concluding comments

− cost-sharing transactions;396 and − business transfers that include intangibles.397 This makes the delineation of the scope of the OECD guidance much clearer – and far less problematic – than the intricate interplay between sections 482 and 367(d) for outbound intangible transfers under US law. For instance, even though the guidance on cost-sharing agreements and valuations is contained in different chapters of the OECD TPG, the material profit allocation turns on the same principles. A taxpayer will therefore gain nothing by structuring an intra-group IP transfer as a cost-sharing transaction as opposed to a sale. The OECD rules are neutral with respect to transaction forms.

3.7. Concluding comments The purpose of this chapter was to explore the extent to which the US and OECD transfer pricing rules are limited by intangibles definitions and provisions that regulate specific intra-group transaction types through which intangibles are transferred. The US and OECD rules represent opposite approaches. The US intangibles definition and specific IP transaction provisions are complex and, in principle, restrict the application of the transfer pricing methodology, a problem which is significant under the pre-2018 version of the US IP definition. Such restrictions do not facilitate a neutral tax system, as they put pressure on the classification and valuation of intra-group intangible transfers. While US law still links the application of the transfer pricing methods and the intangible ownership provisions to a positive definition of intangibles, the 2017 tax reform has amended the definition to include residual intangibles. This will ensure taxation of such IP when transferred intra-group from and including 2018. This amendment of the law is most welcome, but it would likely have been even better to remove the reference to the intangibles definition from IRC sections 367 and 482, thereby entirely freeing the transfer pricing methodology of any potential unnecessary constraints and enabling arm’s length profit allocation for all intangible value. The US approach departs significantly from the relatively straightforward (and neutral) approach taken by the OECD, which requires that all intra396. OECD TPG, at ch. 8. 397. OECD TPG, at paras. 6.92-6.103.

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group IP value transfers are priced as unrelated parties would have done. The OECD approach is not cluttered by arbitrary constraints in the form of a restrictive intangibles definition or provisions that require special treatment for certain forms of IP transfers. This is commendable and should serve as a blueprint for the design of domestic transfer pricing law solutions. The problems illustrated by the pre-2018 version of the US intangibles definition raise the question of whether it is at all sensible to link transfer pricing methodology to a restrictive intangibles definition. In the author’s view, it is not. All intra-group transfers of intangible value should be subject to arm’s length pricing, regardless of whether the transferred value qualifies under an ultimately arbitrary definition. Of course, an intangibles definition may possibly aid in the identification of transferred intangible value, but the same will be sufficiently ensured by a thorough delineation of the actual transaction. The benefits of linking a definition of intangibles to the transfer pricing methodology are unclear, but the dangers are not. As long as such a link exists, taxpayers will have an incentive to classify intangibles as falling outside the definition, thereby escaping transfer pricing. This can be avoided by doing as the OECD has done: removing the link. Both the United States and the OECD should, however, go a step further. Focus should be set on developing the distinction between routine and nonroutine value chain contributions, as it indeed plays a truly significant role in ensuring arm’s length profit allocation.

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Chapter 4 Introduction to Part 2 Operating profits from IP value chains are allocated in two steps under Internal Revenue Code (IRC) section 482 in US law and article 9 of the OECD Model Tax Convention (OECD MTC). The operating profits must first be allocated among the different value chain inputs. This process is governed by transfer pricing methodology, which will be analysed in this part of the book. For instance, say that a Norwegian subsidiary of a USbased multinational performs routine distribution functions and licenses a patent from an Irish group entity in connection with its local sales of a blockbuster drug. The role of the transfer pricing method here is to allocate the profits from the Norwegian sales among the value chain inputs, i.e. the Norwegian routine distribution functions and the Irish-owned patent. Assume that the Norwegian profits are 100 and that the transfer pricing methods indicate that an arm’s length return to the subsidiary is 20. The residual profits of 80 are allocable to the Irish patent. The next step is to allocate the residual profits assigned to the patent among group entities. This second step is governed by the IP ownership provisions in the US regulations and the OECD Transfer Pricing Guidelines (OECD TPG), which are analysed in part 3 of the book. The author’s analysis of the transfer pricing methodology should be seen in the context of the principal model.398 The model is contingent on successful migration of ownership to unique intangibles developed in high-tax countries to a group entity resident in a jurisdiction with low or no taxation (or a favourable intangible property (IP) regime), in the sense that the full value of the IP is not taxed on the way out of the jurisdiction in which it was created. Otherwise, there would be no point in the structure. The 2017 OECD TPG on contractual allocations of risk,399 valuation techniques400 and hardto-value intangibles,401 as well as the 2009 US cost-sharing regulations,402 are responses that seek to ensure that the allocation of operating profits

398. See the discussion in sec. 2.4. 399. See sec. 6.6.5.5. 400. See ch. 13. 401. See sec. 13.3.5. with respect to the consequences of unreliable valuation parameters, as well as the discussion of the new 2015 OECD guidance on periodic adjustments in sec. 16.5. 402. See ch. 14.

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from IP is aligned with value creation by requiring taxation of the full IP value on the way out. Further, the principal model creates tension between local market jurisdictions in which sales are made and routine functions are carried out, on the one hand, and the jurisdiction in which IP ownership is located, on the other. The reason is that the residual profits will be extracted from the former jurisdictions and allocated to the latter. The question here is of how low the normal “routine” return allocable to the market jurisdictions can be set under the current pricing methodology (in particular, the comparable profits method (CPM) and transactional net margin method (TNMM)). The lower this return is, the larger the residual profits (which may be extracted from source) will be. Market jurisdictions now object to the sparse level of operating income afforded to them. Their view is that they should be entitled to something more. Even though the OECD has issued new guidance on the allocation of incremental operating profits generated by location savings, local market characteristics and multinational enterprise (MNE) synergies, it may be challenging to accommodate these jurisdictions under the prevailing transfer pricing methodology, given that no unique IP (know-how, customer relationships, etc.) can be identified in these jurisdictions that may attract a portion of the residual profits. The author will begin his analysis with a discussion of the historical development of the so-called “profit-based” pricing methodology.403 Due to increased difficulties in addressing controlled IP transactions (that resulted in profit shifting) under the traditional, transaction-based pricing methods of the 1968 US regulations in the 1970s and 1980s, a 1986 tax reform amending IRC section 482 was carried out, with subsequent studies forming the platform for new and more effective pricing methods. This eventually resulted in the 1994 US regulations, introducing two specified profitbased pricing methods: (i) the CPM; and (ii) the profit split method (PSM). These methods were quickly incorporated, with some modifications, into the OECD TPG. In light of this historical discussion, the author analyses the current US and OECD transfer pricing methodology relevant to IP value chains. He begins by analysing metaconcepts underlying the US and OECD transfer pricing methodologies to facilitate the subsequent discussions of the particular methods.404 He discusses the relationship between the concept of operating 403. See ch. 5. 404. See ch. 6.

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profits and the transfer pricing methods, the relationship between gross and net profit methods, the selection of an appropriate transfer pricing methodology, the concept of the arm’s length range, the concept of comparability and the aggregation of controlled transactions. He then moves on to discuss the core workings of the current US and OECD transfer pricing methodology. His focus is on how the amount of residual profits allocable for unique and valuable IP employed in the value chain should be determined. First, he discusses how this residual profit amount can be determined directly under the traditional, transaction-based US and OECD comparable uncontrolled transaction (CUT) method.405 After this, he discusses how the residual profit amount alternatively can be determined indirectly through the one-sided US and OECD profit-based methods, i.e. the US CPM and its OECD counterpart, the TNMM.406 His key focus here will be on comparability problems. Next, he discusses how the residual profit amount allocable to a unique IP alternatively can be determined directly under the two-sided profit-based US and OECD PSM.407 The 2017 OECD guidance on the allocation of incremental operating profits due to location savings, local market characteristics and MNE synergies and on the application of the transfer pricing methods in the “post-BEPS” era will then be analysed.408 Further, he discusses the US and OECD rules governing the use of unspecified methods.409 The rest of part 2 of the book is dedicated to analysing particular applications of the transfer pricing methodology. The author discusses the 2017 OECD TPG on IP valuation,410 the 2009 US regulations and the 2017 OECD TPG on cost-sharing arrangements (CSAs),411 as well as taxpayer initiated compensating adjustments and periodic adjustments under US law and the OECD TPG.412 The allocation of IP profits under article 7 of the OECD MTC to a permanent establishment that contributes intangible value chain inputs will be discussed in chapter 17.

405. 406. 407. 408. 409. 410. 411. 412.

See ch. 7. See ch. 8. See ch. 9. See ch. 10 and ch. 11, respectively. See ch. 12. See ch. 13. See ch. 14. See ch. 15 and ch. 16, respectively.

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Part 2

Chapter 5 The Historical Development of ­ Profit-Based Transfer Pricing Methodology 5.1. Introduction The question in part 2 of the book is how to determine the amount of operating profits allocable for unique intangible property (IP). As such, an asset will generally not produce profits on a stand-alone basis, but will be one of several inputs to an intangible value chain designed by the multinational to bring products or services to the global marketplace. The question of the transfer pricing of intangibles is really a question of how the operating profits from the relevant value chain (i.e. from the sale of an end product in different countries) shall be distributed among the group entities that contribute the different value chain inputs, including the unique intangibles. The transfer pricing methodology under US and OECD law governs – and restricts – this allocation process, thereby distributing the profits among the contributing group entities, and thus also among the jurisdictions in which these entities are resident for tax purposes. The material content of the transfer pricing methodology therefore has significant impact on how the profits of multinationals are allocated among jurisdictions. In this chapter, the author will discuss how the US and OECD transfer pricing methodology has evolved over the last decades. The chapter will serve as a lead-in to, and will provide context for, the analysis of the current transfer pricing methodologies in chapters 7-16. The common theme throughout this chapter is that historical experience has demonstrated that there are severe practical problems associated with applying the three traditional transfer pricing methods (the comparable uncontrolled transaction (CUT) method, the resale price method and the cost-plus method) used for the purpose of allocating operating profits from intangible value chains. In the United States, these problems lead to the development of alternative – and more substance-based – profit-based methodologies (methods that allocate net profits to a group entity based on its contributions of functions, assets and risks). Through case law, the profit split method (PSM) was developed, and the US Internal Revenue Service (IRS) designed the so-called “contract manufacturer theory” for profit al125

Chapter 5 - The Historical Development of Profit-Based Transfer Pricing Methodology

location to “routine” group entities (this development is discussed in section 5.2.). These two methodologies would, over time, go on to become highly influential methods for allocating profits to intangibles in international transfer pricing. A step along this path was when the methodologies were implemented into US transfer pricing legislation. The 1986 US tax reform and the process towards implementing the methodology into the 1994 Treasury Regulations are discussed in section 5.3. The methodology was hesitantly incorporated into the OECD Transfer Pricing Guidelines (OECD TPG) in its 1995 revision, and has since gained a central role among the transfer pricing methods accepted by the OECD. This is discussed in section 5.4.

5.2. Development of the US PSM and the contract manufacturer theory through case law 5.2.1. Introduction In this section, the author discusses early US transfer pricing case law on intangibles. These seminal cases were decided under the 1968 regulations and formed the basis for the development of the profit-based transfer pricing methods, i.e. the comparable profits method (CPM) and PSM, which today enjoy a dominant position in international transfer pricing. Essential methodological concepts, in particular the idea that routine value chain inputs should only be allocated a normal market return and that residual profits could be allocated among unique value chain contributions according to their relative values, were developed here. This case law remains relevant, as it illustrates the application of a profit allocation methodology significantly similar to that in the current regulations. It also provides useful analogies for the resolution of current profit allocation problems. The author will refer extensively to these cases throughout his analysis of the current regulations. He has systematized the case law into three groups. First, cases pertaining to inbound intangibles transfers (in which the IP ownership resides with a foreign group entity) are discussed in section 5.2.3. Second, cases pertaining to outbound intangibles transfers (in which IP ownership resides with a US group entity) are discussed. The first group of outbound cases pertains to the transfer of ownership to valuable USdeveloped intangibles to foreign subsidiaries under non-recognition provisions from the late 1960s to the early 1980s. These are discussed in

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section 5.2.4. The second group of outbound cases pertains to “roundtrip transactions”.413 These are discussed in section 5.2.5. Third, there are cases pertaining to the allocation of intangible profits through services and sales contracts. Even though these cases were single instances and not part of an identifiable tax-planning trend, they are illustrative. A brief discussion is provided in section 5.2.6. Seen together, the cases that the author has selected paint a picture of courts struggling with the application of the CUT-based pricing methods of the 1968 regulations, thereby resorting to an alternative profit-based technique, i.e. the PSM. The cases contribute significantly to understanding the background of the 1986 US tax reform, in which the commensurate-with-income standard was introduced and which would eventually result in the 1994 final regulations, introducing the CPM and the PSM as specified transfer pricing methods. Before beginning the case law analysis, it is necessary to tie some comments to the profit allocation rules under the 1968 regulations.

5.2.2. The 1968 regulations and their background414 For more than 30 years prior to the issuance of the 1968 regulations, no significant changes were made to the US transfer pricing rules.415 In the early 1960s, concern had spread as to whether the rules were being properly enforced.416 The US Congress initiated a process to investigate how the foreign business activities of US-based multinationals were taxed, both through their direct presence abroad through permanent establishments 413. Roundtrips were arrangements in which foreign subsidiaries were established to manufacture products based on US-developed intangibles to sell them back to US entities at high market prices for resale to the end customers in the United States. The residual profits were shifted from the United States to the foreign subsidiaries through low royalty payments for the licensed intangibles. 414. On the 1968 US regulations, see, in particular, Culbertson et al. (2003). See also Avi-Yonah (1995); Bischel (1973); McCawley (1990); and Duerr (1972). 415. On the history of US Internal Revenue Code (IRC) sec. 482, see supra n. 95. 416. See Miyatake et al. (1994) for a comprehensive discussion of the historical development. The 1960s saw attention directed at US-based multinationals that operated within the oil industry. The US Internal Revenue Service’s (IRS’s) focus was on the profit allocation of these multinationals to low-tax countries. In the 1970s, the focus shifted to the question of whether these multinationals were entitled to foreign tax credits, which resulted in foreign tax credit regulations. See Exxon Corp. v. CIR, T.C. Memo. 1993-616 (Tax Ct., 1993), affirmed by 98 F.3d 825 (5th Cir., 1996), certiorari denied by 520 U.S. 1185 (S.Ct., 1997), pertaining to an IRC sec. 482 reallocation of profits from crude oil sales.

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(PEs) and through foreign subsidiaries.417 In 1966, the Treasury, in cooperation with the IRS, issued proposed regulations.418 The final regulations were issued in 1968.419 The standard to be applied to determine an arm’s length profit allocation under the 1968 regulations was the amount that would have been paid by an unrelated party for the same IP under the same circumstances.420 Thus, the 1968 regulations required exact or inexact CUTs for the pricing of controlled intangibles transfers, at least as the point of departure. If no CUTs were available, the 1968 regulations prescribed a broad pricing assessment in which a list of 12 factors should be taken into consideration “in arriving at the amount of the arm’s length consideration”.421 This provision was often referred to as the “fourth method” under the 1968 regulations, or simply as the “12-factor list”. The factors were as follows: (1) prevailing industry rates; (2) offers of competing transferers; (3) terms of transfer; (4) uniqueness of the property; (5) degree and duration of protection afforded to the property; (6) value of services rendered by the transferer to the transferee in connection with the transfer;

417. In 1962, the US Congress deliberated on a proposal to introduce formulary methods to allocate income from transactions in tangible property among related enterprises where no comparable uncontrolled prices were available; see H.R. Rep. No. 87-1447 (1962), at p. 28 (reprinted in 1962-3 CB 405). The proposal was rejected, but the conference committee recommended that the US Treasury develop new transfer pricing regulations that provided additional guidance; see H.R. Rep. No. 87-2508, at 18-19 (1962), reprinted in 1962-3 CB 1129, 1146. In 1963, the United States addressed location savings reaped by US-based multinationals that moved manufacturing activities to Puerto Rico to take advantage of low labour costs and tax holidays; see Rev. Proc. 63-10. This was one of the first US attempts to tackle the profit shifting of multinationals; see the discussion in sec. 34.1. 418. The chain of regulatory development was as follows: the 1965 notice of proposed rulemaking (30 FR 4256); the 1966 proposed regulations (31 FR 10394); and the 1968 final regulations (33 FR 5848). 419. 33 FR 5848. Pankiv (2017), at p. 33, asserts that the 1968 US regulations “are an example of how domestic law and regulations can depart from the general arm’s length principle”. The author finds this assertion to be unclear, as profit allocations carried out under the pricing methodology of the 1968 regulations obviously would qualify as arm’s length. 420. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(d)(2)(ii). 421. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(d)(2)(iii).

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(7) prospective profits to be realized by the transferee through its use or transfer of the property; (8) capital investment and start-up expenses required of the transferee; (9) availability of substitutes for the property transferred; (10) arm’s length rates and prices paid by unrelated parties when the property was resold or sublicensed; (11) costs incurred in the transfer or in developing the property; and (12) any other fact or circumstance that unrelated parties would have been likely to consider in determining an arm’s length price. The IRS and the courts made active use of this 12-factor list, as it enabled effective allocation of arm’s length profits for intangibles in the absence of CUTs. The list only provided high-level guidance, resulting in leeway with respect to its application. This provided fertile breeding ground for the courts to develop new transfer pricing methodologies, as they indeed did with the PSM. The downside to the list was that it did not ensure uniform profit allocations, leading to unpredictable transfer pricing outcomes. The 12-factor list has a modern-day parallel in the “unspecified transfer pricing methods” under current US regulations and the OECD TPG,422 which allow discretionary profit allocation solutions as long as they align with the overarching arm’s length principle.

5.2.3. Three inbound cases: Nestlé, French and Ciba 5.2.3.1. Introduction In sections 5.2.3.2.-5.2.3.4., the author discusses three cases pertaining to inbound intangibles transfers. Either directly or indirectly, the question was whether the royalties paid by US group entities for the use of foreignowned intangibles were at arm’s length under IRC section 482. The cases discussed are Nestlé Co., Inc. v. CIR in section 5.2.3.2.,423 R. T. French Co. v. CIR in section 5.2.3.3.424 and Ciba-Geigy Corp. v. CIR in section 5.2.3.4.425

422. See the analysis of unspecified transfer pricing methods in ch. 12. 423. Nestlé Co., Inc. v. CIR, T.C. Memo. 1963-14 (Tax Ct., 1963). 424. R. T. French Co. v. CIR, 60 T.C. 836 (Tax Ct., 1973), distinguished by 1977 WL 191022 (IRS TAM, 1977), 1979 WL 56002 (IRS TAM, 1979) and 1992 WL 1354859 (IRS FSA, 1992). For recent comments on the ruling, see, e.g. Navarro (2017), at p. 244. 425. Ciba-Geigy Corp. v. CIR, 85 T.C. No. 11 (Tax Ct., 1985), acquiescence recommended by AOD-1987-21 (IRS AOD, 1987) and acq. 1987 WL 857882 (IRS ACQ, 1987).

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5.2.3.2.  Nestlé (1963) At issue in Nestlé was whether royalties paid by a US licensee to foreign group licensers for manufacturing and marketing intangibles (patents, know-how and trade name) were deductible as ordinary business expenses under IRC section 23(a)(1)(A).426 Thus, Nestlé did not pertain to a section 482 reallocation, but the theme for assessment was significantly similar to that under IRC section 482.427 The intangibles required for the manufacturing and sales of Nescafé and related products were owned by other group entities, mainly resident in Switzerland, where research and development (R&D) was carried out. For the period under review (the income years 1947-1952), the US licensee paid annual royalties ranging from 7% to 10% on its US sales, limited to a maximum of one third of its net profits. The royalties paid equalled a profit split of two thirds to the US licensee and one third to the foreign licensers. During the late 1930s and the early 1940s, the US licensee incurred significant marketing expenditures to build the local value of the Nescafé brand through marketing. The marketing expenses incurred by the US licensee in 1947-1952 were approximately 33% larger than the royalties paid by the US licensee in the same period. The IRS disregarded the licence agreement and treated the payments as non-deductible dividend distributions from the US licensee.428 The court looked closely at the reasonableness of the outbound royalty payments. The highly profitable US sales of Nescafé grew rapidly in the early 1940s, mainly as a result of the then-unique quality of the product and the marketing efforts of the US licensee. When significant sales materialized, the group revised the US licence agreement for Nescafé. In 1941, it was decided that the US licensee was to pay 5% royalties on its US Nescafé sales. 426. Now IRC sec. 162(a). 427. The agreements would be valid and enforceable if they were fair and reasonably judged by the standards of a transaction entered into by parties dealing at arm’s length; see Granberg Equipment, Inc. v. CIR, 11 T.C. 70479 (Tax Ct., 1948); and Differential Steel Car Co. v. CIR, 16 T.C. 41388 (Tax Ct., 1951). 428. The reallocation was based on several arguments: (i) the controlled licence agreements lacked clauses commonly found in third-party licence agreements; (ii) there was an incentive to choose royalty over dividend payments because of the income tax deductibility of the former type of payment; (iii) group entities usually did not enter into licence agreements; (iv) the agreements were lengthy (over the remaining 14-year life of the Nescafé patent); and (v) the US licensee (in the late 1940s, when the technology, encompassed by the licence agreement, had become common knowledge) should have repudiated the licence agreements and entered into the business on its own.

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Only a year later, it was agreed to increase the royalty substantially, to between 7-10% of sales, limited to a total of one third of the US net profits. The US Tax Court reviewed whether the revision was warranted. It found the profitability of US Nescafé sales largely to be a result of the continuing R&D efforts made by the foreign licenser and that this development warranted a higher royalty. The Court stated that “as long as the amount of the royalty paid was commensurate with the value of the benefits received and was reasonable we would not be inclined to, nor do we think we would be justified to, conclude that the increased royalty was something other than what it purported to be”.429 The author is not aware of any earlier transfer pricing case law that established a principle of proportionality between actual profits related to an intangible and royalties to be paid. In this respect, Nestlé is the seminal case. The decision did not, however, provide much further guidance on the content of the principle. The only legal guidance to be deduced from the ruling is that an increase in profits should generally be followed by an increase in royalties. Significant room was thus left for the taxpayer to adapt its transfer pricing to changes in profits. Further, the author finds it curious that the significance of the US marketing expenditures was not assessed more closely, as they undoubtedly increased the local value of the manufacturing and marketing intangibles. It could be argued that at least part of the expenditures should have been seen as outbound royalty payments or dividend distributions. Alternatively, it could be argued that the US distribution entity had developed local marketing intangibles that entitled it to residual profits.430

5.2.3.3.  French (1963) At issue in French was whether royalties paid by a US licensee to a related UK licenser were at arm’s length under IRC section 482. The IRS denied deductions for outbound royalty payments for the income years 1963 and

429. The Court found that the value of the patents licensed to Nestlé was evidenced by the US profitability (which went from sales of USD 16 million in 1938 to USD 111 million in 1952, and accumulated profits of USD 31 million after royalties in the period of 1939-1952), of which the US subsidiary retained approximately two thirds, despite the increase in royalties. Based on a broad assessment, the Court found the royalties paid to be reasonable for the tested income years. 430. See the analysis of the allocation of profits from intra-group-developed marketing intangible property (IP) under US law in ch. 23.

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1964, based on the view that the US licensee did not receive any benefits in return for its royalty payments.431 The factual pattern was that in 1946, a process (including patents and technical know-how) for making mashed potatoes was licensed from a UK licenser to a US licensee. Under the agreement, the US licensee received the exclusive make-sell rights for mashed potatoes in the United States for the 21-year duration of the patent protection, as well as rights to technical advice and know-how transfers from the United Kingdom. Originally, the royalty rate was set to 3% of the US sales.432 In the early phase of the licence agreement, all R&D was carried out in the United Kingdom, and the US production process followed the patent description closely. The UK licenser shared information relating to developments in the production process with the US licensee. Gradually, the process was improved through US production experience, and the US licensee began performing its own R&D. It was not disputed that the royalty was at arm’s length at the time at which the agreement was entered into.433 The IRS’s argument was that the US licensee did not receive any significant benefits in return for its royalty payments to the UK licenser in the 17th and 18th income years covered by the agreement. The IRS claimed that the process described in the original 1946 agreement was now widely understood in the food industry and therefore had little value left. It also claimed that the US licensee had, by 1963-1964, developed its own research capability and made the results of 431. A peculiar point is that French had little fiscal importance, as almost all US profits were repatriated to the United Kingdom through dividend payments. The royalty payments were insignificant. The author assumes that the case was followed through Tax Court litigation because of the potential precedential value of the question at issue. 432. The licence agreement was altered in 1956 and 1960, when the royalty rate was lowered to 2%. 433. First, a third party owned a significant portion of the UK licenser company at that time. This in itself made profit shifting from the wholly owned US company to the partially owned UK company unlikely. In DHL Corp. & Subsidiaries v. CIR, T.C. Memo. 1998-461 (Tax Ct., 1998), affirmed in part, reversed in part by 285 F.3d 1210 (9th Cir., 2002), the taxpayer also argued that the presence of a third party in price negotiations ensured the arm’s length character of the price. DHL is distinguishable from French in that the third party in DHL was only concerned about the total price for a comprehensive package of assets (shares and rights in a trademark). The third party in DHL was indifferent as to how the taxpayer allocated the total package price among the purchased assets. Second, the UK licenser in French also licensed the same mashed potato process to an unrelated company in France, under a non-exclusive licence for a royalty of 5% of local sales. The unrelated company thus paid more for less, compared to the US licensee. Neither factor left much doubt that the agreement was at arm’s length at the outset.

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this process available to the UK licenser without receiving any royalties in return. The most interesting aspect of the case is how alterations in the balance of the controlled parties’ value chain contributions subsequent to the formation of a long-term licence agreement should be treated for transfer pricing purposes. The court found it inappropriate to view the income years of 1963 and 1964 in isolation, as the royalties paid then were not necessarily compensation for value received in those particular years.434 This observation was based on comparing the royalty payments with the value of the parties’ contributions over the duration of the agreement as a whole as opposed to viewing each income period separately with respect to the value exchanged between the parties. The logic applied by the court seems to be that the UK licenser provided most of the value in the first part of the duration of the agreement by making available the patent and know-how, training US employees and supervising newly established factory processes in the United States, which eventually enabled the US licensee to perform its own research and make improvements to the mashed potato process. In the later stages, the US licensee performed most of the functions, incurred the most risk (research) and controlled the significant asset in the relationship (know-how for the improved process). The shift in functions and risks between the parties seemed mainly enabled by the platform established by the contributions of the UK licenser in the early stages of the agreement. Over the course of 14 years, from 1948 to 1961, the yearly royalty rate paid by the US entity was between 2-3%. Thus, the royalty rate charged by the UK licenser did not vary much depending on the activity performed by him. In the author’s view, it is, to some degree, natural that the relative lack of compensation in stages in which the UK licenser performed the greatest part of the functions was made up for by relative overcompensation in periods in which the UK licenser performed fewer functions. It is, however, not obvious that the holistic reasoning of the Tax Court was correct. First, it could not possibly be clear at the time at which the agreement was entered into that there would be a change of functions performed and risks assumed by the contracting parties over the duration of the agreement. This must particularly be the case for the core performance elements 434. Further, the Tax Court found no reason to believe that an unrelated party in the UK licenser’s position would have allowed the US licensee to avoid its obligation to pay royalties prior to the expiration date of the agreement.

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of the agreement. After all, the agreement was that the UK licenser was to supply the US licensee with the process, not the other way around. The best estimate of the activity to be rendered by the contracting parties over the life of the agreement, foreseeable at the outset, was presumably the required performance as codified in the agreement itself. As royalties were to be paid yearly, it is tempting to deduce from this that the royalty payments were to correspond to a yearly provision of performance by the UK licenser. Second, given that the US licensee performed its own research, which eventually led to a process different from the one described in the licensed patent, it seems likely that the improved process was a new intangible, distinguishable from the licensed process. The new intangible, even if based on the old process, would likely not be covered by the existing agreement, since it was technically different from the patented process and developed and funded by the US licensee. Income should then be allocated to the US licensee pursuant to section 482 as consideration for making the new asset available to the UK licenser.435 This would be more in line with legal and economic realities.436 Third, the view of the Tax Court was one-sided, as it stated that “there is no reason to believe that an unrelated party would have permitted petitioner to avoid its contractual obligations at any time prior to the expiration date of the 1946 and 1960 agreements”. The focus was on whether the agreement turned out to be beneficial for the UK licenser and whether a third party would willingly surrender such a beneficial legal position. The obvious response from the perspective of the US entity would be to ask if an unrelated party would be willing to share its manufacturing intangibles free of charge, which seemed to be exactly what the US licensee did in the later stages of the agreement. The author finds that unlikely.437 Fourth, when the actual conduct of unrelated contracting parties over time deviates from their codified agreement, the likely explanation must be that 435. This line of reasoning would presumably be more consistent with the intellectual property law treatment of the US process pursuant to the third amendment of the agreement, where reference to the original patent had been removed because the actual process deviated from the patent description. 436. The new process would likely qualify as a separate intangible. See the discussion of the US IP definition in sec. 3.2. 437. The fact that the new process represented value for the UK entity was acknowledged by the Tax Court, which stated that “in later years, to be sure, MPP (through Chivers) derived substantial benefits from petitioner’s own considerable research efforts”.

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they have entered into a modified agreement consistent with their actual performance. The court did not assess this rather obvious question, likely due to the one-sided perspective of the review. The core question in French, i.e. whether a transfer pricing review of a long-term licence agreement with fixed pricing should consider each period within the duration of the agreement separately or as a whole, was fundamental. The perhaps somewhat formalistic stand assumed by the Court offered rich tax-planning opportunities for multinational enterprises (MNEs). In essence, French would shield non-arm’s length transfers of intangibles from reassessments, as long as the taxpayer could prove that the agreement was at arm’s length at the outset.438

5.2.3.4.  Ciba (1985) The issue of limiting US income tax deductions for outbound royalty payments also arose in Ciba with respect to payments from a wholly-owned US licensee to a Swiss parent licenser for US make-sell rights to agricultural products.439 The IRS denied deductions in full and reclassified the payments as deemed dividend payments subject to US withholding tax.440 The principal assertion of the IRS was to impute a cost-sharing agreement (CSA) between the US licensee and the Swiss licenser, under which the former was entitled to residual profits, based on the observation that the US licensee had been involved in a joint R&D effort with the parent company. The court rejected this argument, as there was no evidence supporting any significant R&D contribution from the US subsidiary, nor had it agreed to share any costs or benefits in relation to the R&D activities. Further, the IRS claimed that the agreed royalty rate of 10% had to be adjusted downwards to 6%.441 As no CUTs were available, the court rejected the assertion 438. The 1986 US tax reform specifically addressed and rejected the result of French by introducing the commensurate-with-income standard, under which, periodic adjustments are to be carried out in each income year to ensure that the income from intangibles is commensurate with the profits generated by them; see sec. 5.3.3. The author also refers to the discussion of periodic adjustments in ch. 16. 439. Ciba-Geigy Corp. v. CIR, 85 T.C. No. 11 (Tax Ct., 1985), acquiescence recommended by AOD-1987-21 (IRS AOD, 1987) and acq. 1987 WL 857882 (IRS ACQ, 1987). For a discussion of the case, see, e.g. Wittendorff (2010a), at p. 645; and Brauner (2008), at p. 134. 440. At least to the author’s knowledge, at the time at which the case was filed with the Tax Court in August 1985, it was the largest transfer pricing reallocation to be tried before a US court. 441. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(d)(2).

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based on the 12-factor list in the 1968 regulations,442 taking into account royalty offers that the parent company had received from competing licensees, prevailing rates in the industry and required capital investments and start-up costs for the licensee.443

5.2.4. Three outbound cases: Eli Lilly, Searle and Merck 5.2.4.1. Introduction In sections 5.2.4.2.-5.2.4.5., the author discusses three transfer pricing cases litigated in the 1980s and early 1990s involving significant reallocations of residual profits. The cases pertained to structures where high-value, USdeveloped intangibles had been transferred tax-free under non-recognition provisions to related Puerto Rican subsidiaries.444 Eli Lilly and Company and Subsidiaries v. CIR is discussed in section 5.2.4.3.,445 G.D. Searle & Co. v. CIR is discussed in section 5.2.4.4.446 and Merck & Co., Inc. v. CIR is discussed in section 5.2.4.5.447 The first two cases, in particular, Eli Lilly, are relevant to the interpretation of the profit split method of the current US regulations. The third case (Merck) did not result in a reallocation of residual income, but the author includes a modest discussion of it, as it, in his view, should have resulted in a profit split, and is therefore relevant as an analogy in discussions of the profit split method. Before beginning the discussion, the author will provide a brief overview of relevant background law pertaining to US investments in Puerto Rico in section 5.2.4.2.

442. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(d)(2)(iii). 443. Thus, the entire reallocation of approximately USD 23 million fell. 444. The transfers were carried out under IRC sec. 351 as non-taxable contributions to the capital of the involved subsidiaries. For an informed analysis of transfer pricing issues in this context, see O’Brien et al. (2007). 445. Eli Lilly and Company and Subsidiaries v. CIR, 84 T.C. No. 65 (Tax Ct., 1985), affirmed in part, reversed in part by 856 F.2d 855 (7th Cir., 1988). 446. G.D. Searle & Co. v. CIR, 88 T.C. 252 (Tax Ct., 1987). 447. Merck & Co., Inc. v. U.S., 24 Cl.Ct. 73 (Cl.Ct., 1991). The Court of Claims decision was rendered in 1991, but the case pertained to the income years 1975 and 1976 and was decided under the 1968 Treas. Regs. (33 FR 5848). Hence, the author finds the case relevant for the discussion of case law prior to the 1986 US tax reform.

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5.2.4.2. The historical tax treatment of investments in US ­possessions448 US multinationals with business activities in US possessions were originally subject both to federal corporate income tax and taxes levied by the US possession.449 To encourage US investments into possessions and to remove the competitive disadvantage of such investments relative to foreign direct investment (FDI) in the United States by foreign companies,450 Congress exempted business income earned by US companies in a possession from US federal income tax by enacting IRC section 931.451 Local taxation in possessions was also generally beneficial.452 The result was zero taxation of the profits earned by possession subsidiaries, as long as they were not distributed to the US parent as dividends.453 Accumulated profits were often reinvested abroad by the possessions subsidiaries.454

5.2.4.3.  Eli Lilly (1985) Eli Lilly is a landmark transfer pricing case for several reasons.455 First, the court in Eli Lilly developed an allocation pattern for the profit split method, in which the residual profits were divided among the controlled 448. The term “US possession” refers to a specific geographic territory under the jurisdiction of the United States for which the US Congress has decided that the US Constitution is to be applied to the territory’s local government and inhabitants in the same manner as it applies to the local governments and residents of the states of the United States (examples include Puerto Rico and the US Virgin Islands). 449. See sec. II of the Tariff Act of 1913 (Ch. 16, 38 Stat. 166); and the Revenue Act of 1918 (Ch. 18, 40 Stat. 1058). 450. See H. Rept. No. 350, 67th Cong., 1st Sess. 1 (1921), 1939-1 C.B. (Part 2) 168, 174. 451. IRC sec. 931 had its origin in the Revenue Act of 1921, which exempted income from US companies operating within a US possession; see the Revenue Act of 1921, sec. 262, Ch. 136, 42 Stat. 271. The provision was re-enacted without material change in 1928 and 1954 (see, respectively, sec. 251 of the Revenue Act of 1928, Ch. 852, 45 Stat. 850; and sec. 931 of the IRC of 1954, Ch. 736, 68A Stat. 162). The first material change of the provision was made in 1976, when Congress substituted it with an equally favourable tax credit regime; see IRC sec. 936; and the Tax Reform Act of 1976, Pub. L. 94-455, 90 Stat. 1643. 452. In particular, in Puerto Rico, where special investment incentive programmes were put into place. 453. See IRC sec. 246(a)(2)(B). 454. Congress altered the dividends-received deduction in 1976 in order to encourage the multinationals to invest their possession profits in the United States. 455. Eli Lilly and Company and Subsidiaries v. CIR, 84 T.C. No. 65 (Tax Ct., 1985), affirmed in part, reversed in part by 856 F.2d 855 (7th Cir., 1988). On Eli Lilly, see, in particular, Brauner (2008), at p. 136. See also Wittendorff (2010a), at p. 754.

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parties according to the relative value of their intangible value chain contributions. This method would later become highly influential in both US and international transfer pricing jurisprudence, and is now, alongside the US CPM and the OECD TNMM, the de facto profit allocation method for residual profits. Second, Eli Lilly marked the beginning of the IRS’s “contract manufacturer” litigation stance, pursuant to which a group licensee that merely contributed routine inputs to the value chain should not be allocated any residual profits, but receive a normal market return. Also, the contract manufacturer return theory would later become highly influential in US transfer pricing law through the proposed basic arm’s length return method (BARLM) of the 1988 White Paper and the CPM of the 1994 regulations, as well as in international transfer pricing law through the TNMM of the OECD TPG. Third, Eli Lilly was the first of three transfer pricing cases involving Puerto Rican subsidiaries to be litigated in the 1980s. In its time, with a reallocation of USD 71 million, it was the largest transfer pricing case litigated before a US court. The case supposedly also marked the start of a new approach by the IRS in developing big transfer pricing cases for reassessment and litigation, involving large multidisciplinary audit teams. In Eli Lilly, the patents and technical know-how connected to a top-selling drug in the 1960s US pharmaceutical market (the painkiller Darvon and its successor, Darvon-N) were transferred from a US parent company to a wholly owned Puerto Rican subsidiary. These intangibles represented the main value in the Darvon value chain, as the patent protected Eli Lilly from direct competition. The marketing intangibles connected to Darvon (the trade name and so forth) were not transferred. The US parent had developed the drug through its own costly R&D. The idea behind the restructuring was to transfer ownership of the manufacturing intangibles to the Puerto Rican subsidiary. The residual profits allocable for the manufacturing intangible would thus be taxable in Puerto Rico, not the United States. This profit allocation was operationalized through the prices charged for the finished drug from the Puerto Rican subsidiary to the US parent, which would then sell the drug to unrelated customers in the United States. The price was set so that the parent could recover its costs on marketing functions and earn a profit of 90-100% on those expenses. The residual profits allocated to the subsidiary were not subject to tax. The return position of the taxpayer was therefore that the 138

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residual profits from the US-owned marketing intangibles were also allocable to the Puerto Rican subsidiary. The reassessment allocated the entire residual profit (from both manufacturing and marketing intangibles) to the US parent. The Puerto Rican subsidiary was treated as a mere contract manufacturer and remunerated on a cost-plus basis. Thus, the taxpayer and IRS positions were extreme opposites. The principal IRS argument was that the IRC section 351 non-recognition transfer of the manufacturing intangibles was carried out to avoid federal income tax and resulted in a distortion of income for the US parent.456 The court found that IRC section 482 in principle could be used to disregard section 351 transfers in narrow circumstances, but that the factual pattern in Eli Lilly did not qualify for such treatment.457 Even as the Court was unwilling to disregard the intangibles transfer in and of itself, it did find that a section 482 reallocation could be made with respect to the subsequent pricing of goods. The view of the Court was that the controlled pricing of sales from the Puerto Rican subsidiary to the US parent did not allocate sufficient profit to the parent so that it could fund its R&D expenses. The IRS reallocation was, however, set aside because it did not afford any residual profits to the Puerto Rican subsidiary. The CUP, resale price and cost-plus methods of the 1968 regulations were found inapplicable due to a lack of CUTs. The court based its profit allocation on the PSM, which it, perhaps questionably, claimed support for in the 1968 regulations,458 as well as in case law, in particular PPG Industries Inc. v. CIR,459 Eli Lilly & Co. v. U.S.460 and Lufkin Foundry and Mach. Co. v. CIR.461 Distinguishing the Fifth Circuit reversal of 456. The IRS further argued that there was no good reason for the US parent company to transfer its highly valuable intangibles to a wholly owned subsidiary in Puerto Rico. The court rejected this “realistic alternatives” argument on the basis that transfer pri­ cing should be based on the transactions actually carried out by the parties. 457. See prior case law: National Securities Corp. v. CIR, 46 B.T.A. 562 (B.T.A., 1942), affirmed by 137 F.2d 600 (C.C.A.3, 1943), certiorari denied by 320 U.S. 794 (S.Ct., 1943); Southern Bancorporation v. CIR, 67 T.C. 1022 (Tax Ct., 1977); and Northwestern Nat. Bank of Minneapolis v. U.S., 1976 WL 1016, (D.Minn. 1976), affirmed by 556 F.2d 889 (8th Cir., 1977). 458. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(e)(1)(iii). 459. PPG Industries Inc. v. CIR, 55 T.C. 928 (Tax Ct., 1970). 460. Eli Lilly & Co. v. U.S., 372 F.2d 990 (Cl.Ct, 1967). 461. Lufkin Foundry and Mach. Co. v. CIR, T.C. Memo. 1971-101 (Tax Ct., 1971). In the first two cases, PPG Industries Inc. v. CIR and Eli Lilly & Co. v. U.S., the profit split method was only used to support a profit allocation carried out under other transfer pricing methods. In PPG, the court upheld the taxpayer’s comparable uncontrolled price (CUP)-based pricing of sales of from a US parent to a Swiss resale

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Lufkin, the Court found the transactional methods of the 1968 regulations “clearly inapplicable due to a lack of comparable or similar uncontrolled transactions” and that “some fourth method not only is more appropriate, but is inescapable”. The Court then went on to apply the PSM, in which the profits from sales of the Darvon drug for 2 of the income years under review were divided between the US parent and the Puerto Rican subsidiary.462 The PSM applied in Eli Lilly essentially consisted of two elements. First, each controlled party was allocated a normal market return on its functions. Thus, the US parent was allocated a return on its marketing functions, and the Puerto Rican subsidiary a return on its manufacturing activities. Due to the extreme profit associated with the Darvon value chain, these “normal” returns were generous.463 Second, the residual profits were allocated to the intangibles exploited in the Darvon value chain, i.e. the US-owned marketing intangibles and the Puerto Rican-owned manufacturing intangibles. Based on a broad assessment of the relative contributions of these intangibles to the profits from the Darvon drug, the court found that while the manufacturing intangibles were responsible for most of the profits, the marketing intangibles also were central to the value creation. On this basis, 45% of the residual profits were allocated to the US parent.

subsidiary, which split the profit with 55% to the United States and 45% to Switzerland. In Eli Lilly, the court upheld the IRS’s reallocation of profits from a distribution subsidiary to a parent company. Transfer prices on sales from the parent to the subsidiary were set low in order for the subsidiary to realize the bulk of the profits from final sales. In Lufkin, the IRS reallocated income from two export sales and service subsidiaries to a manufacturing parent company. The Tax Court rejected the comparable advocated by the IRS due to functional differences. The taxpayer pricing was accepted based on an overall assessment, the key factor of which was a profit split argument. On appeal, the Fifth Circuit rejected – in the author’s view, on a poorly founded basis – the Tax Court’s decision in Lufkin, holding that the transaction-based methods of the 1968 regulations required “evidence of transactions between uncontrolled” taxpayers. 462. For these 2 years, the patent protection for Darvon applied, and thus there were no comparables available. For the third year on review, the patent protection had expired and competitors had entered the market. Comparables were available for that year, and the CUP method was applied. 463. The parent company was afforded a 25% mark-up on its marketing functions. The Puerto Rican subsidiary received a 100% mark-up on its manufacturing functions. Location savings were exclusively allocated to the subsidiary, as the Court viewed the specific benefits of localization in Puerto Rico (low labour costs, tax holidays and so forth) allocable to the subsidiary only.

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In the author’s view, the profit split between the United States and Puerto Rico was surprisingly even (45/55), given that the manufacturing intangibles were the most valuable assets in the Darvon value chain for 2 of the 3 income years under review. The value of the marketing intangibles was, to some degree, contingent on the continued access to the Darvon patent. Regardless of this, the Court essentially divided the residual profits equally between the two groups of intangibles. The reasoning was not elaborated on. The logical allocation would have been to split the residual profit in proportion to the relative values of the marketing and manufacturing intangibles, which likely would have skewed the profit split further to the benefit of Puerto Rico. Eli Lilly was appealed, but the Court of Appeals upheld the allocation of the Tax Court with only minor adjustments. The most significant element in the Court of Appeals ruling was that it altered the Tax Court’s allocation of R&D expenses, which was an allocation that did not have a corresponding effect on the Puerto Rican subsidiary. The Court of Appeals seemed to have misunderstood this, as it stated: [T]he only cost increase for Lilly P.R. to which Lilly specifically objects on appeal is a charge to Lilly P.R. for general research and development expenses. Because we reject the Tax Court’s basis for allocating general research and development expenses to Lilly P.R., we uphold this objection. In all other respects we affirm the Tax Court’s cost adjustments.

Further, the Court of Appeals stated that “the Tax Court declined to resolve this issue in light of its substantial reallocation of general research and development costs to the subsidiary”. Both statements show that the Court of Appeals was under the impression that the Tax Court reallocated R&D expenses from the parent company to the subsidiary. That is incorrect. The Tax Court simply charged a portion of the general R&D expenses of the parent company to the Darvon profits of the parent. This reduced the combined net income of the two companies, and therefore ultimately also the profits allocated to the parent company under the PSM; the profits to be split became smaller as a result of the charging of general R&D costs. The consequence of the Court of Appeals’ position was, as far as the author can see, that the charging of general R&D costs to the profits of the parent had to be removed, increasing the total net profits of the two companies, and therefore ultimately also the amount of profits to be allocated to the parent company under the PSM.

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5.2.4.4.  Searle (1987) In Searle, a US pharmaceutical parent transferred self-developed manufacturing and marketing intangibles connected to established, high-profit products to a wholly owned Puerto Rican subsidiary.464 The factual pattern in Searle was distinguishable from Eli Lilly in that the subsidiary did not sell the finished drugs back to the parent, but instead sold directly to unrelated US customers.465 The question that Searle had in common with Eli Lilly was whether the Puerto Rican subsidiary should be regarded as the owner of the transferred intangibles for IRC section 482 purposes and thereby allocated the residual profits. The IRS argued that there was no business purpose behind the transfer and that an adjustment was necessary to correct the distortion of income. The IRS in essence disregarded the subsidiary’s ownership position and treated it as a contract manufacturer for profit allocation purposes. The Tax Court, Judge Wiles presiding,466 regarded the subsidiary as both the legal and economic owner of the intangibles, but found that unrelated parties, for the transfer of similar intangibles, would have demanded a lumpsum payment or a substantial share of the profits of the transferee or a royalty. The Court held that the transferred intangibles were of little value to the subsidiary without the marketing, administrative and regulatory services provided by the parent. Using its best judgement, the Court found that 25% of the subsidiary’s total net sales in 1974 and 1975 were to be allocated to the US parent. The result was arguably both suitable for the particular factual pattern in the case and reasonable. The Court, however, did not offer much in the way of reasoning for the chosen profit split. Also, the result seems incompatible with the fact that the court did find the subsidiary to be the legal and economic owner of all relevant intangibles. In light of Eli Lilly, where the profit split was decided by weighing the relative economic contributions and significance of intangibles owned by each contracting party, there should have been specific language addressing why the parent company was legally entitled to a share of the residual profits 464. G.D. Searle & Co. v. CIR, 88 T.C. 252 (Tax Ct., 1987). On Searle, see Brauner (2008), at p. 140. See also Wittendorff (2010a), at p. 646. 465. However, the parent company did provide sales and marketing services under a separate service agreement. 466. Wiles also wrote the Tax Court decision in Eli Lilly.

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when the company did not have any ownership interests in the intangibles in the income years under review. A key point in the profit allocation was what the Court deemed should have been done, not the actual transaction. On this point, the Court went against its own clear statements in Eli Lilly on basing transfer pricing on actual transactions. The ruling may, on this point, be seen as applying the now-established principle that controlled pricing must respect the pricing boundaries dictated by the realistic alternatives of the controlled parties.

5.2.4.5.  Merck (1991) In Merck, a US parent transferred manufacturing intangibles for established pharmaceutical chemicals to a wholly owned Puerto Rican subsidiary as contribution to capital in an IRC section 351 non-recognition transfer.467 Prior to the transfer, the subsidiary licensed these intangibles from the parent. All R&D for the transferred intangibles had been performed in the US by the parent since the 1950s. The subsidiary manufactured and sold the pharmaceutical product directly to foreign group companies for resale in non-US markets. Prior to the transfer, the subsidiary was dependent on three main contributions from the parent: (i) the manufacturing intangibles; (ii) concurrent R&D; and (iii) a marketing programme. The IRS found that the package of these three elements should be compensated with an annual 10% royalty payment from the subsidiary, pursuant to IRC section 482. The twist in Merck was that the IRS, in light of its failures in Eli Lilly and Searle, did not focus on the transferred manufacturing intangibles. Instead, it argued that the parent’s “other contributions”, in particular a marketing programme, were valuable enough to warrant a 7% royalty.468 In essence, the parent’s marketing was nothing more than the vertical integration of the Merck group. The marketing advantage of this structure was simply that every last bit of production by the Puerto Rican subsidiary was purchased by other group entities for resale in their local markets. 467. Merck & Co., Inc. v. U.S., 24 Cl.Ct. 73 (Cl.Ct., 1991). The value of the transferred intangibles was estimated to be USD 235 million in 1975. 468. The IRS viewed the transfer of ownership to the manufacturing intangibles largely as a formality, but the reassessment was based on the argument that the parent company supplied the subsidiary with marketing services that were separate from the transferred intangibles.

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Thus, the subsidiary, in reality, had no inventory or market risk. The subsidiary benefited from the network of companies within the Merck group, as well as the group’s planning and pricing mechanism. The IRS deemed this organizational or synergy value as an intangible owned by the parent company, which the subsidiary was obliged to pay for pursuant to IRC section 482.469 The Court found that for an element to be compensated as an intangible under the 1968 regulations, the element should have “substantial value as an independent property”.470 No contracts were in place that legally required other group entities to purchase products from the subsidiary. The fact that other group entities actually purchased products from the subsidiary was explained by the “group’s vertical integration and system of […] control”. The Court dismissed the assertion that the organizational structure in itself was an intangible for which compensation was required under IRC section 482, with the rationale that “the mere power to determine who in a controlled group will earn income cannot justify a Section 482 allocation from the entity that actually earned the income”. The reallocation fell as a result of the Court’s rejection of the synergy argument. Merck was therefore successful in shifting the entirety of the residual profits from the transferred manufacturing intangibles away from US taxation, resulting in zero taxation of that profit. The result of the ruling stands in contrast to that of Eli Lilly and Searle, which also involved non-recognition transfers of intangibles under IRC section 351. Of course, here, the IRS’s profit split assertion rested solely on the synergy argument. The author will not rule out that the Court may have been influenced by the fact that Merck, as opposed to Eli Lilly and Searle, did not involve sales to the United States of the product produced by the Puerto Rican subsidiary. This might have contributed to giving the factual pattern less of a roundtrip feel. Still, the result of Merck is pronouncedly difficult to reconcile with, in particular, Searle. In both cases, the parent company provided valuable services closely connected to the transferred intangibles, but only in Searle were the services rewarded with a cut of the residual profits.

469. See the discussion of the US IP definition in sec. 3.2. and the discussion of the allocation of incremental profits due to synergies under the OECD Model Tax Convention (OECD MTC) in sec. 10.7.3. 470. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(d)(iii). See the analysis of the US IP definition in sec. 3.2.

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5.2.5. Four roundtrip cases: Bausch, Sundstrand, Perkin and Seagate 5.2.5.1. Introduction By the mid-1970s, the IRS focus went beyond the typical Puerto Rican structures to more elaborate structures involving US-based multinationals with operations in Europe and Southeast Asia, where the manufacturing of products intended for sale in the US market were migrated to low-cost and tax-effective jurisdictions, typically Ireland or Singapore. The end products were shipped back to the United States for sale. Due to the “full circle” structure of these value chains, the transactions were referred to as “roundtrips”. These structures typically involved two legal instruments. First, a licence agreement was used to deploy the required intangibles from the US parent (IP owner) to a foreign manufacturing subsidiary. Second, a sales agreement was used to set the terms for the sale of finished physical products from the foreign subsidiary back to the US parent. Through the combination of low royalty payments for the outbound licensing and high prices for the inbound product sales, these instruments effectively allocated the residual profits from these value chains away from US taxation. Multinationals that undertook this type of reorganization would normally be indifferent towards the amount of profits allocated under each separate instrument, as the point would be the net result of both instruments, provided that each type of income was otherwise subject to the same tax treatment (withholding taxes, tax credits, etc.). Reassessments of roundtrip structures tended to hone in on the licensing agreement, where the issue would be whether the royalty rate was at arm’s length. The reason for this was that a multinational would normally be in a position where it could defend its sales price for the physical end product from the low-tax jurisdiction subsidiary to the high-tax jurisdiction parent due to comparable products. A high sales price into the United States would ensure that the residual profit was placed in the jurisdiction of the selling subsidiary. It would normally be more challenging to defend a royalty rate paid as compensation for the exploitation of a unique intangible, as there likely would be no CUTs available.

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In sections 5.2.5.2.-5.2.5.5., the author discusses four roundtrip cases litigated in the late 1980s and early 1990s.471 All cases resulted in profit splits, where the residual profits were split to provide a middle ground between the extremes of the IRS’s contract manufacturer theory and the tax-motivated allocations of the multinationals. The profit splits in these cases do not seem to follow any particular observable pattern, apart from, of course, avoiding one-sided extremes. Bausch & Lomb Inc. v. CIR is discussed in section 5.2.5.2.,472 Sundstrand Corporation v. CIR is discussed in section 5.2.5.3.,473 Perkin-Elmer Corporation v. CIR is discussed in section 5.2.5.4.474 and Seagate Technology, Inc. v. CIR is discussed in section 5.2.5.5.475

5.2.5.2.  Bausch (1989) In Bausch,476 a US parent licensed self-developed manufacturing and marketing intangibles for contact lenses to a wholly owned Irish subsidiary for an annual royalty of 5% of the subsidiary’s sales. The subsidiary manufactured the lenses in Ireland and sold them to the US parent and foreign group entities.477 The IRS deemed the Irish subsidiary as a contract manufacturer and attacked the transfer pricing under both the inbound sales agreement and the outbound royalty agreement. The argument was that the US parent would not have been willing to pay an unrelated party more for contact lenses than the cost of self-manufacturing. It was clear that the US parent could have manufactured the contact lenses itself domestically at a cost of USD 1.5 per contact lens, but instead chose to purchase lenses from its Irish subsidiary at a cost of USD 7.5. The IRS was indifferent as to whether addi471. Concerning income years from the late 1970s to the mid-1980s. 472. Bausch & Lomb Inc. v. CIR, 92 T.C. No. 33 (Tax Ct., 1989), affirmed by 933 F.2d 1084 (2nd Cir., 1991). 473. Sundstrand Corp. and Subsidiaries v. CIR, 96 T.C. No. 12 (Tax Ct., 1991). 474. Perkin-Elmer Corp. and Subsidiaries v. CIR, T.C. Memo. 1993-414 (Tax Ct., 1993). 475. Seagate Technology, Inc. v. CIR, 102 T.C. No. 9 (Tax Ct., 1994), acquiescence in result only recommended by AOD-1995-09 (IRS AOD, 1995) and acq., 1995-33 I.R.B. 4 (IRS ACQ, 1995). 476. Bausch & Lomb Inc. v. CIR, 92 T.C. No. 33 (Tax Ct., 1989), affirmed by 933 F.2d 1084 (2nd Cir., 1991). For discussions of the ruling, see Brauner (2008), at p. 142; Andrus (2007), at pp. 639-641; Wittendorff (2010a), at pp. 646 and 653-655; and Navarro (2017), at pp. 245 and 262. 477. Approximately 60% of the Irish production in the years under review was sold back to the US parent.

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tional profits were allocated to the United States through a decrease in the outbound product purchase price or an increase in the royalty, as long as the result was that the Irish subsidiary was allocated only a normal market return for its routine contributions to the value chain.478 The first question was whether the USD 7.5 lens purchase price was compatible with IRC section 482. The taxpayer offered third-party agreements supporting the USD 7.5 transfer price as evidence, which the court found sufficiently comparable to apply the CUP method, thereby rejecting the IRS’s argument that the price should be lowered to the USD 1.5 cost level, at which the US parent could have self-manufactured the lenses. The second question was whether the 5% royalty rate was sufficient. In the absence of comparable licensing agreements, the court turned to the 12-factor list of the 1968 regulations,479 pursuant to which the “prospective profits to be realized […] by the transferee through its use […] of the property” and “the capital investment and starting up expenses required of the transferee” could be taken into account. The extreme profits of the Irish subsidiary clearly made an impression. The Court deemed it necessary to adjust the royalty rate upwards from 5% to 20%, in effect constituting a split of the residual profits.480 Even after that adjustment, the Irish subsidiary was enormously profitable, with an internal rate of return of 27%. 478. The IRS claimed that the subsidiary in reality was guaranteed to sell all of its production intra-group and should thus not be entitled to high returns (as it had no price or volume risk). This resembled the synergy argument professed by the IRS in Merck & Co., Inc. v. U.S., 24 Cl.Ct. 73 (Cl.Ct., 1991). In Merck, however, the question was whether the marketing advantage of a vertically integrated multinational enterprise (MNE) structure was a separate intangible for which the US entity should receive additional income. In Bausch, the argument was turned upside-down: the focus was now on the foreign entity, and the question was whether it was entitled to abnormal profits, given its de facto risk-free market position. The Court found that the subsidiary only had “certain expectations as to the volume and price it could anticipate selling to” group entities and that such expectations did not constitute a guarantee that effectively insulated it from market risks. The Tax Court thus rejected the contract manufacturer argument, as there was no legal requirement for the US parent to purchase contact lenses from the Irish subsidiary. 479. Treas. Regs. (33 FR 5848) § 1.482-2(d)(2)(iii). 480. The Court distanced itself from the use of the actual profits in making its profit allocation by stating that “such information would not have been available in 1980 to a potential licensee negotiating a license agreement which was entered on January 1, 1981. The arm’s-length nature of an agreement is determined by reference only to facts in existence at the time of the agreement, R. T. French Co. v. Commissioner, 60 T.C. 836, 852 (1973)”. It relied on taxpayer estimates produced at the time at which the licence agreement was entered into, showing that the Irish subsidiary was likely to be highly profitable. Given this high level of earnings, the Court found that no independent party would have been willing to accept a royalty that would “preclude any reasonable

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In its assessment, the Tax Court chose a middle ground between the contract manufacturer assertion of the IRS, which placed all residual profits in the United States, and the taxpayer assertion, which placed almost all residual profits in Ireland. In particular, the Court placed weight on two elements. First, the Irish subsidiary was only exposed to a “moderate level of risk”, indicating entitlement to a smaller portion of the residual profits. Second, in third-party contexts, each party is usually in possession of some unique quality that makes a licensing relationship interesting for the other party. In this case, the US entity was in possession of all resources required, particularly as it owned both the manufacturing and marketing intangibles. The Irish subsidiary was, at first, not much more than a “cash box”, which would have given it a weak bargaining position when negotiating a licensing agreement at arm’s length. The Court found that an equal split of the residual profits between the US and Irish entities, equalling a royalty rate of 20%, left the Irish subsidiary with a generous cut of the intangible-related profits, given its moderate bargaining position. Given the reasoning of the Court, the author finds the result puzzling. It seems clear that all unique value chain inputs were provided by the US parent. It should therefore have been allocated the entire residual profits, in line with the IRS contract manufacturer assertion. The Irish subsidiary, as a routine functions provider, should have been allocated a normal market return on its contributions. Such a profit allocation, in the author’s view, would have been the result had the case been tried under the current rules, as the CPM then likely would have been applied.481

5.2.5.3.  Sundstrand (1991) In Sundstrand,482 a US high-tech company licensed manufacturing and marketing intangibles for an advanced aircraft component to a Singapore subsidiary. The royalty rate was set to 2% of the subsidiary’s sales. The parent company purchased all components manufactured by the subsidiexpectation of earning a profit through use of the intangibles”. In the author’s view, there was little reality in the Court’s reservation towards using actual profits for the purpose of determining the profit split. The transferred intangibles were fully developed and proven, and the projected profits did not seem to vary noticeably from the actual profits. 481. The same result would also follow from the transactional net margin method (TNMM) in the context of the OECD MTC. 482. Sundstrand Corp. and Subsidiaries v. CIR, 96 T.C. No. 12 (Tax Ct., 1991). On the ruling, see Brauner (2008), at p. 145. See also Wittendorff (2010a), at p. 647.

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ary at the market catalogue price minus a 15% discount. The IRS argued that the subsidiary should be regarded as a contract manufacturer and remunerated on a cost-plus basis. The Tax Court dismissed the argument. First, with respect to the sales agreement, the Court accepted the catalogue-based transfer price, with a minor adjustment of the discount. Second, with respect to the royalty pricing, the Court found no CUTs,483 and therefore went on to consider the 12-factor list of the 1968 regulations.484 It used licence agreements that the parent had entered into with third parties as its point of departure, generally requiring a royalty around 6%. The Court adjusted the royalty upwards, due to specific benefits bestowed upon the subsidiary in the licensing contract, including the benefit of entering a virtually risk-free market and using the parent’s marketing intangibles. Based on an overall assessment, the Court adjusted the royalty rate from 2% to 10%, which was, in effect, a split of the residual profits.485

5.2.5.4.  Perkin-Elmer (1993) In Perkin-Elmer,486 a US parent in the high-tech industry established a wholly owned subsidiary in Puerto Rico to manufacture specialized analytical instruments, accessories and lamps. The parent licensed its manufacturing and marketing intangibles to the subsidiary in exchange for a 3% royalty on the sales of the subsidiary.487 The subsidiary purchased the components necessary for its production from the parent, and the parent purchased the finished products from the subsidiary. The IRS reallocated USD 30 million in income to the United States for the income years under review, based on the contract manufacturer theory, leaving the subsidiary with only a normal market return.488 With respect to the product pricing, the Court did not find the taxpayer’s proposed benchmark transactions sufficiently comparable to apply the re483. The agreements differed in, inter alia, scope of rights licensed, differences in territorial sales restrictions, cost allocation for technical assistance and extension fees. 484. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(d)(2)(iii). 485. Technical assistance provided by the parent company was remunerated on a separate basis. 486. Perkin-Elmer Corp. and Subsidiaries v. CIR, T.C. Memo. 1993-414 (Tax Ct., 1993). For a discussion of the ruling, see Brauner (2008), at p. 149. 487. The licensed intangibles included the right to manufacture the products in Puerto Rico, worldwide sales rights and the rights to all necessary information and knowhow on current and future licensed products. 488. The reallocation used the cost-plus method to allocate income to the subsidiary. The contract manufacturer argument was abandoned by the Commissioner pre-trial.

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sale price method to the sale of finished products from the subsidiary to the parent company.489 The transactions were, however, sufficient to convince the Court that the prices charged fell within the arm’s length standard.490 With respect to the royalty pricing, the parties agreed that a licence agreement that the parent company had entered into with a third party could be used as a comparable under the 1968 regulations. The Court adjusted the royalty rate up from 3% to 7.5%, increasing the profit split in favour of the United States.491

5.2.5.5.  Seagate (1994) In Seagate,492 a US high-tech parent established a wholly owned subsidiary in Singapore to manufacture and sell hard drives. The parent licensed manufacturing (and some marketing) intangibles necessary for the production and sale of the drives for a royalty of 1% of the subsidiary’s US sales. The subsidiary sold finished drives and components back to the parent company at cost plus 25%.493 The IRS reallocated USD 38 million in total taxable income to the parent for the income years under review based on the assertion that the royalty rate paid by the subsidiary should be adjusted upwards to 3%. Seagate argued that the subsidiary had low earnings, equalling approximately only a profit margin of 20-30% on costs, and could therefore not sustain a higher royalty payment. The essence of Seagate’s argument was that the licensed 489. See the resale price method in the 1968 Treas. Regs. (33 FR 5848) § 1.482-2(e) (3). 490. See the discussion of the arm’s length range in sec. 6.6.1. 491. The adjustment only encompassed the sale of instruments; no adjustment was made to the pricing of lamps. 492. Seagate Technology, Inc. v. CIR, 102 T.C. No. 9 (Tax Ct., 1994), acquiescence in result only recommended by AOD-1995-09 (IRS AOD, 1995) and acq., 1995-33 I.R.B. 4 (IRS ACQ, 1995). For comments, see also Wittendorff (2010a), at p. 648. 493. The structure also involved other agreements. In particular, there was marketing (a 5% commission fee for the subsidiary), procurement services (reimbursement by the subsidiary of the parent’s procurement costs), cost sharing (50/50 split between the parent and subsidiary for research and development (R&D) costs for the agreed cost base) and warranty reimbursement agreements in place between the parent and the subsidiary. The Court did not find the 50/50 cost-sharing split to be in accordance with the 1968 Treas. Regs. (33 FR 5848) § 1-482-2(d)(4) on cost sharing because it was expected that the subsidiary would likely benefit the most from the US R&D activities, since most of the production was moved to Singapore (only high-performance, lowcost, low-labour-intensive production would remain in the United States). The Court discretionarily adjusted the cost-sharing split to 25% for the parent and 75% for the subsidiary.

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hard drive intangibles did not yield residual profits, as they did not provide efficient protection from competitors. In order to make profits, the subsidiary relied on cost-efficient manufacturing. With respect to the pricing of the subsidiary’s sales of finished products to the parent, the Court found no CUTs. In accordance with Sundstrand 494 and the 12-factor list of the 1968 regulations, the Court went on to find a best estimate for the price. Even though the subsidiary’s sales transactions with unrelated parties were not comparable, the Court used these transactions as a baseline for further assessment, as it had previously done in Bausch and U.S. Steel Corp. v. CIR.495 The subsidiary had been subject to pressure from its third-party customers to reduce prices, which it had done. It had not, however, performed a corresponding reduction in its sales price to the parent. Based on this, the Court concluded that the arm’s length price for the sale of finished products to the parent was the lowest of the prices actually charged and the average of prices to unrelated customers. Also in reviewing the royalty rate, the Court found no CUTs,496 and therefore based its allocation on the 12-factor list.497 First, the Court found that a royalty rate higher than 1% was necessary in order for the parent company to recover its R&D costs. Second, the parent had made valuable marketing intangibles available to the subsidiary. Seagate was a worldleading manufacturer of hard drives with established global markets for its products. The subsidiary therefore had a market ready and waiting for its products. The Court also found that some compensation was justified for the loss of US sales due to direct sales from the subsidiary to former US customers. Based on the transactions presented to the Court, it found that a royalty in the 3-5% range was appropriate. Due to risks assumed by the subsidiary, such as the age of the transferred intangibles, the volatility of the hard drive market and the absence of cross-licensing provisions, the Court discretionarily set the royalty rate at 3%, entailing an indirect profit split.

494. Sundstrand Corp. and Subsidiaries v. CIR, 96 T.C. No. 12 (Tax Ct., 1991). 495. See Bausch & Lomb Inc. v. CIR, 92 T.C. No. 33 (Tax Ct., 1989), affirmed by 933 F.2d 1084 (2nd Cir., 1991); and U.S. Steel Corp. v. CIR, T.C. Memo. 1977-140 (Tax Ct., 1977), reversed by 617 F.2d 942 (2nd Cir., 1980), and nonacquiescence recommended by AOD-1980-179 (IRS AOD, 1980). 496. See 1968 Treas. Regs. (33 FR 5848) § 1.482-2(d)(2)(ii). 497. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(e)(1)(iii).

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5.2.6. Two cases on controlled services and sales contracts: DuPont (1979) and Hospital Corporation of America (1983) E.I. Du Pont de Nemours and Co. v. the United States is fundamentally a case on the allocation of intangible profits.498 It pertained to sales of proprietary raw materials from a US chemical parent to its Swiss subsidiary. R&D and manufacturing of the raw materials was carried out in the United States. The Swiss subsidiary was used as a sales hub. Also, sales to non-European regions were routed through Switzerland. The subsidiary was to provide technical sales services and marketing functions. One of the motivations behind the structure was to shift profits away from US taxation by selling raw materials from the parent at a low price. The lion’s share of the profit was allocated to Switzerland upon the resale of raw materials to unrelated customers around the world at the high market price. The IRS performed a considerable reallocation, in total USD 18 million, based on a discretionary profit split under the 12-factor list,499 allocating a significant portion of the residual profits to the United States. The Court accepted the IRS reallocation without much hesitation, no doubt in part due to the fact that even subsequent to the reallocation, the profits of the subsidiary were among the highest 4% of functionally comparable companies. In Hospital Corporation of America v. Commissioner,500 a successful US parent, which owned and managed a range of domestic hospitals, entered into a lucrative contract to manage a hospital in Saudi Arabia in the early 1970s via a Cayman Islands subsidiary. The Tax Court assessed the allocation of profits from the management contract to the US parent based on three alternative legal grounds. First, the IRS argued that the profits should be allocated to the US parent directly by disregarding the subsidiary’s ownership of the contract on the basis that it was a sham corporation. Secondly, the IRS argued that the management contract, as a taxable value, had been transferred from the US parent company to the foreign

498. E.I. Du Pont de Nemours and Co. v. U.S., 1978 WL 3449 (Cl.Ct., 1978), adopted by 221 Ct.Cl. 333 (Ct.Cl., 1979), certiorari denied by 445 U.S. 962 (S.Ct., 1980), and judgment entered by 226 Ct.Cl. 720 (Ct.Cl., 1980). 499. 1968 Treas. Regs. (33 FR 5848) § 1.482-2(e)(1)(iii). 500. Hospital Corporation of America v. CIR, 81 T.C. No. 31 (Tax Ct., 1983), nonacquiescence recommended by AOD- 1987-22 (IRS AOD, 1987) and Nonacq. 1987 WL 857897 (IRS ACQ, 1987). For a discussion of the ruling, see, e.g. Wittendorff (2010a), at pp. 657-658 and 755.

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subsidiary, thereby triggering a taxable charge. These arguments were rejected by the Court. Third, the IRS argued that the US parent had rendered services and made intangibles (know-how, management systems, network and goodwill) available to the foreign subsidiary, for which it should have received arm’s length compensation. The Tax Court accepted this argument, as it found that the parent owned intangibles that indeed were made available to the subsidiary. The result was that 75% of the residual profits from the management contract were allocated to the United States through a profit split.

5.3. US legislative and regulatory implementation of “profit-based” methods 5.3.1. Introduction In this section, the author comments on the legislative and regulatory process that led to the 1994 section 482 regulations, which form the bulk of the current rules relevant to the allocation of residual profits.501 This will provide a significant background for the later analysis of the CPM and PSM (in chapters 8 and 9, respectively). The author discusses the relevant aspects of the 1986 tax reform in section 5.3.2., the 1988 White Paper in section 5.3.3. and the development of the 1994 regulations in section 5.3.4.

5.3.2. The 1986 tax reform In 1985, the US House Committee on Ways and Means addressed the profit shifting practices of multinationals, as documented in a separate report (1985 House Report).502 Two main problems were identified. First, multinationals had strong incentives to shift intangible profits away from US taxation to minimize their effective tax rates. One method of doing so was via outbound transfers of US-developed manufacturing intangibles at an early stage of R&D at a low price, where the transferring US group entity could later claim that it was not possible to foresee the profit potential of the in501. On the development of US transfer pricing rules, see Rosenbloom (2006), at p. 341. 502. H.R. Rep. No. 426, 99th Cong., 1st Sess. 424 (1985) (1985 House Report). For a historical analysis of the run-up to the 1986 US tax reform, see Culbertson et al. (2003), at p. 61.

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tangible at the time of transfer. Second, the lack of CUTs in general made the application of the transactional pricing methods of the 1968 regulations difficult.503 On this basis, the Committee concluded that the allocation of residual profits should be commensurate with the income attributable to the transferred intangibles. This concept had two distinct features:504 (i) that the actual profit experience from an intangible should be taken directly into account in the profit allocation; 505 and (ii) that the allocation should be subject to periodic review.506 The conclusions of the 1985 House Report were supplemented in the 1986 Conference Committee Report from the House of Representatives (1986 Committee Report),507 introducing that the profit allocation should reflect “the relative economic activity undertaken by each” controlled party, also in the context of CSAs.508 The 1986 Committee Report recognized that several transfer pricing issues pertaining to intangibles had been left unresolved. A comprehensive study of the profit allocation rules was ordered from the IRS. On this basis, the commensurate-with-income concept was added to IRC section 482 in the following wording: [I]n the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.509

503. The Committee was displeased with certain court interpretations of IRC sec. 482, particularly the use of comparables in U.S. Steel Corp. v. CIR, T.C. Memo. 1977-140 (Tax Ct., 1977), reversed by 617 F.2d 942 (2nd Cir., 1980) and nonacquiescence recommended by AOD-1980-179 (IRS AOD, 1980). In U.S. Steel, the IRS reallocated costs charged to a US entity in a transfer pricing structure concerning the shipping of iron ore from Venezuela to the United States. The Tax Court, in principle, upheld – albeit substantially reducing – the reallocations. The Second Circuit reversed the Tax Court’s decision on the basis that the evidence sufficiently showed that, similarly enough, uncontrolled transactions supported the price paid by the US entity as an arm’s length charge. The IRS recommended non-acquiescence (AOD1980-179). 504. See H.R. Rep. No. 426, 99th Cong., 1st Sess. 424 (1985), at pp. 425-426. 505. Thus, industry norms or “roughly similar CUTs” (comparable uncontrolled transactions) should not provide safe harbours for the allocation of residual profits. 506. The author reverts to this issue in the discussion of periodic adjustments in ch. 16. 507. H.R. Conf. Rep. No. 841, 99th Cong., 2nd Sess. II-638 (1986). 508. Ibid., at p. 637. 509. Tax Reform Act of 1986, Pub. L. No. 99-514, Sec. 1231(e)(1), 100 Stat. 2085, 2562-63 (1986). The wording of the commensurate-with-income standard in the second sentence of IRC sec. 482 has remained unchanged to this day.

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5.3.3. The 1988 White Paper The study of the profit allocation rules for intangibles ordered in the 1986 Committee Report was delivered in October 1988 in the report titled “A study of intercompany pricing”, prepared by the Treasury Department and the IRS (White Paper).510 The document provided an overview of section 482 practices under the 1968 regulations and discussed how the commensurate-with-income standard should be implemented. It delivered three clear messages for the revision of the 1968 regulations. First, it was critical towards the use of CUTs to allocate residual profits. There would normally be no CUTs available, as plainly illustrated by high-profile transfer pricing cases such as Eli Lilly, Searle, Hospital Corporation of America, Ciba and DuPont. Further, if a purported CUT were found, there was a risk that it could be misinterpreted.511 Second, as a response to this, and to cement and further develop the case-law-driven profit split method, it introduced a new profit allocation method: the basic arm’s length return method (BALRM). Third, it signalled a stricter approach towards profit allocation in the context of CSAs. The impact of the White Paper on international transfer pricing jurisprudence can hardly be overstated. It remains relevant to this day, due to its thorough analysis of the methodology used in the CPM, PSM and periodic adjustments. The discussion at this point will be restricted to the BALRM.512 The BALRM was to be applied if no third-party transactions satisfied the strict proposed CUT requirements. The method came in two versions: (i) the BALRM; and (ii) the BALRM with profit split. The one-sided BALRM was designed to allocate a normal market return to the controlled party that contributed only routine inputs to the value chain (tested party).513 Thus, all operating profits, apart from the normal market return, would be allocated to the other party to the controlled transaction, which contributed unique value chain contributions, e.g. unique intangibles and R&D. The logic behind the BALRM was aligned with economic reasoning. As there would be competition among providers of routine value 510. Notice 88-123. For insightful comments on the White Paper, see Clark (1993); and Culbertson et al. (2003), at p. 65. 511. In particular, the White Paper viewed the CUT applied by the Second Circuit in U.S. Steel as economically different from the controlled transaction. 512. For an analysis of the White Paper positions on cost-sharing agreements (CSAs) and periodic adjustments, see the analysis in sec. 16.2.2. 513. For an analysis of the basic arm’s length return method (BALRM), see Clark (1993), at p. 1184; and Culbertson et al. (2003), at p. 70.

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chain inputs, pressing prices down, no residual profits should be allocable to the tested party. Essentially, the BALRM was a profit split method in which 100% of the residual profits were allocated to the party contributing unique functions and assets. As opposed to the profit split method, the BALMR did not require discretionary assessments with respect to the allocation of residual profits. It was a powerful response to the many tax-driven reorganizations of MNEs involving unique intangibles that had plagued the United States for decades. The problem with the BALMR was that its scope for application was narrow. In cases in which the foreign subsidiary owned “some type of intangible that is of major importance to the enterprise, and which few unrelated parties possess”, the BALRM would be inapplicable,514 for instance, where a foreign distribution entity had developed its own local marketing intangibles. In cases where the BALRM was inapplicable, the White Paper prescribed a profit split addition to the method.515 This extension was meant for cases in which the foreign subsidiary performed complex functions, owned significant intangibles and was exposed to real risks. The extension was not as simple as the clean-cut BALRM. However, as opposed to the BALRM, the profit split addition ensured that both controlled parties would be allocated residual profits. This result stood in stark contrast to that of the contract manufacturer litigation position of the IRS during the 1970s-1980s, pursuant to which the intangibles owned516 or licensed517 by foreign manufacturing subsidiaries in effect were disregarded, and the subsidiary was allocated only a normal market return on routine functions. The BALRM with profit split complied with the intentions of the 1985 House Report, which did not require the use of the contract manufacturer theory for allocating profits to foreign related entities in all cases.518 Two alternative profit allocation patterns were available to allocate residual profits under the profit split extension: (i) the comparable profit split; and (ii) a profit split according to the relative values of the unique value chain contributions.

514. Notice 88-123, at p. 99. 515. See Culbertson et al. (2003), at p. 73 for an insightful analysis of the BALRM with profit split. 516. See the discussion on the possessions company string of cases (Eli Lilly, Searle, Merck, etc.) in sec. 5.2.4. 517. See the discussion of the roundtrip case law in sec. 5.2.5. 518. H.R. Rep. No. 426, 99th Cong., 1st Sess. 424 (1985), at p. 426.

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Under the comparative profit split allocation pattern, the residual profits would be distributed using a fraction extrapolated from a CUT. The idea was that one could apply the same profit split as unrelated parties had used, provided that the functions they had performed in connection with the CUT were broadly similar to those performed under the controlled transaction.519 It was apparent that this allocation pattern would not be practical. First, it would be practically impossible to identify and gain access to CUTs for truly comparable functions in order to extrapolate the third-party splits. Second, even if arm’s length profit splits for each of the relevant functions could be ascertained, such third-party splits, on a stand-alone basis, would not necessarily be meaningful. They could, for instance, be determined in the context of a larger contractual package, where it was the net result of several intertwined contracts that mattered for the involved parties, as illustrated, for instance, in GSK-Canada520 and the roundtrip case law.521 Thus, it could be misleading to rely on a single parameter to allocate the residual profits. The second allocation pattern was the significantly more relevant Eli Lillyinspired methodology, pursuant to which the residual profits would be distributed among the controlled parties according to the relative values of the unique intangibles that they contributed to the value chain.522 This allocation pattern mirrored the method that had gradually been developed through the courts as a “fourth” method under the 1968 regulations and was therefore, 519. This was illustrated in the White Paper (Notice 88-123), Appendix E, Example 10, where the R&D of a US parent had resulted in a high-tech patent. The product required customization to be tailored to the needs of each local customer. The parent had a European subsidiary that maintained an R&D staff and self-manufactured all of the devices that it sold. The R&D and design functions performed by the subsidiary were viewed as complex and relatively unique, and thus warranted a profit split. For these functions, the example identified CUTs purely based on broad similarities. 520. GlaxoSmithKline Inc. v. R. (2012 SCC 52 [2012]), which affirmed 2010 CAF 201, F.C.A., [2010], which reversed 2008 TCC 324 [T.C.C., 2008]). See the analysis of this case in sec. 6.7.4. 521. See the discussions in sec. 5.2.5. 522. The White Paper (Notice 88-123) contained an example in which this pattern was applied (Appendix E, Example 11). The example pertained to a US parent that licensed make-sell rights to a new toy to its European subsidiary, which incurred significant marketing expenditures to develop a local trademark and reputation. The subsidiary’s unique marketing intangible justified a split of the residual profits between the US parent and the subsidiary. The split was determined on a discretionary basis by weighing the estimated relative importance of the design and R&D activities and the manufacturing intangibles of the parent against the marketing intangibles of the subsidiary, akin to the profit split assessment in Eli Lilly. Due to the high threshold for applying the comparable profit split, the White Paper, in reality, favoured profit splits pursuant to this pattern.

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in principle, not a new concept in US transfer pricing jurisprudence. The same cannot be said for the White Paper’s introduction of the BALRM. The contract manufacturer theory of the IRS, in its different incarnations, had repeatedly been rejected by the courts in high-profile cases such as Eli Lilly, Searle and Bausch. In Sundstrand,523 the Tax Court rejected the IRS’s proposition that the foreign manufacturing subsidiary should be remunerated on a normal return basis, with the following wording: [W]e are not satisfied from this record that the expert’s “normal” rate of return approximates in any way the proper rate of return for a company such as SunPac or even that it is an acceptable criterion upon which to determine an arm’s length price for SunPac parts.

The BALRM was therefore genuinely innovative, in the sense that it had no basis in current law. The BALRM allocated actual profits, in line with the legislative intentions behind the 1986 tax reform and the commensuratewith-income standard. This aspect of the methodology was perceived as controversial internationally.524 Nevertheless, the White Paper took the position that the 1979 OECD report did not preclude the allocation of actual profits. This stance is, in the author’s view, debatable. There were only brief and ambiguous mentions of profit-based transfer pricing in the 1979 report.525 The little wording there seemed to suggest that actual profits indeed could be taken into consideration in setting transfer prices, but then primarily as a check on the allocation results yielded by the traditional CUT-based methods.526

523. Sundstrand Corp. and Subsidiaries v. CIR, 96 T.C. No. 12 (Tax Ct., 1991). See the discussion in sec. 5.2.5.3. 524. Also, other aspects were criticized, e.g. that the BALRM was difficult to apply, that it was unfair to group companies that experienced returns that deviated from average returns and that it would allocate too much income to the United States. Japan was concerned that if the BALRM was applied, US distribution subsidiaries of Japanese MNEs could be compared to US distribution companies (thereby increasing their taxable income). Apparently, the view was that US distributors of US-manufactured goods were able to reap higher profits than US distributors of Japanese goods due to the high price at which the US distribution entity had to buy from the Japanese manufacturer. See the example drawn up in Miyatake et al. (1994). 525. White Paper (Notice 88-123), at p. 61. See the 1979 OECD Report, at paras. 14 and 70-72. 526. Putting the issue of whether the allocated income should be based on projected or actual profits aside, the White Paper’s positive take on the compatibility between the BALRM and the 1979 OECD Report could arguably be defended for the BALRM with profit split, but seemed more questionable with respect to the clean-cut BALRM that operationalized the IRS’s contract manufacturer theory.

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5.3.4. The 1994 US regulations The White Paper eventually led to proposed regulations in 1992,527 operationalizing most of the key ideas presented in the White Paper. The BALRM from the White Paper was replaced with, or rather renamed as, the comparable profits method (CPM). The criteria for qualifying comparables under the CUT-based methods remained strict.528 Oddly, the profit split method was not expressly presented as an independent pricing method in the proposed regulations.529 The proposed regulations met a critical reception from international commentators,530 in particular from the OECD. Shortly after the publication of the proposed regulations, the Committee on Fiscal Affairs of the OECD established a special task force to provide the US tax administration with the collective views of other OECD member countries on the proposed regulations. The findings of the task force were presented in a report (hereafter the task force report),531 which was speedily approved at the end of 1992. The Business and Industry Advisory Committee to the OECD (BIAC) and the International Chamber of Commerce (ICC) were among the business representatives that provided input to the task force during its work on the report.532 The Committee on Fiscal Affairs also ordered its Working Party to urgently undertake a review of the 1979 OECD report. In this review, the new US transfer pricing approach based on actual profit experience was to be one of the points to be considered for a revised guideline text.

527. 57 FR 3571-01. 528. The 1992 proposed regulations relaxed the requirements for inexact comparables set out in the White Paper. This was, however, compensated for by requiring that income allocation under the CUT, resale price and cost-plus methods that be based on inexact comparables in order to be compatible with the comparable profits method (CPM). 529. A limited provision pertaining to comparable profit splits in the context of profit level indicators was, however, incorporated in § 1.482-2(f)(6)(iii)(C)(3) of the 1992 proposed regulations (57 FR 3571-01). Under the approach of the 1992 proposed regulations for transfer pricing of intangibles, the comparable profit interval was to be used when determining the pricing under the CPM in § 1.482-2(d)(5), or other methods in § 1.482-2(e)(1)(iv). See Langbein (2005), p. 1069, who found that the 1992 residual profit split method (PSM) was so restricted that it offered little utility. 530. Mexico, for example, supposedly threatened to enact similar rules against the United States. 531. OECD, Tax Aspects of Transfer Pricing Within Multinational Enterprises – The United States Proposed Regulations, A report by the Committee on Fiscal Affairs on the Proposed Regulations under Section 482 IRC (OECD 1993). 532. See task force report, at para 1.30.

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The task force report was highly critical of the proposed regulations. The bulk of the critique was directed at the CPM (BALMR), but the provisions on periodic adjustments and sound business judgement also received negative comments. The author finds it somewhat ironic that the profit split method was not subject to the same heavy criticism as the CPM (as both methods use what is essentially the same methodology). In fact, the report is somewhat contradictory on this point, as the profit split method is given a rather favourable mention relative to the comments on the CPM.533 The author will discuss the specific objections as part of his later analysis of the CPM, the PSM and the periodic adjustment authority.534 The temporary regulations were issued in the beginning of 1993535 and largely carried over the approach for allocating residual profits unaltered from the 1992 proposed regulations. However, the dominant position enjoyed by the CPM in the proposed regulations was toned down, primarily through the introduction of the “best method rule”.536 The profit split method was introduced as an independent transfer pricing method. Nevertheless, due to strict requirements for applying both the CUT method and the profit split method, the temporary regulations were, in reality, biased towards the CPM with respect to the allocation of residual profits. The OECD provided its comments in a second 1993 task force report,537 which was not as thorough as the first task force report, and essentially reiterated the viewpoints of its predecessor. The apparent main aim was to encourage the United States to restrict the scope of the CPM to abusive cases and as a method of last resort.538

533. See task force report, at paras. 3.12-3.15. 534. In ch. 8, ch. 9 and ch. 16, respectively. See also sec. 5.4., which deals with the development of the OECD transfer pricing methods leading up to the 2010 OECD Transfer Pricing Guidelines (OECD TPG). 535. 58 FR 5263-02. For an insightful analysis of the 1993 temporary regulations, see Clark (1993). 536. See the discussion of the best-method rule in sec. 6.4. Formally, the rule invited flexibility, with the CUT method as the natural default transfer pricing method for intangibles. 537. OECD, Intercompany Transfer Pricing Regulations under US Section 482 Temporary and Proposed Regulations (OECD 1993). 538. See id., at para. 2.11. See also Clark (1993), at p. 1197, for a discussion of the potential for conflict with foreign tax systems in light of the transfer pricing approaches conveyed by the 1993 temporary regulations.

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The final regulations were issued in 1994, largely corresponding to the temporary regulations.539 The changes that were made generally softened the language without altering the core content of the commensurate-withincome approach.

5.4. OECD implementation of “profit-based” transfer pricing methodology The author will comment in this section on the broad strokes of the development of the OECD transfer pricing methodology for intangibles. He will go more into depth in later chapters of the book in connection with his analysis of the TNMM, the PSM and the OECD periodic adjustment authority.540 The OECD published a discussion draft in 1994 (1994 Draft) on the revision of the 1979 OECD report,541 largely as a response to the new US rules.542 The 1994 Draft approach was two-sided: while in principle accepting the CPM and the PSM, it also discouraged the use of them. The position was that only where the CUT-based methods were inapplicable should the CPM and the PSM be applied on their own to determine transfer prices.543 A 1995 report dealt with some particular issues (1995 Draft), such as the treatment of marketing intangibles, CSAs and periodic adjustments, but provided no principal guidance on the pricing methods.544 Aligned with the 1994 Draft, the final 1995 OECD TPG did allow the use of profit-based methods as stand-alone transfer pricing methodologies,545 539. 59 FR 34971-01. 540. See the discussion of the TNMM in ch. 8, the OECD PSM in ch. 9 and sec. 11.4., the OECD approach to periodic adjustments in sec. 16.5. and periodic adjustments in the context of CSAs in sec. 16.7. 541. It has been asserted that the 1979 OECD report, being a response to the 1968 US regulations (which applied to profit allocation among group entities), has an unclear relationship with the pre-1979 efforts of the OECD (and before that, the League of Nations) on international allocation of business profits, which were focused on branch (permanent establishment) allocation. See Vann (2003), at p. 136 on this issue. 542. OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Part I: Principles and methods, discussion draft (OECD 1994). For a brief overview of the development of the OECD TPG, see also Pankiv (2017), at pp. 2630. 543. Pankiv (2017), at para. 173. See also para. 130 and Note to Readers, at p. 6. 544. OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Draft text of Part II (OECD 1995). 545. 1995 OECD TPG, at paras. 3.50 and 3.56. See Culbertson et al. (2003), at p. 88 for comments on the historical context.

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albeit with hesitation, and preferably merely for the purpose of cross-checking the results of transaction-based pricing methods. The 1995 OECD TPG seemed to fear misapplication of the profit-based pricing methods by tax authorities, in particular, the TNMM.546 The author has found three noteworthy aspects of the 1995 text. First, it renamed the CPM to the TNMM.547 In addition, certain restrictions were also added to the TNMM in order to separate it from the CPM, making consensus on the final 1995 text possible.548 Second, the 1995 OECD TPG contained (in the author’s view, highly questionable) factual assertions pertaining to the profit-based methods.549 In particular, it was stated that “in fact, enterprises rarely if ever use a transactional profit method to establish their prices”.550 No empirical references or support for this factual allegation were offered. The assertion stood in stark contrast to the rapidly growing popularity of profit-based methods in practice, in particular the CPM. Third, the preference for the transactional methods was reiterated. Only in “exceptional cases”,551 in which the transactional methods were inapplicable, and if all “safeguards” set out in the 1995 OECD TPG were observed, should the profit-based methods be applied, and even then only as a “last resort” (for instance, where there was insufficient data on CUTs to apply the transactional methods).552 Over the following decade, the use of profit-based pricing methods – in particular, the TNMM – became so widespread among multinationals and tax administrations that a disparity had become apparent with respect to

546. 1995 OECD TPG, at para. 3.56. 547. The 1994 and 1995 drafts applied the terms “profit-based methods”, “profit-split method” and the “CPM”. The common term “profit-based methods” was altered to “transactional profit methods”, and it was specified that the new term covered “methods that examine the profits that arise from particular transactions among associated enterprises”; see 1995 OECD TPG, at para. 3.1. The profit split method, for the time being, was not renamed. 548. See the discussion on comparability under the TNMM in sec. 8.6. See also interesting comments in Lodin (2009), at pp. 427-437. 549. See also Schön et al. (2011), at p. 125, for critical reflections on factual assertions made in the OECD TPG. 550. 1995 OECD TPG, at paras. 3.2 and 3.54. 551. It can be questioned whether it was useful for the 1995 OECD TPG to refer to such cases as “exceptional”, given the importance of the transfer pricing of unique intangibles for fiscal purposes and that transactional methods had proved to be practically inapplicable (leaving few other options than to apply profit-based methods). For a discussion of the reservation, see Casley et al. (2003), at p. 164. 552. 1995 OECD TPG, at para. 3.50.

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the last-resort qualification of the 1995 OECD TPG. In 2008, the OECD released a discussion draft suggesting revised guidelines for the profit-based methods (2008 Draft).553 It proposed to replace the last-resort qualification with a general requirement to apply the most appropriate method for a particular case. The traditional preference of the OECD TPG towards the transactional methods was markedly toned down. The OECD still deemed the transactional methods to have “intrinsic strengths” relative to the profitbased methods.554 The 2010 revision of the OECD TPG removed the last-resort qualification. The profit-based pricing methods were then the dominant pricing methods in practice, but some countries still opposed the use of them in non-exceptional cases. Paragraph 2.2 stated the principle that the selection of the most appropriate method for each particular case should take into account the nature of the controlled transaction, the availability of CUTs and the reliability of any comparability adjustments that had to be made. Then, paragraph 2.3 modified this by stating that the transactional methods were regarded as the most direct means of establishing whether conditions in the commercial and financial relations between the related parties were at arm’s length. Thus, if a transactional and a profit-based method could be applied in an equally reliable manner, the former would be “preferable”. In particular, the CUT method would be preferable over all other pricing methods. Even though the paragraph 2.3 reservation was important as a statement of principle, in the author’s opinion, it is unlikely that it would be of any relevance for the transfer pricing of intangibles in practice.555 Further, the 2010 OECD TPG contained new guidance on the selection of the appropriate transfer pricing method,556 as well as on the application of the TNMM and the PSM.557 As this will be discussed later in the book as part of the analysis of the current OECD transfer pricing methodology, the author will not go into the guidance here.

553. OECD, Transactional profit methods, discussion draft for public comment (OECD 2008). 554. See id., at Introduction, para. 6. The proposed revision of chs. I-III of the 1995 OECD TPG was released in 2009; see OECD, Proposed revision of Chapters I-III of the Transfer Pricing Guidelines (OECD 2009). The proposed text contained updated general comments on comparability in ch. I and detailed comparability guidance in ch. III. 555. See the discussion of the new OECD guidance on the CUT method in sec. 12.4. 556. OECD TPG, at paras. 2.1-2.11. 557. See OECD TPG, at paras. 2.68-2.107 for the TNMM; paras. 2.115-2.145 for the PSM; as well as Annexes I-III to ch. II and the Annex to ch. VI.

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Also, for the first time, the OECD TPG acknowledged the concept of taxpayer-initiated year-end compensating adjustments,558 or “true-ups”. The OECD TPG refer to the concept as a procedure that allows a taxpayer to report a transfer price for tax purposes that is an arm’s length price for the controlled transaction in question, even though the price would differ from the amount actually charged between the associated entities. The acknowledgement of compensating adjustments should be seen as an additional levying of the position of the profit-based pricing methods in the OECD TPG.559

558. OECD TPG, at paras. 3.70-3.71 and 4.38-4.39. 559. See also Russo, in Weber et al. (2011), at p. 168. The author refers to his analysis of year-end adjustments in ch. 15 for further discussion on this topic.

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Chapter 6 Metaconcepts Underlying the US and OECD Profit Allocation Rules 6.1. Introduction In this chapter, the author will analyse a selection of six interconnected transfer pricing metaconcepts that underlie the US and OECD profit allocation rules. These discussions will form a backdrop for the analysis (in chapters 7-16) of the US and OECD methodology for the transfer pricing of intangibles, where active use is made of these concepts. He will begin with a discussion of operating profits in section 6.2., as a more comprehensive understanding of this concept (than what has been necessary up to this point) will be needed for later chapters. The discussion will be focused on how the concept relates to the different transfer pricing methods, how the different methods test different components (or levels) of operating profits and how the lack of publicly available profit data may restrict the use of certain methods in practice. He will then move on to develop the relationship between the transactionbased gross profit methods (the comparable uncontrolled transaction (CUT) method, resale price method and cost-plus method) and the profit-based net profit methods (the transactional net margin method (TNMM) and profit split method (PSM)) in section 6.3. He discusses how both groups of methods rely on the same basic methodology for allocating profits to group entities. Further, he discusses the traditional OECD point of departure that the gross profit methods are generally more reliable than the net profit methods and shows that the situation is not as clean-cut as the OECD might make it out to be. Next, he will discuss the US and OECD rules that govern which transfer pricing method should be chosen to allocate operating profits in section 6.4. As will be shown, these rules are open-ended in the sense that they generally do not dictate a specific method, but rather emphasize the importance of relative reliability. Nevertheless, as the transfer pricing of intangibles has proven vulnerable to profit shifting practices, the US rules – in the context of intangible property (IP) transfers – now emphasize that the

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selected method must take into account the need to perform aggregated valuations to capture all intangible value transferred intra-group (irrespective of legal form), while the OECD – for many of the same reasons – now leans away from the CUT method and towards the PSM. Subsequently, the author will discuss the US and OECD rules that determine how much deviation is acceptable between controlled profit allocation, on the one side, and third-party profit allocation, on the other side, before a transfer pricing adjustment is triggered (the so-called “arm’s length range”) in section 6.5. He will then go on to discuss the concept of comparability in section 6.6. The US and OECD profit allocation rules generally rely on comparing controlled transactions with (or benchmarking them against) third-party transactions to find acceptable results. The comparability provisions of these rules have two sides. The first side pertains to the controlled transaction, where legal form must give way to economic substance (in the case of conflict) with respect to establishing the material content of the transaction before it is benchmarked against third-party transactions. To put it in the terminology of the OECD, only the actual controlled transaction as “properly delineated” will be given effect. Economic substance is an essential component in the comparability doctrine, not only for identifying the actual controlled transaction that must be priced, but also for “peeling away” artificial legal structures designed to shift profits (e.g. aggressive contractual separations of risk from underlying functions). The second side of the comparability provisions pertains to the uncontrolled benchmarking transactions and is made up of rules that set the standard for how comparable these must be to the controlled transactions (with respect to geographical market, functions, risks, etc.) before they can be applied using an applicable transfer pricing method. The author will end the chapter with a discussion of the aggregation of controlled transactions in section 6.7., which is a topic closely related to the comparability doctrine. The core question here is to what extent the US and OECD profit allocation rules allow that the transfer pricing methods are applied to price several controlled transactions together as one package as opposed to pricing them on a transaction-by-transaction basis. The underlying issue is that the transaction-by-transaction approach may fail to capture all value transferred intra-group in a combination of controlled transactions, thereby triggering a need for an aggregated valuation approach.

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6.2. The relationship between operating profits and the transfer pricing methods 6.2.1. Introduction The transfer pricing methods allocate operating profits to the different value chain inputs contributed by group entities. All of the five specified methods in US and OECD transfer pricing law (the CUT method, resale price method, cost-plus method, comparable profits method (CPM)/TNMM and PSM) – with the possible exception of the CUT method – draw upon a set of profit concepts. The one-sided resale price and cost-plus methods build on the concept of gross operating profit, while the CPM/TNMM and the PSM build on the concept of net operating profit. Until now, the introduction of operating profits provided in chapter 1 has sufficed, but for the purpose of the following analysis of the transfer pricing methods, it will be necessary to have a more developed understanding of the concept. The author discusses the concept of operating profits in section 6.2.2., the components of operating profits in section 6.2.2. and the accounting information on gross profits and transactionallevel profit information in sections 6.2.4. and 6.2.5., respectively.

6.2.2. The concept of operating profits Operating profits are profits that accrue solely from business operations. They do not include income and expense items that derive from the financing of business activities. Operating profits are thus profits before net interest expenses and are similar to the financial accounting term “earnings before interest and taxes” (EBIT).560 The traditional outline of operating profits in transfer pricing is as follows: Sales −

Cost of goods sold

=

Gross profit

−

Operating expenses

=

Net profit = operating profit = EBIT

560. A measure closely related to earnings before interest and taxes (EBIT) is earnings before interest, tax, depreciation and amortization (EBITDA), which is simply EBIT with the twist that depreciation and amortization expenses have been added. EBITDA is normally a better indicator than EBIT of the net cash flows generated by the business (as depreciation and amortization expenses are accruals and do not have cash flow effects) and therefore often used as an input in valuations.

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It is not apparent how these elements should be delineated. A clarifying analysis is necessary because much of the legal arguments that are in favour of or against the application of a particular transfer pricing method draw upon opinions of the usefulness of these underlying income and expense items. This is particularly true for the debate on the utility of net profit methods (i.e. the profit-based methods) relative to the gross profit methods. Neither the OECD Model Tax Convention (OECD MTC) nor the OECD Transfer Pricing Guidelines (OECD TPG) directly define income and expense items.561 This is, however, to some extent, done in the CPM provisions of the US regulations, but further clarification is needed.562 The International Financial Reporting Standards (IFRS) represent the de facto global standard for financial accounting. The author will use the relevant IFRS as legal sources for delineating the elements in operating profits under the US regulations and the OECD TPG. The reasoning behind this methodological choice is that first, the terminology in financial accounting is developed and goes – on many points – deeper in delineating the various income and expense items than the US regulations and the OECD TPG do. Second, the terminology applied in both the US and OECD regimes must be presumed to build upon, and to be coherent with, the terminology applied in authoritative financial accounting standards, as tax returns build on the data generated by the accounting systems of business enterprises as presented in their audited financial statements. Third, there is no sensible reason as to why the concept of operating profits should differ between the US regulations, the OECD TPG and the authoritative financial accounting standards, as third-party accounting data is used directly by the transfer pricing methods to extract the relevant profit margins.

561. Further, art. 7 of the OECD Model Tax Convention on Income and on Capital (OECD MTC) does not define “business income”. Para. 71 of the (2010) Commentaries on the OECD MTC (art. 7, para. 4) states that it “should nevertheless be understood that the term when used in this article and elsewhere in the Convention has a broad meaning including all income derived in carrying on an enterprise. Such a broad meaning corresponds to the use of the term made in the tax laws of most OECD member countries”. Thus, it should be rare that disagreements arise in practice as to whether an item of income earned by an enterprise should be classified as business income. 562. Treas. Regs. § 1.482-5(d).

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6.2.3. Delineating the components of operating profits 6.2.3.1. Sales The first item in operating profits is sales. The US regulations define this as the amount of the total receipts from the sales of goods and provision of services, less returns and allowances.563 As far as the author can see, this is also the understanding of the OECD TPG, even though there is no precise definition. The US definition is materially similar to the one applied in the IFRS. The IFRS, however, use the term “revenue” instead of “sales”. Revenue, according to the IFRS, is defined as the “gross inflow of economic benefits during the period arising in the course of the ordinary activities of an entity when those inflows result in increases in equity, other than increases relating to contributions”.564 This includes only inflows received and receivable by the entity on its own account565 and encompasses income from the use by others of the entity’s assets (i.e. interest, royalties and dividends).566 Income from interests and dividends shall, however, not be included in the operating profits under the US regulations or the OECD TPG.567 These exclusions are natural in a transfer pricing context, as such income will not be connected to any value chains for particular products or services (i.e. business activities), but are the result of financing and investment activities, and should therefore not be relevant under any of the transfer pricing methods.

563. Treas. Regs. § 1.482-5(d)(1). 564. International Accounting Standard (IAS) 18: Revenue, para. 7. The International Financial Reporting Standards (IFRS) may require recognition of income and expense items that have not been realized. Such accruals pertain to the timing of income and expense recognition. The author is only interested in what types of income and expenses are recognized under the IFRS (in other words, classification issues, as opposed to timing issues). 565. E.g. in an agency relationship, revenue is only the amount of commission (IAS 18, para. 8). This was, for instance, the return position of the taxpayer in the Norwegian Supreme Court ruling in Dell Products v. the State (Norwegian Supreme Court ruling dated 2 Dec. 2011, Utv. 2012, s. 1, reversing Utv. 2011, s. 807). See the analysis of this ruling in sec. 25.6.5. 566. IAS 18, para. 1c) and paras. 29-34. 567. Treas. Regs. § 1.482-5(d)(4); and OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TPG), para. 2.80. It should be noted that para. 2.80 of the OECD TPG excludes “non-operating items” and exemplifies interest income and expenses. It does not, however, specifically mention dividend income. In the author’s view, there is clearly no reason to assume that dividend income should be included in operating profits under the OECD TPG.

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6.2.3.2. Costs of goods sold The second item in operating profits is the cost of goods sold (COGS). Even though not explicitly defined in the US regulations or the OECD TPG, it is clear that the term includes direct costs for producing the product or service rendered.568 Under the IFRS (IAS 2: Inventories), the cost of inventories comprises all costs of purchase (purchase price, import duties, transportation, etc.),569 conversion (direct labour costs and systematic allocations of fixed and variable production overheads incurred in converting materials into finished goods) 570 and “other” costs (costs incurred in bringing the inventories to their present location and condition). The COGS for a manufacturing subsidiary, for instance, will typically consist of the costs for raw material and royalties paid for licensing the necessary technology for manufacturing the product (patents, knowhow, etc.).571

6.2.3.3. Gross profit The third item in operating profits is gross profit. This is the amount that remains after the COGS are deducted from sales.572 Gross profit should be interpreted as a preliminary measure of operating profit, as it only signals the ability of the taxpayer to cover its operating expenses.573 The one-sided resale price and cost-plus methods test the allocation of gross profits.

6.2.3.4. Operating expenses The fourth item in operating profits is operating expenses. These encompass all business expenses that are not included in the COGS.574 Both the 568. Such costs fall outside the other category of business costs (operating expenses) in Treas. Regs. § 1.482-5(d)(3). 569. IAS 2, para. 11. Trade discounts, rebates, etc. are deducted in determining the costs of purchase. 570. IAS 2, para. 12. Fixed production overheads are indirect costs of production that remain relatively constant regardless of the volume of production (e.g. depreciation and maintenance of factories). Variable production overheads are indirect costs of production that vary directly (or nearly directly) with the volume of production (e.g. indirect materials and indirect labour). 571. See Bhatnagar (2017), at pp. 26 for a discussion of costs of goods sold (COGS) under applications of the Berry ratio (see sec. 8.4.2.) for distribution entities. 572. Treas. Regs. § 1.482-5(d)(2). 573. See sec. 8.4.2. on the Berry ratio. 574. Treas. Reg. § 1.482-5(d)(3).

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US regulations and the OECD TPG include marketing and distribution costs (e.g. advertising, warehousing, administration and salary costs connected to such functions) in operating expenses.575 A reasonable allowance for depreciation and amortization on plant and equipment will normally also be included.576 This aligns with the core content of the term under the IFRS. Distribution costs, administrative expenses and other expenses will be reported as operating expenses (i.e. below gross profits in the profit-andloss statement) if the function-of-expense method is used.577

6.2.3.5. Net profit The fifth and final item is net profit.578 This is the amount of income from business operations left after all operating costs have been deducted from sales.579 Income from activities not being tested by the selected transfer pricing method580 or extraordinary gains and losses that do not relate to the continuing operations of the tested party are not relevant for transfer pricing purposes.581 As touched upon, net operating profits shall not contain any financial elements, such as interest income or expenses,582 nor shall foreign or domestic income taxes or any other expenses that are not related to the operation of the relevant business activity included.583 The one-sided CPM/TNMM (and one aspect of the profit-split method) 584 test the allocation of net profits.585

575. See OECD TPG, paras. 2.46-2.47, 2.87 and 2.102. 576. See Haugen (2005), at p. 226, who is critical with respect to the lack of guidance provided in the OECD TPG on the issue of how depreciation and amortization costs shall be allocated among COGS and operating expenses. 577. See the discussion in sec. 6.2.4. on the function-of-expense method. See also Bhatnagar (2017), at pp. 26 for a discussion of operating expenses under applications of the Berry ratio (see sec. 8.4.2.) for distribution entities. 578. On net profits, see also, e.g. Wittendorff (2010a), at p. 739. 579. Treas. Regs. § 1.482-5(d)(4); and OECD TPG, para. 2.77. 580. See the discussion of blended profits in sec. 8.6. 581. OECD TPG, para. 2.80. 582. OECD TPG, para. 2.80. 583. Treas. Regs. § 1.482-5(d)(3). 584. The first step of normal return profit allocations to routine value chain inputs under the resale price method before allocating residual profits. See sec. 9.3. 585. See the discussion of the comparable price method (CPM) and transactional net margin method (TNMM) in ch. 8 and of the US and OECD profit split method (PSM) in ch. 9.

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6.2.4. Information on gross profits may be unavailable Publicly available financial statements will not necessarily contain data on gross profits. To do so, business expenses must be presented in the profitand-loss account according to the functions that the underlying costs serve in the enterprise (function method).586 Such presentation may be resourcedemanding, as it will require that a range of different costs are allocated to the COGS (including salary expenses, depreciation, amortization, etc.). Such allocation may involve discretionary assessments (and arbitrary allocations).587 As a minimum under this method, an entity must disclose its cost of sales separately from other expenses. In that way, it will be possible to distinguish gross from net profits. International Accounting Standard (IAS) 1 illustrates cost classification pursuant to the function method as follows:588 Revenue −

Cost of sales

=

Gross profit

+

Other income

−

Distribution costs

−

Administrative expenses

−

Other expenses

=

Net profit before tax

IAS 1 requires the reporting entity to disclose information on the nature of the expenses (see table below) if the function method is used,589 and therefore favours the nature method over the function method.

586. IAS 1, para. 103. The method is also known as the cost-of-sales method. 587. IAS 1, para. 103. 588. Authoritative financial accounting literature is critical towards the method; see Van Breda et al. (1992), at p. 368. The argument is that the method will not put readers of financial statements in a better position to make predictions about the profit-generating ability of the enterprise as a whole, nor will they be able to evaluate the contributions of the diverse functions. 589. See IAS 1, para. 104. The disclosure shall encompass additional information on the nature of expenses, including depreciation and amortization expenses and employee benefits expenses. This requirement comes from the fact that information on the nature of the expenses is useful in predicting future cash flows; see IAS 1, para. 105.

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In practice, with the nature method, business expenses are normally presented according to their nature (e.g. total salary costs or total depreciation costs), with each item presented on a different line in the income statement.590 Under this method, costs are not reallocated according to functions within the entity. This makes the method simple to apply (and thus cost-efficient) and free of discretionary assessments. IAS 1 illustrates classification using the nature method as follows:591 Revenue +

Other income

−

Changes in inventories of finished goods and work in progress

−

Raw materials and consumables used

−

Employee benefits expense

−

Other expenses

=

Net profit before tax

In conclusion, if a reporting entity has classified its operating costs pursuant to the nature method, it will not be possible to extract gross profit margins. This makes it difficult – or outright impossible – to apply the resale and cost-plus methods.592 The only alternative for allocating a normal market return to a group entity that only contributes routine inputs to the value chain will be to apply the CPM or the TNMM, which rely on net profit margins.

6.2.5. Information on transaction-level profits may be unavailable The transfer pricing methods, at least at the outset, require accounting information on a transactional level, as the gross or net operating profit margins of a CUT must be compared to the margins of the controlled transaction.593 In order to provide realistic legal analyses of key issues connected to the transfer pricing methods, it is crucial to recognize that what 590. IAS 1, para. 102. 591. Id. 592. See also Haugen (2005), at p. 224; Casley et al. (2003), at p. 164; Hamaekers (2001), at p. 35; Cools (1999), at p. 178; and Roberge (2013), at p. 232. 593. See the discussion of the aggregation of controlled and uncontrolled transactions for transfer pricing purposes in secs. 6.7. and 8.6., respectively.

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is offered in company-level financial statements is aggregated financial information on the total sales and total business expenses of an enterprise for all products and services sold by it (i.e. not transaction-level profit data).594 The same, but on an even further aggregated level for the entire group, is offered in consolidated financial statements. It is not the presentation of aggregated transactions as such that is the problem from a transfer pricing perspective, but rather that income and expense items contained in the income statement blend different types of transactions that have different profit characteristics. The use of blended profit margins in transfer pricing poses a significant risk of non-arm’s length results. This issue is discussed in depth in section 8.6.

6.3. The relationship between gross and net profit methods 6.3.1. Introduction The resale price and cost-plus methods that use data on third-party gross profits to benchmark the controlled allocation of income, as well as the US CPM and OECD TNMM that use data on third-party net profits, have the same general purpose: to allocate a normal market return to group entities that contribute only routine inputs to the intangible value chain. As they only allocate profits to one group entity (the tested party), they are so-called “one-sided methods”, as opposed to the two-sided CUT method and PSM. In sections 6.3.1.-6.3.5., the author will discuss a selection of aspects pertaining to the relationship between the gross and net profit methods. This will form a backdrop for the later analyses of the CPM and the TNMM (in chapter 8),595 and should be seen in connection with the discussions of the best method rule and comparability.596 Most of the issues discussed below are triggered by the OECD guidance on the TNMM. It should be kept in mind that most of the current guidance on the TNMM is identical to the 1995 consensus text, which hesitantly introduced the methodology into the OECD TPG. The rather negative historical attitude of the OECD towards 594. See also Haugen (2005), at p. 224; and Luckhaupt et al. (2011), at p. 102. 595. The author will not analyse the one-sided gross profit methods in depth, as they are largely redundant with respect to profit allocation from intangible value chains due to the availability of the CPM and TNMM. 596. See the discussions in secs. 6.4. and 6.6., respectively.

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the TNMM may have influenced some of the assertions made in the OECD TPG on the usefulness of the method relative to the traditional cost-plus and resale price methods. The author doubts whether all of the assertions, now 20 years later, are representative of the current attitude of the OECD towards the same problems, but they are nevertheless a part of the current OECD TPG and must therefore be taken at face value.597 The author discusses common methodological traits among the gross and net profit methods in section 6.3.2., relevant parameters under the gross and net profit methods in section 6.3.3., whether operating expenses are relevant under the transactional pricing methods in section 6.3.4. and whether comparability adjustments under the gross profit methods are more reliable than under the net profit methods in section 6.3.5.

6.3.2. Common methodological traits among the gross and net profit methods The fundamental difference between the gross and net profit methods is that operating expenses are deducted in the computation of net profits, while in the computation of gross profits, they are not. Aside from this, the methods are fundamentally similar with respect to the methodology used to allocate income to the tested party. The resale price method, the costplus method, the CPM and the TNMM all apply a two-step approach for allocating income: (i) a profit margin is extracted from the accounting data of comparable unrelated enterprises; and (ii) the extracted profit margin is used to benchmark the corresponding profit margin of the tested party. The author will develop this a bit further in this section. Imagine a transfer pricing structure between a controlled manufacturing entity and a distribution entity, where the latter purchases goods for resale from the former. The question is whether the transfer pricing applied between them is at arm’s length. In practice, only one of the parties to the transaction will be selected as the tested party. In this example, however, the author uses two parties simply to illustrate the application of both the cost-plus method and the resale price method.598

597. The TNMM is still not in vogue with the OECD, but now for different reasons than in 1995. See the analysis in ch. 8 and the comments on the 2017 OECD TPG regarding the TNMM in ch. 11. 598. This example draws inspiration from Culbertson (1995).

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Manufacturer (related) Sales COGS Gross profit

Distributor (related) -

200

150

-

-

-

Assume that the manufacturer’s COGS of 150 stem from purchases from unrelated suppliers and that the distributor’s sales of 200 stem from unrelated customers. Both elements are therefore reliable. The cost-plus and resale methods are selected to allocate income to the manufacturer and distributor, respectively. The first step in applying these methods is to extract gross profit margins from CUTs. The selected unrelated enterprises display the following accounting data:599 600 Manufacturer (unrelated)

Distributor (unrelated)

Sales

600

400

COGS

500

360

Gross profit Gross profit margin600

100

40

20%

10%

It is seen that the gross margins of the unrelated manufacturer and distributor are 20% and 10%, respectively, with the former calculated on the basis of costs and the latter on the basis of sales. The second step is to apply the extracted uncontrolled margins to the data of the tested party. For the related manufacturer, the gross profits will be 20% of its COGS, which is 150 × 20% = 30. For the related distributor, the gross profit will be 10% of its sales, which is 200 × 10% = 20. This will result in a transfer price of 180 for the product, as follows:601 599. It is assumed, rather unrealistically, that the uncontrolled enterprises carry out only one type of transaction and that the transaction is fully comparable to the controlled transaction. 600. The manufacturer’s margin is calculated based on costs (100 ÷ 500 = 20%), while the distributor’s margin is calculated based on sales (40 ÷ 400 = 10%). 601. The fact that the two transfer prices calculated here correspond is just by design of the example. This would be highly unlikely to happen in practice by applying the resale price method and the cost-plus method to two different related entities, even if for the same value chain.

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The relationship between gross and net profit methods

Manufacturer (related)

Distributor (related)

Sales

180

200

COGS

150

180

30

20

Gross profit ÷ COGS

Gross profit ÷ sales

30 ÷ 150

20 ÷ 200

20%

10%

Gross profit Applicable margin Computation Gross profit margin

Thus, on the basis of this example, it may be concluded that the gross profit models allocate income to the tested party equal to the gross profit margin it would have earned if its gross profit margin had been the same as that of an uncontrolled taxpayer. The main problem with a gross profit analysis is that it requires specified accounting data from reliable CUTs, which makes it possible to ascertain the unrelated gross margin.602 The author will now illustrate the parallel methodology of the net profit methods. Let us, for instance, suppose that the distributor from the example above is selected as the tested party under the CPM and that the following accounting data is available from a comparable uncontrolled enterprise:603 Distributor (unrelated) Sales

400

COGS

360

Gross profit

40

Operating expenses

5

Net profit Applicable margin Computation Net profit margin

35 Net profit ÷ sales 35 ÷ 400 8.75%

602. See the discussion in sec. 6.2.4. 603. Again, for the purpose of the example, it is assumed that the unrelated distributor carries out only one type of transaction, which is fully comparable to the controlled transaction.

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The first step, as under the gross profit methods, is to extract the relevant profit margin from the CUTs. The net profit margin is 8.75%, calculated on the basis of sales. When applied to the financial data of the tested party, the extracted net profit margin will yield 17.5 in net profit for the party tested under the CPM: Distributor (related) Sales

200

Net profit

17.5

Thus, it may be concluded that the basic methodology of both the gross and net-profit-based methods follows the same two-step approach to allocate income to the tested party.

6.3.3. Relevant parameters under the gross and net profit methods and their impact on reliability The OECD TPG claim, as an argument against applying the TNMM, that net profits are susceptible to influence by “some factors that would either not have an effect, or have a less substantial or direct effect, on price or gross margins between independent enterprises”.604 This assertion is ambiguous. Oddly enough, the OECD TPG do not offer much in the way of reasoning to support it. Some vague indications of which factors the assertion refers to, however, are provided. It is stated that “factors other than products and functions can significantly influence net profit”,605 and that net profit can be influenced by “the potential for variation of operating expenses across enterprises”. (Emphasis added) 606 Based on these indications, the core of the argument seems to be the observation that operating expenses are not included in gross profits, as well as the OECD’s perception that this weighs in favour of the gross profit methods. In this section, the author analyses to which extent the assertion should be deemed justified. Before beginning this analysis, he would like to point out 604. OECD TPG, paras. 2.64 and 2.70. 605. OECD TPG, para. 2.69. 606. OECD TPG, para. 2.70.

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the relevance of the basic motivation behind the transfer pricing methods. The methods benchmark the controlled profit against the profit realized by unrelated parties that carry out comparable transactions. If the controlled profit lies outside the arm’s length range (see the discussion in section 6.5.), there should be an adjustment so that the controlled allocation of income aligns with the third-party profit data. This logic does not hold up if the differences in profits realized by the tested party and the uncontrolled comparables are caused by differing accounting classifications or transfer pricing. First, differing accounting classification is a comparability problem that must be adjusted for, and will typically pertain to the classification of business costs as COGS or operating expenses.607 Second, it should be ensured that third-party profit data are not affected by any transfer pricing performed by the third party and its related entities. Profit data extracted from such transactions will not reflect profits realized between parties with genuinely conflicting interests, and are thus not reliable. This may present a problem in practice, as a potential comparable unrelated enterprise may be a member of a group.608 The author will now comment on the above assertion that “some factors that would either not have an effect, or have a less substantial or direct effect, on price or gross margins between independent enterprises”.609 First, there seems to be an erroneous factual assumption underlying the assertion. The quoted wording indicates that differences in functions are reflected in the COGS. That will normally not be the case. Differences in the functions performed between enterprises will likely be mainly reflected in the operating expenses.610 Second, the factors that affect gross profits logically also affect net profits. Net profits are gross profits after reduction for operating expenses. How-

607. See sec. 6.2.4. and below in this section. 608. Also, with respect to the tested party, the OECD TPG state that the selected profit indicator should be reasonably independent from controlled transactions; see OECD TPG, para. 2.88. This guidance is not entirely clear. In the author’s view, it should, as the point of departure, be irrelevant whether the profit indicator of the tested party is affected by transfer pricing. In fact, that will presumably be the case, as well as the reason why there is a transfer pricing assessment in the first place. In general, all profit elements of the tested party (sales, COGS and operating expenses) will likely consist of a mix of controlled and uncontrolled transactions. 609. OECD TPG, paras. 2.64 and 2.70. 610. See the discussion of operating expenses in sec. 6.2.4.

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ever, the assertion of the OECD TPG pertains to the reverse causality: that the net profits are influenced by factors that do not affect gross profits. Of course, it should be recognized, from a purely factual point of view, that there is merit to the argument, in the sense that operating expenses are included in the net profits, while in the gross profits, they are not. It may therefore be claimed that gross profit methods have an intrinsic advantage relative to the net profit methods, in that they rely on fewer parameters. This observation in and of itself, however, is not particularly meaningful. The real issue is whether this difference is influential towards the reliability of the results yielded by the gross and net profit methods. Operating expenses come as an additional expense item that must be compared to the corresponding expenses of an unrelated comparable enterprise, adding complexity and additional comparability concerns to a transfer pricing assessment. One could therefore be tempted to assume that it will be easier to achieve sufficient comparability under the gross profit methods. If that were true, the cost-plus method and the resale price methods should generally be preferable over the CPM and the TNMM. That, however, is not the case. On the contrary, there are, as mentioned, limitations on the accounting data available on CUTs that may make a net profit analysis more reliable than a gross profit analysis.611 The author will illustrate this through an example in which the accounting data available for the tested party and a comparable unrelated enterprise is as follows: Distributor (tested party) Sales

Profit margins

Distributor (unrelated)

1,000

1,000

COGS

650

600

Gross profit

350

Operating expenses

250

Net profit

100

35%

400

Profit margins

40%

300 10%

100

10%

The tested party earns a smaller gross profit margin than the comparable enterprise, but the same net profit margin. If a gross profit method were applied to test the pricing, for instance, the resale price method, the result would be that the COGS should be adjusted downwards to 600 in order for

611. See also Culbertson (1995).

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the tested party to earn a comparable gross profit margin.612 An effect of this adjustment would be that the net profit of the tested party is increased to 150, resulting in a higher net profit margin earned by the tested party than the comparable unrelated enterprise. If the tested party and the unrelated enterprise are closely comparable with respect to the functions performed, assets used and risks assumed, it cannot be ruled out that the deviation between their gross profit margins is due to accounting differences with respect to the classification of expenses as COGS or operating expenses. It could be, for instance, that the tested party attributes certain depreciation or warranty costs to COGS, while the comparable enterprise does not. Had the third-party accounting specifications been known, it would have been possible to perform an appropriate comparability adjustment at the gross profit level of the comparable enterprise. In practice, however, it will normally not be possible to conclude with certainty whether the observed differences in gross profit margins are due to accounting differences, as the third-party public financial statements will likely not be sufficiently detailed. Further, the tested party and the tax authorities will normally not have access to the internal management accounting data of a comparable third-party enterprise. In this case, it will normally yield a more reliable transfer pricing outcome if the income of the tested party is tested at the level of net profits because the effect of accounting differences will be eliminated at this level, as net profits include all business expenses. Thus, had a net profit method been applied to the accounting data of the tested party in the above example, no transfer pricing adjustment would have been performed, as both the tested and third party have a net profit margin of 10%. The author therefore concludes that it cannot be claimed without reservation that gross profit methods are intrinsically more reliable than net profit methods simply because they rely on fewer parameters.

6.3.4. Are operating expenses relevant under the transactional pricing methods (CUT, resale and cost-plus)? The OECD TPG contrast the TNMM against the CUP, resale price and cost-plus methods (the transactional pricing methods) for the purpose of 612. The sales of the tested party are to unrelated parties, making COGS the only item in gross profits that are influenced by transfer pricing.

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illustrating that net profits are influenced by factors other than those that influence gross profits. The author will tie some comments to this. As the difference between the calculation of gross and net profits is the inclusion of operating expenses in net profits, a sensible way to assess the assertion of the OECD TPG is presumably to analyse the relationship between operating expenses and the CUP, resale price and cost-plus methods. If the results under these three methods are affected by operating expenses, directly or indirectly, there would logically seem to be less merit to the assertion. If so, the assertion should not be used as an argument against the application of the TNMM. The CUP method compares the price charged in a controlled transaction to the price charged in an uncontrolled comparable transaction.613 The method is particularly suited for the pricing of generic products with readily available objective market prices.614 Over time, prices must be set so that the seller reaps a net profit.615 That is, each product sold must, in the long run, bear its share of the operating expenses of the selling enterprise. Thus, logically, the price of a controlled transaction tested under the CUP method must be influenced by both COGS and operating expenses.616 The resale price method allocates an arm’s length gross profit margin to the tested party.617 More specifically, the resale price of the tested party is reduced by a gross profit margin, extracted from CUTs, to find the price that an unrelated distributor would require in order to cover its operating expenses and provide it with a net profit. The view of the OECD is that a low gross margin will be justified if the related distribution entity does not carry on substantial business activities, but only “transfers the goods to a third party”.618 Conversely, a higher margin is justified when the distributor

613. Treas. Regs. § 1.482-3(b); and OECD TPG, paras. 2.13-2.20. See also the analysis of the US comparable uncontrolled transaction (CUT) method in sec. 7.2. and the OECD CUT method in secs. 7.3. and 11.4. 614. See the unbranded coffee bean example in OECD TPG, para 2.18; identical products apart from delivery terms in OECD TPG, para 2.19; and identical products with only volume differences in OECD TPG, para. 2.20. 615. See the discussion in OECD TPG, para. 2.43. 616. For instance, para. 2.19 of the OECD TPG contains an example of an application of the CUP method where an adjustment is made for differences in transportation and delivery terms. Such costs may be classified as operating expenses. 617. Treas. Regs. § 1.482-3(c); and OECD TPG, paras. 2.21-2.38. 618. OECD TPG, para. 2.31.

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is in possession of particular marketing expertise or if it contributes substantially to the creation or maintenance of marketing intangibles.619 The reasoning behind this position is likely that a distributor that provides more value, through the incurrence of more operating expenses, should be compensated with a larger gross profit margin than a distributor that provides relatively less value and incurs relatively less operating expenses. In other words, as the operating expenses (and risks) of the distributor increase, so should its gross profit margin. The reasoning of the OECD on this point is therefore, in fact, a net profit view.620 The cost-plus method calculates the return due to a supplier as a gross margin mark-up on an appropriate cost base.621 The method is typically suitable for determining the transfer price for semi-finished products or for the provision of services, either by using internal or external comparables. The OECD recognizes that it may be problematic to determine an appropriate cost base in order to apply the cost-plus method.622 There may be differences between the tested party and the unrelated comparables with respect to the level of business expenses incurred, as well as the classification of expenses as COGS or operating expenses. Of particular interest is the recognition by the OECD that it may be necessary in order to establish a cost base for applying the cost-plus method to also include certain operating expenses in order to achieve consistency and comparability,

619. Id. However, if the distribution subsidiary is the owner of unique intangibles, it will be highly unlikely that the TNMM is a suitable transfer pricing method to allocate income to the distribution subsidiary in the first place. 620. If the accounting classifications used in the controlled and uncontrolled transactions differ, adjustments should be made to the accounting data in order to properly apply the resale price method; see OECD TPG, para. 2.35. For instance, it may be that R&D costs are included in the COGS, and thus in the gross margin of the tested party, while classified as operating expenses in the financial statements of the comparable unrelated enterprises. Other practical scenarios where adjustments are required may, for instance, be where the tested party and the comparable unrelated enterprises have classified warranty costs differently; see OECD TPG, para. 2.37. 621. Treas. Regs. § 1.482-3(d); and OECD TPG, paras. 2.39-2.55. 622. See OECD TPG, paras. 2.42-2.43. The author’s focus here is on the classification of business expenses as either COGS or operating expenses, but there are also other relevant classification problems connected to the cost-plus method. For instance, as the method is one-sided, it is limited to taking into account the costs of the controlled supplier, not the controlled buyer. This represents a potential problem, as there will be an incentive to allocate costs to the buyer side of the transaction in order to reduce the basis for allocation of income to the supplier, which is the tested party under the costplus method.

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and that “in these circumstances the cost plus method starts to approach a net rather than gross profit analysis”.623 Further, if the tested party is a pure contract-manufacturing subsidiary, the basis for applying the cost-plus method will be all of the costs contractually connected to the assembling activities.624 The OECD TPG take the same stance with respect to contract research and development (R&D) agreements.625 All costs agreed between the controlled parties for the provision of the R&D services shall be used as the basis for the cost-plus method to remunerate the research provider. Such contractually agreed costs may, and likely will, encompass expense items that, on a stand-alone basis, would be classified as operating expenses. This touches on the greater issue that there is no bright line in all cases between the COGS and operating expenses.626 The OECD also recognizes that variations in accounting standards among countries may render it difficult to draw precise lines between the COGS and operating expenses and that the application of the cost-plus method may include the consideration of some operating expenses.627 Even still, the OECD TPG take the rather theoretical stance that these problems “do not alter the basic practical distinction between the gross and net profit approaches”.628

6.3.5. Are comparability adjustments under the gross profit methods more reliable than under the net profit methods? The OECD TPG assert, in somewhat ambiguous language, that gross and net profits may be influenced by some of the same factors, “but the effect of these factors may not be as readily eliminated” under the TNMM as under the gross profit methods.629 Such factors may include the threat of new entrants, competitive positions, management efficiency and individual strategies, the threat of substitute products, varying cost structures (including age of plant and equipment), differences in the cost of capital and the degree of business experience.630 The author takes issue with this assertion. 623. 624. 625. 626. 627. 628. 629. 630.

OECD TPG, para. 2.46. OECD TPG, para. 2.54. OECD TPG, para. 2.55. See also Haugen (2005), at p. 225 on this issue. OECD TPG, para. 2.48. OECD TPG, para. 2.48. OECD TPG, para. 2.70. OECD TPG, para. 2.71.

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First, the only way in which a comparability factor may influence both gross profit and net profit is if the factors influence either sales or the COGS. Clearly, most of the factors listed by the OECD TPG will have a direct effect on, first and foremost, the sales of the enterprise. This includes the competitive position, strategy and substitute products. Other factors, such as cost structures, will clearly impact both the COGS and the operating expenses.631 The author fails to understand why it should be more onerous to adjust for the same factors under the TNMM than under the resale price or cost-plus methods. No justification for this assertion is offered by the OECD TPG. Of course, it may be difficult to perform reliable comparability adjustments in and of themselves, but that does not weigh on the relative difficulty of adjustment between the gross and net profit methods. Second, the underlying motivation behind the assertion seems to be the perception that the effects may be eliminated under the gross profit methods by way of stricter comparability requirements relative to the TNMM.632 In the author’s view, this is an unrealistic and unfounded point of view. The main comparability problem associated with the use of the TNMM is the extraction of blended profit margins from comparable unrelated enterprises.633 It is crucial that this issue is not associated with the TNMM in particular.634 Both the resale price and the cost-plus methods require data on individual CUTs. Such data is largely unavailable. Both the gross profit margin under the resale price method and the mark-up on costs under the cost-plus method are therefore, in practice, extracted from the financial statements of selected comparable enterprises. It is the case for the net profit methods that it will normally not be possible to separate the transactions of the comparable unrelated enterprise that are relevant for transfer pricing purposes from the transactions that are not. Gross profit methods are susceptible to the same measurement errors from blended profits as the net profit methods are. Third, the OECD TPG support the OECD’s assertion with another assertion, i.e. that net profit indicators can be less sensitive than gross margins to 631. The cost of capital is irrelevant in this context. Neither the gross nor net profit methods include financial income or expense items. Cost of capital should therefore be disregarded. It must be due to an error that the factor is even mentioned in OECD TPG, para. 2.71 as a comparability factor that may influence both gross and net profits. 632. OECD TPG, para. 2.70. 633. See the discussion of the use of aggregated third-party accounting data under the TNMM and blended profits in sec. 8.6. 634. Id.

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differences in the extent and complexity of functions, as well as to differences in risk.635 The 2010 OECD TPG contain three examples that seek to illustrate the relative sensitivity of gross and net profit indicators in certain scenarios.636 More specifically, the examples pertain to whether unadjusted comparability differences will impact gross or net profits more. The author observes that these examples are highly specific and rely fully on the assumptions made. They therefore have little value as general guidance. In the author’s view, the takeaway from the examples should not be more than the fact that unadjusted comparability issues will likely affect the results regardless of whether a gross or net method is used and that the impact of the unadjusted differences may influence gross and net profits differently. The choice of an appropriate transfer pricing method should take this into account. Further, he also finds that it is somewhat inappropriate to directly compare gross and net margins in the way that the examples do. When both margins are calculated based on the same denominator, it is, of course, obvious that gross margins will tend to be larger than net margins. This will again result in the likely scenario, as reflected in the first and second example, that the difference between the controlled and uncontrolled gross and net margins will tend to be larger for the former than the latter, with the exception of cases in which net profits are zero or negative, as the situation was in the third example. For these reasons, the author rejects the OECD assertion that that the effects of the mentioned factors may not be as readily eliminated under the TNMM as under the gross profit methods. The US regulations – opposite to the OECD’s perspective discussed above – take the stance that their net profit method, the CPM, will generally provide a more reliable result than the gross profit methods in cases where the available CUTs contain significant product or functional differences relative to the controlled transaction. It is stated that as “operating profit usually is less sensitive than gross profit to product differences, reliability under the comparable profits method is not as dependent on product similarity as the resale price or cost plus method”.637 Further, it is stated that the “degree of functional comparability required to obtain a reliable result under the comparable profits method […] is generally less than that required under the resale or cost plus methods”.638

635. 636. 637. 638.

OECD TPG, para. 2.70. OECD TPG, annex 1 to ch. 2. Treas. Regs. § 1.482-5(c)(2)(iii). Treas. Regs. § 1.482-5(c)(2)(ii).

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Which transfer pricing method should govern the profit allocation among value chain inputs?

The reasoning behind this position is that differences in functions are often reflected in operating expenses, and therefore that taxpayers performing different functions may have very different gross profit margins, but earn similar net profit margins.639 It is not entirely easy to follow this. If differences in functions primarily are reflected in operating expenses, would the gross profits of the tested party and the comparables not precisely remain unaffected by the functional differences? After all, operating expenses influence net, not gross, profits. A possible interpretation is that net profit methods may be more reliable in cases where it is clear that there are functional differences, but it is unclear, due to a lack of sufficiently detailed accounting data, whether the differences in costs have been classified as COGS or as operating expenses. If this interpretation is valid, the US position is, in reality, a variant of the argument that net profit methods eliminate distortions from differing accounting classifications. The point of departure is that the best method rule determines which pricing method is appropriate.640 However, most comparables will likely suffer from a lack of both product and functional comparability. In light of the factors discussed in this chapter, in particular that the effects of differing accounting classifications are eliminated under the net profit methods, the author agrees that there does not seem to be any convincing reason as to why the CPM should not be the preferred method in these cases.

6.4. Which transfer pricing method should govern the profit allocation among value chain inputs? With respect to the important question of which transfer pricing methodology should govern the allocation of operating profits among value chain contributions, the approach under both the US and OECD regimes is that the most appropriate method for the individual case should be selected, i.e. the so-called “best-method rule”.641

639. Id. 640. Treas. Regs. § 1.482-1(c)(1). 641. For general comments on the best method rule, see, e.g. Wittendorff (2010a), at pp. 702-711. See also Luckhaupt et al. (2011), at p. 116, where it is emphasized that there is a large degree of discretionary assessment associated with (selecting and) applying the OECD transfer pricing methods.

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This rule first surfaced in the 1993 US temporary regulations.642 The US version of the rule states that the arm’s length result of a controlled transaction shall be determined under the transfer pricing method that provides the most reliable measure of an arm’s length result.643 The arm’s length result may be determined under any method without establishing the inapplicability of another method. However, if another method subsequently is shown to produce a more reliable measure of an arm’s length result, that other method must be used. The US regulations recognize that data from uncontrolled comparable transactions provide the most objective basis for determining whether the results of a controlled transaction are at arm’s length.644 In determining which transfer pricing method is the most appropriate for a particular case, the primary factors to take into account are the degree of comparability between the controlled and uncontrolled transactions, as well as the quality of the data and the assumptions used in the analysis. For the purpose of allocating operating profits to intangible value chain inputs, the strict comparability requirements for applying the CUT method will generally ensure that the CPM (or the income method in the context of cost-sharing arrangements (CSAs)) is the preferred method in cases where only one party to the controlled transaction provides unique value chain contributions, and the PSM where more than one party renders such value chain inputs. The author will revert to this in detail in the subsequent analysis of the transfer pricing methods (in chapters 7-16). As touched upon in chapter 3, new temporary and final regulations were issued in September 2015, clarifying the application of the arm’s length standard and the best-method rule with other tax code provisions.645 These aim to ensure that there is an arm’s length charge – based on an aggregated valuation approach – for all intangible value transferred among related entities, regardless of the legal form in which the transaction is carried out.646 In particular, controlled transactions combining sections 367 and 482 642. See Higinbotham et al. (1993) for a discussion. 643. Treas. Regs. § 1.482-1(c)(1). For an overview of the development behind the US best-method rule, see Ahmadov (2011), at pp. 195-196. See also Pichhadze (2015), at sec. 3.1.1. 644. Treas. Regs. § 1.482-1(c)(2). It may also be relevant to consider whether the results of an analysis are consistent with the results of an analysis under another method. 645. 80 FR 55538-01. See the comments on these provisions in the context of the relationship between US Internal Revenue Code (IRC) secs. 367 and 482 in sec. 3.5.8. of this book, on aggregated valuation in sec. 6.7.2. and on intra-group R&D services (contract R&D arrangements) in sec. 21.4. 646. See Treas. Regs. (80 FR 55538-01) § 1.482-1T(a)(i)(A) and (C).

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Which transfer pricing method should govern the profit allocation among value chain inputs?

transfers are targeted.647 While no particular method is emphasized as the best for dealing with such (typically outbound) transfers, the requirement for an aggregated valuation will normally entail that the income method (or an unspecified method of similar content) is selected.648 The residual profits will then be allocated to the group entity that provides unique inputs to the intangible development (R&D, workforce in place, know-how, etc.) or exploitation (unique IP), which, in practice, tends to be the US group entity, leaving only a normal market return to the foreign group entities involved in the controlled transaction. With respect to the OECD TPG, there has been – as touched upon in chapter 5 –a clear historical preference for the traditional transactional transfer pricing methods (the CUT, resale price and cost-plus methods).649 The OECD blatantly disregarded the fact that the CUT method would generally be difficult (if not impossible) to apply in a reliable manner to allocate operating profits from intangible value chains.650 While the 2010 OECD TPG abandoned the sharp divide between the traditional transactional transfer pricing methods and the profit-based methods (the TNMM and PSM), the former were still regarded as the most direct means of establishing arm’s length pricing.651 The OECD has now rid itself of the historical bias towards the CUT method.652 While the 2017 OECD TPG on intangibles do not alter the general (2010) OECD approach for selecting pricing methods, significant supplementary guidance is provided on the selection of pricing methodology in the context of IP value chains. The new guidance expresses scepticism towards the CUT method, combined with a pronounced preference for the PSM.653 This new supplementary guidance on the choice of 647. See the analysis of combined sec. 482 and 367 transfers in sec. 3.5.8. of this book. 648. The income method is discussed in sec. 14.2.8.3. 649. For an instructive discussion of the development of the OECD best-method rule, see Ahmadov (2011), at pp. 184-193. 650. 1995 OECD TPG, paras. 3.50 and 3.54. See also Luckhaupt et al. (2011), at p. 104 on the relationship between the available third-party profit data and the selection of an appropriate transfer pricing method. 651. OECD TPG, para. 2.3. 652. For a different approach (that the author does not agree with), see the views expressed in Kotarba (2009), at p. 154 and p. 170 pertaining to the best-method rule. Kotarba argues, much in light of his analysis on p. 160 of the Australian ruling in Roche Products Pty Ltd. v. Commissioner of Taxation ((2008) 70 A.T.R. 703 (Austl.)), that the use of profit-based methods should be restricted to cases in which the traditional transactional methods cannot be employed. See also Cauwenbergh (1997), at pp. 139-141 for a useful (but now dated) comparative overview of the approach taken by different jurisdictions to the priority of transfer pricing methods. See also Markham (2004) in this respect. 653. OECD TPG, paras. 6.131-6.132.

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methodology is part of the more sophisticated approach introduced in the 2017 OECD TPG for determining ownership of unique intangibles based on the important functions doctrine,654 revised guidance on the application of the PSM,655 as well as new rules on the allocation of incremental operating profits due to cost savings, location-specific advantages and synergies.656 The author will revert to the 2017 OECD TPG on the selection of pricing methodology to allocate profits from intangible value chains in chapter 11.

6.5. The arm’s length range 6.5.1. Introduction The application of a transfer pricing method to a set of CUTs will normally not yield one single arm’s length price or gross or net profit margin, but several.657 The arm’s length range is a spectrum of arm’s length results. If the controlled price (CUT method), gross profit margin (resale price and cost-plus methods) or net profit margin (CPM/TNMM) fall within the arm’s length range, there will be no adjustment under US law or under the OECD MTC.658 The US regulations do not require that the Internal Revenue Service (IRS) determine an arm’s length range prior to making a reassessment.659 For instance, the IRS may propose an allocation based on a single uncontrolled price if the CUT method is applied. If the taxpayer subsequently demonstrates that his return position falls within the arm’s length range produced by equally reliable CUTs, the IRS will not be authorized to reassess.660 The OECD takes a similar stance in that only if a taxpayer is unable to establish that the controlled transaction falls within the arm’s length range, the tax administration will be entitled to reassess. In this respect, the arm’s length range works, under both the US and OECD regimes, as a safe harbour for the taxpayer. Conversely, as seen from the point of view of the tax authorities, the arm’s length range represents a reassessment limitation.

654. See the analysis of the “important functions doctrine” in sec. 22.3.2. 655. See the analysis of the OECD PSM in ch. 9 and the relative role of the method in the post-BEPS OECD regime in sec. 11.4. 656. See the analysis of the allocation of incremental operating profits from local market characteristics, location savings and synergies in ch. 10. 657. For a recent discussion of the arm’s length range (under transfer pricing laws in Denmark, Hungary and the United States), see Koue et al. (2017). 658. Treas. Regs. § 1.482-1(e)(1); and OECD TPG, para. 3.60. 659. Treas. Regs. § 1.482-1(e). 660. Id.

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In the context of allocating operating profits from intangible value chains (where unique IP is used as input), the arm’s length range will, in practice, be relevant mainly for the one-sided pricing methods (in particular the CPM and TNMM), or more specifically, where the purpose is to allocate a normal market return to the routine value chain contributions rendered by the tested party (e.g. compensation of a distribution subsidiary that licenses a trademark from another group entity).661 The close relationship between the arm’s length range and the CPM (which is the key US method for allocating normal market returns to routine entities) is accentuated by the fact that the arm’s length range provision was introduced into the US regulations alongside the CPM.662 The author will comment on the positions taken by the United States and the OECD on use of the arm’s length range in sections 6.5.2.-6.5.3. The main focus will be on the US regulations, as the OECD TPG are brief on this issue.

6.5.2. The level of comparability required to include an uncontrolled transaction in the arm’s length range The selection of CUTs must comply with the comparability criteria set out by the particular pricing method applied and must be sufficiently similar to the controlled transaction in order to provide a reliable measure of an arm’s length result.663 Under the 1993 temporary regulations, all valid applications of transfer pricing methods were included in the arm’s length range.664 The final 1994 regulations amended this rule to reflect the possible use of inexact comparables. The idea behind the amendment was that it would be inappropriate to derive the arm’s length range from a mix of exact and 661. See Markham (2005), at pp. 309-310, who argues that the arm’s length range may “counteract” many of the problems associated with applying the arm’s length principle to intangible transactions. This is, in the author’s view, an unrealistic assertion, as the arm’s length range only pertains to the determination of a normal market return to routine value chain contributions. It does not, in and of itself, aid in the allocation of residual profits from unique intangibles. 662. See the preamble to the 1993 temp. Treas. Regs. (58 FR 5263-02) § 1.482-1T(d) (2). The CPM was favoured in a range of arm’s length results rather than a single arm’s length price. Even though primarily motivated by the CPM, the 1993 temporary regulations extended the use of the arm’s length range to all of the pricing methods. However, to form a part of the range, each application of the applicable pricing method must independently satisfy the criteria for the application of that method and the general comparability standards under temp. Treas. Reg. § 1.482-1(c)(2). 663. Treas. Regs. § 1.482-1(e)(2)(ii). 664. 1993 Temp. Treas. Regs. (58 FR 5263-02) § 1.482-5T(d)(2)(i).

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inexact comparables, as that would assign the same weight to results with potentially widely varying degrees of reliability. The rule under the final regulations is therefore that, as the point of departure, the arm’s length range can only include uncontrolled transactions of “similar comparability and reliability”.665 Third-party transactions with significantly lower levels of comparability and reliability must therefore be discarded.666 This leaves two possible alternatives for determining the arm’s length range. The first alternative would be to include all uncontrolled transactions in the arm’s length range.667 This requires that the information available on the CUTs is “sufficiently complete”, i.e. that it is likely that every material difference between the controlled and each uncontrolled transaction has been “identified” and that each difference has a “definitive and reasonably ascertainable effect” on price, mark-up or profit, and that an adjustment is made to eliminate the effect of such differences. If these requirements are fulfilled, all of the uncontrolled transactions are included in the range.668 The OECD takes a similar stance as the US regulations on this point. Under the OECD TPG, uncontrolled transactions that have a lesser degree of comparability than the other CUTs included in the range should be discarded.669 The second alternative for determining the arm’s length range is to use the so-called “interquartile range”.670 This will be relevant where the abovementioned comparability standard (identification and adjustment of pricerelevant differences in the CUTs) is not met. In this situation (which is highly practical), the arm’s length range will contain uncontrolled transactions of varying degrees of comparability and reliability. Had the whole range been used, that would imply that results with varying degrees of comparability and reliability would be assigned equal weight. This also would violate the rule that uncontrolled comparables with significantly lower levels of comparability and reliability must be discarded from the arm’s length range.671 Because it would be impossible to directly identify and quantify the material differences between the controlled and each uncontrolled transaction, the US regulations require that the differences be taken into account indirectly through the use of a statistical range. When it is highly probable that 665. Treas. Regs. § 1.482-1(e)(2)(i). 666. Treas. Regs. § 1.482-1(e)(2)(ii). 667. Treas. Regs. § 1.482-1(e)(2)(iii)(A). 668. See Treas. Regs. § 1.482-1(e)(5), Example 1. 669. OECD TPG, para. 3.56. 670. Treas. Regs. § 1.482-1(e)(2)(iii)(B). See Culbertson et al. (2003), at p. 108; and Casley et al. (2003), at p. 167 on the interquartile range. 671. Treas. Regs. § 1.482-1(e)(2)(ii).

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the uncontrolled comparables are not of roughly equal comparability, it is reasonable to assume that the results diverging significantly from the norm are not comparable to the controlled transaction. The interquartile range exception (from using only CUTs that satisfy the above-mentioned comparability requirements) allows CUTs that contain material differences (that may affect pricing) relative to the controlled transaction. To compensate for the reduced reliability caused by the use of such comparables, the arm’s length range itself must be adjusted through the application of a valid statistical method so that there will be a 75% probability of a result falling above the lower end of the range and a 75% probability of a result falling below the upper end of the range. The idea behind the interquartile range is to narrow the range of results, thus excluding the lowest and highest prices provided by the selected uncontrolled transactions, in order to increase the reliability of the data by excluding the extremes at both ends of the data range.672 The position taken in the US regulations is that the interquartile range will ordinarily provide an acceptable measure of the arm’s length range (even if the range includes somewhat “incomparable” third-party transactions).673 The OECD takes the same position.674 The interquartile range is the range from the 25th percentile to the 75th percentile of the results from the uncontrolled comparables. For instance, if seven uncontrolled transactions have been identified and the pricing applied in them are 1, 2, 3, 4, 5, 6 and 7, the middle value of the prices, i.e. the median, will be 4. The interquartile range is the range of the middle 50% of the data. The median of the lower half of the data, 2, is the first quartile, while the median of the upper half of the data, 6, is the third quartile. The difference between the first and third quartiles is the interquartile range. Thus, if the controlled pricing of the tested party lies between 2 and 6, there will be no adjustment, as that pricing will be within the interquartile range. However, if the controlled pricing is either below 2 or above 6, there will be an adjustment. 672. The US regulations contain an example pertaining to an outbound structure between a US manufacturing parent and a foreign subsidiary in which the US Internal Revenue Service (IRS) considers applying the CPM; see Treas. Regs. § 1.482-1(e)(5), Example 4. 673. Treas. Regs. § 1.482-1(e)(2)(iii)(B). 674. OECD TPG, para. 3.57. See Koue et al. (2017), where it is argued that there should be additional guidance on how to apply the interquartile range in practice.

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6.5.3. On which point within the arm’s length range may a reassessment be based? If it is clear that the price or profit result of the controlled transaction lies outside of the arm’s length range, there will be an adjustment. The question is then as to which point inside the arm’s length range may the tax authorities reallocate income. The US regulations allow the IRS to reassess the taxpayer’s result at any point within the arm’s length range.675 The OECD takes the same position.676 Nevertheless, if the interquartile range is applied, the taxpayer’s result will normally be adjusted to the median of the interquartile range.677

6.6. Comparability 6.6.1. Introductory comments Comparability is fundamental in transfer pricing. The pricing of a controlled transaction will satisfy the arm’s length standard if it results in the same allocation of profits that would have been realized if unrelated enterprises had carried out the same transaction under the same conditions. Yet, because it will normally not be possible to identify uncontrolled transactions that are identical to the controlled transaction in all respects, the US and OECD transfer pricing methods only require third-party benchmark transactions to be comparable.678 Comparability requirements are specific to the transfer pricing method being applied. As the pricing methods test different parameters, comparability problems will vary from method to method. Thus, it should be recognized that transfer pricing comparability requirements form a heterogene-

675. Treas. Regs. § 1.482-1(e)(3). 676. OECD TPG, para. 3.62. 677. Treas. Regs. § 1.482-1(e)(3). The median of a set of data is the middle-most number in the set. For instance, in the dataset 1, 2, 3, 4 and 5, the median is 3. The OECD TPG find it “appropriate to use measures of central tendency to determine this point … in order to minimise the risk of error due to unknown or unquantifiable remaining comparability defects”; see OECD TPG, para. 3.62. 678. On comparability, see an overview of significant issues in practice in Haugen (2005), at p. 227. See also Higinbotham et al. (1998); Fris et al. (2010); and Luckhaupt et al. (2011), at p. 100.

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ous set of rules, not one coherent norm; there are as many comparability norms as there are pricing methods. For instance, the CUT method applied to allocate profits to unique IP seeks to identify a third-party royalty rate that can be used to benchmark the rate used in the controlled transaction. The CPM/TNMM benchmark the normal return net profit margin allocable to the tested party’s routine value chain contributions against the net profits of comparable third parties. The need to attain transactional comparability is particularly pronounced under the CUT method, while functional comparability is more relevant under the CPM/TNMM.679 Due in part to the manner in which multinationals organize their transactions and business structures through centralized ownership of unique value chain inputs and dispersed performance of routine functions through specialized local group entities, it has, in practice, proven genuinely problematic to achieve the ideal comparability goals of the arm’s length standard as set out by the pricing methods.680 This problem runs deep. First, the comparability problem has historically been the main catalyst for the development of new transfer pricing methods. From its origin in the transaction-oriented CUT method,681 the development has gone through the more functionally-geared CPM/TNMM,682 while the core application of the PSM is to allocate residual profits based not on comparables, but on concrete assessments of the relative values of the unique intangibles contributed to the value chain.683 The latest addition to this development is the income method of the US cost-sharing regulations,684 which require intra-group profit allocations to be aligned with the realistic alternatives of the controlled parties.685 679. OECD TPG, para. 1.109. See also the discussion in sec. 8.6. of this book, with further references. 680. See Francescucci (2004a), at p. 68 for a discussion of how the transactions of group entities may differ from those of third parties. See also Schön et al. (2011), at pp. 102-103, for reflections pertaining to the lack of comparables in transfer pricing. There are also other problematic aspects pertaining to comparables, such as the use by tax authorities of secret comparables; see, e.g. Przysuski et al. (2003). 681. See the discussion of the US CUT method in sec. 7.2. and of the OECD CUT method in secs. 7.3. and 11.4. 682. See ch. 8 on the CPM and TNMM. 683. See ch. 9 on the US and OECD profit split methods. 684. See the discussion of the income method in sec. 14.2.8.3. 685. The “realistic alternatives available” pricing principle has also had significant influence on the new OECD guidance; see, e.g. OECD TPG, paras. 1.38, 1.40, 1.122 and 6.139. See also the discussions of the 2017 OECD TPG on valuation in ch. 13.

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Second, the comparability problem has resulted in tension between the perceived need of some jurisdictions to maintain transfer pricing rules based on ideal comparability requirements, on the one side, and the need to adapt the methods sufficiently to the real-world problems encountered in the field by multinationals and tax authorities – revolving in particular around the lack of reliable disaggregated third-party accounting data – on the other side.686 A consequence of this tension has been that the current OECD consensus on rather fundamental comparability requirements is ambiguous. The author imagines that comparability problems will remain a relevant issue in transfer pricing also in the future, likely necessitating revised or new pricing methods, perhaps with an even stronger emphasis on the realistic alternatives available to the controlled parties, moving transfer pricing (even) further away from traditional, transaction-based comparability assessments. Because comparability is inherently linked to the transfer pricing methods, the author will analyse the specific comparability issues in connection with his discussions of the individual transfer pricing methods.687 Of course, this link makes it difficult to present a generalized overview of comparability without the discussion becoming either too bland or even redundant in the sense that the topics discussed must nevertheless be reverted to when the particular pricing methods are later analysed. Nevertheless, he finds it necessary at this stage of the book to at least introduce some broad information on comparability in this chapter that can form the backdrop for the more specific discussions that will follow. The standard of comparability under the US regulations and the OECD TPG is discussed in section 6.6.2.; the question of whether the required degree of comparability varies between the pricing methods is discussed in section 6.6.3.; some comments on the relationship between comparability and the rules for determining ownership to self-developed intangibles are provided in section 6.6.4.; and the comparability factors under the US regulations and the OECD TPG are discussed in section 6.6.5.

686. See the discussion of the use of aggregated third-party financial profit data as comparables under the TNMM in sec. 8.6. 687. Comparability problems under the US CUT method are discussed in secs. 7.2.2.7.2.3.; under the OECD CUT method in secs. 7.3.2.-7.3.3. and 11.4.; under the CPM and TNMM in secs. 8.5. and 8.6., respectively; and under the US and OECD PSMs in ch. 9. Buy-in pricing under the CUT method of the US cost-sharing arrangement (CSA) regulations is discussed in sec. 14.2.8.2.

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6.6.2. The standard of comparability The US standard of comparability is that an uncontrolled transaction must be “sufficiently similar that it provides a reliable measure of an arm’s length result”688 and, further, that “all factors that could affect prices or profits in arm’s length dealings (comparability factors)” must be taken into account when determining the degree of comparability.689 If there are material differences between the controlled and uncontrolled transactions, comparability adjustments must be made, provided that the effect of the differences on the prices or profits can be ascertained with sufficient accuracy. The adjustments must be made based on commercial practices, economic principles or statistical analyses. If such adjustments cannot be made, the comparable may still be used, but the reliability of the analysis will be reduced. The interquartile range (see section 6.5.2.) may then be used to limit the potential errors caused by the reduced degree of comparability. The OECD comparability standard is largely similar.690 The OECD TPG state: [B]ecause the separate entity approach treats the members of an MNE group as if they were independent entities, attention is focused on the nature of the transactions between those members and on whether the conditions thereof differ from the conditions that would be obtained in comparable uncontrolled transactions.691

Similarly to the US regulations, the OECD TPG also accept comparables when it is not possible to achieve ideal comparability.692 Also here, the interquartile range will normally be used to lessen the potential errors of using uncontrolled transactions with limited comparability.

688. Treas. Regs. § 1.482-1(d)(2). See the comments in Wittendorff (2010a), at p. 393. 689. Treas. Regs. § 1.482-1(d)(1). 690. See the comments in Wittendorff (2010a), at p. 396. See Bullen (2010), at p. 215 on comparability adjustments. 691. OECD TPG, para. 1.6. 692. OECD TPG, para. 2.103.

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6.6.3. Does the degree to which comparability is required vary among the pricing methods? It seems to be suggested from time to time that the degree to which comparability is required varies depending on the method being applied. A typical assertion may be that the CUT method demands the strictest degree of comparability, while the other methods require a lesser degree of comparability. If this assertion were true, it would entail qualitative differences between the profit allocation results yielded by the different methods. The pricing methods work in different ways. The CUT method is wholly reliant on finding an uncontrolled transaction from which the third-party royalty rate is extracted and used to benchmark the rate used in the controlled transaction. The method can only be applied in a meaningful way to allocate profits to unique IP if there is an extreme degree of comparability between the intangibles transferred in the controlled and uncontrolled transactions (in particular, with respect to profit potential).693 The CUT method directly allocates residual profits by way of applying the royalty rate extracted from the third-party transaction to benchmark the controlled profit allocation. Due to the large amount of income directly allocated (residual profits may be larger than normal market returns), shortcomings in comparability may have profound effects on the ultimate allocation of profits among controlled parties. Conversely, one-sided methods directly allocate only a normal market return profit margin to the routine inputs (e.g. contract manufacturing and sales functions) provided by the tested party. Such returns are easier to benchmark, and comparability shortcomings may not have the same impact on the ultimate profit allocation between the controlled parties.694 Thus, the CUT method is most vulnerable to comparability shortcomings when applied to allocate profits to unique IP. This, however, does not entail that its comparability requirements as such are stricter than those of other methods. There must, of course, be sufficient comparability under all methods so that the results yielded by them are reliable. The point is, rather, that the CUT method and the one-sided methods test different classes of third-party transactions. Achieving comparability under the CUT method 693. See also, in this direction, OECD TPG, para. 1.40, which states that “the method becomes a less reliable substitute for arm’s length transactions if not all the characteristics of these uncontrolled transactions that significantly affect the price charged between independent enterprises are comparable”. 694. See the analysis of the aggregation of uncontrolled transactions in sec. 8.6.

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– when applied to allocate profits to unique IP – is reliant on finding thirdparty transfers of IP comparable to the unique IP transferred in the controlled transaction (which, of course, will be difficult), while the one-sided methods rely on third-party comparables for routine inputs. Simply due to this difference in parameters tested under the respective methods, it will, in general, be more likely that sufficient comparability can be attained under the one-sided methods than under the CUT method.695 The assertion that the one-sided methods require a lesser degree of comparability than the CUT method must therefore be rejected, as the comparability requirements cannot meaningfully be compared directly. They pertain to different classes of third-party comparables. The only common factor between the comparability requirements of the one-sided methods and those of the CUT method is that the ultimate profit allocation, irrespective of the method applied, must be sufficiently reliable so as to reflect what unrelated enterprises would have agreed to in a comparable scenario.

6.6.4. The relationship between comparability and the rules for determining ownership of intra-group-developed intangibles As discussed, comparability requirements stem from the transfer pricing methods. The rules for determining intangible ownership are – and have historically been deemed to be – independent of the transfer pricing rules at the outset, and therefore also independent of the comparability requirements.696 The 2017 OECD TPG on the determination of IP ownership, however, draw upon transfer pricing principles, in particular, the profit split method (e.g. that the relative importance of each group entity’s IP development contributions shall be influential for profit allocation purposes).697 Because of this connection, it is no longer possible to operate with a bright line between rules on IP ownership and transfer pricing rules. Likewise, it cannot categorically be stated that comparability considerations are re695. In this direction, see also Luckhaupt et al. (2011), at p. 104 on the relationship between the third-party profit data available and the selection of an appropriate transfer pricing method. 696. The US and OECD intangible ownership provisions are analysed in part 3 of this book. 697. See OECD TPG, para. 6.56. The author refers to his discussions of important functions for determining ownership of co-developed intangibles under the OECD TPG in sec. 22.3.2.; the remuneration of intangible development funding in sec. 22.4.; and the relationship between the rules on intangible ownership and the PSM in sec. 11.4. See also the discussion of risk as a comparability factor in sec. 6.6.5.5.

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served for the transfer pricing stage only. The impact of some comparability factors, in particular the allocation of risk, are perhaps even more pronounced in the context of determining IP ownership than in the context of transfer pricing.

6.6.5. Comparability factors 6.6.5.1. Introduction The ultimate goal of transfer pricing is to ensure that controlled profit allocations reflect arm’s length profit allocations. In order to provide this outcome, all factors having influence on the third-party profit allocation must be taken into account and be comparable to the corresponding factors in the controlled scenario. These factors have traditionally been referred to as “comparability factors” in the US regulations and the OECD TPG. The 2017 OECD TPG, however, go far by replacing the term with “economically relevant characteristics”.698 Neither regime operates with exhaustive lists of comparability factors. The point is rather to ensure that all factors that possibly could affect pricing are properly taken into account. If a relevant factor is disregarded, the application of a pricing method could yield a non-arm’s length result. Due to the comprehensiveness of a proper comparability analysis, there is no bright line separating it from a functional analysis. As a point of departure, a functional analysis pertains to an analysis of the functions, assets and risks contributed to the relevant value chain (and linking these contributions to specific group entities) for the purpose of gaining an overview of the multinational business,699 while a comparability analysis refers to an assessment upon the application of a specific pricing method for the purpose of allocating operating profits (i.e. whether a third-party transaction is sufficiently similar to the controlled transaction so that it can be used for benchmarking purposes).700 A functional analysis is thus carried out prior to the actual pricing and comparability process (the application of a transfer pricing method). Comparability analyses are so intensive that every relevant aspect of a value chain must be clarified, with the result that a typical comparability analysis may resemble a general functional analysis.

698. OECD TPG, para. 1.36. 699. OECD TPG, para, 1.34 700. OECD TPG, para. 1.35.

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Both the US regulations and the OECD TPG contain general guidance on comparability.701 The key comparability factors under both regimes are (i) contractual terms; (ii) functions; (iii) economic conditions; and (iv) risks. These will be commented on in sections 6.6.5.2.-6.6.5.5.

6.6.5.2. Contractual terms 6.6.5.2.1.  Introduction A comparability analysis will normally start with the terms of the controlled transaction (see section 6.6.5.2.2.),702 at least when applying the CUT method for pricing intangibles. The contractual terms of the controlled transaction must, however, align with the economic substance of the actual behaviour of the controlled parties in order to be given effect under the US and OECD regimes. Thus, if there is a discrepancy between the written terms of the controlled agreement and the actual behaviour of the controlled parties, the terms that are indicated by the actual behaviour will prevail over the written terms. Economic substance and the notion of non-recognition are discussed in section 6.6.5.2.3. 6.6.5.2.2.  Comparability of contractual terms All terms contained in the controlled agreement are, in principle, relevant for the comparability analysis, of course apart from the provisions pertaining to compensation (e.g. royalties).703 Price provisions are subject to testing under the pricing methods once comparability has been established for other terms. Significant contractual terms include the form of payment,

701. Treas. Regs. § 1.482-1(d); and OECD TPG, ch. 1, sec. D. 702. On contractual terms as a comparability factor, see also Wittendorff (2010a), at pp. 419-421. 703. See Pichhadze (2015a); and Pichhadze (2015b) for a discussion of the significance of contractual interpretation (US) law for determining the content of the controlled transaction. Pichhadze fears that unless the contractual terms of the actual controlled transaction are interpreted correctly, there will be a risk that comparables will be collected based on misconstrued contractual terms, with the result that income may be allocated incorrectly. While Pichhadze’s views are interesting, this author’s impression is that Pichhadze assigns too much weight to controlled contractual terms. There are several other comparability factors than such terms that must be taken into account for profit allocation purposes, and the current transfer pricing methodology ensures that profit is allocated according to the controlled parties’ contributions of functions, assets and risks.

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volume of sales,704 scope and terms of warranties, rights to updates and revisions, duration of a licence agreement, termination and re-negotiation rights.705 Information on the terms of uncontrolled agreements may, in practice, be limited, or simply unavailable. That may influence the selection of the best pricing method. If the controlled transaction, for instance, is a licence agreement, a lack of information on controlled terms may make it difficult to apply the CUT method (i.e. it will be unclear as to what to compare). If the PSM is applied, however, there may be no particular need for such information (as the residual profits may be allocated based on discretionary assessments of relative value and not comparables). 6.6.5.2.3.  Economic substance and non-recognition As mentioned, the terms of a written controlled agreement will be given effect (i.e. will form the basis for applying a transfer pricing methodology) under US and OECD transfer pricing law only if they are consistent with the economic substance of the actual behaviour of the controlled parties.706 Thus, if there is a discrepancy between the written terms and the actual behaviour, the terms that can be deduced from the actual behaviour will prevail and form the basis for subsequent comparability and transfer pri­ cing assessments.707 The 2017 OECD TPG refer to this “reality check” as the “delineation of the actual transaction”.708 It may, for instance, be that the written controlled agreement reflects that the parent has licensed IP to its foreign subsidiary and agreed to provide relevant technical support in return for royalty payments. The actual conduct of the parties, however, shows that the parent negotiates with the subsidiary’s clients and assists the subsidiary in performing its obligations towards these clients. The subsidiary is not capable of fulfilling its contracts without help from the parent, and it does not independently develop its own business and or act as a licensee. The controlled 704. The US regulations include two examples on comparability adjustments for differences in volumes, undoubtedly motivated by U.S. Steel Corp. v. C.I.R., T.C. Memo. 1977-140 (1977). See Treas. Regs. § 1.482-1(d)(3)(ii)(C), Examples 1 and 2. 705. Treas. Regs. § 1.482-1(d)(3)(ii). 706. Treas. Regs. § 1.482-1(d)(3)(ii)(B)(1); and OECD TPG, para. 1.45. See Bullen (2010), at pp. 433-441; and Monsenego (2014) on economic substance. 707. On this issue, see, e.g. Navarro (2017), at p. 130; and Odintz et al. (2017), at sec. 2.2.3.1. 708. OECD TPG, para. 1.45.

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agreement should therefore not be deemed a licence agreement, but rather a service agreement.709 If there is no written agreement in place between the controlled parties, all aspects of the controlled transaction must be deduced from the actual conduct of the parties.710 In a world apart from delineating the actual controlled transaction lies socalled “non-recognition”.711 Under the 2017 OECD TPG, the actual delineated transaction may be recast: […] where the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances, thereby preventing determination of a price that would be acceptable to both of the parties taking into account their respective perspectives and the options realistically available to each of them at the time of entering into the transaction.712

If these criteria are fulfilled and the controlled transaction is recast, it should be made to comport as much as possible with the facts of the actual transaction while achieving a commercially rational result that would have enabled the parties to arrive at a price acceptable to both of them.713 The OECD non-recognition doctrine is reserved for “exceptional circumstances”.714 Non-recognition is generally inapplicable if it is possible to price the transaction715 and will, in any case, be inapplicable where the controlled pricing is based on a genuine CUT.716 The system of the OECD 709. OECD TPG, para. 1.48. 710. OECD TPG, para. 1.47. On this issue, see Navarro (2017), at p. 137. 711. On non-recognition under the 2017 OECD TPG, see Navarro (2017). For a comprehensive analysis of this subject, based on the pre-2015 BEPS revision language of the OECD TPG, see also Bullen (2010), pp. 215-219 on the distinction between comparability and structural adjustments. See also Pankiv (2017), at p. 114. 712. OECD TPG, para. 1.122. The “previous generation” text in para. 1.65 of the 2010 OECD TPG stated that if the controlled transaction differed from what would have been adopted by rational independent enterprises and the actual structure of the controlled transaction “practically impedes the tax administration from determining an appropriate transfer price”, tax authorities were entitled to restructure the controlled transaction. On the concept of options realistically available, see Parekh (2015), in particular at pp. 297-298, where Parekh finds that the concept has application in three transfer pricing contexts apart from recharacterization, namely (i) comparability analysis; (ii) pricing of IP transactions; and (iii) pricing of compensation triggered by crossborder business restructurings. 713. OECD TPG, para. 1.124. 714. OECD TPG, para. 1.121. 715. OECD TPG, para. 1.122. 716. Id.

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TPG is that the controlled transaction, as delineated in accordance with economic substance, shall be analysed using the rules on intangible ownership and the transfer pricing methods in order to provide an arm’s length profit allocation. Given the scope, depth and sophistication of these rules, there is little left for the non-recognition doctrine to deal with. Comparatively, the US regulations use the realistic alternatives of the controlled parties as a central component in the pricing methods (which is also the case under the OECD TPG),717 but will not restructure the controlled agreement as if the alternative had been adopted by the taxpayer.718 The author will elaborate a bit on why the non-recognition doctrine plays such a modest role in transfer pricing practice. First, as stated by the OECD, “nonrecognition can be contentious and a source of double taxation”.719 The guidance on intangible ownership and the transfer pricing methods seek to ensure uniform profit allocations. Even if the current transfer pricing methodology certainly provides some leeway with respect to the profit allocation patterns that are acceptable, the spectrum of allowed solutions will normally be reasonably limited (e.g. the arm’s length range lists the acceptable profit margins that can be used to allocate a normal market return to the tested party). The hope is that the methodology is applied in the same manner by both treaty jurisdictions, thereby yielding the same pricing outcomes and avoiding double taxation. The non-recognition doctrine triggers a more significant risk of disharmonized profit allocations, and thereby double taxation. If the criteria for applying the doctrine are not sufficiently restrictive, there is a risk that a controlled transaction may be subject to non-recognition, even if it is susceptible to arm’s length pricing. This would be detrimental to the international transfer pricing system, as controlled transactions priced at arm’s length provide parity in the taxation between related and unrelated parties, and should be respected. As expressed by the OECD: [N]onrecognition of a transaction that possesses the commercial rationality of an arm’s length arrangement is not an appropriate application of the arm’s length principle. Restructuring of legitimate business transactions would be a wholly arbitrary exercise the inequity of which could be compounded by

717. See, e.g. the income method in the new cost-sharing regulations, as discussed in sec. 14.2.8.3. 718. Treas. Regs. § 1.482-1(f)(2)(ii). 719. Id.

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double taxation created where the other tax administration does not share the same views as to how the transaction should be structured.720

Closely related to this is that the profit allocation effect of non-recognition is elusive and unpredictable, and may first be determined after the ­pricing methods have been applied to price the recast controlled transaction. Given the amount of freedom that tax administrations have with respect to restructuring the controlled transaction (provided that the criteria for applying the doctrine are fulfilled), it does not seem far-fetched to assume that there is a risk that the transaction may be recast in a manner that maximizes profit allocation to the relevant jurisdiction,721 creating an obvious potential for double taxation. Second, there is a negative correlation between the relevance of the nonrecognition doctrine, on the one side, and the effectiveness of the rules on intangible ownership and the transfer pricing methods, on the other. The more developed the latter rules are, the more redundant a non-recognition doctrine will be. Non-recognition has traditionally been discussed in the context of pronouncedly BEPS-motivated transactions. It will normally be possible to price the actual delineated transaction in most of these cases, as the controlled parties tend to provide some form of routine or non-routine value chain contributions that are susceptible to arm’s length pricing.722 The 2014 proposed OECD guidance on non-recognition provides an example that illustrates this point.723 It pertains to a subsidiary, resident in jurisdiction P, which owns a valuable, self-developed trademark crucial to its business and carries out extensive local marketing. The trademark is sold to a foreign group entity resident in a low-tax environment for a lump sum. The foreign entity then licenses rights to the marketing intangible back to the subsidiary for a fixed royalty rate, combined with a service agreement pursuant to which the subsidiary is to provide local marketing. 720. OECD TPG, para. 1.123. 721. The degree of freedom is limited by the requirement that the recast transaction, once priced, yields a profit allocation outcome that is aligned with the realistic alternatives of the controlled parties. Nevertheless, it will likely, in most cases, be possible to accommodate a range of different “recast alternatives”, offering considerable leeway for profit allocation. 722. For instance, the main reason why the IRS argued non-recognition in the Puerto Rican cases discussed in sec. 5.2.4. was that the domestic rules at the time allowed the transfer of valuable intangibles without triggering a taxable event (tax continuity), rendering the transfer pricing methods inapplicable. In normal contexts, however, transfer pricing will be triggered when intangibles are transferred among group entities. 723. OECD, Guidance on Transfer Pricing Aspects of Intangibles, Action 8: 2014 Deliverable (OECD, 2014) [hereafter 2014D, D4], paras. 90-93.

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The transaction is not recognized, on the basis that it does not enhance or protect the subsidiary’s commercial and financial position.724 The ultimate logic is that the subsidiary would be better off had it not entered into the controlled transaction. The author finds it clear that it was inappropriate to apply non-recognition in the example. The first question should have been: What is the consequence of not recognizing the actual delineated transaction? The answer is that the subsidiary would be treated as the owner of the intangible, resulting in allocation of the residual profits from the trademark to jurisdiction P.725 The next question should have been: What is the consequence of pricing the actual delineated transaction? The subsidiary developed the marketing intangible, and should therefore be allocated all residual profits from it.726 There would likely be no existing CUT on which to base the pricing, probably resulting in an application of the TNMM in the context of a net present value (NVP) calculation.727 Key in this assessment are the realistic alternatives available to the controlled parties.728 For the subsidiary, this would, of course, be to not sell the intangible, but to continue its ownership and marketing efforts as before. The NPV of the operating profits allocable to it under this alternative forms the lowest acceptable price for the marketing intangible. No rational economic actor would sell below this amount. However – as is the author’s point – if the transfer price equals or exceeds this amount, the subsidiary will either be neutral or better off by selling the intangible. Thus, the question of whether the actual controlled transaction “enhances or protects” the subsidiary’s “commercial or financial position” is entirely dependent on the pricing of the transaction. The example seems to disregard this fundamental point. Also, if the transfer price of the marketing intangible lies below the NPV of the subsidiary’s best realistic alternative, this would constitute normal mispricing, which should be corrected in the proper way, i.e. through transfer pricing, not through non-recognition.

724. 2014D, D4, para. 91. 725. 2014D, D4, para. 92. 726. See the analysis of the OECD intangible ownership guidance on “important functions” in sec. 22.3.2. 727. See the discussion of the OECD guidance on valuation in ch. 13. This application of the TNMM would largely be parallel to an analogical application of the income method under the US cost-sharing regulations; see sec. 14.2.8.3. 728. See the discussion of the significance of the alternatives realistically available in the context of valuation in section 13.5.

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Fortunately, this example was scrapped in the final 2017 consensus text and replaced with a new example, which indicates a significantly higher threshold for applying the non-recognition doctrine.729 It pertains to a group entity that self-develops intangibles through its own R&D and transfers unlimited rights to all intangibles that may arise from its future work over the next 2 decades for a lump-sum payment to a foreign group entity. The example deems the controlled transaction to be commercially irrational for both parties. Neither company has any reliable means to determine whether the payment reflects an arm’s length valuation, as it is uncertain as to what future R&D activities will be carried out, making a valuation of the potential outcomes entirely speculative.730 In light of the omitted 2014 draft example, there should be no doubt that the final 2017 example is intended to establish a significantly narrow scope of application for the doctrine. The point of the latter example is that the controlled transaction is so comprehensively nonsensical (essentially a transfer of unspecified rights) that an application of the transfer pricing methodology would not be meaningful, distinguishing the scenario from normal cases of valuation uncertainty and mispricing in which non-recognition clearly is inapplicable. In the author’s view, the steep threshold indicated in the 2015 example for application of the non-recognition doctrine is both useful and necessary to preserve the arm’s length transfer pricing system, while at the same time ensuring that there is an “emergency” mechanism in place to adjust absurd transactions so that it may be possible to attain an arm’s length profit allocation in such outlier scenarios as well.731

6.6.5.3. Functions The US regulations require that the degree of comparability between the economically significant functions performed by the controlled and uncontrolled taxpayers must be ascertained.732 Such functions include R&D, 729. OECD TPG, at para. 1.128. An additional example is provided, also indicating a comprehensively high threshold for non-recognition; see OECD TPG, para. 1.126. 730. The example suggests that the controlled transaction should be recast in accordance with the economically relevant characteristics, e.g. as the provision of financing by company S2 or as the provision of research services by company S1, or if specific intangibles can be identified, as a licence with contingent payment terms. 731. See also Navarro (2017), at p. 237, where it is concluded that non-recognition should never not be applied to deal with the assignment of IP ownership, as this issue shall be dealt with through remuneration of the involved group entities (transfer pri­ cing). The author agrees with this. 732. Treas. Regs. § 1.482-1(d)(3)(i). For critical comments on the role of the functional analysis in transfer pricing, see Roberge (2013), at p. 226.

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product design and engineering, manufacturing, production and process engineering, product fabrication, procurement, marketing and distribution functions, transportation and warehousing and management services. The analysis must take into account the resources (e.g. unique intangibles) employed in connection with the functions performed. The message of the 2017 OECD TPG is essentially the same.733 The new 2017 text elaborates on “capabilities” and “fragmented functions”.734 It is stated that the actual contributions and capabilities of a controlled party will affect its realistic alternatives. Further, it is stated that multinationals have the ability to fragment functions into highly specialized group entities that, as a whole, are interdependent of each other, because the functions refer to the same value chains. Sufficient functional comparability is particularly important under the CPM and the TNMM.735 The guidance on fragmented functions is related to the revised text on “highly integrated operations” under the OECD PSM (see section 9.2.3.).736

6.6.5.4. Economic conditions 6.6.5.4.1.  Introduction The US regulations and the OECD TPG require that significant economic conditions that may affect profits be taken into account when determining the degree of comparability.737 This includes the similarity between geographical markets (relative size, extent of economic development and competition, whether expanding or contracting, etc.), at which level of the value chain transactions take place (wholesale or retail), product market shares, location-specific costs and the alternatives realistically available to the buyer and the seller.738 733. OECD TPG, paras. 1.51-1.55. 734. OECD TPG, paras. 1.52 (capabilities) and 1.55 (fragmented functions). 735. See the analysis of the CPM and TNMM in ch. 8. 736. See ch. 9. 737. Treas. Regs. § 1.482-1(d)(3)(iv); and OECD TPG, paras. 1.110-1.113. Vann (2003), at p. 167, argues that there is a “clash” between the focus of the (1995 version of the) OECD TPG on the identification of economic value drivers in the form of functions, assets and risks, on the one side, and the transactional focus of the OECD TPG, on the other. Vann seems to admit, however, that the introduction of the profit-based pricing methods into the OECD TPG in reality relaxed the transactional paradigm; see Vann (2003), at p. 168. 738. The OECD TPG additionally mention the availability of substitute goods and services, the degree of local consumer purchasing power and the extent of government regulation; see OECD TPG, para. 1.110.

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The author will revert to some of these factors when analysing the transfer pricing methods (in chapters 7-16). Here, he will just briefly comment on the US and OECD positions on the use of comparables from other markets, location savings and temporary pricing strategies, as these issues are not necessarily particular to any specific pricing method. 6.6.5.4.2.  Use of comparables from other markets The point of departure under both the US regulations and the OECD TPG with respect to the use of comparables from other markets is that CUTs normally should be chosen from the same market in which the tested party operates, as there may be significant differences in the economic conditions prevailing in different markets.739 Nevertheless, if there are no CUTs available in the same market, comparables from other markets may be used, provided that proper comparability adjustments are carried out. Even if there is not enough information available to carry out such adjustments, the CUTs may still be used, but unadjusted differences will affect the reliability of the pricing method applied.740 6.6.5.4.3.  Location savings The stance of the US regulations on how incremental operating profits that are due to location savings shall be allocated among the controlled parties is that comparability adjustments must be made for significant differences in costs if the tested party and the unrelated comparable (benchmark) en-

739. Treas. Regs. § 1.482-1(d)(4)(ii)(A); and OECD TPG, para. 1.110. See, e.g. the Stanley Black & Decker Norway AS v. Skatt Øst ruling by the Oslo City Court (Utv. 2016/1143), where the Court rejected the taxpayer’s assertion that comparables from a range of European countries should be used under the TNMM to determine the profits allocable to a Norwegian group distribution entity (the Norwegian tax authorities had reassessed based on Norwegian comparables). Further, it should be noted that there may also be a wide spread of profit margins on comparables that are drawn from within the same market, and such “third-party” comparables may also be group entities (making reliance on their profit data problematic); see Rozek et al. (2003). 740. The US regulations contain an example in which a foreign subsidiary manufactures products for sale to its US parent; see Treas. Regs. § 1.482-1(d)(4)(ii)(B). In the absence of CUTs, the IRS considers applying the cost-plus method or the CPM to remunerate the subsidiary. However, information is not available on uncontrolled taxpayers performing comparable functions under comparable circumstances in the same geographical market. Thus, data from US manufacturers, adjusted for differences between the US and the foreign market, are considered in order to apply the cost-plus method.

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terprises operate in different geographical markets.741 In other words, the allocation of profits to the tested party should be based on third-party comparables from the same market. For instance, if the total costs of operating in the controlled manufacturer’s market are less than the total costs of operating in other markets, that will normally justify higher profits to the manufacturer only if the cost differences would increase the profits of comparable uncontrolled manufacturers operating at arm’s length in the same market. This position will normally entail that incremental profits due to cost savings are extracted from local taxation. For instance, imagine that a US clothing company contracts a foreign subsidiary to manufacture clothes.742 The cost of sewing in the foreign jurisdiction is significantly lower than in the United States. Several competitors in geographic markets similar to that of the subsidiary offer the same services. The US regulations assume the position that the fact that the production is less costly in the country of the subsidiary does not in and of itself justify allocating additional profits to it, as the operating profits of the local benchmark competitors indicate that arm’s length the profits would not be retained by the subsidiary. The OECD has now assumed essentially the same position (see the discussion in chapter 10). Where local comparables are available, these should be used to benchmark the profits allocable to the tested party.743 Where local comparables are unavailable, the bargaining position of the controlled parties will determine the allocation of the incremental operating profits from cost savings.744 Where the tested party is a routine input provider, as normally is the case, this will likely entail that the profits are extracted from taxation at source. 6.6.5.4.4.  Temporary pricing strategies To increase the market share of a particular product in an existing market or to enter an entirely new market, unrelated taxpayers may adopt strategies involving temporarily increased operating costs or reduced sales ­prices.745 741. Treas. Regs. § 1.482-1(d)(4)(ii)(C). On this, see Andrus (2007), at p. 641; and Allen (2004). 742. See the example in Treas. Regs. § 1.482-1(d)(4)(ii)(D). 743. OECD TPG, para. 1.142. 744. OECD TPG, para. 1.143. See also paras. 9.148-9.153. 745. Treas. Regs. § 1.482-1(d)(4)(i); and OECD TPG, para. 1.115. From a business point of view, market share improvement strategies, in addition to temporary pricing

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The question is to what extent such temporary prices are acceptable also in controlled transactions. The US regulations will only give effect to such pricing strategies if four criteria are satisfied: (1) it must be shown that an unrelated taxpayer was engaged in a comparable strategy under comparable circumstances for a comparable period of time;746 (2) the costs incurred for implementing the market strategy must be borne by the same taxpayer that will obtain the potential future profits from the strategy, and there must be a reasonable likelihood that the strategy will result in future profits that reflect an appropriate return relative to the costs incurred for implementing it;747 (3) the market share strategy must be pursued only for a reasonable period of time;748 and (4) the controlled agreement that allocates current costs and future profits must have been established before the strategy was implemented.749 The OECD position seems to rest on the same causality-based approach as adopted in the US regulations.750 The question is whether there is a plausible expectation that (i) the business strategy will produce a return sufficient to justify its costs within a reasonable timeframe; and (ii) an unrelated party at arm’s length would be willing to sacrifice profits temporarily in expectation of a greater future reward.

6.6.5.5. Risks 6.6.5.5.1.  Introductory comments on risk The notion of risk is problematic in transfer pricing. Economic logic dictates that there is a positive correlation between risks and return.751 The connected to penetration strategies, also encompass market maintenance and market expansion strategies; see Przysuski et al. (2004b), at p. 631. 746. Treas. Regs. § 1.482-1(d)(4)(i). 747. Treas. Regs. § 1.482-1(d)(4)(i)(A). 748. Treas. Regs. § 1.482-1(d)(4)(i)(B). 749. Treas. Regs. § 1.482-1(d)(4)(i)(C). 750. OECD TPG, paras. 1.116-1.117. 751. See, in particular, Schön (2014), at p. 17. See also, e.g. Penelle (2014), at p. 239; and Hafkenscheid (2017), at p. 19. For a recent comparative overview of the treatment of risk in different (IFA branch) jurisdictions, see Rocha (2017), at p. 223.

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riskier the investment is, the higher the return a rational economic actor will require. Applied to transfer pricing, this rationale entails that a group entity that bears a particular risk should be allocated the profits associated with it, and the higher the risk, the more profits it should be allocated. The problem with this logical axiom is that it may incentivize multinationals to contractually allocate risks to group entities resident in low-tax jurisdictions, even if the operational business activities that generate the risks (R&D, manufacturing, etc.) are performed by other group entities resident in high-tax jurisdictions, thereby facilitating profit shifting.752 Contractual risk allocations (separation of risks from underlying business activities) have traditionally been given effect for transfer pricing purposes, and have therefore become classic taxpayer strategies. The risk separation practices that have garnered the most attention in recent years include:753 – contractually stripping local routine value chain input providers (contract manufacturers and low-risk distributors) of as much risk (inventory, raw material, exchange rate, obsolescence, capacity risks, etc.) as possible in order to allocate a minimum amount of operating profits (typically under the TNMM) to such entities (and thereby to the local jurisdictions where they are resident);754 and – contractually stripping ownership of self-developed IP from the group entity that carries out R&D and actually creates intangible value (typically resident in a high-tax jurisdiction) and assigning the IP ownership to a group entity resident in a low-tax jurisdiction (typically an IP holding or “cash box” entity) in order to facilitate low taxation of the intangible profits. 752. On the role of contractual risk (stripping) in transfer pricing in general, see, in particular, the seminal article in Schön (2014). See also Andrus et al. (2017), at p. 90; Vann (2003), at p. 153; Navarro (2017), at p. 219; Pankiv (2017), at p. 95; Musselli et al. (2008a); Musselli et al. (2008b); Kane (2006); Vann (2010); Reyneveld et al. (2012); Durst (2012c); Kofler (2013); Weisbach (2004); Glaize et al. (2011); Osborn et al. (2017), at sec. I.A-C; Pantelidaki et al. (2013); a seminal economic study in Hines (1990); Musselli et al. (2007b); Musselli (2006); Heggmair (2017); Gonnet (2016), at p. 40; and Koomen (2015b), at p. 238. With respect to contractual risk stripping in the context of contract R&D agreements in particular, see Musselli et al. (2017); and the analysis in sec. 22.3.3. of this book. 753. These strategies should be seen in the context of the centralized principal model; see sec. 2.4. On stripping manufacturing entities, see Vann (2003), at p. 153; and Musselli (2008b). 754. E.g. the conversion of local fully-fledged manufacturers or distributors to contract manufacturers and low-risk distributors in connection with business restructurings.

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The fundamental issue is to what extent such controlled contractual risk allocations should be given effect for transfer pricing purposes.755 The author’s ambition in this chapter is to provide some general comments on key points756 in order to form a backdrop for his later discussions. 6.6.5.5.2.  Contractual risk allocation among group entities Both the US regulations and the OECD TPG require that the profit-relevant risks in the tested and uncontrolled transactions are comparable before the uncontrolled transaction can be used under an applicable transfer pricing method to benchmark the pricing of the controlled transaction.757 Relevant risks include (i) market risks (fluctuations in cost, demand, pricing and inventory levels); (ii) R&D risks (success or failure); (iii) financial risks (fluctuations in foreign currency rates or exchange and interest rates); (iv) credit and collection risks; (v) product liability risks; and (vi) general business risks. The position taken in both the US regulations and the OECD TPG is that contractual risk allocation will be respected only if it is consistent with the economic substance of the actual transaction.758 This is not a comparability criterion in and of itself, but rather a premise for accepting the controlled risk allocation for transfer pricing purposes (which thereafter will be compared to the risk allocation found in CUTs). In considering the economic substance, three main factors are relevant: (i) whether the actual behaviour of the controlled taxpayer over time is consistent with the contractual allocation of risk;759 (ii) whether the group entity that is contractually assigned

755. Vann (2010) argues for non-recognition of such provisions. On the targeted nonrecognition approach expressed in Schön (2014), see infra n. 773. 756. On risk as a comparability factor, see also, e.g. Wittendorff (2010a), at pp. 407411. 757. Treas. Regs. § 1.482-1(d)(iii); and OECD TPG, para. 1.73. The nature and degree of risks incurred may be indicative of the level of profits that should be allocated to the tested party; e.g. a distributor that is reimbursed for marketing costs will generally command a lower return than a distributor that must bear its own marketing costs. 758. Treas. Regs. § 1.482-1(d)(iii)(B); and OECD TPG, para. 1.98. Controlled allocations of risk after the outcome of the risk is known or reasonably knowable lack economic substance. Osborn et al. (2017), under sec. II, argue that the 2017 OECD TPG on control allow considerably less deference for contracts and thus rely even more on economic substance considerations to allocate risks, with the result that the US and OECD provisions are not consistent. 759. Treas. Regs. § 1.482-1(d)(3)(iii)(B)(1); and OECD TPG, paras. 1.86 and 1.88.

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the risk has the financial capacity to bear the losses that will occur if the risk materializes;760 and (iii) whether the group entity that is contractually assigned the risk is in control of it.761 The 2017 OECD TPG contain voluminous information on risk,762 which significantly influences key parts of the new intangibles guidance, in particular the provisions on intangible ownership (which are analysed in part 3 of the book). Risk is defined broadly as “the effect of uncertainty on the objectives of the business”,763 encompassing all risks relevant for transfer pricing purposes (e.g. strategic, financial and hazard risks). The centre of attention of the new guidance, however, is on operational business risks.764 The core assumption underlying the OECD approach to risks is that third parties generally will not be willing to assume risks that they do not have control over.765 For instance, if a supplier determines which products a distributor should sell and at which volumes and prices, as well as which marketing campaigns to implement, the supplier directly affects the risks associated with the distributor’s business. At arm’s length, the distributor would likely find it difficult to determine the additional return that it would require from the supplier if it were to assume stock obsolescence risk, as that risk would be determined by the supplier. Moral hazard considerations would likely also be relevant, as the supplier could be inclined to maximize its returns at the expense of the distributor.

760. Treas. Regs. § 1.482-1(d)(3)(iii)(B)(2) and OECD TPG, para. 1.64. See Treas. Regs. § 1.482-1(d)(3)(iii)(C), Example 1 for an illustration of contractual allocation of market risk and financial capacity. 761. Treas. Regs. § 1.482-1(d)(3)(iii)(B)(3); and OECD TPG, para. 1.65. The US regulations contain examples on currency and product liability risk; see Treas. Regs. § 1.482-1(d)(3)(iii)(C), Examples 3 and 4. See also Bullen (2010), at pp. 496-506, on control of risk (with respect to the previous generation [1995/2010] OECD TPG text on risk). 762. OECD TPG, paras. 1.56-1.106. The treatment of risk has received heightened attention in the 2017 OECD TPG compared to the previous 1995/2010 generation versions. 763. OECD TPG, para. 1.71. 764. OECD TPG, para. 1.72. 765. On this, see, in particular, Schön (2014), at p. 18. For critical comments on the 2017 OECD “functional” approach to risk allocation, see Hafkenscheid (2017), at p. 20 and p. 23, where he argues that the new language on risk may be subject to diverging interpretations and thus raises a potential for tax planning and controversy.

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The 2017 OECD guidance defines “control”, largely based on the 2009 business restructuring wording,766 as the “capability to make decisions to take on … and … whether and how to respond to the risks”.767 In line with this,768 the new guidance distinguishes between “control” and “risk management”. The latter concept encompasses control, but is broader in that it also includes the capability to take measures that affect risk outcomes, i.e. so-called “risk mitigation”.769 The distinction is not clear-cut, as the capability to decide how to respond to risks (the second element of the control concept) seems rather similar to risk mitigation. The point of the distinction seems to be that a group entity may retain control and, therefore, entitlement to the returns associated with the controlled risk, even if it outsources risk mitigation to another group entity.770 However, the entity that outsources the risk mitigation function must, in order to retain the return associated with the risk it purports to control, have the capacity to (and actually): determine the objectives of the outsourced activities, to decide to hire the provider of the risk mitigation functions, to assess whether the objectives are being adequately met, and, where necessary, to decide to adapt or terminate the contract with that provider, together with the performance of such assessment and decision-making.771

766. See OECD TPG, paras. 9.23 and 9.28. On control of risk (under the 2010 OECD TPG), see Monsenego (2014), at p. 14; Huibregtse et al. (2011); Musselli et al. (2009); Rosalem (2010); Gonnet (2016), at pp. 41-42; and Picciotto (2014). 767. OECD TPG, para. 1.65. On risk capacity, see, in particular, Schön (2014), at p. 17. See also Bullen (2010), at pp. 482-492, with respect to the 1995/2010 OECD TPG text. For an analysis of the content of the control criterion under the 2017 OECD TPG in the context of determining IP ownership and allocating profits to R&D financing, see secs. 22.3.2. and 22.4.3., respectively. See also Schön (2014), at pp. 20-22, where scepticism is expressed with respect to putting (too much) weight on the performance of control functions for the purpose of assigning risk to group entities for transfer pri­ cing purposes. Schön observes that this OECD approach seems to draw on the Key Entrepreneurial Risk-Taking (KERT)functions doctrine (see the discussion in sec. 17.4.2. of this book), originally developed for allocating profits to permanent establishments of financial enterprises under article 7 of the OECD MTC, and states that the approach is not as well suited to the context of art. 9 of the OECD MTC (where he argues that contractual risk allocation should be recognized to a larger extent). 768. See OECD TPG, paras. 9.23 and 9.24. 769. Risk management is defined in OECD TPG, para. 1.61. 770. OECD TPG, para. 1.65. 771. Id.

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The issue of risk and outsourcing is particularly relevant in the context of determining the ownership of self-developed manufacturing intangibles,772 where the question is whether the entity that purports to be the owner of the IP (and thus entitled to the residual profits) controls the outsourced R&D functions of the group entity that actually creates the IP. It should, in the author’s view, be brought into question as to whether this sophisticated doctrine is indeed useful. It will, to some extent, respect controlled transactions that separate risks (and the connected profits) from the business activities that generate them.773 The doctrine is therefore somewhat suspect in the sense that it may potentially be seen as conflicting with the stated purpose behind the 2015 BEPS revision of the intangibles guidance that operating profits from unique intangibles should be allocated to jurisdictions where the intangible value was created.774 With this doctrine, the OECD has attempted to strike a balance between the need to respect controlled transactions that may be seen, at least to some degree, as parallels to third-party outsourcing, while at the same time preventing structures that enable BEPS. The aim of the guidance is likely to ensure that structures that are supported by some degree of economic substance are respected, while those that assign risks to “empty” foreign IP holding companies and perhaps even cash box companies without employees that have the necessary technical, R&D or business expertise to make 772. The issue is also relevant in other contexts. For instance, asset ownership alone will not entail that the risk and opportunities associated with the asset should be allocated to the owner entity; see OECD TPG, para. 1.85. 773. On a more principal (and partly de lege ferenda) basis, see Schön (2014), at p. 29 (following an extensive analysis), where he reaches the conclusion that contractual risk allocations should, as a general rule, be recognized for transfer pricing purposes. To avoid profit shifting, however, Schön (i) does not recognize risk allocations in transactions that purely shift risks among group entities (e.g. intra-group captive insurance schemes and intra-group debt financing); and (ii) finds that IP income should be taxed on a commensurate-with-income basis (ex post). The author’s impression is that Schön, on this point, (i) advocates a more severe look-through of contractual risk allocations than what is the current OECD TPG solution (but at the same time, the OECD TPG seem to go further in not recognizing contractual risk allocations based on “control function” considerations than what would be in line with Schön’s reasoning); and (ii) argues for an ex post solution akin to the one now adopted in the 2017 OECD TPG (see the discussion in sec. 16.5. of this book), but at the same time, it seems clear that the new 2017 OECD TPG “important functions doctrine” goes further than what can be aligned with Schön’s general line of reasoning. 774. See Schön (2014), at p. 20 for comments on the OECD tendency to increase the threshold for control in transfer pricing. Note also that the issue of outsourcing and risk seems to be controversial within the OECD, as there apparently are diverging – and incompatible – viewpoints on the very same issue depending on the context; see the discussion in sec. 2.5. of this book and supra n. 217.

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decisions on operating risks are not. Only experience will show whether the doctrine is useful. 6.6.5.5.3.  Risks affect pricing, not the other way around A point emphasized in the 2017 OECD guidance is that pricing arrangements are not determinative of risks.775 The idea is that the manner in which a group entity is compensated in a controlled transaction may indirectly also be a statement as to which risks it is deemed (by the group) to incur. Such taxpayer assertions on controlled risks cannot, of course, be given effect unless the criteria in the OECD guidance on risk are satisfied. The point made by the OECD is interesting, but should, in all fairness, be rather obvious, as risk should be influential on the pricing outcome and not the other way around. A controlled manufacturing entity compensated under the cost-plus method, for instance, should not automatically be deemed to be shielded from risks pertaining to raw material or other input price fluctuations or to the utilization of its manufacturing capacity (even if the pricing could indicate that it does not incur such risks).

6.7. The aggregation of controlled transactions 6.7.1. Introduction The point of departure under both the US and OECD regimes is that a specific controlled transaction should be tested against a specific CUT. Nevertheless, both regimes allow aggregation of both controlled and uncontrolled transactions. Aggregation of uncontrolled transactions pertains to the issue of using (under the selected transfer pricing method) profit data from a “pool” of uncontrolled transactions with varying degrees of comparability to the controlled transaction. This issue is highly relevant in practice, as more comparable, disaggregated, transaction-level third party profit data often will be unavailable. Whether uncontrolled transactions can be aggregated is a comparability issue and should be addressed in connection with the analysis of the particular transfer pricing method that triggers the issue. The author refers to his discussion in section 8.6., where he provides an extensive analysis of whether aggregated third-party profit data can be used 775. OECD TPG, para. 1.81. On this issue, see Barbera (2003), at p. 71.

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pursuant to the current OECD TPG when applying the TNMM, under which, this comparability issue is particularly pronounced. The topic in sections 6.7.2.-6.7.4. will be the aggregation of controlled transactions. This issue pertains to whether it is appropriate to treat several different controlled transactions as one for pricing purposes (i.e. deeming the transactions as a whole and then applying a transfer pricing method to this whole). Whether such treatment should be applied will depend primarily on which transfer pricing method is suitable for the case and which third-party comparables are available to benchmark the controlled transaction (profit comparison should refer to the same level of aggregation on the side of both the controlled and uncontrolled transactions). The author discusses the US and OECD positions on the aggregation of controlled transactions in sections 6.7.2. and 6.7.3., respectively. The aggregation of controlled transactions under the OECD TPG was an issue in the illustrative 2012 Canadian Supreme Court ruling in GlaxoSmithKline Inc. v. R,776 the ruling of which is discussed in section 6.7.4.

6.7.2. The US regulations The final 1994 US regulations introduced the rule that the combined effect of two or more separate controlled transactions could be considered in determining an arm’s length profit allocation if this would yield the most reliable result.777 This essentially entailed a requirement to take into account the entire value chain for the purpose of determining transfer prices. This approach was necessary in order to ensure proper application of the profit-based CPM and PSM (introduced in the same regulations).778 For instance, a CPM allocation will require an aggregated approach, where the royalty allocable to an IP-owning parent is determined as the residual profits after a normal market return is allocated to a subsidiary as the tested party. Thus, the income allocable to the parent is determined indirectly (by way of testing the transactions of the subsidiary) and not directly through benchmarking the income of the parent against third-party royalty rates from CUTs. This, in reality, aggregates the transactions of the tested party 776. 2012 SCC 52 (2012), which affirmed 2010 CAF 201 (F.C.A., 2010), which reversed 2008 TCC 324 (T.C.C., 2008). 777. Treas. Regs. § 1.482-1(f)(2)(i). That would normally be the case for related products or services; see Treas. Regs. § 1.6038A–3(c)(7)(vii). 778. The US regulations contain four examples illustrating the 1994 guidance; see Treas. Regs. § 1.482-1T(a)(i)(E), Examples 1-4.

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for benchmarking purposes, as it is allocated a net profit as total remuneration for its total contribution of functions, assets and risks. The US aggregation provisions were significantly expanded in September 2015 to ensure that all intangible value transferred in controlled transactions is captured for taxation, regardless of how the value transfer has been legally structured.779 For instance, if a range of different IP is transferred together as a whole and the value of the package is greater than the sum of the stand-alone IP values, it will not be appropriate to price the transfer on a transaction-bytransaction level, as that would not capture all of the value transferred. The 2015 amendment was driven by two main factors. First, the profitbased methodology (the CPM and PSM) during the last 2 decades has been further developed and adapted to the context of valuation, in particular in the form of the income method and residual profit split model for valuing buy-in transactions in CSAs.780 These methods apply aggregated discounted cash flow (DCF) valuation methodology aimed at also capturing residual intangible value (e.g. goodwill, going concern value and workforce in place).781 This methodological development has been combined with an increased focus on economic substance and value chain analysis. The 2015 aggregated approach to valuation applies generally, also outside the context of CSA transactions (for which the income method was originally tailored). Second, experience has amply demonstrated a need for coordinated and aggregated analysis of controlled transactions that are speculatively split into single transactions by multinationals for treatment under different Internal Revenue Code (IRC) provisions (typically those of sections 367 and 482) in an attempt to migrate US-developed intangibles without triggering a tax charge, or at least a charge less than that what would have been levied had the complete transaction been assessed as a whole under a single IRC provision (typically, of section 482 alone).782 The author refers in particular to his 779. T.D. 9738; see Treas. Regs. § 1.482-1T(a)(i)(B), at (A) and (C). See Odintz et al. (2017), at sec. 2.2.5.2, on this. See also the comments in this book on these new provisions in the context of the relationship between IRC secs. 367 and 482 in sec. 3.5.8.; the best-method rule in sec. 6.4; and intra-group R&D services (contract R&D arrangements) in sec. 21.4. 780. See the analysis of these methods in secs. 14.2.8.3. and 14.2.8.6., respectively. 781. This is illustrated by the IRS allocation assertion in Veritas Software Corporation & Subsidiaries v. CIR (133 T.C. No. 14 [U.S. Tax Ct. 2009], IRS nonacquiescence in AOD-2010-05; see the analysis of the ruling in sec. 14.2.4.), which was based on the predecessor of the specified 2009 income method. 782. See Treas. Regs. § 1.482-1T(a)(i)(E), Example 9, where the taxpayer transfers manufacturing intangibles in a sec. 367 transaction, and then subsequently enters into

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discussion in section 3.5.4. While the 2015 provisions on aggregation are geared towards the relationship between section 367 and 482 transactions,783 they also deal with intangible value transferred in connection with the rendering of intra-group services, targeting contract R&D arrangements.784 The IRS’s aggregation approach was incorporated into IRC section 482 in the 2017 US tax reform, clarifying that the service may, going forward, base its transfer pricing assessments on aggregated valuations and on the realistic alternatives principle.785

6.7.3. The OECD TPG The language contained in the OECD TPG on the aggregation of controlled transactions dates back to the 1995 revision. It permits aggregation in three scenarios:786 (1) where separate transactions are so closely linked or continuous that they cannot be evaluated on a separate basis (e.g. licence agreements, typically priced indirectly through the TNMM).787 The US roundtrip case law discussed above,788 as well as the Canadian GlaxoSmithKline Inc. v. R. ruling discussed below,789 are examples of structures involving closely linked transactions;

a CSA transaction in which marketing intangibles connected to the same product are contributed as a buy-in. The example finds that the value of the intangibles is greater in the aggregate due to synergies among the intangibles than if valued as two separate transactions. It therefore requires that the synergies are taken into account in determining the arm’s length results for the transactions. See also Treas. Regs. § 1.482-1T(a)(i) (E), Example 5, on the aggregation of a transfer of ten interrelated patents. 783. For a further analysis of the relationship between secs. 367 and 482 in the context of CSAs, see the discussion in sec. 3.5.8. 784. See Treas. Regs. § 1.482-1T(a)(i)(E), Example 10; and the discussion in sec. 21.4. of this book. 785. See sec. 1.7. 786. OECD TPG, paras. 3.9-3.12. 787. Further, as an example of transactions that should be viewed together, the OECD TPG mention the licensing of manufacturing know-how and the supply of vital components to an associated manufacturer. The position of the OECD TPG is that the licensing transaction and the sales transaction “should be evaluated together using the most appropriate arm’s length method”. Another example is where a transaction is routed through another group company. The OECD TPG find it more appropriate to consider the routed transaction chain in its entirety rather than to consider the individual transactions on a separate basis. 788. See the discussion in sec. 5.2.5. 789. See the discussion in sec. 6.7.4.

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(2) where it is appropriate to use a portfolio approach. This may, for instance, be where a product is marketed with a low profit or at a loss in order to create a demand for other products or services;790 and (3) for so-called “package deals”, e.g. where patent licences, technical and administrative services and the lease of production facilities are contracted as one integrated transaction.791 The 1995 OECD wording on aggregation of controlled transactions must now be regarded as being relatively outdated when compared to the updated 2017 guidance contained elsewhere in the OECD TPG (the wording on intangibles, risk, CSAs, etc.) and when taking into account the shift in OECD preferences with respect to the choice of pricing methodology (from the CUT method to the profit-based methods, in particular, the PSM). In order to ensure that the new 2017 guidance can be applied as intended, it is necessary to interpret the older 1995 wording so that it can be harmonized with the pronouncedly substance-based content of the 2017 wording (on intangibles, in particular). It is the author’s view that the 1995 wording does not restrict the aggregation of controlled transactions in any cases in which, after a thorough functional analysis, it is clear that (i) the economic substance of the controlled transactions seen together would be better reflected (and thus be more susceptible to arm’s length pricing) if the transactions were treated as one; (ii) a transfer pricing methodology can be reliably applied to benchmark the aggregated controlled transaction; and (iii) there is third-party benchmarking profit data available for the selected transfer pricing method.

6.7.4.  GlaxoSmithKline (Canada) 6.7.4.1. Introduction In October 2012, the Supreme Court of Canada announced its first ever ruling in a transfer pricing case, GlaxoSmithKline Inc. v. R.792 The case 790. OECD TPG, para. 3.10. A portfolio approach is a business strategy in which the taxpayer bundles certain transactions for the purpose of earning an appropriate return across the portfolio rather than necessarily on specific single products within the portfolio. 791. OECD TPG, para. 3.11. 792. GlaxoSmithKline Inc. v. R., 2008 TCC 324 (T.C.C., 2008), reversed by 2010 CAF 201 (F.C.A., 2010), application/notice of appeal filed in 2010 CarswellNat 4089 (S.C.C., 2010), and leave to appeal allowed by 2011 CarswellNat 682 (S.C.C., 2011), affirmed by 2012 SCC 52 (S.C.C., 2012). For a discussion of the ruling, see also, e.g. Schön et al. (2011), at pp. 221-224; Schön (2011b), at p. 64; Pichhadze (2013); Vidal (2009); Dujsic et al. (2008); and Pichhadze (2015), at sec. 3.1.2.

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shows that a multinational may ensure a specific profit allocation through a combination of different types of controlled transactions and that it may be entirely necessary to aggregate them in order to ensure an arm’s length profit allocation under the OECD TPG.793 Because the case provides a practical illustration of a typical context in which aggregation of controlled transactions will be useful under the OECD TPG, as well as of how such aggregation should be achieved, the author will devote some space to analysing the case.

6.7.4.2. The factual pattern GlaxoSmithKline is a UK-headquartered multinational operating in the pharmaceutical industry.794 The relevant parts of the group structure for the period under analysis are illustrated in figure 6.1.795 Figure 6.1 Glaxo Holdings PLC GGL Glaxochem Ltd. Montrose & Bernard Castle VIC

Glaxo Far East (Pte) Ltd

Glaxo Operations UK Ltd. Glaxo Export

1991

Adechsa (Switzerland)

Glaxo Canada

Glaxo Pharmaceuticals (Pte) Limited (Ranitidine factory)

GGR UK 1982 1991

Glaxo Pharmaceuticals UK Ltd.

Glaxochem (Pte) Ltd.

Glaxo Far East (Pte) Ltd

50%

Shin Nihon 45% Jitsugoyo Co Ltd.

Glaxo Kabushiki Kaishai

793. On this topic, see also Wittendorff (2013). 794. The Glaxo group is among the ten largest pharmaceutical groups in the world. The case concerns the income years 1990-1993. 795. The figure was produced by the Tax Court of Canada and is appendix III to the Tax Court ruling in this case (2008 TCC 324). In sec. 6.7.4.3., the author refers to the Tax Court case as the TC ruling. The TC ruling was written by Judge Gerald J. Rip, Chief Justice of the Canadian Tax Court.

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During the income periods at trial, the Glaxo group performed secondary manufacturing and sales of the ulcer drug Zantac in Canada through the company GlaxoSmithKline Inc. (Glaxo Canada). Pharmaceutical products are manufactured in two basic stages, normally referred to as primary and secondary manufacturing. Primary manufacturing is the making of the active pharmaceutical ingredient for a pharmaceutical product. Secondary, or pharmaceutical, manufacturing refers to the process of placing the active ingredient into a delivery mechanism (e.g. a tablet, liquid or gel), as well as packaging. Glaxo Canada was a subsidiary of the UK company Glaxo Group Ltd. (GGL). GGL owned intangibles required for the manufacture and sale of Zantac. The essential intangibles in this context were the patent and trademark required to manufacture and sell Zantac. GGL was a wholly-owned subsidiary of the ultimate parent company of the group Glaxo Holdings Plc (Glaxo Holdings), also a UK company. The Zantac value chain was organized as follows. The primary manufacturing of the active ingredient used for Zantac, ranitidine, sold in Canada, was performed by a group entity in Singapore, Glaxo Pharmaceuticals (Pte) Limited (Singapore Sub). Ranitidine was sold from Singapore Sub to a group clearing company in Switzerland, Adechsa S.A. (Swiss Sub), and then resold to Glaxo Canada through a supply agreement between Swiss Sub and Glaxo Canada. Transfer prices for all stages of the value chain were determined by the ultimate parent company, Glaxo Holdings. The necessary intangibles to produce and sell Zantac in Canada were licensed from GGL to Glaxo Canada through a licence agreement. The strategy of the Glaxo Group for minimizing its worldwide taxes was to recognize as much profit as possible in Singapore, then to recognize as much of the remaining profit as possible in the United Kingdom and to ensure that the group did not pay tax on the same income twice.796 The price of Zantac in Canada was determined by Glaxo Holdings, based on an assessment of the quality of the product compared to the best competing product at the time of introduction of Zantac.797 Glaxo Holdings decided that local distributors for Zantac, such as Glaxo Canada, should retain a gross margin of 60%,798 and the remaining 40% should be remitted back to Glaxo Group in the United Kingdom in the form of royalties or transfer prices.799 The transfer price for the active ingredient throughout the whole value chain was designed in order to realize the 60% Canadian gross 796. 797. 798. 799.

2008 TCC 324, para. 13. Id., para. 45. The term “gross margin” is net sales minus COGS. 2008 TCC 324, para. 47.

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profit retention ratio. An important factor is that Canada levied withholding tax on both dividend and royalty payments from Canada to the United Kingdom. The domestic rate was reduced to 10% under the Canada-United Kingdom treaty.800 The Singapore Sub did not pay any tax in Singapore on the profits it made from producing and selling ranitidine to the Swiss Sub.801 When the profits of the Singapore Sub were brought into the United Kingdom through dividend distributions, UK tax was only payable on any excess of the UK tax rate over the Singapore tax rate.802 The transfer price for the active ingredient when sold from Singapore Sub to Swiss Sub was therefore set high in order to realize as much of the profits from the value chain as possible in Singapore. Singapore Sub earned gross profits of approximately 90% in Singapore during the income years covered by the case. In Switzerland, there was an agreement between the Swiss tax authorities and the Swiss Sub concerning its income taxation. It was agreed that taxes were to be paid on the basis that the company earned a profit of 4% on the resale of the active ingredient to Glaxo Canada. If the profits from the sales exceeded 4%, taxation would be based on actual profits. Under the licence agreement between Glaxo Canada and GGL, Glaxo Canada paid a royalty of 6% of its net sales of Zantac as consideration for the provision by GGL of the make-sell rights to Zantac, as well as the right to use trademarks, receive technical support, use registration materials, access new products and improvements, etc. A highly significant point for the case is that, by virtue of the licence agreement, Glaxo Canada was required to purchase the active ingredient from a Glaxo group entity and adhere to Glaxo standards.803 Under the supply agreement, Glaxo Canada purchased ranitidine from Swiss Sub for generally five times the price that generic ranitidine was sold for between unrelated parties in Canada during the period at issue. It was clear that Glaxo ranitidine and generic ranitidine were chemically 800. See Canada-United Kingdom treaty, art. 10, nr. 1 a) for dividends; and art. 12, nr. 2 for royalties. 801. 2008 TCC 324, para. 47. This was due to a 10-year relief tax holiday that began in 1982. After this period, the tax rate was 10%. Under the relief programme, the Glaxo group benefitted from tax sparing between Singapore and the United Kingdom. 802. Apparently, Singapore income was deemed by the UK tax authorities to have been taxed at the full Singapore tax rate. 803. See TC ruling, para. 86; and Supreme Court ruling (SC ruling), para. 46.

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equivalent and bioequivalent. Thus, there were no substantial differences between generic and Glaxo ranitidine.804 In the years covered by the case, Glaxo Canada made a gross profit on sales on Zantac of approximately 57% – In other words, very close to the targeted 60% gross profit margin set by Glaxo Holdings. The Canadian tax authorities increased the income of Glaxo Canada for the income years at issue on the basis that Glaxo Canada overpaid the Swiss Sub for the purchase of ranitidine. The increased amount was treated as deemed dividend distributions to its UK parent company, GGL. The increased amount was therefore also subject to Canadian withholding tax.

6.7.4.3. The 2008 Tax Court ruling The question before the Tax Court (TC) was whether the transfer price for ranitidine between the Swiss Sub and Glaxo Canada was set in accordance with the domestic transfer pricing provision of the Canadian Income Tax Act.805 The TC found that the Canadian tax authorities relied on the OECD Guidelines when assessing transfer pricing matters under domestic law. The Federal Court of Appeal had also stated that the OECD Commentaries should provide information on the interpretation and application of the domestic transfer pricing provisions.806 The tax authorities argued before the TC that the arm’s length price for ranitidine under the domestic arm’s length provision should, as in the reassessment, be set on the basis of the price agreed between the generic companies for the purchase of ranitidine from unrelated suppliers, based on the CUP method. The unrelated Canadian companies, Apotex and Novopharm, had paid to their third-party suppliers of ranitidine a price only one fifth of the price that Glaxo Canada had paid to the Swiss Sub during the

804. See TC ruling, para. 96. 805. The 1985 version of sec. 69(2) of the Canadian Income Tax Act applicable for the income years of the case had the following wording: “Where a taxpayer has paid or agreed to pay to a non-resident person with whom the taxpayer was not dealing at arm’s length as price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in this subsection referred to as ‘the reasonable amount’) that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm’s length, the reasonable amount shall, for the purpose of computing the taxpayer’s income under this Part, be deemed to have been the amount that was paid or is payable therefor.” 806. TC ruling, para. 59.

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same period. The tax authorities supported their assertion with an analysis under the cost-plus method.807 Glaxo Canada asserted that the generic ranitidine transactions did not represent appropriate CUPs for two reasons. First, the actual business circumstances of Glaxo Canada were wholly different from those of the unrelated generic ranitidine purchasing companies, Apotex and Novopharm. The thrust of this argument was that the pricing under the supply agreement had to be seen in the context of the licence agreement. Second, the ranitidine purchased from the Swiss Sub was not comparable to the ranitidine purchased by the generic ranitidine purchasing companies Apotex and Novopharm from their respective unrelated suppliers because Glaxo ranitidine was produced under Glaxo good manufacturing practices. The first question to be assessed by the TC was whether the transfer pricing of ranitidine under the supply agreement should take the licence agreement into consideration, i.e. whether the controlled transactions should be aggregated. The tax authorities relied on a domestic Supreme Court case (Singleton v. R.) for the proposition that the assessment should look at the transaction at issue and not at the surrounding circumstances.808 Glaxo relied on two other cases in which the courts had found some contracts ancillary and incidental to a genesis contract.809 The TC found that the licence agreement and the supply agreement could stand alone and that neither was ancillary to the other. Glaxo argued that the point of the transfer pricing structure was that Glaxo Canada should retain 60% of the profits, while 40% should be remitted to foreign Glaxo companies. It further argued that it made no difference whether the 40% were remitted through transfer pricing, royalties or a combination of the two.810 This is a key point of the case. The TC disagreed with the view of Glaxo Canada and stated that the purpose of the case was to find a proper transfer price for the ranitidine in order to determine the tax liability of Glaxo Canada.

807. The cost-plus assessment used the cost of manufacturing the ranitidine and added a suitable profit margin. 808. The 2001 Singleton case, Singleton v. R., 1996 CarswellNat 1816 (T.C.C., 1996), reversed by 1999 CarswellNat 1009 (Fed. C.A., 1999), leave to appeal allowed by 2000 CarswellNat 653 (S.C.C., 2000) and affirmed by 2001 SCC 61 (S.C.C., 2001). 809. R. v. Koffler Stores Ltd., 1975 CarswellNat 336 (Fed. T.D., 1975), affirmed by 1976 CarswellNat 200 (Fed. C.A., 1976); and GSW Appliances Ltd. v. R, 1985 CarswellNat 346 (T.C.C., 1985). 810. TC ruling, para. 76.

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Royalty payments from Canada were subject to withholding tax. Royalty payments would go to the intangible-owning UK company, GGL, and be taxed there. Conversely, the purchase price paid for ranitidine by Glaxo Canada to the Swiss Sub would not be subject to withholding tax in Canada, and the profits would be taxable in Switzerland, then go to Singapore and ultimately back to the United Kingdom through dividend payments from Singapore. The TC was of the view that it could very well be that a 40% remittance of the total profits of Glaxo Canada was reasonable, but this was not the question in the case. The question was whether the ranitidine purchase price paid by Glaxo Canada satisfied the arm’s length requirement. In the view of the TC, the transfer pricing of Glaxo Canada combined two transactions, namely the purchase of ranitidine under the supply agreement and the payment for intangibles under the licence agreement, and thereby ignored the distinct tax treatment that followed from each.811 The TC supported its view with the domestic Singleton case,812 as well as the US Tax Court case Bausch & Lomb, Inc. v. Commissioner.813 Glaxo Canada further argued that the circumstances in which the unrelated generic ranitidine companies Apotex and Novopharm purchased ranitidine were not comparable to the circumstances in which Glaxo Canada bought ranitidine. Thus, in the view of Glaxo Canada, the unrelated ranitidine transactions could not be used as comparable transactions under the CUP method. Glaxo Canada listed a range of factors, with reference to the 1995 OECD Guidelines, that supposedly supported its view.814 A key argument from Glaxo Canada was that it was required to purchase the ranitidine from the Swiss Sub, pursuant to its licence agreement with GGL. The TC found it clear that Glaxo Canada was contractually obligated to purchase ranitidine from the Swiss Sub, but the question was whether a person in Canada, dealing at arm’s length, would have accepted the conditions and paid the price that Glaxo Canada did. The evidence before the TC demonstrated that it was the marketing efforts of Glaxo Canada and the value of the brand name Zantac that enabled Glaxo Canada to charge a premium price for Zantac in the Canadian market. There was no evidence 811. TC ruling, para 78. 812. See supra n. 808. 813. Bausch & Lomb Inc. v. CIR, 92 T.C. No. 33 (Tax Ct., 1989), affirmed by 933 F.2d 1084 (2nd Cir., 1991). See the discussion of the ruling in sec. 5.2.5.2. of this book. 814. TC ruling, para. 80.

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that the price or value of ranitidine had any causal relationship with the external market price of Zantac. Further, Glaxo Canada argued that the price of ranitidine should be high due to the regulatory approval and marketing assistance it received from GGL and the use of the trademark Zantac to sell the drug in Canada. The TC found this irrelevant, as the provision of intangibles should be priced under the licence agreement with GGL and not under the supply agreement with the Swiss Sub.815 The second main argument from Glaxo Canada was that the ranitidine transactions between unrelated generic companies and their suppliers were not comparable to the ranitidine purchases by Glaxo Canada from Swiss Sub, because the latter ranitidine was produced under the Glaxo groups good manufacturing practice. After an extensive evidentiary assessment, the TC rejected the assertion by Glaxo Canada. The TC found that the Glaxo manufacturing practice did not change the nature of the good. Glaxo Canada also admitted that the generic ranitidine was chemically and biologically equivalent, as required by the Canadian health authorities. The TC found that the Glaxo manufacturing practice could have some minor positive price effect but that it did not affect the comparability with the ranitidine used by the unrelated generic companies. After a thorough transfer pricing assessment, the TC found the CUP method to be applicable. Glaxo Canada relied on a specific application of the resale price method. The resale price method compares gross margins, i.e. sales revenues minus the COGS.816 As stated by the TC, the resale price method is most reliable when it measures the return of only one function, it is isolated to a particular product and there is a high degree of similarity in functions and risks between the companies being compared. Because costs not directly related to goods sold vary extensively between companies – perhaps especially between companies in different jurisdictions – what will be an arm’s length gross margin in one country will not necessarily be the same for another company in another jurisdiction. For example, a company resident in a country with low marketing expenses will be able to accept a lower gross margin than a company resident in a jurisdiction that requires large marketing expenses. Glaxo Canada argued that its gross profit margins were largely in line with those earned by European distributors. The TC rejected this argument on the grounds that Glaxo Canada performed many more functions and assumed more risks than the European licensees. In the 815. TC ruling, para. 91. 816. COGS excludes all other costs than direct product costs. See the discussion in sec. 6.2.3.2.

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eyes of the TC, this fact should have justified a higher gross profit margin to Glaxo Canada through a lower transfer price for ranitidine. Further, Glaxo Canada supported its resale price method-based transfer price for ranitidine with a TNMM analysis, which compared net profits between companies.817 The TC rejected the analysis by Glaxo Canada on the basis that the selected companies for comparison were not reasonable and that there was insufficient evidence of other functions undertaken by the comparables. The Canadian tax authorities, however, supported their CUP assessment with the cost-plus method. The cost-plus assessment used as its point of departure the manufacturing costs for ranitidine, and added a suitable profit. During the income years at trial, the Singapore Sub had cost-plus margins between 766% and 1,059% of manufacturing costs. If the profit margin of the Singapore Sub alternatively had been 25% (as the Canadian tax authorities viewed as arm’s length) and the profit margin of the Swiss Sub was 4%, as agreed with the Swiss tax authorities, then the transfer price for ranitidine to Glaxo Canada would have been approximately the amount assessed under the CUP method. The TC concluded that the CUP method was the preferred method for setting the transfer price for ranitidine and that the generic companies in Canada were appropriate comparables. Glaxo Canada was therefore, in computing its taxable income, not allowed to deduct the excess price it had paid for ranitidine to the Swiss Sub. On this point, the reassessment of the Canadian tax authorities was therefore upheld (apart from a marginal adjustment for the value added to the ranitidine through the Glaxo manufacturing standard).818 The second question before the TC was whether the treatment by the Canadian tax authorities of the excess transfer price paid for the ranitidine should be regarded as deemed dividend payments from Glaxo Canada to GGL, pursuant to a domestic tax law provision on the allocation of income.819 In the McClurg v. R. case, the purpose of this domestic alloca817. See 1995 OECD TPG, para. 2.58. 818. The Tax Court’s CUP analysis was criticized by commentators. See, e.g. Hill (2008), at p. 269; Rhee (2008), at p. 671; Vincent (2008), at p. 177; Dujsic et al. (2008), at p. 203; and McCrodan et al. (2009), at sec. 23:1-21. 819. Subsec. 56(2) of the Canadian Income Tax Act, which then contained the following wording: “A payment or transfer of property made pursuant to the direction of, or with the concurrence of, a taxpayer to some other person for the benefit of the taxpayer or as a benefit that the taxpayer desired to have conferred on the other person (other than by an assignment of any portion of a retirement pension pursuant to section 65.1 of the Canada Pension Plan or a comparable provision of a provincial pension plan as

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tion provision was characterized as ensuring that payments that otherwise would have been received by the taxpayer would not be diverted to third parties as an anti-avoidance technique.820 If the excess amount were deemed to be a dividend payment to GGL, the amount would be subject to withholding tax. The TC found that the excess amounts that were paid to the Swiss Sub were not payments for ranitidine. Further, the Swiss Sub did not provide any other goods or services to Glaxo Canada, and was therefore not entitled to the excess payments.821 The TC viewed GGL as being entitled to the excess payments. Had the excess amounts not been paid to the Swiss Sub, they would have, at some point, been distributed to GGL in the form of dividend payments. This funnelling of excess profits to the Swiss Sub was caused by the setting of the transfer price by Glaxo Holdings and by the concurrence of GGL that the Swiss Sub could receive funds that GGL was entitled to. The TC therefore regarded the excess amount as received by GGL as deemed dividend payments. The reassessment concerning withholding tax on deemed dividend distributions from Glaxo Canada to GGL was therefore upheld by the TC.822

6.7.4.4. The 2012 Supreme Court ruling The TC ruling was appealed to the Federal Court of Appeal, which found that the licence agreement was a circumstance that had to be taken into account when determining whether the prices paid by Glaxo Canada for ranitidine were reasonable. This ruling was appealed to the Supreme Court of Canada (SCC). The issue on appeal before the SCC was the correct interpretation of section 69(2) of the Canadian Income Tax Act, in particular with regard to which circumstances were to be taken into account when determining the reasonable arm’s length price. Similarly to the TC, the SCC found that the OECD TPG were not controlling as if they were a Canadian statute and that the test of transactions or defined in section 3 of that Act or of a prescribed provincial pension plan) shall be included in computing the taxpayer’s income to the extent that it would be if the payment or transfer had been made to the taxpayer.” 820. McClurg v. R., 1984 CarswellNat 369 (T.C.C., 1984), reversed by 1986 CarswellNat 244 (Fed. T.D., 1986), affirmed by 1987 CarswellNat 556 (Fed. C.A., 1987), leave to appeal allowed by 1988WL876606 (S.C.C., 1988) and affirmed by 1990 CarswellNat 520 (S.C.C., 1990). See the latter ruling, at pp. 1052-1053. 821. TC ruling, para. 173. 822. Apart from the marginal adjustment for value from the Glaxo manufacturing process.

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prices ultimately had to be determined according to the domestic transfer pricing provision rather than any particular methodology or commentary set out in the OECD TPG. However, as the domestic transfer pricing provision did not provide any guidance on concrete transfer pricing methodology, the SCC relied on the methods set out in the OECD TPG.823 The SCC interpreted the TC ruling to say that the Singleton case precluded the TC from considering the licence agreement.824 In its summary of the TC ruling, the SCC observed that the Canadian tax authorities argued that earlier SCC cases of Singleton825 and Shell Canada Ltd. v. R.,826 as well as the OECD TPG, required a transaction-by-transaction approach for the determination of an arm’s length transfer price. The SCC did not agree with this view. The Court found that both Singleton and Shell were inapplicable for determination under section 69(2).827 The Court then went on to comment on the arguments from the tax authorities concerning the OECD TPG. The 1995 version of the OECD TPG, relevant for the case at trial, stated that as a point of departure, the arm’s length principle should be applied on a transaction-by-transaction basis,828 but that in some situations, where separate transactions are so closely linked or continuous that they cannot be evaluated adequately on a separate basis, the transaction-by-transaction approach should give way for a holistic approach to setting the transfer price.829 The Court found that the OECD TPG required the economically relevant characteristics between the controlled and uncontrolled transactions to be sufficiently comparable.830 Only when there are no related transactions or when related transactions are not relevant to the determination of the reasonableness of the transfer price in issue did the Court find that a transaction-by-transaction approach would be useful.

823. SC ruling, para. 21. 824. SC ruling, para. 30. 825. See sec. 6.7.4.3. 826. Shell Canada Ltd. v. R., 1997 CarswellNat 401 (T.C.C., 1997), reversed by 1998 CarswellNat 170 (Fed. C.A., 1998), leave to appeal allowed by 1998WL1727462 (S.C.C., 1998), leave to appeal allowed by 1999WL33183768 (S.C.C., 1999) and reversed by 1999 CarswellNat 951 (S.C.C., 1999), additional reasons in 1999 CarswellNat 1808 (S.C.C., 1999). 827. SC ruling, para. 38. 828. See 1995 OECD TPG, para. 1.42. 829. Id. 830. See SC ruling, para. 42; and 1995 OECD TPG, para. 1.15.

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The Court found the rights under the licence agreement between Glaxo Canada and GGL to be contingent on Glaxo Canada entering into the supply agreement with the Swiss Sub and paying the ranitidine transfer price under the agreement as set by Glaxo Group. Further, the Court concluded that the result of the price paid was to allocate to Glaxo Canada what Glaxo Group considered suitable compensation for its secondary manufacturing and marketing activities. The Court recognized that the payments under the supply agreement for ranitidine included payments for some of the rights and benefits under the licence agreement.831 The Court further found that the generic comparables did not reflect the economic and business reality of Glaxo Canada, nor did they indicate the arm’s length price for ranitidine. The Court remitted the case back to the TC for re-determination of the arm’s length price for ranitidine, under the instruction that the transfer price of ranitidine under the supply agreement should be determined in light of the rights and benefits under the licence agreement. In other words, the controlled transactions should be aggregated for the purpose of determining an arm’s length profit allocation.832

6.7.4.5. Observations on the Supreme Court ruling The Canadian GlaxoSmithKline case illustrates a general point: the transfer prices applied in different types of controlled transactions that all pertain to the same value chain will normally be aligned and determined as a package by the management of the multinational on a centralized global level with the aim of providing the involved group entities with an arm’s length total compensation (taking into account all transactions). In the author’s view, the TC’s ruling represents an analytical and thorough transfer pricing assessment. In this section, the author presents his comments on the SCC ruling, with which he partly disagrees. First, however, it must be stressed that the GlaxoSmithKline case was decided on the basis of domestic Canadian tax law, i.e. the former section 69(2) of the Canadian Income Tax Act. The author’s comments will be limited to the interpretation and application of the OECD TPG. Nevertheless, both the TC and SCC rulings are heavily reliant on the OECD Guidelines in their interpretation of Canadian income tax law. The ruling of the SCC seems, in essence, founded on its interpretation of paras. 1.15 and 1.42 of the 1995 OECD Guidelines.833 831. SC ruling, para. 51. 832. The Tax Court was scheduled to hear the case on 12 Jan. 2015, but the matter was settled between the Canada Revenue Agency and GlaxosmithKline Inc.; see Tax Notes Intl., 12 Jan. 2015, at p. 124. 833. See SC ruling, paras. 39-43.

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First, the SCC seems to overstate the significance of the Singleton case and the Shell case for the assessment by the TC that the transfer price for ranitidine under the supply agreement should be assessed on a stand-alone basis. The author’s impression of the TC ruling on this point is that the TC simply used the Singleton case as a supportive argument for what is largely an evidentiary assessment of the material content of both the supply and licence agreements.834 Second, the SCC seems to ask the wrong question. According to the SCC, the question is of what “an arm’s length purchaser would pay for the property and the rights and benefits together where the rights and benefits are linked to the price for the paid property”.835 The SCC finds that the “result of the price paid was to allocate to Glaxo Canada what Glaxo Group considered to be appropriate compensation for its secondary manufacturing and marketing function”836 and that “whatever price was determined by Glaxo Group would be subject to s. 69(2) and the requirement that the transfer pricing transactions be measured against transactions between parties dealing with each other at arm’s length”.837 It is clear that the only performance rendered by the Swiss Sub under the supply agreement was the sale of ranitidine.838 Further, there was no doubt that the Glaxo Canada ranitidine and the generic ranitidine were chemically and biologically equivalent. It is therefore simply not logical that the transfer price – for an admittedly generic performance and for that performance only – should be set higher than the established and observable market price. Also, it was clear that the excess price paid under the supply agreement for ranitidine was payment for the benefits bestowed upon Glaxo Canada 834. Under para. 74 of the TC ruling, Judge Rip states “I have made no similar finding of fact. Both the License Agreement and the Supply Agreement can stand alone; neither is ancillary to the other”. Further, in para. 78, he states: “It may very well be that a 40 percent total profit to Glaxo Group is reasonable; however, the issue before me is whether the purchase price of the ranitidine was reasonable. One cannot combine the two transactions and ignore the distinct tax treatments that follow from each.” The author views these statements as clearly pertaining to an analysis of the material content – and the legal consequences – of the transfer agreements. Further, the TC also supported its assessment on this point with the US Tax Court Bausch & Lomb case. Neither the quoted statements nor Bausch & Lomb are commented by the Supreme Court of Canada; focus rests with the Singleton case and, to some extent, the Shell case. 835. SC ruling, para. 44. 836. SC ruling, para. 49. 837. SC ruling, para. 50. 838. SC ruling, para. 51, indirectly.

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in the licence agreement with GGL. The significant portion of this value came from the effect of the trade name Zantac and other intangibles made available by GGL to Glaxo Canada.839 These intangibles were owned by GGL, not by the Swiss Sub. Therefore, GGL was entitled to compensation for the provision of these intangibles. The view of the SCC, i.e. that the decisive point is whether the total amount of compensation – across all contracts – to Glaxo Canada is at arm’s length, seems simplistic in this context. The view would perhaps be defendable in a purely domestic transfer pricing case, where the income from the different contracts were treated equally for tax purposes. In this case, however, where the different controlled transactions were entered into between different group entities in different jurisdictions, the view must be rejected. Fundamentally, this is as much of a question of correct allocation, or disaggregation, of income between taxpayers, as it is a transfer pricing issue. The question is whether a taxpayer, by way of intra-group contractual arrangements, is free to allocate income without regard to the underlying legal relationships. Specifically for this case, this would mean whether GGL was free to decide – with binding effect for the domestic tax treatment – that compensation that it was entitled to, as the owner of unique and highly valuable intangibles (the Zantac trade name, patent and know-how), should not be paid to the United Kingdom as royalties from Canada, but as an excessively high transfer price for raw materials to another group company resident in Switzerland. In this case, it may be argued that (at least some of) the excess price should have been reclassified as royalty payments for the provision of intangibles from GGL to Glaxo Canada. This would be more in line with the legal and economic reality of the licence agreement and GGL’s ownership of intangibles. Thus, the question should be whether the agreed royalty payments of 6% under the licence agreement were arm’s length. The facts of the case may indicate that this was not so. Glaxo Holding decided that 40% of the gross profits of Glaxo Canada were to be remitted to Glaxo Holding. Thus, it would seem that the lion’s share of this 40% may have been allocated to the most tax-beneficial of the controlled transactions in the value chain (in this case, as an excess transfer price for ranitidine from Glaxo Canada to Switzerland, from there to Singapore and ultimately to the United Kingdom).

839. SC ruling, para. 52; and TC ruling, para. 91.

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The Supreme Court touched upon the issue of whether the excess payments for ranitidine under the supply agreement were linked to the provision of specific intangibles under the licence agreement,840 but did not conclude on this issue. It did, however, note that if the purchase price for ranitidine included compensation for intellectual property rights granted to Glaxo Canada by GGL, there would have to be consistency between that and Glaxo Canada’s position with respect to withholding tax. Further, the SCC held the issue open for reassessment by the TC of whether compensation for intellectual property rights was justified in this case. This is a peculiar statement. GGL owned highly valuable and unique intangibles, which it made available to Glaxo Canada. This performance was, of course, in principle, subject to transfer pricing, and was priced, at 6% of the net sales of Glaxo Canada. The question is therefore not of whether the provision of intangibles from GGL in the United Kingdom to Glaxo Canada should be subject to transfer pricing, but whether the agreed royalty rate of 6% represented an arm’s length transfer price for the provision by GGL of rights to the patent, trade name and other intangibles required by Glaxo Canada in order to perform secondary manufacturing and sales of Zantac in Canada. The facts indicated that there existed large residual profits in Glaxo Canada (from the Zantac value chain) equal to the excess payment for ranitidine and that this excess return was caused by the high price that Zantac demanded in the Canadian marketplace. The reason for this high return was largely due to the trade name Zantac, or in other words, IP owned by GGL. It therefore seems highly questionable whether the agreed 6% royalty represented an arm’s length compensation to GGL from Glaxo Canada for the use of the patent and trade name for Zantac. The SCC left considerable leeway for the TC to re-determine the transfer price for ranitidine under the supply agreement.841 However, for the reasons above, to the extent that the SCC recommended that the transfer price be set above the market price for generic ranitidine, the author disagrees. The TC should not have altered its determination of the transfer price of ranitidine as such. Of course, whether the TC would have felt authorized to leave its previously determined transfer price for ranitidine largely unaltered in light of the SCC ruling is an open question. Nevertheless, on one decisive point, the TC should have altered its assessment. The excess amount paid for the ranitidine should not be classified as dividend distributions, but as royalty payments from Glaxo Canada to GGL. Reclassification of the ex840. SC ruling, para. 57. 841. See SC ruling, paras. 61-63.

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cess amount from payment for ranitidine to the Swiss Sub to royalties paid to GGL would bring the tax treatment in line with the legal and economic realities of the case. GGL owned the IP applied in the Canadian Zantac value chain and was therefore entitled to compensation. As it does not seem doubtful that the lion’s share of the excess payments de facto was due to the high price of Zantac as a result of the marketing power of the trade name, treatment as royalties will be the natural transfer pricing classification. Further, the reassessment by the tax authorities, whereby the entire excess amount was reclassified as deemed dividend distributions, seems unnecessarily harsh, and also somewhat out of sync with the realities of the case. Royalty payments represent a business cost for Glaxo Canada and would therefore, contrary to dividend payments, be deductible for tax purposes in Canada. The only domestic difference between the treatment as asserted by Glaxo Canada in its original tax return, where the excess amount was treated in full as payment for ranitidine, and a tax treatment where the excess amount is treated as royalties will be that the latter payments are subject to withholding tax in Canada. Both payments would, however, be tax deductible for Glaxo Canada. In the author’s view, the TC should have, upon re-determination, upheld its transfer pricing assessment for the payment of ranitidine and classified the excess amount paid for ranitidine as royalty payments to GGL. This would have ensured that the point behind aggregating controlled transactions, i.e. to realize arm’s length compensation among group entities by taking into account all value transfers, would have been fulfilled, while at the same time ensuring that the total amount of compensation (as calculated based on the aggregated approach) would be allocated correctly among the individual controlled transactions relating to the value chain. While the solution drawn up by the SCC managed to allocate in total an arm’s length compensation to the Canadian group entity, it failed to allocate the compensation correctly among the controlled transactions. The result was that what should have been deemed to be royalty payments (subject to withholding tax and allocable to the United Kingdom) were instead treated as COGS (not subject to withholding tax and allocable to Switzerland). Thus, in the end, while the total compensation allocated by the SCC to the aggregated controlled transactions was arm’s length, the portion of this amount allocated to the individual controlled transactions were not.

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Chapter 7 Direct Transaction-Based Allocation of Residual Profits to Unique and Valuable IP: The CUT Method 7.1. Introduction This chapter is dedicated to a discussion of the transaction-based US and OECD methodology for directly allocating operating profits for unique intangible property (IP) used in an intangible value chain, namely the comparable uncontrolled transaction (CUT) method.842 This method is a specified pricing method under the US regulations and the OECD Transfer Pricing Guidelines (OECD TPG) 843 and evaluates whether the royalty charged in a controlled transfer of IP is at arm’s length by reference to the royalty charged in a CUT. While relatively ideal for the pricing of generic inputs for which there are efficient markets (e.g. oil, sugar and other commodities),844 it is generally ill-suited for the purpose of allocating operating profits from intangible value chains based on unique and valuable intangibles, for which there is no true competition, and therefore no CUTs. Contrary to the purpose behind it, the CUT method – in the context of IP-driven value chains – may, in practice, be particularly attractive for taxplanning purposes, and thus represent an obvious potential for BEPS. Below-arm’s length royalty rates may be sought to be justified through the use of purported CUTs that, in reality, pertain to IP transfers with economic characteristics that differ from those of the IP transferred in the controlled transaction. In combination with ambiguous comparability adjustments, the outcome of the CUT method may be manipulated to yield the desired result. The CUT method may become a “black box” pricing methodology in the sense that it will only offer a limited degree of transparency with respect 842. For discussions of the comparable uncontrolled transaction (CUT) method, see, e.g. Wittendorff (2010a), pp. 649-650 and pp. 713-720; Markham (2005), at pp. 94-97; and Andrus (2007), at p. 643. For a historical overview of the CUT method, see the 1992 International Fiscal Association (IFA) general report in Maisto (1992), at p. 32. 843. Treas. Regs. § 1.482-4(c); and OECD TPG, paras. 2.13-2.20 and 6.146-6.147 (see also Examples 23 and 26 in the annex to ch. VI of the OECD TPG). 844. See Rocha (2017), at p. 193, where it is stated that most IFA branch jurisdictions use the CUT method for transactions with commodities (see also the discussion at pp. 227-229 of the same work).

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to the underlying assessments that were determinative for the third-party royalty rate. It will also normally be difficult to ascertain whether the intangibles transferred in the controlled and uncontrolled transactions in fact share the same economic characteristics, which will be decisive for ascertaining an arm’s length allocation of operating profits among controlled parties. For these reasons, the United States severely restricted the application of the CUT method to allocating profits for IP already in the 1994 final regulations. The author will analyse the US provision in section 7.2. The OECD, however, has traditionally embraced the CUT method as its flagship method, but has now distanced itself from its prior position, as will be elaborated in the analysis in section 7.3.

7.2. The US CUT method 7.2.1. Introduction To apply the US CUT method for allocating profits for IP, the purported CUT must pertain to the same intangible as transferred in the controlled transaction, or to a comparable intangible.845 This will be discussed in sections 7.2.2. and 7.2.3., respectively. Thus, the topic pertains to the CUT method comparability requirements that are specific to the context of intangibles. The general US comparability requirements (discussed in section 6.6.) form the backdrop for this analysis.

7.2.2. The purported CUT pertains to a transfer of the same intangible as transferred in the controlled transaction If the same intangible is transferred in a controlled and uncontrolled transaction, the royalty used in the latter transaction may be the most direct and

845. Treas. Regs. § 1.482-4(c). The US regulations reject two types of uncontrolled transactions as comparables, namely (i) transactions that are not made in the ordinary course of business (see Treas. Regs. § 1.482-1(d)(4)(iii)(A)(1); and Treas. Regs. § 1.4821(d)(4)(iii)(B), Example 1); and (ii) transactions designed to establish an arm’s length result for the controlled transaction (see Treas. Regs. § 1.482-1(d)(4)(iii)(A)(2); and Treas. Regs. § 1.482-1(d)(4)(iii)(B), Example 2). See Brauner (2008), at p. 128 on the US CUT method.

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reliable measure of the arm’s length result of the former transaction.846 The US regulations, however, emphasize that the general comparability factors must align similarly for both transactions in order for the CUT pricing to be acceptable as a benchmark. This requirement is illustrated in two examples. The first example pertains to a US parent that has developed and patented a new drug and has governmental authorization to make and sell the drug in the United States and other countries.847 It licenses make-sell rights to the drug for country X to a local subsidiary and for the neighbouring country Y to a local unrelated company. The countries are similar in terms of population, distribution of income among citizens, as well as the occurrence of the disease that the drug targets, and they provide similar protection for intellectual property rights. The costs of manufacturing and marketing the drug in countries X and Y are expected to be approximately the same. The terms of the controlled and uncontrolled agreements are materially identical, including the royalty used. The drug is expected to be sold in similar quantities and at similar prices in both countries. The conclusion of the example is that the CUT is a reliable measure of the arm’s length royalty rate.848 The second example uses the same facts as the first example, but with the twist that the incidence of the disease is much higher in country Y.849 Thus, the profit potential from exploiting the right to make and sell the drug is likely to be much higher in country Y than in country X. It is therefore concluded that the CUT is unlikely to provide a reliable measure of the arm’s length royalty rate for the controlled agreement.

7.2.3. The purported CUT pertains to a transfer of a different intangible than that transferred in the controlled transaction 7.2.3.1. Introduction In order for a purported CUT pertaining to the transfer of a different intangible than the one transferred in the uncontrolled transaction to determine 846. Treas. Regs. § 1.482-4(c)(2)(ii). See also Ainsworth et al. (2012), where a comparative study concludes that exact comparables trump all other pricing approaches in the jurisdictions encompassed by the study. 847. Treas. Regs. § 1.482-4(c)(4), Example 1. The example is reiterated in Treas. Regs. § 1.482-8, Example 7. 848. See also Roberge (2013), at p. 223 on the use of external CUTs from small markets. 849. Treas. Regs. § 1.482-4(c)(4), Example 2.

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the controlled allocation of operating profits, two criteria must be fulfilled under the US regulations. The IP transferred in the controlled and uncontrolled transactions must (i) be used in connection with similar products or processes within the same industry or market; 850 and (ii) have similar profit potential.851 The author will focus on the similar profit potential criterion, as this, in practice, is the single most important requirement under the CUT method (and has significantly influenced the 2017 OECD TPG).852 The criterion made its debut in the 1993 temporary regulations853 and was introduced because the 1992 proposed regulations suggested that the new comparable profits method (CPM) should be used as a mandatory check on the pricing results yielded by all other pricing methods.854 This proposed “sanity check” requirement was scrapped in the 1993 temporary regulations (which, in and of itself, reduced the relative position of the CPM compared to the position initially intended for it in the 1992 proposed regulations). The 1993 preamble observed that the removal was “offset by incorporating a reference to profit potential in the definition of comparability, reflecting Congressional concern that royalty rates for “high-profit” intangibles could “be set on the basis of industry norms for transfers of much less profitable items”.855 The need to reliably measure profit potential increases as the total amount of operating profits relative to the investment go up. Reliability is affected by the extent to which the profit attributable to the IP can be isolated from the profit attributable to other value chain inputs (e.g. manufacturing and marketing functions). The estimation of profit potential is a problematic exercise, even with respect to the controlled transaction (for which detailed information is normally available). The operating profits from an intangible value chain may not only need to be split among routine value chain contributions (e.g. contract manufacturing) and unique IP, but it will normally also be necessary to split the residual profits among two or more unique intangibles (e.g. 850. Treas. Regs. § 1.482-4(c)(2)(iii)(B)(1)(i). 851. Treas. Regs. § 1.482-4(c)(2)(iii)(B)(1)(ii). 852. See the discussions in secs. 6.6.3. and 11.4., with further references. 853. 1993 Temp. Treas. Regs. (58 FR 5263-02) § 1.482-4T(c)(2)(ii)(A)(3). 854. 1992 Prop. Treas. Regs. (57 FR 3571-01) § 1.482-2(d)(4)(i). 855. See 1993 Temp. Treas. Regs. (58 FR 5263-02), Preamble (the discussion of § 1.482-4T(c)). See also H.R. Rep. No. 426, 99th Cong., 1st Sess. 424 (1985), at pp. 425426.

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patents and marketing intangibles that refer to the same product). It may be unrealistic to accomplish this based on purported CUTs due to a lack of detailed information on the third-party value chains to which the CUTs refer. The profit potential of the intangibles transferred in the controlled and uncontrolled transactions should, as the main rule, be determined directly. The author will comment on this in section 7.2.3.2. Nonetheless, a direct assessment may not always be feasible based on the information available. The US regulations therefore, in some of these cases, allow the determination to be based on an indirect assessment. The author will discuss this in section 7.2.3.3., and will then tie some comments to the determination of profit potential in other cases in section 7.2.3.4.

7.2.3.2. Direct assessment of profit potential The US regulations take the position that the profit potential of an intangible is most reliably measured by directly calculating the net present value (NPV) of the operating profits allocable to the intangible, typically through a discounted cash-flow (DCF) analysis.856 A range of factors must be taken into consideration in this determination, such as the capital investment and start-up expenses required and the risks to be assumed.857

7.2.3.3. Indirect assessment of profit potential The US regulations allow the profit potential of certain low-value intangibles to be estimated indirectly when the information necessary to directly calculate the NPV allocable to the intangible transferred in the uncontrolled transaction is unavailable858 and the “need to reliably measure profit potential is reduced because the potential profits are relatively small in terms of total amount and rate of return, [and] comparison of profit potential may be based upon the factors referred to in paragraph (c)(2)(iii) (B)(2)”.859 856. Treas. Regs. § 1.482-4(c)(2)(iii)(B)(1)(ii), second sentence. 857. See the discussion of valuation in ch. 13, as well as the more particular issues connected to the valuation of buy-ins in the context of cost-sharing arrangements (CSAs) in ch. 14. 858. Treas. Regs. § 1.482-4(c)(2)(iii)(B)(1)(ii), fourth sentence. 859. Treas. Regs. § 1.482-4(c)(2)(iii)(B)(ii). These factors are (i) the terms of the transfer (whether the IP rights are exclusive, any restrictions on the use or geographic area in which the rights may be exploited, etc.); (ii) the stage of development of the IP; (iii) the rights to receive updates; (iv) the uniqueness of the IP (including the degree and duration of protection); (v) the duration of the licence (including the termination

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The threshold for bypassing the direct assessment requirement is ambiguously described in the quoted text. It is, however, clear that the authority is reserved for cases in which the “potential profits are relatively small”. Based on the wording of the exception, as well as an example contained in the regulations,860 the author finds that the exception only applies to generic intangibles that do not account for a substantial part of the operating profits from the products into which they are used as inputs. Such “normal return” intangibles will likely be common within certain industries, for instance, in the computer hardware industry, where competition is fierce and competitors offer relatively similar components, as was the case in Seagate.861 Thus, the exception should be inapplicable if the IP transferred in the controlled transaction is unique and valuable. There is, of course, not always a distinct line between unique intangibles that generate considerable residual profits and more generic intangibles that do not account for a substantial portion of the operating profits from the value chain. The exception should be limited to cases in which it is clear that the intangible transferred in the controlled transaction is not a high-value intangible. The author bases this conclusion on the fact that the example contained in the regulations lists specific circumstances that justify an application of the exception (e.g. the existence of competing products and the fact that it was apparent that the intangible was not responsible for a significant portion of the profits).862

7.2.3.4. Assessment of profit potential in other cases The question at issue in this section is how to compare the profit potential of the IP transferred in the controlled and uncontrolled transactions when the information available on the purported CUT is insufficient to perform a direct assessment and the IP transferred in the controlled transaction is unique, high-value IP that does not qualify for the indirect assessment or renegotiation rights); (vi) the economic and product liability risks to be assumed by the transferee; (vii) the existence and extent of any collateral transactions or ongoing business relationships between the transferee and transferer; and (viii) the functions to be performed by the transferer and transferee. 860. Treas. Regs. § 1.482-4(c)(4), Example 3. 861. Seagate Technology, Inc. v. CIR, 102 T.C. No. 9 (Tax Ct., 1994), acquiescence in result only recommended by AOD-1995-09 (IRS AOD, 1995), and acq. 1995-33 I.R.B. 4 (IRS ACQ, 1995). See the discussion of the case in sec. 5.2.5.5. 862. Another thing entirely is that the example is not wholly logical, in the sense that it contains so much information on the CUTs that it seems peculiar that it would not be possible to directly assess their profit potentials.

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exception. The author imagines that this is the most relevant question in practice, as the intangible value chains of multinationals tend to rely on high-profit IP for which there are no CUTs available. This issue is not addressed by the US regulations, which offer only the two options discussed in sections 7.2.3.2.-7.2.3.3. (direct assessment of profit potential through a DCF analysis or indirectly through a comparison of terms and conditions). If none of these options are feasible, one could logically assume that the CUT method simply will be inapplicable. The author does not favour that interpretation. The CUT method should not be rejected unless there are no reliable CUTs available. Of course, in order to conclude on that issue, one must first determine whether the controlled and uncontrolled transfers have similar profit potential. In order to resolve this problem, the author suggests that the profit potential of the IP transferred in the controlled transaction be determined directly through a DCF valuation. It will normally be possible both for the multinational and the tax authorities to do this based on profit data possessed by the multinational pertaining to its own business and value chains (e.g. management accounting records). When the NPV has been estimated, the question becomes how much of this value would be allocated to the transferer under his best realistic alternative to the licensing transaction. The realistic alternative will normally be for the licenser to make and sell the products itself instead of licensing out. An unrelated transferer would logically not accept an alternative use of his intangible that would put him worse off than he would be with his best alternative. The NPV result can be converted into a royalty rate using the same technique as the one prescribed under the US lump-sum provisions (aimed at constructing the equivalent royalty rate).863 The result under the best realistic alternative provides a precise indication of the lowest acceptable royalty rate in the controlled transaction. If the royalty rate in the purported CUT is lower than this rate, this will, in the author’s view, be a convincing indication that the IP transferred in the CUT does not have profit potential similar to the IP transferred in the controlled transaction. The purported CUT should therefore be rejected. This solution falls within an ordinary linguistic understanding of the language used in the direct estimation provision, i.e. that “the profit potential

863. See the analysis of the US lump-sum provisions in sec. 16.4.

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of an intangible is most reliably measured by directly calculating the net present value of the benefits to be realized”. (Emphasis added) 864 This wording does not require the profit potential of both intangibles to be directly assessed. The author’s interpretation ensures a direct assessment of the profit potential of the intangible transferred in the controlled transaction. Economic logic will then dictate that the profit potential of the intangible transferred in the purported CUT cannot be similar if the royalty rate in the CUT is below the royalty rate that the controlled transferer would receive in his best realistic alternative to licensing out the intangible. Further, the author’s interpretation is supported by the historical link between the profit potential criterion and the best realistic alternative assessment. The restrictive effect that the profit potential criterion has on the CUT method was originally illustrated in the 1993 temporary regulations through a roundtrip example with a factual pattern akin to that in Bausch.865 The example pertained to a US parent that owned the patent to a successful product with a market price of USD 6. Even a selling price of USD 2 would have provided the parent with a reasonable return on its costs, had it produced the product itself. The parent instead chose to license make-sell rights to the patent to a foreign subsidiary for a royalty of USD 1, based on a purported CUT involving the licence of a similar proprietary process. The parent then purchased finished products from the subsidiary at the market price of USD 6,866 effectively allocating the entire residual profits from the value chain to the foreign subsidiary. For the purpose of determining whether the intangibles had similar profit potential, the example authorized the US Internal Revenue Service (IRS) to take into account the parent’s “alternative of producing and selling product X itself as a factor that may affect the amount P would demand as a royalty for the proprietary process if dealing with an uncontrolled taxpayer at arm’s length”.867

864. Treas. Regs. § 1.482-4(c)(2)(iii)(B)(1)(ii), second sentence. 865. 1993 Temp. Treas. Regs. (58 FR 5263-02), § 1.482-4T(c)(2)(iv). See also Bausch & Lomb Inc. v. CIR, 92 T.C. No. 33 (Tax Ct., 1989), affirmed by 933 F.2d 1084 (2nd Cir., 1991); and the comments on the case in sec. 5.2.5.2. 866. The remaining part of the subsidiary’s production was sold to unrelated parties for the same price. 867. 1993 Temp. Treas. Regs. (58 FR 5263-02), § 1.482-4T(c)(2)(iv), second paragraph.

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As the parent could have chosen to make and sell the product itself, thus reaping the whole USD 4 of residual profits, the US parent was “unlikely to accept a royalty for the proprietary process of less than $4”.868 The intangible transferred in the unrelated transaction with a royalty of USD 1 was therefore not considered comparable to the intangible transferred in the controlled transaction, due to having a different profit potential. This result was in accordance with the IRS’s litigation stance in Bausch. The example was criticized.869 The OECD was concerned that the relative position of the CPM would be elevated by the inclusion of the profit potential comparability requirement.870 The OECD’s arguments were that the taxpayer would have to form an opinion of the profit potential of its own intangible, which could be speculative, and gather data on the uncontrolled intangible in order to calculate a profit potential for it.871 The 2nd task force report stated that it could be “difficult, if not impossible” to obtain the details of the CUT. These arguments were, as far as the author can see, circular. The lack of data on the purported CUT would indicate that the CUT method was not appropriate in the first place. Indeed, the report seemed to indicate a generally relaxed attitude towards comparability under the CUT method. It suggested that some of the comparability data required under the temporary regulations, including the “uniqueness of property, expected economic life of the property, provisions of third party agreements, and so forth”, would be difficult or impossible to obtain.872 Even though not directly stated, the report could be interpreted to express that the CUT method should be available even in the absence of such information. The Baush-inspired example was replaced in the final 1994 regulations.873

868. 1993 Temp. Treas. Reg. (58 FR 5263-02), § 1.482-4T(c)(2)(iv). See also Bausch & Lomb Inc. v. CIR, 92 T.C. No. 33 (Tax Ct., 1989), affirmed by 933 F.2d 1084 (2nd Cir., 1991); and the comments on the case in sec. 5.2.5.2. 869. See Tax Notes Intl., 1 Mar. 1993, at p. 525. 870. 2nd task force report, paras. 3.8, 3.11 and 3.13. 871. Id., at para. 3.7. 872. Id., at paras. 3.10 and 3.12. 873. The new example pertains to a US parent that has developed a drug to treat migraines (which replaces an existing drug); see Treas. Regs. § 1.482-4(c)(4), Example 4. The question is whether the royalty rate used in an uncontrolled licence agreement for the existing drug can be used to benchmark the royalty rate for the new drug. The example rejects the licence agreement for the older drug as a CUT, as the new drug has superior qualities that will enable it to make larger profits. Where there is no predecessor intangible available that one can use to benchmark the profit potential against, profit potential should, in the author’s view, be determined on the basis of the realistic alter-

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In the author’s view, the removal of the Bausch-like example has no bearing on the relevance of the best-realistic-alternatives assessment under the profit potential criterion. The idea that transfer pricing results should be compatible with the results that could be achieved through the best options realistically available is a fundamental principle in US transfer pricing law. It is expressed as a comparability factor under the general comparability provisions,874 it lies at the core of what can be accepted as an unspecified pricing method875 and it is the foundation for the logic behind the income method of the new cost-sharing regulations.876 It would therefore be wholly inconsistent if the profit potential of a purported CUT could be deemed similar to that of the controlled transaction if the royalty rate of the CUT made the controlled licenser worse off than he would have been with his best realistic alternative. The author therefore concludes that the profit potential of unique, high-value IP transferred in a controlled transaction should not be deemed similar to the profit potential of IP transferred in a purported CUT if the royalty rate extracted from the CUT results in a lesser allocation residual profits to the licenser than he would have achieved with his best realistic alternative.877 If the profit potential is not similar pursuant to this assessment, the CUT should be rejected (and it can thus not be used under the CUT method).

7.2.4. There are no CUTs available If there are no uncontrolled transactions available that fulfil the comparability requirements discussed in sections 7.2.2.-7.2.3., the CUT method will yield an unreliable result. It is therefore not likely that it will be deemed the best method in such cases.878 natives available to the controlled parties, similarly to the assessment in the original Bausch-like example of the temporary regulations. 874. Treas. Regs. § 1.482-1(d)(3)(iv)(H). 875. Treas. Regs. § 1.482-4(d). 876. Treas. Regs. § 1.482-7(g)(4). See also Treas. Regs. § 1.482-7(g)(2)(iii). The costsharing regulations are also relevant to controlled agreements outside the context of CSAs; see Treas. Regs. § 1.482-4(g). 877. Often, the best realistic alternative for the licenser will be to make and sell the product itself. 878. See Treas. Regs. § 1.482-1(c)(1) and (2)(i), last sentence. See also § 1.482-9(c) (4), Example 4, where the CUT method is deemed inappropriate when a US parent renders research and development services to a foreign subsidiary and uses a proprietary software program (which it owns) to render these services. No uncontrolled parties are

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The OECD CUT method

7.3. The OECD CUT method 7.3.1. Introduction The historical OECD position on the applicability of the CUT method for allocating profits from value chains that make use of unique IP has been reversed 180 degrees with the 2017 OECD TPG.879 The 1995 consensus text (which was carried over to the 2010 text without alterations) expressed a preference for the CUT method and was brief, ambiguous and problematic.880 It contained relaxed guidance on acceptable CUTs,881 which could be interpreted to convey an acceptance of the use of industry averages and bids to benchmark controlled royalty provisions.882 The 1995 wording is now legal history and of little relevance for the interpretation of the new 2017 OECD guidance. While the 2017 text has not made any changes to the general CUT guidance contained in chapter II of the OECD TPG, it has introduced significant supplemental guidance on the relevance of the CUT method in the context of unique IP, emphasizing comparability. The author will discuss the new guidance on comparability requirements in section 7.3.2., comparability adjustments in section 7.3.3. and the use of commercial databases in section 7.3.4. Concluding comments are provided in section 7.3.5.

identified that perform services identical or with a high degree of similarity to those performed by the parent, and reliable comparability adjustments cannot be made. 879. The OECD has also changed its view on other important aspects of transfer pricing. For instance, the OECD no longer upholds its historically critical attitude (as expressed in the 1993 OECD report commenting on the 1992 proposed US regulations) towards applying the concept of the realistic options available; see Parekh (2015), at p. 298. 880. Least problematic was the list of relevant comparability factors; see 1995/2010 OECD TPG, paras. 6.20-6.21. 881. 1995/2010 OECD TPG, para. 6.23. The wording did not seem to require similar expected benefits from the IP transferred in the controlled and uncontrolled transactions, as the wording was merely that expected benefits “should be considered”. 882. See also the discussion of Ciba (Ciba-Geigy Corp. v. CIR, 85 T.C. No. 11 (Tax Ct., 1985), acquiescence recommended by AOD-1987-21 (IRS AOD, 1987) and acq. 1987 WL 857882 (IRS ACQ, 1987)) in sec. 5.2.3.4., where the Court used royalty offers and industry average rates to support its position. It should be noted that the Tax Court ruled on the basis of the 1968 regulations. The author does not find it likely that the Court would have ruled similarly if the case had been decided under the CUT provisions of the 1994 regulations.

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7.3.2. Comparability requirements for unique IP under the CUT method Unique and valuable intangibles (that generate residual profits) will generally be exclusive,883 legally protected rights884 within a certain geographical area.885 These are the basic parameters that must be comparable between the controlled and uncontrolled transactions. In this section, the author will focus on the more problematic aspects for which there also must be sufficient comparability. The IP transferred in the controlled and uncontrolled transactions must be comparable with respect to useful life, as the value of an intangible is the present value of the profits allocable to it over its lifetime. Thus, all else equal, the longer an intangible generates profits, the more valuable it will be.886 The useful life can be affected by: − the extent and duration of legal protections and the rate of technological change; − rights to enhancements, revisions and updates; 887 − the purposes for which the intangible is transferred (e.g. the transfer of make-sell rights or rights to use the IP for further research and development); 888 and − the stage of development of the transferred IP (IP relating to established products are normally more valuable than IP connected to partly developed or not-yet-commercialized products).889 However, it is likely that the single most important comparability factor is the expectation of future benefits (as the above factors will be reflected in the expected NPV of the transferred IP).890 This factor is the OECD’s par-

883. OECD TPG, para. 6.118. 884. OECD TPG, para. 6.119. 885. OECD TPG, paras. 6.119-6.120. 886. OECD TPG, paras. 6.121-6.122. 887. OECD TPG, paras. 6.125-6.126. 888. The author discusses this issue in greater detail in the context of valuing buy-in contributions to CSAs in ch. 14. 889. OECD TPG, paras. 6.123-6.124. On the significance for transfer pricing purposes of the life-cycle stage of the IP, see Dolman (2007), under the section entitled “Life cycle of IP”. 890. OECD TPG, para. 6.127.

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allel to the US profit potential comparability criterion.891 The new OECD guidance states that: in the case of a transfer of an intangible … that provides the enterprise with a unique competitive advantage in the market, purportedly comparable intangibles or transactions should be carefully scrutinised. It is critical to assess whether potential comparables in fact exhibit similar profit potential.892

If there is a significant discrepancy between the anticipated future benefit from the controlled and uncontrolled intangibles, it will be “difficult to consider the intangibles as being sufficiently comparable to support a comparables-based transfer pricing analysis in the absence of reliable comparability adjustments”.893 The emphasis on future benefits as a comparability factor is new in the 2017 OECD TPG894 and relatively surprising, as the OECD historically has disapproved of this as a comparability factor.895 The assessment of future benefits will normally be carried out through a DCF valuation, in which all factors that may materially affect the future benefits must be taken into account.896 Relevant factors include risks related to the further development of a partially developed intangible and successful commercialization, infringement, product liability, etc.897 The new wording on valuation will be guiding in this assessment. The author refers to the discussion in chapter 13 for further analysis of valuation techniques in the context of transfer pricing of unique intangibles.

7.3.3. Comparability adjustments for unique IP under the CUT method The 2017 OECD TPG are sceptical towards making comparability adjustments to purported CUTs in the context of unique IP, as such adjustments 891. Treas. Regs. § 1.482-4(c)(2)(iii)(B)(1)(ii). See also the discussion in sec. 7.2.3.1., with further references. 892. OECD TPG, para. 6.116. 893. Id. 894. The notion of profit potential is, however, used in ch. IX of the OECD TPG on restructurings (see OECD TPG, paras. 9.39-9.47), but then not as a comparability factor, but as an indicator of whether the stripped-down local entity transferred something of value to the foreign party in the controlled transaction that requires remuneration. 895. 2nd Task Force Report, Paras. 3.8, 3.11 and 3.13. 896. OECD TPG, paras. 6.153-6.178. 897. OECD TPG, para. 6.128.

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can be difficult to carry out reliably.898 Adjustments that are largely relative to the royalty charged in the purported CUT may indicate that the IP transferred in the controlled and uncontrolled transactions are not sufficiently comparable. If so, the position of the OECD is that it may be necessary to select a different pricing method (in practice, the transactional net margin method or the profit split method).

7.3.4. Commercial databases Several commercial actors now offer transfer pricing database services.899 Typical clients include multinationals, law and accounting firms and tax authorities. The royalty data contained in these databases is extracted from publicly available licence agreements, most of which are public due to filing requirements for multinationals that raise capital in the United States, and may be found on Electronic Data Gathering, Analysis, and Retrieval (EDGAR), a government database created and maintained by the US Securities and Exchange Commission (SEC).900 A significant portion of the filed licence agreements have the royalty rate, or other forms of compensation, redacted.901 In addition to this, multinationals often do not license their unique IP to third parties at all, as there is a need to maintain control over the entire value chain.902 It should therefore be assumed that the thirdparty licence agreements filed with the SEC generally do not pertain to 898. OECD TPG, para. 6.129. 899. Such companies include Royaltystat (http://www.royaltystat.com), Ktmine (http://​ www.ktmine.com) and Royaltyrange (http://www.royaltyrange.com). 900. From 1996, all publicly traded US companies are required to make their filings on the Electronic Data Gathering, Analysis, and Retrieval (EDGAR), except for filings made on paper due to a hardship exemption. Third-party filings with respect to these companies, such as tender offers and schedule 13D, are filed on EDGAR. 901. The background for this practice is the US Securities and Exchange Commission’s (SEC’s) confidential-treatment-request process. The 1933 US Securities Act Rule 406 (17 CFR 230.406) and the 1934 US Securities Exchange Act of 1934 Rule 24b-2 (17 CFR 240.24b-2) allow the confidential treatment of information contained in a Securities Act or Exchange Act filing, respectively. Other provisions allowing requests for confidential treatment include 1933 Act Rule 418 (17 CFR 230.418) and 1934 Act Rule 12b-4 (17 CFR 240.12b-4) for certain types of supplemental information requested by the SEC staff in connection with Securities Act and Exchange Act filings, as well as Rule 83 of the SEC’s Rules of Practice (17 CFR 200.83). In order to gain confidential treatment, the relevant information must be exempt from disclosure under the US Freedom of Information Act (FOIA) (5 U.S.C.A. § 552). The FOIA contains nine exceptions, the most relevant in this context being 5 U.S.C.A. § 552(b)(4) pertaining to “trade secrets and commercial or financial information obtained from a person and privileged or confidential”. 902. See the discussion of foreign direct investment in sec. 2.3.

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unique and valuable IP (that generates residual profits). Thus, the commercial databases that draw upon the EDGAR database (which the author gathers is most of them) contain incomplete information, which is unsuitable for the purpose of benchmarking controlled allocations of operating profits from value chains that rely on unique IP. The OECD position on the use of royalty rates extracted from these commercial databases is that it is important to assess whether such publicly available information is sufficiently detailed to permit an analysis of the specific IP comparability factors.903 The author agrees with this (for the reasons mentioned above). Further, tax authorities should question any applications of the CUT method that rest on purported CUTs extracted from these commercial databases, as the information will normally not provide sufficient background to properly carry out the comparability analysis.

7.3.5. Concluding comments The core problem with the CUT method is that it directly allocates residual profits by reference to what third parties have agreed in other licensing transactions. In order for the method to provide a reliable result, it is crucial that there is an extreme degree of comparability between the IP transferred in the controlled and uncontrolled transactions. That is an unreasonable contingency when it comes to unique intangibles. Also, the CUT method is subject to reduced relevance on a more general level under the 2017 OECD TPG due to its position relative to the other OECD pricing methods (which the author will revert to in depth in chapter 11).

903. OECD TPG, para. 6.130.

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Chapter 8 Indirect Profit-Based Allocation of Residual Profits for Unique and Valuable IP: The CPM (US) and TNMM (OECD) 8.1. Introduction In this chapter, the author will discuss the US and OECD one-sided profitbased transfer pricing methodologies as they stand in the current US regulations and the 2017 OECD Transfer Pricing Guidelines (OECD TPG). The US method is named the comparable profits method (CPM), while its OECD counterpart is the transactional net margin method (TNMM).904 Both utilize what is essentially the same profit allocation methodology, the core content of which is to allocate a portion of the net operating profits from a value chain, equal to a normal market return, to the group entity that provides only routine value chain inputs.905 The rest of the net operating profits (residual profits) are thereby indirectly allocated to the other party to the controlled transaction that contributes unique and valuable intangible property (IP). The methodology plays a truly significant role in how residual profits from IP value chains are allocated internationally.906 The author will underline that this chapter should be read in light of the analysis of the historical development of the contract manufacturer theory in chapter 5, in particular, the analysis of case law in section 5.2.5., the design of the basic arm’s length return method (BALRM) in the 1988 US White Paper in section 5.3.3. and the US and OECD implementation of profit-based methodology in sections 5.3.4. and 5.4., respectively. The one-sided profit-based methodology was developed by the US tax authorities. The basic idea was to deal with the difficult issue of transfer 904. For a historical overview of the methodology, see the 1992 IFA general report in Maisto (1992), at p. 56. For early and thorough analyses, see Horst (1993); and Culbertson (1995). For an early comparison of the comparable price method (CPM) and transactional net margin method (TNMM), see Taly (1996); and Rozek et al. (1999). For a relatively recent and brief discussion of the CPM, see Wittendorff (2010a), at pp. 651-656 and pp. 735-753. See also Brauner (2008), at p. 130; Hamaekers (2003); Markham (2005), at. pp. 107-116; and Casley et al. (2003). 905. For a thorough historical analysis of the debate over net income benchmarking, see Culbertson et al. (2003), at p. 77. See also Maisto (1992), at pp. 42-50. 906. See discussion of the centralized principal model in sec. 2.4.

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pricing of unique and valuable IP by going through the “back door”. As it was generally not possible to find comparable uncontrolled transactions (CUTs) upon which to directly benchmark controlled royalty rates, a far more accessible approach was developed. This consisted of benchmarking the profits allocable to the controlled generic value chain inputs (contract manufacturing, simple distribution functions, etc.) and then asserting that what was left of the operating profits after such routine inputs had been remunerated necessarily had to be the residual profits due to the unique and valuable IP employed in the value chain. This chapter will focus on three key issues, which the author will analyse after having presented a lead-in to the methodology in section 8.2. The first issue is to clarify in which scenarios the one-sided profit-based methodology can be applied, i.e. to delineate the scope of application of the methodology. This will be analysed in section 8.3. The second issue is to clarify how the methodology works, i.e. how operating profits can be allocated under the methodology. This will be analysed in section 8.4. The third issue is how the comparability standard for the methodology shall be interpreted, in particular, with respect to the TNMM. The rest of the chapter will be devoted to this third issue in sections 8.5.-8.9.907 The 2017 OECD TPG regarding intangibles envision a more elevated role for the profit split method, in practice, likely at the cost of the TNMM. The author will revert to the relative importance of the TNMM in the context of the OECD TPG in chapter 11, after having discussed the new OECD 2017 guidance on the profit split method in chapter 9 and the guidance on the allocation of incremental operating profits from location savings, local market characteristics and synergies in chapter 10.

8.2. A lead-in to the methodology The BALRM of the 1988 US White Paper was introduced as a specified transfer pricing method in the 1994 US regulations in the form of the CPM.908 The methodology was originally intended as a weapon for the US 907. The author discusses comparability under the CPM in sec. 8.5. and under the TNMM in sec. 8.6. In sec. 8.7., he discusses whether the TNMM has converged towards the 1988 White Paper basic arm’s length return method (BALMR). In sec. 8.8., he asks whether the TNMM comparability standard is a problem in practice, before ending the chapter with closing comments on comparability under the one-sided, profit-based methods in sec. 8.9. 908. On this, see also Casley et al. (2003), at p. 162.

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A lead-in to the methodology

Internal Revenue Service (IRS) against outbound profit-shifting structures (roundtrip transactions).909 Its introduction was met with criticism.910 The OECD hesitantly adopted the methodology in the 1995 OECD TPG as the TNMM, with some modifications. The TNMM is now likely the most applied transfer pricing method in the world.911 Multinationals began applying the methodology to their advantage. TNMM-based allocations of normal market return profits to source jurisdictions where routine functions are carried out are an integral part of the principal model.912 The other side of such allocations is that the residual profits from local sales are extracted from taxation at source to a foreign group entity, normally resident in a low-tax jurisdiction, that holds ownership of the group’s unique IP (the principal). In this sense, the one-sided profit-based methodology has gone from being a tool developed by tax authorities aimed at ensuring that IP ownership entities in high-tax jurisdictions are allocated residual profits (a purpose for which it is still used; see, in particular, section 14.2.8.3. on the US income method) to facilitate taxpayer structures in which IP ownership enti-

909. In outbound contexts in which a US parent had a foreign subsidiary that performed routine functions, the method would indirectly allocate the residual profits to the United States. In inbound contexts in which a US licensee performed routine functions, the method would allocate only a normal return to the United States. Example 12 of the White Paper (Notice 88-123), however, concerning an inbound licensing arrangement in which the foreign parent carried out research and development (R&D), indicated that the US tax authorities would use a profit split approach in cases in which the US subsidiary performed functions that were arguably complex. Nevertheless, it is clear that the final methodology, as adopted in the 1994 regulations, would allocate only a normal market return to a US entity that contributes only routine inputs to the value chain. 910. The main arguments against the CPM raised in the 1993 OECD task force report were that (i) inappropriate comparables could be applied (paras. 3.8, 3.11 and 3.49); (ii) the CPM could penalize controlled entities that were commercially unsuccessful by comparing their actual profits to those of more successful third parties (paras. 3.11 and 3.12); (iii) the CPM was reliant on the theory of profit-maximizing companies, which could be difficult to apply, due to deviating short-term motives, such as market penetration motives (paras. 3.10 and 3.11); (iv) the use of current profit experience could entail hindsight (paras. 3.6 and 3.7); (v) the profit split method was preferable to the CPM (paras. 3.12-3.15); (vi) the CPM would entail compliance burdens for small companies (para. 3.55 and Executive Summary, section E(f)); and, finally (and, in the author’s view, much of the reason behind the comprehensive OECD criticism), (vii) the CPM’s allocation of residual profits was deemed unreasonable (paras. 2.19 and 3.49). 911. Likewise, the CPM seems to be the most applied methodology with respect to the United States. See Brauner (2010), at p. 2; Chandler et al. (2003); and Hyde et al. (2005). 912. See the discussion of the centralized principal model in sec. 2.4.

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ties in low or no-tax jurisdictions are allocated the residual profits.913 The methodology remains controversial, but the critical audience has changed from mainly multinationals in the mid-1990s to source-state tax authorities, particularly those of developing countries, due to the modest level of operating profits allocated to them under these methods (see the analysis in sections 11.2.-11.3.).914 The CPM and TNMM are not the only methods that are capable of allocating a normal market return to a group entity that contributes only routine inputs to the value chain. The resale price method and the cost-plus method may also be used for this purpose. These latter methods are, however, gross profit methods, in the sense that they benchmark the gross profits of the controlled transaction against the gross profits of comparable uncontrolled transactions (CUTs). In order to do so, they require disaggregated financial information from third parties so that it is possible to identify the gross profits. Such information is often not available.915 In contrast, the CPM and TNMM check net profits, which is data that is normally available.916 While the resale price and cost-plus methods are sensitive to accounting classifications (only the cost of goods sold (COGS) are included in gross profits), the CPM and TNMM avoid this problem (net profits include all operating costs). Thus, even though the resale price and cost-plus methods, on the one side, and the CPM and TNMM, on the other side, may all be used to allocate normal market returns to controlled routine input providers, the latter may be applied when it is not possible to apply the resale and cost-plus methods in a reliable manner due to information constraints. This is not to say that that the CPM and the TNMM are not plagued by

913. Therefore also in the context of valuation, as reflected in the US income method for pricing cost-sharing arrangement (CSA) buy-ins (see the discussion of the investor model and income method in secs. 14.2.7. and 14.2.8.3., respectively), and, indirectly, also in the OECD guidance on valuation (see the discussion in ch. 13, in particular, sec. 13.5.) through the use of the realistic alternatives of the controlled parties to guide the valuation. The TNMM is also popular among tax authorities for the purpose of serving as the default method for advance pricing agreements (APAs); see Yamakawa (2007), at p. 6 and p. 19. For an updated US perspective on APAs, see Thomas et al. (2018). 914. Tax authorities in source jurisdictions generally argue that they should be allocated incremental profits on top of the normal return, due to factors such as cost savings, local market characteristics or locally developed marketing intangibles. See the discussion of location savings, market characteristics and synergies in ch. 10. See also the analysis in secs. 11.2. and 11.3. 915. See Haugen (2005), at p. 224; Casley et al. (2003), at p. 164; Hamaekers (2001), at p. 35; Cools (1999), at p. 178; and Roberge (2013), at p. 232. See also the analysis in sec. 6.2.4. 916. Albeit not always on a transaction level, as the author will revert to in detail in sec. 8.6.

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The scope of application of the methodology

comparability complications, because they indeed are (see the discussion in section 8.6.), but not to the extent that is the case for the resale price and cost-plus methods. The CPM and TNMM are, in practice (alongside the profit split method), the leading methods for allocating residual profits. The core methodologies underlying these profit-based methods are closely related. The allocation of profits under the profit split method is generally carried out in a two-step process. First, each controlled party is allocated a normal market return for its routine value chain contributions. Second, the residual profit is generally allocated according to the relative values of their unique contributions. The first step is essentially the same allocation as under the CPM and TNMM. Thus, the CPM and TNMM are best seen as an application of the profit split methodology in the specific scenario in which one of the parties to the controlled transaction (the tested party) does not own any unique IP and is therefore allocated 0% of the residual profits, while the other party to the controlled transaction is allocated 100% of those profits.

8.3. The scope of application of the methodology Because the one-sided profit-based transfer pricing methodology will allocate only a normal market return to the tested party, both the US regulations and the OECD TPG limit the scope of application of the methodology to cases in which the tested party does not possess any unique and valuable IP.917 The US regulations state that “in most cases the tested party will be the least complex of the controlled taxpayers and will not own valuable intangible property or unique assets that distinguish it from potential uncontrolled comparables”.918 The wording of the 1992 proposed and 1993 temporary US regulations more clearly emphasized that the tested party could not be in possession 917. On this issue, see the Canadian Tax Court ruling in Alberta Printed Circuits Ltd. v. The Queen (2011 TCC 232). The Canadian tax authorities denied deductions claimed by a Canadian company for royalty payments made to its subsidiary in Barbados based on the view that the Barbados subsidiary was a routine entity that did not own any unique and valuable intangible property (IP) and thus could be allocated profits based on the TNMM. The Court, however, found that unique and valuable IP was indeed contributed to the value chain by the Barbados subsidiary, which thus could not serve as the tested party under the TNMM. For comments on the ruling, see Pankiv (2017), at p. 87; and MacIsaac et al. (2012). See also Wittendorff (2010a), at p. 739, on the tested party under the CPM/TNMM. 918. Treas. Regs. § 1.482-5(b)(2)(i).

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of unique value chain inputs.919 Why this language was watered down in the 1994 final regulations is unclear. After all, the whole point of the CPM is to allocate a normal market return to the tested party, thereby indirectly allocating all residual profits to the other party to the controlled transaction that owns unique and valuable IP. In spite of the more relaxed language in the final regulations, the author finds it clear that the CPM should not be applied where both controlled parties own unique IP relevant to the examined transaction. The residual profits should then be split between these parties, making the one-sided CPM allocation of residual profits irrelevant. The main area of application for the CPM is in licence agreements between group entities that own unique IP, on the one side, and routine contract manufacturers or low-risk distributors (LRDs), on the other side. The fact that this core component of the CPM was not diluted in the 1994 final US regulations is clearly illustrated by an example of its application,920 which is the same roundtrip transaction example used in the 1992 proposed and 1993 temporary US regulations (with some superficial changes). In the example, the entire residual profits are allocated to a US parent, while a foreign manufacturing subsidiary only receives a normal return on its routine functions. Parallel to this, the OECD TPG state that the TNMM is applicable where “one of the parties makes all the unique contributions involved in the controlled transaction, while the other party does not make any unique contribution”.921 Thus, the OECD has made the application of its one-sided profit-based methodology contingent on the tested party not owning any unique and valuable IP.

919. § 1.482-2(f)(4)(ii) of the 1992 proposed regulations (57 FR 3571-01) stated that “the tested party is the party to the controlled transaction whose operating income can be verified using the most reliable data and with the fewest and most accurately quantifiable adjustments. In the case of a transfer of an intangible, the tested party ordinarily will be the transferee”. § 1.482-5T(b)(1) of the 1993 temporary regulations (58 FR 5263-02) stated that “the tested party ordinarily will be the participant in the controlled transaction that does not use valuable, non-routine intangibles that it either acquired from uncontrolled taxpayers and with respect to which it bears significant risks and possesses the right to significant economic benefits or developed itself”. 920. Treas. Regs. § 1.482-5(e), Example 4. 921. OECD TPG, para. 2.59. See also OECD TPG, paras. 3.18-3.19.

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How operating profits may be allocated to the tested party under the methodology

8.4. How operating profits may be allocated to the tested party under the methodology 8.4.1. Introduction The determination of an arm’s length result under the CPM and TNMM is based on the amount of operating profits that the tested party would have earned from the controlled transaction if its profit level indicator were equal to that of a comparable unrelated enterprise. The determination of this hypothetical profit lies at the heart of the methodology and follows three stages: (i) an appropriate profit level indicator is selected (discussed in section 8.4.2.); (ii) profit data is extracted from uncontrolled taxpayers that engage in similar business activities under similar circumstances using the selected profit level indicator (discussed in section 8.4.3.); and (iii) the selected profit level indicator data is applied to the financial data of the tested party to compute the comparable profits (discussed in section 8.4.4.).

8.4.2. Selecting an appropriate profit level indicator A profit level indicator is a ratio that measures the relationship between profits and costs incurred or resources employed, e.g. operating profits divided by sales.922 The point of the indicator is to provide a reliable measure of the operating profitability of independent enterprises that are comparable to the tested party. The US regulations and the OECD TPG do not pose any limitations on which profit level indicators can be used under the CPM and the TNMM, respectively.923 As emphasized in the OECD TPG, the profit level indicator should be tailored to the business activity and value creation of the tested party.924

922. Profit level indicators should be derived from a sufficient number of years of data to reasonably measure returns that accrue to uncontrolled comparables. Under the US regulations, this should, as a minimum, encompass the taxable year under review and the preceding 2 taxable years; see Treas. Regs. § 1.482-5(b)(4). 923. See Clark (1997), at p. 807, on the choice of profit level indicators, where it is asserted that the choice may have significant impact on the resulting transfer prices. 924. E.g. sales or operating expenses may be appropriate to use as the denominator if the tested party is a distribution entity; operating expenses may be appropriate for a service provider entity; and operating assets may be appropriate if the tested party carries out capital intensive functions (e.g. a contract manufacturer).

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As the selection of an appropriate profit level indicator will depend on the specific case, neither the CPM nor the TNMM is a homogeneous method across applications. When referring to a specific application of the CPM or TNMM, it should be specified as to which profit level indicator was chosen in order to facilitate a meaningful discussion, e.g. that a returnon-capital-employed (ROCE)-based CPM or sales-based TNMM was applied. The US regulations systematize profit level indicators into three groups, namely (i) the ROCE rate; (ii) financial ratios; and (iii) other profit level indicators. This classification also fits in with the context of the TNMM. The ROCE rate is the ratio of operating profits to operating assets.925 As an example, assume that the following data is extracted from unrelated enterprises. In order to produce an arm’s length ROCE range, one simply divides the operating profits by the operating assets for each enterprise. The arm’s length range in this case stretches from a ROCE of 9.3% to 16.8% (see Example 1). Example 1 Independent Independent Independent Independent Independent enterprise 1 enterprise 2 enterprise 3 enterprise 4 enterprise 5

15,000

30,000

20,000

50,000

15,000

Operating profit (EBIT)

1,400

5,000

3,000

8,400

1,660

ROCE (EBIT/CE)

9.3%

16.7%

15.0%

16.8%

11.1%

Operating assets

EBIT = Earnings before interest and taxes; CE = Capital employed

925. See sec. 6.2. for a discussion on operating profits. If the Berry ratio (see infra n. 927) is used, the relevant numerator will be the gross operating profits. Under the US CPM provisions, operating assets are defined as the value of all assets used in the relevant business activity of the tested party, including fixed (e.g. plant and equipment) and current (e.g. cash, cash equivalents, accounts receivable and inventories) assets; see Treas. Regs. § 1.482-5(d)(6). Operating assets do not include financial investments, such as subsidiaries, excess cash and portfolio investments. The OECD TPG use a similar definition of operating assets (see OECD TPG, para. 2.97). See Yamakawa (2007), at p. 11, who finds that the return on capital employed (ROCE) is suitable for testing the presence of barriers to entry.

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How operating profits may be allocated to the tested party under the methodology

The reliability of the ROCE as a profit level indicator increases as operating assets play a greater role for the creation of operating profits, and is therefore appropriate for capital-intensive businesses, such as manufacturing or shipping. Reliability further depends on the extent to which the composition of the tested party’s operating assets is similar to that of the uncontrolled comparable. If there are difficulties in valuing the operating assets, the reliability of the ROCE will diminish. This may be the case for businesses that rely on unique IP, e.g. start-ups with modest assets apart from the goodwill associated with its employees. Financial ratios measure relationships between gross or net operating profits, on the one side, and sales revenue or costs, on the other side.926 The ratio of operating profits to sales is commonly used as a profit level indicator. The ratio of gross profits to operating expenses (the Berry ratio) may also be relevant, but it is contingent on access to third-party accounting data that distinguishes between the COGS and operating expenses.927 Such data will often be unavailable,928 rendering the Berry ratio inapplicable. The reliability of the Berry ratio will also depend on the extent to which the composition of the tested party’s operating expenses is similar to that of the comparable unrelated enterprises. As an example of the use of financial ratios as the profit level indicator, assume that the data in Example 2 is extracted from comparable unrelated enterprises.

926. Treas. Regs. § 1.482-5(b)(4)(ii). Under the OECD TPG, the costs must relate to the controlled transaction under review; see OECD TPG para. 2.92. See Yamakawa (2007), at p. 9, for an informed discussion of the use of return on costs as a profit level indicator. Certain applications of the cost-plus method (using net profit margins) in practice have, in reality, been disguised (cost-based) applications of the TNMM; see Haugen (2005), at p. 225. 927. A Berry-ratio coefficient of 1 or more indicates that the enterprise is making profit above all operating expenses, whereas a coefficient below 1 indicates that the enterprise is losing money. The OECD TPG find the Berry ratio suitable where the resale price or cost-plus methods are inapplicable (see para. 2.101), but not where the operating expenses of the tested party are materially affected by controlled costs (e.g. head office charges, rental fees or royalties). See Bhatnagar (2017) for a recent discussion of the Berry-ratio (including Indian case law), where the author emphasizes that the ratio is only suitable for benchmarking profit allocation to pure routine group entities (i.e. limited risk distributors and service providers) when a clear causal link exists between the operating expenses of the entity (seen as a measure of value added provided by the entity) and its gross profits. For further comments on the Berry ratio, see, e.g. Wittendorff (2010a), at p. 745. For a thorough analysis, see Przysuski et al. (2005). 928. See sec. 6.2.4.

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Example 2 Independent Independent Independent Independent Independent enterprise 1 enterprise 2 enterprise 3 enterprise 4 enterprise 5 Capital employed

15,000

30,000

20,000

50,000

15,000

Sales

10,000

50,000

35,000

65,000

25,000

Operating profit (EBIT)

1,400

5,000

3,000

8,400

1,660

EBIT/sales

14.0%

10.0%

8.6%

12.9%

6.6%

The ratio of operating profits to sales is selected as the profit level indicator, as the financial statements of the independent enterprises do not provide information on gross profits. The arm’s length range in this case stretches from 6.6% to 14%. Functional differences generally have a greater effect on financial ratios than on the ROCE rate.929 For this reason, the US regulations require closer functional comparability between the tested party and the selected unrelated enterprises if a financial ratio is used as the profit level indicator than what is the case under the ROCE. Other profit level indicators may be used if they provide reliable measures of the income than the tested party would have earned if it had dealt with controlled taxpayers at arm’s length.930

8.4.3. Extracting the profit level indicator data from comparable independent enterprises Under both the CPM and TNMM, the profit level indicator data must be extracted only from comparable unrelated enterprises.931 The greater the 929. Treas. Regs. § 1.482-5(b)(4)(ii). 930. Treas. Regs. § 1.482-5(b)(4)(iii); and OECD TPG, para. 2.76. Under the US regulations, profit level indicators based solely on internal data may not be used, as they are not objective measures of profitability derived from uncontrolled taxpayers engaged in similar business activities under similar circumstances. See Yamakawa (2007), at p. 10, for a discussion of return on assets, and at p. 11 on return on equity. 931. Treas. Regs. § 1.482-5(a); and OECD TPG, para. 2.58 and paras. 3.27-3.28. The 1993 temporary US regulations also allowed that “other statistical techniques and criteria” could be used for finding the arm’s length range; see Temp. Treas. Regs. (58 FR 5263-02) § 1.482-5T(d)(2)(ii). Arguments for using statistical techniques in transfer

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degree of comparability between the tested party and the selected comparable enterprises is, the more reliable the results will be.932 The comparability requirements of the CPM are, in reality, what separates it from its OECD counterparty. The 1993 US temporary regulations indirectly expanded the scope of the CPM by allowing for a relaxed degree of comparability between the tested party and independent enterprises chosen as comparables. As the CPM measured the total annual operating profits of the relevant business activity of the tested party, the comparability requirement for independent enterprises was that they “need be only broadly similar, and significant product diversity and some functional diversity between the controlled and uncontrolled transactions is acceptable”.933 Of course, as the OECD wanted to limit the general scope of its CPM implementation to abusive cases, the allowance for broadly similar unrelated parties as comparables was criticized.934 The 1993 temporary regulations, however, went further with the introduction of the arm’s length range provision, a feature of which was to allow the use of profits from independent enterprises that did not even meet the “broadly similar” comparability requirement.935 If such “incomparable” comparables were used, only the interquartile range between the 25th and 75th percentile of the comparable profit interval (CPI) could be used as benchmark data. The interquartile restriction, which had the effect of eliminating the outer borders of the observed variation in actual third-party return data, was inserted precisely to compensate for dilution of the CPM comparability requirements. The author will elaborate on the CPM comparability requirements in section 8.5. The TNMM is burdened with more restrictive comparability requirements than the CPM. The OECD’s point of departure is that the transactions of both the tested party and the unrelated enterprises must be segregated so that the net profit margin of the controlled transaction is benchmarked only

pricing cases had previously been rejected by the courts. See Seagate Technology, Inc. v. CIR, 102 T.C. No. 9 (Tax Ct., 1994), acquiescence in result only recommended by AOD1995-09 (IRS AOD, 1995), and acq., 1995-33 I.R.B. 4 (IRS ACQ, 1995), where the use of average prices was found wanting. 932. Treas. Regs. § 1.482-5(c)(2)(i). 933. See 1993 Temp. Treas. Regs. (58 FR 5263-02) § 1.482-5T(c)(1). 934. See 2nd Task Force Report, para. 2.21. 935. See 1993 Temp. Treas. Regs. (58 FR 5263-02) § 1.482-5T(d)(2)(ii). See also the analysis of the US and OECD arm’s length range provisions in sec. 6.5.

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against the corresponding margins from CUTs. Thus, the OECD demands transactional comparability. The material content of this important requirement will be thoroughly analysed in section 8.6.

8.4.4. Applying the extracted profit level indicator data to the tested party The extracted third-party profit level indicator data is compared to the reported profits of the tested party. A transfer pricing income adjustment must be performed if the controlled profits lie outside the arm’s length range. The author will illustrate this. The following data is extracted from comparable unrelated enterprises: Independent Independent Independent Independent Independent enterprise 1 enterprise 2 enterprise 3 enterprise 4 enterprise 5 Capital employed

15,000

30,000

20,000

50,000

15,000

Sales

10,000

50,000

35,000

65,000

25,000

EBIT

1,400

5,000

3,000

8,400

1,660

ROCE (EBIT/ CE)

9.3%

16.7%

15.0%

16.8%

11.1%

14.0%

10.0%

8.6%

12.9%

6.6%

EBIT/sales

The data of the tested party is as follows: Capital employed

45,000

Sales

27,500

EBIT

22,000

ROCE (EBIT/CE)

48.9%

EBIT/sales

80.0%

In this example, it is clear that the tested party has realized an operating profit significantly above the profits of the comparable independent enterprises. The tested party realized a ROCE of 48.9%, with the arm’s length range being 9.3%-16.8%. Further, the tested party realized EBIT/ sales of 80%, while the corresponding arm’s length range is 48.9%. If the third-party profit level indicators (ROCE and EBIT/sales) are applied to

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Comparability under the CPM

the financial data of the tested party, the following arm’s length range is generated: ROCE (EBIT/CE)

6,300

4,500

3,857

5,815

2,988

EBIT/sales

2,567

4,583

4,125

4,620

3,043

Depending on which profit level indicator provides the most reliable result in this particular case, the reported operating profits of the tested party of 22,000 will be adjusted downwards to an appropriate point within the arm’s length range. If ROCE is chosen, the reported profits will be adjusted downwards to somewhere within the ROCE arm’s length range of profits of 2,988-6,300. Alternatively, if EBIT/sales is chosen, the reported profit will be adjusted downwards to a point within the arm’s length range between 2,567 and 4,620.936

8.5. Comparability under the CPM The analysis of the general comparability requirements under the US regulations in section 6.6. forms the backdrop for the discussion in this section. The CPM provisions require that the chosen profit level indicator be extracted from an independent enterprise that engages in “similar business activities under similar circumstances” as the tested party.937 If the tested or independent parties carry out other business activities than the activity connected to the controlled transaction, an allocation of income, costs and assets between these activities must be performed.938 This allocation can be done directly, if there is a factual relationship that supports it, or indirectly,

936. The procedure for applying the CPM is illustrated in four examples in the regulations; see Treas. Regs. § 1.482-5(e), Examples 1-4. 937. Treas. Regs. § 1.482-5(a). See also Casley et al. (2003), at p. 165. 938. Treas. Regs. § 1.482-1(f)(2)(iii). The profits of the tested party shall ordinarily be compared to uncontrolled profits from the same taxable year. It may, however, be appropriate to consider the controlled and uncontrolled profits for 1 or more years before or after the year under review. If such multiple year data is used, the controlled profits must still be benchmarked against uncontrolled profits from the same income years. The 1993 temporary regulations (58 FR 5263-02), § 1.482-1T(b)(2)(iii)(B), allowed for average controlled profits to be benchmarked against average uncontrolled profits over the same period, but this option was removed in the final regulations. On carving out the profits from the controlled transaction from the other transactions of the tested party, see Yamakawa (2007), at p. 16.

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through a reasonable allocation formula.939 If direct allocations cannot be made, the reliability of applying the CPM will be reduced relative to other methods that require fewer allocations. The degree of functional comparability required to obtain a reliable result under the CPM is generally less than that required under the resale price or cost-plus methods,940 as differences in functions will be reflected in operating expenses. Taxpayers performing different functions may have different gross profit margins but nevertheless earn similar levels of operating profits.941 Further, as operating profits are normally less sensitive than gross profits to product differences, the CPM is not as dependent on product similarity as the resale price or cost-plus methods.942 Comparability adjustments must be made if there are differences between the tested party and an independent enterprise that would materially affect operating profits.943 Direct adjustments of the operating profit of the independent party may be needed, for instance, for differences in accounts payable or in the use of stock-based compensation.944 Asset-based adjustments will indirectly adjust operating profits (e.g. reclassifying from expensing to capitalizing will increase operating profits) and may require economic accounting adjustments, such as changing principles for accounting for in-

939. Treas. Regs. § 1.482-5(c)(3)(iii). 940. Treas. Regs. § 1.482-5(c)(2)(ii). 941. The resale price and cost-plus methods will not take differences in functions performed into account, as the object of investigation under those methods is gross profits. The CPM has been criticized for providing a less-than-reliable measure of an arm’s length result, due to the possibility that the method may be affected by differences in cost structure, management efficiency, etc. between the tested party and the uncontrolled comparables; see, e.g. Rozek et al. (1999), at p. 1556. 942. Treas. Regs. § 1.482-5(c)(2)(iii). 943. Treas. Regs. § 1.482-5(c)(2)(iv). See Yamakawa (2007), at p. 12 for an informed discussion of comparability adjustments. See also Wittendorff (2010a), at p. 749 on accounting adjustments. 944. The US regulations contain two comparability adjustment examples. The first concerns the adjustment of operating assets and profit for differences in accounts receivable (Treas. Regs. § 1.482-5(e), Example 5). Third-party accounts receivable are adjusted downwards to achieve the same proportion of accounts receivable to sales as the tested party, and third-party operating profits are adjusted by deducting imputed interest income on the excess accounts receivable. In the second example, adjustments are made to operating profits for differences in accounts payable (Treas. Regs. § 1.482-5(e), Example 6). There are significant differences in the level of accounts payable between the independent distributors and the US subsidiary in the example, as the latter carries out all purchases on a cash basis. To adjust for this, the operating profit of the uncontrolled distributors is increased to reflect the interest expense imputed to the accounts payable.

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Comparability under the TNMM

ventory (e.g. from “last, in first Out” (LIFO) to “first in, first out” (FIFO)), altering depreciation periods and working capital adjustments.945

8.6. Comparability under the TNMM 8.6.1. Introduction The analysis of the general OECD TPG comparability requirements in section 6.6. forms the backdrop for the discussion in this section. The TNMM benchmarks the profit margin of the controlled transaction by reference to the profit margin that the tested party realizes from its own CUTs (internal comparables), if such comparables are available, and if not (which normally is the case), by reference to the profit margin earned in CUTs by an independent enterprise (external comparables).946 The comparability considerations discussed in section 8.5. for the CPM are also relevant under the TNMM.947 For the TNMM, however, the clearly most significant comparability issue is to what extent third-party profit margins that stem from a portfolio of unrelated transactions that are both comparable and incomparable to the controlled transaction (so-called “blended profits”) may be used to benchmark the allocation of operating profits in the controlled transaction. This comparability problem is among the most significant in international transfer pricing. The author is not aware of any legal literature in which this problem has been subject to thorough analysis.948 In principle, this problem applies to all OECD transfer pricing methods apart from the CUT method. Due to the immense popularity of the TNMM, however, the problem will, in practice, arise in connection with the application of this method. As the author will revert to in the analysis in this section, this problem was the single most controversial aspect of the OECD’s implementation of the one-sided profit-based pricing methodology in the 1995 OECD TPG. It has been the subject of repeated OECD 945. See the discussion on the distinction between accounting and economic adjustments in sec. 8.8., and particularly infra n. 1013. 946. OECD TPG, para. 2.58. 947. Historically, the comparability standards of the CPM have, however, been perceived as less strict than those of the TNMM. See Culbertson et al. (2003), at p. 89. The TNMM has nevertheless attracted criticism for having too-relaxed comparability standards; see, e.g. Fris (2003), at p. 194. 948. E.g. Pankiv (2017), at p. 75 touches upon comparability issues in relation to the TNMM, but does not provide an analysis.

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discussions since then. As the OECD TPG are ambiguous regarding this problem, the author’s task will be to clarify how the OECD consensus text should be interpreted. Such clarification is important and necessary, because the OECD comparability standard with respect to this problem will determine the amount of freedom that taxpayers and tax authorities have to choose third-party comparables data that are more or less comparable to the data of the tested party, and thereby also (indirectly) the amount of freedom to determine the arm’s length range of acceptable normal market return profit margins to be applied in the controlled transaction. The more freedom there is, the more the profit margin can be designed to fit within the profit allocation preferences of the taxpayers or tax authorities applying the TNMM. For instance, if a multinational wants to extract a maximum amount of residual profits from a market jurisdiction,949 it will seek to remunerate the market jurisdiction routine distribution entity based on an application of the TNMM that uses third-party profit data that exhibits a minimum amount of normal market returns. The market jurisdiction tax authorities will, on the other side, seek to identify third-party profit data that exhibits a maximum amount of normal market returns in order to restrict the multinational’s extraction of residual profits to a minimum. Thus, the OECD TNMM comparability standard will determine how far taxpayers and tax authorities can go with respect to “cherry-picking” third-party comparables in this manner.

8.6.2. The concept of blended profits illustrated by an example The author will illustrate the problem of blended profits through an example (see Example 3). The tested party in this example is a related distribution entity that distributes golf balls as its sole activity. The tested party realizes an aggregated net profit margin of 15%. Due to insufficient accounting information on gross margins, it is determined that a net profit method should be applied. An unrelated distribution entity that distributes golf balls is identified. The unrelated entity is comparable to the tested party with respect to functions performed, assets used and risks incurred. In addition to golf balls, the unrelated enterprise also sells tennis and basketballs. The only profit information available on the unrelated enterprise is its public financial statements. These show that the enterprise earns an aggre­ 949. See sec. 2.4. on the centralized principal model.

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Comparability under the TNMM

gated net profit margin of 16.2%. That margin results from the sale of golf, tennis and basketballs. It is not possible to deduct from the financial statements how much of the total net profits stem from the sales of golf balls and how much of the profit is attributable to the two other groups of transactions carried out by the independent distributor. Thus, information on the decomposition of sales, COGS and operating expenses among the three transaction types is unknown. The unavailable disaggregated management accounting of the independent enterprise shows the following breakdown of profits (values are rounded). Example 3 Golf balls transactions

Tennis balls transactions

Basketballs transactions

Total transactions (aggregated)

Sales

1,900

880

730

3,510

COGS

1,000

650

620

2,270

Gross profit

900

230

110

1,240

Operating expenses

450

120

100

670

Net profit

450

110

10

570

Net profit margin

23.7%

12.5%

1.4%

16.2%

Contribution to total net margin

54.1%

25.1%

20.8%

100.0%

Data on the above individual three types of transactions are not available in public financial statements (available only internally to the management of the unrelated enterprise)

Aggregated transaction data is available in public financial statements

Let us suppose that the net profit margin from the sale of golf balls is 23.7%, but that these profits only contribute 54.1% to the total blended profits of the independent enterprise. The remaining blend comes from the sale of tennis balls at a net profit margin of 12.5% (which contributes 25.1% to the total net margin) and from the sale of basketballs at a net profit margin of 1.4% (which contributes 20.8% to the total net profits of the enterprise). Given that it realistically will not be possible to separate the three groups of transactions based on the public financial statements of the unrelated enterprise, the application of a net profit method will have to be based on 269

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the aggregated, or blended, net profits of 16.2%. The relatively close proximity of the return position of the tested party of 15% and the blended net profit of the independent enterprise of 16.2% would likely place the income of the tested party within the arm’s length range. Thus, no adjustment will be carried out. Of course, with further insight into the composition of the blended profits of the comparable enterprise, one would learn that the true uncontrolled net profit margin for the distribution of golf balls is 23.7%, representing a gap of 8.7% from the reported net profits of the tested party. Had the net profits from the comparable uncontrolled transaction been known, it would likely have resulted in an adjustment of the taxable income of the tested party. This example illustrates that the application of net profit methods becomes problematic when it is not possible, based on the financial information available on independent enterprises, to separate profits from transactions that are comparable to the controlled transaction from profits due to transactions that are not comparable as such. This is because the arm’s length standard of article 9 of the OECD Model Tax Convention (OECD MTC) requires that the pricing of a controlled transaction be tested against comparable transactions only. Had information that would allow the separation of profits generated from the sale of golf balls from the overall profits of the third party been available, it would have been unproblematic to use the profit margin of the comparable golf ball transactions to determine an arm’s length profit for the controlled transaction of the tested party. The fundamental issue is the lack of relevant accounting data on uncontrolled comparable enterprises. As stated in the 2006 OECD report on comparability: [T]hird parties rarely publicly disclose detailed information on their transactions, even on aggregated transactions at the product line level. Indeed, enterprises are generally required to disclose financial information only at the company or even group level, and information on prices or margins per transaction is often regarded as confidential business information.950

One could argue that this problem may be alleviated if one carefully selects unrelated comparable entities that only carry out one type of transaction that is comparable to the controlled transaction. Thus, in Example 3, an 950. Comparability: Public invitation to comment on a Series of draft issues notes (OECD 2006) [hereafter the 2006 OECD Comparability Report], p. 64., para. 1. See sec. 8.6.4. for a discussion of the 2006 OECD Comparability Report.

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Comparability under the TNMM

unrelated distributor that only sells golf balls should be selected. This argument is valid – and at the same time, unrealistic – in the vast majority of cases. As stated in the 2006 OECD report on comparability, “it is in effect very rare that an independent enterprise limits its activity to a single type of transaction”.951 One is therefore left with the disadvantageous fact that the unrelated enterprises that bear the closest resemblance to the tested party with respect to functions, assets and risks will normally carry out a significant amount of different types of transactions. For instance, unrelated distributors that are selected to measure the profit from the distribution of golf balls may sell a range of other sporting gear products, often encompassing thousands of products. If the overall net profits from such enterprises are used to determine the allocation of income to the tested party, the transfer pricing assessment will be based on a blended profit, which melts the profits from the sale of golf balls with the profits from a variety of different product groups with varying profit characteristics. There is no question that applying such a blended profit margin to allocate income to the tested party represents a significant comparability problem. Depending on the degree to which the profit from the uncontrolled comparable transaction is diluted by profits from other transactions carried out by the independent enterprise, one could, in effect, end up comparing apples to oranges by using the total net profit margin of the independent enterprise to determine the pricing of the controlled transaction. This will have a clearly negative effect on the reliability of the net profit method being applied, as the profit determined for the tested party on the basis of the extracted blended net profit margin will include the profits from transactions that are not comparable to the controlled transaction. Normally, it will be clear whether the total net profits of the independent enterprise consist of profit contributions from transactions other than those comparable to the controlled transaction. However, the extent to which this is true will not be readily ascertainable, because public financial statements do not offer the information necessary to disaggregate the total net profits of the independent enterprise into profits from individual groups of transactions. This again poses a dilemma. If the total net profits of the independent enterprise are only mildly diluted by the profits from incomparable transac951. 2006 OECD Comparability Report, p. 65, para. 5.

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tions, the negative effects of applying a blended net profit margin may be negligible. For instance, if Example 3 was altered so that the profit contribution from golf balls accounted for 90% while the profits from tennis and basketballs each accounted for 5% of the total profits, the total net profits of the independent enterprise would be approximately 22%.952 This is relatively close to the 23.7% net profit margin generated by the sale of golf balls on a stand-alone basis – so close, in fact, that use of the blended profit margin to allocate income to the tested party likely would not significantly affect the reliability of the results. Conversely, if the example were altered so that the profit contribution from sales of golf balls only accounted for 25% while the profits from tennis and basketballs each accounted for 37.5% of the total profits, the total profits would be approximately 11.1%.953 This is far below the true net profit margin of the comparable golf ball transactions of 23.7%. If the blended net profit margin of 11.1% were used to determine the income of the tested party, uncontrolled transactions that are incomparable to the controlled transaction would, in fact, have a decisive influence on the allocation of income under article 9 of the OECD MTC. Such a result is fundamentally problematic, as the arm’s length principle requires that the income of a related party be set by reference to the income realized by unrelated parties through comparable transactions. This leaves a transfer pricing assessment – particularly under the one-sided methods – in a precarious position. Depending on the composition of the total net profits of an independent enterprise, they may be more or less comparable to the profits of the uncontrolled transaction. Often, there will be no reliable way of ascertaining the degree to which the total net profits have been tainted by the profits from incomparable transactions. A significant degree of uncertainty surrounding the application of the transfer pricing methods will therefore normally exist if the benchmark profit margin is extracted from third-party blended profits. The uncertainty, however, goes both ways. As touched upon above, even if the total transactional portfolio of the comparable enterprise encompasses transactions that are incomparable to the controlled transaction, this does not necessarily entail that the total net profit margin of the enterprise will diverge significantly from what it would have been had the enterprise only carried out the comparable transaction, e.g. a distributor that only realizes a normal return across all of its transactions. 952. 23.7 × 0.9 + 12.5 × 0.05 + 1.4 × 0.05 = 22% 953. 23.7 × 0.25 + 12.5 × 0.375 + 1.4 × 0.375 = 11.1%

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This will typically be relevant for a range of enterprises that operate under fierce competition, for instance, a retail computer hardware distributor that realizes a relatively stable profit margin on the products it distributes. If Example 3 is changed so that the net profit margins realized from the sale of golf, tennis and basketballs are 13%, 3.5% and 14%, respectively, the relative influence from each product group on the total net profit margin of the distributor will not make much of a difference, as the total net profits in any case will lie between 13% and 14%. Again, in practice, it will be difficult to ascertain the degree to which the total net profit margin of an independent enterprise diverges from the net profit margin it realizes on the comparable transactions. Decomposing the total blended profits of an independent enterprise into profits from comparable and incomparable transactions would – even if some supporting information were available – be a discretionary and complex affair. Even if sales could be tracked to individual groups of transactions, the COGS and operating expenses would need to be allocated among the transaction groups, likely triggering difficult discretionary assessments.954 Realistically, it would likely be necessary to have access to the management accounting data of the selected independent enterprise in order to find reliable information on single product or product group profits. Even such profit information may be based on discretionary allocations. Further, management accounting information is not available in public financial statements. This is also information that unrelated enterprises cannot be expected to willingly share with others, for commercial and competition reasons.

8.6.3. The 1995 consensus text on the TNMM with respect to aggregation of transactions Prior to the finalization of the 1994 US regulations, commentators feared that the proposed CPM could be applied to the overall activities of an unrelated, complex multinational enterprise, and thus result in the extraction of an aggregated net profit margin that also encompassed profits from transactions that were irrelevant to the transfer pricing assessment and that contributed differently to the total profits of the enterprise than the contribution from the comparable transactions. As the level of profits realized from the different types of transactions could vary, the reliability of basing a transfer pricing assessment on such blended net profits could be severely impeded. 954. See also 2010 OECD TPG, para. 3.37, fifth sentence.

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The 1993 OECD task force report presented some views on the CPM of relevance to the issue of blended profits. First, the report expressed concern that the applicable business classification of the tested party would be difficult to carry out properly.955 Such classification was of importance because unrelated enterprises would be selected from within the same classification. The report expressed concern that this could lead the IRS to apply sector averages for net profits. The concern was reiterated in the 1994 report, which stated that net profit margins derived from uncontrolled enterprises that are “only broadly similar” would not necessarily achieve an arm’s length result.956 At the time, few (if any) countries apart from the United States had implemented a one-sided net profit transfer pricing method in their domestic legislations. Several OECD countries were sceptical towards this transfer pricing methodology, and the 1994 OECD discussion draft leading up to the 1995 revision of the OECD TPG discouraged the use of net profit methods on a general level.957 It should be noted that the 1994 discussion draft discussed the implementation of the CPM as such. Also at that time, the OECD had not yet envisioned restricting the method to a purely transactional basis. This is evident by the fact that the draft focuses on comparing the tested party as such to unrelated enterprises.958 In the spring of 1995, the OECD negotiations on the final version of the 1995 OECD TPG were at a standstill. Negotiations had halted on the issue of whether the guidelines should accept the application of the CPM of the newly enacted 1994 US regulations.959 Two fractions emerged, one of which maintained that the CPM was not compatible with the arm’s length principle of article 9 of the OECD MTC, on the basis that the method could be applied to the overall profits of complex enterprises, resulting in rough comparisons. The second fraction took the opposite view, i.e. that the CPM indeed was compatible with article 9, as the method would be applied to segmented groups of transactions to extract an uncontrolled net profit margin, which 955. 1993 task force report, para. 3.51. 956. 1994 task force report, para. 2.21. 957. 1994 OECD discussion draft, para. 173. 958. The core concern was that “where differences in the characteristics of the enterprises being compared have a material effect on the operating margins being used, it would not be appropriate to apply the comparable profits method without making adjustments for such differences”; see 1994 OECD discussion draft, para. 176. 959. See Taly (1996). Michel Taly was head of the tax policy department in the French Ministry of Finance and Vice Chairman of the OECD Committee on Fiscal Affairs.

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was considered to be aligned with the arm’s length principle. The views of the second fraction prevailed. This is evident by the fact that the OECD distinguished its one-sided net profit method from the CPM of the final 1994 US regulations by emphasizing a transactional character, as signalled by the chosen name, i.e. the transactional net margin method.960 The final consensus text of the 1995 OECD TPG, as set out in paragraph 3.42, expressed the requirement that the TNMM should be applied only to the profits of the tested party that were attributable to “particular” controlled transactions.961 As a point of departure, it was deemed inappropriate to apply the TNMM on a company-wide basis if the tested party engaged in a variety of different controlled transactions that could not appropriately be compared on an aggregated basis with those of an unrelated enterprise. However, the 1995 OECD TPG allowed the aggregation of closely linked or continuous controlled transactions.962 In scenarios in which this was allowed, the aggregated transactions would be regarded as one coherent transaction for pricing purposes, i.e. the aggregated transactions would be priced as one transaction. The author will not discuss the aggregation of controlled transactions further. The reason for this is that it will normally be possible to disaggregate the operating profits of a tested party down to a product or product group level, due to access to the management accounting data of the tested party. Thus, the issue of aggregation of the tested party’s transactions is largely a question of whether it is appropriate to do so. Pursuant to the 1995 OECD TPG, this will depend on whether the controlled transactions are strongly interrelated (package deals) or unsuitable for stand-alone pricing (continuous transactions). The author will instead focus on comparability problems associated with extracting net profit margins from aggregated and blended third-party profits. Paragraph 3.42 of the 1995 OECD TPG is of particular relevance for this discussion. It stated that the following: [W]hen analysing the transactions between the independent enterprises to the extent they are needed, profits attributable to transactions that are not similar to the controlled transactions under examination should be excluded from the comparison.963 (Emphasis added) 960. See also Lodin (2009), at p. 430. 961. 1995 OECD TPG, para. 3.42. 962. 1995 OECD TPG, para. 1.42. See the similar text in the 2010 OECD TPG, para. 3.9. 963. Id.

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On the basis of this wording, seen in light of the positions taken by the OECD on this issue in the preceding task force reports and discussion drafts, it must be concluded that the 1995 OECD TPG rejected the use of profit margins extracted from blended profits. The position of the 1995 OECD TPG, with respect to the extraction of profit margins, may be summarized in table 8.1 (it is assumed that both the tested and unrelated enterprise carry out a variety of transactions).964 Table 8.1 1995 OECD TPG Total transaction portfolio (tested party)

Segregated transactions 964 (tested party)

Total transaction portfolio (unrelated party)

The profit margin from company-wide controlled transactions is benchmarked against a company-wide, third-party profit margin (not allowed)

The profit margin from a specific controlled transaction is benchmarked against a company-wide, third-party profit margin (not allowed)

Segregated transactions (unrelated party)

The profit margin from company-wide controlled transactions is benchmarked against a company-wide, third-party profit margin (not allowed)

The profit margin from a specific controlled transaction is benchmarked against the profit margin from a specific CUT (the only application of the TNMM allowed under the 1995 OECD TPG)

964. The 1995 OECD TPG allowed aggregation of the tested party’s transactions where the transactions formed a continuum or were closely linked, such as long-term contracts for the supply of commodities, IP licence agreements and the pricing of closely linked products (product lines); see 1995 OECD TPG, para. 1.42. See also OECD TPG, para. 3.9, which contains an almost identical text. The aggregated controlled transactions would then be regarded as one coherent transaction and would be priced as such. The author disregards this aggregation option for the purposes of table 8.1, as the issue here is to illustrate comparability problems associated with testing the net profit of different transaction types that are incomparable. This is, to some extent at least, distinguishable from aggregating transaction types that either are strongly interrelated (package deals) or transactions that are not suitable for stand-alone pricing (continuous transactions).

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8.6.4. The 2006 comparability report The segregation requirement of the 1995 OECD TPG proved to be problematic in practice. As part of its ongoing monitoring of the implementation of the 1995 OECD TPG, Working Party 6 identified that further development was necessary with respect to the guidance on comparability issues encountered when applying the OECD pricing methods, as well as on the application of the transactional profit methods. The first issue was addressed in the 2006 comparability report (the 2006 report). As a way of background for the 2006 report, transfer pricing practice subsequent to the 1995 OECD TPG applied net profit margins extracted from blended third-party profits to a significant degree. The 2006 report found that: […] practitioners … often try to overcome the difficulty of comparing the gross or net profit margin arising from their particular controlled transactions with the gross or net profit margins earned on aggregated transactions performed by independent enterprises performing comparable activities.965 (Emphasis added)

The argument underlying these practices was typically that, in the absence of better alternatives, net profit margins from blended profits should be allowed, as long as the third-party enterprise from which the profit margin was extracted was functionally comparable to the tested party. Most of the business commentators who responded to the 2006 comparability questionnaire issued in connection with the 2006 report stressed that it was difficult to find third-party data on a transactional level. This was simply because the information available in public financial statements was not presented on a transactional level. Further, the 2006 report stated that public financial statements provided no insight into the pricing decisions or cost allocations pertaining to particular products that would explain the profit margins reflected in the financial statements. Some commentators stated that “there may not always be a relevant difference between third party transactional data and third party company-level data … which … should be acceptable unless transactional data are available and provide a more reliable measure”.966

965. 2006 OECD comparability report, para. 7. 966. Id., at para. 8.

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Practitioners tended to consider that the transactional focus of the OECD TPG was sufficiently respected by ensuring that the comparisons were made with third parties that exclusively or mainly undertook the type of transaction under analysis.967 The point of departure in the 2006 report was that aggregation of thirdparty transactions generally reduced the reliability of a comparability analysis. A transactional analysis would generally be preferred when transactional data were available.968 The problem was that “in practice such data may not be available”,969 and therefore: OECD countries agreed that there was a need to recognize that in practice there are circumstances in which aggregated comparable data should be used, but only where its use provided the most reliable available evidence to inform the arm’s length nature of transfers between associated enterprises.970

Thus, the stance of the OECD with respect to the segregation of thirdparty transactions was softened in the 2006 report relative to the hardline approach taken by the 1995 OECD TPG. Working Party 6 was of the opinion that a transactional analysis should be retained as “the starting point” for the comparability analysis. It was not found desirable that the OECD TPG should allow the use of highly aggregated data on third-party profits as comparables,971 in particular, because such an approach could be interpreted as an endorsement of using “default” comparables in typical scenarios. The 2006 report emphasized that the transactional focus of the OECD transfer pricing methods did not mean that transfer pricing should be analysed at “the level of each individual sale”.972 Further, third-party transactions could be aggregated along the lines allowed by the OECD TPG for aggregating the transactions of the tested party.973 For instance, if the tested party was an LRD, it could be that, in the market concerned, there were only a few unrelated enterprises with publicly available financial statements that undertook low-risk distribution functions. These LRDs could then be chosen as comparables regardless of whether 967. Id., at para. 7. 968. Id., at para. 9. 969. Id. 970. Id. 971. Id., at para. 10. 972. Id., at para. 14. 973. See supra n. 964. Similarly, the 2006 report suggested that third-party transactions could be aggregated where they “form an aggregate of comparable transactions that are subject to the same economic factors and decision making process”; see 2006 OECD comparability report, para. 13.

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their transactions were comparable to the controlled transaction. This was viewed as posing a risk of transfer pricing assessments becoming more formulaic. The 2006 report recognized that it would normally be possible to segregate the transactions of the tested party. Management accounting information from the tested party would allow a breakdown of individual transactions. The relevant question was whether aggregation of the individual transactions of the tested party was appropriate. The problem faced with respect to third-party transactions was the reverse. Here, the issue was the lack of accounting data sufficiently detailed to segregate the third-party transactions. The 2006 report recognized that the relevant question was whether aggregated third-party accounting data at all could be segregated. Normally, this would not be the case. The report found that aggregated third-party profit data could be useful when the third party engaged in a single type of transaction that was comparable to the controlled transaction.974 The problem was there when the third party also carried out other transactions that had different economic profiles than the controlled transaction and these other transactions had a material impact on the total profits of the third party.975 In other words, the relevant problem was the use of net profit margins extracted from blended profits. The 2006 report found that aggregated third-party profits could be used where the transactions of the third party were subject to the “same or similar economic factors” and therefore could “be regarded as one transaction” for comparability purposes.976 This is illustrated in an example in which the controlled transaction is a related party’s importation of a particular type of blender from a foreign group entity for local resale to third parties.977 The resale price method is chosen as the transfer pricing method.978 An unrelated retailer is identified, but this retailer sells dozens of different blenders from a range of suppliers. The example states that it is not necessary to examine each individual blender transaction from each individual supplier. One should instead exercise judgement and determine whether 974. 2006 OECD comparability report, Aggregation of Transactions, para. 17. 975. Id. 976. Id. 977. 2006 OECD comparability report, Aggregation of Transactions, para. 15. 978. Thus, gross profit is the relevant measure of profitability.

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the independent party’s purchase and sale of the blenders are subject to the same or similar economic conditions and therefore can be regarded as one transaction for comparability purposes. An important point is that the example does not elaborate on what it means by “similar economic conditions”. The author interprets the wording as expressing whether it reasonably can be assumed that the gross profits from resale of the different blenders are similar. The author will add two points to this. First, the “similar economic conditions” exception, even though well-intended, seems rather useless. The reason for this is that, in practice, it will not be possible to determine whether the different third-party transactions indeed are subject to similar economic conditions. Product-level profit information is simply not publicly available. Second, the exception could therefore (unintentionally) become a safe harbour for taxpayers. It will be difficult in practice to disprove a taxpayer assertion that the different transactions are subject to similar economic conditions; the actual data that will verify or reject the assertion is unavailable. A twist to the example is provided, where the unrelated distributor now sells, in addition to blenders, toasters.979 Thus, the profits of the unrelated distributors are blended. No CUT exists, and the financial statements of the unrelated distributor do not provide information on gross profits. The TNMM is therefore selected as the appropriate pricing method. The question is whether a net profit margin extracted from the blended profits of the unrelated distributor can be used under the TNMM. The report states that this will “not necessarily” be the case.980 The blended net profit margin can only be used if it can reasonably be assumed either that (i) the five comparability factors are satisfied, in particular, that the incomparable toaster transactions have “similar functional analysis and have similar economic characteristics” as the sale of blenders; or (ii) the toaster transactions “represent a negligible portion of the total” profits of the unrelated distributor. The author’s interpretation of the first criterion is that the net profits generated by the incomparable third-party transactions must be similar to the net profits generated by the comparable transactions. Otherwise, the profits 979. 2006 OECD comparability report, Aggregation of Transactions, para. 18. 980. Id.

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from the incomparable transactions would cause the total net profits of the enterprise to deviate from the profits of the comparable transactions. Where to draw the line with respect to which profits are “similar” is not addressed in the 2006 report. With respect to the second alternative criterion, the author’s interpretation is that blended net profit margins may be used if the net profit margins of the incomparable transactions have only marginally affected the total net profits of the unrelated distributor. It will, in practice, be difficult or impossible to verify whether the two alternative criteria are fulfilled. The 2006 report also admits this.981 Thus, there is an obvious risk that this will provide a safe harbour for taxpayers, as it will be very challenging to disprove a taxpayer assertion that the blended net profit margin applied under the TNMM is valid, either because the incomparable transactions that are included in the blended profits have a net profit margin similar to the comparable transactions or that the incomparable transactions only have a negligible impact on the blended profits. In summary, it is the author’s view that the criteria proposed by the 2006 report for determining whether aggregated third-party accounting information can be used as comparables under the OECD pricing methods were theoretically well-founded. The criteria sought to ensure comparability between the controlled and uncontrolled transactions. Nevertheless, the main goal of the 2006 report was to address the practical problems encountered in applying the pricing methods. In the author’s view, the report failed to find a useful solution to this. The wording of the 2006 report on this issue is also decidedly soft, in that the aggregated company-level data “might not” or will “not necessarily” provide satisfactory comparable data, indicating that the criteria were not absolute in any case. The 2006 report did, however, draw a bright line against comparing the aggregated net profits of the tested party and an unrelated party solely because they operate in the same industry sector. Such a comparison was found unacceptable because it would not take account of the differences between the tested party and the independent party with respect to intangibles, risks and organizational models. Also, such a comparison would lie close to using industry averages as comparables. The 2006 report found it inconsistent with the arm’s length principle to make company-wide comparisons of all distributors of electronic goods without giving proper regard to whether the transactions performed 981. Id., at para. 18: “[It] might be very difficult to demonstrate in practice.”

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by these companies satisfied the comparability factors as well as the aggregation criteria. Thus, the 2006 report rejected typical database-searchbased applications of the TNMM in which no comparability adjustments would be made to the results from the search. The positions of the 2006 report can be summarized in table 8.2.982 983 Table 8.2 2006 comparability discussion draft Total transaction portfolio (tested party)

Segregated transactions982 (tested party)

Total transaction portfolio (unrelated party)

The profit margin from company-wide controlled transactions is benchmarked against a company-wide, third-party profit margin (not allowed)

The profit margin from a specific controlled transaction is benchmarked against a company-wide, third-party profit margin (allowed if (i) the transaction portfolio of the third party (including both comparable and incomparable transactions) have similar profit margins; or (ii) the profits from the incomparable transactions only have a negligible impact on the total profits of the third party) 982

Segregated transactions (unrelated party)

The profit margin from company-wide controlled transactions is benchmarked against a company-wide, third-party profit margin (not allowed)

The profit margin from a specific controlled transaction is benchmarked against the profit margin from a specific CUT (allowed)

8.6.5. The 2008 discussion draft The work of the OECD on the application of the transactional profit methods resulted in a 2008 discussion draft (the 2008 report).984 It also ad-

982. See supra n. 964. 983. See 2006 OECD comparability report, paras. 13, 15, 17 and 18. 984. Transactional profit methods, Discussion draft for public comment (OECD 2008) [hereinafter 2008 OECD discussion draft].

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dressed problems pertaining to the use of aggregated third-party accounting data as comparables under the pricing methods. The 2008 report recognized that, due to the lack of publicly available and disaggregated third-party accounting information, the segmentation of the tested party’s profits would be less problematic than the segmentation of a third party’s profits, as long as the tested party’s accounting system was able to track profitability on an appropriately segmented basis.985 Similarly to the 2006 report, it admitted that there could be cases where aggregated third-party transactions could provide valid comparables for a particular, non-aggregated controlled transaction. A new tone was evident in the 2008 report. It drew the conclusion that, due to the lack of public third-party accounting data that could allow profit margins to be determined for specific transactions or groups of transactions, there needed to be sufficient comparability between the “economically significant functions of the tested party and of the third party comparables”.986 (Emphasis added) The functions performed by the third party in its total operations had to be closely aligned to the functions performed by the tested party with respect to the controlled transaction in order to allow a net profit margin extracted from the blended third-party profits to be used to determine an arm’s length outcome. The conclusion of the 2008 report was that when it was impossible in practice to achieve the transactional level set out as the ideal in the OECD TPG, it would still be important to achieve the highest level of comparability possible through making suitable adjustments based on the available evidence.987 Strong concerns had been expressed by several countries in relation to the segregation of transactions, with respect to both the tested party and third parties. The draft therefore concluded that paragraph 3.42 of the 1995 OECD TPG should be amended in accordance with the views expressed in the 2006 and 2008 reports.988 This conclusion was ambiguous, as the proposed solutions in the 2006 and 2008 reports were not necessarily reconcilable. The author will revert to this issue in section 8.6.6.

985. 986. 987. 988.

2008 OECD discussion draft, para. 110. Id., at para. 115. Id., at para. 117. Id., at para. 120.

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8.6.6. The final 2010 OECD TPG on the use of aggregated third-party profits as comparables 8.6.6.1. Introduction The final 2010 OECD TPG express three different norms for determining whether it is allowed to use aggregated third-party profits as comparables under the OECD pricing methods. At least as a point of departure, these norms are not immediately reconcilable. The fragmented and seemingly conflicting character of the OECD TPG on this issue must be seen in light of the differing opinions of the OECD member countries. Apparently, there are difficulties in reaching a clear consensus with respect to the use of aggregated third-party profits as comparables. In sections 8.6.6.2.-8.6.6.6., the author will endeavour to interpret these three norms and reconcile his interpretations in order to provide a coherent norm for the use of aggregated third-party profits as comparables under article 9 of the OECD MTC.

8.6.6.2. The first norm: Aggregated third-party profits may be used as comparables as long as they are the result of “similar” third-party transactions The 1995 consensus text in paragraph 3.42 of the 1995 OECD TPG on the use of aggregated third-party accounting data as comparables expressed that “when analysing the transactions between the independent enterprises to the extent they are needed, profits attributable to transactions that are not similar to the controlled transactions under examination should be excluded from the comparison”. In the discussion in section 8.6.3., the author concluded that this wording rejected the use of profit margins extracted from blended profits.989 In September 2009, the OECD published proposed revisions to chapters I-III of the OECD TPG.990 The revision kept the text of paragraph 3.42 of the 1995 OECD TPG intact. The author finds this rather surprising, given the conclusions of the 2006 and 2008 reports. The original 1995 wording on the use of aggregated third-party accounting data is now incorporated 989. See the discussion of the 1995 OECD TPG text in sec. 8.6.3. 990. Proposed revision of chapters 1-3 of the transfer pricing guidelines (OECD 2009) [hereinafter 2009 OECD proposed revisions].

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into paragraph 2.79 of the 2010 OECD TPG. Paragraph 2.79 is placed in chapter II of the OECD TPG on transfer pricing methods as part of the TNMM guidance. Thus, pursuant to paragraph 2.79, the use of aggregated third-party profit data as comparables should be rejected if the total profits are influenced by the profits from transactions that are not comparable to the controlled transaction.

8.6.6.3. The second norm: Aggregated third-party profits may be used as comparables as long as they are not the result of “materially different” third-party transactions The 2009 revision draft added a new last sentence to paragraph 3.42 of the 1995 OECD TPG. The sentence read: “[S]ee paragraphs 3.9-3.12 on the evaluation of a taxpayer’s separate and combined transactions and paragraph 3.36 on the use of non-transactional third party data”.991 This sentence is now incorporated into paragraph 2.79 of the 2010 OECD TPG. The 2009 proposed paragraph 3.36 addressed whether aggregated third-party accounting information could provide reasonably reliable comparables.992 The 2009 report draft text for paragraph 3.36 was incorporated into paragraph 3.37 of the 2010 OECD TPG without alterations. Paragraph 3.37 is placed in chapter III of the OECD TPG on comparability analyses as part of the guidance on comparable uncontrolled transactions.993

991. 2009 OECD proposed revisions, para. 2.143. 992. Thus, the proposed text did not address the more impractical issue of whether the tested party’s aggregated company-wide transactions (in cases where it carried out more than one type of transaction) could be reliably compared to the results of aggregated third-party transactions. This was presumably because, in most cases, it will be feasible to segregate the tested party’s transactions, due to the insight of the tax authorities into the management accounting documents of the taxpayer. 993. The OECD TPG also state that company-wide, third-party data may provide better comparables than segmented third-party data in certain circumstances, for instance, where the activities underlying the company-wide, third-party profit data correspond to the set of controlled transactions. This is difficult to accept. The whole point of segregating third-party transactions will be to separate third-party transactions that are comparable to the controlled transaction from those that are not. If such segregation is carried out, resulting in the identification of third-party comparables, it seems difficult to accept that third-party, company-wide profit data nevertheless should be preferred, regardless of whether the purported degree of functional similarity is largest with respect to the company-wide or segregated third-party transactions.

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With respect to the use of aggregated third-party accounting information as comparables, the 2009 text took the stance that this would depend in particular on: “whether the third party performs a range of materially different transactions”.994 It is not entirely clear what is meant by “materially different transactions”. The wording itself may indicate that if unrelated enterprises carry out significantly different types of transactions, it will not be appropriate to use the aggregated profit data as comparables. This interpretation entails that the requirement is relaxed as compared to the 1995 text, which demanded the exclusion of third-party transactions as long as they were not “similar” to the controlled transaction.995 Seen in light of the discussion in the 2006 report, the author finds it reasonably clear that the guidance seeks to restrict the use of blended profit margins that are the result of third-party transactions that contribute significantly different net margins to the total profits. Of course, the decisive question is how large the deviation must be between the net profit margins contributed by the different third-party transactions before they are considered “materially different”. That question is left unanswered in the 2009 text. In practice, the answer will also be irrelevant. The reason for this is that even if a specific threshold were set, it would not be possible to determine whether it was reached, given the limitations of publicly available accounting data.996 Thus, the author’s conclusion is that the wording of paragraph 3.37 of the OECD TPG rejects the use of blended third-party profits as comparables,

994. 2009 OECD proposed revisions, para. 3.36. 995. See 2010 OECD TPG, para. 2.79, which reiterates the original 1995 OECD TPG (para. 3.42) text on this point. 996. Further, the guidance does not clearly state that aggregated third-party profit data cannot be used as comparables, even if the data stems from third-party transactions that are materially different to the controlled transaction. On the other side, it is not easy to see that there could be any other purpose to the language than to restrict the use of aggregated third-party profit data as comparables. The language goes on to state the rather obvious fact that where segmented third-party data is available, it can provide better comparables than company-wide, non-segmented, third-party profit data, due to its more transactional focus. The guidance does, however, recognize that segmented data may trigger issues in relation to the allocation of business expenses among the segmented groups of transactions.

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to the extent that the third-party transactions contribute “materially different” net profit margins to the total blended profits.

8.6.6.4. The third norm: Aggregated third-party profits may be used as comparables if the total functions performed by the third party are closely aligned with the functions ­performed by the tested party with respect to the ­controlled transaction The 2009 report also introduced a new paragraph 2.144, which was incorporated into the 2010 OECD TPG in paragraph 2.103 without material changes. Paragraph 2.103 addresses the use of aggregated third-party accounting information as comparables. Paragraph 2.103 is placed in chapter II of the OECD TPG on transfer pricing methods, as part of the TNMM guidance. Paragraph 2.103 specifically states that comparability issues connected to the use of aggregated third-party accounting data are not particular to the TNMM. Rather, the problem in practice is more acute under the TNMM as compared to the gross profit methods, due to the heavy reliance on external comparables under the TNMM.997 The paragraph recognizes that there is often insufficient accounting data publicly available to allow for third-party net profit margins to be extracted on a transactional level. In light of this: the functions performed by the third party in its total operations must be closely aligned to those functions performed by the tested party with respect to its controlled transactions in order to allow the former to be used to determine an arm’s length outcome for the latter.998 (Emphasis added)

This wording is materially the same as that of the 2008 report.999 It is difficult to interpret it in any other way than approving the use of aggregated third-party accounting data on net profits as a comparable in a controlled transaction when the total functions performed by the third party are closely similar to the functions performed by the tested party with respect to its controlled transaction. This regardless of whether, as well as the extent to which, the aggregated third-party profits are blended. 997. This explanation is not convincing. The gross profit methods place the same amount of reliance on external comparables as the TNMM. The author therefore assumes that the added actuality of the problem under the TNMM is simply due to the fact that the TNMM is the most commonly applied transfer pricing method. 998. OECD TPG, para. 2.103. 999. See 2008 OECD discussion draft, para. 115.

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This interpretation is supported by the realistic acknowledgement in paragraph 2.103, where it is stated that in the case that it is impossible in practice to achieve the transactional level set out as the ideal in the OECD TPG, it is still important “to try” to find the most reliable comparables through making adjustments based on the evidence that is available.1000 In comparison, the proposed 2009 revision text plainly stated that it was “important to achieve the highest level of comparability”.1001 The final 2010 OECD TPG text therefore strikes a more liberal tone than the 2009 proposed text. This again lends support to the interpretation that the OECD TPG allow the use of non-segregated third-party profit data. In the author’s view, the consensus text in paragraph 2.103 of the OECD TPG is fundamentally important, and something of an earthquake in the landscape of the OECD TPG. It indeed allows the use of non-transactional third-party profit data as comparables under article 9 of the OECD MTC. Also significant is the fact that the guidance should not be regarded as limited to the TNMM, but should apply also to the other pricing methods. The rule entails, for instance, that the total net profit margins extracted from third-party manufacturers and distributors that produce or distribute a range of different products may, where it is not possible to segregate the data, be used as comparables against a specific controlled transaction carried out by the tested party, given that there is a strong functional similarity between the tested party and the selected third-party enterprises. No guidance is provided as to what functions should be regarded as similar. Presumably, this will often be self-evident. In complex, unrelated enterprises that perform a range of different functions, however, it will not necessarily be easy to determine whether the quantitative and qualitative aspects of such functions are similar to the functions performed by the tested party with respect to the controlled functions. The relevant threshold under paragraph 2.103 is that the total third-party functions must be “closely aligned” with the controlled functions. The language itself could indicate that the relevant third-party functions must almost be identical to the ones performed by the tested party with respect to the controlled transaction. The author objects to this interpretation. In his view, an overly detailed assessment on this point may contribute to continued ambiguity in the OECD TPG on the important issue of the use of 1000. OECD TPG, para. 2.103. 1001. 2009 OECD proposed revisions, para. 2.144.

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third-party account data as comparables. Instead, the language should be interpreted in light of the overall purpose of the TNMM, which is to allocate a normal market return to the tested party. The single most important aspect will therefore be to ensure that the third party only performs routine functions, that it does not own any unique and valuable intangibles and that it only incurs normal levels of risk. If the third party is closely similar to the tested party on these parameters, the use of its blended profits to extract a profit margin to be used under the OECD pricing methods should be accepted pursuant to paragraph 2.103. Further, as long as the selected third-party enterprise is similar to the tested party with respect to functions, assets and risks, the negative effects on comparability of using different blended profits should be limited. The tested party will often be a contract manufacturer or an LRD. Similar third-party enterprises will typically only earn a normal return, due to their generic functions, routine assets and limited risks. Thus, it may, to some extent, be argued that even if the profit margins on the different products or services sold vary, the variance may be limited, as all transactions may be assumed to only yield a normal return. This supports the argument that the “closely aligned” guidance should be interpreted to mean that the third party must be similar to the tested party with respect to functions, assets and risks, as opposed to an overly-detailed focus on the performance of particular functions.

8.6.6.5. Harmonizing the three norms through interpretation In summary, the following stances are taken in the 2010 OECD TPG with respect to the use of aggregated third-party profits as comparables: − the first norm rejects such comparables if some of the third-party transactions are “not similar to the controlled transactions” (paragraph 2.79); − the second norm rejects such comparables if the third party performs a “range of materially different transactions” (paragraph 3.37); and − the third norm rejects such comparables if it cannot be concluded that the “functions performed by the third party in its total operations [are] closely aligned with the functions performed by the tested party with respect to its controlled transactions” (paragraph 2.103). Clearly, there seems to be a conflict between the three norms. This ambiguity must be seen in light of the fact that there are differing views among

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the OECD member countries on whether profit margins extracted from blended profits may be used under the OECD pricing methods. It was therefore likely difficult to achieve a clear consensus. On the one hand, some countries likely acknowledged the dire need to adapt the OECD TPG to what is clearly common transfer pricing practice internationally, as well as to recognize that, in the vast majority of cases, there simply will not be sufficiently detailed accounting data available to segregate the transactions of third parties. This view is reflected in paragraph 2.103. Other countries likely took the more principal (and rather theoretical) view that using company-wide data is inconsistent with the traditional transactional focus of the OECD TPG and that comparables that do not succumb to these requirements should be rejected, as seemingly expressed in paragraph 3.37. It is of importance to determine a coherent interpretation of the OECD TPG with respect to the acceptability of using aggregated third-party profits. Such profits will, presumably, in almost every case, be blended, in the sense that the total profits consist of profits from third-party transactions that are both comparable and incomparable to the controlled transaction. First of all, paragraph 2.79 (“not similar”) is a remnant from the 1995 consensus text, which was directly carried over to the 2010 OECD TPG. This is surprising, given the considerable development both in global transfer pricing practice since 1995 and the OECD movement on this issue, as reflected in the 2006 and 2008 reports and in paragraphs 3.37 and 2.103 of the OECD TPG. It was not commented as to why this text was carried over to the 2010 OECD TPG. Further, the text is difficult to reconcile with paragraph 3.37. Both norms pertain to the composition of the third-party transactions. Paragraph 2.79 draws the line at “not similar”, and paragraph 3.37 at “materially different”. Thus, these norms address the same object, but the paragraph 3.37 norm is more relaxed than its predecessor norm in paragraph 2.79. The author does not find these two norms to be reconcilable. His conclusion is that the predecessor norm in paragraph 2.79 should be rejected on the basis of the lex posterior principle. Simply put, the “materially different” norm expressed in paragraph 3.37 of the 2010 OECD TPG would not have any effect if the 1995 “not similar” norm in paragraph 2.79 were to apply. Such a result could not possibly have been the intention when the 2010 OECD TPG text was agreed upon. In this section, the author will therefore disregard the “not similar” norm in paragraph 2.79. 290



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The question is then whether the use of aggregated third-party net profit data is allowed when that data reflects materially different transactions (blended profits), but the total functions carried out by the third party are closely similar to the functions carried out by the tested party with respect to the controlled transaction, i.e. whether blended profit comparables are allowed in situations in which the guidance both in paragraphs 3.37 and 2.103 is triggered. The author refers to his interpretation of paragraphs 3.37 and 2.103 in sections 8.6.6.3. and 8.6.6.4., respectively. The question now is how the paragraphs relate to each other. First, for the purpose of deducting a coherent rule for the use of aggregated third-party data as comparables, it is, in the author’s view, important to recognize that the guidance contained in paragraph 3.37 is ambiguous, while paragraph 2.103 is relatively clear. It does not seem meaningful to give paragraph 3.37 priority over paragraph 2.103, as that would entail that one replaces clear guidance with ambiguous guidance. Second, it is difficult to disregard the fact that the guidance in paragraph 3.37 will not be possible to apply in real-world transfer pricing cases. The extent to which third-party transactions are materially different will be unknown, due to insufficiently detailed publicly available accounting data. In contrast, it may be relatively easy to ascertain whether the functions, assets and risks of the independent enterprise are similar to those of the tested party. In the author’s view, the “materially different transactions” guidance in paragraph 3.37 is not useful, while the “closely aligned” functions guidance in paragraph 2.103 is. This is a clear argument for giving paragraph 2.103 priority over paragraph 3.37. Third, it cannot with certainty be concluded that the guidance in paragraph 3.37 on materially different transactions is wholly incompatible with the guidance in paragraph 2.103 on similar functions due to the ambiguous language of the former. Paragraph 3.37 makes the use of aggregated thirdparty profit data contingent on whether the data can provide “reliable” comparables. Paragraph 3.37 finds that this will depend on whether the third party performs a range of “materially different transactions”. Thus, the problem is seen as a reliability issue. Of course, comparability is not black and white; the extent of reliability will vary depending on the comparability factors. A plausible interpretation of paragraph 3.37 therefore seems to be that aggregated third-party data may be used, even if such data encompasses materially different transactions. However, as the degree of materially differ291

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ent transactions increases (i.e. as profits become more blended), the degree of reliability associated with using the aggregated data as a comparable will decrease correspondingly. If this interpretation of paragraph 3.37 is adopted, one might end up in a situation where the degree of comparability, and thus reliability, associated with aggregated profit data as a comparable is questionable, but in principle, acceptable under paragraph 3.37. Fourth, the question is whether there are any other transfer pricing alternatives available that will yield a more comparable and reliable result than basing the pricing on a profit margin extracted from blended profits. The author does not find this likely, as the problem of blended third-party net profits pertains to all OECD transfer pricing methods, apart from the CUT method. Should it be, however, that a superior third-party comparable for which it is possible to ascertain profits on a transactional basis does exist, the best-method rule will dictate that a method is chosen that selects the best comparable available.1002 A more realistic scenario seems to be the one described in paragraph 2.103 that the only third-party data available is aggregated net profit information. In this situation, there simply will be no alternative comparables that are more reliable. This is important, as the paragraph 3.37 argument of reduced reliability becomes less important if there are no better alternative comparables upon which to base the transfer pricing assessment. This point also supports giving paragraph 2.103 priority over paragraph 3.37.

8.6.6.6. Conclusion In light of the discussions in sections 8.6.6.2.-8.6.6.5., the author adopts the following interpretation of the OECD TPG with respect to the use of aggregated third-party profit data as comparables. As the point of departure, the OECD TPG allow the use of aggregated third-party profit data, even if those data encompass transactions that are materially different. If the profit data are blended, however, the reliability of the transfer pricing analysis will be reduced as compared to the reliability that would have been the result had the third-party profit data only encompassed segregated transactions that were comparable to the controlled transaction. 1002. See OECD TPG, para. 2.2.

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The decisive threshold for whether blended third-party profit data may be used as comparables is the paragraph 2.103 instruction that the functions performed by the third party in its total operations must be closely aligned with the functions performed by the tested party with respect to its controlled transaction. Under this interpretation, there will be coherence between the guidance in paragraph 3.37 on “materially different transactions” and the guidance in paragraph 2.103 on functions “closely aligned”. Because the guidance in paragraph 2.103 pursuant to the above interpretation will be decisive with respect to whether aggregated third-party profit data may be used as comparables under the OECD pricing methods, it is, in the author’s view, important that the sparse guidance of the paragraph is interpreted in a purposeful manner. In particular, the single most important aspect will be to ensure that the third party only performs routine functions, that it does not own any unique and valuable intangibles and that it only incurs normal levels of risk. If the unrelated enterprise satisfies these criteria, its blended profits should be allowed to be used as comparables. The stance of the current OECD TPG with respect to aggregation of transactions may be summarized in table 8.3 (assuming that both the tested and unrelated enterprises carry out a variety of transactions).1003 Table 8.3 2010 OECD TPG Total transaction portfolio (tested party)

Segregated transactions1003 (tested party)

Total transaction portfolio (unrelated party)

The profit margin from company-wide controlled transactions is benchmarked against a company-wide, third-party profit margin (not allowed)

The profit margin from a specific controlled transaction is benchmarked against a company-wide, third-party profit margin (allowed)

Segregated transactions (unrelated party)

The profit margin from company-wide controlled transactions is benchmarked against a company-wide, third-party profit margin (not allowed)

The profit margin from a specific controlled transaction is benchmarked against the profit margin from a specific CUT (allowed)

1003. See supra n. 964.

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8.6.7. Applying the 2010 OECD TPG rule to the golf ball example The author will illustrate the implications of the interpretation of the OECD TPG in section 8.6.6.6. by reverting to the golf ball example (see Example 3 in section 8.6.2.). The tested party realizes a 15% net margin on its controlled golf ball sales. The independent enterprise realizes the following margins: the net profit margin from the sale of golf balls is 23.7%, which contributes 54.1% to the total blended profits of the independent enterprise. The remaining blend comes from the sale of tennis balls at a net profit margin of 12.5%, which contributes 25.1% to the total net margin, and from the sale of basketballs at a net profit margin of 1.4%, which contributes 20.8% to the total net profits of the enterprise. Thus, the aggregated third-party net profits in this example are blended and consist of contributions from clearly materially different transactions. The comparable transaction yields net profits of 23.7%, while the two incomparable transactions yield 12.5% and 1.4%. The impact of the incomparable transactions on the blended profits is significant, as the difference between the net profit of the comparable transaction of 23.7% and the overall blended profits of 16.2% is 7.5%. Pursuant to the author’s interpretation of the OECD TPG in section 8.6.6.6., neither the fact that the aggregated third-party profits are tainted by the incomparable transactions nor the degree to which they are are relevant for determining the admissibility of using the profits as a comparable under the OECD pricing methods. This is an important recognition, because the actual result of using this net profit margin will be erroneous. The true arm’s length net profit margin in this case is 23.7%. Nevertheless, the end result of applying the TNMM using the blended net profit margin is that the return position of the tested party of 15% is measured against the blended “arm’s length” profit margin of 16.2%. This result is regrettable, as it does not yield a true arm’s length allocation of income. Of course, in the real world, it will not be possible to ascertain the degree to which the result of using a blended net profit margin deviates from the true arm’s length net profit margin. However, one can logically be reasonably sure that a blended profit margin will not reflect the precise and true arm’s length net profit margins.

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Has the TNMM converged towards the 1988 White Paper BALRM?

It is important to see the reduced reliability of using blended profit margins in the bigger picture. The use of such margins is relevant mainly under the one-sided OECD pricing methods. With respect to the transfer pricing of intangibles, the TNMM is, in practice, the only method for which the issue is normally relevant. The purpose of the one-sided methods in general, and the TNMM in particular, is to allocate a normal market return to the tested party. As long as a proper functional analysis is carried out and it is concluded with a high degree of certainty that the independent enterprise does not perform non-routine functions, own unique and valuable intangibles or incur extraordinary risks, the transactions of the independent enterprise will likely yield a normal return. Thus, for the purpose of ensuring a proper allocation of residual profits among jurisdictions, it does not seem to be a detrimental problem that there is some uncertainty connected to ascertaining an arm’s length profit margin that provides a normal return. The simple reason for this is that a normal return is, in itself, limited to an average or typical market return. This will narrow the potential interval for variance significantly. Ultimately, transfer pricing is not a precise science. Even though the use of net profit margins extracted from third-party blended profits undoubtedly will entail a great deal of uncertainty with respect to their predictive value as indicators of arm’s length results, there cannot, in the author’s view, be any doubt that such margins will, regardless, allocate a normal return to the tested party. In practice, that normal return will be imprecise. In the bigger picture, however, the most important result is that the tested party is not allocated any intangible super profits. The interpretation of the OECD TPG in section 8.6.6.6., at least, seems to ensure this objective.

8.7. Has the TNMM converged towards the 1988 White Paper BALRM? The question is whether the material content of the TNMM, as understood in the above interpretation (see section 8.6.6.6.) and in current transfer pricing practice, has converged towards the content of the BALRM and CPM. If so, that would be ironic, in light of the significant historical resistance from factions within the OECD against the US approach. The BALRM is rooted in microeconomic theory, which professed that, in competitive markets, where the factors of production are homogeneous and mobile across business sectors, competition would cause above-normal re295

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turns to become zero in the long run.1004 A fundamental conclusion was that there would be equality between the revenues of an enterprise and the sum of the market returns that could be earned by all of the factors of production employed by the enterprise.1005 The White Paper drew the conclusion that this relationship could be used to determine the allocation of income among related parties by identifying and valuing the factors of production owned by a related entity and assigning the market return that each factor could have earned on its best alternative use in the marketplace.1006 The equality between revenue and production factor market returns could not be assumed to be sustained in two specific and practical scenarios, namely in (i) monopoly situations; and (ii) the presence of unique IP.1007 The existence of super profits could not be ruled out in these scenarios, due to lack of competition. The first step under the BALRM was to identify functions that utilized generic factors of production (as opposed to unique IP).1008 The second step was to assign income to these functions by way of extracting normal market return profit data from third-party enterprises that were functionally similar to, and owned similar assets as, the tested party, thereby indirectly also allocating the residual profits from unique and valuable IP to the other party to the controlled transaction.1009 Transfer pricing practice, as well as paragraph 2.103 of the 2010 OECD TPG, has sought to limit the negative consequences of using blended profit

1004. White Paper (Notice 88-123), p. 83. See also Lipsey et al. (1981), at pp. 229-231; and Henderson et al. (1980), at pp. 107-110. This did not entail that a related party that operated in a competitive market using standard and mobile factors of production would earn a taxable income of zero, but rather that the entity would earn just a normal rate of return and not residual profits. 1005. White Paper (Notice 88-123), p. 84. 1006. Id. 1007. Id., at p. 85. 1008. Id., at p. 96. 1009. Under the BALRM, assets were divided into cash working capital and other op­ er­ating assets. Working capital was assigned its actual return, while the return on operating assets was identified or estimated. The BALRM was presented in the White Paper (Notice 88-123) primarily as a method that measured returns on operating assets, but the model was also open to using other financial ratios; see White Paper, p. 97. The Berry ratio (see sec. 8.4.2. and supra n. 927), for instance, could be useful in measuring the returns on service activities and in other situations in which operating assets are difficult to measure consistently. Even though the White Paper did not go into details on how the BALRM would identify the relevant market returns, there would not be any alternatives to using transaction-based measures of return (e.g. the rate of return on operating assets or other financial indicators).

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Is reduced transactional comparability under the TNMM a ­significant ­problem?

margins under the TNMM by requiring functional comparability between the tested party and the selected uncontrolled enterprises.1010 Thus, the justification for asserting that the selected uncontrolled enterprises are comparable to the tested party will not, in practice, be similarities between the controlled and uncontrolled transactions themselves, but rather between the functions performed, assets used and risks incurred by the tested and independent enterprises. On this basis, it must be concluded that the TNMM, as interpreted in section 8.6.6.6. and applied in practice, displays fundamental similarities to the BALRM of the 1988 White Paper. There is little basis left on which to contrast the TNMM against the BALRM and the CPM.

8.8. Is reduced transactional comparability under the TNMM a significant problem? A typical application of the TNMM will entail uncertainty. It is unlikely that a blended profit margin extracted from independent enterprises (that are comparable to the tested party with respect to functions, assets and risks) will be fully comparable to the profit margin of the controlled transaction. The question here is thus whether this poses a significant problem in reality. First, the author presumes that the use of blended net profit margins will normally allocate an income to the tested party that is roughly equal to an arm’s length income. In other words, the result of applying such margins will likely not significantly distort the allocation of income between related parties relative to the “true” arm’s length allocation of income that would have been the result had there been full transactional comparability between the extracted third-party profit margin and the controlled profit margin. The reason for this is that the TNMM can only be applied where the tested party is a “simple” entity that contributes only routine value chain inputs. Such entities will, due to competition from third parties, only yield normal market returns on all of their transactions. The extracted blended profit margin will therefore likely only vary within a limited normal return range. Measurement errors will also be mitigated by the arm’s length

1010. In addition to functional comparability, unrelated comparable enterprises are, in practice, typically also selected on the basis of similarity in the areas of business, assets, size, employees, etc.

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range (which was the reason why it was introduced concurrently with the CPM).1011 Second, one should surrender the ideal of a perfectly comparable third-party transaction.1012 As discussed above, the reason why blended profits are used under the TNMM is the simple fact that public third-party financial statements do not provide enough disaggregated information to separate gross or net profit margins on a product (or product group) level. Even if the necessary management accounting information to carry out such segregation were publicly available, it would be difficult to ensure full comparability between the tested and uncontrolled transactions because the gross and net profit margins for single products (or product groups) are not “objective” sizes. Such margins depend on a range of highly discretionary management assessments for which it may be difficult to carry out reliable comparability adjustments (e.g. allocation of variable and fixed costs among different products).1013 1011. See the analysis of the “arm’s length range” concept in sec. 6.5. It should be noted that the OECD TPG hesitate to accept that the arm’s length range may mitigate the potential level of inaccuracy produced by the TNMM, as it may not “account for situations where a taxpayer’s profits are increased or reduced by a factor unique to that taxpayer” (see OECD TPG, para. 2.73). The stated rationale behind this position is that the arm’s length range may then not include points representing the profits of independent enterprises that are affected in a similar manner by a unique factor. The author finds this unclear. First, if the tested party is in possession of unique functions or assets (e.g. uniquely skilled research personnel or unique IP), it is clear that the TNMM (or any other one-sided transfer pricing method, for that matter) should not be applied to allocate profits to the tested party in the first place. Second, the arm’s length range is a statistical tool, designed specifically to alleviate problems associated with information on the transactions of unrelated enterprises being insufficiently complete to ensure that there are no material differences between them and the controlled transactions of the tested party. It is difficult, in this light, to see why the arm’s length range should not offer the same comfort in this situation. 1012. See also Luckhaupt et al. (2011), at p. 116, where it is emphasized that there is a large degree of discretionary assessment associated with applying the OECD transfer pricing methods. 1013. Two types of comparability adjustments are, in practice, relevant with respect to third-party profit data, i.e. (i) accounting adjustments; and (ii) “economic” adjustments. Accounting adjustments do not affect the profit-and-loss statement, and thus the net profit, of the unrelated enterprise of which the profit data is being adjusted, while economic adjustments do. Accounting adjustments are performed in order to ensure that the tested party and the unrelated enterprise has accounted for income and expense items in a similar manner. Typical accounting adjustments include reclassifying expenses among costs of goods sold and operating expenses. Accounting adjustments are irrelevant under net profit methods. Economic adjustments include adjusting the principles for accounting for inventory (LIFO/FIFO), reclassifying from expensing to capitalizing costs, working capital adjustments, adjustments to assets (e.g. depreciation/amortization periods), adjustments for foreign exchange items, capacity utilization

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Third, transfer pricing imprecision is not limited to problems associated with the use of blended profit margins under the one-sided, profit-based pricing methodology. For instance, the use of royalty rates from purported CUTs involving similar IP (inexact comparables) under the CUT method may – even if a range of comparability adjustments are carried out – deviate significantly from the “true” arm’s length allocation of income. A measurement error under the CUT method, when applied in order to allocate residual profits from unique and valuable IP, will generally result in significantly larger allocation errors (in absolute amounts) than measurement errors from applying a blended profit margin under the one-sided methods used to allocate normal market returns. The same can be said for the profit split method, which allocates residual profits based on a broad and discretionary assessment of relative values (see the analysis in chapter 9). For instance, the question under the CUT method may be whether the royalty should be 20-30% of sales, while the issue under the one-sided methods may be whether the tested party should be entitled to a normal market return for its routine functions of, for instance, 5-10% on costs. The author therefore concludes that the partial lack of transactional comparability from using blended profit margins under the TNMM, although not ideal, should not be regarded as a detrimental comparability problem in transfer pricing.

8.9. Closing comments on comparability under the o­ ne-sided, profit-based methodology As illustrated in the discussions in this chapter, attaining a high degree of comparability under the CPM and the TNMM is not an easy task. Practice has shown that even for group entities that contribute solely routine inputs to the value chain, it is generally difficult to find truly comparable thirdparty profit data upon which to base benchmarking of controlled profit allocations under the CPM and TNMM. This may be due to several factors, but one particularly pronounced problem is that multinationals often segregate and disperse their functions among group entities in a highly fragmented and specialized manner, while third-party comparables candiadjustments and stock option adjustments. Such adjustments alter the accounting profits of the unrelated enterprise and are relevant both under gross and net profit methods. Due to the lack of detailed accounting information (see secs. 6.2.4. and 6.2.5.) and the complexity associated with making accounting and economic adjustments, such comparability adjustments are often not carried out in practice.

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dates normally carry out a more holistic set of business functions. Further, it may also be that there are no true independent third-party comparable enterprises available. It may be that the closest that one comes to finding a comparable unrelated routine input provider is an enterprise that belongs to a third-party group. That is a problem if the transactions of that entity mainly consist of transactions with other entities within its group (as will often be the case). The author gathers that, in practice, it is often necessary to resort to such comparables for a lack of better alternatives.1014 The comparability problems associated with the one-sided, profit-based methodology are among the reasons why the OECD now has extended the scope of application of the profit split method in the 2017 OECD TPG (see the discussion in section 9.2.3.) and generally favours the profit split method over the other pricing methods (see the discussion in section 11.4.). The problem is that this methodological development triggers new and additional transfer pricing issues, which will be discussed in chapter 9.

1014. For instance, operating profit margins extracted from group entities within vertically integrated contract manufacturing multinationals, e.g. Flextronics (see http:// www.flextronics.com), Celestica (see http://www.celestica.com) or Jabil (see http:// www.jabil.com), may, in practice, be used to benchmark the profits of the tested party.

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Chapter 9 Direct Profit-Based Allocation of Residual Profits to Unique and Valuable IP: The Profit Split Method 9.1. Introduction In this chapter, the author will discuss the US and OECD two-sided, profit-based transfer pricing (profit split) methodologies as they stand in the current US regulations and the 2017 OECD Transfer Pricing Guidelines (OECD TPG).1015 The core content of the PSM (PSM) is that it allocates the net operating profits from a value chain among the group entities that contribute value chain inputs in proportion to the relative value of those contributions. The method is particularly relevant in the context of intangible value chains, as it may be used to allocate residual profits from unique and valuable intangible property (IP) without the need for comparable uncontrolled transactions (CUTs), which generally will be unavailable. The author would like to emphasize that this chapter should be read in light of the analysis of the historical development of profit-based transfer pricing methodology in chapter 5, in particular the analysis of Eli Lilly in section 5.2.4.3. and of the US and OECD implementation of the profit-based methodology in sections 5.3. and 5.4., respectively. From being developed through US case law as a reaction to – and a way of dealing with – the lack of comparables upon which to base application of 1015. The following discussion with respect to the OECD profit split method (PSM) is based on the OECD BEPS Action 10: Revised guidance on profit splits discussion paper (OECD 2017), as the final consensus text has not yet been released at the time of writing. It is anticipated that the final text will not deviate on significant points from the discussion paper. For a historical overview of the methodology, see the 1992 IFA general report in Maisto (1992), at pp. 51-53. For a recent comparative overview of the application of profit splits in the context of value chains in different (IFA branch) jurisdictions, see Rocha (2017), at p. 229. See also Chand et al. (2014) for a recent discussion of the PSM under the OECD Transfer Pricing Guidelines (OECD TPG), taking into account the new BEPS country-by-country documentation requirements. For recent commentary on the OECD PSM guidance, see Robillard (2017a). For a comparison between the PSM and formulary apportionment, see Kroppen et al. (2011), where a positive outlook on the PSM is presented due to its ability to allocate, in an arm’s length manner, profits without the need for direct third-party comparables. For further recent discussions on the PSM, see, e.g. Milewska et al. (2010); Kadet (2015); Robillard (2017b); and Feinschreiber et al. (2016).

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the traditional, transaction-based transfer pricing methods, the PSM has, over time, grown into the role of being one of the most practically important transfer pricing methods internationally. The 2017 OECD TPG on intangibles envision a significantly more central role for the methodology than the OECD originally intended when it introduced the method into the OECD TPG in 1995. The author will revert to the relative importance of the method in the context of the OECD TPG in chapter 11, after discussing the new OECD guidance on the allocation of incremental operating profits from location savings, local market characteristics and synergies in chapter 10. This chapter will focus on two key issues. The first issue is the clarification of in which scenarios the PSM can be applied, i.e. the delineation of the scope of application for the methodology. This will be analysed in section 9.2. The second issue is the clarification of how the method works, i.e. how operating profits can be allocated under the methodology. This will be analysed in section 9.3. The author will then comment on how the PSM can be applied in valuation scenarios in section 9.4. Lastly, in section 9.5., the author discusses how the OECD PSM is limited to information known or reasonably foreseeable at the time at which the controlled transaction is entered into.

9.2. The scope of application of the methodology 9.2.1. Introduction Having a critical approach to the scope of application for the PSM is important because the methodology relies greatly on discretionary assessments and was originally designed only to be applied where no CUT-based methods could be used instead. If the scope of application becomes very broad, this could trigger the risk that both taxpayers and tax authorities resort to the method even though there may be other transfer pricing methods available that could offer more reliable and precise profit allocation results.

9.2.2. The US PSM In the United States, the PSM was first introduced into the Internal Revenue Code (IRC) section 482 (temporary) regulations in 1993.1016 The meth1016. 58 FR 5263-02; see the notice of proposed rulemaking in 58 FR 5310-01, at § 1.482-6T. See Brauner (2008), at p. 132, on the US PSM.

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od played a surprisingly modest role in those regulations, given the fact that the methodology had been applied frequently in case law over decades and that it was aligned with the new commensurate-with-income approach.1017 Application of the method was limited to cases in which “each controlled taxpayer owns a valuable, non-routine intangible”.1018 This limitation was scrapped in the final version of the PSM in the 1994 US regulations, which still applies today. Subsequently, there were some alterations to the PSM provision in connection with the introduction of the 2009 intra-group services regulations,1019 most notably, the inclusion of a definition of non-routine contributions.1020 The US PSM can, in principle, be applied even if one of the controlled parties does not contribute valuable and unique IP to the value chain.1021 The best-method rule, however, will normally restrict application of the method to cases in which both parties indeed contribute such value chain inputs. Where one of the parties contributes only routine inputs, the data and assumptions pertaining to this party will likely be significantly more reliable than for the party contributing unique IP, typically favouring the comparable profits method (CPM).1022 Further, the strict requirements for 1017. This “backseat” position was, in the author’s view, likely due to the fact that (i) the US, in outbound transfers of US-developed unique intangibles, where research and development (R&D) expenses normally had been deducted concurrently throughout the development phase against US income, simply did not deem a split of residual profits with the transferee jurisdiction to be reasonable; and (ii) the US preferred the comparable price method CPM) as its flagship method in order to prevent BEPS. 1018. See 58 FR 5310-01, § 1.482-6T(b)(1). This triggered discussions of what qualified as non-routine intangibles. Langbein (2005), at p. 1071, seems to attribute the restrictions of the 1993 temporary regulations on the use of the PSM to the political commitment of the US to the arm’s length principle (as opposed to formulary apportionment). 1019. 74 FR 38830-01. The general US PSM in Treas. Regs. § 1.482-6 applies also to controlled service transactions, along with some specific guidance in Treas. Regs. § 1.482-9. 1020. See Treas. Regs. § 1.482-6(c)(3)(i)(B), where the US regulations define a nonroutine contribution negatively (simply as a contribution that is not accounted for as a routine contribution). This definition was introduced following a debate that began already in 1993, when the notice of proposed rulemaking (58 FR 5310-01) outlining the proposed PSM requested comments on a possible definition. See the analysis in sec. 3.4.3. on non-unique value chain contributions. 1021. This, however, is not the case for the PSM for intra-group services. See Treas. Regs. § 1.482-9(g)(1), which states that the method cannot be used where only one controlled taxpayer makes significant non-routine contributions to the controlled transaction. 1022. See the discussion on the scope of application for the CPM in sec. 8.3. See also the preamble to Treas. Regs. § 1.482-6 in the final 1994 regulations (59 FR 34971-01). See also Treas. Regs. § 1.482-6(c)(2)(ii)(D).

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using the comparable profit split allocation pattern (see the discussion in section 9.3.2.) make the residual profit split allocation the practical application of the PSM. The latter allocation pattern presupposes that both parties own valuable and unique IP that contributes to the residual profits. Thus, in spite of not being a formal requirement, there is little doubt that the practical area of application for the general US PSM is to controlled transactions in which both parties contribute unique and valuable IP to the value chain. As the split of residual profits under the PSM will ordinarily not be based on third-party data, the US Internal Revenue Service (IRS) asserts that the PSM should generally be considered a method of last resort.1023 The author takes issue with this. The PSM will normally be the only method applicable when both parties to a controlled transaction contribute non-routine inputs, as the CUT method will generally be unavailable due to the lack of CUTs.1024 In these situations, the PSM should be deemed the most appropriate method, not a last resort. Further, the author finds the basic premise behind the IRS’s position, i.e. that the results of pricing methods that apply internal data in all cases will be inferior to those that apply external data, to be questionable.1025 Meaningful and reliable external benchmarks for splitting residual profits will be unavailable in the vast majority of cases. Also, the PSM partly relies on external data for the allocation of income, as the first step of allocating normal market returns to routine functions uses a comparable profits method (CPM) approach. Further, splitting the residual profits on the basis of a concrete assessment of causality has proven to yield reliable results in practice, e.g. in Eli Lilly.1026

9.2.3. The OECD PSM The 1993 introduction of the PSM into the US regulations was the motivation behind the OECD’s adaptation of the PSM (along with the transactional net margin method (TNMM)) in the 1995 OECD TPG. The OECD’s implementation was sceptical towards the profit-based methods in general 1023. See the preamble to the 1994 regulations (59 FR 34971-01). 1024. Treas. Regs. § 1.482-1(c)(1). 1025. The US Internal Revenue Service’s (IRS’s) position may possibly be due to an excessive focus on typical outbound scenarios, where unique US-developed intangibles employed in the value chain are owned by a US entity and the foreign entity is a mere routine input provider (i.e. “standard” CPM scenarios). This may, in practice, very well be the most relevant scenario, but it should not be forgotten that there necessarily also will be cases in which the foreign entity does provide unique inputs to the intangible value chain. In such cases, there will likely be no alternative to the PSM. 1026. See the analysis of the case in sec. 5.2.4.3.

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and limited their application in ways that the US regulations did not (e.g. with the transactional approach and ex ante approach).1027 The historical point of departure, as reflected in paragraph 2.109 of the 1995/2010 OECD TPG, was that the PSM should not be used when one party to the controlled transaction only contributed routine functions, such as contract manufacturing or low-risk distribution. While this point of departure was not discarded in the new 2017 consensus text, it has certainly been relaxed through a broadening of the scope of application of the PSM. The 2017 OECD TPG allow the application of the PSM in three main scenarios. First, the OECD PSM can be applied if both parties to the controlled transaction contribute unique and valuable IP to the value chain.1028 This is still the core area of application for the method. Thus, it will normally not be appropriate to apply the PSM when one party to the controlled transaction performs only routine functions.1029 Sharing profits in such cases will be unlikely to reflect arm’s length profit allocation.1030 This first area of application of the OECD method is parallel to the main area of application of the US PSM. Second, the OECD PSM can be applied to allocate profits from highly integrated operations where a one-sided method would not be appropriate.1031 While the 1995/2010 OECD TPG did mention that the method could offer a solution for highly integrated operations,1032 this area of application of the methodology was quite notably elaborated on in the 2017 text, indicat1027. The PSM, like the transactional net margin method (TNMM), may only be applied on a transactional basis. In other words, the OECD TPG restrict the extent to which both the controlled and uncontrolled transactions may be aggregated. See the discussions of the aggregation of controlled and uncontrolled transactions in sec. 6.7. and sec. 8.6., respectively. With respect to controlled transactions, the OECD transactional requirement largely mirrors the “relevant business activity” delimitation of the US PSM; see Treas. Regs. § 1.482-6(a), which states that the combined operating profits must be derived from the most narrowly identifiable business activity of the controlled taxpayers for which data is available that includes the controlled transactions. The aggregation problem is not nearly as pronounced under the PSM as under the onesided methods, as the allocation of residual profits under the PSM will normally not be based on third-party profit data. 1028. BEPS Action 10, Revised guidance on profit splits, para. 6. The draft text contains a definition of unique and valuable value chain contributions in para. 16. This definition is materially similar to that contained in para. 6.17. The author refers to the analysis in sec. 3.4.3. 1029. The TNMM will normally be applied in these scenarios; see the discussion in sec. 8.3. 1030. Id., at para. 14. 1031. Id., at para. 7. 1032. 1995/2010 OECD TPG, para. 2.109.

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ing the intention of the OECD that the method should be applied going forward, also outside of cases in which both parties contribute unique and valuable IP to the value chain. The logic underlying this “expansion” of the scope of application of the PSM is not immediately apparent.1033 The business operations and value chains of multinationals will normally be integrated. The economic gain that can be achieved through such integration is one of the core reasons why some businesses choose to become multinationals in the first place.1034 The question then becomes how to separate “normal” multinational enterprise (MNE) integration, which will not in itself indicate that the PSM could be applied, from “high” MNE integration, which – now according to the 2017 OECD TPG – will indicate that the PSM can be applied. The 1995/2010 version of the OECD TPG did not define the concept of highly integrated operations, but the 2017 version does, as follows: [O]ne party to the transaction [that] performs functions, uses assets and assumes risks is interlinked with, and cannot reliably be evaluated in isolation from, the way in which another party to the transaction performs functions, uses assets and assumes risks.1035

This wording indicates that the “highly integrated expansion” will be relevant when it is not possible to apply a one-sided pricing method to remunerate one of the parties to the controlled transaction. That will be the case when the relevant party contributes unique and valuable IP to the controlled transaction. Outside of such cases, however, it should almost always be possible to use a one-sided pricing method, taking into account that the comparability requirements generally are relaxed.1036 Even still, there will undoubtedly be situations in which it will be problematic to find reliable comparables. Multinationals tend to separate functions into different legal entities, with single entities devoted to logistics, warehousing, marketing, etc., making it difficult to find similar unrelated enterprises. Third-party enterprises that are candidates for being used as comparables under one-sided methods will typically carry out a range of other activities and transactions in addition to those comparable to the functions and transactions of the tested party. In such cases, however, it should normally be preferable to resort to comparability adjustments than to apply 1033. See also, in this direction, Robillard (2017a), where it is argued that the application of the PSM may depart from third-party profit allocations in integrated business models, such as franchising structures. 1034. See the discussions in secs. 2.2. and 2.3. 1035. Id., at para. 19. 1036. See the analysis in sec. 8.6. with respect to the popular TNMM.

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the PSM. The reason for this is that if the group entity to be remunerated is a routine provider, it should only make a normal market return (which is likely what the third-party comparables also are making). Thus, even if significant comparability adjustments must be made, these will likely not affect the end profit allocation result much. The routine entity will only be allocated a normal market return. Application of the PSM, however, could open up even more discretionary and imprecise profit allocations in such scenarios. There can even be a risk that the routine entity is allocated above normal market returns if the PSM is applied. It is therefore not clear that the “highly integrated expansion” can serve a useful purpose. The ambiguity underlying the “highly integrated expansion” is reflected on several points in the 2017 OECD TPG. For instance, the text argues that the expansion will be relevant if both parties to the controlled transaction contribute significant assets to a long-term arrangement.1037 If the contributed assets are unique and valuable IP, the PSM would be applicable, even under its “traditional” scope of application, without any need for the “highly integrated expansion”. If, however, the significant assets are not unique but are generic, their contribution should normally be susceptible to pricing based on either the CUT method or the one-sided methods. There should then not be any need for the expansion. Nevertheless, it should not, in principle, be ruled out that the expansion could be relevant in some narrow cases outside of scenarios in which both parties contribute unique and valuable IP. This could, for instance, be the case when both parties contribute relatively unique and significantly valuable assets to a long-term cooperation when there are no realistic options available for replacing the contributed assets with equivalent value chain input factors. An example could be a business cooperation within the oil sector, where one group company contributes unique IP in the form of seismic technology (software, know-how, etc.) and the other group company contributes a highly valuable and one-of-a-kind specialized vessel. A profit split could be justified here under the “highly integrated operations” expansion. The profit split allocation to the group entity that does not contribute unique IP (i.e. the entity that contributes the vessel) should then be subject to a “sanity check” under a one-sided method (cost-plus or TNMM) in order to have some assurance that it is not allocated too much profit. The 2017 OECD TPG further argue that the highly integrated expansion can be relevant when the contributions are highly interrelated or interde1037. BEPS Action 10, Revised guidance on profit splits, para. 21.

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pendent.1038 This is illustrated by reference to a situation in which the controlled parties contribute unique and valuable IP to the value chain and where combinations of IP are transferred intra-group. The 2017 text does not contain any examples of a situation in which a highly integrated structure by itself (i.e. without the presence of contributions of unique and valuable IP from both parties) justifies the application of the PSM.1039 It seems peculiar that the OECD has chosen to expand the scope of the “highly integrated” application of the PSM without coming up with a single practical example of how the doctrine can be applied. It is the author’s impression that the “highly integrated expansion” is so ambiguous that it can be misused, for instance, by asserting that the contributions from what is, in reality, a routine input entity in a low-tax jurisdiction shall be allocated a portion of the residual profits from unique IP (that it does not own) under the assertion that its value chain contribution is “highly integrated”. If it is possible to remunerate the relevant group entity based on a one-sided pricing method, tax authorities should not accept allocations based on the “highly integrated expansion” of the PSM. Such allocations will likely be more imprecise than profit allocations based on one-sided pricing methodologies and may yield what are, in reality, nonarm’s length results (e.g. if a routine entity is allocated residual profits). Comparability problems associated with applying a one-sided pricing method should not justify the application of the PSM if, in principle, it is clear that a one-sided pricing structure would be more appropriate, taking into account the nature of the controlled parties’ value chain contributions. Third, the OECD PSM can be applied if both parties to the controlled transaction share the assumption of one or more economically significant risks pertaining to the controlled transaction1040 – including when the economically significant risks are separately assumed by each controlled party – if the risks are so closely interrelated that the playing out of the risks cannot be isolated from each other.1041 This “economically significant risks” expansion is ambiguous.1042 Outside of transfer pricing of financial services (where risk is key for allocating 1038. Id., at para. 22. 1039. The 22 June 2017 OECD discussion draft on the amendment of the PSM guidance even requested input on examples of scenarios in which “highly integrated” by itself would lead to application of the PSM. 1040. Id., at paras. 6 and 25. 1041. Id., at para. 26. 1042. See also, in this direction, the critical comments in Robillard (2017a).

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profits),1043 it is unclear whether the expansion is meaningful on a standalone basis. This point is illustrated by the examples contained in the 2017 OECD TPG. One example professes that the PSM should be applied to allocate profits among two group entities that each assume economically significant risks when the risks are closely interrelated and interdependent.1044 Ironically, the PSM would be applicable in the example regardless of the risks, as both group entities contribute unique and valuable IP to the value chain. Thus, the expansion has no true independent significance in the example. Another example states that the PSM should be applicable to allocating profits among two car manufacturing group entities that trade car components among themselves, as their manufacturing risks are highly interdependent.1045 Also here, both group entities contribute unique and valuable IP to the value chain. The method would thus be applicable even if the risks are not highly interdependent. In summary, while the above expansions may increase the availability of the methodology, there is obvious danger in allowing profit splits in these ambiguously defined scenarios. A profit split will – regardless of the chosen allocation key – always have some degree of inherent imprecision.1046 Such discretionary profit allocation may be relatively unproblematic when it is clear that both parties do indeed contribute unique and valuable IP to the value chain. Even if the exact extent to which the parties contribute value is unclear, it will, in such scenarios, be near certain that both parties do contribute significantly. If, however, discretionary profit splits are also allowed among two group entities that contribute significantly different values (e.g. one contributes unique and valuable IP while the other does not), there is a risk that a profit split will allocate too little income to one of the parties and too much to the other. The revised “highly integrated” and the new “economically significant risks” expansions should therefore be applied in only very narrow cases. The line should be drawn where it is possible to remunerate one of the group entities using a one-sided method. This goes to the core of the arm’s length principle. A one-sided method will only allocate a normal market return to a group entity that contributes routine inputs to the value chain because that is what similar third parties earn. Likewise, super profits can 1043. See id., Example 7, in which the controlled parties share the assumption of fund management risks. 1044. Id., at Example 3. 1045. Id., at Example 10. 1046. See also, e.g. Roberge (2013), at p. 234.

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only be earned through unique and valuable assets, typically IP. An application of the PSM should never result in profit allocations that contradict these fundamental economic axioms. Thus, if the PSM is applied in the “highly integrated” or “economically significant risks” scenarios, the allocation should be subject to a sanity check under a one-sided method. Such a dual methodology approach will, to some extent at least, mitigate the potential dangers of the 2017 OECD expansion of the PSM.1047 This also comes to another point. The 2017 expansion of the OECD PSM contributes to a dilution of the boundary between the scope of application of the PSM and the one-sided methods. There may now be overlapping areas of application of the two classes of transfer pricing methodologies. This overlap underlines the need to focus on the profit allocation result that is yielded by the applied methodology and to substantiate that result by way of reference to more than one transfer pricing method. For instance, the result yielded through applying the PSM (based on “highly integrated” or “economically significant risks” scenarios) could be supported through an application of the cost-plus method or the TNMM to one of the group entities participating in the controlled transaction, as well as a check against the “realistic alternatives” pricing principle. The 2017 OECD TPG expansion of the PSM should be seen in light of the generally dominant position that the OECD envisions that this methodology shall have in relation to the other transfer pricing methods (a topic that is discussed in section 11.4.), as well as the profit split-like“important functions doctrine” that the OECD adopted in the 2017 OECD TPG for determining IP ownership (which is discussed in section 22.3.2.). The OECD has completely rejected its historical preference for the CUT method (with respect to the transfer pricing of IP) and legal ownership (for determining ownership of IP developed intra-group) as expressed in the 1995/2010 OECD TPG in favour of a holistic profit split approach that spans across both the transfer pricing and IP ownership provisions of the 2017 OECD TPG. The potential downside of this comprehensive OECD preference for the PSM is that almost every profit allocation problem can now arguably be dealt with using the highly discretionary PSM, resulting in imprecise profit allocations that are difficult to verify the accuracy of and that may lead to irreconcilable profit allocations among the involved jurisdictions, and thus ultimately also to double taxation.

1047. On the use of more than one transfer pricing method (under the previous generation of the OECD TPG), see, e.g. Ahmadov (2011), at p. 191.

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9.3. How operating profits may be split under the methodology 9.3.1. Introduction The PSM allocates operating profits from a particular value chain among the group entities that contribute inputs to that value chain in proportion to the relative values of those inputs.1048 An illustrative example of this is Eli Lilly,1049 where the core issue was the allocation of the residual profits earned by the Puerto Rican subsidiary from sales of the Darvon pill among the manufacturing IP owned by the Puerto Rican subsidiary and the marketing IP owned by the US parent company. The question that will be discussed in sections 9.3.2.-9.3.3. is that of how profits can be split under the method, i.e. what kinds of assessments can be used to estimate the relative values of the value chain contributions to allocate profits to the involved group entities. This is a question of which allocation patterns are allowed under the methodology.

9.3.2. Profit split allocation patterns allowed under the US regulations The US regulations allow two specified alternatives for allocating profits under the PSM, namely1050 (i) the comparative profit split; and (ii) the 1048. See Robillard (2017b) for critical comments on the OECD guidance on the delineation of the profits to be split. Robillard argues that the delineation may trigger difficult accounting documentation (must often resort to internal management accounting to document product-level profits) and classification issues (e.g. discretionary allocation of costs among different product lines). 1049. See the analysis in sec. 5.2.4.3. 1050. The 1993 temporary US regulations contained two additional profit split patterns, which were scrapped in the final 1994 regulations. The first of these was the “capital employed allocation” (see 58 FR 5310-01, § 1.482-6T(c)(3)), which divided the residual profits according to the average capital employed by each controlled party in relation to the total capital employed in the intangible value chain. The preamble to the final 1994 regulations found that, with one exception, it had not been possible to describe a case in which it would be possible to conclude with certainty that two or more controlled taxpayers faced equal levels of risk (see 59 FR 34971-01). The exception was that of joint venture agreements in which the parties, ex ante, agree to share costs and benefits proportionately. Such scenarios are addressed by the cost-sharing arrangement regulations. The capital employed allocation pattern was therefore omitted in the final 1994 US regulations. See also Wittendorff (2010a), at pp. 759-766, on allocation patterns under the PSM. The second additional profit split pattern was the “unspecified profit split” (see 58 FR 5310-01, § 1.482-6T(c)(5)).

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residual profit split.1051 In addition, profit splits as an unspecified pricing method can be used. The comparable profit split alternative benchmarks the controlled split of operating profits against splits adopted by unrelated enterprises engaged in similar transactions under similar circumstances.1052 Thus, this application of the method splits the profits in the same fraction as is done in a CUT. The more unique and valuable the contributions from the parties to the controlled transaction are, the more difficult it will be to find a CUT, and therefore, it will be more unlikely that this allocation pattern can be used in practice.1053 In cases in which it is at all possible to identify a CUT, it will be highly likely that comparability adjustments must be made to the selected CUT.1054 It will be practical to adjust for differences in the financial accounting data of the controlled and uncontrolled taxpayers that could materially affect the division of operating profits.1055 It will first be necessary to ensure that the accounting data of both parties are properly segregated “between the relevant business activity and the participants’ other business activities” so that the third-party profits used to benchmark the controlled profits are truly comparable (i.e. they stem from a comparable value chain).1056 Further, as the PSM is a net profit method, differences in accounting classifications with respect to the profits in the controlled and CUT will not affect measurement (e.g. classification of expenses as costs of goods sold (COGS) or operating expenses). Economic accounting differences, however, are clearly relevant (e.g. whether an item is capitalized or expensed).1057 The accounting treatment of, for instance, research and development (R&D) expenses and the depreciation and amortization of assets must be checked for consistency. 1051. See Treas. Regs. § 1.482-6(c)(2) and (3), respectively. For critical reflections on the restrictions imposed on allocation patterns under the US PSM, see Horst (1993). 1052. Treas. Regs. § 1.482-6(c)(2)(i). The comparable profit split allocation pattern was first introduced in the 1988 White Paper (see Example 10) and then in the 1993 temporary regulations (see 58 FR 5310-01, § 1.482-6T(c)(4)). 1053. See Treas. Regs. § 1.482-6(2)(ii)(D), which asserts that reliability “may be enhanced by the fact that all parties to the controlled transaction are evaluated under the comparable profit split”. This ambiguous wording may refer to the general point that the PSM is a two-sided method. If so, the argument must be rejected, as a one-sided method clearly may be better suited for pricing than a two-sided method, given the facts and circumstances of a particular case. 1054. See Treas. Regs. § 1.482-5(c)(2). 1055. See Treas. Regs. § 1.482-1(d)(2). 1056. Treas. Regs. § 1.482-6(2)(ii)(C)(1). 1057. See supra n. 1013 with respect to accounting adjustments.

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The comparable profit split alternative is unavailable if the return on capital employed (ROCE) earned by the selected uncontrolled enterprises varies significantly from that of the controlled taxpayers.1058 Such scenarios will indicate that the profit potential of the unique IP owned by the controlled and uncontrolled taxpayers differs significantly. It must then be assumed that the CUTs from which the third-party profit split is extrapolated are unreliable. The strict criteria set out in the US regulations for the application of the comparable profit split will make the method unlikely to be applied much in practice.1059 The residual profit split allocation pattern was first introduced in the 1993 temporary US regulations.1060 The pattern bears some resemblance to the methodology applied in Eli Lilly1061 and in the White Paper’s basic arm’s length return method (BALMR) with profit split,1062 as it splits the operating profits from a value chain between the controlled taxpayers that contribute value chain inputs through a two-step process. First, a normal market return is allocated to each controlled party as compensation for its routine contributions.1063 Thereafter, the residual profits are split based on the “relative value” of the controlled parties’ non-routine value chain contributions. A non-routine contribution will, in practice, be unique IP, the relative value of which may be measured through1064 (i) external market benchmarks (i.e. CUTs); (ii) capitalized R&D costs; or (iii) the amount of current R&D expenditures in recent years.1065 External benchmarks will be generally be

1058. Return on capital employed (ROCE) is operating profits as a percentage of assets. The regulations do not elaborate on what is meant by a significant departure. This will necessarily create uncertainty, but likely no major practical problems, as the comparable profit split pattern will rarely be applicable. 1059. As recognized already in the White Paper (Notice 88-123), at p. 88, it is unlikely that a comparable uncontrolled price will be available if the multinational does not also license the intangible transferred in the controlled transaction to unrelated parties (e.g. in certain territories). 1060. See 58 FR 5310-01, § 1.482-6T(c)(2). 1061. 84 T.C. No. 65 (Tax Ct., 1985), affirmed in part, reversed in part by 856 F.2d 855 (7th Cir., 1988). 1062. See Notice 88-123 and its Example 11. 1063. The normal return should be determined under a suitable pricing method. In practice, a one-sided method, likely the CPM, will be applied; see Treas. Regs. §§ 1.482-6(c)(3)(i)(A), 1.482-3, 1.482-4, 1.482-5 and 1.482-9. 1064. Treas. Regs. § 1.482-6(c)(3)(i)(B)(2). 1065. This last measure will only be relevant where R&D costs are relatively constant over time and the useful lives of the IP contributed by all parties is approximately the same.

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unavailable in practice.1066 One is therefore left with estimating the relative values of the contributed IP based on capitalized or current R&D costs. The author finds this restriction somewhat peculiar for two reasons. First, there tends to be little correlation between R&D costs and the value of successful IP.1067 Intangible development costs are therefore generally unsuitable as proxies for the value of unique intangibles. The use of such data for benchmarking purposes may yield unreliable transfer pricing allocations. The author shares the view of Professor Langbein that the specified US PSM “in effect … is a method of fractional apportionment that used a single allocation factor – intangible property development costs – to accomplish the allocation of combined profit”.1068 Second, the determination of IP development costs is dependent on a range of management and financial accounting assessments, for instance, on how indirect costs shall be allocated between the relevant business activity and the other activities of the controlled taxpayer, as well as assumptions regarding the useful life of the IP. Such assessments may be manipulated in order to provide a certain outcome.1069 Why the regulations in light of this have made a profit split based on R&D costs the default US solution is a good question. Presumably, this is due to the fact that R&D costs are verifiable “objective” amounts.1070 1066. The 1993 proposed PSM provisions (§ 1.482-6T in 74 FR 38830-01) recognized that external benchmarks for the relative value of unique intangibles employed in a controlled transaction would normally be unavailable. See also the 1988 White Paper (Notice 88-123), at p. 101. 1067. The 1988 White Paper (Notice 88-123), the preamble to the 1994 regulations (59 FR 34971-01), as well as the final PSM provisions themselves in Treas. Regs. § 1.482-6 recognize that IP development costs generally will have no bearing on the true value of the developed IP. 1068. Langbein (2005), at p. 1071. 1069. Treas. Regs. § 1.482-6(c)(3)(ii)(C)(3). 1070. The author also finds it unfortunate that the US regulations chose to illustrate the PSM solely through an example in which capitalized R&D costs are used as proxies for relative values; see Treas. Regs. § 1.482-6(c)(3)(iii). The example pertains to a US parent that has developed a patented material (Nulon), which it licenses to its European subsidiary. To determine the royalty rate to be paid by the subsidiary, the example uses the ratio of capitalized R&D and marketing expenditures divided by sales. The fundamental problem with the example is that R&D costs generally cannot serve as an estimate of the value of the developed IP (simply because the value of the IP rarely will have any causal link to the development costs). Thus, there is no way of knowing whether the royalty rate professed by the example also allocates business profits from the locally owned marketing IP to the parent, even though the parent should have no stake in that profit. It can also be noted that the 2009 final services regulations (74 FR 38830-01) provide two profit-split examples; see Treas. Regs. § 1.482-9(g)(2), Examples 1 and 2. Both are rather voluminous and ultimately provide little guidance.

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The residual allocation pattern of the specified US PSM should be seen as inherently unreliable due to its dependence on R&D costs. The methodology should generally be rejected under the best-method rule. Instead, an unspecified application of a residual profit split should be used. The proposed profit split provisions included in the temporary 1993 US regulations allowed “other methods of approximating the relative values”, i.e. an unspecified profit split.1071 To apply this pattern, it had to be shown, to the satisfaction of the IRS, that the selected measure provided an economically valid basis for the allocation of the residual profits. This profit allocation pattern was omitted as a specified allocation pattern in the 1994 final regulations, due to the general availability of using unspecified pricing methods.1072 Thus, an unspecified application of the residual profit split will, in fact, constitute an unspecified transfer pricing method under the US regulations. This unspecified method should split the residual profits pursuant to a critical facts-and-circumstances-based assessment of the causal relationship between unique IP contributed to the value chain and the residual profits akin to the assessments applied in pre-1994 regulation case law, with Eli Lilly being the prime example. The assessments rested on a thorough functional analysis of the intangible value chain and had a tendency towards an equal split of the residual profits.1073 The major innovation in Eli Lilly and the 1988 White Paper, and later the CPM, was to decompose the value chain inputs into routine and non-routine contributions. Allocating normal returns to routine contributions may 1071. 58 FR 5310-01. 1072. See Treas. Regs. § 1.482-4(d). 1073. In PPG Industries Inc. v. CIR (55 T.C. 928 [Tax Ct., 1970]), the split was 55/45; in Eli Lilly & Co. v. US (372 F.2d 990 [Cl.Ct, 1967]), the split was 68/32; in Eli Lilly and Company and Subsidiaries v. CIR (84 T.C. No. 65 [Tax Ct., 1985], affirmed in part, reversed in part by 856 F.2d 855 [7th Cir., 1988]), the split was 45/55; in G.D. Searle & Co. v. CIR (88 T.C. 252 [Tax Ct., 1987]), the split was 25% of the foreign subsidiary’s net sales, allocated to the United States (the split of the residual profits is unknown, but presumably, it was rather equal); in Bausch & Lomb Inc. v. CIR (92 T.C. No. 33 [Tax Ct., 1989], affirmed by 933 F.2d 1084 [2nd Cir., 1991]), the split was 50/50; the precise split in E.I. Du Pont de Nemours and Co. v. US (1978 WL 3449 [Cl.Ct., 1978], adopted by 221 Ct.Cl. 333 [Ct.Cl., 1979], certiorari denied by 445 U.S. 962 [S.Ct., 1980], and judgment entered by 226 Ct.Cl. 720 [Ct.Cl., 1980]) is unknown, but a considerable portion of the residual profits were allocated to the United States; and the split in Hospital Corporation of America v. CIR (81 T.C. No. 31 [Tax Ct., 1983], nonacquiescence recommended by AOD- 1987-22 [IRS AOD, 1987], and Nonacq. 1987 WL 857897 [IRS ACQ, 1987]) was 75/25, in favour of the United States.

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be relatively straightforward once these contributions have been identified. The crux lies in the allocation of residual profits to two or more items of unique IP that are all necessary components in the value chain. It is the author’s assertion that this particular problem will normally not be possible to solve with any objective accuracy. One should have realistic expectations of the precision of profit splits. Metaphorically put, both hot water and ground coffee beans are necessary ingredients to make a good cup of coffee, and one would be of little value without the other for the purpose of yielding the intended result. The ideal of an accurate allocation of residual profits that align with the actual relative value of the involved IP based on causality should realistically be relinquished.1074 Weighing the relative values then becomes a matter of judgement. In the author’s view, there should be two guiding stars for this assessment. First, unique IP should only be allocated residual profits that it actually has contributed to. In other words, causality must be proven, even if the extent of causality is unknown. Second, if all items of IP employed in the value chain are necessary components for the generation of residual profits, there should be a presumption of an equal profit split.1075 This will limit the extent of potential allocation errors. The author finds this reasoning to be largely in line with the following description of the BALRM with the profit split addition in the 1988 White Paper: In splitting this residual amount between the related parties, it is not necessary to place a specific value on each party’s intangible assets, only a relative value. Of course, it is easier to state this principle than to describe in detail how it is to be applied in practice. In many cases, there will be little or no unrelated party information that will be useful in determining how the split would be determined in an arm’s length setting. Furthermore, the costs of developing intangibles, even if known, may bear no relationship to value, especially in the case of legally protected intangibles, and generally should 1074. It may often be possible to estimate the value of IP underlying successful products (with established track records, current cash flows and projections of future growth) with reasonable reliability. The Darvon pill in Eli Lilly and the Zantac pill in GlaxoSmithKline Holdings (Americas) are examples of such products. Even though such IP can be valued in and of itself, it will be difficult to allocate the value chain profits among the IP value chain contributions. 1075. Alternatively, it may be that one of the intangibles employed in the value chain clearly is of lesser importance for the generation of residual profits. For instance, sales of patented pharmaceutical products are often driven by the extent to which physicians prescribe the pharmaceuticals to their patients. It is reasonable to assume that physicians are mainly motivated by the qualitative aspects of the compounds, including side-effects and required dosages, and less by the trademarks they are sold under. In such cases, it may be reasonable to attribute the lion’s share of the residual profits to the manufacturing intangible.

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How operating profits may be split under the methodology

not be used to assign relative values to the parties’ intangible assets. Splitting the intangible income in such cases will largely be a matter of judgment.1076 (Emphasis added)

Such a facts-and-circumstances-based assessment stands in stark contrast to the arbitrary allocation of residual profits yielded by the default R&D cost solution under the specified US PSM. The dangers of not basing the allocation of residual profits on underlying causal relationships has also been amply demonstrated in practice, where multinationals have used the “Nulon” example (contained in the US profit split method regulations) to actively argue for unrealistically low buy-in payments under the previous generation of US cost sharing regulations.1077

9.3.3. Profit split allocation patterns allowed under the OECD TPG Like the US regulations, the OECD TPG also describe two main allocation patterns for the PSM, i.e. contribution analysis and residual analysis.1078 The main content of these allocation patterns is essentially the same as under the US regulations. The contribution analysis splits the profits based on what independent enterprises would have adopted in comparable transactions, while the residual analysis first allocates a normal market return to routine value chain contributions before the residual profits are split among the unique IP value chain contributions. Profits may be split under both allocation patterns based on the division extrapolated from CUTs, such as from joint venture arrangements, pharmaceutical collaborations or co-marketing or co-promotion agreements.1079 If there are no reliable CUTs upon which to base the profit split (which will normally be the case), the assumption will be that independent parties would have split the relevant profits in proportion to the value of their respective contributions to the generation of profits in the controlled transaction.1080 The split may then be based on an assessment of the relative value 1076. See White Paper (Notice 88-123), at p. 101. 1077. See Treas. Regs. § 1.482-6(c)(3)(iii); and supra n. 1070. 1078. BEPS Action 10, Revised guidance on profit splits, paras. 35 and 37, respectively. 1079. Id., at para. 52. 1080. See the critical comments in Robillard (2017a) and Robillard (2017b), where it is argued that this application of the PSM resembles formulary apportionment, taking into account that external benchmarking data is not applied to allocate the profits. While the author sees the logic in this, he does not agree. It must be assumed that unrelated parties would have allocated profits according to their respective bargaining

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contributions as measured by the contributed functions, assets and risks through profit-splitting factors.1081 Contrary to the US regulations, the OECD TPG do not set out any real restrictions on which profit-splitting factors may be used to allocate profits, as long as the factors reflect the key contributions to value in relation to the controlled transaction.1082 Asset-based profit-splitting factors (tangibles, intangibles, capital employed, etc.) may be used when there is a strong correlation between the contribution of the relevant assets and the creation of value in the controlled transaction.1083 The valuation of such assets for the purpose of determining relative values will be highly discretionary.1084 Market values should, in the author’s view, generally be used, as historical cost values (e.g. based on capitalized R&D expenses) are generally not indicative of real value. Further, cost-based profit-splitting factors can be used when it is possible to identify a strong correlation between relative expenses incurred and relative value contributed to the controlled transaction.1085 Other profit-splitting factors are also allowed, such as incremental sales, employee compensation and hours worked.1086 Such factors will generally not be appropriate for allocating residual profits, as they will lack influence on the relative values of unique value chain contributions. In summary, the 2017 OECD TPG contain a broad description of allowed profit-splitting factors, which, in essence, does not restrict how the PSM can be applied; “all bets are off”, so to speak.1087 In the author’s view, the core area of concern for the OECD should have been to provide guidance on how to ensure that the profit-splitting factors selected are truly correlated with the creation of value in the controlled transaction. After all, the powers and realistic alternatives, as indicated by the relative worth of their value chain contributions. 1081. BEPS Action 10, Revised guidance on profit splits, para. 53. This is, in reality, the same as a split according to the relative bargaining powers of the respective parties. On use of the concept of bargaining power in transfer pricing, see Blessing (2010b), where it is argued that application of the concept should be confined to splitting residual profits from IP value chains under the PSM. Blessing also ties the concept to the realistic alternatives of the controlled parties; see Blessing (2010b), at p. 170. See also infra n. 1125. 1082. BEPS Action 10, Revised guidance on profit splits, at para. 54. 1083. Id., at para. 64. 1084. Id., at para. 60. 1085. Id., at para. 66. 1086. Id., at para. 57. 1087. This may trigger a risk of diverging profit split assessments from taxpayers and jurisdictions. Poor harmonization among jurisdictions in the application of profit splits has already been highlighted by IFA branches; see Rocha (2017), at p. 231.

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How operating profits may be split under the methodology

whole point is to ensure that the profit split reflects the relative value of the controlled value chain contributions. To achieve this, it is crucial that the profit-splitting factors chosen are capable of dividing profits pursuant to underlying causality of value drivers. The focus of the current OECD TPG on describing possible profit-splitting factors is likely due to the fact that the PSM has been perceived to be subjective, supposedly caused by allocation keys that can be difficult to verify from objective evidence. Due to this, there has likely been a drive towards presenting profit-splitting factors as being objective. The author is sceptical of this “objective” allocation key approach. Even if the keys themselves are objective, in the sense that the number of employees, costs, etc. are easily verifiable, the relationship between the keys and residual profits are not. Quite on the contrary, “objective” allocation keys will normally be poor indicators of the relative value of unique IP employed in a value chain. If “objective” allocation keys are used to distribute residual profits without any sanity check with respect to whether the chosen allocation key actually is capable of reflecting underlying causality, this will, in effect, be formulary apportionment.1088 The author finds it important to bear in mind that the PSM does not – and cannot – allocate income with objective precision.1089 In his view, the most reliable allocation of residual profits under the PSM will be based on a concrete, facts-and-circumstances assessment of causality, not formulaic allocation keys. When the precise influence (causality) of each item of IP on the residual profits is impossible to ascertain objectively, an equal profit split may realistically be the most sensible solution. In the author’s opinion, no formulaic allocation key may replace the effectiveness of a critical functional analysis and thorough assessment of the evidence in each particular case. The elaboration on “objective” allocation keys contained in the 2017 OECD TPG can be seen as a step in the wrong direction. An example of the unfortunate consequences that basing the split of residual profits under the PSM on “objective” formulaic allocation keys may have is the experience of the US tax authorities under the previous costsharing regulations, where taxpayers argued in favour of low buy-in valuations based on rapid depreciation of capitalized intangible development costs, resulting in the migration of valuable, US-developed intangibles at 1088. For discussions on theoretical proposals for profit splits based on formulary apportionment, see, e.g. Avi-Yonah (2010); and Avi-Yonah et al. (2009). 1089. In this direction, see also Schön (2010a), at p. 248.

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low valuations.1090 In the author’s view, there is a clear risk of BEPS if “objective” allocation keys are further embraced by the OECD. Instead, the OECD TPG should more clearly emphasize that the split of residual profits over the entire duration of the controlled agreement should reflect the relative values of the non-routine contributions of the controlled parties to the intangible value chain. Only then will the allocation of intangible operating profits be aligned with the creation of intangible value. Nevertheless, the use of “objective” allocation keys to split operating profits may be more reliable when the PSM is applied to allocate operating profits from value chains that rely solely on routine contributions, such as the sale of generic products or services, as an alternative to the one-sided methods in cases in which there are reliability concerns surrounding the available comparables (e.g. in the “economically significant risks” applications discussed in section 9.2.). It may be reasonable to assume that the potential causal link between such “objective” keys and routine market returns is stronger than the case would be for a causal link between such “objective” keys and residual profits.

9.4. The PSM in valuation scenarios The PSM will, in practice, typically be used to determine an annual royalty rate for intra-group transfers of limited rights to unique IP (licensing scenario), i.e. to allocate profits among controlled parties on a yearly basis. The method may, however, also be used for the purpose of determining the value of full rights to IP that is transferred intra-group (valuation scenario). The 2017 OECD TPG contain some guidance on this latter application of the PSM.1091 While the US regulations lack a direct counterparty to this general OECD profit split valuation guidance, the US cost-sharing regulations allow the application of the PSM for the purpose of determining the value of a buy-in payment (which is valuation in a specific context). The author will tie some comments to this, with a focus on the OECD guidance. 1090. See the discussion of the 2007 US CIP valuation approach in sec. 14.2.3. 1091. The 2013 OECD Revised discussion draft on transfer pricing aspects of intangibles (2013 RDD) introduced guidance on the application of the PSM in some particular valuation contexts (including some examples); see paras. 166-170. The wording was brought over without changes to para. 6.146 of the 2014 OECD Guidance on Transfer Pricing Aspects of Intangibles, OECD/G20 Base Erosion and Profit Shifting Project, Action 8: 2014 Deliverable (2014D), but was not finalized (as opposed to the guidance for a range of other issues), indicating that there was controversy surrounding para. 6.146. The 2015 text contains the same language as that in the 2014D.

320

The PSM in valuation scenarios

Firstly, the 2017 OECD TPG assert that the PSM may be applied to price a sale of full rights to IP.1092 This means that the method will be applied to allocate among the controlled parties the value estimate that results from a discounted cash-flow (DCF)-based valuation.1093 The author is not convinced by the logic of the OECD TPG on this point. If the purpose is to price the transfer of ownership of a specific item of IP from one controlled entity to another, why should there be a basis to apply a profit split? Surely, the transferer should be entitled to the entire value of an intangible that it owns. In the author’s view, the method should be inapplicable in this case, because the transferee will not have contributed value that should entitle it to a split of the profits. He refers to the discussion of the US income method to price the contribution of a pre-existing intangible to a cost-sharing arrangement (CSA) in section 14.2.8.3., which is significantly similar to the issue at hand in most respects. Further, the 2017 OECD TPG suggest that the PSM, through a DCF valuation, can be applied to pricing transfers of partially developed intangibles.1094 The relative value of the IP-development contributions rendered prior to the transfer (as embodied in the transferred intangible) and after the transfer may then be used to determine the split. The value of partially developed unique IP comes from its potential for coming to fruition, i.e. reaching completion and being applied in a value chain to earn profits. A valuation must therefore, in the author’s view, rest on two main estimates. First, the future profits allocable to the completed IP must be determined, likely using a DCF valuation. This is the “normal” assessment under the PSM, albeit in a valuation context. The assessment will refer to the value chain for a particular future product. The valuation must be based on the best estimates of revenue, costs and growth in future periods, discounted using a risk-adjusted rate. The net present value (NPV) of the operating profits from the sales of the product must – as always under the PSM – be allocated between the routine and non-routine contributions to the value chain, with normal market returns and residual profits, respectively. If the non-routine contributions also include other intangibles than the completed IP, the valuation must include a split of the NPV of the residual profits between these intangibles, based on the normal assessment of the relative values of the non-routine contributions. 1092. OECD TPG, para. 6.149. 1093. The new guidance on valuation must be taken into account; see OECD TPG, paras. 6.153-6.180. See also the discussion of the new 2015 guidance on valuation in ch. 13. 1094. OECD TPG, para. 6.150.

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Second, it must be determined how much of the value allocable to the completed IP is due to the partially developed intangible. The question here will, in practice, be to determine whether the transferer, subsequent to the transfer of the partially developed intangible, will continue to perform the important development functions.1095 If he does, the entire value allocated to the completed IP should be used as the price for the partially developed intangible. For instance, it may be that the transferer has carried out the important functions pertaining to R&D up until the transfer, and will continue to do so subsequent to the transfer, while the transferee funds the remaining development. In this case, the transferer should be entitled to the entire residual profits after a risk-adjusted return has been allocated to the intangibles’ development funding.1096 It will normally be contrary to the alternatives realistically available to the transferer entity to not allocate all residual profits to it. In reality, this is akin to applying the TNMM in the context of a valuation. However, if the transferee does contribute important development functions that contribute to the completion of the partially developed intangible, the transferee should be allocated a portion of the NPV of the completed IP that corresponds to the relative value of his development contributions. This will reduce the value allocable to the transferer, and thereby the arm’s length transfer price of the partially developed intangible. This solution would be akin to applying the PSM in the context of a valuation. The recent US cost-sharing regulations include provisions on the valuation of pre-existing intangibles that are contributed to a CSA.1097 These rules assume that the entire value of the pre-existing intangibles should be allocated to the transferer, based on the view that the first-generation intangible is the platform and the key value driver for subsequent versions of the intangible developed under the CSA. The regulations allow a profit split only if the transferee contributes other unique inputs to the cost-sharing activity.1098 Outside of CSAs, it cannot, in the author’s view, always be presumed that the transferee should not be entitled to any residual profits from a partially developed intangible. This issue must be assessed concretely, and the question will be whether the transferee

1095. See the analysis of the “important functions doctrine” in sec. 22.3.2. 1096. See sec. 22.4. for an analysis of the remuneration of IP development funding under the 2017 OECD TPG. 1097. Treas. Regs. § 1.482-7. 1098. Treas. Regs. § 1.482-7(g)(7).

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The OECD PSM is limited to information known or reasonably foreseeable at the outset

contributes any important R&D functions to the remaining development process. Lastly, the 2017 OECD TPG state that the PSM can be applied in order to price the transfer of limited rights to a fully developed intangible.1099 In this scenario, the method is used to evaluate the relative values of the nonroutine contributions to the intangible value chain in order to determine the split of the residual profits. The question is what portion of the combined operating profits is allocable to the transfer of the limited rights to this particular IP. In other words, this is the traditional licensing scenario seen from the point of view of one of the parties contributing unique intangibles to the value chain. The author refers to the discussion of the endorsed OECD profit split allocation patterns in section 9.3.3.

9.5. The OECD PSM is limited to information known or reasonably foreseeable at the outset The 1995/2010 OECD TPG restricted application of the PSM to anticipated profits,1100 i.e. to profits that were “known or reasonably foreseeable” at the time at which the controlled transaction was entered into.1101 The US PSM is not limited in the same way, due to the US commensurate-withincome approach, which ensures that the allocation of operating profits under the method is aligned – in every income period – with the actual IP value chain contributions of the controlled parties. The 1995/2010 OECD limitation was relevant in two contexts: (i) when the initial taxpayer pricing was based on the PSM; and (ii) when other pricing methods were applied.1102 With respect to context (i), the 1995/2010 OECD TPG warned that the taxpayer “could not have known what the actual profit experience of the business activity would be at the time that the conditions of the controlled transaction were established”.1103 1099. OECD TPG, para. 6.152. 1100. 1995/2010 OECD TPG, paras. 2.128 and 2.130. 1101. This should be seen in light of the general stance that the 1995/2010 OECD TPG took on the issue of periodic adjustments to controlled intangibles transfers with fixed pricing structures. See the analysis of periodic adjustments in ch. 16. 1102. This structure stems from the 1994 OECD discussion draft (see paras. 139 and 141). 1103. OECD TPG, para. 2.128. This wording is, in essence, the same as in the 1994 OECD discussion draft, para. 139.

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This logic is, in the author’s view, flawed. Expected profits are relevant, but not decisive, for agreeing on a split. The point under the PSM is that the controlled parties beforehand agree to split the operating profits, whatever they may prove to be, based on an assessment of the relative value of the functions, assets and risks that they are going to contribute to the intangible value chain. Thus, the focus will be on the relative value of the inputs that each controlled party brings to the value chain, not on the absolute amount of monetary outputs. Logically, it should not matter whether the actual operating profits prove to be significantly smaller or larger than projected at the time at which the controlled transaction was entered into. Contrary to the 1995/2010 OECD TPG restrictions on periodic adjustments of controlled transactions that use fixed pricing structures, controlled PSMpricing provisions should be seen as dynamic, as the relative values of the non-routine contributions may fluctuate during the course of the controlled agreement. With respect to context (ii), where the PSM is used to review an initial pricing based on a method other than the PSM (e.g. the CUT method), the 1995/2010 OECD TPG limited application of the PSM to taking into account the “information known or reasonably foreseeable by the associated enterprises at the time the transactions were entered into, in order to avoid the use of hindsight”.1104 Here, the problem was whether the initial, and typically fixed, pricing should be shielded from a subsequent PSM-based reassessment if the actual profits were outside what reasonably could have been expected at the time at which the controlled transaction was entered into. This issue would rarely be triggered in practice because the initial allocation of residual profits would then have been founded on a CUT-based method, which would be a rare occurrence.1105 Much has happened in international transfer pricing jurisprudence since the “known or reasonably foreseeable” PSM delimitation was introduced into the 1995 OECD TPG. The allocation of operating profits based on data of actual profits is now commonplace. The widespread use of the TNMM and taxpayer year-end adjustments is a testament to this.1106 The 2017 1104. OECD TPG, para. 2.130. See also paras. 2.11 and 3.74; and the discussion in the 1994 OECD discussion draft, para. 141. 1105. Such a reassessment would, in effect, constitute a periodic adjustment. The author refers to the discussion on periodic adjustments in ch. 16. 1106. See the analysis of year-end adjustments in ch. 15.

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The OECD PSM is limited to information known or reasonably foreseeable at the outset

OECD TPG have kept the “known or reasonably foreseeable” limitation, but have watered it down considerably.1107 Controlled profit splits of actual profits are now allowed when the controlled parties share the assumption of the same economically significant risks or separately assume closely related economically significant risks.1108 Outside of such scenarios, however, controlled profit splits are limited to anticipated profits.1109 Regardless of whether the agreed profit split refers to anticipated or actual profits, the basis upon which the profits are split (i.e. the selection of profit splitting factors, the calculation of profits, etc.) must generally be determined using information known or reasonably foreseeable at the time at which the controlled transaction was entered into, unless major unforeseen developments have occurred that would have resulted in a renegotiation of the agreement had it occurred between independent parties. In order for this restriction to bear any meaning, it must be interpreted as “locking” the basis of the profit split at the time at which the controlled transaction is entered into. An arm’s length profit split should not, in the author’s view, be locked at the outset. It should reflect the actual controlled value contributions on an annual basis. It will often be the case that the relative value of the controlled parties’ non-routine contributions to the intangible value chain will change over the years. For instance, with a patent being the most valuable contribution initially, the marketing IP becomes more valuable in later phases. If the split is fixed at the outset and does not take into account such changes, the split should not, in the author’s view, be regarded as set pursuant to the relative values of the parties’ contributions, as causality will be lacking in subsequent periods. This is a problem. For instance, if the split was locked at 60/40 at the outset based on estimates of the values that would be contributed to the value chain by the controlled parties while it later turns out that the split should have been 50/50 if it was to reflect the actual values contributed, the locked royalty will overcompensate one group entity and undercompensate the other group entity based on the actual relative values. Such results should not be accepted, as they do not reflect profit allocations that are aligned with value creation. Profit splits that are locked at the outset represent obvious risks of BEPS, as it will be difficult for tax authorities to prove that 1107. BEPS Action 10, Revised guidance on profit splits, para. 46. 1108. Id., at para. 44. 1109. Id., at para. 45.

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the basis for the split was not founded on sound information at the time at which the controlled transaction was entered into. The OECD should, in the author’s view, discard the current remnants of the “known or reasonably foreseeable” limitation and adopt an approach akin to the US commensurate-with-income standard to ensure that the only profit splits that are accepted are those that, on an annual basis, reflect the actual relative values of the controlled parties’ value chain contributions.

326

Chapter 10 Location Savings, Local Market Characteristics and Synergies 10.1. Introduction In this chapter, the author will analyse the 2017 OECD Transfer Pricing Guidelines (OECD TPG) on the allocation of incremental operating profits due to location savings, other local market features and synergies.1110 These profit allocation issues have not previously attracted much attention in the OECD TPG.1111 The 2017 guidance should be seen as a response from the OECD to the growing discontent among some jurisdictions, particularly high-growth developing economies (e.g. China and India), with respect to the modest income assigned to them by multinationals under controlled profit allocations based on the one-sided pricing methods.1112 These jurisdictions feel entitled to something more than just a normal market return on routine functions.1113 It was therefore important for the OECD that these issues were addressed as part of the larger BEPS Project.1114 The debate on where incremental operating profits due to local market features should be taxed is best seen as part of the larger discussion on the alignment of operating profits with value creation. The topic is not whether such incremental profits should be taxed, but where (more precisely, whether the source state should be entitled to tax these incremental operating profits).1115 Regarding terminology, both “location savings” and “other local market features” fall under the umbrella term “location-specific advantages” (LSAs).1116 In this chapter, however, the author will refer to location savings separately in order to follow the structure of the 2017 OECD TPG. Further, in line with established terminology, he will refer to incremental operating 1110. OECD TPG, paras. 1.139-1.173. 1111. Some brief and general comments were made in the 2010 OECD TPG; see paras 1.55 and 1.57. 1112. See the analyses in sec. 2.4. on the principal model and in ch. 8 on the one-sided profit-based methods. 1113. For comments on the UN transfer pricing manual, see, e.g. Wittendorff (2012a). For comments on the India chapter in the manual, see PwC (2012). 1114. The BRICS countries (Brazil, Russia, India, China and South Africa) participated in the deliberations of Working Party 6. 1115. On this topic, see Francescucci (2004a), at p. 72. 1116. On this topic, see also Schön et al. (2011), at pp. 82-83; and Wilkie (2014a).

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profits from location savings and LSAs as cost savings and location rents, respectively.

10.2. A lead-in to the topic: The incremental operating profits at stake As discussed in the previous chapters, the OECD transfer pricing methods rest on the fundamental distinction between routine and non-routine value chain contributions. The methods fundamentally assume that the residual profits that are left after a normal market return has been attributed to routine inputs are due solely to the non-routine inputs employed in the value chain (normally, unique intangible property (IP)). The methods are, in this sense, rudimentary tools. They see only two things, namely (i) routine inputs entitled to a normal market return; and (ii) non-routine inputs entitled to the residual profits.1117 While the economic logic behind this paradigm is undoubtedly sound, critical voices are questioning the view on causality inherent to – as well as the equity of – the assumption that residual profits are entirely due to unique IP. This problem goes to the core of why multinationals exist. These enterprises reap a range of benefits that solely domestic enterprises do not. The critical voices argue that residual profits in fact include some incremental operating profits that are caused by cost savings, other local market characteristics and synergies, and that these profits should be taxable at the source (as opposed to being allocated as royalties to a foreign IP-owning group entity). This argument is fuelled by the perception that there may not always be a bright line between unique IP and LSAs.1118 The author would like to illustrate the issue at hand through an example. Imagine that a multinational based in Norway owns valuable patents and trademarks for an established luxury yacht brand with an outstanding reputation. It decides to enter the Chinese market and distribute and sell yachts there. China has a large and growing market for such luxury products, consumers with significant purchasing power and a preference for Western products. Also, the degree of local competition for this specific type of boat is limited, and the infrastructure for doing business in China is ideal. These local market features will likely interact with the unique IP that is 1117. See also Francescucci (2004a), at p. 73, on this point. 1118. The author will revert to this issue in the discussion of the allocation of profits from LSAs in sec. 10.7.

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A lead-in to the topic: The incremental operating profits at stake

applied in the yacht value chain, in the sense that, under the specific market conditions in China, the IP is more valuable in this market than in some other markets. Let us assume that the group distribution and sales entity in China realizes the following operating profits in 2017: Sales Cost of goods sold (COGS)

10,000 2,200

Gross profit

7,800

Operating expenses

3,300

Operating profit

4,500

The activities performed locally in China are routine assembly, distribution and sales functions. Let us say that the transactional net margin method (TNMM) is applied to remunerate these functions, and the arm’s length range displays a median of a 6% operating margin. This will entail that the Chinese distribution entity should be allocated an operating profit of 600 as taxable income. The residual profits of 3,900 are allocated to the Norwegian parent as royalty payments for the unique IP licensed to the Chinese distribution entity. Similar results are likely not entirely uncommon in practice under the widespread application of the one-sided methods by multinationals. Let us for now assume that, in theory, it is possible to break down the Chinese operating profits of 4,500 as follows: Operating profits due to routine functions Operating profits due to unique intangibles

600 3,300

Operating profits due to cost savings

200

Operating profits due to other LSAs

400

As in the outset scenario, it will be straightforward to determine that the normal market return for routine functions of 600 should be allocated to China and that the residual profits due to the unique intangibles of 3,300 should be allocated to Norway. What is more challenging is to determine which jurisdiction should be allocated the right to tax the 200 in cost savings and the 400 in location rent. That question – or more specifically, the

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OECD’s position on it – will be the theme of discussion in the rest of this chapter. Before the author embarks on that analysis, however, he would like to comment on some basic positions pertaining to how incremental operating profits from location savings and LSAs arguably should be allocated.

10.3. Which jurisdiction should be entitled to tax incremental operating profits: The basic arguments The transfer pricing rules generally turn on causality. For instance, the one-sided methods allocate normal market returns on routine value chain contributions because such inputs create normal returns. Further, the profit split method (PSM) splits residual profits among each unique item of IP employed in the value chain based on the assumption that each item of IP contributes to the creation of the residual profits (in proportion to the relative IP values). The same logic applied to cost savings and location rents results in the argument that incremental operating profits should be allocated to the jurisdiction where they materialize, i.e. the source state. The typical counter-argument to this causality position is that incremental operating profits should be allocated based on the bargaining power of the group entities participating in the controlled transaction. This argument is closely linked to the underlying logic of the current OECD transfer pricing methodology, which attributes the greatest bargaining position to group entities that contribute non-routine value chain inputs. Thus, group entities that perform only routine functions (e.g. contract manufacturing and distribution) will have a lesser bargaining position than group entities that own unique IP. This reasoning will result in the extraction of cost savings and location rents from source state taxation by foreign group entities that own the unique intangibles. Further, a multinational could object to the allocation of incremental operating profits to source states’ routine value chain contribution entities by arguing that it could alternatively have outsourced the relevant routine functions to a third-party service provider in the same market for a price that would pass along the incremental operating profits to it as a buyer and only allocate a normal market return to the provider as compensation for its generic functions. This is equal to claiming that comparable third-party enterprises in the same market are unable to retain cost savings and loca330



What are location savings?

tion rents due to price pressure from competitors. This argument goes to the heart of the arm’s length principle. If the third-party routine function providers were truly comparable to the tested party, it would be contrary to the arm’s length principle to allocate more income to the controlled party than to an unrelated party that carries out comparable transactions under similar circumstances. The outsourcing argument is forceful, but only valid if it indeed is a realistic alternative for the multinational in question to outsource the relevant activity to third parties. That may not always be the case. Factors such as highly integrated value chains, the protection of sensitive business information from potential competitors and quality control may keep it from outsourcing its business activity to third parties. A multinational will generally want to protect its valuable IP.1119 Notions of equity may also be used as arguments for allocating incremental operating profits, from the perspective of both source states and multinationals. Perceptions of equity are subjective. The author’s view is that cost savings and location rents should be allocated to the source state if the following two factors are present: (i) it indeed is possible to distinguish incremental operating profits caused by location savings and LSAs from profits due to the unique IP employed in the value chain; and (ii) the business activity of the local entity could not realistically have been outsourced to third parties. This may be the case if the local entity contributes unique inputs to the value chain (e.g. goodwill or know-how) and therefore is entitled to a cut of the residual profits. It may also be the case if the local entity is a mere routine input provider, but the multinational, for business reasons (secrecy, quality control, etc.), is unable or unwilling to outsource the relevant functions to third parties.

10.4. What are location savings? The 2017 OECD TPG refer to location savings as “cost savings attributable to operating in a particular market”.1120 The notion of location savings is also discussed in the business restructuring guidance, where it is stated that “location savings can be derived by an MNE [multinational enterprise] group that relocates some of its activities to a place where costs … are lower than in the location where the activities were initially performed”.1121 1119. See sec. 2.3. for comments on business rationales underlying intangible property (IP) value chains. 1120. OECD TPG, para. 1.139. 1121. OECD TPG, para. 9.126.

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Thus, location savings fundamentally make up a relative concept that is only meaningful if the costs of performing an activity in one market are compared to the costs associated with a realistic alternative of performing the same activities in another market. This is, as the author will revert to below, a problematic point of departure. Arm’s length pricing is based on benchmarking controlled profit allocations against the profits of comparable third parties, which implies that the controlled and third parties must carry out their business in the same market. In the context of a business restructuring, it will be easy to identify the alternative market. This will be the high-cost country in which the activity was performed prior to the relocation. Location savings are the specific cost savings of performing the business activity in the country to which the activity was relocated, compared to the costs that were incurred in the country where the activity was performed prior to the restructuring. In other contexts, however, it does not seem obvious as to how cost savings should be determined. For instance, a multinational carries out distribution, marketing and sales in many jurisdictions. The salaries paid to the local employees, as well as other operating expenditures, such as housing costs and social security payments, may be lower in China and India as compared to, for instance, France or Norway. If one were to determine the location savings that accrue to the Chinese entity, which country should one choose as the cost benchmark? Obviously, there is no true alternative country available, in the sense that distribution, marketing and sales in China can only be carried out there. The 2017 OECD TPG do not offer any indication of how to solve this. One possible solution could be to use comparative average cost data from the multinational’s operations in other jurisdictions (average hourly wage, rent per square feet, etc.). Alternatively, one could use general statistical data available on wages, rent, etc. in different jurisdictions. This data could then be compared to the costs of the relevant local entity in order to determine whether any location savings have accrued to it. These approaches would result in hypothetical cost savings from not performing the activities in other markets, as opposed to cost savings compared to similar unrelated entities operating in the same market. Unrelated entities in other markets are not comparable to the tested party, as they operate under different market conditions. The approach would be contrary to the arm’s length principle, which requires parity in the treatment between group entities and comparable third-party enterprises. By allocating such 332



The allocation of cost savings

hypothetical cost savings to a local entity, the local jurisdiction would eat into operating profits that should be taxed in the jurisdiction where the other party to the controlled transaction is resident. Thus, if the Chinese entity in the example in section 10.2. is a routine contract manufacturer, its profits should be compared to similar unrelated contract manufacturers in China. If the profits of the Chinese entity lie within the arm’s length range of the operating margins realized by the comparable third-party contract manufacturers, no additional income should be attributed to it. The author will not go further into this here, as the allocation of cost savings will be discussed in section 10.5. However, because the notion of cost savings is a relative concept, it was necessary to provide these comments in order to introduce the concept.

10.5. The allocation of cost savings 10.5.1. Introduction The 2017 OECD TPG on the allocation of cost savings draw upon the solutions carved out in the 2009 business restructuring guidance.1122 The OECD position is that retained cost savings should be allocated as independent enterprises operating under similar circumstances would have done.1123 Two scenarios are discussed in the OECD TPG, namely the allocation of cost savings in the presence and the absence of local comparables, which are analysed in sections 10.5.2.-10.5.3.

10.5.2. Local comparables are available The OECD’s position is that location savings most reliably can be allocated based on profit data extracted from “comparable entities and transactions in the local market”.1124 If such local comparable third-party enterprises can be identified, no comparability adjustments shall be performed. This position will, in practice, likely result in full extraction of incremental operating profits due to cost savings from the source jurisdiction to a foreign group entity. The result is contrary to the causality argument that value should be taxed where it is created. It may also be of questionable equity. 1122. 2010 OECD TPG, paras. 9.148-9.153; see also OECD TPG, para. 1.140. 1123. For the US position on location savings, see the discussion in sec. 6.6.5.4. 1124. OECD TPG, para. 1.142.

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The result is, however, consistent with the view that group entities that possess little in the way of bargaining power should only reap a normal rate of return on their routine value chain contributions.1125 The result is also consistent with a multinational’s realistic alternative of outsourcing routine functions to third parties for a normal market fee that passes along the cost savings to it. This argument is, as mentioned, not relevant if the multinational is unable or unwilling to outsource local functions.1126 If so, the use of local comparables to benchmark the profits of the tested party will break away from the fundamental principle that transfer pricing should be aligned with the alternatives realistically available to the controlled parties. This is not a trivial problem. The question is whether the realistic alternatives metanorm, or the specific rule that local comparables may be used if they are available, should prevail. The wording of the specific rule seems to convey a conscious position of the OECD on this issue. The author’s understanding of paragraph 1.142 of the OECD TPG is that it forces the use of local comparables, even if it concretely would not be realistic for the multinational to outsource the functions performed by the tested party. The specific rule should thus trump the realistic alternatives principle based on a lex specialis view. The use of local comparables to remunerate group entities in markets with pronounced location savings (and other LSAs) may cause disagreements between a multinational and the foreign jurisdiction, on the one side, and the source jurisdiction, on the other. The multinational and the foreign jurisdiction will likely argue that they have complied with the OECD TPG as long as they have remunerated the local group entity under a one-sided method using local comparables. The source state could argue that the application of one-sided pricing methodology using local comparables will not be reliable unless comparability adjustments are carried out (specifical-

1125. For an informed discussion of the use of the bargaining power concept in transfer pricing, see Blessing (2010b), at p. 168. Blessing warns, at p. 173, that the concept is not suitable for application outside the context of allocating residual profits from IP value chains under the profit split method. His text was written before the 2017 OECD guidance on the allocation of incremental profits from location savings, local market characteristics and synergies was issued. Based on Blessing’s reasoning, however, the author finds it likely that his warning would not apply to the use of the bargaining power concept for allocating incremental profits from location savings and the like, as this indeed lies close to the allocation of residual profits under the profit split method. For further information on bargaining power, see Parekh (2015), at p. 305. 1126. See the comments on the reasons underlying foreign direct investment (FDI) in sec. 2.3.

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The allocation of cost savings

ly, that the operating profits of the local comparables should be increased to reflect hypothetical cost savings). The author will illustrate this through an example. Let us assume that a multinational in the consumer electronics industry has a low-risk distribution entity in China that performs routine distribution, marketing and sales functions. The entity licenses valuable marketing IP from a foreign group entity. Using Chinese third-party distributors of electronic devices as comparables, the arm’s length range under the TNMM shows that the low-risk distributor (LRD) should earn an operating margin between 6-10%, with a median of 8%. Chinese LRD (with cost savings)

TNMM (local comparables)

Sales

10,000

COGS

3,000

Gross profit

7,000

Operating expenses

2,000

Operating profit

5,000

800

50%

8%

Operating margin

This will result in the allocation of an operating profit of 800 to the Chinese LRD. The residual profits of 4,200 are, in their entirety, allocated to the foreign licenser entity as royalties for the licensed marketing IP. It is, however, clear that the Chinese LRD benefits from hypothetical location savings in the form of low labour and housing costs. Compared to the average costs of these items in the other jurisdictions in which the multinational operates, the Chinese LRD realizes cost savings of 20%. If one adjusts for these location savings, the following operating profit data is achieved: Chinese LRD Chinese LRD Difference (with cost savings) (without cost savings) Sales

10,000

COGS

3,000

3,600

Gross profit

7,000

5,800

Operating expenses

2,000

2,400

400

Operating profit

5,000

4,000

1,000

50%

40%

Operating margin

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The hypothetical cost savings are 1,000. If these are added to the normal market return of 800 that the LRD is supposed to earn pursuant to the TNMM, the total income taxable in China would be 1,800, with the residual profits of 3,200 allocated to the foreign licenser entity. This theoretical example of a source state reassessment illustrates two things. First, a comparability adjustment was carried out for the local third-party comparables in order to take into account hypothetical location savings that were not reflected by said comparables at the outset. Through this adjustment, the source state was able to identify that 1,000 of the LRD’s operating profits were due to hypothetical location savings. As discussed, the OECD’s position is that such adjustments should not be performed.1127 This position, if a one-sided method is applied to allocate income to a tested party, will ensure that the entire local operating profits, apart from a normal market return on the routine functions carried out by the local LRD, are allocated to the other party to the controlled transaction, similar to the outset scenario in the example above. Second, the example allocated the entirety of the hypothetical location savings to the tested party. This may arguably be justified by the causality argument: because the hypothetical cost savings were created in the source state, in the sense that the multinational would incur relatively higher costs had it alternatively performed the same functions in a different, high-cost, jurisdiction, the hypothetical incremental profits should be taxed in the source state. To this, a multinational could object on two grounds. First, it would be contrary to the arm’s length principle to allocate hypothetical cost savings to the source state. The Chinese group entity would be made worse off than comparable unrelated contract manufacturers also operating in China. Second, the multinational alternatively could have outsourced the routine functions performed by its local entity to unrelated third parties in the same jurisdiction for a normal market fee. The MNE would then be able to extract the location savings. The author finds that the economic logic underlying the OECD’s position is convincing. Transfer pricing rules must ensure that group entities are subject to the same treatment as comparable unrelated enterprises. However, the author is not entirely convinced that this result necessarily will

1127. OECD TPG, para. 1.142, last sentence.

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The allocation of cost savings

provide an equitable allocation of operating profits among jurisdictions in all cases. At least to this author’s knowledge, one of the first transfer pricing cases that properly dealt with the issue of location savings was Eli Lilly.1128 In that case, the location savings that were derived from manufacturing the Darvon pill in Puerto Rico were entirely allocated to the local contract manufacturing subsidiary. At that time, the US Tax Court did not even question whether this was the correct allocation choice. After all, it was clear that the location savings were sourced from Puerto Rico and that they were distinct from profits both from the manufacturing patents owned by the Puerto Rican subsidiary and the marketing IP owned by the US parent. The author finds this worthy of contemplation.1129 It seems, however, that multinationals over time have designed their transfer pricing structures so that profits from location savings are extracted from local market jurisdictions, typically in connection with the transfer pricing of IP, labelling incremental profits as residual profits. This practice is, of course, fully in line with the accepted OECD transfer pricing methods, in particular the TNMM. As a commentary on these practices, the 2017 OECD TPG express that “the transfer of intangibles … may make it possible for one party to the transaction to gain the benefit of local market advantages … in a manner that would not have been possible in the absence of the … transfer of the intangibles”.1130 The tax authorities in developing countries, such as China and India, have clearly stated that they do not find it equitable that the entire profits from cost savings (or other LSAs) are extracted from source taxation.1131 Chinese tax authorities have expressed that they find that the extraordinarily

1128. See the analysis of the case in sec. 5.2.4.3. 1129. It should, however, be noted that in Eli Lilly and Company and Subsidiaries v. CIR (84 T.C. No. 65 [Tax Ct., 1985], affirmed in part, reversed in part by 856 F.2d 855 [7th Cir., 1988]), the relevant manufacturing functions were migrated from the United States to Puerto Rico, giving the factual pattern a distinct business restructuring flavour. The allocation of incremental operating profits from cost savings in Eli Lilly should therefore not be taken as a strong argument in favour of source state taxation outside the context of business restructurings. 1130. OECD TPG, para. 1.148. 1131. It was apparently important for the United States to reject the proposal from China in the run-up to the 2015 revision of the OECD TPG providing that incremental profits from cost savings and local market characteristics should be allocable to the local group entity. See Brauner (2017), at sec. 2.3.1.

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high profits displayed by local group entities are “rightly earned” by the Chinese taxpayer entity1132 and that they will tax the entire location savings from contract R&D carried out by Chinese group entities.1133 Comparatively, the Indian tax authorities favour the PSM for allocating cost savings (and location rents).1134 They view the competitiveness of the Indian market, the availability of substitutes and cost structure as key elements in determining the bargaining power of the controlled parties. This is, as far as the author can see, effectively the same as deeming these factors unique value chain contributions. The Indian tax authorities will thus likely not accept full allocation of cost savings to a foreign group entity, even if the local group entity pursuant to a traditional functional analysis focused solely on functions, assets and risks is sufficiently remunerated under a one-sided pricing method. While the Chinese and Indian tax authorities differ in their methodological approaches, they both agree that local comparables cannot be used to determine the benefit from cost savings.1135 The Indian tax authorities argue that benchmarking the tested party based on local comparables would not be consistent with the arm’s length principle, as any arm’s length transaction fundamentally will be reliant on both parties benefiting from the transaction. Thus, cost savings (and location rents) should be split between the controlled parties in a manner that leaves neither party with none or all of the incremental profits,1136 seemingly in contrast to the resolute view of the Chinese tax authorities.

1132. 2017 United Nations Practical Manual on Transfer Pricing for Developing Countries (UN PMTP 2017), para. D.2.4.4.7. 1133. UN PMTP 2017, para D.2.4.4.9, provides an example of a contract R&D scenario in which this position is applied. Taxation of the location savings is carried out by way of rejecting the costs of the local Chinese subsidiary as the base upon which the profits are calculated, instead using the average cost base for the multinational’s R&D centres in developed countries. In the example, the cost base of the Chinese entity is 100, while the average cost base of R&D centres in developed countries is 150. The relevant full cost mark-up is 8%. If applied to the cost base of the Chinese entity, it would yield a taxable income of 100 × 0.08 = 8. The income is, however, calculated on the basis of the higher cost base of the R&D centres in developed countries of 150, yielding an income for the Chinese entity of 150 × 0.08 = 12, thereby taxing the entirety of the location savings in China. 1134. UN PMTP 2017, para. D.3.7.3. 1135. UN PMTP 2017, paras. D.2.4.3 and D.3.7.4 for China and India, respectively. 1136. Compare UN PMTP 2017, paras. D.2.4.4.11 and D.2.4.4.12 for China with para. D.3.7.3 for India.

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The allocation of cost savings

In conclusion, the current OECD stance with respect to intra-group allocation of cost savings in the presence of local comparables is clear. The allocation must be based on local comparables, and no comparability adjustments shall be made to the data.1137 The author suspects that this position will result in continued use by multinationals of the TNMM to remunerate their local routine entities. It appears that the objections from developing countries have not been accepted by the OECD. It remains to be seen whether these jurisdictions will adhere to this rule.1138

10.5.3. Local comparables are unavailable There will often be local comparables available on which to base benchmarking of local routine entities under a one-sided method. This will, in part, be due to the relaxed comparability requirements under the TNMM.1139 Nevertheless, local comparables may be unavailable in some cases, for instance, if the tested party performs highly specialized functions within a small niche market. The 2017 OECD TPG state that the allocation of cost savings in such cases shall be based on the fact that “the conditions that would be agreed between independent parties would normally depend on the functions, assets and risks of each party and on their respective bargaining powers”.1140 This position is illustrated through an example in which a multinational relocates the routine manufacturing of branded clothes to a low-cost coun-

1137. OECD TPG, para. 1.142. This will result in the extraction of incremental profits due to cost savings from the source state, which is the same result as under the 1995 OECD TPG; see Francescucci (2004a), at p. 73. 1138. For insightful and critical comments on the OECD position, see also Brauner (2016), at p. 104, as well as at p. 109, where it is stated that “ the final report does not pick up on the locational savings point which rejects the demand of developing countries such as China and India for profit allocations to market economies. This decision demonstrates the failure of the developing countries in BEPS, the importance of agenda setting, where changes require consensus and are otherwise rejected to the benefit of those enjoying the status quo … and the success of the OECD in the deferral of the discussion of the demands of source countries for more taxation with its pseudo economic agenda of arm’s length tweaking”. 1139. See the conclusions on the interpretation of the transactional net margin method’s (TNMM’s) comparability requirements in sec. 8.6.6.6. 1140. OECD TPG, para. 1.143, see also OECD TPG, para. 9.149. See the critical comments on this solution in Brauner (2016), at p. 104: “At what point of difference would it be better to consider a transaction as not having appropriate comparables and deserving of special measures (beyond arm’s length)? These questions were left unresolved.”

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try.1141 With respect to whether local cost savings should be allocated to the low-cost country manufacturing entity, the OECD TPG state: [I]n such a situation, a contract manufacturer at arm’s length would generally be attributed very little, if any, part of the location savings. Doing otherwise would put the associated manufacturer in a situation different from the situation of an independent manufacturer, and would be contrary to the arm’s length principle.1142

This position is based on the premise that the multinational “has the option realistically available to it to use either the affiliate … or a third party manufacturer”.1143 The logic behind this is that the OECD assumes that a third-party manufacturing entity would pass along all of its cost savings to the multinational. While that may be true, it cannot automatically be assumed that it would be a realistic option for a multinational to outsource part of its value chain to third parties, as there may be a need to, for instance, protect business secrets.1144 Nevertheless, this “bargaining power” rule that the OECD has now established to allocate profits from cost savings will generally strip local routine group entities from all profits from cost savings, as such entities normally will be deemed to have inferior bargaining power as compared to group entities that own unique and valuable IP.1145 Even though the above-quoted wording is relatively clear on the point that the tested (routine) party shall normally not retain any incremental profits from cost savings, it must be equally clear that the OECD’s position only applies to group entities that do not contribute any unique value chain inputs. Thus, if a local manufacturing or distribution entity owns valuable know-how or local marketing IP, it may have a relatively strong bargaining position and should likely be allocated a portion of the profits from cost savings. The OECD’s position is that “in appropriate circumstances … e.g. if there are significant unique contributions such as intangibles used by both … the use of a transactional profit split may be considered”. Thus, the OECD approves of the use of the profit split method here to allocate profits (in-

1141. OECD TPG, paras. 9.150-9.151. 1142. Id. 1143. OECD TPG, para. 9.151. 1144. See the discussion in sec. 2.3. 1145. See Blessing, supra n. 1125.

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What are other LSAs?

cluding incremental profits from cost savings).1146 The 2017 OECD TPG include an example of when such a profit split approach would be appropriate, in which a multinational outsources specialized engineering functions to a subsidiary in a country where wage costs are significantly lower and the subsidiary is in possession of technical know-how.1147 Cost savings are allocated along with the residual profits in proportion to the relative values of the contributed IP, based on the logic that the relative IP values are indicative of the bargaining positions of the parties, and therefore that they should determine also the allocation pattern for location savings.

10.6. What are other LSAs? The following discussion is not limited to the business restructuring context, but is geared towards the more general situation in which a multinational performs its activity in a range of jurisdictions that offer varying degrees of LSAs. According to the 2017 OECD TPG, “other local market features” include (i) purchasing power and product preferences of local buyers; (ii) whether the local market is growing or contracting; (iii) the degree of competition; (iv) local infrastructure; (v) the availability of skilled workers; (vi) the proximity to markets; and (vii) other “similar” factors that may affect local operating profits.1148 These factors affect distribution, marketing and sales. Thus, most LSAs pertain to the marketing and sales part of a value chain. Further, LSAs will normally be more pronounced in developing than in developed countries, typically due to market growth and increasing consumer bases, a preference for Western products, the availability of skilled workers, etc. LSAs attract both horizontal and vertical foreign direct investment.1149 For instance, Western multinationals in the consumer electronic business may invest in China to take advantage of highly-educated, low-cost labour and a sophisticated network of suppliers and operate assembly plants in China in order to take advantage of being in close proximity to the market.1150

1146. Incremental profits would be split also under the 1995 OECD TPG if the profit split method were applied; see Francescucci (2004a), at p. 73. 1147. OECD TPG, paras. 9.152-9.153. 1148. OECD TPG, para. 1.144. 1149. See the discussions on FDI in secs. 2.2. and 2.3. 1150. See UN PMTP 2017, para. D.2.4.4.1.

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The fundamental assumption is that LSAs contribute to increased operating profits for the local group entity, either through increased sales or decreased COGS or operating expenses, relative to what the profits would have been without the LSAs. Nevertheless, LSAs are elusive. First, while hypothetical cost savings can be estimated with reasonable reliability based on third-party benchmarks of cost levels in other markets, the same cannot be said for most LSAs. For instance, how is one to determine the amount of increased sales in China due to specific local consumer preferences? Second, and likely most important, some LSAs may be closely connected to the concept of unique IP.1151 It may, for instance, be difficult to determine when an LSA (e.g. local consumer preferences) becomes so particular that it must be deemed unique IP (e.g. goodwill) owned by the local group entity. In such cases, it may be challenging to separate the location rent from the particular LSA from the residual profits generated by the unique IP employed in the value chain. Further, in markets where there are significant LSAs present, there will likely be strong interactions between the unique IP employed in the value chain and the LSAs. Trademarks and goodwill related to specific products will typically interact with LSAs, such as consumer preferences and purchasing power, adding increased local value to the IP. It might therefore be useful to think of LSAs as drivers that can add more value to unique IP owned by a multinational. The more valuable the unique IP is (e.g. the Apple logo) and the more pronounced the LSAs are (e.g. Chinese consumers’ preference for Western products), the stronger this interaction will likely be. An interesting question is whether the added value resulting from this interaction should be viewed as a non-routine value chain contribution from the local group entity. If so, it will be clear that the local entity shall be entitled, as the owner of the local IP, to a portion of the residual profits from local sales, i.e. a profit split approach shall be applied. If not, the local entity will only be entitled to a normal market return on its routine contributions under a one-sided approach. The point of departure is, of course, that LSAs are not IP. If the interactions between the unique IP owned by a multinational and LSAs are strong and particular enough, however, the existence of local marketing IP should be recognized (e.g. know-how or goodwill).

1151. On this issue, see also Wilkie (2014a), at p. 356.

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The allocation of location rents

10.7. The allocation of location rents 10.7.1. Introduction As for location savings, the existence and extent of location rents must be determined, as well as whether they are passed along to suppliers or customers. If location rents that are not passed along are found to exist, the question will be of how these shall be allocated among the group entities contributing to the controlled transaction under the 2017 OECD TPG. This will be discussed in the following sections, with respect to scenarios in which local comparables are present and absent in sections 10.7.2. and 10.7.3., respectively.

10.7.2. Local comparables are available The position taken in the 2017 OECD TPG is that location rents should be allocated among group entities based on: […] comparable uncontrolled transactions in that geographic market between independent enterprises performing similar functions, assuming similar risks … such transactions are carried out under the same market conditions as the controlled transaction, and, accordingly… specific adjustments for features of the local market should not be required.1152

It follows from this that incremental operating profits due to location rents may be allocated based on unadjusted local comparables. This entails that profit data from functionally comparable local third-party enterprises can be used under the TNMM to allocate a normal market return to the tested party.1153 This OECD’s position will likely extract all or most of the location rents from source taxation.1154

10.7.3. Local comparables are unavailable If profit data from comparable local third-party enterprises upon which to base the allocation of incremental operating profits due to location rents

1152. OECD TPG, para. 1.145. 1153. See also Wittendorff (2016), at sec. III.D. See the analysis of the TNMM comparability requirements for the use of aggregated third-party profit data in sec. 8.6. of this book. 1154. This is the same result as under the 1995 OECD TPG; see Francescucci (2004a), at p. 73. See also the comments from Brauner (2016), supra n. 1138.

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cannot be identified, the position taken in the 2017 OECD TPG is that it will be necessary to consider the following:1155 − whether a market advantage or disadvantage exists; − the amount of any increase or decrease in operating profits, vis-à-vis identified comparables from other markets, that are attributable to the local market’s advantages or disadvantages; − the degree to which benefits or burdens of local market features are passed on to independent customers or suppliers, as well as where they are not fully passed on; and − the manner in which independent enterprises operating under similar circumstances would allocate such benefits or burdens among themselves. Foreign comparables may be used under the 2017 OECD TPG to ascertain the amount of location rent. This will result in a hypothetical location rent, in the sense that the tested party is compared to third-party enterprises operating in other markets. The author imagines that it will likely be challenging to ascertain whether the incremental operating profits of the foreign comparables are in fact due to foreign LSAs or to unique IP. Once the hypothetical location rent has been identified, the question is of how it shall be allocated. As for the allocation of cost savings, this will depend on the bargaining power of the group entities involved in the controlled transaction.1156 If the local party is a routine input provider, the location rent should be allocated in full to the party that contributes non-routine inputs to the value chain. If the local entity contributes unique IP, it is entitled to a portion of the residual profits (including location rents) that is commensurate with the relative value of its non-routine contribution to the value chain. Thus, a profit split approach is adopted by the OECD in this latter scenario.1157

10.8. Synergies The 2017 OECD TPG state: MNE groups … may benefit from interactions or synergies amongst group members that would not generally be available to similarly situated independent enterprises. Such group synergies can arise … as a result of combined pur1155. OECD TPG, para. 1.146. See the critical comments on this OECD position in Brauner (2016), supra n. 1140. 1156. OECD TPG, para. 1.146. See also OECD TPG, para. 9.153; and Blessing, supra n. 1125. 1157. Incremental profits would be split also under the 1995 OECD TPG if the profit split method were applied; see Francescucci (2004a), at p. 73.

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chasing power or economies of scale, combined and integrated computer and communication systems, integrated management, elimination of duplication, increased borrowing capacity, and numerous similar factors.1158

Positive synergies may result in incremental operating profits.1159 While the previous generation of the OECD TPG did not specifically address the issue of how incremental operating profits due to group synergies shall be allocated among group entities, the 2017 OECD TPG deal with the issue. The point of departure taken in the OECD TPG is that no separate allocation is necessary for incremental operating profits due to incidental benefits that a group entity realizes solely as the result of being part of a larger MNE group.1160 This will be the situation when a subsidiary, due to the high credit rating of its parent, is able to borrow from unrelated lenders at a lower rate than it could have attained on a stand-alone basis and then borrows at the same rate from a related lender.1161 The interest rate charged on the internal loan is at arm’s length because it is the same rate charged in the uncontrolled transaction. No adjustment is required with respect to the synergy that enabled the subsidiary to borrow at the low rate from the unrelated lender, as it arose from the subsidiary’s group membership alone and not from any deliberate, concerted action by the MNE. As there is no requirement to separately allocate incremental operating profits from this category of synergies, the profits will blend into the residual profits from unique IP. Separate allocation is, however, required for incremental operating profits due to synergies from deliberate, concerted group actions,1162 for instance, benefits in the form of group discounts due to centralized group procurement1163 or if the parent in the example above had provided a guarantee to

1158. OECD TPG, para. 1.157. On the allocation of profits from synergies, see, in particular, the thorough discussion in Peng (2016). For a recent comparative overview of the treatment of synergies in different (IFA branch) jurisdictions, see Rocha (2017), at p. 218. 1159. See Kane (2014) for an analysis of whether synergy value should be characterized as an intangible, with the profits allocable by way of a formula. See also Koomen (2015b), at p. 240 on synergies, as well as Brauner (2015), at p. 78. 1160. OECD TPG, para. 1.158 (see also para. 7.13). This is also the result under the US regulations (which deal with synergies as comparability factors), pursuant to which passive association benefits are not compensable; see Treas. Regs. § 1.482-9(l)(3)(v). See Odintz et al. (2017), at sec. 2.2.4.2 on this point. On the topic of passive association, see, in particular, Blessing (2010b), at p. 155. 1161. OECD TPG, paras. 1.164-1.166, Example 1. 1162. OECD TPG, para. 1.161. This is also the result under the US regulations, which require compensation for purposeful group activities; see Treas. Regs. § 1.482-9(l)(1). See Odintz et al. (2017), at sec. 2.2.4.2 on this issue. 1163. OECD TPG, para. 1.160. For a very thorough (and interesting) discussion of procurement and allocation of profits, see Peng (2016), at pp. 385-392.

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the third-party lender that put the subsidiary in the position to borrow at the lower rate.1164 The incremental profits from this category of synergies shall be allocated among group members “in proportion to their contribution to the creation of the synergy”.1165 For instance, incremental profits due to large-scale procurement strategies will typically be allocated pursuant to each group entity’s purchase volume. In other cases, such as in the guarantee example, it will be more appropriate to price the specific synergistic benefit separately. Either way, incremental operating profits from deliberate, concerted group action synergies must be specifically allocated among group entities. The 2017 OECD TPG do not offer any justification as to why they distinguish between incremental operating profits that arise from incidental benefits, on the one side, and from synergies from deliberate, concerted group actions, on the other side.1166 The author imagines that it may be difficult to reliably identify some of the more ambiguous synergy benefits (incidental) and that it therefore would not be meaningful to require specific allocation of such benefits. However, in the example in which the subsidiary is able to borrow at a lower rate solely due to its status as a group member, the benefit is easily identifiable. The author therefore struggles to see that there is a logical reason for why this benefit should not be attributed to the subsidiary.

1164. OECD TPG, para. 1.167. On the transfer pricing of guarantees, see, in particular, the informed discussion in Blessing (2010b), at p. 162, which includes comments on General Electric Capital Canada Inc. v. The Queen (2010 DTC 1007, affirmed by the Federal Court of Appeal [2011 DTC 5011]), where the disallowance by the Canadian tax authorities of a tax deduction for a 1% guarantee fee taken by the Canadian subsidiary of a US parent was rejected on the basis that the fee was found to be consistent with what would have been paid to an arm’s length guarantor. On this case, see also Horst (2011); Ward (2010); Roin (2011), at p. 216; and Koomen (2015b), at p. 240. For further information on guarantees, see also, e.g. Pankiv (2017), at p. 58; Ledure et al. (2010); Riedy et al. (2010); and Boidman (2011). 1165. OECDTPG, para. 1.162. See Peng (2016), at p. 380 and p. 385, where he underlines the positive aspects of applying a profit split approach to allocate the synergy profits. 1166. See also critical comments on this in Brauner (2016), at p. 105, as well as p. 109, where it is stated that “[t]he problem is that synergies cannot really be contributed to – they occur because of the affiliation of the parties involved. It is nonsense, therefore, to seriously attempt to allocate them to particular parties”. On the distinction, see, in particular, Peng (2016), at p. 382.

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Chapter 11 Transfer Pricing of Intangibles in the Post-BEPS Era under the OECD TPG 11.1. Introduction In this chapter, the author will briefly analyse how the 2017 OECD Transfer Pricing Guidelines (OECD TPG) envision the application of the currently accepted pricing methodology in the context of transfer pricing of intangible property (IP). The relevant methods for allocating operating profits from IP value chains are, in practice, the methods that were the subject of analysis in the previous chapters, namely (i) the comparable uncontrolled transaction (CUT) method; (ii) the transactional net margin method (TNMM); and (iii) the profit split method (PSM). Historically, there is no question that the OECD has preferred the CUT method. The recent BEPS revision of the intangibles chapter of the OECD TPG reveals an altered attitude of the OECD. The CUT method is no longer in vogue, but the PSM is. This PSM endorsement can be seen as a reaction to the shortcomings of both the CUT method (i.e. a lack of reliable comparables for unique IP) and the TNMM (i.e. that it allocates too little profits to source jurisdictions).1167 This new methodological preference from the OECD triggers an interesting question: Does it entail that the one-sided allocation of normal market return profits to source jurisdictions under the TNMM must be modified or brought to a stop? The author will discuss this in sections 11.3. and 11.4., respectively, after making some contextualizing remarks in section 11.2.

11.2. A transfer pricing paradigm under pressure Perhaps the most basic trait of the transfer pricing rules is that they are designed to allocate residual profits among jurisdictions in a way that mirrors where the intangible value is created. An implication of this is that residual profits shall not be allocated to jurisdictions that do not partake in IP development. This paradigm has drastic consequences for the international allocation of taxing rights over the operating profits of multinationals. There

1167. With respect to the transactional net margin method (TNMM), in this direction, see also Linares (2005), at p. 37. See also Vidal (2002), at p. 414.

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may be vast differences in the amount of taxable income allocated to countries that are entitled to residual profits and those that are not. The author will illustrate this through an example. Imagine that a multinational, through its Norwegian parent, performs and funds research and development (R&D) and holds ownership of all resulting IP. The multinational is present in 40 other countries, where it carries out routine distribution and marketing. Because the Norwegian entity alone provides the unique value chain inputs, it may extract all foreign operating profits that are left after TNMM-based normal market returns are allocated to the local routine input entities. Seen from the perspective of the Norwegian group entity, the transfer pricing rules function as “extraction tools” for the residual profits.1168 This form of centralized allocation of operating profits is controversial. A source jurisdiction in which a multinational carries out routine functions may observe that the local group entity has many employees, owns valuable tangible assets and carries out transactions that result in significant operating profits locally. Yet, very little of this profit is left for taxation at source. In other words, there may be a perceived mismatch between the level of local economic activity and local taxation. This appeared to be the case in the well-publicized Amazon.com and Starbucks hearings in the United Kingdom in 2012.1169 Such a perceived mismatch may trigger a sense of inequity, particularly in jurisdictions that offer significant location-specific advantages (LSAs) that multinationals benefit from, which may be further exacerbated if there is an impression that the extracted residual profits are not subject to much taxation in the jurisdiction where the foreign owner of the unique IP employed in the value chain is resident. This criticism is a protest against the core content of the current transfer pricing paradigm. Critics seem to be under the impression that the international community would be better off with transfer pricing rules that allocate operating profits commensurately with the overall economic activity carried out in source states, for instance, as indicated by the number of local employees, tangible assets, revenues, etc. (so-called “formulary apportionment”). The current rules are not designed for this purpose; rather, they seek to align the allocation of operating profits among the different entities within a multinational as third parties acting under similar circumstances 1168. See also sec. 2.4. for an overview of the centralized principal model. 1169. See, for instance, http://www.bbc.com/news/business-20559791 (accessed 1 Sept. 2015).

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would have done. Specifically, the current rules distinguish between routine and non-routine inputs to IP value chains, where the former inputs are only entitled to a normal market return, ensuring that residual profits are allocated only to the jurisdictions where intangible value is created. The formulary apportionment alternative professed by the critics would spread the residual profits across all jurisdictions in which the multinational does business. This would overcompensate most jurisdictions, in the sense that they would be allocated more operating profits than the routine value chain inputs provided by group entities resident in them are worth. The jurisdictions where intangible value is created would be undercompensated by not being allocated the entirety of the residual profits. In other words, they would not be assigned operating profits that are commensurate with the worth of the unique value chain inputs provided by the group entities resident there. Such a system would provide a form of equality, in the sense that taxing rights over the worldwide profits of a multinational would be divided equally among jurisdictions based on some predetermined allocation key (employees, assets, etc.). This alternative system would not, however, be rooted in economic reasoning, as it assumes that all value chain inputs, routine and non-routine, are worth the same. It would be unable to emulate the profit allocation results of transactions among third-party enterprises with genuinely conflicting interests, the hallmark of which is that competition will drive the prices for routine value chain contributions down to a level where the providers only reap a normal market return. This alternative system would therefore fail to provide parity in the tax treatment of unrelated and related parties. Even though the current system both allows and invites the use of onesided pricing methods to remunerate related routine input providers, there is the current perception that multinationals are applying the TNMM too aggressively and that the returns allocated to related routine value chain input providers in source states are unreasonably sparse. This criticism is rooted in the perspective of source states. The OECD has sought to address these concerns through the combination of the new rules on allocation of profits from location savings, LSAs and synergies (analysed in chapter 10), as well as the new guidance on the relative role of the transfer pricing methods, which will be analysed in this chapter. Before the author begins his analysis, however, he would like to point out that the perspective of the jurisdictions in which IP value is created must not be forgotten. These jurisdictions will likely not share the views of the 349

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source states. The argument will be that since the unique IP employed in the value chain – which, after all, is responsible for generating residual profits – is created there, the taxing rights to these profits should also be assigned there. The argument is supported by economic logic, which dictates that non-routine contributions should be allocated residual profits. In order to accomplish this allocation, it is necessary to apply the one-sided methods (in practice, the TNMM) to allocate a normal market return only to jurisdictions in which related routine value chain input contributors are resident so that no residual profits “leak” into these jurisdictions. Thus, there is tension between the interests of jurisdictions where the unique value chain inputs are developed and the jurisdictions in which they are exploited and their value materializes. The 2017 OECD TPG on IP ownership are designed to protect the first group of jurisdictions through the use of the “important functions doctrine” for assigning entitlement to residual profits.1170 At the same time, the new guidance on location savings, LSAs and synergies, as well as the new language on the use of transfer pricing methods in the context of IP value chains, seeks to take into account the perspective of the source states. This is not an easy balancing act for the OECD. The fundamental question is whether it is possible to allocate something more than a normal market return for the routine value chain inputs emanating from source states without diluting or fracturing the core economic logic upon which the arm’s length transfer pricing system is based.

11.3. Shall something more now be allocated to source jurisdictions? The TNMM is the king of the transfer pricing methods. It is likely the most applied method globally. Nevertheless, the 2017 OECD TPG display a lack of endorsement for the methodology in the context of IP value chains. This is done indirectly in two ways. First, a generally sceptical attitude towards the use of one-sided methods is expressed as follows:1171 “[O]ne sided methods, including the resale price method and the TNMM, are generally not reliable methods for directly valuing intangibles.”1172 This point is reiterated in paragraph 6.58 of the 1170. See the analysis of the “important functions doctrine” in sec. 22.3.2. 1171. See OECD TPG, paras. 6.129, 6.131, 6.138, 6.141, 6.146 and 6.209. 1172. OECD TPG, para. 6.141.

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OECD TPG, which states that “the reliability of a one-sided transfer pricing method will be substantially reduced if the party or parties performing significant portions of the important functions are treated as the tested party or parties”.1173 Given that it is outside the scope of application of the TNMM to allocate income to a tested party that contributes non-routine inputs to the intangible value chain, these statements convey a readily apparent truth, but nevertheless tone down the relevance of the one-sided methodology for IP pricing purposes. Second, the fact that the 2017 OECD TPG contain significant supplemental language on the CUT method and the PSM and introduce entirely new and thorough guidance on valuation techniques while adding nothing new for the TNMM further signals a reduced position of the TNMM.1174 Also, the new language on the PSM in the intangibles chapter of the OECD TPG states that “it should not be assumed that all of the residual profit after functional returns would necessarily be allocated to the licensor/transferor in a profit split analysis related to a licensing agreement”.1175 This can be read as a warning against applying the TNMM to remunerate a group entity that only provides routine inputs to the controlled transaction. In light of this generally negative attitude towards the TNMM, it can be asked whether the new 2017 OECD TPG entail a requirement to allocate something more to routine group entities in scenarios in which the TNMM nevertheless is applied. The clear point of departure is that no changes are made to the general guidance contained in the OECD TPG on the TNMM.1176 However, it is now stated: In some circumstances such mechanisms can be utilised to indirectly value intangibles by determining values for some functions using those methods and deriving a residual value for intangibles. However, the principles of para-

1173. The wording of the 2013 Revised discussion draft on transfer pricing aspects of intangibles (2013 RDD) is slightly different; see 2013 RDD, para. 81, which states that “the reliability of a one-sided transfer pricing method will be substantially reduced if the party performing the important functions is treated as the tested party”. (Emphasis added) The alteration is clarifying, but has no material impact on the message delivered. 1174. See OECD TPG, paras. 6.146-6.180. 1175. See OECD TPG, para. 6.152, last sentence. 1176. OECD TPG, paras. 2.56-2.107.

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graph 6.133 are important when following such approaches and care should be exercised to ensure that all functions, risks, assets and other factors contributing to the generation of income are properly identified and evaluated.1177 (Emphasis added)

The question is whether the quoted wording entails that the TNMM can no longer be applied as described in chapter II of the OECD TPG, or more specifically, whether an additional return must be allocated to source states on top of the normal TNMM market return for local routine value chain inputs. If so, the emphasized portion of the statement should be regarded as nothing less than an earthquake in international transfer pricing jurisprudence. The quoted statement is ambiguous. First, the distinction between directly and indirectly valuing intangibles is not entirely clear. Both the TNMM and the PSM fundamentally rely on first allocating a normal return to routine functions before allocating residual profits. In principle, the difference between the profit-based methods is, as mentioned, that under the TNMM, the residual profits are, in their entirety, allocated to one of the parties to the controlled transaction, while the PSM divides the residual profits among them. Thus, both methods “indirectly value intangibles”. In this regard, the TNMM is no different from the PSM. Second, the wording seems to limit the application of the TNMM to “some circumstances”, without clarifying what these are. Given that the TNMM already at the outset is a narrow method, confined to being applied only where the tested party is a pure routine input provider, it is not immediately intuitive whether the wording seeks to further narrow its field of application. The author’s impression is that it does indeed intend to do so. This interpretation is supported by the following sentence, which states that if the TNMM is applied, all functions, risks, assets and “other factors” contributing to the generation of profits must be properly identified and evaluated. This seems to indicate that a normal market return will no longer be sufficient, as routine group entities shall also be rewarded for “other factors”. Third, the delimitation is not technically clear. Paragraph 6.141 refers to paragraph 6.133, which, in broad language, lists a variety of factors to take into consideration (and presumably remunerate), such as “risks borne, spe-

1177. OECD TPG, para. 6.141.

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cific market characteristics, location, business strategies, and [multinational enterprise] group synergies among others”. The position taken by the 2017 OECD TPG on location savings and LSAs is to allow the use of local comparables to benchmark the profits that are attributable to local routine function providers.1178 This will normally result in the extraction of cost savings and location rents from source jurisdictions.1179 Thus, even though paragraphs 6.133 and 6.141 seem to indicate that the TNMM shall allocate an “additional” return to source states, the acceptance of local comparables effectively puts an end to that ambition in most practical scenarios. What if there are no local comparables available? The bargaining power of the controlled parties will then be key for allocating income.1180 If the local entity is a routine function provider while the foreign party to the transaction contributes unique IP, it is likely that cost savings and location rents will be extracted from the source. Thus, the result is similar to a standard application of the TNMM.1181 The new guidance on synergies will normally entail a separate pricing, which will not affect the general application of the TNMM.1182 Further, the reference in paragraph 6.133 to “risks borne”, “business strategies” and “others” introduces a general uncertainty as to which specific factors shall now attract remuneration pursuant to the 2017 OECD TPG, as well as under which methodology income shall be allocated to them and whether the remuneration shall be some form of a normal market return or a portion of the residual profits from unique IP. With respect to the factors of “others” and “business strategies”, an answer to this will necessarily first require a clarification of what is referred to by 1178. See OECD TPG, para. 1.142 for location savings (see also the discussion in sec. 10.5.2.); and OECD TPG, para. 1.145 for location-specific advantages (LSAs) (see also the discussion in sec. 10.7.2.). 1179. This was also the result under the 1995 OECD TPG; see the discussion in Fran­ cescucci (2004a), at p. 72. See also Roberge (2013), at p. 222. 1180. On the concept of bargaining power in transfer pricing, see Blessing (2010b). See also infra n. 1125. 1181. Alternatively, local comparables may be unavailable if the local group entity owns unique intangibles. The TNMM will then be inapplicable (this method only allocates a normal market return to controlled routine input providers), necessitating an application of the profit split method (PSM). The cost savings and location rents will be split among the controlled parties, along with the residual profits. 1182. See the discussion on the allocation of profits from synergies in sec. 10.7.3.

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these terms. “Risks borne”, in the context of unique IP, presumably refers to financial risk incurred through R&D funding, but this is far from clear. Financial risk should be rewarded a financial return commensurate with the risks taken, as determined on a separate basis. Such funding should not attract a general profit split.1183 “Business strategies” should not, in the author’s view, in and of themselves be subject to compensation. Of course, strategies will result in transactions, functions, assets and risks that are compensable, but that is a different matter entirely, not to mention that it will likely be impossible to reliably price “strategies” on a separate basis in practice. In conclusion, it is the author’s view that paragraphs 6.133 and 6.141 will not limit the application of the TNMM. It will still be possible to apply the method to allocate a normal return only to local routine functions and thereby extract residual profits from the source. The author will also add that he sees no sound basis for restricting application of the TNMM. The methodology should, in the author’s view, apply with full strength in the narrow circumstances for which it was designed, i.e. when the tested party renders only routine value chain contributions. If access to the TNMM is cut off in such ordinary scenarios, multinationals would likely be better off by outsourcing routine functions to third parties willing to perform them for a normal market return.1184 In other words, the allocation of an “additional” return to group entities that render routine value chain inputs will result in less favourable taxation of related parties than for unrelated parties. Transfer pricing rules must seek to attain parity in the taxation of controlled and uncontrolled transactions. Another thing is that tax authorities should be vigilant with respect to whether multinationals indeed do apply the TNMM in the manner that it was intended. With this, the author refers to the possibility that local IP should be recognized to a larger extent than what currently is the case. It is likely that a range of local “routine input providers” have developed goodwill, know-how or outright local marketing IP. If that is the case, the local group entity cannot be treated as the tested party under the TNMM. The method will be inapplicable in these scenarios. That may leave no other alternative than to apply the PSM. That will attract not only residual profits

1183. See the analysis of research and development funding remuneration under the OECD TPG in sec. 22.4. 1184. There may, however, be costs connected to such outsourcing; see the discussion on the choice between third-party outsourcing and foreign direct investment in sec. 2.3.

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from the local marketing IP to the source jurisdiction, but also a cut of the location savings and rent.1185

11.4. The relative roles of the CUT method, TNMM and PSM for the transfer pricing of intangibles The 2017 OECD TPG state that “the transfer pricing methods most likely to prove useful in matters involving transfers of one or more intangibles are the CUP method and the transactional profit split method”.1186 The danger with the CUT method is that it does not directly take into account the value chain contributions from the controlled parties. Instead, it refers to how third parties have priced a purportedly comparable IP transfer. If the transferred intangibles are not fully comparable, the CUT method may result in profit allocations that conflict with economic logic, e.g. that residual profits are allocated to an IP holding company without substance or to a group entity that performs only routine functions. In light of the new OECD emphasis on similar profit potential as a comparability requirement for CUTs involving unique IP,1187 as well as the scepticism towards comparability adjustments to such transactions,1188 the CUT method should, in practice, rarely be relevant for allocating operating profits from IP value chains.1189 That leaves the TNMM and the PSM. In contrast to the CUT method, where the main concern is the lack of reliability, the meagre OECD enthusiasm for the TNMM is due to the fact that it allocates a bare minimum of income to source states. In contrast, the PSM will provide more balanced results, allocating a portion of the residual profits from unique IP, as well

1185. The incremental profits from location savings and rent will be allocated along with the residual profits pursuant to the bargaining powers of the controlled parties, as determined by the relative values of their unique value chain contributions. 1186. OECD TPG, para. 6.145. 1187. OECD TPG, paras. 6.116 and 6.127. 1188. OECD TPG, para. 6.129. 1189. The author finds reason to add that the CUT method is also subject to reduced relevance on a more general level. The TNMM and the PSM will normally be easier to apply in the context of unique intangibles and will provide enough flexibility to render the CUT method largely redundant, both from the perspective of multinationals and tax authorities. The CUT method was more relevant in earlier transfer pricing practices, when there were fewer and less developed specified pricing methods available.

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as location savings and rent to source states.1190 Thus, an application of the PSM will likely be favoured by source states, but less so by multinationals and jurisdictions in which intangible value is created. There is no question that the 2017 OECD TPG prefer the PSM for the transfer pricing of intangibles.1191 As analysed in chapter 9, the 2017 OECD TPG have extended the scope of application for the PSM so that it now partly overlaps the scope of application of the TNMM. Further, the core profit allocation methodology underlying the PSM has gained increased significance in the OECD TPG through the new IP ownership provisions. The OECD guidance on IP ownership states that “in identifying arm’s length prices for transactions among associated enterprises, the contributions of members of the group related to the creation of intangible value should be considered and appropriately rewarded”.1192 The quoted statement signals a holistic approach to the allocation of operating profits from IP value chains, encompassing both the rules on transfer pricing and IP ownership. The difference between profit allocation assessments carried out under the OECD IP ownership rules and the PSM lies mainly the context in which the assessments are performed. The assessment of IP ownership pertains to the phase prior to the completion of the IP development. This will typically be before the intangible starts to generate cash flows. After this time, the IP may be employed in a value chain, along with other non-routine and routine contributions, and the PSM may be applied to allocate the residual profits. The important question is whether this comprehensive OECD preference towards the PSM has resulted in any concrete requirements to use the method in scenarios in which this previously was not the case. Given that the only alternative to the PSM in practice will be the TNMM, this question can largely be rephrased as an issue of whether the new guidance limits the application of the TNMM. The author’s conclusion in section 11.3. was that this is likely not the case.

1190. OECD TPG, para. 6.2. It should be noted that OECD TPG, para. 6.132 also emphasizes the importance of considering the economic consequences of the transaction when selecting a transfer pricing method. 1191. See Schön et al. (2011), at pp. 267-290, for a discussion of the future role of the PSM in transfer pricing (based on the 2010 OECD TPG) and a comparison with formulary apportionment. 1192. OECD TPG, para. 6.48.

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Thus, while the 2017 OECD TPG clearly encourage the application of the PSM, the author finds that there is little basis for claiming that there are any new requirements to do so. As the scope of application of the TNMM seems largely untouched, the principal point of departure remains that the TNMM can be applied when one party to the controlled transaction only contributes routine inputs. Going forward, the TNMM can therefore, as before, be used to extract residual profits from source jurisdictions by way of allocating only a modest normal market return to the routine group entities resident there. In this sense, the 2017 OECD TPG have brought little in the way of change.

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Chapter 12 Allocation of Residual Profits for Unique and Valuable IP Based on Unspecified Pricing Methods 12.1. Introductory comments Unspecified pricing methods are normally only used when the specified methods (i.e. the comparable uncontrolled transaction (CUT) method, resale price method, cost-plus method, transactional net margin method (TNMM) and profit split method (PSM)) are perceived as insufficient to allocate income from the controlled intangible property (IP) transaction.1193 Historically, unspecified methods have served as important drivers for the development of new specified methods. The TNMM, for instance, started out as an unspecified method under US law. The US Internal Revenue Service (IRS) developed the so-called “contract manufacturer” theory, which it used as its primary pricing argument in the roundtrip cases litigated in the 1970s-1980s, then as a “fourth method” under the 1968 US regulations.1194 According to this theory, a foreign group entity that has only contributed routine inputs to the value chain should not be allocated any residual profits. This theorem later resulted in the basic arm’s length return method (BALRM) of the 1988 White Paper and the comparable profits method (CPM) of the final 1994 regulations, which then led to the international adaptation of the TNMM in the 1995 OECD Transfer Pricing Guidelines (OECD TPG). Another example, and a modern-day parallel to the contract manufacturer theory, is the IRS’s assertion for the pricing of US-developed IP under the pre-2009 cost-sharing regulations, pursuant to which foreign group participants in a cost-sharing arrangement (CSA) that only contribute IP development funding should not be allocated residual profits.1195 The theory has now been codified as the specified income method of the current cost-sharing regulations.1196

1193. On the use of unspecified methods, see, e.g., Wittendorff (2010a), at pp. 658662. 1194. The author refers to the discussions in sec. 5.2.5. 1195. The 2007 Coordinated Issue Paper (CIP) outlines the unspecified income method; see the analysis in sec. 14.2.3. See also the discussion of Veritas Software Corporation & Subsidiaries v. CIR (133 T.C. No. 14 [U.S.Tax Ct. 2009], IRS nonacquiescence in AOD-2010-05) in sec. 14.2.4. 1196. Treas. Regs. § 1.482-7(g)(4).

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This illustrates that there is an interaction between the current specified transfer pricing methods, on the one side, and the development of unspecified methods, on the other. First, the more developed the specified transfer pricing methods are, the less need there will be to resort to unspecified methods. The point of the above IRS assertions was to allocate residual profits in an arm’s length manner in the context of new value chain structures that gave rise to challenges that could not properly be addressed through the then-available specified methods. Thus, unspecified methods may serve as “contingency valves” that can be used to allocate residual profits from controlled structures that are not susceptible to pricing under the current specified methods.1197 Second, there is an unclear line between dynamic interpretation of the current specified methods and the use of unspecified methods. It will depend on local jurisprudence and legal traditions and to what degree courts are willing to interpret and apply specified methods in a manner that they arguably were not originally designed for. In the case of the United States, the author’s impression is that the courts tend to follow the wording of the regulations closely and express an unwillingness to resort to dynamic interpretations based on the fundamental principles embodied in the relevant specified pricing method. An illustrative example of this is the US Tax Court’s rejection of the unspecified income method assertion of the IRS in Veritas. In the author’s view, the assertion could largely be seen as a tailored application of the existing specified CPM (due to the material similarities between the CPM and the income method as professed by the IRS). The IRS did not, however, argue along this line, so the issue was not addressed by the Court.1198 Given the sophistication of the specified methods available for the pricing of controlled IP transfers in the current US regulations and the 2017 OECD TPG, unspecified methods will generally rarely be relevant. To the extent that they are relevant, they will likely mainly serve as tools for tax authorities (e.g. the contract manufacturer and income method theories discussed above).1199 The one example of a taxpayer application of an unspecified 1197. It should also be acknowledged that the five specified pricing methods are flexible. A single specified pricing method may accommodate different pricing approaches. For example, an array of allocation parameters are allowed under the transactional net margin method (TNMM) and the OECD profit split method (PSM) (see the discussions in secs. 8.4. and 9.3.3., respectively). 1198. See sec. 14.2.4. for further discussion. 1199. This is because (i) the specified methods are so wide that they can normally accommodate taxpayer pricing assertions; and (ii) there may be increased penalty risks for taxpayers connected to the use of unspecified methods under US law; see IRC

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method that the author is familiar with pertains to US multinationals that, in their pricing of buy-ins under the pre-2009 cost-sharing regulations, used capitalized and depreciated research and development (R&D) costs to allocate residual profits under the PSM.1200 In sections 12.2. and 12.3., respectively, the author will discuss the extent to which tax authorities and taxpayers may apply unspecified transfer pricing methods under the US regulations and the 2017 OECD TPG to allocate residual profits in controlled IP transfers.

12.2. Unspecified methods under the US regulations The US regulations allow the application of an unspecified pricing method to allocate profits in controlled IP transfers.1201 The method must then “take into account the general principle that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, and only enter into a particular transaction if none of the alternatives is preferable to it”.1202 Further, “an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction”.1203 Thus, the realistic alternatives of the controlled parties is the decisive pri­ cing principle that all unspecified methods applied to allocate residual profits from controlled IP transfers under US law must adhere to.1204 The regulations contain an example that illustrates this restriction.1205 It pertains to a US parent that makes and sells a proprietary adhesive product in the United States. The parent licenses make-sell rights to the manufacturing IP on which the product is based for the European market to a local

sec. 6662(e), 26 U.S.C.A. § 6662, supplemented by the 2011 regulations in 26 C.F.R. § 1.6662-6. For an instructive and rather detailed analysis of transfer pricing penalties under US law, see Levey et al. (2007), at pp. 209-224, with further references. 1200. See sec. 14.2.3. 1201. Treas. Regs. § 1.482-4(a). If used, the methodology must comply with the general provisions of the regulations, including the best-method rule, the comparability requirements and the provisions for the arm’s length range; see Treas. Regs. § 1.482-1. The controlled allocation of IP income will be subject to periodic adjustments; see Treas. Regs. § 1.482-4(f)(2). The author analyses the US periodic adjustment provision in ch. 16. 1202. Treas. Regs. § 1.482-4(d)(1). 1203. Id. 1204. In this direction, see also Odintz et al. (2017), at sec. 2.2.5.1. 1205. Treas. Regs. § 1.482-4(d)(2).

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subsidiary, which in turn sells the product to related and unrelated parties for the market price of 550 per tonne. The controlled royalty rate is set to 100 per tonne. In determining whether the rate is at arm’s length, the realistic alternative for the parent to producing and selling the adhesive product itself for the European market is considered. Reasonably reliable estimates indicate that if the parent directly supplies the product to the European market, a selling price of 300 per tonne would cover its costs and provide it with a reasonable profit for its functions, risks and investment of capital. In other words, by licensing the manufacturing IP to the subsidiary, the parent forgoes a profit of 250 per tonne compared to the income that would accrue to it with its best realistic alternative. The example therefore concludes that the controlled royalty of 100 is not at arm’s length. This illustrates that the realistic alternatives requirement may serve as an effective barrier against controlled non-arm’s length allocations of operating profits. The focal point of the realistic alternatives assessment will normally be the allocation of profits to the transferer. The reason for this is simple: the transferer is the owner of the unique IP and should therefore, as the point of departure, be entitled to all residual profits from its own intangible. The realistic alternatives principle, as well as economic logic (and even common sense), dictate that there must be convincing reasons as to why the transferer should relinquish any of his residual profits to the transferee.1206 Such reasons will not exist according to the realistic alternatives principle if the controlled allocation of operating profits places the transferer worse off than he would have been with his best realistic alternative. The realistic alternatives principle is of fundamental importance in transfer pricing.1207 It underpins all transfer pricing methods and is the basic material link between the specified and unspecified methods. The CPM and the income method, for instance, may be seen as concrete manifestations 1206. This is the same basic reasoning that formed the foundation for the buy-in pri­ cing approach of the current US regulations. See Brauner (2016), at p. 114, where he describes the approach of the 2005 proposed cost-sharing regulations as follows: “The thought was that the party with existing intangibles and research capability would not permit a third party to invest in future development of crown jewel intangibles and receive profits beyond normal financial profits.” See also infra n. 1986. 1207. The significance of the realistic alternatives principle is pronounced in the context of valuation. The author refers to the discussions of the 2017 OECD valuation guidance in sec. 13.5. and of the income method of the US cost-sharing regulations (see Treas. Regs. § 1.482-7(g)(4)) in sec. 14.2.8.3. See also Bullen (2010), at pp. 544-562, on the role of the realistic alternatives principle in the context of non-recognition under the 1995/2010 OECD TPG, as well as for reflections pertaining to use of the principle in the context of transfer pricing at pp. 736-737.

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of the principle in the sense that the tested party is only allocated a normal return. This result aligns with the best realistic alternatives of a transferer (non-tested party) that transfers unique IP to a transferee (tested party) that only contributes routine inputs. The principle is also significant in determining whether there is sufficient comparability between the controlled transaction and purported CUTs, in particular, with respect to the issue of whether the IP transferred in the controlled and uncontrolled transactions have similar profit potential.1208 Further, the US regulations contain a rule that coordinates the CSA provisions with the general transfer pricing provisions applicable to intra-group IP transfers.1209 The point of the provision is to ensure that the principles, methods and comparability requirements set out in the CSA regulations are applied analogically to the pricing of IP transfers that do not qualify as CSAs (i.e. controlled IP development efforts where the participating entities share costs and risks under an arrangement that does not qualify as a CSA). Nonetheless, as the United States’ unspecified-method rule and CSA income method (the specified go-to method for buy-in pricing in the context of CSAs) are both based on the “realistic alternatives” principle, the primary consequence of this coordination rule will likely be to merely provide guidance on how to apply the highly-developed CSA pricing methods analogically, not to dictate pricing results that diverge from those that follow from the CSA pricing methods.

12.3. Unspecified methods under the OECD TPG As indicated in section 12.1., the development and use of unspecified methods is often linked to domestic law, e.g. as reactions to perceived insufficiencies of the specified pricing methods available or as a way to address transfer pricing problems that may be rather specific to a particular jurisdiction. Methodology akin to the unspecified IRS-professed income method in Veritas, for example, may not be relevant for jurisdictions where little R&D is carried out or where the use of CSAs is uncommon.

1208. For comments on the similar profit potential comparability criterion under the US regulations, see sec. 7.2.3. on the US CUT method, sec. 14.2.3. on the valuation approach of the 2007 CIP (LMSB-04-0907-62) and sec. 14.2.4. on Veritas Software Corporation & Subsidiaries v. CIR (133 T.C. No. 14 [U.S.Tax Ct. 2009], IRS nonacquiescence in AOD-2010-05). With regard to this criterion under the OECD TPG, see secs. 7.3. and 11.4. on the OECD CUT method. 1209. Treas. Regs. § 1.482-4(g).

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International tax law (here, articles 9 and 7 of the OECD Model Tax Convention) will be decisive for the question of whether the controlled allocation of income pursuant to an unspecified method can be upheld with effect for the distribution of operating profits among the contracting jurisdictions. The 2017 OECD TPG allow the use of unspecified pricing methods to allocate income in controlled IP transactions.1210 The use of such methods should be supported by an explanation as to why the specified OECD pricing methods were regarded as less appropriate and the reason why the selected unspecified method was regarded as providing a better solution.1211 The application of an unspecified pricing method must comply with the general OECD pricing requirements. The functional analysis must take into account “all factors that contribute to value creation”.1212 If the pricing is not based on a CUT, the applied methodology must take into account factors such as the functions, assets and risks of the controlled parties, as well as the options realistically available to each of the parties to the transaction.1213 With respect to IP valuation techniques, the 2017 OECD TPG state that “depending on the facts and circumstances, valuation techniques may be used … as a part of one of the five OECD transfer pricing methods described in Chapter II, or as a tool that can be usefully applied in identifying an arm’s length price”.1214 It is not entirely clear whether the use of valuation as a stand-alone tool should be regarded as a specified or unspecified method under the OECD TPG. A discounted cash-flow analysis may not necessarily constitute a 1210. See OECD TPG, para. 2.9 and para. 6.136, last sentence. 1211. The wording of OECD TPG, para. 2.9 on unspecified methods (the current wording is the 2010 consensus text) was to be revised as part of the 2015 BEPS package to take account of the new guidance on valuation techniques; see 2014D, at p. 24. It was also to be considered whether the current wording should be modified to reflect other guidance on transfer pricing methods and special measures that were adopted in connection with the 2015 work on BEPS. For some reason (likely pressure to complete the BEPS deliverables on time), para. 2.9 was not revised as part of the 2015 BEPS package. 1212. OECD TPG, para. 6.133. 1213. OECD TPG, para. 6.139. Other relevant factors include the competitive advantages conferred by the intangibles, especially the relative profitability of products and services related to the IP, and the expected future economic benefits from the transaction. On applying the options-realistically-available principle in the absence of comparables, see Parekh (2015), at p. 307. 1214. OECD TPG, para. 6.153.

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stand-alone transfer pricing method, but could rather be characterized as an overlay for the specified pricing methods. Regardless, the methodology must comply with the OECD guidance on pricing methods in chapters I-III of the OECD TPG, the realistic-alternatives pricing principle1215 and the guidance on controlled risk allocations.1216 Further, the OECD TPG allow the use of unspecified cost-based pricing approaches for intra-group IP transfers in limited circumstances.1217 Such methodology will likely only be reasonable to apply when the aim is to allocate operating profits from routine IP that does not generate residual profits. This may include IP developed for internal use, such as in-house software systems. The 2017 OECD TPG warn, however, that cost-based pricing approaches may raise serious comparability issues if applied for pricing IP that relates to products that are sold in the marketplace and that they are deemed inappropriate for pricing IP when there is a first-mover advantage,1218 where the IP carries legal protections or exclusivity characteristics1219 or for partially developed IP.1220 Lastly, the 2017 OECD TPG reject the use of rules of thumb to allocate residual profits in intra-group IP transfers.1221 Rules of thumb have likely been applied to some extent in practice. For instance, licensing rates may have been regarded as “ok” if the licenser was left with a royalty of one third of the licensee’s profits. Such practices, however, have no legal basis in the OECD TPG.

1215. OECD TPG, paras. 1.34 and 6.154. 1216. OECD TPG, paras. 1.56-1.106. See also the comments on the 2017 OECD TPG on risk in sec. 6.6.5.5. 1217. OECD TPG, para. 6.143. 1218. A future product that is meant to be similar to an already available product may not be as valuable as the latter. The current product may have additional value due to being the first product to reach the marketplace. Estimated future replacement costs (with respect to the IP connected to the future product) will therefore not be a good proxy for the value of IP transferred currently (the IP connected to the available product). 1219. In this case, the IP will exclude potential competitors from the marketplace, likely resulting in residual profits. Such additional value will not be reflected in replacement costs. 1220. Research and development costs will not reflect the income potential connected to such IP. 1221. OECD TPG, para. 6.144.

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Chapter 13 Allocation of Residual Profits to Unique and Valuable IP through Valuation 13.1. Introduction In this chapter, the author will analyse how valuation techniques may be applied to estimate an arm’s length transfer price for a unique and valuable intangible under the 2017 OECD Transfer Pricing Guidelines (OECD TPG).1222 The focus will be on intangible property (IP), typically a patent or a trademark, that is used in an existing value chain for a specific successful product or service (e.g. for sales of product X in jurisdiction Y). The valuation of such intangibles is a significant problem in practice and is also the central point of attention in the new OECD guidance. IP value can be ascertained through a two-step process. Step (1) entails estimating the future operating profits from sales of the relevant product or services (in the relevant jurisdictions) and then discounting the future profits to present value. This necessitates estimates of the size and timing of sales, costs of goods sold and operating expenses allocable to the product for each year of its life, as well as the determination of a suitable risk-adjusted discount rate. Step (2) entails that the present value must then be allocated, pursuant to the transfer pricing methods, among the different value chain inputs (which include the IP). This is where the real transfer pricing assessment comes into play. Thus, step (1) finds the total operating profits, and step (2) allocates them among the controlled parties.

1222. On transfer pricing valuation of intangible property (IP), see, in particular, Brauner (2008). For a discussion on the now historical 2010 OECD TPG on the valuation of intangibles, see, e.g. Wittendorff (2010a), at pp. 673-674; Wittendorff (2010b); and Wittendorff (2010c). See also Levey et al. (2008a); Levey et al. (2008b); Levey et al. (2008c); Verlinden et al. (2010); Hughes et al. (2010); Oestreicher (2011); and Laine (2012). See Boos (2003), at chs. 3 and 4, for a discussion on the valuation of intangibles from an economics perspective. See also Anson et al. (2005); and Lagarden (2014), at p. 338, on IP valuation. See also the comprehensive (but rather general) European Commission Study on the Application of Economic Valuation Techniques for Determining Transfer Prices of Cross Border Transactions between Members of Multinational Enterprise Groups in the EU (2016) and comments on the study in Treidler et al. (2017).

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The same two-step approach can, in principle, be used to value IP that is only partially developed. There will, however, be more uncertainty connected to the valuation parameters, as it will remain to be seen whether the product or services that the IP relates to actually will become successful. This chapter will not address the valuation of IP that is not specifically connected to a value chain. Such IP may, for instance, be technical know-how of a general character or high-level marketing IP (e.g. a firm logo or name). While such IP certainly may contribute to the profits of an enterprise, it may be difficult to establish a concrete cause-and-effect relationship with individual products and services, and thus to directly estimate the profits it has contributed to on a value chain level. The most fruitful approach in such cases will likely be to simply value the group entity which owns the IP on a going-concern basis (i.e. an ordinary business valuation) and then allocate an appropriate portion of the total asset value of the enterprise to the IP, akin to a purchase price allocation analysis. It may be challenging to separate the value of the high-level IP from residual intangible value (goodwill, going concern value, etc.). Such ordinary business valuations will, in principle, follow the same overall methodology discussed in this chapter, albeit on a more aggregated level (which includes profits from all value chains that the relevant entity contributes to). Further, in some contexts, several items of IP may be transferred together as a package, for instance, when know-how, patents and marketing IP connected to a product are transferred intra-group in the same agreement. In these cases, it may be argued based on the current OECD TPG that the package transfer should not be valued as simply the sum of the stand-alone IP values, but rather deemed a going-concern business transfer, given that the latter approach would better reflect an arm’s length value for the package. As such transfers typically are carried out through cost-sharing arrangements (CSAs), the author refers to the discussions in chapter 14.1223 The author discusses the valuation techniques endorsed by the 2017 OECD TPG in section 13.2., valuation parameters in discounted cash flow (DCF)based valuation in section 13.3., allocation of the valuation amount among the controlled value chain contributions in section 13.4. and the options realistically available as a restriction on the possible allocation outcomes

1223. See, in particular, sec. 14.2.3., with further references.

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in section 13.5. Lastly, in section 13.6., the author asks whether there is a legal basis for applying a discount to the transfer price.

13.2. The valuation techniques accepted under the OECD TPG There are, in general, three categories of valuation approaches.1224 The first category is intrinsic valuation, where the value of an asset normally is determined using DCF analysis as the present value of the expected future cash flows that the asset will generate over its economic life.1225 DCF valuation has not previously been embraced by the OECD TPG as a method for valuing intangibles. Under the 2010 OECD TPG, the expected benefits from an intangible were relevant mainly as a comparability factor for determining whether a purported comparable uncontrolled transaction (CUT) could be used to benchmark the controlled royalty.1226 The second category of valuation techniques is relative valuation, where the value of an asset is estimated based on how the market prices similar assets.1227 The traditional transfer pricing methods (the comparable uncontrolled price (CUT), resale price and cost-plus methods), as well as the transactional net margin method (TNMM) and, to some extent, the residual profit split method1228 are fundamentally relative pricing methods due to their reliance on comparables (but these methods have a year-to-year focus, as opposed to valuations that encompass all income years in which the intangible generates value). 1224. The following discussion draws, to a large extent, on the classification of subject matter and terminology applied in Damodaran (2006) and Damodaran (2012). 1225. A discounted cash flow (DCF) valuation requires the following inputs: (i) an estimate of the size and timing of cash flows generated by the intangible over its life; and (ii) an estimate of the discount rate to apply to the cash flows to convert them into present values. These inputs may be challenging to estimate and may be influenced by biases of the person carrying out the valuation. 1226. 2010 OECD TPG, para. 6.20. The 2010 OECD TPG also mentioned that DCF analysis could be applied as part of a transfer pricing analysis under the profit split method (PSM) in para. 2.123. 1227. Relative valuation approaches are generally most appropriate when a large number of assets comparable to the one being valued exist, the comparable assets are frequently priced in a market through a large number of transactions and some common variable exists that may be used to standardize the price (e.g. market price to book value). 1228. The normal return allocated under the (first step of the) PSM will be determined with reference to comparables. See OECD TPG, para. 2.121; and the discussion in ch. 9 of this book.

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The third category is that of option-based valuation techniques, in which the value of an asset is estimated based on its relationship with an underlying asset.1229 No guidance is provided in the OECD TPG on such techniques. In the terminology of the OECD TPG, however, “valuation techniques” also encompass techniques other than the DCF method.1230 It should therefore be clear that the OECD TPG, in principle, do not reject the use of option-based valuation.1231 Thus, it may be observed that the OECD TPG, in principle, allow all three classes of valuation techniques. The technique employed must, however, be used consistently with the arm’s length principle,1232 in particular, the realistically-available-options premise. Valuations of intangibles based on (development) costs will generally not be in accordance with the arm’s length principle.1233 The main focus of the new guidance is on the DCF valuation technique.1234 The comments in this chapter will be limited to this methodology.

1229. Option pricing may be relevant for investments that would be difficult to price under DCF or relative valuation models, such as research and development (R&D) investments or transfers of unproven intangibles at an early stage of development. A range of different option-pricing models is available, the Black & Scholes option-pri­ cing model being perhaps the best-known model; see Bodie et al. (2005), at pp. 758766, with further references. Normally, in valuation, risk decreases the value of an asset. For options, however, risk or variation increases the value of the option, because the downside of an option is limited to its cost price. The inputs required for option valuation are difficult to estimate and may be uncertain. 1230. OECD TPG, para. 6.153. 1231. “Real options” are contingent business decisions or the ability of an enterprise to respond to uncertainty (e.g. the alternative of an enterprise of entering into an unprofitable project if that project makes it possible to develop a new and profitable project, the option to postpone an investment or the option to abandon a project that proves unprofitable). The value of real options may be priced using financial theory. During the public consultation hearing on the 2014 Public discussion draft BEPS Action 10: Discussion Draft on the use of profit splits in the context of global value chains (PSMDD) held at the OECD in Paris on 19-20 March 2015, the lack of guidance on real-option pricing in the context of unique intangibles was criticized by business commentators. The core of the criticism was that a typical DCF valuation will value an R&D project based on the presumption that the project has a fixed life without taking into account the value of the real options that are available to the group entity performing the R&D. 1232. OECD TPG, para. 6.154. 1233. OECD TPG, paras. 6.142 and 6.156. See Brauner (2008), at p. 109, for thorough and critical reflections on the cost approach to IP valuation. See also Lagarden (2014), at p. 339, where costs as a basis for valuation are rejected. 1234. OECD TPG, para. 6.153.

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The valuation parameters in DCF-based valuation

13.3. The valuation parameters in DCF-based valuation 13.3.1. Introduction The purpose of a DCF analysis in the context of this chapter is to estimate the present value of future operating profits from an intangible value chain. The analysis is dependent on estimates of a range of parameters (future operating profits, useful life, growth rates, terminal value and discount rate). The author will tie some comments to the OECD guidance on these parameters in sections 13.3.2.-13.3.4.1235

13.3.2. The estimation of future operating profits Arguably, the most important parameter in a DCF valuation is the estimate of future operating profits generated by the product that makes use of the intangible in question.1236 All else equal, the larger the estimated future operating profits, the larger the amount yielded by the valuation will be. Taxpayers will tend to argue for relatively low future operating profits, and the opposite goes for tax authorities. Whether the profit projections later turn out to be correct or not (i.e. whether they correspond with the profits actually realized) will depend on developments in the marketplace that are unknown at the time at which the valuation is undertaken. The projections are therefore speculative in nature. Their underlying assumptions must be carefully examined, as there will

1235. In line with this, the OECD finds that the reliability of a valuation may be influenced by the purpose for which it was produced; see OECD TPG, para. 6.155. Valuations performed for non-transfer pricing purposes are generally deemed to be more reliable than those prepared exclusively for transfer pricing purposes. Further, valuations of intangibles reflected in a purchase price allocation (PPA) performed for financial accounting purposes are not decisive for transfer pricing purposes. The most important global accounting standard governing PPAs is International Financial Reporting Standard (IFRS) 3 (Business combinations). In the United States, a PPA will normally be carried out pursuant to the Financial Accounting Standards Board’s (FASBs) Financial Accounting Standard (FAS) 141 (Business Combinations) and FAS 142 (Goodwill and Other Intangible Assets). See also Chandler et al. (2010). 1236. Thus, the estimates of financial projections will pertain to accrual-based measures of income as opposed to cash flows. The new guidance suggests that accrual-based measures may not properly reflect the timing of cash flows, which can generate a difference in the outcome between an income and cash flow-based approach; see 2015TPR, at n. 19. It is, however, also recognized that the use of income projections may yield a more reliable result than cash-flow projections.

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normally be strong biases both on the side of the taxpayer and of the tax authorities for skewing the estimates in the desired direction.1237 If the product that makes use of the transferred intangible has a proven track record, its historical sales and costs may serve as useful indicators of future performance.1238 Projections for products that are still in development or that have yet to be commercialized are inherently less reliable. The further into the future the intangible in question is expected to yield profits, the less reliable the projections of income and expenses are likely to be.1239 A relevant question is whether intangible development costs should be included in the projections of operating profits. If the transferred intangible is continually developed and has an indefinite useful life, the OECD finds it appropriate to include future development costs.1240 For intangibles that are fully developed and will not serve as a platform for the development of other intangibles, however, no development costs should be included.1241

13.3.3. The estimation of useful life, growth rates and terminal value A DCF analysis estimates the operating profits from an intangible value chain over the useful life of the products to which the relevant intangibles refer.1242 The useful life estimate is one of the critical assumptions supporting the valuation model. All else equal, the longer the useful life, the larger the amount yielded by the valuation will be. Taxpayers will tend to argue for relatively short useful lives, and the other way around for tax authorities. This was the case in both Veritas and Amazon.com, where the taxpayer argued for a short useful life of the transferred intangibles, while 1237. Valuation methods normally leave substantial room for discretionary judgement for the person carrying out the valuation. In a transfer pricing context, this is a problem. Multinationals and tax authorities will normally be biased towards low and high valuations, respectively. Also, there is significant information asymmetry between multinationals and tax authorities. The R&D personnel of a multinational will be in a vastly superior position relative to the tax authorities when it comes to judging whether a partially developed medicine has the potential to be successfully developed and commercialized. A tax authority may struggle to critically assess the information provided by the multinational due to a lack of R&D knowledge and specialized business expertise. 1238. OECD TPG, para. 6.166. 1239. OECD TPG, para. 6.165. 1240. OECD TPG, para. 6.167. 1241. Id. 1242. OECD TPG, para. 6.174.

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the US Internal Revenue Service (IRS) applied a going-concern perpetuity approach.1243 The useful life may be affected by the nature and duration of the legal protections afforded to the intangible, the rate of technological change in the industry and other factors affecting competition. The author discusses useful-life assessments more in depth in the analysis of CSAs in chapter 14.1244 Further, a key element in many DCF valuations is the projected growth rate.1245 Growth is normally estimated as a yearly percentage increase in revenues. All else equal, the larger the growth rate, the larger the amount yielded by the valuation will be. Taxpayers will tend to argue for relatively modest growth rates, and the opposite goes for tax authorities (as the case was in both Veritas and Amazon.com). Enterprises that reinvest portions of their earnings into the business and generate high returns on these investments should grow at high rates. As the enterprise grows, it will gradually become more difficult to maintain a high growth rate. Eventually, the company will not be able to grow at a rate larger than the growth rate of the economy of which it is a part. This growth rate, the “stable growth rate”, may, in theory, be sustained in perpetuity. This premise makes it possible to value all operating profits that are generated in the stable growth phase as a terminal value for a going concern, which is the present value at a future point in time of all future operating profits from the value chain. A terminal value may be useful when it is clear that the intangible value chain in question is likely to generate profits beyond the period for which reasonable financial projections exist.1246 Some intangibles may yield profits in years after the legal protections have expired or the products to which

1243. Veritas Software Corporation & Subsidiaries v. CIR (133 T.C. No. 14 [U.S.Tax Ct. 2009], IRS nonacquiescence in AOD-2010-05); and Amazon.com v. CIR (148 TC No 8). See the analysis in secs. 14.2.4. and 14.2.5., respectively. 1244. On useful life, see also the discussion of the 2007 Coordinated Issue Paper (CIP) (LMSB-04-0907-62) valuation approach in sec. 14.2.3.; the comments on Veritas in sec. 14.2.4., the comments on Amazon.com in sec. 14.2.5., the discussion of the income method of the US cost-sharing regulations (Treas. Regs. § 1.482-7(g)(4)) in sec. 14.2.8.3.; and the discussion of the general 2017 OECD periodic adjustment authority in sec. 16.5. See also the discussion of comparability factors under the US regulations in sec. 6.6.5. 1245. OECD TPG, para. 6.169. 1246. OECD TPG, para. 6.177. Estimating operating profits beyond this period is not practical and involves a range of estimation risks, reducing the credibility of the estimates.

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they relate have ceased to exist,1247 e.g. when one generation of intangibles forms the basis for the research and development (R&D) of future generations. The OECD finds that it may be appropriate that some portion of the continuing profits from projected new products should be attributed to otherwise expired intangibles when such follow-up effects exist.1248 The new guidance warns, however, that while some intangibles may have an indeterminate useful life at the time of valuation, this does not imply that residual profits will be allocable for such intangibles in perpetuity.1249 It is unusual for revenues derived from a particular product group to grow at a steady rate over a long period.1250 Thus, tax authorities should exercise caution in accepting simple models containing linear growth rates that are not justified on the basis of either experience with similar products and markets or a reasonable evaluation of likely future market conditions. It will presumably be difficult to find reliable growth rates for value chains driven by unique intangibles. It is normally unrealistic to acquire access to disaggregated profit data from unrelated enterprises for specific comparable products.1251 The internal profit data of a multinational from similar products may be relevant. There is reason to be sceptical of the use of terminal values in DCF valuations. The terminal value is generally dependent on pronouncedly subjective assessments, and is thus susceptible to manipulation. The terminal value may represent a significant portion of the total estimated operating profits. For instance, in an example illustrating the application of the income method with a terminal value calculation, the total value of the intangible (the buy-in payment) was set to 1,361,1252 of which the terminal value accounted for approximately 62%. The author also refers to the analysis of Veritas in section 14.2.4. and of Amazon.com in section 14.2.5., where the IRS valuation assertions were based on the presumption of perpetual useful lives for the transferred intangibles, combined with high growth rates, resulting in significant terminal values. If the valuation includes a terminal value, it is crucial that multinationals and tax authorities clearly outline the assumptions used in the valuation and provide detailed explanations of the rationale behind the assumptions. 1247. OECD TPG, para. 6.176. 1248. Id. 1249. Id. 1250. OECD TPG, para. 6.169. 1251. See the discussion of publicly available third-party financial accounting profit data in sec. 6.2.5. 1252. Treas. Regs. § 1.482-7(g)(4)(viii), Example 7.

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13.3.4. The estimation of discount rates The discount rate used in a DCF valuation represents the investors’ cost of capital.1253 All else equal, the larger the discount rate, the smaller the present value amount yielded by the valuation will be. Taxpayers will tend to argue for relatively high discount rates, and the opposite goes for tax authorities (as also illustrated in Veritas and Amazon.com). The OECD position is that no single measure for a discount rate is deemed appropriate in all instances for transfer pricing purposes.1254 When the purpose of the valuation is to value the total capital of a business, the weighted average cost of capital (WACC) is used.1255 In this context, however, where the purpose is to value an intangible, the WACC will generally not be a suitable cost of capital, as the discount rate should be consistent with the riskiness of the profits being discounted. The guidance emphasizes that intangibles, particularly those still in development, may be among the most risky components of a multinational’s business. Risk will, however, generally be moderate for IP connected to products and services that are successfully established in the marketplace. Risks should be taken into account either in the estimates of future operating profits or in the discount rate, but not in both.1256 Thus, if the estimated operating profits have been reduced to take into account potential risk, the discount rate should be lower than it would have been without such a reduction, and vice versa. Both multinationals and tax administrations must document and explain the assumptions behind the discount rate.1257 1253. It is the minimum return that the investor requires in order to invest in the asset. The discount rate consists of two elements. The first element is compensation for the time value of money. Had the investor not invested the funds in the asset in question, he could alternatively have invested in other income-generating assets. The second element is compensation for the risk of receiving cash flows that are smaller or that materialize later than estimated. 1254. OECD TPG, para. 6.171. 1255. The weighted average cost of capital (WACC) is the cost of equity weighted by the ratio of equity to total capital, plus the cost of debt after taxes weighted by the ratio of debt to total capital. There is a variety of competing financial models available for setting the cost of equity for an enterprise. The available models are usually variants of the capital asset pricing model (CAPM) (see Bodie el al. (2005), at p. 281, with further references). The CAPM states that the expected return on equity for an investor is equal to a risk-free rate plus an additional interest rate for non-diversifiable risk. The cost of debt is the rate at which the enterprise may currently borrow. The cost of debt will reflect the default risk of the enterprise and the level of interest rates in the market. 1256. OECD TPG, para. 6.173. 1257. OECD TPG, para. 6.170.

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13.3.5. What are the consequences of using unreliable valuation parameters? The 2017 OECD TPG on valuation are linked to the 2017 wording on periodic adjustments for hard-to-value intangibles.1258 If there is any reason to believe that the “projections behind the valuation” of an intangible are “unreliable or speculative”, the guidance on hard-to-value intangibles is applicable.1259 The author observes that the quoted wording seems to reserve the link to the periodic adjustment guidance solely for the financial projections used in the valuation. Nevertheless, he finds no sensible reason as to why financial projections in this context should not be read to also include the terminal value used in the valuation, as well as the parameters underlying it (useful life and growth rate) and the discount rate. The author concludes that if any of the parameters used in the valuation are deemed unreliable or speculative, the 2017 guidance on periodic adjustments must apply.

13.4. Allocation of the valuation amount among the controlled value chain contributions The outcome of the valuation is an estimate of the present value of the future operating profits from the relevant intangible value chain (i.e. sales of the product that makes use of the unique intangible in question). The problem then turns into how this value shall be allocated among the controlled value chain inputs.1260 This is the real transfer pricing assessment in the context of valuations. The new valuation guidance does not specifically address this issue, as the allocation, in principle, relies on an application of the relevant transfer

1258. For an analysis of how the valuation may be adjusted if the hard-to-value intangibles guidance on periodic adjustments is triggered, see the discussion in sec. 16.5. 1259. OECD TPG, para. 6.168. 1260. The OECD TPG leave substantial freedom for the multinational to define the form of payment for the transfer of an intangible (see OECD TPG, paras. 6.179-6.180). Payment may take the form of a single lump-sum payment, periodic payments or payments contingent on future events (e.g. sales thresholds). The payment form may affect the level of risk incurred by a controlled party. For example, the contingent payment form will generally involve greater risk for the transferer than a lump-sum payment at the time of the transfer of the IP. The form of payment must be consistent with the economic substance of the controlled transaction. See the discussion of controlled risk allocations in sec. 6.6.5.5. Payments should reflect the relevant time value of money and risk features of the chosen form of payment (see OECD TPG, para. 6.180).

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pricing methodology.1261 The transfer pricing methods and the new guidance on location savings, local market characteristics and synergies1262 will split the valuation amount so that (i) routine value chain contributions (manufacturing, distribution, etc.) are allocated a normal market return; (ii) location savings and rent are allocated incremental profits; and (iii) residual profits are allocated among the non-routine value chain contributions (unique IP). A complicating factor is that the structure of the value chain contributions may change over the valuation horizon (for instance, relatively more marketing efforts during the first years and less in later years).1263 In principle, it should be estimated how much of each value chain contribution is used in each income period covered by the valuation, but this may be difficult to achieve in practice. It will likely, in general, be necessary to presume that the current structure will be applicable throughout the valuation horizon. If the product that makes use of the transferred intangible only relies on this particular intangible while all other value chain inputs are routine inputs, the entirety of the residual profits from the value chain will be allocable for this intangible. Thus, in these cases, the total net present value of the profits left after the routine inputs have been allocated a normal market return pursuant to a one-sided method and incremental profits have been allocated to location savings and rent will be the value of the intangible. Normally, however, the residual profits will stem from more than one intangible. In these cases, the residual profits must be disaggregated and split among the intangibles so that the transfer price only contains the profits connected to the intangible that is actually transferred in the controlled transaction.1264 In the absence of CUTs, the profit split method (PSM) must be applied, the core of which is to allocate the residual profits pursuant to the relative value of the unique intangibles employed in the value chain. The author refers to the previous discussions of the PSM.1265 A complicating factor in this context will be that the relative values of the unique intangibles must be estimated for each of the future income periods encompassed by the valuation. This may be problematic, as the relative values may change over 1261. The author refers to the analysis of the transfer pricing methods in chs. 7-9 and 11. 1262. See the discussion in ch. 10. 1263. This will be relevant in particular for long-term transfer pricing structures. See, for instance, the discussion of French in sec. 5.2.3.3. 1264. Such analysis will be demanding. On this, see also Brauner (2008), at p. 116. 1265. The US and OECD PSMs are discussed in ch. 9.

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time. This was the case in French, where the value of the patent gradually became less important for the generation of profits than the continually developing manufacturing know-how. An additional layer of complexity will be added to the profit allocation if the transferred intangible is not fully developed. There will be a legal basis under the 2017 OECD guidance on intangible ownership to also allocate residual profits to the transferee if it contributes important R&D functions.1266 The allocation of residual profits between the transferer and the transferee must then depend on the extent to which the transferred intangible was developed at the time of the transfer. The intangible is only capable of generating profits once completed, and in these cases, the transferee may complete the R&D. If there is a genuine contribution of value through R&D performed by the transferee, the residual profits from the fully developed intangible should be split in proportion to the intangible value added through the parties’ R&D contributions.1267 It is crucial that this assessment is performed with a critical view, as transfers of partially developed intangibles are often carried out to shift intangible profits away from high-tax jurisdictions.1268 Under the 2017 OECD guidance (as opposed to the previous stance expressed in the 2009 OECD TPG text), the transferee should not be allocated residual profits if the transferer is a group R&D centre that develops the initial stages of the intangible and then transfers it (typically to a foreign “cash box” entity transferee) and continues to perform R&D after the transfer on a contract research basis (or under similar arrangements) while the funding of the R&D efforts is provided by the foreign transferee. The transferee should nevertheless be allocated an arm’s length return on its funding investment.1269 1266. OECD TPG, para. 6.56. See the analysis of the “important functions doctrine” in sec. 22.3.2. 1267. See the discussion of the use of profit splits for transfers of partially developed intangibles (OECD TPG, para. 6.150) in sec. 9.4. 1268. See the analysis of the 2017 OECD guidance on hard-to-value intangibles in sec. 16.5. Under US law, problems associated with the transfer of partially developed intangibles have proven problematic in the context of CSAs, in which the transferer contributes a pre-existing intangible to a CSA while the other CSA participants contribute intangible development costs. The author analyses the US CSA regulations (Treas. Regs. § 1.482-7) in ch. 14. The methods developed for valuing the contribution of preexisting intangibles (buy-in pricing) also apply for IP transfers that fall outside the scope of Treas. Regs. § 1.482-7, including arrangements for the sharing of costs and risks of developing IP in arrangements other than CSAs. See the discussion of unspecified methods in ch. 12. 1269. OECD TPG, para. 6.62. See the analysis of profit allocation for R&D funding contributions in sec. 22.4.

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13.5. The options realistically available as a restriction on the possible allocation outcomes The 2017 guidance envisions that the “realistic options available” principle shall play a key role in the allocation of operating profits for the unique intangible being priced, primarily as a restriction on which allocation results are acceptable under the arm’s length principle. The premise for the following discussion is that a DCF valuation has been performed, resulting in an estimate of the present value of the future operating profits from the intangible value chain. Further, this value, pursuant to the transfer pricing methodology, has been allocated among the value chain contributions, including residual profits to the intangibles employed in the value chain. The question is whether the realistic-options-available principle can be used as a “sanity check” with respect to whether the profits allocated for the relevant intangible are at arm’s length, i.e. whether the principle restricts the possible allocation outcomes. The realistic-options-available principle is a fundamental pricing assumption underlying the OECD transfer pricing methodology. It dictates that the transferer and transferee in a controlled transaction must be presumed to act in accordance with rational economic reasoning. The core of the principle is to demand that controlled resources are utilized in an optimal manner. If controlled allocations of residual profits that do not adhere to this basic logic were to be accepted with effect for the distribution of operating profits among jurisdictions, the results yielded by international tax law would depart from basic economic reasoning and third-party market behaviour. Intangible income would then not be allocated according to intangible value creation. The principle is powerful when applied in a valuation context because it may be relatively straightforward to calculate the profits associated with the transferer’s alternative of not transferring the intangible, but rather carrying on its business activities as before the controlled transaction took place. The profits from this “status quo” alternative will normally represent a lower limit for an acceptable transfer price. Correspondingly, the best realistic option available for the transferee may be to not enter into the controlled transaction. Normally, this will lead to the conclusion that the transferee must receive at least a normal market return on its investment in order to not be placed worse off by entering into the controlled transaction.

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Even though the realistic options available must be assessed from the perspectives of both the transferer and the transferee,1270 the main focus in a transfer pricing valuation will generally be on the allocation of profits to the transferer (which, as opposed to the transferee, typically is resident in a high-tax jurisdiction and has often developed the IP). The reason for this is that the transferer is the owner of the intangible, and thus entitled to all residual profits from it. Had it not transferred the intangible, but instead utilized it to make and sell the derivative products itself, it would have been in a position to reap the entire residual profits alone. A transfer of the intangible should not, according to the realistic-options-available principle, make it worse off. The principle demands that there must be a convincing reason as to why the transferer should relinquish the residual profits that it is entitled to. That reason must be an arm’s length compensation.1271 The 2017 OECD TPG contain an illustration of the significant role played by the realistic-options-available principle in the context of a valuation.1272 It pertains to a parent that has developed patents and trademarks related to product F, which it has manufactured and sold to local distribution subsidiaries throughout the world. The parent establishes a subsidiary in a foreign jurisdiction where the tax rate and production costs are significantly lower than in its jurisdiction, and transfers its production to the subsidiary and sells the product F patents and trademarks to the subsidiary for a lump sum. The question is how an arm’s length price should be set for the transferred intangibles. The example considers three alternative perspectives for determining the lower and upper boundaries of an acceptable transfer price: (1) The first scenario is seen from the perspective of the transferring parent. The present value of the residual profits from the intangibles is estimated based on the operating profits derived by the parent from the manufacturing and sale of product F in the “status quo” scenario where it owns the intangibles and makes and sells the products itself. This is the value that the intangibles would have for the parent had it instead

1270. OECD TPG, para. 6.139. 1271. See also, in this direction, Brauner (2010), at p. 17, with respect to the similar issue in the context of buy-ins under the US CSA regulations. 1272. OECD TPG, annex to ch. 6, Example 29 (Pervichnyi). The 2013 Revised discussion draft on transfer pricing aspects of intangibles (2013 RDD) version of the example was materially the same as that of the 2014D and the final 2015 text, but in addition, contained detailed calculations explaining the numbers arrived at.

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chosen not to enter into the controlled transaction. The present value of the residual profits in this scenario is 601. (2) The second scenario is relatively the same, but with the twist that the parent contracts the subsidiary to perform manufacturing in order to reap the benefits of lower local production costs. The present value of the residual profits for the parent in this scenario is 853. (3) The third scenario is seen from the perspective of the subsidiary, where it owns the intangibles and makes and sells product F. Without taking into account the investment of the subsidiary required to purchase the intangibles, the present value of the residual profits generated by the intangibles is 1,097. As the second scenario is deemed to be a realistic option for the parent, that option must be taken into account for the purpose of determining the transfer price. Otherwise, the transfer price cannot be deemed to be at arm’s length. The new guidance finds that “there is no reason” for the parent to sell the intangibles at a price that would yield an after-tax cash flow with a present value of less than 853.1273 Thus, the present value of the best realistic option for the parent is the lowest acceptable transfer price. Further, the guidance finds that the subsidiary would not be expected to pay a price for the transferred intangibles that would leave it with an after-tax return lower than which could be achieved by not engaging in the controlled transaction.1274 The upper limit for the price of the intangibles is therefore 1,097. If the subsidiary pays more than that, it would not only miss out on a return, but it would incur a loss. In general, as long as the net present value of entering into the controlled transaction is calculated using the discount rate of the buyer, any transfer price that is less than the net present value of his best realistic alternative will place it better off by entering into the controlled transaction. This must be the fundamental criterion when applying the realistic-options-available principle from the side of the buyer, as it then will be ensured an investment with a positive net present value. The author finds the emphasis of the 2017 OECD guidance on the role of the realistic-options-available principle in the context of valuation both 1273. OECD TPG, annex to ch. 6, para. 108. 1274. OECD TPG, annex to cha. 6, Example 29, para. 109.

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necessary and potent. It is necessary in the sense that it would be deprived of economic logic to force a sales price upon the seller that is lower than which he could have achieved with a realistic alternative. It is potent in the sense that the net present value of the seller’s best alternative will be persuasive for the transfer price determination, and will thus form an efficient minimum arm’s length amount.

13.6. Is there a legal basis for applying a discount to the transfer price? The valuation of a unique intangible will likely entail a great deal of uncertainty, regardless of where the transferred intangible is in its life cycle at the time of transfer.1275 Further, the value will be theoretical, in the sense that it will not necessarily be a value that the intangible actually could be sold for to an unrelated party. For instance, a partially developed medicine would likely be difficult to sell to a buyer who does not possess the multinational’s ongoing R&D capabilities. It is conceivable that such factors in practice could open up for price negotiations. The question is whether there is a legal basis to apply a “discount” to the theoretical value yielded by the transfer pricing valuation akin to a discount that a potential third-party buyer might demand in order to purchase the intangible. In the absence of a CUT stating otherwise, there can be no legal basis for a discount. The reason for this is simple. The one-sided methods and the PSM allocate operating profits among the controlled parties based on their contributions of routine and non-routine inputs to the value chain. Any uncertainty in the valuation will be exhaustively taken into account either in the estimation of the future operating profits from the intangible value chain or in the determination of the applicable discount rate used to convert the estimated future profits to present values.

1275. On the significance for transfer pricing purposes of the life cycle stage of the IP, see Dolman (2007), under the section “Life cycle of IP”.

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Chapter 14 Allocation of Residual Profits to Unique and Valuable IP through Cost-Sharing Structures 14.1. Introduction This chapter is dedicated to a discussion of how operating profits are allocated through cost-sharing arrangement (CSA) “buy-in” pricing under the US regulations and the OECD Transfer Pricing Guidelines (OECD TPG).1276 Controlled CSAs are transactions in which group entities pool resources to co-develop intangibles.1277 Each CSA participant is deemed to “own” specified rights to the intangibles developed under the CSA.1278 No royalties are therefore paid among the CSA participants with respect to their subsequent exploitation of the cost-shared intangibles.1279 Each participant 1276. For informed discussions on cost sharing, see the writings of Brauner, in particular, Brauner (2010) and Brauner (2016). For a recent comparative study of costsharing arrangements (CSAs), see Okten (2013). For a broad analysis (not limited to buy-ins) and criticism of the 1995-generation US cost-sharing regulations, see Benshalom (2007). Brauner (2017), at sec. 2.3.1.2, as well as Brauner (2016), at pp. 98, 102 and 112, asserts that the US cost-sharing regulations were likely the single most important trigger behind the OECD BEPS Project. There is, in the author’s view, probably much truth in this due to the publicity afforded to US multinationals that based their tax planning on cost sharing (Apple, Google, etc.) and the growing political will to tighten tax rules. In this general direction, see also Avi-Yonah (2017), at p. 3; Musselli et al. (2017), at pp. 333 and 335; and Zuurbier (2016), at p. 12. 1277. The OECD’s terminology corresponding to the US terminology of CSAs is “cost contribution arrangements” (CCAs). For the sake of simplicity, the author will use the term CSA regardless of whether the legal context is US or OECD transfer pricing jurisprudence. 1278. The author will, in this chapter, refer to intangibles developed under a CSA as “cost-shared intangibles”. 1279. The fact that CSAs are at all recognized as valid legal vehicles in current international transfer pricing has been criticized due to the obvious potential for misuse (migration of IP ownership from high-tax jurisdictions), based on the simple observation that group entities that contribute valuable research and development (R&D) efforts to the CSA will normally be resident in high-tax jurisdictions, while the other participating group entities often are “cash box” entities in low-tax jurisdictions. If the ongoing R&D efforts are not based on pre-existing intangible property (IP) (thus with no buy-in), the foreign entities will end up with (co-)ownership of the developed IP based on cash contributions only. See, e.g. Brauner (2010), at p. 18; and Benshalom (2007), at pp. 651 and 676. In Brauner (2016), at p. 112, recognition of CSAs is described as representing “extraordinary benefit endowed to the [multinational enter-

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is, due to its “ownership”, entitled to the residual profits from the exploitation of its rights. CSA participants generally contribute three main types of development inputs, namely (i) pre-existing intangibles; (ii) ongoing research and development (R&D); and (iii) financing of R&D.1280 It is, in particular, the contribution of pre-existing (often established high-profit) intangibles that triggers profit allocation concerns.1281 These inputs represent the accumulated value of prior R&D efforts and are generally the platform upon which the further R&D that is to be carried out through the CSA will build. Conversely, ongoing R&D activities and financing represent concurrent contributions that normally do not require compensation at the outset of a CSA. The buy-in refers to the arm’s length charge that the other participants in the CSA, which gain access to the contributed pre-existing intangible (firstgeneration intangible property, or IP) and subsequently receive ownership stakes in new versions of it developed under the CSA (second-generation IP), must pay the contributing participant in return for the contribution. Seen from the perspective of the R&D jurisdiction in which the CSA participant that developed the pre-existing intangible is resident, the contribution of the intangible to a CSA, in reality, represents a migration of it. The R&D jurisdiction will generally be allocated only a modest fraction of the future residual profits from subsequent versions of the migrated intangible developed through the CSA.1282 The buy-in pricing represents the last

prises (MNEs)]”. See also Avi-Yonah (2017), at p. 4, where it is argued for repeal of the cost-sharing regulations. The traditional pro-argument for continued recognition of CSAs is reduced compliance burdens combined with a safe harbour for taxpayers; see Benshalom (2007), at p. 658. See also Odintz et al. (2017), under sec. 2.2.6, where the US CSA rules are described as focusing on the cost contributions of the controlled parties, as opposed to the 2017 OECD IP ownership provisions that focus on value contributions, i.e. the United States (through the CSA regulations) allows IP ownership to be determined by way of costs, while the OECD provisions are only willing to assign ownership to internally developed manufacturing IP to group entities that perform development, enhancement, maintenance, protection and exploitation (DEMPE) functions (see the discussion of the OECD’s “important functions doctrine” in sec. 22.3.2.). 1280. The bulk of the cash contributions will normally come from a foreign cash-box entity located in a jurisdiction with a regime that imposes low or no tax on intangible income. Conversely, pre-existing IP will normally come from a group entity located in a high-tax jurisdiction. See also the analysis of the parallel problem under the US and OECD IP ownership rules with respect to internally developed manufacturing intangibles in secs. 21.2. and 22.2., respectively. 1281. On this point, see Brauner (2010), at p. 7. 1282. See the discussion of the centralized principal model in sec. 2.4.

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chance for the R&D jurisdiction to tax the full value of the pre-existing intangible that was developed within its borders. The buy-in is the most significant tax issue connected to CSAs.1283 Buy-inrelated reallocations have garnered significant controversy in recent years, as illustrated by Veritas Software Corp. v. CIR and Amazon.com Inc. v. CIR,1284 in which the US Internal Revenue Service (IRS) carried out significant reassessments of the taxpayers’ buy-in values. The author discusses buy-in pricing under the US regulations and articles 9 and 7 of the OECD Model Tax Convention (OECD MTC) in sections 14.2., 14.3. and 17.5., respectively. The relationship between the US and OECD buy-in pricing is discussed in section 14.4.

14.2. Buy-in pricing under the US regulations 14.2.1. Introduction The author begins by tying some comments to the development of the US cost-sharing regulations in section 14.2.2. He then discusses the valuation approach taken by the IRS in a 2007 Coordinated Issue Paper in section 14.2.3., before tying some comments to the US Tax Court rulings in Veritas and Amazon.com in sections 14.2.4. and 14.2.5., respectively. Concluding comments on the rulings are provided in section 14.2.6. The key concepts and buy-in methodology of the current CSA regulations are discussed in sections 14.2.7. and 14.2.8., respectively.

14.2.2. The development of the US cost-sharing regulations The development of the US buy-in provisions largely mirrors that of the general transfer pricing rules discussed in section 14.1.1285 In particular,

1283. The buy-in issue was also key under the previous-generation (1995) cost-sharing regulations. For an interesting discussion, see Culbertson et al. (2003), at p. 102. 1284. Veritas Software Corporation & Subsidiaries v. CIR, 133 T.C. No. 14 (U.S. Tax Ct. 2009), IRS nonacquiescence in AOD-2010-05. Veritas is analysed in sec. 14.2.4. Amazon.com Inc. v. CIR, 148 TC No. 8 (U.S. Tax Ct. 2017). Amazon.com is analysed in sec. 14.2.5. 1285. For a thorough and analytical discussion of the historical development of the US cost-sharing regulations, see Brauner (2010), at p. 5; and Brauner (2016), at pp. 111-120.

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the absence of CUTs provided breeding ground for the development of unspecified pricing methods. The 1968 regulations contained a brief provision for the sharing of costs and risks,1286 which essentially required the terms of a CSA to be comparable to those that would have been adopted by unrelated parties under similar conditions in order to be considered arm’s length.1287 The 1968 regulations contained no buy-in requirement. When the commensurate-with-income standard was introduced into the US Internal Revenue Code (IRC) section 482 almost 2 decades later, the legislature indicated how the 1968 CSA provision should be revised.1288 The position was that CSAs would be respected to the extent that their profit allocation reasonably reflected the actual economic activity undertaken by the parties to the CSA.1289 Further, if one party actually contributed funds towards R&D at a significantly earlier point in time than the other or was effectively putting its funds at risk to a greater extent than the other, an appropriate return to that party would be required to reflect its investment. The 1988 White Paper addressed the problem of multinationals selecting specific high-profit unique intangibles for migration via CSAs (“cherrypicking”).1290 A buy-in requirement was suggested, pursuant to which the contribution of a pre-existing intangible to a CSA should command an arm’s length compensation from the other participants. The White Paper contained several interesting positions, some of which would later be re1286. 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(4); see also the 1979 OECD report on Transfer Pricing and Multinational Enterprises, para. 109. The final regulations were preceded by the 1966 proposed regulations (31 Fed. Reg. 10394) § 1.4822(d)(4), which contained extensive rules for cost sharing. These were scrapped in favour of the high-level requirements contained in the 1968 regulations. 1287. Further, after 1982, US Internal Revenue Code (IRC) sec. 936(h) required that the intangible income of a domestic company that qualified for the possessions tax credit had to be included in the income of the US shareholder. One available way to reduce the addition to US income was to choose a cost-sharing option. 1288. H.R. Conf. Rep. No. 841, 99th Cong., 2nd Sess. II-638 (1986), at p. 638. 1289. Also, the entity that contributed cash to the CSA, typically a foreign entity, should bear its portion of all R&D costs, encompassing both unsuccessful and successful products within a product area, at all stages of the R&D. Further, the allocation of costs should be proportionate to the profit before deduction for R&D costs. 1290. This “cherry-picking” practice entailed that the profits from massively successful intangibles were shifted abroad, combined with US deductions for R&D costs (including also costs for unsuccessful R&D projects). To counter this, the White Paper (Notice 88-123), at p. 127, suggested that CSAs had to encompass broad product areas (based on the 3-digit SIC code). On cherry-picking, see also Benshalom (2007), at p. 662; and Avi-Yonah (2017), at p. 4.

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vised. One of which was that, apart from make-sell rights,1291 all rights to pre-existing intangibles contributed to a CSA – most importantly, the right to use the intangible for the purpose of further research – should command a buy-in amount equal to the full market value.1292 The 1992 proposed regulations required an arm’s length compensation for the transfer of a pre-existing intangible to a CSA.1293 No detailed guidance was provided for the determination of the buy-in amount. Contrary to the intention of the White Paper, the 1992 provisions contained no delimitation for make-sell rights to pre-existing intangibles. The final 1995 cost-sharing regulations largely carried over the 1992 proposed buy-in provisions.1294 1291. The White Paper did not intend for make-sell rights to be encompassed by the buy-in requirement. Such rights should command ordinary royalty payments from the licensee. 1292. The buy-in should also compensate participants for contributing basic R&D that was not connected to any particular products, as well as the going concern value connected to participant’s research facilities and capabilities that could be utilized in the CSA. The White Paper was open to declining basis buy-in payments, since “intangibles generally have greater value in the earlier stages of their life cycle” (White Paper, p. 122). The White Paper did not require the buy-in compensation to be paid as a lump sum. Also, periodic payments over the average expected life of contributed intangibles were deemed acceptable. 1293. 1992 Prop. Treas. Regs. (57 FR 3571-01) § 1.482-2(g)(4)(iv). See Brauner (2016), at p. 113, where he notes that there is a similarity between the 1992 US proposed requirement that CSA participants had to use the CSA-developed IP in active conduct of trade or business (the requirement was scrapped in the 1996 revision of the CSA regulations) and the 2017 OECD TPG rule that pure cash-box entities cannot end up with the residual profits from unique IP. 1294. 1995 Treas. Regs. § 1.482-7 (60 FR 65553-01). Some alterations were made to the 1992 examples illustrating the buy-in provisions, none of which pertained to the determination of the buy-in amount. In 2003, in the aftermath of Xilinx Inc. and Subsidiaries v. CIR (125 T.C. No. 4 [Tax Ct., 2005], affirmed by 598 F.3d 1191 [9th Cir., 2010], recommendation regarding acquiescence AOD-2010-03 [IRS AOD, 2010], and acq. in result, 2010-33 I.R.B. 240 [IRS ACQ, 2010]), guidance requiring the inclusion of stock-based compensation as intangibles development costs was introduced into the cost-sharing regulations. For comments on Xilinx, see Brauner (2010), at p. 10; White (2016), at p. 200; the 2010 report from the Joint Committee on Taxation (JCX-37-10), at pp. 32-33; Blessing (2010b), at p. 174 (including a general discussion on the accounting of equity-based compensation in CSAs); Schön et al. (2011), at pp. 204-206; Horst (2009); Lang et al. (2011), at p. 233; Levey et al. (2010), at pp. 156-158; Avi-Yonah (2009a); Benshalom (2007), at p. 699 (see also p. 672); and Dix (2010). In Xilinx, a US parent entered into a CSA with a wholly owned Irish subsidiary. Both entities performed R&D, manufacturing and sales. All new technology developed under the CSA would be jointly owned, and the intangibles development costs would be shared pursuant to the reasonably anticipated benefit (RAB) shares of the participants. At issue was the treatment of costs connected to employee benefits in the form of stock options and employee stock purchase plans for stock in the parent, granted to the R&D staff of the parent and subsidiary. The parent deducted the costs of employee stock benefits as business expenses over the income years at issue. There was a reimbursement agreement in

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Experience with the 1995 regulations demonstrated a need for additional buy-in guidance.1295 Multinationals applied a range of different delimitations (e.g. short intangible life spans) in their CSAs to justify low buy-in valuations, resulting in offshore migration of significant rights to highly valuable US-developed intangibles, for what was presumably only a fraction of their true worth.1296 The 2005 proposed regulations were introduced to tackle these challenges.1297 Similar to the observations made in the White Paper almost 2 decades earlier,1298 no evidence was found that agreements comparable to typical controlled CSAs actually existed among third parties.1299 Purported CUTs (e.g. agreements on cost-plus “generic” research) presented to the IRS by taxpayers were “not viewed as analogous to cost sharing agreements”,1300 as they normally involved materially different divisions of benefits, costs and risks than those applied in controlled CSAs. This absence of CUTs was the reason why the 2005 proposed regulations adopted the basic buy-in pricing premise that the allocation of residual profits should mirror the result that would have been realized if unrelated parties under similar circumstances had engaged in a transaction similar to the CSA (investor model). Inherent to this premise was the assumption that a controlled party would act as an unrelated, rational investor would.

place between the parent and the subsidiary so that costs connected to employee stock benefits for the Irish R&D staff would be levied on the subsidiary. The employee stock benefit costs were not included as shared costs under the CSA. The US Internal Revenue Service (IRS) took issue with this treatment. The taxpayer ultimately prevailed. Xilinx is interesting on several levels, but its relevance for the purposes of this book is limited. It does not touch upon the buy-in issue, and the interpretation of the court in Xilinx is (in the author’s view, thankfully) no longer of relevance for CSAs entered into subsequent to the 2003 amendment of the CSA regulations. 1295. See the preamble to the 2005 Prop. Treas. Regs. (70 FR 51116-01) § 1.482-7. See also Dolan (1991); and Koomen (2015a), at p. 147. 1296. See Ballentine (2016), where typical buy-in pricing under the 1995 US CSA regulations is described as “wildly inconsistent with the arm’s length standard”. 1297. On these proposed regulations, see Kirschenbaum et al. (2005). 1298. See White Paper, ch. 12, sec. A. 1299. This, of course, triggers the question as to why CSAs, with their obvious potential for misuse, were allowed in the first place. The prevailing view is that the acceptance of CSAs in transfer pricing arose organically, without being backed up by any form of real study or justification, likely based on a naive belief that such agreements were common among third parties and that all participants in a CSA would bring contributions of somewhat equal value to the table. For good reflections on this important issue, see Brauner (2010), at pp. 7, 15 and 17. 1300. See the preamble to the 2005 Prop. Treas. Regs. (70 FR 51116-01) § 1.482-7.

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Unrelated parties would not grant valuable, pre-existing intangibles to a CSA unless they received an appropriate award for doing so.

14.2.3. The 2007 Coordinated Issue Paper In 2007, the IRS finalized a Coordinated Issue Paper (CIP) on buy-in adjustments,1301 aimed at providing guidance for IRS auditors and appeals settlements.1302 The CIP was withdrawn in 2012, but its material content remains relevant for audit cases for income years prior to those governed by the current 2011 cost-sharing regulations.1303 More importantly, the CIP provides valuable context for the interpretation of the current cost-sharing regulations (which has further developed the CIP buy-in doctrine). The author therefore finds a discussion of the CIP to be justified. The CIP provides guidance on the valuation of pre-existing IP that is made available to a CSA. The valuation will also incorporate the pricing of rights that are not transferred for the purpose of research, on an aggregate basis.1304 The CIP valuation approach was an answer to speculative taxpayer applications of the specified pricing methods of the 1995 regulations to value buy-ins.1305 A popular taxpayer approach was to use uncontrolled make-sell licences of the pre-existing intangible as a basis for applying the CUT method to value

1301. LMSB-04-0907-62. For comments on the IRS’s 2007 Coordinated Issue Paper (CIP), see Femia et al. (2008). 1302. The majority of US buy-in disputes were resolved at the examination or appeals stages. At the time at which the CIP was finalized, only one buy-in case was pending before the US Tax Court, Veritas, which was a major priority for the IRS. 1303. The current regulations apply to transactions entered into on or after 5 January 2009. 1304. Typically, the US parent also contemporaneously licenses make-sell rights in the current generation of the pre-existing intangible to the foreign subsidiary (that is party to the CSA). The CIP finds that licensed make-sell rights do not constitute buy-in intangibles, as they are not “made available for purposes of research”; see Treas. Regs. § 1.482-7(g)(2). Thus, standing alone, such rights do not give rise to an obligation to make a buy-in payment (the arm’s length payment for such licences should be determined under sec. 1.482-4). Nevertheless, an important aspect of the CIP approach is that the buy-in intangible and the make-sell licence is valued on an aggregate basis. See also the comments on the US best-method rule in sec. 6.4. and the aggregation of controlled transactions in sec. 6.7.2. 1305. The specified methods were incapable of allocating profits to intangibles development funding. See the analysis of R&D funding remuneration under the current OECD TPG in sec. 22.4.

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the buy-in.1306 The implicit taxpayer assertion was that uncontrolled makesell licences for a pre-existing intangible were comparable to making the same intangible available to a CSA for the purpose of further R&D.1307 Royalties extracted from such CUTs would normally be adjusted downwards throughout the useful life period to account for obsolescence of the licensed intangible. The result was that the lion’s share of the ownership of, and residual profits from, future versions of the pre-existing intangible could be migrated for a price not larger than the present value of the royalties from standard makesell rights to the first-generation intangible. Thus, none of the residual profits from the future intangibles developed under the CSA would be allocated to the United States (where the pre-existing intangible, and thus the basis for the subsequent research, had been created). The CIP rejected these applications of the CUT method.1308 The IRS made significant efforts in court to defend its CIP doctrine against taxpayers’ CUT method applications for buy-in pricing in the high-profile Veritas (2009) and Amazon.com (2017) cases, but did not succeed.1309 Another taxpayer strategy was to use the residual profit split method (RPSM) to determine the buy-in amount. The taxpayer application of the RPSM placed the risks that are assumed by the foreign subsidiary in making cost-sharing payments with respect to subsequent-generation intangibles on par with the risks assumed by the US parent in prior years

1306. The useful life was often determined on the basis of the current-version product life. This tended to limit the period during which buy-in compensation was to be paid by the foreign subsidiary, often to a period of only 2-4 years following the formation of the CSA. 1307. The result was that the buy-in payments would consist only of rapidly declining royalties over the period in which the current make-sell rights become obsolete. The value of all residual rights to the contributed pre-existing intangible, including the rights to use the pre-existing intangible as a basis for further research, would then fall outside the scope of the buy-in. 1308. The CIP claims that make-sell rights generally will not be comparable to R&D rights to the pre-existing intangible, in particular with respect to the similar profit potential requirement (see the discussions in secs. 7.2.2. and 7.2.3.). The author finds it fairly obvious that this must be correct. Make-sell rights simply allow the licensee to reap some profits from the manufacturing and sale of a current-generation product over its lifetime. R&D rights in the same intangible entail that the CSA participants receive co-ownership rights to future versions of the intangible. R&D rights are therefore, in reality, a vehicle to migrate ownership of an intangible. 1309. The rulings are analysed in secs. 14.2.4. and 14.2.5., respectively, with concluding comments in sec. 14.2.6.

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when it developed the first-generation, pre-existing intangible.1310 The residual profits from the cost-shared intangibles were split in proportion to the foreign subsidiary’s capitalized and amortized share of ongoing R&D costs, as compared to the sum of the US parent’s capitalized and amortized past development costs for the pre-existing intangible plus its capitalized and amortized share of ongoing R&D costs.1311 In other words, if the foreign subsidiary funded 80% of the intangible’s development costs, it would be allocated 80% of the residual profits. Multinationals claimed that this was consistent with the profit split method (PSM) provisions of the regulations.1312 The CIP rejected this approach.1313 Further, certain valuation methods were used by taxpayers to attribute substantial positive net present value to the projected R&D expenses of foreign “cash box” subsidiaries that only provided R&D funding. The logic behind this methodology was that because the current version of the buy-in intangible was expected to become obsolete, over time, the cost-shared intangibles resulting from the R&D should account for an increasing share 1310. The CIP finds that there is unlikely to be a parity of risks in the funding of past and future R&D. 1311. The buy-in payments would decline (“ramp down”) significantly over time, as the US parent’s past development costs are fully amortized (the useful life would often be set to a short period of 2-4 years, based on the useful life of the make-sell rights to the pre-existing intangible). After this period, the residual profit from the cost-shared intangibles would be allocated between the parent and the subsidiary pursuant to their RAB shares. 1312. Treas. Regs. § 1.482-6(c)(3). 1313. The example in Treas. Regs. § 1.482-6(c)(3) pertains to the determination of an appropriate make-sell royalty for a licence for a fully-developed intangible when both parties contribute pre-existing intangibles to the operations of the foreign subsidiary. While the regulations prefer a split of the foreign subsidiary’s residual profits on the basis of the relative value of the intangible property contributed by each controlled taxpayer, they do allow the use of capitalized and amortized costs of development as an allocation key. The CIP, however, argues that the use of cost as an allocation key is unreliable, as the foreign subsidiary in a CSA context bears only prospective risk, while the US parent brings both its past risks as well as its commitment to bear a share of the prospective development risks, and these respective risks are not comparable. The author agrees with the IRS’s conclusion. However, the principal reason as to why the residual profit split method (RPSM) should be inapplicable in these cases is the general requirement that the method may only be applied when both controlled parties provide unique inputs. The residual profits should be allocated in full to the party that contributes unique inputs, while the funding entity should be allocated a risk-adjusted “normal” return on its financial contribution. The CPM would have been a candidate for application, had it not been for the difficulty of obtaining reliable data on the return on intangibles development funding contributions. See sec. 22.4. on the allocation of profits to R&D funding under the OECD TPG; and sec. 22.4.7. with respect to the US CSA regulations.

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of the residual profits from future operations. Thus, for instance, if the US parent and the subsidiary funded 20% and 80%, respectively, of the ongoing R&D costs, the parent and subsidiary would be allocated 20% and 80% of the residual profits, respectively. The CIP found that such approaches violated established principles of transfer pricing – most notably, that controlled pricing should respect the pricing boundaries dictated by the best realistic alternatives available to the controlled parties – and therefore should be rejected.1314 The CIP’s answer to these base-eroding taxpayer buy-in valuations was to introduce the “unspecified income method”, which: […] determines the value of the buy-in intangible (along with any licensed make-sell rights) as the present discounted value of the stream of projected operating profits of the [controlled foreign company (CFC)] (or affiliated CFCs), after reduction by routine returns and projected cost sharing payments for the CFC’s share of the R&D projected under the CSA.

All intangibles that, at the time of the buy-in, were reasonably anticipated to contribute to the R&D under the CSA were deemed to be buy-in intangibles, for which an arm’s length charge had to be paid.1315 In other words, the buy-in amount was estimated by first valuing the entire foreign subsidiary. From this value, deductions were made for normal market returns allocable to the subsidiary, as well as the subsidiary’s share of the projected cost-sharing payments under the CSA. This allocated the entire residual profits to the US parent.1316 This valuation approach was the reverse of the standard “transaction-bytransaction” transfer pricing methodology, as its objective was to provide an aggregated valuation.1317 The method simply projected and discounted 1314. The CIP asserts that at arm’s length, the US parent would seek to retain that potential future premium for its own benefit (aligned with its best realistic alternative), unless the subsidiary provided sufficient compensation to make its net present value zero (the subsidiary then receives an allocation of income equal to its discount rate). See also the discussion of the best-realistic-alternatives principle in the context of valuation under the OECD TPG in sec. 13.5. 1315. The CIP argued that the synergy value of the research team responsible for the buy-in intangible had to be included in the buy-in, regardless of whether the research workforce as such was deemed to be an intangible. 1316. The income method applies the discounted cash-flow (DCF) business valuation approach. See the analysis of valuation under the OECD TPG in ch. 13. 1317. The aggregated valuation approach of the CIP would become influential for the further development of the US IRC sec. 482 regulations; see the discussion in sec. 6.7.2.

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Buy-in pricing under the US regulations

the subsidiary’s total future profits without taking into account which specific assets, functions and risks were responsible for the profit. The author finds no obvious reason why it should be appropriate to include in the buy-in valuation, as the CIP income method did, in the value of rights other than the right to use the contributed pre-existing intangible for the purpose of further research, as such other rights may not contribute to the R&D under the CSA (e.g. make-sell rights to the current-generation intangible).1318 On this point, the CIP approach was too aggressive. The author suspects that such rights were included because the method would be difficult to apply otherwise. The justification offered by the CIP for its aggregated valuation approach was, however, not this practical consideration, but a more principled argument: if the US parent combined a transfer of the rights to use the pre-existing intangible for the purpose of further R&D with a make-sell licence for the same intangible, the total transfer would be so comprehensive that it should be deemed as being akin to a sale of the current-generation intangible. This entailed that the valuation could be carried out on a goingconcern basis, taking into account future income streams for perpetuity, as opposed to a limited number of years. This methodology purportedly had a number of advantages over the specified methods available at the time. First, it provided remuneration for R&D funding, in the form of an expected return on cost-sharing payments. This was not possible to accomplish through the existing specified methods, such as the comparable profits method (CPM). Second, as it took into account the projected operating profits of only the foreign subsidiary, it automatically excluded the effect of any operating intangibles that solely benefitted the US parent (i.e. intangibles that were not transferred), such as US goodwill and going-concern value. This distinguished the income method from the market capitalization method that was also introduced into the

1318. Where transactions between the US parent and the foreign (cash-box) subsidiary are limited to one value chain, an aggregated valuation approach seems useful. If, however, the foreign subsidiary is an established entity with functions, assets and risks besides those relevant to the examined CSA, a reliable application of the income method will be contingent on a successful separation of the profits connected to the CSA intangibles (including any licensed make-sell rights and marketing intangibles) from the other business profits of the subsidiary so that the buy-in valuation does not encompass profits from intangibles other than those relevant to the CSA. This was an issue in Amazon.com; see the discussion in sec. 14.2.5.

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CIP.1319 Third, the method could, simultaneously with the determination of the buy-in amount, also set an arm’s length charge for other pre-existing operating intangibles owned by the US parent that were used by the foreign subsidiary in its operations (aggregated valuation). The main weakness of the unspecified CIP income method was, in the author’s view, its ambiguous approach to the allocation of operating profits to the R&D funding provided by the foreign subsidiary.1320 The method focused on the allocation of income to the US parent and on the best realistic options available to it. The CIP should have more thoroughly considered the controlled transaction from the point of view of the foreign subsidiary, in particular, that the subsidiary’s best realistic option for entering into the CSA would be to invest its R&D funding in alternative projects with similar risk-return profiles and should thus be allocated a risk-adjusted return through the calculation of the buy-in amount.

14.2.4. Case law: Veritas (2009) The 2009 US Tax Court ruling in Veritas Software Corporation v. CIR dealt with the valuation of a buy-in payment.1321 The ruling is significant, as it illustrates several key issues pertaining to buy-in valuations. The IRS 1319. The market capitalization method was introduced as an unspecified method to evaluate an initial buy-in. The total value of all intangibles owned by the US parent was determined as the difference between market capitalization of the US parent (market value of equity plus liabilities), minus the value of tangible property. The initial buy-in amount under the market capitalization method was set as the foreign subsidiary’s pro rata share of the buy-in intangible amount, where the pro rata share was the RAB share of the subsidiary. 1320. The CIP could arguably be interpreted so that routine returns shall be allocated only to the functions of the subsidiary, while its cost-sharing payments shall be refunded at their nominal amounts. The subsidiary would, of course, have a better realistic option available relative to entering into a CSA if it were to receive no return on its CSA funding contribution. The author refers to the discussion of the arm’s length remuneration of intangible development funding in the context of the OECD TPG in sec. 22.4., which should also be relevant here (the transfer pricing considerations are the same). 1321. Veritas Software Corporation & Subsidiaries v. CIR, 133 T.C. No. 14 (U.S. Tax Ct. 2009), IRS nonacquiescence in AOD-2010-05. Veritas was presided by Tax Court Judge Foley, who also ruled in Xilinx Inc. and Subsidiaries v. CIR, 125 T.C. No. 4 (Tax Ct., 2005), affirmed by 598 F.3d 1191 (9th Cir., 2010), recommendation regarding acquiescence AOD-2010-03 (IRS AOD, 2010), and acq. in result, 2010-33 I.R.B. 240 (IRS ACQ, 2010). For discussions of Veritas, see Brauner (2010), at p. 13; JCX-37-10, at pp. 33-34; Schön et al. (2011), at pp. 206-210; Wittendorff (2010a), at pp. 644-645, 651 and 660; Levey et al. (2010), at pp. 152-153; Hughes et al. (2010); Lin et al. (2010); and Odintz et al. (2017), at sec. 2.2.5. See also Brauner (2016), at p. 117 on the ruling.

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Buy-in pricing under the US regulations

argued that the CIP valuation approach should be applied under the 1995 cost-sharing regulations. As the specified income method of the present CSA regulations represents a further development of the 2007 CIP approach, many aspects of the case are relevant to the interpretation of the current regulations. Veritas is also relatively unique, as it is one of only two transfer pricing cases (that the author is aware of) that provides a detailed buy-in valuation analysis, with the other case being Amazon.com.1322 The case pertained to a US parent that, in 1999, entered into a CSA with a newly established Irish subsidiary for the purpose of developing and manufacturing software products. The CSA consisted of a package of three agreements, in which the parent (i) assigned all existing sales agreements with European-based group entities to the subsidiary; (ii) entered into an agreement with the subsidiary for the sharing of R&D costs, for which the parties agreed to pool their respective resources and R&D efforts related to software products and manufacturing processes and to share the R&D risks going forward; and (iii) entered into a technology licence agreement with the subsidiary in which make-sell rights to the covered products in Europe, the Middle East, Africa and the Asia-Pacific region were granted. In exchange for these rights, the subsidiary agreed to pay royalties to the parent. The subsidiary was a marketing and distribution entity, largely performing routine functions. No R&D was carried out in Ireland. The parent had developed a range of pre-existing software that it contributed to the CSA. The products were commercially established and well known. At the time at which the CSA was entered into, the parent sold its products either directly to customers or through third-party original equipment manufacturers (OEMs), distributors and resellers, including Sun, HP and Dell Products. The calculation of royalties under the OEM licence agreements was based on list price, revenues or profits, and ranged from 10% to 40% for bundled products and 5% to 48% for unbundled products, depending on the profit potential and sales volume of the products. The market for the Veritas software was intensely competitive. The current-version software products lost value quickly, as new functions were duplicated by competitors. At the time at which the CSA was entered into, the Veritas current-version products, on average, had a useful life of 4 years. The core of the IRS’s argument was that the parent’s transfer of pre-existing intangibles was “akin to a sale” and that the transferred assets collec1322. 148 TC No. 8; see the discussion in sec. 14.2.5.

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tively possessed synergies that provided the whole with greater value than each asset standing alone, and that the controlled transactions therefore should be aggregated for valuation purposes.1323 The IRS argued that this approach was permissible under the general aggregation provision in section 1.482-1(f)(2)(i)(A) of the US IRC section 482 regulations, according to which transactions could be aggregated if they produced the “most reliable means of determining the arm’s length consideration for the controlled transactions”. The taxpayer asserted that this valuation approach was motivated by the fact that, if valued separately, the transferred intangibles should be deemed to have finite useful lives, but if valued aggregately as a business transfer, a perpetuity or going-concern approach could be applied, taking into account intangibles that were subsequently developed under the CSA rather than pre-existing at the time at which the agreement was entered into. A valuation premised on perpetual lives for the underlying intangibles would yield a higher buy-in price than a valuation premised on finite useful lives, as the valuation then would encompass estimated operating profits from more future income years. The basic discounted cash-flow (DCF) methodology employed by both the taxpayer and the IRS was fundamentally the same. The differences between their pricing approaches pertained to the component elements in the valuations. The taxpayer based its estimates of income on royalty rates extracted from uncontrolled make-sell licence agreements with OEMs, while the IRS used income projections. Further, the taxpayer assumed finite income streams limited to the duration of the make-sell licences, while the IRS assumed perpetual income.1324 The taxpayer valuation therefore did not contain a terminal value, and no growth rate was used.1325 Further, the taxpayer applied a higher discount rate than the IRS.1326 1323. Under the now-current regulations, the buy-in pricing would have been subject to the specified income method; see Treas. Regs. § 1.482-7(g)(4), discussed in sec. 14.2.8.3. See also the comments on the US best-method rule in sec. 6.4.; and on the aggregation of controlled transactions in sec. 6.7.2. 1324. The longer the useful lives of the intangibles being valued, the larger the output of the valuation will be. Thus, a taxpayer will normally be inclined to argue for short useful lives, and the opposite goes for the tax authorities. 1325. The higher the growth rate used in a valuation, the larger the value of the valuation will be (the growth rate will reduce the discount rate used to calculate the terminal value, thus increasing the terminal value and thereby the total valuation amount). Thus, a taxpayer will normally be inclined to use a low growth rate, and the opposite goes for the tax authorities. 1326. The lower the discount rate used in a valuation, the larger the value of the valuation will be. Thus, a taxpayer will normally be inclined to use a large discount rate, and

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Buy-in pricing under the US regulations

The fundamental problem with the ruling, as the author sees it, is that it fails to carry out a proper transfer pricing analysis of the transferred rights to use the existing software for the purpose of further research. The taxpayer hand-picked uncontrolled make-sell agreements between the parent and third-party OEMs to determine a 20% appropriate starting royalty rate for the buy-in payment with a useful life of between 2 to 4 years, which was ramped down over the buy-in period. The IRS argued that the agreements were incomparable to the controlled transaction, but this was rejected by the Court.1327 The author struggles to follow the reasoning of the Court, as the parent, on top of the transfer of make-sell rights, also transferred rights to use the preexisting intangibles for the purpose of further research. As a consequence, the Irish subsidiary would become the owner of the rights to exploit future software developed under the CSA in its markets. Ownership rights to future intangibles are clearly distinct from make-sell rights to existing software; the income from current-version, pre-existing intangibles will be generated over the finite useful life period of the software. The income from future software developed under the CSA will continue to be generated as long as new programs are developed. The income streams from these two types of rights in the pre-existing software, and thus the associated profit potential, therefore differ significantly. The parent, by entering into the CSA, in reality relinquished the ownership rights to future software developed under the CSA with respect to the subsidiary’s markets. It is the loss of income potential resulting from this relinquishment for which the buy-in should compensate the parent. The income from the make-sell rights to the existing software would, in any case, be taxable to the parent, as it was the owner of those rights. Thus, what the Court ended up doing in Veritas was pricing the make-sell rights that the parent transferred to the subsidiary, not the rights to use the the opposite goes for the tax authorities. 1327. The author takes issue with this. Under the comparable uncontrolled transaction (CUT) method, there must be sufficient comparability between the significant economic activities under the uncontrolled and controlled transactions; see Treas. Regs. § 1.482-4(c)(2)(iii)(A). A clearly significant activity under the CSA was the performance of R&D. Third-party licences were purely make-sell agreements, under which no R&D was to be performed. The uncontrolled and controlled transactions were therefore not comparable on this point. The justification of the court for disregarding this fact, i.e. that its interpretation of sec. 482-7(g)(2) did not include income from future software, is not convincing. In reality, the court failed to respect the comparability requirements of the CUT method.

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existing software for the purpose of further R&D. Even if the 1995 costsharing regulations contained only sparse guidance on the issue of buy-in valuation (relative to the current CSA regulations), it must be recognized that the background law on transfer pricing was quite well developed. The Court focused on the words “pre-existing intangible property” in the US Treasury Regulations (Treas. Regs.) § 1.482-7(g)(2) and interpreted this to mean that the buy-in valuation should only take into consideration income from the existing versions of the software, not income from software subsequently developed through the CSA. What the Court in fact did here was to infer a stance on the transfer pricing of the buy-in from the first sentence of section 482-7(g)(2), an issue that the provision did not address. In the author’s opinion, the focus of the Court should instead have rested on the second sentence of section 482-7(g)(2): “[T]he buy-in payment by each such other controlled participant is the arm’s length charge for the use of the intangible under the rules of §§ 1.482-1 and 1.482-4 through 1.482-6, multiplied by the controlled participant’s share of reasonably anticipated benefits.” Had the Court instead focused on the transfer pricing principles expressed in the 1994 regulations – as the 1995 buy-in provision specifically instructed – the outcome of the case should have been different.1328 Most importantly, the Court should have taken the alternatives realistically available to the parent and the Irish subsidiary into consideration. This approach would have had a solid legal basis in the 1994 regulations, as the realistic alternatives principle was expressed in several provisions therein.1329 The fact that the principle was applicable also when applying the transfer pricing methods, regardless of whether the relevant methodology was a specified method or not, was clearly expressed in the preamble to the 1994 regulations: [A]n unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction. This guidance has been included because it is a principle that is consistent with all methods that apply the arm’s length standard. (Emphasis added)

1328. See Treas. Regs. (59 FR 34971-01), sec. 482-7(g)(2). 1329. E.g. in Treas. Regs. (59 FR 34971-01) sec. 1.482-1(d)(3)(iv)(H) as a comparability consideration with respect to economic conditions; in sec. 1.482-3(b)(2)(ii)(B)(8) as a comparability consideration with respect to the transfer pricing of tangibles; as well as a principle that must be complied with when using an unspecified method to price tangibles and intangibles in secs. 1.482-3(e)(1) and 1.482-4(d)(1), respectively.

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Had the Court applied the realistic alternatives principle, it should have recognized that if the parent had not entered into the CSA, but instead developed new versions of the software itself, it would have been entitled to the residual profits from the future software from all regions of the world. By entering into the CSA, it effectively relinquished the residual profits from future versions of the software from the markets of the subsidiary (which included all worldwide markets apart from the US markets). The buy-in payment should compensate the parent for this value transfer and put it at least as well off as it would have been had it instead developed the future software itself and licensed out make-sell rights. From the point of view of the subsidiary, the best alternative to entering into the CSA would have been to let the parent develop the future software. It then would not have incurred any of the financial risks associated with the intangible development, as it would have no obligation to pay any share of the R&D costs associated with the CSA software development. It would simply have licensed the fully developed intangible at an arm’s length royalty rate. After this analysis of the options realistically available, the Court should have selected an appropriate transfer pricing method. A functional analysis of the parent and the subsidiary should have resulted in the acknowledgement that the parent provided all unique inputs to the intangible development. All R&D was carried out in the United States by the parent, based on its unique, self-developed intangibles, using its existing R&D teams. The Irish subsidiary only contributed R&D funding. As only one of the parties to the controlled transaction furnished unique inputs, a one-sided methodology akin to the CPM would be the natural choice for determining the buy-in payment. The CPM would set the buy-in amount so that all residual profits from future versions of the software developed under the CSA would be allocated to the parent, while the subsidiary would receive a normal return on its routine contributions. Nevertheless, the CPM could not have been applied directly, as there would be no comparable data available that reflected an arm’s length return on the subsidiary’s R&D funding.1330 An unspecified method that compensated 1330. See also the analysis of the remuneration of R&D funding under the OECD TPG in sec. 22.4. See also Odintz et al. (2017), at sec. 2.2.5.1, where it is argued that remuneration should be provided for R&D funding under applications of the unspecified income method.

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the subsidiary for its funding should therefore have been used. The main trait of the CPM, i.e. that all residual profits are allocated to the party that provides unique inputs, however, should have been carried over to this unspecified method.1331 Thus, the subsidiary should have been allocated an arm’s length remuneration for its functions and intangible development funding only, as opposed to the residual profits effectively allocated to it by the Tax Court. Remuneration of the subsidiary’s funding contributions would have triggered challenging issues. Provided that the CSA R&D activity pertained to further development of established and successful software products, the remuneration should be based on the assumption that the intangible development costs were subject to relatively modest risk levels.1332 In conclusion, it may be observed that the parent was compensated for its loss of ownership rights to the future intangibles developed under the CSA (with respect to the subsidiary’s markets) by discounting an arm’s length make-sell royalty for the income generated by the current-version, preexisting software. This did not compensate the parent for its actual loss of value. The parent instead received a value that it would have been entitled to regardless of its participation in the CSA (as the pre-existing software was developed prior to the formation of the CSA). It is therefore difficult to accept the ruling as an appropriate application of the transfer pricing methods and the best-options-realistically-available principle. The author does not find the result in Veritas to be compatible with the IRC section 482 arm’s length standard.1333

1331. As the goal would be to compensate the parent for its loss of income potential from the future software, the useful life of the software should be assumed to be perpetual if there are no clear indications that the CSA development will cease at some specific future point, or at least significantly longer than the useful life of the currentversion pre-existing software. The discount rate applied by the taxpayer should likely be accepted. The growth rate applied by the IRS should be rejected; the rate used in the terminal value should be a “steady state” growth rate. All residual profits from the subsidiary’s exploitation of the marketing intangibles should be allocated to the parent, given that the subsidiary does not incur marketing expenses that exceed an arm’s length level. 1332. See the analysis of the remuneration of R&D funding under the OECD TPG in sec. 22.4. 1333. Brauner (2010) is also critical of the ruling. Brauner (2010), at p. 14; and Brauner (2016), at p. 118, however, seems to read the ruling as having implications not only for the interpretation of the previous-generation (1995) US cost-sharing regulations (the interpretation of which was at issue in the case), but also for the current, new-generation regulations. The author’s impression is that Brauner reads too much into the ruling. The author’s view is that the ruling has no direct relevance for the interpretation of the current regulations.

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14.2.5. Case law: Amazon.com (2017) The primary issue in the 2017 Tax Court ruling in Amazon.com v. CIR was the determination of an arm’s length buy-in payment for an outbound transfer of US-developed intangibles.1334 The factual pattern of the case was, in essence, as follows:1335 A US entity in the Amazon group had developed, through its own R&D, a range of valuable intangibles pertaining to the group’s global, web-based retail business, including (i) software technology; (ii) marketing intangibles (Amazon domain names, trademarks, trade names, etc.); and (iii) customer information. In 2005, this US entity entered into a CSA with a Luxembourg group entity and contributed its self-developed intangibles to the CSA for the purpose of further developing the IP on a joint basis with the Luxembourg entity. All R&D efforts going forward would, as before, be carried out by the US entity, but the Luxembourg entity would now co-fund the R&D costs. The US and Luxembourg group entities would become co-owners of any new intangibles developed under the CSA and thus be entitled to the residual profits from these in proportion to their respective ownership shares. Prior to the formation of the CSA, the US entity was entitled to all residual profits from the worldwide exploitation of its IP. By entering into the CSA, it surrendered to the Luxembourg entity its right to residual profits from exploitation of the current and future IP in the European market. The core issue of the case was to determine how the US entity should be compensated for its contribution of IP items (i)-(ii) to the CSA. As in Veritas, the case pertained to income periods governed by the previous-generation (1995) cost-sharing regulations, which did not contain the income method as a specified method for pricing buy-ins. The available methodologies for pricing contributions of pre-existing IP to a CSA were those of the CUT method, CPM, PSM and unspecified methods.1336

1334. 148 TC No. 8. At issue was also the allocation under Treas. Regs. § 1.482-7(d)(2) of certain cost items to the intangibles development cost pool (which the cost-sharing payments were based on), in light of the invalidation of the regulation in the 2005 Tax Court ruling in Altera v. CIR (145 TC 91). The author will limit his comments to the buy-in issue. See also, e.g. Odintz et al. (2017), at sec. 2.2.5; and Avi-Yonah (2017) on the Amazon.com ruling. 1335. The factual pattern of the case is comprehensive (the ruling spans 207 pages). The author has somewhat simplified it for the purpose of this discussion. 1336. Treas. Regs. § 1.482-1(c).

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The taxpayer valued the transfer of IP groups (i)-(iii) separately and then summarized the individual values, thereby not triggering any residual intangible value (goodwill, going concern value and workforce in place) that could have arisen if the transfer had been valued as a whole. The taxpayer’s argument was that the CSA contribution consisted of transfers of several single assets (each with a 7-year useful life), not of an ongoing business.1337 The result was a value of USD 254.5 million. Faithful to the CIP approach,1338 the IRS’s reassessment valued the transfer of IP items (i)-(iii) as a “package” (i.e. a business transfer), based on the rationale that the buy-in pricing should be consistent with the best realistic alternatives available to the parties. The alternative for the transferring US entity would be to continue its full IP ownership position, assume all costs and risks of further IP development and license out the European rights to the resulting IP to the Luxembourg entity, thereby retaining entitlement to all residual profits from worldwide exploitation of future versions of its IP. According to the IRS, the buy-in price should be set so that the US transferer would not be put worse off than if it instead had chosen this alternative. This is simply because the US entity would never have transferred the IP to a third party for a lower price. The result was a value of USD 3.466 million. The Court rejected the IRS’s approach for several reasons. First, even though it did not seem to take issue with the fundamental assertion that no third party would have entered into a CSA and transferred its IP if the price was below what the third party could have achieved with a realistic alternative, the Court simply observed that such “realistic alternatives pricing” would make the option of entering into a CSA, which the regulations endorsed, meaningless.1339 The reason is because the price of the buy-in would then be set as if there were no CSA. The Court found that “realistic alternatives pricing” would be equal to a restructuring of the actual transaction, which the regulations only allowed if it lacked economic substance (which it did not).1340 This was, in the author’s view, an important misstep by the Court. IRC section 482 requires that intra-group profit allocation must mirror arm’s 1337. The taxpayer valuation itself was DCF-based, with the future estimation of income based on royalties from purportedly comparable third-party agreements under the CUT method. 1338. LMSB-04-0907-62. See also the discussion in sec. 14.2.3. 1339. See the ruling in 148 TC No. 8, p. 83. 1340. Treas. Regs. § 1.482-1(f)(2)(ii)(A).

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length, third-party dealings. The Court recognized this principle, but disregarded it. Applying transfer pricing to a controlled transaction to adjust the controlled price so that it corresponds to what a third party would have charged is a world apart from restructuring the actual transaction. The pricing assertion of the IRS was, in principle, nothing more than an ordinary transfer pricing adjustment. Thus, the logic of the Tax Court seems to imply that all transfer pricing reassessments (i.e. adjustments to the controlled price using transfer pricing methodology) would be equal to a restructuring of the actual transaction. Such a view is, of course, nonsensical. The IRS pricing did respect the actual controlled transaction. Even with the IRS pricing, the Luxembourg entity would still be obliged to contribute intangible development costs (IDCs), and for this, would become co-owner of future IP developed under the CSA. The point of the IRS was that the price required to be paid by the Luxembourg entity for the future benefits it would receive under the CSA should be equal to the present value of the benefits. It is true that with such a high price, the CSA alternative would not have been as attractive for the Luxembourg entity. It would not stand to gain or lose anything; the price would simply be equal to the worth of what it got in return. For the US entity, however, this high price would be the only rationale for entering into the CSA. It would simply not make any sense to enter into the CSA at a lower price, as that would mean that the US entity would give up value for nothing in return. No third party would do so. It is the author’s view that the Tax Court failed to adhere to the fundamental core of section 482 when it dismissed the IRS’s “realistic alternatives” pricing assertion. Even if the cost-sharing regulations applicable to the income years at issue did not include the income method as a specified transfer pricing method for buy-in pricing, the Court could have – as in Veritas –found legal basis for the IRS’s assertion by way of applying a one-sided method (e.g. the CPM with some adjustments) to the Luxembourg entity, thereby leaving the residual profits to be allocated to the US entity through the buy-in. Such one-sided methodology would likely not have been entirely precise in this case, but would nevertheless have aligned the result with sound transfer pricing logic and respected the fundamental purpose of IRC section 482. Further, the Court supported its rejection of the IRS’s pricing approach on the basis that it did not provide the most reliable means of establishing an arm’s length charge for the buy-in transaction. This was founded on two

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Chapter 14 - Allocation of Residual Profits to Unique and Valuable IP through Cost-Sharing Structures

main points.1341 First, the IRS’s approach mixed together IP that was compensable under the applicable previous-generation cost-sharing regulations (pre-existing IP contributed to the CSA) and IP that was not (IP subsequently developed under the CSA).1342 It is true that the IRS’s pricing approach treated the contribution of preexisting IP to the CSA as a business transfer that effectively transferred all future income streams from the European part of the Amazon business to the Luxembourg entity. The IRS simply valued the business of the Luxembourg entity, and from this, deducted the present value of certain expenditures (mainly IDCs). In effect, this treated the pre-existing intangibles that were contributed to the CSA as if they had indeterminate useful lives, thereby also encompassing subsequently developed intangibles. There is no doubt that the question under the applicable cost-sharing regulations was to determine the arm’s length buy-in value for the pre-existing IP that was contributed by the US entity to the CSA.1343 However, that does not imply that the pricing had to be artificially restricted to a separate group-by-group valuation when the US IP items (i)-(iii), in fact, were transferred together to the Luxembourg entity as a package of assets. The effect of the CSA arrangement as a whole was to transfer the right to future residual profits from European exploitation of the pre-existing and future IP created – using the pre-existing IP as the research platform – under the CSA to the Luxembourg entity. The software, marketing IP and customer information were designed to be used as an integrated whole. The value of each IP category would be highly contingent on being used together with the other IP categories transferred. Also, proper compensation should include the research value of the pre-existing IP. That value could necessarily only be reflected as a portion of the value of the successor IP. It seems that the focus of the Court –as in Veritas – was merely on the exploitation value of the pre-existing IP (which, of course, was limited) at the expense of a more thorough and critical examination of the research value inherent to it. The Court’s tunnel-vision-based application of the cost-sharing regulations ignored that the controlled pricing should align with the pricing boundaries dictated by the realistic alternatives of the controlled parties.1344 1341. Ruling in 148 TC No. 8, p. 82. 1342. See Treas. Regs. § 1.482-7(a)(2) and (g)(2). 1343. Id. 1344. The author uses the term “tunnel vision” here much in the same way as Brauner (2016), at p. 99 applies the term “literal arm’s length” to indicate rather formalistic transaction-by-transaction pricing assessments based on limited studies of comparability.

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Buy-in pricing under the US regulations

Second, the Court rejected the IRS’s pricing assertion on the basis that it also entailed compensation for residual intangible value that did not satisfy the pre-2018 version of the US IP definition referred to in IRC section 482. This objection from the Court does, in the author’s view, carry substantial weight. US transfer pricing is indeed restricted by the IRC section 936 definition.1345 While the current-generation cost-sharing regulations bypass this restriction through the platform contribution concept,1346 there was no such bypassing in the previous-generation (1995) regulations applicable to the income years at issue in this case. The IRS’s reassessment valuation violated the pre-2018 version of the section 936 definition’s restriction. The Tax Court, however, did not properly assess the classification of the IRS’s value among specified IP (which falls under the pre-2018 section 936 definition) and residual intangible value (which falls outside the pre-2018 section 936 definition). It is therefore unclear as to what extent the IRS’s valuation would have had to have been reduced in order to comply with the pre-2018 section 936 definition. Further, the Court rejected the underlying premise of the IRS’s valuation – in essence, an implication of applying realistic alternatives pricing – that the residual profits from the European exploitation of IP developed under the CSA should be allocated to the group entity that provided the most valuable intangible development contributions to the CSA. This was the US entity, as it provided the R&D. The IRS allocated relatively generous compensation to the co-funding contributions of the Luxembourg entity of 18% of the IDCs.1347 The Court, however, found this unacceptable, as it deemed the Luxembourg entity to own the European rights to the intangibles, and therefore held that it should be entitled to the entire residual profits from these intangibles. The Court’s justification on this point was that the applicable cost-sharing regulations did not distinguish between actual technology development and CSA contributions in the form of cash. That observation is, in isolation, correct. However, in order for cost-sharing to work as intended, there must be an arm’s length buy-in payment when a party to the agreement contributes pre-existing IP. The determination of that buy-in must take into account the realistic alternatives of the controlled parties, pursuant to which it undoubtedly will be relevant to assess whether a third party that performs promising and valuable R&D would be willing to give up future fruits from that R&D simply for being reimbursed for its R&D costs, which, of course, would be unlikely. 1345. See the analysis of the US IP definition in sec. 3.2. 1346. See the discussion of platform contributions in sec. 14.2.7.5. 1347. Ruling in 148 TC No. 8, p. 86.

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Chapter 14 - Allocation of Residual Profits to Unique and Valuable IP through Cost-Sharing Structures

The Court’s rejection of the CIP-based aggregated pricing approach alone in reality determined, in broad strokes, the outcome of the case, as the implication of this stance was that IP categories (i)-(iii) then had to be valued separately. That meant that no residual intangible value due to the integration between the transferred IP (goodwill, going concern value, etc.) could be allocated to the US entity through the buy-in. The author will comment on some of the main points pertaining to the Court’s buy-in valuation of the separate IP categories (i)-(iii). IP category (i): Website technology (software) As the IRS’s CIP-pricing approach had been rejected, the parties agreed that the CUT method should be used to price the buy-in on the basis of royalty rates extracted from transactions between Amazon and independent retailers. There was disagreement on the applicable royalty rate, the useful life of the transferred IP, the revenue base on which to apply the royalty rate, as well as the appropriate discount rate. The most interesting aspect of the ruling on this point is the Court’s assessment of the useful life of the transferred IP.1348 Contrary to the IRS’s “infinite life” assertion, the Court found that the transferred IP on average had a useful life of only 7 years. Further, the Court found that the concepts and code of the existing software became obsolete relatively quickly and that there was no indication that new software developed under the CSA relied on old code or prior ideas to any significant extent. The Court did, however, recognize that the transferred IP had residual value that was not captured by the 7-year premise, and therefore added a “tail period” of an additional 3.5 years with reduced royalty payments to compensate for this residual value. The Court seemed to have been in some doubt with respect to whether this tail actually captured the residual value appropriately, but ultimately found it to be sufficient, as the IRS had not offered any alternative means of calculating an appropriate tail period. The author is sceptical as to whether the Court, through this approach, managed to appropriately allocate income to the US entity in order to compensate it for the research value inherent to the transferred software technology. It also seems fairly obvious that the Luxembourg entity, through the CSA, acquired access to the know-how, experience and workforce in place of the US entity’s R&D team and that the CUT valuation did not manage to reflect this value.

1348. Ruling in 148 TC No. 8, p. 103.

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IP category (ii): Marketing IP (Amazon name, trademarks, trade names, domain names and trade dress, including for the significant French, ­German and UK markets) The lion’s share of the IRS’s reassessment value was attributable to these marketing intangibles.1349 The parties also agreed here that the pricing should be CUT-based,1350 but disagreed on the applicable royalty rate, the useful lives of the transferred IP (the revenue base of which the royalty rate should be applied to), as well as the appropriate discount rate. The two most significant issues were (i) the determination of the useful lives; and (ii) whether the buy-in value should be reduced because the Luxembourg entity already owned portions of the marketing IP. First, with respect to useful life, the Court found that the marketing IP items (which had strong positions in the relevant markets at the time of transfer) had longer lives than the software, although not indefinite. The Luxembourg entity was responsible for marketing development efforts in Europe. As the value of the marketing IP would be strongly correlated with the value of the other Amazon IP – which the Luxembourg entity coowned through the CSA – and as the Luxembourg entity, through its local marketing efforts, would build the future value of the European marketing IP, the Court found that no third party under such circumstances would be willing to pay royalties for the use of the marketing IP forever. The Court concluded that the marketing IP had a useful life of 20 years, a period long enough to capture most of the present value asserted by the IRS on this point. Second, with respect to whether the buy-in should be reduced to take into account prior ownership, the claim from the taxpayer was that the Luxembourg entity already owned part of the marketing intangibles (most prominently, the editorial content of the Amazon websites in France, Germany and the United Kingdom, as well as Amazon trademarks and domain 1349. The taxpayer valuation, using royalty rates ranging from 0.125% to 1%, a useful life between 10-15 years and a discount rate of 18%, was in the interval of USD 251312 million, minus a reduction of 50% in order to account for prior ownership by the Luxembourg entity of certain marketing IP, resulting in a value between USD 114-165 million. The IRS’s valuation, using a royalty rate of 2%, a useful life between 10-15 years and a discount rate of 18%, concluded with a value for the marketing intangibles of USD 3.13 billion, not allowing a reduction for any previously owned marketing intangibles of the Luxembourg entity. 1350. With royalty rates extracted from transactions between independent parties from the ktMINE database, available at https://www.ktmine.com/ (accessed 10 Sept. 2015).

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names for these jurisdictions) at the time at which the CSA was entered into, and that the valuation amount therefore should be reduced by 50%.1351 The IRS opposed this, based on the assertion that the US entity should be deemed the “true equitable owner” of the marketing IP, as it had made all investments and taken all risks associated with building the marketing value of the IP in Europe. The court observed that the applicable section 482 regulations required that intangible ownership should be determined with reference to legal ownership, provided that this would not be contrary to the economic substance of the underlying arrangement.1352 European group entities were registered locally as owners of relevant marketing intangibles,1353 and the Court found that there were sound business reasons for such practices (in some instances, required by local law). The European group entities had also used the relevant marketing intangibles in their local business activities. The Court therefore found the European marketing IP ownership to have economic substance, and was thus unwilling to set aside legal ownership. With respect to the IRS’s assertion that the US entity bore the costs and risks of the European marketing efforts, the Court simply noted that because the European group entities only received sales commissions, they incurred business risks (i.e. no guarantee that they would earn a profit). The author finds the Court’s assessment on this point to be superficial. The question was not whether the European legal owner entity incurred normal business risks, but whether it took the risk of developing the value of the marketing IP locally i.e. whether it incurred the marketing costs. If it in fact was the US entity that bore the European marketing costs, that should clearly indicate that the economic substance of the marketing arrangement between the US and Luxembourg group entities indeed was that the US entity was the owner and that the Luxembourg entity functioned only as a title-holding agent. If so, the US entity should have been entitled to the residual profits from the European exploitation of the marketing intangibles. There would then be no basis upon which to reduce the buy-in price for previously owned IP. The Court should have assessed this more thoroughly. The result on this issue was a reduction of the buy-in price with 25% for 1351. Ruling in 148 TC No. 8, p. 147. 1352. Treas. Regs. § 1.482-4(f)(3)(ii)(A). 1353. There was a reorganization of the European part of the group around the time at which the CSA was formed, in which marketing IP registered to other European entities in the Amazon group was transferred to the Luxembourg entity. Thus, for the purpose of assessing European ownership of the marketing IP, the court had to take into account prior practices between the US entity and the other European group entities.

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Buy-in pricing under the US regulations

prior ownership, still leaving a considerable 75% for the buy-in value allocable to the US entity. IP category (iii): Customer information The US entity contributed information on European customers to the CSA, thereby, in effect, referring its existing European customers to the Luxembourg entity. Also here, it was agreed that the CUT method should be applied, on the basis of internal CUTs on third-party referral fees to Amazon. The IRS claimed that this did not capture all residual value inherent to the customer information. The Court agreed, in principle, but found that the residual value was short-lived and had been sufficiently taken into account in the valuation of the marketing IP.

14.2.6. Concluding comments on Veritas and Amazon.com Through the decades, high-value, US-developed intangibles have been transferred outbound through CSAs to group entities resident in jurisdictions with favourable taxation of IP income without triggering taxation of the “full” IP value on the way out, made possible through low buy-in valuations. Eventually, the IRS developed the “realistic alternatives”-based CIP approach to buy-in valuation to counter these practices. The CIP doctrine was not incorporated into the cost-sharing regulations until 2009 (through the income method; see the discussion in section 14.2.8.3.), but the IRS nevertheless started applying the doctrine to prior income years even if it had not yet been anchored in the regulations as a specified pricing method. Therein lies the heart of the problem in both Veritas and Amazon.com: the Court did not find room in the previous-generation (1995) cost-sharing regulations to apply the CIP approach. While it is true that there was no specified income method that the Court could have used,1354 it would have been, in the author’s view, natural to apply one of the available one-sided methods to remunerate the foreign cash-contributing entity (e.g. the CPM, with some adjustments). While the tunnel-vision, item-by-item valuations under the CUT method in both Veritas and Amazon.com may come across as straightforward applications of 1354. Avi-Yonah (2017), at p. 4 suspects that the result would have been the same in Amazon.com had the case been tried under the current cost-sharing regulations (which contain the specified income method). The author does not share this view.

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buy-in methodology set out in the previous-generation cost-sharing regulations, there should be no doubt that this CUT approach failed to capture significant intangible value transferred out of the United States. There should also be no doubt that the CUT method results do not respect the acceptable price boundaries dictated by the realistic alternatives principle (which had a clear legal basis in the 1994 regulations).1355 In both Veritas and Amazon.com, the US entity, through its cost-sharing contribution, in reality transferred its right to future residual profits to a group financing entity that contributed nothing apart from cash to the ongoing R&D activities carried out (by the US entity) under the CSA. The US entity would simply be better off by continuing its ownership position and then licensing out the results to other group entities. A true arm’s length buy-in price should, of course, reflect this fact. No third party would be willing to settle for less. It is not as the Tax Court claimed in Amazon.com that “realistic alternatives” pricing would be equal to a restructuring of the actual controlled transaction. The CSA would stand as such, and the only consequence of applying the IRS’s pricing approach would be the allocation of more income to the US entity. Thus, the price of the CSA contribution would go up, but everything else would remain the same. This is pricing, not restructuring. It should also be noted that the IRS was too aggressive in both cases. The valuation in Veritas contained errors. The Amazon.com valuation clearly contained value that was attributable to functions and assets already present in the Luxembourg entity before the CSA was formed, and thus not caused by the IP transferred from the US entity. This value should therefore have been kept outside of the buy-in price. One can hope that the IRS will not repeat such mistakes in its future valuations under the income method. With respect to its unwillingness to accept the CIP approach in Amazon. com, the author finds it peculiar that the Court did not reflect more thoroughly on the appropriateness of remunerating the Luxembourg entity as a routine value chain contributor under a one-sided methodology. In this also lies the observation that the taxpayer structure was tax-driven. The Luxembourg entity, while far from being a simple cash box, seems to have functioned – among other things – as an IP holding entity in Europe, and its royalty income was likely not taxable by much in Luxembourg.

1355. See supra n. 1329.

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In the end, the result of Amazon.com was not entirely negative for the IRS. Yes, the battle over the CIP approach was lost (again), but the Tax Court did recognize that there was considerable value inherent to the transferred marketing IP (which accounted for the lion’s share of the reassessment). On this point, the IRS achieved a relatively significant victory, as the valuation parameters applied by the Court (the useful life of 20 years, the royalty rate of 1% and only a 25% reduction due to prior ownership) generally yielded a higher valuation than asserted by the taxpayer. Further, while the CUT-method valuation assessments of the Court may possibly provide some guidance for future cases, the effect of this will be negligible, due to the comprehensively high threshold set in the current-generation cost-sharing regulations for applying this methodology.1356 The current cost-sharing regulations, with the specified income method and bypass of the pre-2018 version of the IRC section 936 IP definition allowing for the capture of residual intangible value in the buy-in amount, will ensure that the IRS does not face the same struggles going forward as it did in Veritas and Amazon. com. Why, then, would the IRS go through the trouble of relitigating Veritas as it did with Amazon.com? The author assumes that the litigation risk must have been apparent to the IRS. Even if the Tax Court would be willing to accept the CIP approach as a pricing methodology as such, the IRS would still be facing the problem that the pre-2018 version of the section 936 IP definition rejects the taxation of outbound residual intangible value. The portion of the reassessment value in Amazon.com attributable to workforce in place and other residual value could therefore, in any case, not stand. The significant income at stake undoubtedly incentivized the IRS to try. Also, the IP structure established under the Amazon CSA will deprive the United States of (likely) significant residual profits from intangibles developed under the agreement going forward, perhaps over decades, even though the intangible value will be created in the United States through ongoing R&D there (and the US entity’s R&D costs will even be tax-deductible in the United States). That has likely been a difficult pill to swallow for the IRS.1357

1356. See sec. 14.2.8.2. on the CUT method for buy-in pricing. 1357. The IRS appealed the Amazon.com ruling to the US Court of Appeals for the Ninth Circuit on 29 September 2017. At the time of writing this book, the content of the IRS’s legal arguments in support of the appeal is not known.

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14.2.7. Key concepts under the current cost-sharing regulations 14.2.7.1. Introduction The cost-sharing regulations make use of some key concepts with rather particular terminology. In order to analyse how operating profits are allocated pursuant to the current buy-in pricing methods, it is necessary to first present these concepts.1358 The author does so in sections 14.2.7.2.-14.2.7.5. before discussing the buy-in pricing methods in section 14.2.8.

14.2.7.2. Cost-sharing transactions All controlled participants in a CSA must commit to and engage in costsharing transactions, in which they make payments to each other so that in each taxable year, each controlled participant’s share of the IDCs is in proportion to its respective reasonable anticipated benefit (RAB) share.1359 Intangible development costs include all costs, in cash or in kind (including stock-based compensation),1360 in the ordinary course of business incurred after the formation of a CSA, which are directly identified with or are reasonably allocable to the intangible development activity.1361

14.2.7.3. RAB share The concept of RAB shares is important, as they determine how intangible development costs and ownership interests in the intangibles developed

1358. For a walkthrough of the main concepts, see also Brauner (2010), at pp. 3-5. For a discussion of the concepts under the 1995-generation cost-sharing regulations (which are still partly relevant), see, e.g. Benshalom (2007), at p. 653. 1359. Treas. Regs. § 1.482-7(b)(1)(i). A reasonably anticipated cost-shared intangible is any intangible (within the meaning of § 1.482-4(b)) that the controlled participants intend to develop under the CSA; see Treas. Regs. § 1.482-7(d)(1)(ii). 1360. The cost-sharing regulations include elaborate provisions pertaining to stockbased compensation in Treas. Regs. § 1.482-7(d)(3) that were implemented in the wake of the Xilinx case. See also the 2015 Tax Court ruling in Altera v. CIR (145 TC 91), invalidating the requirement to include stock-based compensation in the intangibles development costs pool. On cost allocation for CSAs, see, in particular, Dix (2010). 1361. Treas. Regs. § 1.482-7(d)(1)(iii). This includes costs incurred in attempting to develop cost-shared intangibles, regardless of whether the costs ultimately lead to successful development of the anticipated intangibles, other intangibles developed unexpectedly or no intangibles.

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under the CSA (cost-shared intangibles) are allocated among the CSA participants. RABs are measured either on a direct or indirect basis.1362 A direct basis measurement is the estimated benefits generated through the exploitation of the cost-shared intangibles, typically based on additional revenue plus cost savings less any additional costs incurred. An indirect basis measurement is made by reference to certain parameters that reasonably may be assumed to relate to future benefits (e.g. units used, produced or sold, sales or operating profits). A controlled participant’s share of RABs is equal to its own RABs divided by the sum of the RABs.1363

14.2.7.4. Non-overlapping (ownership) interests in intangibles ­developed under the CSA Each controlled participant must receive a non-overlapping interest in the cost-shared intangibles without further obligation to compensate another controlled participant for such interest (divisional interests).1364 Thus, for transfer pricing purposes, each participant will be considered the owner of its respective interest in the developed intangible, and therefore, as the point of departure, entitled to the residual profit from it. The interests can be divided among the CSA participants (i) on a territorial basis (the world market must then be divided into two or more non-overlapping geographic territories);1365 (ii) based on all uses to which cost-shared intangibles are to be put (all anticipated uses must be identified, each controlled participant must be assigned at least one such use and, in the aggregate, all of the participants must be assigned all of the anticipated uses);1366 or (iii) on some other basis (e.g. the site of manufacturing), provided that a set of criteria is met.1367

1362. Treas. Regs. § 1.482-7(e)(2)(ii), Example 1. If there is a significant divergence between projected benefit shares and benefit shares adjusted to take into account any actual benefits to date (adjusted benefit shares), the IRS may use adjusted benefit shares as the most reliable measure of RAB shares and adjust the intangibles development cost shares accordingly; see Treas. Regs. § 1.482-7(i)(2)(ii). See also Treas. Regs. § 1.4827(i)(2)(ii)(D), Examples 1-4. 1363. Treas. Regs. § 1.482-7(e)(1)(i). 1364. Treas. Regs. § 1.482-7(b)(1)(iii). 1365. Treas. Regs. § 1.482-7(b)(4)(ii). 1366. Treas. Regs. § 1.482-7(b)(4)(iii). 1367. Treas. Regs. § 1.482-7(b)(4)(iv).

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14.2.7.5. Platform contributions All controlled participants must commit to and engage in platform contribution transactions (PCTs), to the extent that there are such contributions.1368 In a platform contribution transaction, each controlled participant is obligated to make arm’s length payments (buy-in) to each controlled participant that provides a platform contribution. The entity that renders the platform contribution (typically, a unique, pre-existing intangible) is called the PCT payee, while the entity that must pay the platform contribution transaction payment (buy-in amount) is called the PCT payer. The author will, for the sake of simplicity, try to avoid these rather cumbersome terms when possible. The regulations define a platform contribution as: […] any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to contribute to developing cost shared intangibles.1369

The regulations have a relatively relaxed view as to which rights, capabilities and resources may constitute a platform contribution, both with respect to the degree of causality required between the contribution and the intangible development, as well as with respect to the type of contribution. First, with respect to causality, it is not required that the contribution itself is subject to further development, only that it may aid in developing costshared intangibles. For instance, if the aim of a CSA is to develop and test new pharmaceutical compounds and a patented research tool to develop the compounds is contributed to the CSA, the research tool will constitute a platform contribution because it is anticipated to contribute to the research activity covered by the CSA. This is true even if the CSA activity is not anticipated to result in the further development of the research tool itself or in new patents based on the research tool.1370 Second, with respect to the type of contribution, development inputs that traditionally have not been considered to qualify as intangibles under the IRC section 936(h)(3)(B) definition (residual intangibles, such as the value 1368. Treas. Regs. § 1.482-7(b)(1)(ii). 1369. Treas. Regs. § 1.482-7(c). 1370. Treas. Regs. § 1.482-7(c)(4)(ii), Example 3. See also Treas. Regs. § 1.482-7(b)(1) (iv), Example 2.

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of a workforce or research team in place) may also be considered platform contributions.1371 For instance, if a US parent commits a research team with a successful track record to a CSA for the development of a vaccine, the expertise and existing integration of the research team is regarded as a unique resource or capability that is reasonably anticipated to contribute to the development of the new vaccine. This represents a regulatory bypass of the pricing restrictions inherent to the section 936 IP definition1372 and is necessary for the IRS in order to capture residual intangible value in the buy-in price. Commentators have – and rightly so – criticized the platform contribution concept for being in conflict with the section 936 IP definition.1373 Any right to exploit an existing resource, capability or right without further development, such as the right to make, replicate, license or sell existing products (make-sell rights), does not constitute a platform contribution, unless exploitation without further development is reasonably anticipated to contribute to developing a cost-shared intangible.1374 For instance, if a US parent contributes the rights to further develop version 1 of a software program to a CSA with a foreign subsidiary and, at the same time, licenses make-sell rights to the software to the subsidiary, only the former rights will be considered platform contributions.1375 The ordinary transfer pricing rules must be applied to determine the arm’s length consideration in connection with the make-sell licence arrangement.1376 A platform contribution is presumed to be exclusive, in the sense that the resource, capability or right is not reasonably anticipated to be committed to any business activities other than the CSA activity.1377 This is an 1371. Treas. Regs. § 1.482-7(c)(5), Example 2. See also the analysis of the US IP definition in sec. 3.2. 1372. See the discussion of the US IP definition in sec. 3.2. 1373. Id. 1374. Treas. Regs. § 1.482-7(c)(4). 1375. Another thing entirely is that the platform contribution and the make-sell rights may be valued in the aggregate. See the discussion of the income method in sec. 14.2.8.3. See also the comments on the US best-method rule in sec. 6.4. and on the aggregation of controlled transactions in sec. 6.7.2. 1376. Treas. Regs. § 1.482-7(c)(4)(ii), Example 1. 1377. Treas. Regs. § 1.482-7(c)(2). The 2005 proposed CSA regulations (70 FR 51116-01) introduced the concept of a reference transaction designed to benchmark the buy-in profit allocation, which was criticized for being overly broad. The concept was scrapped in the 2009 temporary regulations (74 FR 340-01) and replaced with the presumption that a party with a pre-existing intangible would provide resources, capabilities or rights to a CSA on an exclusive basis, i.e. the external contributions were reasonably expected to contribute only to the CSA and not to other business activities. This presumption had pricing implications, as the value of an exclusive contribution generally would be higher than the value of a non-exclusive contribution.

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important assumption, as the pricing of the platform contribution will then encompass the entire value from the relevant use of the contribution. Nevertheless, the taxpayer has the possibility of rebutting the exclusivity presumption.1378 For instance, if the platform contribution is a research tool, the controlled participants could rebut the presumption by establishing that, as of the date of the PCT, the tool is reasonably anticipated to contribute to the CSA activity and also be licensed to an uncontrolled taxpayer.1379

14.2.8. The buy-in pricing methods 14.2.8.1. Introduction The final 2011 cost-sharing regulations contain a range of buy-in pricing methods.1380 The methods are meant to be – and are – comprehensively restrictive.1381 As the IRS answer to the profit shifting practices of multinationals, pursuant to which US-developed intangibles have been migrated for artificially low buy-in amounts, the pricing methods now ensure that residual profits are allocated in a manner that reflects where the underlying intangible value creation took place. Two fundamental assumptions underlie these methods. First, the pricing must be aligned with the upfront contractual terms and risk allocation, with respect to anticipated benefits and obligations, over the entire anticipated term of the CSA. This is the so-called “investor model principle”, pursuant to which the profits allocable to each participant in the CSA must be appropriate for the risks connected to the CSA activity carried out by the participant. The regulations illustrate the principle through an example that rejects taxpayers’ CSA practices in which the buy-in is based on an 1378. Treas. Regs. § 1.482-7(c)(2)(ii). 1379. The value of the contributed resource from uses other than the CSA activity should not be included in the platform contribution transaction (PCT) payment; see Treas. Regs. § 1.482-7(c)(2)(iii). If there are such other applications of the resource, the value of the PCT payment must be prorated in proportion to the relative economic value reasonably anticipated from the platform contribution to the CSA activity, compared to the value reasonably anticipated from the platform contribution to other business activities; see Treas. Regs. § 1.482-7(c)(2)(iii)(B). 1380. Treas. Regs. § 1.482-7(g)(1). See also Brauner (2010), at p. 8 for a discussion of the CSA transfer pricing methods. The discussion in sec. 14.2.8. pertains to the pricing methodology. It should be noted that the regulations also contain (flexible) rules on the form of payment for buy-ins; see Treas. Regs. § 1.482-7(h). 1381. The transfer pricing methodology set out in the US cost-sharing regulations is generally perceived as highly technical and complicated, which was also the case under the previous-generation (1995) regulations. See Benshalom (2007), at p. 666.

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Buy-in pricing under the US regulations

unspecified version of the RPSM and the royalties paid to the US parent are rapidly ramped down after the formation of the CSA.1382 The implications of the investor model principle, as an independent legal norm, seem unclear.1383 Second, and most importantly, the buy-in pricing must ensure consistency with the realistic alternatives of the controlled party that makes the platform contribution (the PCT payee).1384 This condition is not met when the anticipated present value from participation in the CSA is less than that which could be achieved through an alternative arrangement realistically available.1385 The income method (discussed in section 14.2.8.3.) operationalizes the realistic alternatives principle in the context of a buy-in valuation. The IRS’s position taken in the 2009 temporary regulations is that the principle supplements the best-method rule to help determine which method will provide the most reliable measure of an arm’s length result for the buy-in calculation.1386 The author finds it doubtful whether the principle in and of itself can play any significant role for pricing purposes alongside the specified pricing methods of the current CSA regulations.1387 In sections 14.2.8.2.-14.2.8.7., the author will tie some comments to the available buy-in pricing methodology.

14.2.8.2. The CUT method The CUT method may be applied to evaluate whether the buy-in amount is at arm’s length by reference to the amount charged in a CUT.1388 Appli1382. See the discussion in sec. 14.2.3. 1383. E.g. if (even though unlikely) a genuine CUT is found upon which the buy-in valuation is based and this results in a generous allocation of income to a foreign cashbox entity, could it be argued on the basis of the investor model that the foreign entity has been allocated too high of a return? Such an argument should, in the author’s view, be rejected. 1384. See also Brauner (2010), at p. 8 on this point. See the 2011 budget proposal (JCS3-11 No. 11) for a convincing discussion of the realistic alternatives principle. 1385. On the use of projections in the CSA regulations, see Brauner (2010), at p. 9. 1386. See the preamble to the 2009 temporary cost-sharing regulations (74 FR 34001). On the 2009 regulations, see Kochman et al. (2009); and Dickenson (2010). 1387. See also the comments on this issue in the 2005 proposed CSA regulations (70 FR 51116-01). 1388. Treas. Regs. § 1.482-7(g)(3). In this context, the CUT method refers both to § 1.482-4(c) and § 1.482-9(c). That value must then be multiplied by each PCT payer’s respective RAB share in order to determine the arm’s length PCT payment due from each PCT payer. The reliability of a CUT that yields a value for the platform contribution only in the PCT payer’s division will be reduced to the extent that the value is not

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Chapter 14 - Allocation of Residual Profits to Unique and Valuable IP through Cost-Sharing Structures

cation of this method is contingent on the identification of a CUT, which must be similar to the controlled CSA with respect to contractual terms, the degree to which allocation of risks is proportional to the RABs from exploitation of the R&D results and the profit potential of the R&D efforts. Given the strict comparability criteria, this method should rarely be relevant. Further, the profit allocation that results from applying this method must align with the results that would follow from a valuation based on the estimated future operating profits from the intangible developed under the CSA. This restriction will effectively ensure that CUT-based buy-in pricing is consistent with the results of the income method and the PSM, which both rely on DCF analysis.

14.2.8.3. The income method The income method represents a further development and regulatory implementation of the unspecified 2007 aggregated CIP approach to buyin valuation as a specified transfer pricing method. The methodology is founded on and operationalizes the realistic-alternatives-available principle in the context of CSA buy-in valuations. The core idea is that the buy-in cannot result in a lower amount of operating profits to the US entity than what would have been the result for this entity if it instead had chosen to not enter into the CSA and gone for its best realistic alternative.1389 The income method is potent, in particular, because its application of the realistic alternatives principle is combined with the IRC section 936 IP definition bypass, which is the platform contribution concept.1390 This will capture, in the buy-in amount, also residual intangible value (goodwill, workforce in place and going concern value), even if such value does not qualify under the section 936 definition.1391 The income method will be the go-to method in typical CSA scenarios,1392 in which a US group entity with self-developed unique and valuable intangibles and an R&D team in place enters into a CSA with a foreign cash-box group entity that will only contribute

consistent with the total worldwide value of the platform contribution multiplied by the PCT payer’s RAB share. For a discussion of the CUT method in the context of CSAs, see, e.g. Wittendorff (2010a), at p. 576. 1389. It must clearly be assumed that third parties would not have been willing to enter into a CSA for less. See also Brauner (2010), at p. 17. 1390. See sec. 14.2.7.5. for a discussion on platform contributions. 1391. See the discussion of the US IP definition in sec. 3.2. 1392. Treas. Regs. § 1.482-7(g)(4). For a general discussion of the income method, see, e.g. Wittendorff (2010a), at p. 577.

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Buy-in pricing under the US regulations

funding to the joint development.1393 The method is designed to allocate all residual profits to the US entity in such cases. The underlying methodology and profit allocation pattern of the income method is akin to that of the CPM. It requires the tested party (the PCT payer) to pay a buy-in amount that makes the present value of its participation in the CSA equal to the present value of its best realistic alternative,1394 which is to license make-sell rights to the fully developed intangibles, thereby not committing to share any of the R&D costs and risks. Conversely, the best realistic alternative of the PCT payee (the US entity that renders platform contributions to the CSA) would be to undertake the commitment to bear the entire R&D risk and license the resulting intangibles to an uncontrolled licensee. As for the CPM, the scope of the income method is confined to scenarios in which the tested party only contributes routine development inputs. Otherwise, if the tested party also contributes nonroutine development inputs (pre-existing intangibles or R&D), the RPSM will be the relevant method.1395 The buy-in amount determined by the income method is the difference between the net present value for the tested party of the CSA and licensing alternatives. The cost-sharing alternative is the actual CSA, pursuant to which the tested party must bear cost contributions throughout the duration of the CSA and make the buy-in payment.1396 The value of this alternative is the present value of the divisional profit minus operating cost contributions minus cost contributions and PCT payments over the duration of the CSA.1397 The licensing alternative is the same, apart from the cost contributions and buy-in payment being replaced with an obligation to pay an arm’s length royalty rate.1398

1393. The income method does not allow the PCT payer a return on its contributions to the intangibles development funding. The author finds this aggressive allocation of income in favour of the United States to be in conflict with the arm’s length principle; see the comments in secs. 14.2.8.3., 22.4.11. and 26.3. 1394. Treas. Regs. § 1.482-7(g)(4). The present values of the cost-sharing and licensing alternatives should, in general, be determined by applying post-tax discount rates to post-tax income; see Treas. Regs. § 1.482-7(g)(4)(i)(G)(1). 1395. Treas. Regs. § 1.482-7(g)(4)(1)(D). The RPSM is discussed in sec. 14.2.8.6. A profit split will also be used if the foreign subsidiary has mature operations and possesses significant operating intangibles (e.g. local marketing IP) that will contribute to the profit from exploiting the cost-shared intangibles or from existing make-sell rights. 1396. Treas. Regs. § 1.482-7(g)(4)(i)(B). 1397. Treas. Regs. § 1.482-7(g)(4)(ii). 1398. Treas. Regs. § 1.482-7(g)(4)(1)(C).

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The arm’s length royalty rate charged to the tested party in the licensing alternative may be determined on the basis of rates extracted from CUTs under the CUT method1399 or, more practically, indirectly under the CPM through the allocation of a normal market return for the tested party’s routine contributions (the residual profits will be equal to the royalty payment). In the latter alternative, the tested party is completely stripped of residual profits. The present value of the CSA and licensing alternatives must be determined using an appropriate discount rate.1400 When the market-correlated risks in the alternatives are not materially different, it may be possible to use the same discount rate.1401 Normally, however, the discount rates should be different. The tested party will incur less risk as a licensee, as it will not contribute any cost contributions, and therefore will not share the R&D risks, resulting in a lower discount rate in the licensing alternative than in the CSA alternative.1402 The determination of discount rates has proven to be a source of contention and was at issue in both Veritas and Amazon. com.1403 A closely related and problematic issue is the determination of the useful life of the platform intangible (the horizon over which the buy-in valuation shall be performed). The 2007 aggregate CIP approach for buy-in valuation effectively treated platform intangibles as having perpetual useful lives, as argued in Veritas and Amazon.com. When the income method was introduced in the 2005 proposed regulations,1404 it was criticized for presuming that the platform contribution would have a perpetual useful life. Indeed, the proposed regulations did imply that for pricing purposes, the pre-existing intangible contribution would be valued using techniques 1399. Treas. Regs. § 1.482-7(g)(4)(ii); see also § 1.482-4(c)(1) and (2). If the licensing alternative is evaluated using the CUT method, the additional comparability and reliability considerations stated in § 1.482-4(c)(2) pertaining to the CUT method may apply; see Treas. Regs. § 1.482-7(g)(4)(vi)(C) and § 1.482-4(c)(2). 1400. See Treas. Regs. § 1.482-7(g)(2)(v) and § 1.482-7(g)(4)(vi)(F). 1401. Treas. Regs. § 1.482-7(g)(4)(i)(F). 1402. Conversely, self-development will be riskier for the licenser than entering into a CSA (as the latter alternative would partly relieve the licenser of its funding burden), necessitating a higher discount rate. 1403. The IRS’s assertion is that taxpayers inappropriately seek to reduce the PCT payment through the use of a discount rate for the CSA alternative that is significantly higher than the discount rate used for the licensing alternative, while taxpayers argue that the fixed cost profile of R&D development costs under the CSA alternative (as opposed to the variable royalty costs under the licensing alternative) warrants a significant discrepancy between the discount rates; see Finley (2016). 1404. 70 FR 51116-01.

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Buy-in pricing under the US regulations

that presumed the contribution to be perpetual. The idea was that the main bulk of value came from core technology, which would be the basis, or the platform, for future improvements, the value of which was derived from and contingent on the core technology. The 2009 temporary regulations modified this view by recognizing that, depending on the facts and circumstances, the value of the technology invested by the PCT payee in the platform contribution could have a “finite, not a perpetual, life”.1405 The IRS now seems to have abandoned its prior infinite-life assertion in favour of relatively long useful lives, typically ranging from 25-40 years.1406 Taxpayers typically argue for useful lives based on short-term product life cycles. Different approaches to discount rates and useful lives will likely yield significant discrepancies between IRS and taxpayer buy-in valuations. This may trigger a potential for future controversies over the application of the income method. This will, however, only be relevant if taxpayers going forward at all choose to structure their outbound transfers of US-developed IP through CSAs, in light of the powerful buy-in pricing methodology now available to the IRS through the income method. The author will go through two of the income method examples contained in the regulations, as they illustrate key aspects of the methodology. The first example pertains to a US parent that has developed version 1 of a new software application and enters into a CSA with a foreign cash-box subsidiary to develop future versions.1407 The agreement assigns the US exploitation rights to future versions of the software to the parent, while the subsidiary is assigned rights for the rest of the world. Version 1 and the parent’s R&D team are reasonably anticipated to contribute to the development of future versions. Both inputs are deemed to be platform contributions that require compensation.1408 The example determines and compares the net present values for the subsidiary from participating in the CSA and from its best alternative of entering into a licence agreement with the parent when the parent alone has fully developed future versions of the software. The projected sales and operating costs are the same under both alternatives for the 15-year lifespan of the software. 1405. 74 FR 340-01. 1406. See Finley (2016). 1407. Treas. Regs. § 1.482-7(g)(4)(viii), Example 1. 1408. The subsidiary will not perform any R&D and it does not furnish any platform contributions to the cost-sharing arrangement, nor does it control any operating intangibles at the inception of the CSA.

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The difference lies in the cost contribution payments under the CSA alternative and the royalty payments under the licensing alternative, as well as in the discount rates applied to calculate the net present values. The arm’s length royalty payments are determined to be 35% of the subsidiary’s sales. The CSA is deemed to be more risky than the licence agreement, thus justifying a higher discount rate. The discount rate is set to 15% in the CSA alternative and 13% in the licensing alternative. The net present value for the subsidiary for participating in the CSA is 889, and 425 for the licensing alternative. Thus, for the subsidiary to be allocated the same amount of profits under the CSA alternative as in the licensing alternative, it must make a buy-in payment to the parent equal to the difference between 889 and 425, which is 464. This ensures that the subsidiary is allocated a normal market return for its routine contributions, while all residual profits are allocated to the US parent. The next example illustrates the application of the income method with the addition of a terminal value.1409 The example pertains to a US parent that has developed technology Z and enters into a CSA with a foreign cash box subsidiary. The parent is assigned the right to future applications of technology Z in the United States, while the subsidiary is assigned the rights for the rest of the world. Both the R&D team of the parent and the rights to further develop and exploit future applications of technology Z are reasonably anticipated to contribute to future applications of technology Z and are thus regarded as platform contributions. The subsidiary does not perform any R&D, does not furnish any platform contributions to the CSA and does not control any operating intangibles at the inception of the CSA that would be relevant to the exploitation of either current or future applications of technology Z. The subsidiary determines that entering into the CSA is a riskier alternative than a licence agreement in which the parent develops future applications of technology Z. Further, the appropriate discount rate for the licensing alternative, based on the discount rates of comparable uncontrolled companies undertaking similar licence agreements, is 13%, while the rate for the CSA alternative is 14%. Income projections are drawn up individually for the first 8 years of the CSA. After year 8, the subsidiary expects its sales of all products based on 1409. Treas. Regs. § 1.482-7(g)(4)(viii), Example 7.

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Buy-in pricing under the US regulations

the exploitation of technology Z in the rest of the world to grow at a rate of 3% per year in the future. Neither the parent nor the subsidiary anticipates cessation of the CSA activity with respect to technology Z at any determinable date. The subsidiary estimates that its manufacturing and distribution costs for exploiting technology Z will equal 60% of gross sales from technology Z from year 1 onwards, and anticipates cost contributions of 25 per year for years 1 and 2, 50 for years 3 and 4 and 10% thereafter. Had the parent further developed technology Z on its own, it would have charged an uncontrolled licensee a royalty of 30% of the licensee’s revenues. In light of the expected sales growth and the fact that the CSA activity will not cease at any determinable date, the buy-in valuation must include a terminal value calculation.1410 The subsidiary determines that its present value under the CSA (divisional profits minus operating cost contributions and other cost contributions) is 1,361, while the present value of the licensing alternative is 528. In order for the present value of the cost-sharing alternative to equal that of the licensing alternative, the buy-in payment must be 833. This payment ensures that the subsidiary is allocated a normal market return for its routine contributions, while the residual profits in their entirety are allocated to the US parent. It may be observed that the present value of the income estimates of the individual first 8 years of the CSA represents approximately only 38% of the total present value in both the cost-sharing and licensing scenarios. The rest of the buy-in amount (62%) is due to the terminal value. This illustrates the importance of the assumptions made in the terminal value calculation, which was also a key issue in Veritas.1411 A fundamental assumption in this example is that the cash flows from both the cost-sharing and licensing alternatives will continue in perpetuity. In other words, the terminal value represents the present value of the cash flows from and including year 9 and into eternity. This will often be unrealistic, as the cost-shared intangibles will likely have limited useful lives. An 1410. See the discussion of useful lives, growth rates and terminal values in sec. 13.3.3. 1411. Veritas Software Corporation & Subsidiaries v. CIR, 133 T.C. No. 14 (U.S. Tax Ct. 2009), IRS nonacquiescence in AOD-2010-05. See the discussion in sec. 14.2.4.

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intangible may eventually become technically or commercially obsolete, which was the view of the Tax Court in Amazon.com with respect to the transfer of pre-existing software technology.1412 The perpetuity assumption may, in some cases, be unsuitable if the valuation pertains to a specific R&D process, which will normally relate to a concrete product or group of products.1413 Platform contributions may, however, in practice, often encompass several different items of IP and resources transferred together as a package (e.g. workforce in place, know-how and pre-existing manufacturing and marketing intangibles). That was the case in both Veritas and Amazon.com. Such package transfers may be akin to business transfers, making the perpetuity assumption comprehensively more suitable.1414 Also, the growth assumptions made in the terminal value calculation are significant,1415 as seen in Veritas. The larger the growth rate, the larger the terminal value will be. The example assumes that the subsidiary’s “sales of all products based upon exploitation of Z in the rest of the world [will] grow at 3% per annum for the future”.1416 Due to the impact of the growth rate on the terminal value calculation, there should be concrete – and well-founded – reasons for choosing a particular rate. The fact that terminal values often are responsible for a significant portion of the total present value and that the calculation of it is dependent on assumptions of how long profits will be generated and on annual growth rates makes these DCF-based valuations susceptible to speculative assessments from both taxpayers and tax administrations and should be reviewed critically. In conclusion, the income method, like the CPM, will be relevant where only the US parent contributes non-routine development and exploitation contributions to the value chain that generates the residual profits (e.g. unique, pre-existing IP and workforce in place). This will typically be the case if the foreign subsidiary is a cash-box entity that only provides intangible-development funding.

1412. 148 TC No. 8. See also the discussion in sec. 14.2.5. 1413. The weight of this argument is somewhat reduced by the fact that the further into the future the cash flows lie, the less impact they will have on the present value due to a high discount factor. 1414. Perpetuity assumptions are commonly used in DCF business valuations where the value of an entire enterprise as a going concern is estimated. 1415. See the discussion of useful lives, growth rates and terminal values in sec. 13.3.3. 1416. Id.

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Buy-in pricing under the US regulations

If, however, the foreign entity is an established enterprise (as the case was to some extent in Amazon.com) that has developed valuable local marketing intangibles (customer lists, know-how, goodwill, etc.) that contribute to the residual profits, the income method should not be applied. In these cases, the residual profits should be split between the US and foreign entities pursuant to the relative values of their non-routine development and exploitation contributions under the PSM.1417

14.2.8.4. The acquisition price method The acquisition price method evaluates whether the buy-in amount is at arm’s length by reference to the amount charged for the stock or asset in an uncontrolled transaction (acquisition price).1418 The method is ordinarily used where substantially all of the acquired target’s non-routine contributions are covered by a buy-in. The regulations illustrate the methodology in an example in which a US parent enters into a CSA in year 1 with a foreign subsidiary to develop group Z products. The parent is assigned the US rights to exploit the group Z products, while the subsidiary is assigned the rights for the rest of the world.1419 The RAB shares of the parent and subsidiary are 60% and 40%, respectively. In year 2, the parent acquires company X for USD 110 million in cash.1420 The value of company X consists of workforce in place and technical intangibles of USD 100 million and tangibles of USD 15 million, minus liabilities of USD 5 million. The workforce and technical intangibles are reasonably anticipated to contribute to the development of group Z products and are therefore platform contributions for which the subsidiary must make a buy-in. As the subsidiary’s share of the anticipated benefits is 40% and the value of the platform contributions is 100, the platform contribution payment is 40. The scope of application of this method is narrow due to its reliance on highly particular CUTs and will therefore likely rarely be relevant. Further, the profit allocation that results from applying this method must align with the results that would follow from a valuation based on the estimated future operat1417. See the discussion of the RPSM in sec. 14.2.8.6. 1418. Treas. Regs. § 1.482-7(g)(5). For a discussion of the acquisition price method, see, e.g. Wittendorff (2010a), at p. 582. 1419. Treas. Regs. § 1.482-7(g)(5)(v), Example. 1420. The parent and company X are treated as one taxpayer for income tax purposes in the United States.

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ing profits from the intangible developed under the CSA. This restriction will effectively ensure that CUT-based buy-in pricing is consistent with the results of the income method and PSM, which both rely on DCF analysis.

14.2.8.5. The market capitalization method The market capitalization method evaluates whether the buy-in amount is at arm’s length by reference to the average market capitalization of the controlled participant that provides platform contributions to the CSA and whose stock is regularly traded on an established securities market.1421 The US regulations illustrate the methodology in an example in which a US parent enters into a CSA with a foreign subsidiary to develop software.1422 The parent owns software under development that is not yet ready for the market. The CSA assigns the exclusive right to exploit the software in the United States to the parent, and the foreign rights to the subsidiary. The parent’s RAB share is 70%, and it is 30% for the subsidiary. The parent’s assembled team of researchers and in-process software are reasonably anticipated to contribute to the CSA development,and therefore deemed as platform contributions for which compensation is due from the subsidiary. The average market capitalization of the parent is 205 at the time at which the CSA is entered into. The value of tangibles and other assets is 5, and there are no liabilities. Aside from these elements, the value of the parent consists of only the value of the research team and the in-process software. The value of the platform contributions of the parent is therefore 200. As the RAB share of the subsidiary is 30%, the buy-in payment is 200 × 0.3 = 60.1423 The method can only be used when substantially all of the participants’ non-routine contributions are encompassed by the CSA. As this restriction comes in addition to the ordinary CUT requirements, it is safe to say that the method is limited to a narrow field of application.1424 Further, the profit allocation that results from applying this method must align with the 1421. Treas. Regs. § 1.482-7(g)(6). For a discussion of the market capitalization method, see, e.g. Wittendorff (2010a), at p. 583. 1422. Treas. Regs. § 1.482-7(g)(6), Example 1. 1423. For an extension of the example, see Treas. Regs. § 1.482-7(g)(6), Example 2. 1424. The significance of the restriction is illustrated in an example in which the parent has significant non-routine assets that will be used solely in a separate business division that is unrelated to the CSA and are not deemed platform contributions and are not covered by the buy-in; see Treas. Regs. § 1.482-7(g)(6), Example 3.

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Buy-in pricing under the US regulations

results that would follow from a valuation based on the estimated future operating profits from the intangible developed under the CSA. This restriction will effectively ensure that CUT based buy-in pricing is consistent with the results of the income method and PSM, which both rely on DCF analysis. Also, this method will likely capture all intangible value contributed to the CSA, including residual intangible value (workforce in place, goodwill and going concern value) that does not qualify as IP under the pre-2018 version of the IRC section 936 IP definition, due to the platform contribution bypass of the definition.1425

14.2.8.6. The RPSM The RPSM evaluates whether the buy-in amount is at arm’s length by reference to the relative value of each CSA participant’s non-routine development and exploitation contributions to the operating profits from the cost-shared intangibles.1426 The method may not be used where only one controlled participant makes significant non-routine contributions. In those cases, the income method will, in practice, be the relevant method. The income method allocates the entire residual profits from the exploitation of the cost-shared intangibles to the single CSA participant that renders nonroutine contributions, while the RPSM divides the residual profits among several participants that contribute non-routine inputs. The residual profits to be split, pursuant to the relative values of the nonroutine contributions, equal the present value of the operating profits from the value chain to which the cost-shared intangibles are connected over the duration of the CSA, minus market returns for routine contributions, operating cost contributions and cost contributions, using an appropriate discount rate.1427 As under the general PSM, the relative values may be

1425. See the discussions of the US IP definition and platform contributions in secs. 3.2. and 14.2.7.5., respectively. 1426. Treas. Regs. § 1.482-7(g)(7). The relationship between the general PSM in § 1.482-6 and the RPSM for CSA buy-ins is that the former shall only apply to CSAs to the extent provided (and as modified) in § 1.482-7(g). For a discussion of the general US PSM, see ch. 9. See also Wittendorff (2010a), at p. 584 for a discussion of the RPSM in the context of CSAs. 1427. Market returns for routine contributions include market returns for operating cost contributions and exclude market returns for “pure cash”cost contributions; see Treas. Regs. § 1.482-7(g)(7)(iii)(B).

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measured by external market benchmarks that reflect fair market value or through the capitalized cost of developing the non-routine contributions.1428 The regulations contain an example that illustrates the key points of the methodology.1429 It pertains to a US parent that has partially developed a nano-disc technology and enters into a CSA with a foreign subsidiary to further develop the technology for commercial exploitation. The subsidiary has developed significant marketing intangibles outside of the United States (customer lists, ongoing OEM relationships and established trademarks). The CSA assigns the US and foreign rights to exploit the nano-disc technology to the parent and the subsidiary, respectively. The parent’s technology is reasonably anticipated to contribute to the development of commercially exploitable nano-discs and thus is deemed to be a platform contribution for which arm’s length buy-in compensation is due. The subsidiary does not contribute any inputs to the intangible development, but contributes its local marketing intangible to the subsequent exploitation of the cost-shared intangible. Thus, it is only in the territory of the subsidiary that both the parent and the subsidiary make significant nonroutine contributions (to the development and exploitation, respectively). The relative value of the respective contributions to the residual divisional profit attributable to the cost-sharing activity must therefore be determined only in the territory of the subsidiary.1430 The determination of the present value of the residual profits in the territory of the subsidiary is founded on the following assumptions:1431 − revenues: no sales in year 1 and sales of 200 in year 2, with a 50% increase per year through year 5. The annual growth rate is then expected to decline to 30% per year in years 6 and 7, to 20% per year in years 8 and 9 and to 10% in years 10 and 11, and then 5% per year thereafter; 1428. See the discussion of the general US PSM in ch. 9. If the non-routine contributions are also used in other business activities, the value must be allocated among all of the business activities in which they are used in proportion to the relative economic value of the relevant business activity as the result of such non-routine contributions; see Treas. Regs. § 1.482-7(g)(7)(iii)(C)(2). 1429. Treas. Regs. § 1.482-7(g)(7(v), Example 1. 1430. The parent is entitled to the entire residual profits from exploitation of the costshared intangible in its territory, as it alone contributes non-routine value chain inputs there. 1431. The value of the residual profits in the territory of the subsidiary for each year of the CSA is determined as the following (with all elements only from the subsidiary’s territory): revenues minus routine costs and market returns for routine contributions.

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Buy-in pricing under the US regulations

− routine costs are anticipated to equal 40 in year 1, 130 in year 2, 200 in year 3 and 250 in year 4;1432 − total operating expenses connected to product exploitation (including operating cost contributions) equal 52% of sales per year; − the subsidiary undertakes routine distribution activities in its markets that constitute routine contributions. It is estimated that the total market return on these contributions will amount to 6% of the routine costs; and − the subsidiary expects its cost contributions to be 60 in year 1 and 100 in years 2 and 3, decline to 60 in year 4 and thereafter equal 10% of revenues. The appropriate discount rate is set to 17.5%. This yields a present value of the residual profits from the exploitation of the cost-shared intangible in the subsidiary’s territory of 1,395. The parent and subsidiary determine that the value of the parent’s nano-disc technologies relative to the value of the subsidiary’s marketing intangibles is approximately 150%. In other words, the parent is entitled to 60% of the present value of the residual profits,1433 which are 837, in the form of a buy-in payment from the subsidiary.1434 In conclusion, it may be observed that the RPSM will generally be the relevant pricing method when the foreign subsidiary is an established enterprise, as it may have developed valuable local marketing intangibles (customer lists, know-how, goodwill, etc.) that contribute to the residual profits generated by the exploitation of the cost-shared intangibles in its market. This was, in effect, the view of the Tax Court in Amazon.com with respect to the transfer of marketing intangibles, as it reduced the buy-in value to take into account prior ownership of the foreign group entity.1435 Thus, when the foreign subsidiary contributes valuable operating intangibles, there will be no room to apply the income method. In such cases, the residual profits shall be split under the RPSM between the US and foreign entities pursuant to the relative values of their non-routine development and exploitation contributions.

1432. Routine costs are costs other than cost contributions, routine platform and operating contributions and non-routine contributions. 1433. 150 ÷ (150 + 100) = 0.6. 1434. The second RPSM example pertains to a scenario in which the residual profits from both the parent and subsidiary markets are split; see Treas. Regs. § 1.482-7(g)(7) (v), Example 2. 1435. See the discussion of the ruling in sec. 14.2.5.

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14.2.8.7. Unspecified methods The cost-sharing regulations allow the use of unspecified methods.1436 Such methodology must be based on the realistic alternatives of the controlled parties and provide information on the prices or profits that the controlled participants could have realized by choosing a realistic alternative to the CSA.1437 As with any method, an unspecified method shall not be applied unless it provides the most reliable measure of an arm’s length result under the best-method rule.1438 In light of the highly developed specified pricing methods available under the current cost-sharing regulations and the fact that the go-to income method and RPSM can be used in the absence of CUTs, there should not be much need to apply unspecified methods. If an unspecified method has been used, its resulting profit allocation should be reviewed critically.1439

14.3. Buy-in pricing under the OECD TPG The OECD TPG have historically been sparse with respect to the allocation of operating profits through CSAs.1440 At the time at which the 1979 OECD Report on Transfer Pricing and Multinational Enterprises was written, CSAs were not seen as posing any particular risk of base erosion.1441 The Report discussed how the right to deductions for R&D costs should be delimited in the context of CSAs,1442 but did not directly touch upon how 1436. Treas. Regs. § 1.482-7(g)(8). See Wittendorff (2010a), at p. 586 for a discussion of the use of unspecified methods in the context of CSAs. 1437. See the discussion of unspecified transfer pricing methods in ch. 12. 1438. See the discussion of the US best-method rule in sec. 6.4. 1439. See sec. 14.2.3. for a discussion on the use of unspecified methods under the pre2009 CSA regulations. 1440. See also Brauner (2010), at p. 10 and the critical comments in Brauner (2016), at p. 111, where it is noted: “Perhaps the least intellectually defensible part of the OECD TPG was that this chapter had not enjoyed much analysis or any other attention preBEPS; however, the importance of cost sharing, the idiosyncratic United States rule that had inspired the discussion of CCAs, forced the OECD to try and pour some content into this formerly essentially empty bucket. It did not do that.” While the author certainly shares some of these views, he will not go quite as far in his criticism. 1441. 1979 OECD Report, para. 109. The United States was apparently the only country with domestic legislation on the transfer pricing of CSAs. Other countries had only limited experience in the field; see para. 110 of the 1979 OECD Report. Germany, however, developed guidelines for cost sharing where R&D costs could only be valued in the aggregate. 1442. 1979 OECD Report, paras. 102-124. The Report also took, in the author’s view, the questionable position that cost contributions should contain a profit element; see para. 119. The 1968 US IRC sec. 482 regulations (33 Fed. Reg. 5848) allowed deduc-

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Buy-in pricing under the OECD TPG

the residual profits from exploitation of cost-shared intangibles should be allocated.1443 The 1995 OECD TPG introduced a chapter on CSAs. It stated that any contribution of pre-existing rights should be “compensated based upon an arm’s length value for the transferred interests”.1444 No elaboration was offered with respect to the acceptable pricing methodology.1445 Considerable doubt was left as to which buy-in measurements would be acceptable.1446 In 1997, the OECD adopted a report on cost contribution agreements, which did not entail significant changes to the 1995 text.1447 The guidance contained in the 2010 OECD TPG was virtually, in all respects, the same as in the 1995 OECD TPG. The new 2017 chapter in the OECD TPG on CSAs, although not a voluminous text, contains substantial restrictions on buy-in pricing.1448 The principle approach is that CSA pricing is subject to the same analytical framework for review as other intangibles transactions. The logic behind this position is that parties performing activities under arrangements with similar economic characteristics should receive similar expected returns, irrespective of whether the contractual arrangement is classified as a CSA, contract R&D agreement, etc. The 2017 guidance on risk,1449 intangible ownership (the “important functions doctrine” and the guidance on the tions for actual expenses without the addition of a mark-up. There should, in the author’s view, be no profit element in the cost contributions. The profits should be taxed subsequently, when the cost-shared intangible is exploited and generates profits. 1443. According to the 1979 OECD Report, each CSA participant should bear its fair share of costs and risks, and in return be entitled to its share of the results; see 1979 OECD Report, para. 103. The Report did not go further into the division of the results, but stated that costs should usually be divided among the contributing parties in proportion to the relevant entity’s use or return from the intangible developed under the CSA; see para. 106. 1444. 1995 OECD TPG, para. 8.31. 1445. 1995 OECD TPG, ch. VIII. The need for additional buy-in guidance was emphasized; see 1995 OECD TPG, para. 8.1. Brauner (2010), at p. 10 argues that while the US CSA regulations provided a firm taxpayer a safe-harbour solution, the OECD TPG only offered more “loose” assurances for taxpayers (i.e. that tax authorities should refrain from reassessments). 1446. See 1995 OECD TPG, para. 8.15, which stated that countries had experience with both the “use of costs and with the use of market prices for the purposes of measuring the value of contributions to arm’s length CCAs”. 1447. OECD 1997 Report on Cost Contribution Arrangements. 1448. See, however, Brauner (2014a), at p. 100, where he criticizes the OECD for not putting enough effort into guidance on CSAs (given the significant focus on revising the general intangibles guidance in the BEPS revision of the OECD TPG). 1449. OECD TPG, paras. 1.56-1.106. The new risk guidance is discussed in sec. 6.6.5.5. of this book.

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determination of a risk-adjusted funding return) 1450 and hard-to-value intangibles also apply in the context of CSAs.1451 Under the new guidance, the value of each participant’s CSA contribution must be consistent with the value that independent enterprises in comparable circumstances would have assigned to it.1452 A distinction is drawn between contributions of pre-existing value (e.g. unique intangibles) and current contributions (e.g. ongoing R&D). If a pre-existing intangible is contributed to the CSA, its value should be determined pursuant to the transfer pricing methods and the new guidance on valuation.1453 The value of current functional development contributions is not based on the potential value of the resulting technology, but on the value of the functions performed.1454 This value is determined under the transfer pricing methods, the new guidance on intangibles and the guidance on intra-group services. Thus, the rule for both categories of contributions is that the pricing should reflect their value, not costs.1455 It is warned that a cost-plus-based compensation with a “modest mark-up” will not reflect the anticipated value of – or the arm’s length price for – the contribution of an R&D team in all cases.1456 Further, the pricing of current development contributions at cost will generally not provide a reliable basis for the application of the arm’s length principle.1457

1450. OECD TPG, paras. 6.50-6.58 (the “important functions doctrine”); and paras. 6.60-6.64 (R&D funding remuneration). The “important functions doctrine” and R&D funding remuneration guidance are analysed in secs. 22.3. and 22.4., respectively. 1451. OECD TPG, paras. 6.181-6.195. This guidance on hard-to-value intangibles is discussed in sec. 16.5. 1452. OECD TPG, para. 8.25. 1453. OECD TPG, para. 8.26. 1454. Id. 1455. Measurement of current contributions at cost is allowed when this may be more administrable; see OECD TPG, para. 8.27. 1456. Id. This statement should be read in light of the 2015 rejection of the previous 2009 OECD position that an R&D entity could be remunerated on a cost-plus basis under a contract R&D agreement that allocated the residual profits to the cash-box entity; see OECD TPG, paras. 7.4 and 9.26. See also the discussion in sec. 22.3.3.2., with further references. 1457. OECD TPG, para. 8.28. See, however, Brekel et al. (2016), where it is argued that concurrent R&D contributions could be remunerated using cost-plus, while the residual profits are subsequently split among the same participants that contributed the ongoing R&D inputs. As long as this would yield an allocation of residual profits similar to that which would have been the case had the important functions doctrine (see the discussion in sec. 22.3.2.) been applied to allocate the residual profits, the author would agree.

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Buy-in pricing under the OECD TPG

It is, in the author’s view, clear that a group entity that renders important development functions should be entitled to a portion of the residual profits from the intangible developed under the CSA.1458 In other words, allocation of a concurrent normal return remuneration to this entity pursuant to a one-sided pricing method will not satisfy the arm’s length standard. This restriction is entirely necessary in order to avoid BEPS and to align profit allocation with the underlying intangible value creation. In the end, the author questions whether the distinction between pre-existing value and current contributions is at all useful, in particular, as the new guidance states that both types of contributions should be priced at value.1459 In practice, it will often be the same group entity that contributes pre-existing intangibles and ongoing R&D, and an aggregated valuation approach will presumably often be appropriate. In these cases, it is not meaningful to distinguish between non-routine contributions, as they are priced together. It therefore remains to be seen whether multinationals will argue for low buy-ins based on the assertion that compensation for ongoing R&D should be “carved out” of the buy-in amount and priced separately on a cost-plus basis. Pre-existing intangibles and ongoing R&D should, in the author’s view, be priced together as a whole, since the value of both elements is reflected in the estimated future profits generated through the exploitation of the intangible developed under the CSA. This is also the US approach.1460 The new guidance contains an example that illustrates that a group entity that only provides intangibles development funding to the CSA will be allocated only a risk-adjusted return, while the residual profits will be allocated to the CSA participant that contributes non-routine inputs.1461 The example pertains to Companies A and B, which enter into a CSA to develop an intangible. Company B provides a pre-existing intangible that forms the basis for the development, as well as the R&D team, while Company A only provides intangibles development funding (an annual 100 in years 1-5). 1458. See the discussion of the OECD “important functions doctrine” in sec. 22.3.2. 1459. See also Storck et al. (2016), at p. 219, where it is made clear that the question of whether current R&D efforts should also be subject to market-value buy-in under the new OECD TPG has attracted attention and that some are of the view that cost allocation could be sufficient for such ongoing R&D efforts. 1460. See the discussion of the new US guidance on aggregated valuation of controlled transactions in sec. 6.7.2. (on the effects of the new guidance on the best-method rule, see sec. 6.4.). 1461. OECD TPG, ch. VIII, Example 4.

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Chapter 14 - Allocation of Residual Profits to Unique and Valuable IP through Cost-Sharing Structures

The value of Company B’s contribution is determined indirectly as the residual of the total anticipated operating profits and the return allocable to Company A’s funding contribution. It is estimated that the exploitation of the cost-shared intangible will generate global profits of 550 per year in years 6-15, with 60% of the profits generated in the market of Company A and 40% in the market of Company B. The controlled pricing allocates 330 in operating profits to Company A in each year. This pricing is benchmarked against the best realistic alternative of Company A, which is to receive a risk-adjusted rate of return on its funding capital (essentially the same pricing approach as that applied in the US income method).1462 This return is determined to be 110 per year in years 6-15, equal to an internal rate of return of 12%.1463 Thus, in order for the pricing to be at arm’s length, Company A must surrender (through balancing payments) 220 per year to Company B so that the profits allocable to Company A in each year is 110, equal to its best realistic alternative.1464 The example describes Company A as a typical cash-box entity that only provides intangibles development funding to the CSA. In cases involving similar entities, it is the author’s view that it must be assumed that a rate around the 12% return on invested capital is the OECD-endorsed arm’s length profit allocation. The author observes that the examples in the new guidance on cost sharing seems to indicate that the cash-box funding entity (Company A) will not be entitled to any remuneration for its R&D funding contributions if it is not deemed to control the financial risks associated with its funding.1465 Such a solution would be contrary to the general approach towards the remuneration of R&D funding that the OECD has taken in the new guidance on 1462. See the discussion of the income method in sec. 14.2.8.3. 1463. It should be noted that footnote 1 of the new CSA guidance does not explain how the 110 in annual income to the funding investment in years 6-15 is derived. It is just assumed that this level of profit represents an arm’s length return. It is further stated that this result is shown just to demonstrate the principles of the example and is not meant to offer any “guidance as to the level of arm’s length returns to participants in CCAs”. While the author recognizes this reservation, he finds it difficult to see that the rate of return used in the example should have no relevance in cases pertaining to pure cashbox entities. After all, the rate of return selected is used to illustrate an arm’s length return. 1464. Navarro (2017), at p. 269, finds that the result of the example is contrary to the arm’s length principle. The author strongly disagrees with this assertion, based on much of the same reasoning as for his objection to Navarro’s approach for remunerating group entities that carry out DEMPE functions (see infra n. 1988). 1465. OECD TPG, ch. VIII, annex, Example 5, para. 22.

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The relationship between US and OECD buy-in pricing

intangibles, pursuant to which the funding entity is entitled to a risk-free return in cases in which it does not control the financial risk.1466 Further, given that the new guidance on cost sharing is based on the view that the economic characteristics of the controlled parties’ activities should guide the profit allocation, irrespective of the legal form in which the activity is organized (CSAs, contract R&D agreements, etc.), as well as the fact that paragraph 8.9 of the OECD TPG explicitly states that paragraphs 6.606.64 apply for the purpose of remunerating R&D funding contributions, it seems clear that paragraph 22 of Example 5 should be interpreted as requiring the allocation of a risk-free rate of return for R&D funding contributions from a cash-box entity that is deemed to not control the financial risks associated with its funding contribution.

14.4. The relationship between US and OECD buy-in pricing On the basis of the discussions in this chapter, it may be observed that there are clear similarities between the US and OECD approaches to buy-in pricing.1467 While the new OECD guidance lacks the detailed and instructive character of the US cost-sharing regulations,1468 as well as pricing methodology specifically tailored to the CSA context, the realistic alternatives principle will no doubt form an effective restriction on CSA pricing, as it also does through the US income method.1469 The material core of the pricing approaches is therefore essentially the same. Both the US and OECD rules will strip residual profits from a cash-box entity that only provides intangibles development funding to the CSA.1470 1466. See the discussion in sec. 22.4.3. 1467. See also, however, Brauner (2016), at p. 111, where it is emphasized that there are significant differences between the US and OECD regimes, particularly with respect to the US CSA regime being a transfer pricing safe harbour and a legal vehicle to avoid the US partnership taxation rules, as well as the OECD regime encompassing more than just joint development of IP. While the author agrees with this, his focus merely rests on the buy-in pricing aspects of the US and OECD regimes, and on this point, there are clear similarities, as the pricing must qualify as arm’s length under both regimes. 1468. Brauner (2016), at p. 123 notes that it may be difficult to avoid circumvention of the OECD CSA regime without more detailed rules. 1469. See the discussion of the US income method in sec. 14.2.8.3. 1470. See also the critical comments on the structure and content of the OECD CSA rules in Brauner (2016), at pp. 124-126. Brauner seems to attribute little in the way of specific content to the OECD TPG CSA chapter, in particular due to the risk that the (partly ambiguous) OECD provisions may be interpreted in diverging and relaxed ways by jurisdictions. While the author, to some extent, agrees with this, he still finds the core content of the OECD CSA buy-in guidance to be clear: it will strip cash-box enti-

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Chapter 14 - Allocation of Residual Profits to Unique and Valuable IP through Cost-Sharing Structures

The difference lies in the fact that the US regulations will allocate a CPMbased normal market return to this entity, while the OECD TPG are more generous, as they allow the cash-box entity to earn a risk-adjusted rate of return on the capital that it has invested into the CSA R&D. While the author finds the OECD approach to be the most principled of the two (i.e. the OECD and US approaches), as capital by itself should indeed attract an arm’s length return, it does trigger a risk of relatively substantial “leakage” of operating profits from high-tax jurisdictions (where R&D typically is carried out) to low or no-tax jurisdictions. The United States avoids this risk through its “cut-off” approach to intangibles development funding under the income method.1471

ties of residual profits. In reality, this OECD profit allocation approach is much akin to that of the income method of the US CSA regulations. 1471. For a further analysis of the problems connected to these approaches to intangibles development funding, the author refers to the discussions in secs. 22.4.11. and 26.3.

436

Chapter 15 Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing 15.1. Introduction The question in this chapter is to what extent a group entity may report in its tax return a transfer price that is an arm’s length price for the controlled transaction in question, but differs from the amount actually charged throughout the income year, i.e. whether the controlled taxpayer may perform a compensating or year-end adjustment.1472 This stands in contrast to the issue of whether tax authorities may carry out periodic adjustments (which is the topic of analysis in chapter 16). Due in part to the practical significance of year-end adjustments as a result of the dominant role of the transactional net margin method (TNMM) in global transfer pricing practice and in part to the legal uncertainty surrounding some aspects of year-end adjustments, the author finds it necessary to carry out a fairly broad analysis of the subject.1473 The author will first provide a lead-in to the topic of year-end adjustments in section 15.2. The TNMM will be used as an illustration tool, but what is said largely applies analogously for the resale price and cost-plus methods.1474 The author will then analyse the authority to perform yearend adjustments under US law and the OECD Transfer Pricing Guidelines (OECD TPG) in sections 15.3. and 15.4., respectively. In section 15.5., he discusses a recommendation from the EU Joint Transfer Pricing Forum (JTPF). Lastly, he will analyse case law on year end-adjustments in sections 15.6.-15.10.

1472. These terms will be used interchangeably throughout the chapter. 1473. See De Simone et al. (2015) for a recent and interesting economic analysis of how multinationals “shift” profits between jurisdictions after the year’s end so that the reported profits in each jurisdiction conform to an arm’s length return. 1474. The relevant difference between the methods is that the transactional net margin method (TNMM) sets a target net profit margin, while the resale price and cost-plus methods set a target gross profit margin.

437

Chapter 15 - Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

15.2. A lead-in to compensating adjustments Compensating adjustments are inherently linked to the application of onesided transfer pricing methods (see the analysis of the comparable profits method (CPM) and TNMM in chapter 8). As the determination of the amount of some of the elements in the tested party’s operating profits may be contingent on external factors (customer demand, raw material market prices, etc.), it will not be possible at the start of the year for a group to adapt its transfer prices so that the arm’s length profit margin is reached. Only in rare circumstances will the budgeted amounts align exactly with the amounts actually realized. Without a year-end adjustment, to be carried out when the actual results have become known (i.e. after the end of the income year), it will simply not be possible for the taxpayer to achieve the arm’s length transfer pricing result dictated by the TNMM. Let us say, for instance, that a Norwegian group that designs, manufactures and sells luxury yachts decides that its low-risk US distribution entity shall be allocated a TNMM-based return for the income year 2008 going forward. The Norwegian parent owns all unique intangible property (IP) employed in the value chain and carries out research and development (R&D) and manufacturing. In the late autumn of 2007, the group performs a transfer pricing analysis of comparable unrelated US distributors based on financial accounting data from commercial databases. Because audited financial statements are ready at the earliest some months after the end of the accounting period to which the accounts refer, there is a lag in the available third-party profit data. The most current data is for the income year 2006. Based on the averages for the years 2004-2006, the analysis shows an interquartile net profit margin range between 5.25% and 6.5%, with a median of 5.8%. The study therefore concludes that the net profit return for the US distribution entity for 2008 going forward should be set to 5.8%. This is the target TNMM return for the US distribution entity for 2008. The list (transfer) prices for yachts sold from the Norwegian parent to the US subsidiary are then designed to realize the target return based on estimates of what the external sales and operating expenses of the US distribution entity will be in 2008 going forward. The transfer prices will enable the subsidiary to reap the annual 5.8% net profit return. Because there is uncertainty connected to the estimates upon which the prices are based, the controlled parties agree on a year-end adjustment pro438



A lead-in to compensating adjustments

vision. Let us suppose that the list prices for the Norwegian yachts are based on the budget for the US distribution entity shown in table 15.1. Table 15.11475 Parent (Norway) 1475

Subsidiary (United States)

Margins (subsidiary)

Sales

17,500

2,500

-

Cost of goods sold (COGS)

12,600

1,800

-

Gross profit

4,900

700

28.0%

Operating expenses

3,892

556

-

Net profit

1,008

144

5.8%

The subsidiary’s sales and operating expenses are external. Given the budgeted sales of 2,500 and operating expenses of 556, a transfer price of 1,800 for the yachts (COGS) will result in the target net profit margin of 5.8%. In 2008, the financial crisis impacts the US market for luxury boats significantly. By the end of 2008, the US subsidiary has generated the actual results displayed in table 15.2. Table 15.2 Parent (Norway)

Subsidiary (United States)

Margins (subsidiary)

Sales

17,500

2,125

-

COGS

12,600

1,800

-

Gross profit

4,900

325

15.3%

Operating expenses

3,892

556

-

Net profit

1,008

−231

−10.9%

Due to a 15% reduction in sales, the subsidiary was unable to reach the 5.8% target TNMM net profit return rate for 2008. Instead, it incurred a loss (negative net profit margin of −10.9%). 1475. The data for the parent includes its worldwide transactions (also transactions with entities other than the US subsidiary).

439

Chapter 15 - Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

This is not an arm’s length net profit margin. In order to align the actual results with the profit allocation result prescribed by the TNMM, the Norwegian parent carries out a compensating year-end adjustment by reducing the sales prices charged for the boats sold to the US subsidiary by 355, thereby lowering the COGS for the subsidiary from 1,800 to 1,445. This brings the net profit margin of the US subsidiary in line with the TNMM, as it then realizes the target net profit margin of 5.8% (shown in table 15.3). Table 15.3 Parent (Norway)

Subsidiary (United States)

Sales

17,145

2,125

COGS

Margins (subsidiary) -

12,600

1,445

-

Gross profit

4,545

680

32.0%

Operating expenses

3,892

556

-

653

124

5.8%

Net profit

In this example, the year-end adjustment is performed by reducing the price of goods. Alternatively,1476 it could have been performed by lowering royalties paid by, or administrative expenses allocated to, the subsidiary, or simply by the parent reimbursing some of the subsidiary’s operating expenses (e.g. marketing costs).1477 1476. An interesting issue is whether the taxpayer is free to adjust prices of goods that have a clear market price (e.g. commodity goods such as sugar and oil). When the pri­ cing is based on a one-sided method, it will be the profit margin allocated to the tested party that determines whether the pricing is at arm’s length. The one-sided methods do not ask what the arm’s length price is for any specific controlled exchange among the controlled parties, but rather what the arm’s length net remuneration is that the tested party must be left with as a result of all of its controlled transactions with the entrepreneur (i.e. an aggregated pricing approach). For this view to be valid, however, all controlled transactions in the relevant value chain must be carried out between the same taxpayers. This was not the case in GlaxoSmithKline Inc. v. R. (see sec. 6.7.4.), in which the Canadian distribution entity of GSK purchased raw materials from Switzerland and licensed manufacturing and marketing intangible property (IP) from the United Kingdom. Further, even when all controlled transactions are carried out between the same group entities, the classification of a year-end adjustment may be relevant for nontransfer pricing purposes (e.g. VAT, customs and foreign exchange). 1477. See Barmentlo et. al. (2013), who argue that companies may not be able to defend year-end adjustments to royalties and service charges due to difficulties in classifying payments and identifying comparables to support the charges applied. While the author shares the Barmentlo’s view that it is important for year-end adjustments to

440



A lead-in to compensating adjustments

For the controlled parties, the compensating adjustment ensures that the actual profit allocation, as reflected in their tax return positions, corresponds to the arm’s length result dictated by the applicable one-sided method (here, the TNMM). The pre-adjustment profit allocation in the example was not in accordance with the arm’s length principle. No unrelated distributor would be willing to perform marketing and distribution services for a negative net profit margin. The post-adjustment return, however, corresponds to what comparable unrelated distributors would demand as compensation. For the involved jurisdictions, year-end adjustments may increase or decrease the tax base. When the actual net profit margin of the tested party is less than the target arm’s length return and the taxpayer does not perform a year-end adjustment, its residence jurisdiction is likely to carry out a reassessment. Further, the jurisdiction of the non-tested party will likely react if a compensating adjustment is performed, as it will reduce its tax base, thus bearing the “cost” of the adjustment, as the case was in Vingcard (discussed in section 15.6.). In the reverse situation, where the tested party realizes a net profit that exceeds the target return, a downward year-end adjustment should ensure that the residual profit is allocated to the non-tested party. The jurisdiction of the tested party may possibly want to perform a transfer pricing assessment to test whether the TNMM has been applied correctly, as its tax base will be reduced by the adjustment, as the case was in T.Srl (discussed in section 15.7.). It is important to bear in mind that compensating adjustments refer to the process of correcting an actual result so that the controlled profit allocation is brought in line with the arm’s length allocation required by the TNMM. It is not a question of reassessing the arm’s length ­pricing as such. The 5.8% target arm’s length net profit margin result in the example is the same both before and after the adjustment. A year-end adjustment be founded in written agreements that were in effect for the year to which the adjustment refers, the author does not share the concern with respect to comparables. Most year-end adjustments are carried out in order to align the results of the tested party with the profit margin yielded by the one-sided methods. In such cases, there is no need for a comparable transaction supporting that a year-end adjustment in and of itself may be made. The margin yielded by the one-sided methods will, in itself, justify the adjustment. The Norwegian Vingcard Elsafe AS v. Skatt Øst, Utv. 2012 p. 1191, reversing in part, Utv. 2010 p. 1690 pertained to year-end adjustments carried out partly through a price reduction for goods sold and partly through the reimbursement of guarantee and marketing expenses. See the discussion in sec. 15.6.

441

Chapter 15 - Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

is therefore a matter of reconciliation: preliminary pricing is adjusted so that the return position of the taxpayer reflects the arm’s length result. This separates the issue from ordinary transfer pricing disputes in which the problem is to determine the appropriate net profit margin to be used under the TNMM. For instance, this could occur when the tested party’s return position is that it should earn a 5.8% net profit margin while the tax authorities claim that a correct application of the TNMM yields a net profit margin of 7.2%. This is, in principle, a normative question, as the problem is to determine whether the pricing reflects a correct interpretation and application of the relevant transfer pricing method. However, the author admits that the line between a reconciling year-end adjustment and a normative transfer pricing adjustment is thin. This is true in particular when the year-end adjustment is not motivated by the desire to align controlled prices charged throughout the year so that the total net profit margin corresponds with the arm’s length TNMM margin, but rather that the transfer pricing study that formed the basis for the target margin is updated at the time of filing the tax return to include a more recent accounting period. This update may alter the arm’s length profit margin itself. Such a year-end adjustment is, in practice, rather indistinguishable from a transfer pricing adjustment. Further, a year-end adjustment refers to the process of correcting an actual, but unassessed, result. The adjustment is carried out before the taxpayer files its tax return for the income year to which the adjustment refers.1478 The basic system of the OECD TPG (and US transfer pricing law for that matter) is that transfer pricing should be based on the transactions actually carried out by the controlled parties. This refers to the controlled transaction as such, including all pricing mechanisms contained within it. The concurrent transfer prices used throughout an income year may be single components in a larger pricing system agreed to by the controlled parties. For instance, the pricing mechanism in the distribution agreement in the above example consists of two provisions, namely (i) the list prices used throughout the year; and (ii) the adjustment provision for aligning the actual net profit of the tested party to the arm’s length TNMM margin. The

1478. Year-end adjustments may entail a range of non-income tax complications, particularly with respect to VAT, customs, foreign exchange, regulatory price control (e.g. for pharmaceutical products) and financial accounting. Such issues are becoming increasingly important in many OECD member countries; see the 2006 OECD comparability report, Timing issues in comparability, para. 41. For further discussions, see Pheiffer et al. (2015), at p. 302; and Cottani (2007).

442



Taxpayer-initiated adjustments under US law

list prices are preliminary in this context. The ultimate point of the p­ ricing framework is to remunerate the US distribution entity for its market­ing, sales and distribution functions with an arm’s length net profit for its ­efforts. Year-end adjustments can therefore be seen as a transfer pricing documentation issue, as the taxpayer is not assessed based on its preliminary pricing, but on its return position. The focus should therefore be on whether the group has sufficiently documented the controlled pricing provisions and its efforts to align its preliminary pricing as closely as possible with the prices that, at the beginning of the year, it estimated would result in an arm’s length net profit for the tested party.

15.3. Taxpayer-initiated adjustments under US law The US Internal Revenue Code (IRC) section 482 regulations allow taxpayer-initiated year-end adjustments.1479 It is stated in the regulations that, if necessary to reflect an arm’s length profit allocation, a controlled taxpayer “may report on a timely filed U.S. income tax return (including extensions) the results of its controlled transactions based upon prices different from those actually charged”.1480 (Emphasis added) The provision applies regardless of the type (upwards or downwards) and form (COGS, royalties, reimbursements, etc.) of adjustment. The quoted provision was incorporated into the final 1994 US regulations, likely making the United States the first jurisdiction to adopt a year-end adjustment provision.1481 The introduction of the provision coincided with the 1994 regulatory introduction of the CPM, PSM, the best-method rule and the commensurate-with-income standard and should be seen in light of the fact that it would be difficult to properly apply the profit-based ­pricing methods, in particular the CPM, without access to year-end adjustments.

1479. Even though year-end adjustments are allowed under the US Internal Revenue Code (IRC) sec. 482 regulations, such adjustments may be barred or limited by VAT and customs regulations. For instance, where “property [is] imported into the United States in a transaction … between related persons”, the taxpayer is not entitled to report a cost of goods sold (COGS) higher than that used for calculating the value for customs purposes; see IRC sec. 1059A. 1480. Treas. Regs. § 1.482-1(a)(3). The 1993 temporary regulations (58 FR 5263-02), section 1.482-1T(e)(2), spoke of “compensating adjustments” when the taxpayer made adjustments (before filing the tax return) for reimbursements or other payments necessary to ensure that the controlled transactions yielded an arm’s length return. This terminology was scrapped in the final 1994 regulations (59 FR 34971-01). 1481. See Rosenbloom (2007).

443

Chapter 15 - Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

The taxpayer is not allowed to perform a downwards profit adjustment in an untimely or amended return, but an upwards adjustment is allowed. An example of the former may, for instance, be if a US taxpayer realizes that it has made a transfer pricing error by allocating too little profits to a foreign subsidiary, resulting in an underpayment of foreign tax and overpayment of US tax. In this situation, there are two main alternatives. First, if the multinational files an amended return in the foreign jurisdiction, increasing the profit allocation, and pays the additional tax, it would incur double taxation, as the incremental foreign profits also have been taxed in the United States. This alternative is therefore unfavourable for the multinational.1482 Second, if the multinational does not file an amended return in the foreign jurisdiction but rather awaits the tax assessment, it could seek relief from the US competent authorities in the case of a reassessment in the foreign jurisdiction. A connected issue is whether the taxpayer may perform an adjustment of its assessed return position at an even later stage, e.g. in the course of an examination, during consideration by Appeals or in a docketed case. This depends on an interpretation of the commensurate-with-income standard expressed in the second sentence of IRC section 482.1483 Even though the language of the provision itself may seem to allow otherwise, the author finds it clear on the basis of the legislative discussions,1484 the White Paper1485 and the IRS interpretation of IRC section 482, as reflected in the current regulations, that the commensurate-with-income standard entitles only the IRS (and not the taxpayer) to perform periodic adjustments. The Office of Chief Counsel of the IRS concluded likewise in a 2007 memorandum.1486 The author is not convinced that this asymmetrical solution necessarily is for the best. From a US perspective, the point of departure is that the tax1482. The US competent authority generally accepted cases of taxpayer-initiated adjustments if the foreign jurisdiction would grant reciprocity in similar cases, but that position changed in 2010; see Elliott (2011). There are, however, signals that the US Internal Revenue Service (IRS) is considering reverting to its previous position. 1483. The second sentence reads: “[I]n the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” 1484. 1985 House Report, pp. 425-426. The discussion is geared towards preventing base-eroding outbound transactions of US-developed intangibles. See also the discussion of the US periodic adjustment authority in sec. 16.2. 1485. See, e.g. White Paper (Notice 88-123), at p. 480: “Because Section 482 may be applied only by the Service […].” 1486. IRS AM 2007-007, issue 1.

444



Taxpayer-initiated adjustments under US law

payer is afforded the right to perform a year-end adjustment, as long as it is reflected in a timely filed return. The taxpayer also has the right to perform an adjustment in an amended return, as long as the adjustment increases US income. What remains is that the taxpayer is cut off from the right to perform a subsequent adjustment that decreases US income. The IRS would likely argue that the taxpayer is free to choose a contingent payment form that will ensure that the profits allocated to the United States are commensurate with the income generated by the transferred IP. If, on the other hand, the taxpayer chooses a fixed-payment structure, it chooses to accept the risk that the actual results may deviate from those projected at the time at which the agreement was entered into, and the taxpayer must stand by its original choice. Implicit in this logic lies the assumption that the multinational will only wish to adjust the pricing if it is beneficial for it to do so. For instance, let us say that a US parent sells early-phase, unproven IP to a foreign subsidiary for 100, which equals the present value of the profits estimated at the time at which the transaction was entered into. If the actual profits reaped by the foreign subsidiary from its subsequent exploitation of the IP are higher than estimated, and thus indicate that the price should have been 200, it is unlikely that the taxpayer would wish to adjust the transfer price, as that would increase US income tax. The IRS, on the other hand, would likely want to do so. Conversely, if the actual profits are lower than expected and thus indicate that the price should have been set to only 50, the taxpayer would likely want to adjust the transfer price in order to lower its US income tax. The IRS would likely have the taxpayer stand by its initial fixed payment form “bet”. Thus, the asymmetry of the commensurate-with-income provision lies in the fact that in the first scenario, the multinational does not wish to adjust, but the IRS may have the right to do so. In the second scenario, the multinational wishes to adjust, but it does not have the right to do so. The author thinks that there is a lot of merit to the argument that the taxpayer is free to choose the form of controlled compensation. The essence is that if the taxpayer chooses a fixed-payment structure, it should stand by it, even if the subsequent actual profits indicate that the fixed payment should have been lower. However, had the situation instead been that the actual results indicated that the price should have been higher, the author finds it unlikely that the IRS would exercise restraint and not carry out a periodic adjustment. 445

Chapter 15 - Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

As the author discusses in chapter 16 on periodic adjustments, the US regulations set the bar high for respecting a fixed-payment structure when the actual and projected profits diverge significantly. This indicates that the IRS may make an adjustment even if the actual profits were not reasonably foreseeable at the time of the transaction, as long as the extraordinary events were not entirely beyond the control of the related parties, e.g. if the increased profits were due to unexpected demands caused by successful marketing. In the author’s view, the main problem with the asymmetrical structure of the commensurate-with-income rule is that it will allow for non-arm’s length profit allocations in which the taxpayer is not entitled to adjust its transfer pricing. In the example above, the IP was migrated from the United States for 100, but the lower-than-expected profits indicate that the price should have been 50. The United States may have been allocated more income than an application of the transfer pricing methods – taking into account the actual profit experience – would allow for.1487 In the context of unique IP, this may entail that intangible value (residual profit) is not allocated to the jurisdiction where it was created. The author does not find it apparent that this asymmetry is aligned with the arm’s length principle, as it purposefully blocks taxpayer-initiated income adjustments that would reflect an arm’s length allocation of income. He thinks that the achievement of arm’s length results should carry more weight than the argument that the taxpayer is free to choose the form of compensation and therefore must accept the risk that follows with it if a fixed-payment form is adopted.1488 1487. E.g. assume that the original price was set based on the comparable price method (CPM), designed to leave the transferee with only a normal return on its routine functions, given that its profits turned out as projected. If the foreign transferee’s actual profits turn out lower, but it still paid the original 100 transfer price based on the projected profits, this will mean that the transfer price steals all, or at least portions, of the normal return compensation that was intended for the transferee. In other words, the result is not compatible with an application of the CPM. However, had a subsequent downward adjustment of the original transfer price from 100 to 50 been performed, that would have left more profit with the foreign transferee, thus ensuring that the actual result was compatible with the CPM. A similar issue was raised in GlaxoSmithKline Holdings (Americas), Inc. v. CIR, 117 TC 1 (see sec. 15.10., with further references). 1488. IRS AM 2007-007 also addressed the connected issue of whether a taxpayer may apply the commensurate-with-income (CWI) standard to challenge an IRC sec. 482 adjustment in a situation in which the IRS did not itself apply the CWI provision. The memorandum position is that CWI results may be achieved by the taxpayer through upfront contingent payment forms that comport with economic substance, and may therefore not invoke sec. 482 to make a CWI adjustment that enables it to “walk

446



Year-end adjustments under the OECD TPG

15.4. Year-end adjustments under the OECD TPG The OECD TPG introduced a discussion of year-end compensating adjustments in 2010.1489 The text refers to the fact that some OECD member countries practice the arm’s length principle in a manner that embraces year-end adjustments, while others do not. The practice of not accepting year-end adjustments is referred to as the “arm’s length price-setting approach”.1490 The taxpayer must then, in its transfer pricing documentation, demonstrate that it made reasonable efforts to comply with the arm’s length principle at the time at which the controlled transaction was carried out, based on information that was reasonably available at that point.1491 Conversely, the practice of accepting year-end adjustments is referred to as the “arm’s length outcome-testing approach”.1492 When filing the tax return, the taxpayer tests the outcome of its actual transactions to demonstrate that it is consistent with the arm’s length principle. The OECD TPG take no stance with respect to the priority of the two approaches.1493 The text recognizes that if compensating adjustments are permitted only in the residence jurisdiction of one of the parties to the controlled transaction, double taxation may occur, as corresponding

away from a deal it struck for itself”. It may, however, be of aid to the taxpayer that Treas. Regs. § 1.482-1(g)(4) provides the right to a setoff against an IRS sec. 482 reassessment for another non-arm’s length transaction (primary transaction). The setoff and primary transactions must be “between the same controlled taxpayers” and “in the same taxable year”. Further, the taxpayer must establish “that the transaction that is the basis of the setoff was not at arm’s length” and must establish “the amount of the appropriate arm’s length charge” for such setoff transaction. 1489. OECD TPG, paras. 3.70-3.71 and 4.38-4.39. Para. 4.38 refers to the fact that at least one OECD member country has a procedure under its domestic law for year-end adjustments. Given the similarity between the wording of the OECD TPG on this point and § 1.482-1(a)(3) of the US regulations, the OECD member country being referred to is presumably the United States. 1490. OECD TPG, para. 3.69. 1491. This includes not only information on comparable uncontrolled transactions (CUTs) from previous years, but also on economic and market changes that may have occurred between those previous years and the year of the controlled transaction. 1492. OECD TPG, para. 3.70. 1493. OECD TPG, para. 4.39 makes the factual assertion that most OECD member countries do not recognize compensating adjustments on the ground that the tax return should reflect the actual transactions carried out. However, as discussed in sec. 15.5., the EU Joint Transfer Pricing Forum (JTPF) conducted a recent survey of the domestic laws of EU Member States (of the 34 OECD member countries, 21 are EU Member States), indicating that the domestic laws of many EU Member States do indeed allow year-end adjustments, even if there is no specific legislation in place in most countries.

447

Chapter 15 - Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

adjustment relief may be unavailable if no primary adjustment has been made.1494 The OECD TPG see compensating adjustments as a comparability issue. The problem with this perspective is whether a year-end adjustment should be performed in order to align the controlled profit allocation with updated profit data from third-party comparable uncontrolled transactions that become available after the end of the income year. As commented on in section 15.2., this issue strongly resembles a genuine transfer pricing issue, in contrast to the situation in which there is a need to align the actual controlled profit allocation with the TNMM target return because the actual results from external factors (e.g. the revenues or costs of the tested party from its transactions with third parties) deviates from the estimates made before the start of the income year and on the basis of which the transfer prices were designed. Information from contemporaneous third-party transactions is deemed to be the most reliable information for benchmarking controlled profit allocations.1495 Such information reflects how independent parties behaved in an economic environment similar to that in which the controlled transaction took place.1496 Of course, this information will eventually become available, but, as recognized in the 2006 OECD comparability report, likely not until after the taxpayer’s filing date.1497 Outcomes from third-party transac1494. The OECD TPG encourage competent authorities to use their best efforts to resolve double taxation due to different country approaches to year-end adjustments. Resorting to a mutual agreement procedure (MAP), however, will, in practice, be easier said than done. Rosenbloom (2007) argues that arts. 9 and 25 of the US Model Income Tax Convention (the transfer pricing and MAP provision, respectively) contain language broad enough to encompass taxpayer adjustments. The same is argued in Rev. Proc. 2006-54 (now superseded by Rev. Proc. 2015-40). The author is inclined to apply a similar view with respect to arts. 9 and 25 of the OECD Model Tax Convention (OECD MTC). The arm’s length income taxed in one jurisdiction under art. 9 (1) shall be relieved from taxation in the other jurisdiction under art. 9(2). There is no exemption for cases in which the arm’s length income taxed in the first jurisdiction comes to be as a result of a taxpayer-initiated year-end adjustment. The broad wording of art. 25 also encompasses taxpayer adjustments, as even matters concerning “double taxation in cases not provided for in the Convention” are covered; see OECD MTC, art. 25(3). 1495. The OECD has stretched the term “contemporaneous” information further than the language itself indicates. The 2006 OECD Comparability Report, in the section on timing issues, at para. 32, states that “contemporaneous” does not necessarily refer to data from the same tax year. An example is provided in which a transaction that took place in November 2001 could be more comparable to a transaction that took place in January 2002 than one that took place in January 2001. 1496. OECD TPG, para. 3.68. 1497. 2006 OECD Comparability Report, section on timing issues, para. 30.

448



Year-end adjustments under the OECD TPG

tions in years prior to the relevant income year may therefore be the only information available on which to base a TNMM transfer pricing study. An example contained in the 2006 comparability report illustrates this. In the late fall of 2004, the taxpayer designs the transfer prices for 2005 based on third-party accounting data for 2002 and 2003. In the spring of 2006, when preparing the tax return for 2005, the transfer prices are updated with third-party data from 2004, which differs significantly from the data from 2002 and 2003 used to design the transfer prices.1498 The 2006 report draws up two alternatives for the taxpayer. The first alternative is to consider the 2005 prices actually charged as arm’s length prices set on the basis of the information that was available at the time at which the prices were designed (i.e. the third-party profit data from 2002-2003).1499 In this scenario, there will be no need for a year-end adjustment.1500 The second alternative is to recognize that the transfer prices did not conform to the arm’s length range based on the third-party information available at the time of filing the 2005 tax return. A compensating adjustment should then be carried out to bring the profit margin of the tested party within the updated arm’s length range. Thus, all information available at the time of filing the tax return is relevant (including the third-party profit data from 2004).1501 Even though the OECD TPG take no position on whether year-end adjustments must be respected,1502 the transfer pricing methodology embraced in the OECD TPG may arguably nevertheless insist on a year-end adjustment. It will simply not be possible for a taxpayer to apply the one-sided methods properly without the ability to perform year-end adjustments.1503 1498. Some years after the filing of the 2005 return, the tax authorities audit the return on the basis of third-party data from 2005. The data indicates that the prices charged by the taxpayer fall outside the arm’s length range. This is a transfer pricing problem (see the discussion of periodic adjustments in sec. 25.5.), not an issue of year-end adjustments. 1499. 2006 OECD Comparability Report, section on timing issues, para. 14. 1500. There might still be a need to perform a year-end adjustment if the actual results from the tested party’s third-party transactions deviated from the results that were estimated prior to the income year (and on which the transfer prices were based). 1501. 2006 OECD Comparability Report, section on timing issues, para. 18. This information will normally not include third-party accounting data for 2005, as such data will typically not be available then; see para. 21. 1502. OECD TPG, paras. 3.67-3.71 and 4.38-4.39. 1503. See the lead-in discussion in sec. 15.2. At the time of filing the tax return, there may be updated information available on CUTs indicating that the arm’s length range must be modified.

449

Chapter 15 - Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

If a taxpayer performs a year-end adjustment in order to report a taxable income in line with that which is dictated by an applicable OECD pricing method, that adjustment should, in the author’s view, prevail with effect for taxation in both jurisdictions. Otherwise, there could be double taxation of the adjusted amount. The author will add that the current OECD TPG wording on year-end adjustments, limited as it is, cannot easily be reconciled with other, and older, sections of the OECD TPG.1504 In particular, this was true for the historical 1995/2010 guidance on periodic adjustments.1505 The traditional persistence of the OECD with respect to restraining the pricing methods to only taking into account information available at the time at which the controlled transaction was entered into was diluted by the introduction of the TNMM and profit split method (PSM) in 1995, but was still clearly present when the guidance on compensating adjustments was penned. In June 2012, the OECD issued a draft on timing issues, proposing revised language on compensating adjustments.1506 The draft text was not significantly different from the existing 2010 text. It reiterated the point of departure that transfer pricing should be based on data from contemporaneous uncontrolled transactions, but opened the door for both the arm’s length price-setting approach and the arm’s length outcome-testing approach.1507 The draft expressed fear that some OECD member countries could be less willing to accept revisions of the 2010 OECD TPG text on uncertain IP valuation (in the run-up to the BEPS revision of the intangibles chapter of the OECD TPG) if the guidance on timing issues took a restrictive position on which information could be used to test the reasonableness of ex ante valuation profit projections. In light of the fact that the OECD finally managed to reach consensus on new wording on periodic adjustments (in particular, for hard-to-value intangibles) in the autumn of 2015,1508 the time 1504. See OECD TPG, paras. 3.72-3.73, as well as scattered statements on hindsight; see paras. 2.130, 3.74, 6.32, 8.20, 9.56, 9.57 and 9.88. See also the annex to ch. IV, para. 49; and the annex to ch. VI (2010 version), para. 4. 1505. The 1995/2010 guidance on periodic adjustments was contained in paras. 6.286.35. The 2015 guidance encompasses paras. 6.181-6.195. 1506. OECD 2012 Draft on timing issues relating to transfer pricing (2012 OECD timing draft). This draft was issued on the same day that the OECD released its 2012 Discussion draft Revision of the special considerations for intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions (2012D).The coincidence of these drafts were not accidental, as timing issues were relevant to certain controversial issues on the transfer pricing of intangibles (e.g. periodic adjustments). 1507. 2012 OECD timing draft, para. 3.68. 1508. OECD TPG, paras. 6.181-6.195. See the discussion in sec. 16.5. on the OECD’s periodic adjustment provision.

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is now ripe for a revision of the OECD TPG wording on compensating adjustments to bring more clarity to the rules. A natural point of departure for the OECD would be to embrace the work carried out by the EU JTPF (discussed in section 15.5.).

15.5. Year-end adjustments in the European Union In October 2002, the European Commission established the EU JTPF to find pragmatic solutions to problems arising from the application of the arm’s length principle within the European Union.1509 In 2011, the JTPF carried out a survey of the domestic tax laws of EU Member States on year-end adjustments. The responses reflect the situation as of 1 July 2011 and present an interesting and fairly recent empirical picture of the domestic law in the European Union.1510 To provide a brief overview, no EU Member States had legislation that prevents yearend adjustments. Of the 27 respondents, 15 Member States generally accepted year-end adjustments.1511 All 15 Member States allowed compensating adjustments to be carried out before the closure of the financial statements.1512 Most Member States regarded a deviation from an arm’s length result as a sufficient reason to perform a year-end adjustment. The Member States were asked whether an intercompany agreement was necessary for claiming a year-end adjustment, but no clear response was provided in the survey summary. The majority of Member States did not have provisions explicitly obliging taxpayers to make a compensating adjustment.1513

1509. The JTPF is an expert group, with one representative from each EU Member State and 16 non-government members, chaired by an independent person. 1510. JTPF/019/REV1/2011/EN. 1511. These 15 states have legal guidance or administrative practice in place governing year-end adjustments. Some of these states require year-end adjustments to be reflected in the financial statements or only allow adjustments where third parties would have been contractually obliged to carry out a year-end adjustment, or under exceptional circumstances. 1512. In some states, the permissibility of year-end adjustments after the closing of the financial statements depends on whether the adjustments result in lower or higher taxes. Further, the majority of the 15 states allow compensating adjustments before the tax return is filed, but only a few allow adjustments subsequent to the filing. 1513. Some EU Member States, however, see the performance of a year-end adjustment as a necessary consequence of the general requirement to conform with the arm’s length principle.

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A report on compensating adjustments was issued in November 2013.1514 The conclusion of the report was that a taxpayer-initiated year-end adjustment, downwards as well as upwards, shall be accepted if the same prices are reported by each of the Member States involved, and1515 (i) the taxpayer makes reasonable efforts to achieve an arm’s length outcome before the relevant transactions are carried out and describes this in the transfer pricing documentation; (ii) the taxpayer makes the adjustment symmetrically in the financial statements of both Member States involved; (iii) the same approach is applied by the taxpayer over time; (iv) the adjustment is made before filing the tax return; and (v) the taxpayer is able to explain why the forecast did not match the actual result, when required by the internal legislation of at least one of the Member States involved. The report takes the stance that the adjustment should be, to the most appropriate point, in the arm’s length range.1516

15.6. Case law: Vingcard (Norway, 2012) 15.6.1. Introduction At issue in the Norwegian Vingcard Elsafe AS v. Skatt Øst case was whether the taxable income of a Norwegian parent could be reduced through year-end adjustments.1517 The reassessment disallowed the adjustments in full. It was upheld by the first-tier Oslo City Court, while the Borgarting Appellant Court upheld the reassessment for one of the two income years 1514. JTPF/009/FINAL/2013/EN. In June 2014, the European Commission invited the European Council to endorse the report, and the EU Member States to implement its solutions in their domestic laws (COM(2014) 315 Final, para. 3, second section). The report was endorsed by the European Council in March 2015 (7249/15). The report recommendations are applicable only to compensating adjustments that the taxpayer has reflected in its financial statements and are elaborated on in its transfer pricing documentation; see para. 8 of the report. They have no bearing on the ability of a tax administration to make an audit adjustment at a later stage or in MAPs; see para. 19 of the report. The report recognizes that the different approaches of the EU Member States (i.e. the price-setting versus outcome-testing approach) were often grounded in disparate understandings of fundamental transfer pricing concepts, including timing issues, information on contemporaneous CUTs, as well as what constitutes inappropriate use of hindsight; see para. 6 of the report. 1515. JTPF/009/FINAL/2013/EN, para. 17. The decision of whether to oblige a taxpayer to make an adjustment is left to the discretion of the EU Member States (para. 16). 1516. JTPF/009/FINAL/2013/EN, para. 18. See also OECD TPG, para. 3.55. 1517. Ruling by Borgarting Appellant Court dated 18 June 2012 (Utv. 2012 p. 1191), reversing in part the ruling by Oslo City Court dated 29 November 2010 (Utv. 2010 p. 1690).

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at issue.1518 The case illustrates several interesting aspects of year-end adjustments. The author therefore finds an analysis justified. He will outline the factual pattern of the case in section 15.6.2. The stances of the Oslo City Court and the Borgarting Appellant Court on the use of comparables are discussed in section 15.6.3., and their stances on the application of the TNMM for allocating income are discussed in section 15.6.4.

15.6.2. The factual pattern of the case The Norwegian company Vingcard Elsafe AS (VEAS) was leading in the field of card-based security systems for hotels and cruise liners. It carried out product development and owned all unique IP employed in the value chain. 75% of its products were sold through local group distribution entities. The United States was the most important market for VEAS. Local distribution was carried out by the subsidiary Assa Abloy Hospitality Inc (AAH). The US hotel market had a downturn during the 2000s due to the 11 September 2001 attack, impacting the sales of AAH negatively. The profit allocation among VEAS and AAH was based on official price lists determined by VEAS, designed to provide its local distribution entities with an arm’s length gross profit margin pursuant to the resale price method. This transfer pricing policy became difficult to realize without year-end compensating adjustments. In early 2005, in connection with the preparation of the 2004 financial statements, it became clear that AAH would incur a significant loss due to reduced sales and increased costs. To align its taxable result with the transfer pricing policy of the group, it was decided that VEAS would, with effect for 2004, compensate AAH for the difference between the budgeted and actual gross profit margin of AAH (33% and 23%, respectively). As a result, VEAS went from positive to negative taxable income in Norway, while the US income of AAH went from a negative to a (relatively small) positive result. For the income year 2005, the group adopted a TNMM-based profit allocation, based on the advice in a report by PricewaterhouseCoopers.1519 This 1518. The case was decided under the domestic arm’s length provision in sec. 13-1 of the Norwegian Tax Act (NTA), for which the significant source of law for interpretation in international transactions are the OECD TPG. 1519. The PwC report compared the net profit margin of the aggregated profits of AAH with the net profit margin of the aggregated profits from the selected 18 European distributors. Even though not found to be a methodological error in and of itself, the Court found the comparison of blended net profit margins to add further uncertainty

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pricing guaranteed AAH an annual net profit margin between 1% and 5%, ensuring that it would always generate a positive net margin. As the actual 2005 result of AAH was not sufficient to meet the agreed TNMM profit interval, VEAS compensated AAH with approximately NOK 26.4 million, bringing the 2005 net profit margin of AAH up from 3.8% to 1%.

15.6.3. The comparables supporting the taxpayer profit allocation One of the two main issues in the case was whether the reassessment should be upheld, on the basis that the third-party profit data used under the taxpayer’s application of the resale price method and TNMM did not meet the comparability requirements of the respective methodologies. The Oslo City Court rejected the profit data extracted from the unrelated distributors selected by the taxpayer as comparables because the distributors operated in other business sectors than AAH did. It had not been proven that the distributors were afflicted by a market downturn similar to that which struck the hotel sector subsequent to 11 September 2001. As the taxpayer had not performed any comparability adjustments that satisfied the Court, the yearend adjustments were rejected. The author does not share the view of the Court. First, there was undoubtedly a difference between the law as it was written in the 1995 OECD TPG and the law as it was practiced by multinationals and tax authorities in the mid-2000s. Subsequent to the adoption of the 1995 OECD TPG, global use of the TNMM became widespread.1520 The practice of using blended third-party profit margins as comparables was one of the reasons behind the revision of the 1995 OECD TPG text on comparability and the profitbased methods.1521 Thus, during the income years at issue, the OECD was to the transfer pricing assessment. In the author’s view, the Court should have pointed out that this was not a problem here, as AAH carried out only transactions relevant to the transfer pricing assessment. The Court referenced para. 3.42 of the 1995 OECD TPG, which required that “profits attributable to transactions that are not similar to the controlled transactions under examination should be excluded from the comparison”. However, the attorney general did not protest the examination on this ground. The Court therefore accepted that the blended third-party net profit margins could be used as the arm’s length range under the TNMM. 1520. This assumption is consistent with the business comments referred to in the 2006 OECD Comparability Report in the section on aggregation of transactions, at paras. 8-9. See also the 2008 OECD discussion draft, at para. 115. 1521. See the preface of the 2006 OECD Comparability Report, as well as the section on putting a comparability analysis and search for comparables into perspective, at para. 8.

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in the process of relaxing the comparability requirements relevant to the TNMM. In this context, the wording of the 1995 OECD TPG should not have been interpreted narrowly. Both multinationals and tax authorities normally seek to adjust their transfer pricing positions based on signals from the OECD, even if those signals have yet to materialize in adopted consensus texts. Second, AAH should only be entitled to a normal return for its routine marketing, resale and distribution functions. A comparability adjustment could have, in this case, resulted in negative margins for AAH, or at least margins close to zero. Such a result would be unreasonable. No unrelated party would be willing to perform marketing, resale and distribution services close to free of charge or at a loss. Further, the overall differences between AAH as the tested party and the selected comparables seem so notable that it is not clear whether an adjustment for decreased revenues would have provided a more reliable result. On top of the hotel market decline, there were likely also other significant differences, e.g. different geographical markets, different market types, different products and different relationships to suppliers. The comparability adjustment requested by the Court as justification for its rejection of the comparables would, in the author’s view, only be meaningful if the comparables had been European distributors of customs security systems for hotel chains and cruise liners. Third, the TNMM pricing was restrained by the interquartile arm’s length range. This compensated for potential material differences between the tested party and the selected comparables. In contrast to the Oslo City Court, Borgarting Appellant Court found the selection of TNMM comparables to be reasonably representative, and thus upheld the TNMM pricing. For the reasons above, the author agrees. This leads to the next point. The concurrent pricing between AAH and VEAS throughout 2004 and 2005 was based on the USD price list. The TNMM was applied indirectly through the year-end adjustment, which aligned the initial USD price list-based transfer pricing result to what the profit allocation would have been had the TNMM been applied at the outset. When the Oslo City court disallowed the use of year-end adjustments, it therefore effectively based the transfer pricing solely on the USD price list, i.e. on the comparable uncontrolled price (CUP) method with the USD

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price list as the comparable transaction.1522 In light of the fact that the USD and EUR price lists were standard terms used by VEAS for sales to related and unrelated distributors,1523 the author questions whether this yielded a more reliable pricing method than the TNMM with the 18 European distributors as comparables would have. First, the prices charged to unrelated distributors were increased by 1016% (relative to prices charged to related distributors) to compensate for marginal administration expenses and small-volume purchases. Conversely, AAH was the exclusive distributor in the largest and most important market for the VEAS products. It is unlikely that such a distributor would be willing to purchase at the same prices used for marginal distributors.1524 If no adjustment were made for this fact, the prices should be rejected as comparables.1525 1522. The Oslo City Court found the USD price list to be the best method to determine the transfer prices. The Court specifically stated that it did not find relevant the question of whether the price list qualified as a comparable under the comparable uncontrolled price (CUP) method of the 1995 OECD TPG. The reason for this was that the status of the 1995 OECD TPG as a source of law under sec. 13-1 of the NTA was, in principle, only guiding and not binding. The Court found the basis for this understanding in the 2001 Norwegian Supreme Court ruling in Norsk Agip AS v. The State, Rt 2001 1265. Subsequent to Agip, sec. 13-1(4) was introduced with effect from 2008, enhancing the position of the OECD TPG as a source of law under domestic Norwegian law. With respect to Vingcard, the author finds, for the reasons stated in the text, that the unadjusted USD price list did not qualify as a comparable under the CUP method of the 1995 OECD TPG. It was therefore a significant breach of the OECD TPG when the Oslo City Court allocated income to the controlled parties based on an erroneous application of the CUP method. The author finds it clear that there was no legal basis in the Agip ruling on which to apply a transfer pricing method under sec. 13-1 of the NTA that was directly contrary to fundamental principles drawn up in the OECD TPG. 1523. The price lists were, however, mainly used for determining transfer prices for goods sold within the group. Of course, the price terms used for group distributors are irrelevant under the CUP method, as they cannot be regarded as uncontrolled transactions. 1524. A useful approach would, in the author’s view, be to see the issue of adopting a discount as a comparability adjustment to the USD list price with the 10-16% increase. The question would simply be whether that comparable had to be adjusted for the fact that AAH had a significantly greater bargaining position towards VEAS than any of the unrelated distributors and whether VEAS would have had a clear self-interest in keeping AAH afloat through a difficult period in order to retain its footing in the US market. In the author’s view, the answer to this question is likely a yes. Para. 2.9 of the 1995 OECD TPG stated that every effort should be made to adjust the data so that it may be used appropriately with the CUP method. As no comparability adjustment for a discount was adopted, the author finds it highly doubtful as to whether the USD price list could actually be regarded as a valid comparable under the CUP method. 1525. The reassessment would then be based on terms used in the controlled – not the uncontrolled – agreements of the group. It is unacceptable to use a controlled transaction as a comparable under the arm’s length principle.

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Second, the CUP method resulted in lower-than-budgeted gross profits and a negative net return for AAH.1526 Consistent negative returns over a 6-year period, two of which were at issue, can hardly be considered realistic returns for an unrelated distributor. Further, the Court failed to recognize that the taxpayer’s TNMM allocation, on an overall basis, provided a more reliable result than the CUP allocation. There was clearly functional comparability between AAH and the European distributors selected as comparables. Further, application of the TNMM as a benchmark for determining the size of the year-end adjustment provided AAH with a normal return.1527 The author finds it more plausible that an unrelated distributor would be willing to undertake distribution functions for the low positive net result yielded by the TNMM than for the negative net result yielded by the CUP method. The author’s impression is therefore that the Oslo City Court’s application of the CUP method may have been based on insufficiently comparable transactions and resulted in a non-arm’s length profit allocation.

15.6.4. The contractual risk allocation The second issue of the case pertained to the allocation of risk among VEAS and AAH. Even though the Oslo City Court rejected the TNMM comparables, the bearing basis for its dismissal of the year-end adjustments was that the business risks of AAH could not, with effect for taxation, be contractually allocated to VEAS to the extent done in the controlled distribution agreement. The Court stated that “when applying the TNMM it must be adjusted for failures that are due to the circumstances of the buyer, which the compensating adjustments did not take into account”.1528 Further, it stated that 1526. The negative results came from declining sales and increased operating expenses. AAH also generated negative results in 2001-2006, clearly indicating that the list prices were too high. 1527. For 2005, the adjusted net profit margin of AAH was 1%. Such a modest return should not be viewed as anything but an honest attempt by the taxpayer to allocate an arm’s length result to the US group entity. Perhaps even this result is too low for an unrelated distributor to be interested in distributing the VEAS products over a longer period of time, but at least there is data suggesting that unrelated and functionally similar distributors earn a comparable net profit. 1528. Unofficial translation of the following Norwegian wording from the ruling: “Ved bruk av TNMM må det korrigeres for resultatsvikt som skyldes kjøpers egne forhold, noe priskorreksjonene ikke tok høyde for.”

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the responsibility for risks casually linked to AAH (e.g. bad management and lack of control over spending) could not be contractually allocated to VEAS. The Court asserted that AAH’s negative 2004 and 2005 results were due to an increase in costs that were not directly related to products purchased from VEAS, e.g. installation service costs and inventory writedowns.1529 Further, it asserted that AAH should have borne the risk of the market decline in the hotel sector,1530 and that a “floating guarantee” for AAH to earn a positive net profit margin could not be established. The author takes issue with this. First, the Court did not provide a legal basis for its assertion. It almost seems as if it based its views on an analogy for the principles of general contract law. This is not a sensible interpretation of the 1995 OECD TPG.1531 In the author’s view, the Court should have recognized that a tested party under the TNMM would be allocated a modest and fixed net profit margin every year. The tested party had no risk of being allocated a negative result under the TNMM. The flip side of this is that it had no real upside; its income would never exceed the agreed arm’s length net profit margin. All residual profits were allocated to the other party to the controlled agreement, i.e. the entrepreneur. That income will vary from year to year, from potentially negative to sizeable. The entrepreneur therefore incurs significant risks. A year-end adjustment was therefore literally the price that VEAS had to pay for the privilege of being the risk-bearer in the controlled agreement and for being entitled to the residual profits. There is asymmetry in the position of the Oslo City Court. On the one side, it refused to accept that AAH was stripped of risks, entailing that AAH could incur losses. On the other side, it was seemingly fine with accepting that AAH had no possibility of earning a profit above the normal return of the agreed interquartile arm’s length net profit range and that VEAS was allocated the residual profits in good years. This asymmetrical solution entailed that AAH would not earn a taxable income reflective of its risks.

1529. Based on the accounting data referred in the ruling, the author finds it clear that the main cause of AAH’s negative results were its operating expenses (including marketing, resale and distribution costs), as opposed to the price of products purchased from VEAS. 1530. If so, the reasoning of the Court was inconsistent, as the drop in AAH’s sales was due to a general market decline that also affected other distributors. 1531. It is unclear as to which norm the Court applied to distinguish the costs that could be validly allocated to VEAS from those that could not.

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The Borgarting Appellant Court sided with the taxpayer on the risk allocation issue,1532 based on a functional analysis in which VEAS was identified as the entrepreneur of the group. The Court found that VEAS, in reality, carried the significant value chain responsibilities, e.g. for installation and maintenance services. However, as the TNMM-based distribution agreement with year-end adjustments was not in place until 2005, the Court accepted the 2004 reassessment, in which the allocation of income between VEAS and AAH was based on the USD price list, with no year-end adjustment. The taxpayer allocation based on applying the USD price list with a year-end compensating adjustment was upheld for 2005.1533

15.6.5. Concluding comments The controlled pricing structure in this case was beneficial for Norway. It is easy to overlook this fact, as the tested party lost money in the income years at issue. However, had the situation instead been that AAH made significant profits, the TNMM would have ensured extraction of the residual profits from the United States to Norway, leaving the United States with only a normal return from local sales. The pricing logic is that the Norwegian entity was the risk bearer. It was precisely this entity’s risk of incurring a negative result that materialized in the income years under review. In the author’s opinion, the Norwegian tax authorities should not have challenged the controlled profit allocation, based on the recognition that the Norwegian entity indeed was entitled to residual profits in good years. Had the reassessment not been partially overturned by the Borgating Appellant Court, it would have been a win-win for Norway, i.e. residual profits in good years and no risk of losses in bad years. Such legally unfounded 1532. The attorney general argued that the controlled risk allocation should be rejected, as it would allow AAH to enjoy high profits in periods with positive results and to “pass on the bill” to VEAS in periods with negative results. Apart from being positively erroneous, the argument is of such low quality that it should not have been presented before a court of law. The state further argued that an unrelated distributor would have the risk of incurring negative results, while AAH would always end up with a positive net result. That argument is, in and of itself, correct, but of course, an unrelated distributor with full risk would also have the possibility of earning a return above the interquartile arm’s length net profit margin. That was not the case for AAH. 1533. Like the Oslo City Court, the Borgarting Appellant Court viewed the reimbursement of installation, guarantee and general ledger costs as a contribution of capital. The Appellant Court’s assessment seems influenced by the fact that there were some ambiguities concerning the reimbursed costs that the taxpayer had not sufficiently attempted to clarify.

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and unbalanced pricing assertions should be avoided. The reassessment position of the Norwegian tax authorities also seems unacceptable from the point of view of the United States. A local low-risk distribution entity that consistently reports losses would likely attract US audit attention, on the basis that such an entity should not incur losses at all.1534

15.7. Case law: ITCO (Italy, 2010) A recent Italian case illustrates a downward profit adjustment for a tested party,1535 a situation opposite of that in Vingcard. An Italian distribution subsidiary purchased software products for local resale from a UK sister company. On the last day of the 2004 fiscal year, the UK company sent an invoice to the Italian subsidiary for the amount of GBP 947,456. This was an upward price adjustment for products sold during the year. The tax authorities disregarded the year-end adjustment under the rationale that the transfer of income from Italy to the United Kingdom constituted tax avoidance under the domestic general anti-avoidance rule.1536

15.8. Case law: H1 A/S (Denmark, 2010) A Danish 2010 Western High Court ruling pertained to rent payments from a subsidiary to a parent in connection with the lease of a discotheque in 2001 and 2002.1537 In the original agreement, dated 22 March 2001, the monthly rent was set to DKK 300,000. During 2001, the subsidiary incurred expenses to decorate the locales and purchase inventory. On 1534. This point is underlined by the consistent losses of the US distribution entity in the period of 2001-2006. 1535. Ministry of Finance (Tax Office) v. ITCO, Case No. 11949 (Supreme Court of Italy, 2012). The case was tried as an anti-avoidance matter under the local general antiavoidance rule. The legal arguments are therefore not directly relevant to the discussion in this chapter. 1536. The argument was founded on the fact that (i) the adjustment was performed on the last day of the fiscal year; (ii) it was an adjustment of prices actually charged; and (iii) the adjusted prices deviated from the average purchase price for goods paid by the subsidiary. The taxpayer appealed the reassessment to the Provincial Tax Court, where it prevailed. The Lombardy Regional Tax Court rejected the appeal of the tax authorities. The case was then appealed by the tax authorities to the Supreme Court regarding a burden-of-proof issue, which found that this particular case pertained to the issue of proving the existence and relevance of intra-group costs. For that question, the burden of proof rested with the taxpayer. 1537. H1 A/S v. Skatteministeriet, SKM2010.455.VLR (Vestre Landsret, 2010). For comments on the case, see Wittendorff (2010d); and Pedersen (2010).

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2 January 2002, it was agreed that the total rent for 2001 should be set to DKK 975,000, a reduction of approximately 64% relative to the original agreement, due to market conditions and the level of competition. The agreement was also amended so that the concurrent rent payments should be regarded as preliminary payments and that the final annual rent should be determined on a yearly basis upon the consideration of market conditions. It was not disputed that the post-adjustment rent was at arm’s length. With respect to 2001, the Court found that there was no legal basis for the year-end adjustment. With respect to 2002, for which the amended agreement was in effect, the Court found, under a concrete interpretation, that the wording of the agreement was too imprecise to justify a year-end adjustment. The reasoning of the Court has, and justly so, been subject to criticism.1538

15.9. Case law: H1.1.1 A/S (Denmark, 2012) The author will also briefly mention a 2012 ruling by the Supreme Court of Denmark pertaining to the 1999 and 2000 tax assessments of a Danish insurance subsidiary.1539 At issue was the transfer pricing treatment of a debt instrument used by the subsidiary as part-financing for the purchase of shares from its US parent.1540 The tax authorities decreased the 1999 income of the subsidiary though imputed interest expenses on the deemed loan, calculated from 1 July to 15 October, and increased its 2000 income by the same amount, effectively moving the deductions from 2000 to 1999. The Danish subsidiary was unable to utilize the deductions in the 1999 income period. The Supreme Court upheld the reassessment. The evidence did not support the taxpayer’s assertion that a binding agreement for compensation in the form of a zero-coupon note was entered into before 15 October 1999.

1538. Id. 1539. H1.1.1 A/S v. Skatteministeriet, SKM2012.92.HR (Supreme Court of Denmark, 2012). For comments on the case, see Wittendorff (2012b); and Wittendorff (2012c). The case primarily turned on an interpretation of the statute of limitations for making transfer pricing adjustments under Danish law. Wittendorff sees the case as a retroactive transfer pricing adjustment. The author does not fully agree, as the Court relied on a rather concrete interpretation of the controlled agreements. Further, the case does not pertain to the issue of aligning the actual results of the taxpayer with the result dictated by a transfer pricing method. 1540. In June 1999, it was clear that the purchase would be partly loan-financed. The form of compensation was not final at that time. It first became clear on 15 October 1999 that the loan should be in the form of a zero-coupon note.

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15.10. The US GlaxoSmithKline settlement (2006) In part 3 of the book (on IP ownership), the author will discuss the notable US case of GlaxoSmithKline Holdings (Americas), Inc. v. CIR, which ended in a settlement in 2006.1541 Among the issues in that case was the allocation of profits to a US distribution subsidiary (GSK US) in the GlaxoSmithKline group with respect to the distribution and sale of the blockbuster drug Zantac. The group allocated only a normal market return to the US distribution entity based on the assertion that it only provided routine functions to the value chain and that all unique IP was owned by the UK parent (GSK UK).1542 The profits of the US entity were reduced in the income years at issue through what were essentially year-end adjustments in order to ensure full extraction of the residual profits from the US to the United Kingdom. In order to reduce the profits of the subsidiary to what the GSK group deemed to be “appropriate gross margins”, a licence agreement was introduced.1543 To achieve concurrent alignment of the gross profit margins actually earned by the subsidiary with the appropriate gross profit margins, the royalty rates and prices were adjusted, presumably on an annual basis. The adjustments increased the prices for goods sold, as well as royalties for the licensing of manufacturing and marketing intangibles charged, by the UK parent to the US subsidiary. GSK commenced its US distribution activities in 1978. By 1987, GSK US had become immensely profitable. The taxpayer’s view was that without adjusting the prices for goods and of the royalties charged by GSK UK, the US subsidiary would have earned residual profits, for which there was no transfer pricing justification. The IRS took issue with this on the basis that no increase in the value of the licensed patents or other manufacturing IP had occurred that justified such upward adjustments of the royalty rates under the licence agreement.1544 1541. GlaxoSmithKline Holdings (Americas), Inc. v. CIR, 117 TC 1 (Tax Ct. Docket No. 5750-04, 2004). 1542. See the discussion in sec. 19.2.5.2. 1543. See the taxpayer petition dated 2 April 2004 (available at Tax Analysts, doc. 2004-7600), at p. 20 (sec. x). 1544. The Notice of deficiency disregarded the periodic upward adjustments of the royalty rates because they were “inconsistent with dealings between arm’s length entities and because there was no increase in the value of the licensed patents and other manufacturing intangibles or in the income attributable to these intangibles”; see the Notice of deficiency, dated 6 January 2004 (included as exhibit A in the taxpayer petition dated 2 April 2004 (id.)), explanation of adjustments, at sec. b) (Royalties). GSK, on the other hand, argued that the CWI standard “required moderation of Petitioner’s profit levels to reflect the income commensurate with Glaxo Group’s intangible con-

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The US GlaxoSmithKline settlement (2006)

GSK argued that the income allocated to the US entity should be consistent with its functions performed, assets used and risks incurred. In other words, as a routine distribution entity, it should be stripped of all residual profits and left with only a normal market return. This allocation pattern was achieved by applying a tailored “resale minus pricing” method, under which the parent charged the subsidiary a percentage of the end market price for the particular product,1545 designed to leave it “with a gross profit margin for the product portfolio sufficient to cover the costs of its activities and earn at least an appropriate profit”.1546 Thus, parallel to the allocation pattern of the CPM, the subsidiary was treated as the tested party and allocated a return based on the earnings of purported comparable distributors. The author finds it unlikely that the taxpayer and the IRS were completely accurate in their assertions. The most interesting question was not whether adjustments to the royalty rate could be made, but the extent to which they could be made, i.e. whether the pricing that resulted from the adjustments was at arm’s length. Further, the US marketing and sales activity performed by, as well as the sales and assets of the US entity, gradually expanded. In the author’s view, this indicated that GSK, for instance, by applying the PSM, would be entitled to allocate more residual profits to the parent company, given that the cause of the increased profits indeed were the manufacturing intangibles owned by the parent. For the income years 1989-1996, the return position of GSK was to allocate 31% of the total residual profits from US sales of USD 12.7 billion to the subsidiary. This approximate 30/70 position in favour of the United Kingdom was based on the view that most of the residual profits were due to patents and other manufacturing intangibles owned in the United Kingdom. Based on the information contained in the court documents, it seems clear that the parent created the patent for Zantac and other relevant pharmaceutical products through its own R&D efforts in the United Kingdom. The subsidiary only carried out secondary manufacturing and did not provide any unique inputs in this respect. The author therefore finds it likely that the parent was entitled to the entire residual profits from the manufacturing IP licensed to the subsidiary. In other words, the resale-minus method advocated by GSK, or any other method that treated the subsidiary as the tributions to U.S. sales”, that “Zantac is exactly the type of product contemplated by Congress when I.R.C. section 482 was amended in 1986” and that “the 1987 License achieved the objective of giving additional returns to Glaxo U.K., the inventor of the intangible”; see taxpayer petition dated 2 April 2004 (id.), at p. 20 (sec. z). 1545. See taxpayer petition dated 2 April 2004 (id.), at p. 18. 1546. Id.

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Chapter 15 - Taxpayer-Initiated Compensating Adjustments to Indirect IP Pricing

tested party for that matter, could be applied to set the royalty rate for these intangibles. However, as the US distribution subsidiary likely owned unique marketing intangibles, it could not be remunerated based on a onesided method. A split of the residual profits would be necessary, entailing application of the PSM. In principle, a year-end adjustment in the form carried out by GSK should then not be acceptable. However, in the author’s view, there was good reason to adjust the royalty charged to the US subsidiary, provided that its increase in profits was due to an increase in the value of the UK manufacturing intangible relative to the US marketing IP.

464

Chapter 16 Periodic Adjustments of Controlled IP Transfer Pricing 16.1. Introduction In this chapter, the author will discuss the periodic adjustment provision of the US regulations and the OECD Transfer Pricing Guidelines (OECD TPG), both with respect to intangibles transfers in general and in the specific context of cost-sharing arrangement (CSA) buy-in payments.1547 “Periodic adjustment” refers to the question of whether a controlled intangibles transfer with a fixed-price term that was at arm’s length at the outset of the agreement can be adjusted in later income periods if subsequent events cause the profit allocation to no longer be at arm’s length. Without a periodic adjustment provision, such transfers would be shielded from reassessments. The result of a periodic adjustment is simply to ensure that the controlled profit allocation is at arm’s length for the income periods under review. The author begins by commenting on the development of the US commensurate-with-income standard in section 16.2. The periodic adjustment provision under the current US regulations is discussed in section 16.3. The application of this provision to lump-sum payments is discussed in section 16.4. The author then turns to the OECD’s periodic adjustment provision in section 16.5. Periodic adjustment of CSA buy-ins is discussed in sections 16.6. and 16.7. for the US regulations and the OECD TPG, respectively.

16.2. The development of the US periodic adjustment concept 16.2.1. Introduction The author will tie some comments to the legislative development that eventually resulted in the periodic adjustment provision of the current 1994 1547. For early commentaries on periodic adjustments, see, e.g. Levey et al. (1987), at p. 636; Lashbrooke (1989), p. 189; McSchan (1989); Ungerman (1989), at sec. II.B.; and Clark (1993), at sec. II. For relatively recent commentaries on periodic adjustments, see, e.g. Navarro (2017), at p. 242; Wittendorff (2010a), at pp. 675-694; Bullen (2010), at pp. 326-333; Martinez (2010); and Andrus (2007), at pp. 647-650.

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US regulations. He will comment on the 1985 House Report and the 1988 White Paper in section 16.2.2., on the relationship between the transfer pricing methods and the periodic adjustment provision in the White Paper in section 16.2.3. and on the exceptions from the White Paper’s periodic adjustment provision in section 16.2.4.

16.2.2. The 1985 House Report and the 1988 White Paper The 1985 House Report recognized the problem of multinationals deliberately shifting intangible income out of the United States in order to lower their effective tax rates. At the time, typical BEPS transactions included “roundtrips” and early-stage transfers of unproven US-developed intangibles for a low price, where the multinationals subsequently would claim that it was not possible to foresee the profit potential of the intangibles at the time of the transfer. The House Report concluded as follows: The committee does not intend, however, that the inquiry as to the appropriate compensation for the intangible be limited to the question of whether it was appropriate considering only the facts in existence at the time of the transfer. The committee intends that consideration also be given the actual profit experience realized as a consequence of the transfer. Thus, the committee intends to require that the payments made for the intangible be adjusted over time to reflect changes in the income attributable to the intangible. (Emphasis added) 1548

Thus, the conclusion of the 1985 House report was that payments for migrated intangibles should be commensurate with the actual profits attributable to the transferred intangibles. The legislative discussion resulted in the following sentence being added to US Internal Revenue Code (IRC) section 482 in the 1986 tax reform: “In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” No detailed discussion of the periodic adjustment authority was provided until the 1988 White Paper addressed the issue. The White Paper found, with reference to the 1985 House Report, that an intangible transfer that is commensurate with the income attributable to the intangible must reflect “the actual profit experience realized as a consequence of the transfer”.1549 1548. 1985 House Report, at pp. 425-426. 1549. White Paper (Notice 88-123), at p. 63.

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The development of the US periodic adjustment concept

The core of the periodic adjustment discussion in the White Paper pertained to adjustments of controlled intangibles transfers for non-contingent lump-sum royalty or sale payments (in other words, fixed-price arrangements). According to the White Paper, periodic adjustments were necessary to reflect substantial changes in the income stream from a transferred intangible, taking into account the activities performed, assets employed and risks borne by the related parties.1550 Substantial changes in the income stream referred to the level of discrepancy between the income projected at the time of transfer and the actual income subsequently realized. The White Paper found that periodic adjustments were consistent with the arm’s length principle for two reasons.1551 First, unrelated parties generally provide some mechanism to adjust for change in the profitability of transferred intangibles. Second, the actual profit experience is generally the best indication available of the anticipated profit experience that unrelated parties would have taken into account at the outset of the arrangement. The White Paper tied its discussion of periodic adjustments to two base scenarios. The first base scenario pertained to a long-term licence with a fixed royalty, which yielded an arm’s length allocation of income at the outset of the agreement. Due to subsequent alterations in the functions performed, assets contributed and risks incurred, the allocation in later stages was not at arm’s length (the French scenario). This discussion must be seen in the historical context of the White Paper, and particularly in light of French, in which the Tax Court judge took the questionable stance that it was “inappropriate to view 1963 and 1964 in isolation. [R]oyalties were not necessarily paid for value received during those particular years”.1552 The logic behind this reasoning was that the judge in French viewed all income years under the licence as a coherent whole for pricing purposes. The decisive factor was thus whether the income derived under the en1550. The US Internal Revenue Service (IRS) in general will not reallocate income if it would only result in minor changes relative to the taxpayer’s return position. See also 1985 House Report, at p. 426, where it is stated that “adjustments will be required when there are major variations in the annual amounts of revenue attributable to the intangible”. 1551. Periodic adjustments were intended to be prospective, and thus only apply for the income years under review and subsequent years; see White Paper (Notice 88-123), at p. 67. 1552. R. T. French Co. v. CIR, 60 T.C. 836 (Tax Ct., 1973), distinguished by 1977 WL 191022 (IRS TAM, 1977), distinguished by 1979 WL 56002 (IRS TAM, 1979) and distinguished by 1992 WL 1354859 (IRS FSA, 1992). See the analysis of the ruling in sec. 5.2.3. of this book.

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tire duration of the agreement was balanced. In French, this meant two decades. The legal consequence of the ruling was that, prior to the 1986 revision of IRC section 482, controlled licence agreements with fixed pricing were shielded from subsequent reassessment, as long as they provided arm’s length results at their inception. The introduction of the commensurate-with-income standard and the periodic adjustment authority was a legislative rejection of French. The White Paper contains an example in which a periodic adjustment was carried out to reflect changes in functions in an outbound licensing structure.1553 In the example, a US parent manufactured and marketed widgets domestically in addition to performing research and development (R&D). A European subsidiary produced and marketed widgets for the European market and also maintained an R&D department. The R&D activity of the parent company resulted in promising technology. A licence agreement was entered into with the subsidiary, under which the subsidiary was to further develop the technology. At the time at which the agreement was entered into, it was envisaged that it would take 4 years and considerable effort from the subsidiary’s staff of researchers to ready the technology for mass production. Due to those assumptions, the licence agreement fixed a 50/50 profit split between the parent and subsidiary. It became apparent that the process of preparation for mass production of the technology was not as demanding as originally assumed, and it was completed 5 years ahead of schedule. The contributions from the subsidiary were fewer and less complex than planned. The White Paper approached the example by recognizing that the brief duration of development, as well as the fact that the subsidiary did not contribute any unique intangibles to the development, necessitated an adjustment to the fixed-price structure. The solution prescribed by the White Paper was to switch pricing methods from the profit split method to the basic arm’s length return method (BALRM). The result was to go from an equal division of residual profits among the controlled parties to a scenario in which the US parent was allocated the entire residual profits.1554 1553. White Paper (Notice 88-123), appendix E, Example 13. 1554. The author finds the example somewhat opportunistic. The basic arm’s length return method (BALRM) was intended for cases in which one of the controlled parties contributed purely routine functions to the value chain. It is not entirely clear that this was the case in the example. Even if the subsidiary’s functions were modest and less complex that planned, were they routine? The solution of this outbound example is also not easily reconcilable with another example presented in the White Paper, pertaining

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The development of the US periodic adjustment concept

The second base scenario discussed in the White Paper pertains to structures in which unproven high-profit-potential intangibles were transferred to a foreign group entity at a low price (a “cherry-picking” scenario). Such strategies were common among multinationals at the time. The transferred intangibles would typically be ongoing R&D, or completed R&D that was not yet commercialized. It would be challenging to ascertain an arm’s length consideration for such transfers at the time at which the controlled agreement was entered into, not only due to the unique character of the intangibles, but because there would often not be any commercial experience available on which to base the price assessment on. The 1986 introduction of the commensurate-with-income standard made it clear that actual profits would be given priority in assessing whether the initial pricing was at arm’s length. The White Paper touches upon this issue in an example that deals with periodic adjustments to reflect changes in profitability indicators.1555 In the example, a US pharmaceutical parent performed R&D and patented a new drug, which it licensed to a foreign subsidiary for manufacturing and worldwide marketing. At the time at which the agreement was entered into, it was assumed that the product would attain profitability akin to that of existing products. Uncontrolled licence agreements between the parent and third parties for existing products were thus used as comparables, all of which were based on an assumption that the product would achieve a 15% market share. The actual market share of the new product proved to be 8% in year 2, 16% in year 3 and 21% in year 4. The parent decided that its original pricing based on the 15% market share assumption was still valid. Then, in year 5, the market share went up to 50%. The White Paper commented that the 50% market share was far beyond what was envisioned in the comparable uncontrolled transactions (CUTs). Further, because the product proved to be more profitable than assumed, the comparables would no longer be valid. Due to the unique intangible at play, no new comparables were found. The White Paper solution was to switch the transfer pricing method for year 5 from the CUT method to the BALRM. to an inbound licensing structure (see White Paper (Notice 88-123), Appendix E, Example 12). The US subsidiary in the inbound example also performed marketing and manufacturing functions, and here, the White Paper argued for a profit split solution, not the BALRM. In the author’s view, a more suitable result in the outbound example would have been to adjust the profit split in favour of the US entity, due to the change in functions, but not strip all residual profits from the European subsidiary by applying the BALRM. 1555. White Paper (Notice 88-123), Example 14.

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Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

16.2.3. The relationship between the transfer pricing methods and the periodic adjustment provision in the White Paper The relationship between the transfer pricing methods for intangibles proposed in the White Paper (the BALRM and the BALRM with profit split) and the concept of periodic adjustments is not immediately clear. It is stated that “periodic adjustments are easier to analyze for the arm’s length return method than for the methods involving comparable transactions”.1556 The impression given by the White Paper is that the solutions provided under the BARLM and the periodic adjustment concept are more or less similar. Also illustrative of the almost invisible line between the profit-based transfer pricing methods and the concept of periodic adjustments is the clarification of the White Paper that even a substantial increase in the residual profits allocable to a foreign entity in a licence agreement would not necessarily lead to an adjustment of the taxable income of the US entity.1557 If the intangible-related income increased “solely due to the efforts of the transferee”, no part of the increased income should be allocated to the US transferer. This should not be regarded as an exception to the periodic adjustment provision as such, but as a result of applying the profit-based transfer pricing methods.1558 In this scenario, the functions performed, assets used and risks incurred would show that it was the increased efforts of the licensee that created the additional residual income, and that the licensee therefore should be entitled to it. The question is then whether the periodic adjustment concept was necessary on top of the new pricing methods introduced by the White Paper. The answer to this question lies in the legislative rejection of French through the 1986 incorporation of the commensurate-with-income standard in IRC section 482. There is no doubt that the White Paper envisioned that reallocations of income by way of periodic adjustments should be carried out using either the BALRM or BALRM with profit split. However, in order to carry out such adjustments in the first place to fixed-pricing intangibles transfers that yielded arm’s length results at the outset, special authority

1556. Id., at p. 102. 1557. Id., at p. 65. 1558. Presumably this would only apply to the BALRM with profit split. If the ­BALRM was applied to a foreign entity as the tested party, it should only be allocated a normal return and be stripped of any excess profits, regardless of whether the profits were due solely to the efforts of the foreign entity.

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The development of the US periodic adjustment concept

was needed, due to the immunity from subsequent allocations granted to such agreements in French. Such authority was provided with the commensurate-with-income standard. Thus, in the context of the White Paper, the periodic adjustment provision should be viewed as a prerequisite for applying the proposed profit-based methods to reallocate income in subsequent periods under a fixed-price intangibles transfer agreement.

16.2.4. Exceptions from the White Paper’s periodic adjustment provision Two exceptions to the periodic adjustment rule were envisioned in the White Paper. First, the existence of exact CUTs would preclude periodic adjustments.1559 The exception would presumably not be of much significance in practice, as the CUT would have to pertain to a transfer of the same intangible as transferred in the controlled transaction under substantially similar conditions, but could potentially play a role for make-sell rights that were licensed also to third parties. The White Paper had a sceptical attitude towards the use of inexact CUTs.1560 This is highlighted by the fact that if a royalty rate was based on an inexact comparable, the taxpayer would have to use the BALRM to justify the royalty rate. Thus, inexact comparables did not provide a safe harbour from periodic adjustments.1561 The second exception applied where the unexpected profits could not have been foreseen at the time at which the agreement was established. There were several requirements for this exception to apply.1562 First, the controlled agreement could not contain an adjustment clause under which unrelated parties would have adjusted the royalty. Second, unrelated parties would not have included an adjustment provision that covered the development causing the unexpected profitability. Due to concerns of abusive behaviour, the White Paper envisioned a high standard of proof for this exception, requiring clear and convincing evidence that the subsequent profitability could not have been anticipated. 1559. An exact comparable is described in the White paper (Notice 88-123), at p. 106, as an uncontrolled transfer of the same intangible under substantially similar circumstances as in the controlled transaction. 1560. An inexact comparable is described in the White paper (Notice 88-123), at p. 106, as an uncontrolled transfer of an intangible similar to that transferred in the controlled transaction, with definitive and ascertainable differences, so that reliable comparability adjustments can be performed. 1561. White Paper (Notice 88-123), at p. 94. 1562. White Paper (Notice 88-123), at p. 65.

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Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

16.3. The US periodic adjustment provision 16.3.1. Introduction In the following sections, the author will discuss the periodic adjustment provision for controlled intangibles transfers under US law. The main rule is analysed in section 16.3.2., and the exceptions from the authority are discussed in section 16.3.3.

16.3.2. The main rule: The profit allocation must be commensurate with income Under IRC section 482, the reported income from controlled intangibles transfers must be aligned with the actual profit experience. This commensurate-with-income principle is operationalized through the periodic adjustment rule finalized in the 1994 regulations.1563 The rule states that if an intangible is transferred under an arrangement that covers more than 1 year, the consideration charged in each taxable year may be adjusted to ensure that it is commensurate with the income attributable to the intangible. In determining whether to make such adjustments, all relevant facts and circumstances throughout the period in which the intangible is used may be considered. The determination in an earlier year that the amount charged was at arm’s length will not preclude the adjustment of an amount charged for the intangible in a subsequent year.1564 Periodic adjustments are relevant for controlled agreements with fixed pricing structures that were at arm’s length at the outset. Before commencing his interpretation, the author will tie some comments to the reasoning that underlies the periodic adjustment rule. It should be observed that the rule will ensure an arm’s length allocation of income in every period under a multiple-year licence agreement. The simple reason for this is that the actual income will be allocated among the controlled parties according to the transfer pricing methods. Without a “true-up” rule, a fixed-price, multiple-year transfer agreement for intangibles will be shielded from subsequent adjustments, even if it results in non-arm’s length

1563. Treas. Regs. § 1.482-4(f)(2). 1564. A periodic adjustment under the US commensurate-with-income requirement may be made in a subsequent taxable year without regard to whether the taxable year of the original transfer remains open for statute-of-limitation purposes.

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The US periodic adjustment provision

allocations of income in subsequent income periods. Such an outcome in general does not seem sensible to the author. Critics of the commensurate-with-income standard and the periodic adjustment authority will generally argue that fixed-price arrangements should be shielded, as long as the original pricing was based on the best information available at the time of the transfer, as unrelated parties generally must adhere to their agreements regardless of whether the deal in hindsight turns out to be “good” or “bad”. The author finds this argument to be of limited relevance. It is based on the fundamental assumption that third-party agreements are comparable to controlled intangibles transfers. The argument is thus closely linked to the CUT method. In the vast majority of cases, however, there will be no CUTs available upon which to base the pricing of unique and valuable intangibles. The transactional net margin method (TNMM) or residual profit split method (RPSM) will typically be applied to price the controlled transfer. The fundamental assumption behind the argument will thus generally not hold. The debate on whether periodic adjustments are justified seems to hinge on a question of priorities, specifically whether one wants a transfer pricing system that shields non-arm’s length profit allocations under the banner of “information available at the time of transfer” or a system that ensures that the actual profit allocation conforms to the arm’s length pricing methods (in practice, the TNMM and RPSM) in every period covered by the controlled agreement. The author finds that a sensible transfer pricing system should not accept non-arm’s length allocations of income, unless there is clear evidence that unrelated parties in fact would have adopted a similar initial fixed price. In other words, periodic adjustments should, in the author’s view, ideally only be cut off in cases in which the initial pricing is based on a “genuine” CUT that pertains to the same intangible transferred in the controlled agreement. If no such CUT is available, there should, in the author’s view, only be narrow exceptions (if any) to the periodic adjustment provision. Accepting the shielding of fixed-priced agreements in these cases could defy the core idea that the allocation of income in controlled agreements should mirror that which would have been agreed by third parties. The closest one can get to an estimate of what third parties would have agreed on in cases in which there is no CUT available are the results yielded by the accepted transfer pricing methods (in practice the TNMM and RPSM). 473

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

Of course, from a US domestic perspective, this debate is purely theoretical. The United States made its choice with the 1986 commensurate-withincome standard, which allows adjustments based on actual results, with some narrow exceptions. The author will interpret the periodic adjustment rule of the US regulations. The content of the rule itself seems clear: reassessments may be based on the actual profits allocable to the transferred intangible, regardless of whether this information was available at the time at which the controlled agreement was entered into. Of course, the original taxpayer pricing will be based on an application of a transfer pricing method using information on projected income available at the time of the transfer. A subsequent US Internal Revenue Service (IRS) periodic adjustment, however, will be based on an application of a transfer pricing method using information on actual profits that first becomes available after the controlled agreement is entered into. The periodic adjustment rule is fundamentally a one-sided “true-up” rule, in the sense that only the IRS is entitled to reassess the controlled pricing based on the actual profit experience. Comparatively, taxpayers are afforded the right under US law to perform year-end adjustments based on actual results.1565 Interestingly, the IRS does not seem to fully agree with the author’s view on the content of the periodic adjustment rule. In 2007, the Office of Chief Counsel released an IRS memorandum addressing the issue of whether the word “income” in the second sentence of IRC section 482 referred to past, projected or actual profits.1566 The memorandum states that the arm’s length standard requires that a controlled transaction be priced so as to realize results consistent with those that uncontrolled taxpayers would have realized if they engaged in the same transaction under the same circumstances.1567 Further, a key consideration in determining the transfer price for an intangible under the arm’s length standard is the profit potential that uncontrolled taxpayers would have reasonably anticipated as of the time of the transfer. The memorandum refers to statements in the legislative history of the commensurate-with-income standard, as well as in the White Paper, expressing concerns about the disadvantage that the IRS faces in examining the profit potential that could reasonably be expected at the time of 1565. See the discussion of taxpayer-initiated adjustments under US law in sec. 15.3. 1566. IRS AM 2007-007, at p. 10 (issue 3). 1567. See also Treas. Regs. § 1.482-1(b)(1).

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The US periodic adjustment provision

controlled intangibles transfers.1568 The position of the memorandum is that the periodic adjustment authority allows the IRS: […] in its discretion, provisionally to treat the income actually resulting from the transferred intangible as evidence of what should have been projected at the time of the transfer and to make periodic adjustments to reflect the pricing had such results been projected at such time. (Emphasis added) 1569

The memorandum asserts that the legislative history does not suggest that the actual profit experience should be “determinative”, but rather that “the intention is to give the IRS a presumptive basis for making periodic adjustments”.1570 The memorandum supports its assertion with reference to statements in the White Paper claiming that the actual profit experience, in the absence of comparables, generally is the best indication available of the anticipated profit experience that arm’s length parties would have taken into account at the outset of the arrangement.1571 Further, the regulations allow taxpayers to rebut this assumption by showing that the actual profit results were beyond the control of the taxpayer and could not reasonably have been anticipated at the time of the transaction. The memorandum therefore concludes that the word “income” in the second sentence of IRC section 482 generally should be construed as operating profits attributable to the intangible that the taxpayer would “reasonably and conscientiously have projected at the time it entered into the controlled transaction”,1572 or in other words, projected profits. The memorandum then adds that the IRS, examining a transaction only after the fact, is inherently at a disadvantage in assessing whether the pricing was supported by upfront, reasonable and conscientious evaluation of projected operating profits attributable to the transferred intangible. 1568. The 1985 House Report, at p. 424, stated: “Taxpayers may transfer such intangibles to foreign related corporations or to possession corporations at an early stage, for a relatively low royalty, and take the position that it was not possible at the time of the transfers to predict the subsequent success of the product. Even in the case of a proven high-profit intangible, taxpayers frequently take the position that intercompany royalty rates may appropriately be set on the basis of industry norms for transfers of much less profitable items.” The White Paper echoed these concerns when it observed that taxpayers often looked solely at the “purportedly limited facts” known at the time of the transfer to justify an inappropriately low charge for the intangible, or when it noted that “[p]eriodic adjustments will also obviate the need for the often fruitless inquiry into the state of mind of the taxpayer and its affiliate at the outset”; see White Paper (Notice 88-123), at p. 47 and footnote 173. 1569. IRS AM 2007-007, at p. 11. 1570. Id. 1571. See White Paper (Notice 88-123), at p. 71 (under conclusions, no. 2). 1572. IRS AM 2007-007, at p. 12.

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The author’s impression is that the memorandum downplays the role of actual profits under the commensurate-with-income standard. First, clear statements in the legislative history and in the White Paper indicate that actual results shall play a rather decisive role in IRS reassessments.1573 Also, the current regulations themselves, as will be discussed in sections 16.3.3.16.3.5., seem to place a more central role on actual results than recognized in the memorandum. Second, the main assertion of the memorandum is that the role of actual profits under the periodic adjustment rule is that of the “best evidence” of the results that were reasonably foreseeable at the time at which the controlled transaction was entered into, as opposed to being “determinative”. In practice, the author assumes that the line between these two roles is rather ambiguous. It is indeed difficult to imagine that actual profits, given that they are deemed as the best evidence of the profits that should have been projected, will not be determinative of the profit allocation in a reassessment. Third, the memorandum repeatedly states that the taxpayer is entitled to rebut the presumption that the actual profits are indicative of the profits that should have been projected at the time of the transaction. The problem here is that the current regulations set the bar very high. An exception is made from the periodic adjustment authority for actual profits due to extraordinary events that were beyond the control of the taxpayer and that could not reasonably have been anticipated at the time at which the controlled transaction was entered into. The regulations give an example of such an extraordinary event: an earthquake. A similar exception is made for periodic adjustments in the context of cost-sharing arrangements (CSAs), in which an example refers to the “severe, unforeseen disruptions in their supply chains”.1574 Fourth, the decisive role played by actual profits run through the US regulations as a red thread. In all other cases in which the initial controlled pri­ cing is based on a “genuine” CUT, a periodic adjustment will be performed if the actual results deviate more than +/- 20% from the profits projected 1573. 1985 House report, at p. 425: “The committee does not intend, however, that the inquiry as to the appropriate compensation for the intangible be limited to the question of whether it was appropriate considering only the facts in existence at the time of the transfer. The committee intends that consideration also be given to the actual profit experience realized as a consequence of the transfer.” (Emphasis added) 1574. Treas. Regs. § 1.482-7(i)(6)(vi)(A)(2).

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The US periodic adjustment provision

at the time at which the controlled agreement was entered into. The role of actual profits in the context of periodic adjustments for CSAs is even more pronounced. Under the current regulations, a periodic adjustment examination will be triggered if the actual profits of a foreign CSA participant exceed 150% of the participant’s investment. Thus, in this case, the actual profits are not even compared to the profits that were projected at the time at which the buy-in contribution was rendered, but rather benchmarked against a pre-set absolute limit for allowed returns.1575 It can therefore be concluded that the US regulations in general do not tolerate actual profits that move outside of certain pre-determined ranges. If they do, periodic adjustments will be triggered. One may speculate whether the interpretation of the memorandum is influenced by the treaty obligations of the United States. In any case, it is difficult to reconcile the memorandum’s interpretation of the second sentence of IRC section 482 with the legislative history, the White Paper, as well as the plain language of the 1994 final regulations. In conclusion, it seems relatively clear that the regulations indeed do allow periodic adjustments to be carried out based on actual profits, regardless of whether they were foreseeable at the time of the transaction, provided that none of the narrow exceptions from the periodic adjustment rule are triggered. The author will now tie some comments to the further guidance in the regulations. The periodic adjustment rule is illustrated in an example in which a US parent has developed a new drug that is expected to gain a dominant market share and command a premium price.1576 The parent licenses makesell rights to the drug to its European subsidiary for 5 years. The royalty rate is based on projections of annual sales and profits from the subsidiary’s exploitation of the licensed rights. Due to the significant profit potential of the drug, the parent is unable to locate a CUT, and therefore concludes that the CUT method will not provide a reliable measure of an arm’s length result. The comparable profits method (CPM) is applied, yielding a royalty of 3.9% as compensation to the parent, which enables the subsidiary to earn an arm’s length return for its manufacturing and marketing functions.

1575. A periodic adjustment of a CSA buy-in will be based on information known (including actual results) as of the determination date. With respect to the remainder of the cost-sharing arrangement (CSA) period, the projected results, as determined by the IRS as at the determination date, will replace the results projected by the taxpayer at the outset of the CSA. 1576. Treas. Regs. § 1.482-4(f)(2)(iii), Example 1.

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Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

In year 5, it is examined whether the royalty rate is commensurate with the income attributable to the drug. In particular, the projected and actual profits attributable to the drug are compared. They are as follows: Year

Projected profits

Actual profits

Actual/projected

1

200

250

125%

2

250

300

120%

3

500

600

120%

4

350

200

57.1%

5 Total

100

100

100%

1400

1450

103.6%

In making this determination, it is considered whether any of the exceptions to the periodic adjustment rule are applicable.1577 Based on these amounts, it is concluded that the actual total profits earned through year 5 were not less than 80%, nor were they more than 120% of the profits that were projected when the licence agreement was entered into. If it is determined that the other requirements of the exception are met,1578 no adjustment will be made. A twist is then added to the example, where the actual profits of the European subsidiary are much higher than the projected profits, as follows:1579 Year

Projected profits

Actual profits

Actual/projected

1

200

250

125%

2

250

500

200%

3

500

800

160%

4

350

700

200%

5

100

600

600%

1400

2850

203.6%

Total

1577. The exceptions are discussed in sec. 16.3.3. 1578. See the discussion in sec. 16.3.3.4. of the periodic adjustment exception that applies when the original pricing was based on a method other than the CUT method. 1579. Treas. Regs. § 1.482-4(f)(2)(iii), Example 2.

478



The US periodic adjustment provision

In this case, the profits earned through year 5 are more than 120% of the projected profits. The exception to the periodic adjustment rule can therefore not be applied. A periodic adjustment is therefore performed.1580 The result of the periodic adjustment is that the subsidiary is stripped of all profits above those that must be allocated to it in order to achieve the target CPM normal market return on its routine value chain contributions. This is done by increasing the royalty payable to the parent, in effect allocating all residual profits to it.

16.3.3. Exceptions to the periodic adjustment rule 16.3.3.1. Introduction In light of the 1986 amendment to IRC section 482 and the 1988 White Paper, it was expected that the final 1994 regulations would include a periodic adjustment rule. The bulk of the controversy surrounding the rule did not pertain to the main principle itself, but rather to the exceptions to the adjustment provision. The periodic adjustment rule (including 3 exceptions) was first introduced in the 1992 proposed regulations, with a clear link to the CPM.1581 Overall, the 1992 proposed exceptions were broadened, compared to the principal lines drawn up in the 1988 White paper, but nevertheless remained narrow.1582

1580. For purposes of determining whether an adjustment should be made to the royalty rate in year 5, the IRS aggregates the actual profits from years 1-4 (even though they are closed under the statute of limitations) with the profits of year 5. An adjustment will only be made with respect to year 5. 1581. 1992 Prop. Treas. Regs. (57 FR 3571-01) § 1.482-2(d)(6). Two of the proposed exceptions pertained to cases in which the profits did not move outside the comparable profit interval (CPI) (the range of acceptable comparable price method (CPM)-based returns allocable to the tested party); see supra n. 528 and n. 931). The last exception pertained to when the profits moved outside of the CPI due to economic conditions that were “beyond the control” of the group and that could be neither “anticipated nor reasonably foreseeable”. 1582. See the comments in sec. 16.2.4. on the exceptions in the White Paper (Notice 88-123). Also, closely connected to the 1992 proposed periodic adjustment provision was the concept of sound business judgement, introduced in the same regulations. Under this concept, it was to be assessed “whether uncontrolled taxpayers, each exercising sound business judgment on the basis of reasonable levels of experience (or, if greater, the actual level of experience of the controlled taxpayer) within the relevant industry and with full knowledge of the relevant facts” would have agreed to the contractual terms corresponding to those under examination; see 1992 Prop. Treas. Regs. (57 FR 3571-01) § 1.482-1(b)(1). This also highlighted that integrated intra-group transactions could be examined as a whole, e.g. roundtrips, in which US-developed intangibles are

479

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

The 1992 proposed regulations attracted considerable criticism for this, most notably from the 2nd OECD Task Force Report, which reiterated the recommendation of the original Task Force Report that periodic adjustments should be confined to “truly abusive cases”.1583 The response of the 1993 temporary regulations was to modify the exceptions. According to its preamble, the scope of the exceptions was “broadened”. The author finds that characterization debatable. The 1994 final regulations added three exceptions. In sections 16.3.3.2.-16.3.3.5., the author will discuss the 1994 final exceptions to the periodic adjustment rule.

16.3.3.2. First exception: Initial fixed pricing based on CUTs ­involving the same intangible (“genuine” CUT exception) If the same intangible is transferred to an uncontrolled taxpayer in a fixed pricing CUT under substantially the same circumstances as in the controlled transaction, the CUT may serve as the basis for applying the CUT method to test the allocation of income in the first taxable year in which substantial periodic consideration is required to be paid.1584 If the amount paid in that first year is at arm’s length, no allocation will be made in a subsequent year. There is no doubt that this exception, which was not introduced until the final 1994 regulations, even though substantially the same as drawn up in the White Paper,1585 is narrow. It will typically be relevant when a multinational licenses rights to the same intangible to both controlled and uncontrolled parties located in similar markets. For instance, if a US parent licenses make-sell rights to the same intangible to a subsidiary in Norway and to an unrelated party in Denmark, the latter licence agreement may arguably by used to test the pricing in the former agreement, as the Norwegian and Danish markets have similar traits. As discussed in section 16.3.2., critics of the periodic adjustment provision normally assert that only information available at the time at which the controlled transaction is entered into should be relevant in a transfer pricing reassessment. This exception is the answer of the US regulations licensed to a foreign subsidiary that manufactures the tangible using the licensed intangible and then sells the product back to the United States. 1583. 2nd Task Force Report, para. 2.23. 1584. Treas. Regs. § 1.482-4(f)(2)(ii)(A). 1585. See the discussion of the periodic adjustment exceptions in the White Paper (Notice 88-123) in sec. 16.2.4.

480



The US periodic adjustment provision

to this criticism. Periodic adjustments are precluded if the pricing is based on a “genuine CUT”, i.e. an uncontrolled transaction pertaining to the same intangible under substantially the same circumstances. The author agrees that an application of the periodic adjustment provision in this context would conflict with the arm’s length principle, simply because a truly comparable unrelated transaction exists in these rare cases and thus illustrates that unrelated parties indeed would fix the pricing of the intangibles transfer at the outset.

16.3.3.3. Second exception: Initial fixed pricing based on CUTs ­involving a comparable intangible (inexact CUT exception) If the fixed price of the controlled transaction is determined by applying the CUT method, where the third-party reference transaction pertains to the transfer of a comparable intangible under comparable circumstances, the US regulations take a more sceptical stance. This is made clear by the fact that the regulations will not tolerate the aggregate actual profits of the controlled transaction being less than 80% or more than 120% of the prospective profits foreseeable at the time at which the comparability of the CUT was established. This range of allowed profits is absolute, in the sense that a periodic adjustment will be triggered if it is breached. The following criteria must be fulfilled in order for the inexact CUT exception to be applicable:1586 (1) The controlled taxpayers entered into a written agreement that provided for an amount of consideration with respect to each taxable year covered by the agreement, this consideration represented an arm’s length amount for the first taxable year in which substantial periodic consideration was required to be paid and the agreement remained in effect for the taxable year under review. (2) There is a written agreement setting out the terms of the CUT relied upon to establish the arm’s length consideration that contains no provisions that would permit any change in the amount of consideration, a renegotiation or a termination of the agreement, in circumstances comparable to those of the controlled transaction in the taxable year under review (or that contains provisions permitting only specified, non-contingent, periodic changes to the amount of consideration).

1586. Treas. Regs. § 1.482-4(f)(2)(ii)(B)(1)-(6).

481

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

(3) The controlled agreement is substantially similar to the CUT, with respect to the time period for which it is effective and the adjustment provisions described in criterion (2). (4) The controlled agreement limits the use of the intangible to a specified field or purpose in a manner that is consistent with industry practice and any such limitation to the CUT. (5) There were no substantial changes in the functions performed by the controlled transferee after the controlled agreement was executed, except for changes required by events that were not foreseeable. (6) The aggregate profits actually earned or the aggregate cost savings actually realized by the controlled taxpayer from the exploitation of the intangible in the year under examination and all past years are not less than 80% or more than 120% of the prospective profits or cost savings that were foreseeable when the comparability of the uncontrolled agreement was established. For the purpose of analysing this exception, the author finds it useful to sort away the criteria that pertain to the more formal sides of the arrangement. This goes for the requirements for written, long-term controlled and uncontrolled licence agreements with fixed pricing and without adjustment clauses (see criteria 1 (partly), 2, 3 and 4). These criteria are clearly important, but in the author’s opinion, they are more prerequisites than substantial material requirements. The real hurdles for the taxpayer are, in particular, criteria 1 (partly), as well as 5 and 6, which the author will comment on further in this section. The requirement for an arm’s length payment for the first taxable year in which substantial periodic consideration is required to be paid under the agreement (criterion (1)) must presumably be satisfied by confirming that the controlled transaction provided a royalty payment equal to that paid under the CUT for the relevant period. The strict comparability requirements of the final regulations, in particular, the profit potential criterion (also introduced in 1994),1587 severely limit the relevance of the exception.

1587. See the discussion of the profit potential comparability criterion for the CUT method in sec. 7.2.3.1. See supra n. 1208 for further references with respect to the profit potential criterion.

482



The US periodic adjustment provision

Further, if there were substantial changes in the functions performed by the related parties under the controlled agreement (criterion (5)), the exception will not apply, unless the changes are due to unforeseeable events. The likelihood of significant changes may vary depending on where the transferred intangible is in its lifecycle at the time of transfer. The intangible may be unproven and only partially developed, or proven and established and generating profits at the time of the transfer. The situation may also, for that matter, lie somewhere in between. For instance, the controlled transaction may be a licence agreement pertaining to a fully developed intangible, but manufacturing know-how will be gradually developed and exchanged between the controlled parties, akin to the factual pattern in French.1588 Many of the tax structures used by multinationals to shift intangible income out of the United States in the decades prior to the 1994 regulations, as reflected in, for instance, Eli Lilly and Bausch,1589 pertained to proven and established intangibles. In these “roundtrip” transactions, the structure of functions to be performed by the controlled parties was typically fixed at the time of the agreement and was unlikely to change afterwards. The whole point was to allocate certain assets and functions abroad, typically migrating manufacturing intangibles and connected functions, while retaining distribution functions in the United States. For transfers of unproven and partially developed intangibles, the situation may be different. The White Paper example on periodic adjustments in the context of a shift of functions pertains to a process that was under development and would not reach commercialization for several years after the agreement was entered into.1590 The agreement therefore had similarities to a CSA in some ways. A key element in the example was that the royalty rate was based on the premise that the subsidiary would contribute complex functions to the further intangible development, which turned out not to be necessary, thereby triggering a need to adjust the controlled pricing. This example will likely provide some guidance as to whether “substantial changes in the functions” 1588. R. T. French Co. v. CIR, 60 T.C. 836 (Tax Ct., 1973), distinguished by 1977 WL 191022 (IRS TAM, 1977), distinguished by 1979 WL 56002 (IRS TAM, 1979) and distinguished by 1992 WL 1354859 (IRS FSA, 1992). 1589. Eli Lilly and Company and Subsidiaries v. CIR, 84 T.C. No. 65 (Tax Ct., 1985), affirmed in part, reversed in part by 856 F.2d 855 (7th Cir., 1988); and Bausch & Lomb Inc. v. CIR, 92 T.C. No. 33 (Tax Ct., 1989), affirmed by 933 F.2d 1084 (2nd Cir., 1991). 1590. See White Paper (Notice 88-123), Appendix E, Example 13; and the discussion in sec. 16.2.2. on the 1985 House Report and the White Paper.

483

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

have occurred. The line will presumably be drawn for changes subsequent to which the original pricing can no longer be defended. For instance, this can occur when the RPSM is originally chosen to price the agreement but later developments make it inapplicable, thus necessitating a shift of pricing method to the CPM, or vice versa. The exception for changes due to events that were “not foreseeable” is presumably not very practical for partially developed intangibles, as these intangibles may entail such high risks that a considerable span of different outcomes may be equally probable at the time of the transfer. This will often depend on whether the R&D is “blue sky” or whether the development is based on a pre-existing intangible. There will generally be less risk involved in developing second and subsequent generations of an established intangible. The last criterion (criterion (6)) is that the aggregate actual profits allocable for the transferred intangible do not deviate from the aggregate profits estimated at the time at which the CUT was deemed to be comparable by more than +/- 20%. This establishes a range of allowed profits. Under the 1993 temporary regulations, the profits subject to comparison were those for all open years. Under the 1994 final regulations, the comparison applies to all years, thus making the pool of data potentially larger. The view of the final regulations is that it therefore will be less likely that the actual profits fall outside the range of projected profits solely due to timing differences, thus making period adjustments less frequent. The +/- 20% criterion represents a link to the profit potential comparability requirement of the CUT method.1591 The immediate observation is that if there is a discrepancy of some magnitude between (i) the estimated profits of the intangible that, at the inception of the agreement, had to be based on those expected from the CUT; and (ii) the actual profits under the controlled agreement, this could indicate that the controlled and uncontrolled transactions indeed were not comparable in the first place. If so, the exception would not apply at all, as the CUT method would be inapplicable. Further, it does not seem entirely clear to the author that a +/- 20% deviation between projected and actual results is useful for licence agreements. Typically, a licence agreement does not set fixed amounts to be paid, only a fixed royalty rate. Thus, the licenser and licensee will share 1591. See sec. 7.2.3.1. on the profit potential comparability criterion for the CUT method (as well as supra n. 1208 for further information on the profit potential criterion).

484



The US periodic adjustment provision

risk. If the licensee does not generate sales, the licenser will not receive royalty payments. Because only the division of actual profits, and not absolute amounts, is set at the time of the agreement, there is no obvious logic in operating under a concept of actual profits deviating from those foreseeable at the time of the agreement. The author does, however, admit that this is a theoretical argument. What the regulations clearly are concerned about in these scenarios is that the (normally foreign) subsidiary will be left with larger profits than intended under the original transfer pricing if the royalty rate is not adjusted upwards to take into account the increased profitability of the subsidiary. For instance, if a 5% royalty of the reference CUT was set based on a comparable price method (CPM) analysis in which the subsidiary would be left with a normal return on its routine functions after paying the royalty, and actual sales are larger than the projected sales, this will leave the subsidiary with some portion of the residual profits from the transferred intangible. It is this profit that will be stripped from the subsidiary if its actual profits are outside of the allowed +/- 20% range. The logic behind the +/- 20% criterion therefore seems sound in cases in which the initial controlled pricing was determined based on a one-sided method. It does not seem obvious that the same can be said for cases in which the initial pricing was based on the CUT method. After all, a CUT may allocate profits differently than the other pricing methods, depending on the bargaining positions of the unrelated parties. For instance, there is no guarantee that a low-risk distributor will not be allocated residual profits in a CUT, even though economic reasoning would argue otherwise. Nevertheless, the +/- 20% criterion refers to the profits foreseeable at the time at which the comparability between the controlled transaction and the reference CUT was established. There is no “check” as to whether the income allocation under the CUT conforms to the result that would have been yielded by the CPM or RPSM. The decisive parameter is solely whether the actual returns deviate by more than +/- 20% from the CUT-based projections, whatever they were. The 2nd Task Force Report observed that where the original pricing was CUT-based, it would be contrary to the arm’s length standard to perform periodic adjustments if the CUT remained comparable for the entire period and there was no change in the functions performed by the controlled

485

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

parties.1592 This argument refers to a situation in which there is no lack of comparability, but the actual profits from the transferred intangible simply move outside the allowed +/- 20% range of profits. The author must admit that he finds this argument rather convincing. It is difficult to find a periodic adjustment justified in these cases, especially considering the strict comparability requirements for applying the CUT method. After all, if the CUT remains comparable for the entire period, chances are that it may also have experienced the same increase in profitability as the controlled transaction. The final regulations, however, do not accept this argument. This is a clear expression of the US scepticism towards CUT-based pricing of unique intangibles transfers. In summary, the author’s impression of the CUT-based exception is that it is narrow, ensuring wide application of the periodic adjustment rule. The exception does not allow for relatively high profit fluctuations (outside the +/- 20% range), which may typically be the case for unproven intangibles. Then again, the CUT method will likely not be applicable to such transfers due to the obvious risk of lack of comparables, reducing the relevance of the discussion significantly. Pricing of unproven intangibles will also be challenging for multinationals to carry out properly, likely necessitating a range of highly discretionary comparability adjustments to the purported CUT. This raises obvious questions: Why then adopt a fixed-price structure? Why not include a provision to adjust the pricing in light of the actual results? These questions no doubt underlie the scepticism towards transfer pricing based on fixed-price-structure CUTs that is expressed through the +/- 20% criterion. Nevertheless, it does allow for relatively low profit fluctuations (inside the +/- 20% range), which may more likely be the case when proven intangibles are transferred, as future income may be more predictable than for unproven intangibles. This also makes it more plausible that no price adjustment clauses were included in the CUT. Overall, the author finds the +/- 20% criterion useful, as a deviation between the actual and projected profits outside of this range raises serious questions as to whether the fixed-price reference CUT was sufficiently comparable in the first place.

1592. 2nd Task Force Report, para. 2.29.

486



The US periodic adjustment provision

16.3.3.4. Third exception: Initial fixed pricing based on methods other than the CUT method If the initial fixed arm’s length transfer price is determined under any method other than the CUT method, no allocation will be made under the periodic adjustment rule if the following criteria are fulfilled:1593 − the controlled taxpayers entered into a written agreement that provided for an amount of consideration with respect to each taxable year covered by the agreement, and the agreement remained in effect for the taxable year under review; − the consideration called for in the controlled agreement was an arm’s length amount for the first taxable year in which substantial periodic consideration was required to be paid, and relevant supporting documentation was prepared contemporaneously with the execution of the controlled agreement; − there were no substantial changes in the functions performed by the transferee since the controlled agreement was executed, except for changes required by events that were not foreseeable; and − the total profits actually earned or the total cost savings realized by the controlled transferee from the exploitation of the intangible in the year under examination and all past years are not less than 80% or more than 120% of the prospective profits or cost savings that were foreseeable when the controlled agreement was entered into. For this exception to apply, the non-CUT-based transfer pricing has to be supported by relevant contemporaneous documentation. Similarly to the CUT-based exceptions, this exception demands that an arm’s length payment is carried out in the first year in which a substantial periodic consideration is required to be paid under the controlled agreement. The taxpayer will thus have to document that the royalty paid in that period, typically pursuant to the CPM or RPSM, represented an arm’s length consideration. The testing of the asserted arm’s length consideration will likely be more intensive when more residual profits are allocated to the foreign entity. If the consideration is deemed arm’s length, a periodic adjustment can be made if there are substantial changes in the functions performed by the contracting parties subsequent to the formation of the agreement. As in the CUT1593. Treas. Regs. § 1.482-4(f)(2)(ii)(C). As this exception applies when the initial pricing is based on methods other than the CUT method, the requirements under the CUT-based exceptions pertaining to the terms of the CUT and similarities to the controlled agreement are not relevant. The requirement to specify the licensed use of the intangible in the controlled agreement was, for some reason, removed.

487

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

based exception discussed above, if the alternation in functions performed is caused by unforeseeable events, a periodic adjustment cannot be performed. In order to avoid a periodic adjustment, the actual intangible profits for all open income years under review must also here lie within the acceptable range of +/- 20% of the projected profits. The author refers to his discussion of this criterion above under the CUT-based exception and will only comment on two particularities here. First, if the initial taxpayer profit allocation was determined using the CPM, for instance, to achieve a target return for the tested party of 8% on the basis of projected earnings, there must be a subsequent adjustment that strips or adds profit from or to the tested party, depending on whether its actual profits prove to be higher or lower than projected. This is because it will be unlikely that the actual return of the tested party achieves precisely the target return due to variance in external factors, such as sales to and costs of third parties. In practice, the taxpayer will often have performed a taxpayer-initiated compensating adjustment (true-up) in these cases.1594 If so, the issue will not be left for the IRS to resolve. Second, if the RPSM was used to set the original transfer price, the royalty was deemed arm’s length in the first year in which a substantial payment was made and there were no other changes apart from the actual profits being larger than estimated, the author does not quite see the rationale for making an adjustment. After all, the relative split of the profits will be the same as it was in the year of the first substantial arm’s length payment. However, also here, the intention is likely to seek to limit the return allocable to the foreign entity. That return will, of course, become greater as the profits grow beyond what was foreseeable at the time of the transaction, regardless of whether the relative split is the same. If there were no changes in the functions performed, assets contributed or risks incurred by the parties, however, there will be no reason under the RPSM to restrict the profits allocable to the foreign entity.

16.3.3.5. Fourth exception: Extraordinary events The last exception pertains to extraordinary events.1595 No periodic adjustment will be carried out even if the aggregate actual profits fall outside the allowed +/- 20% range of projected profits due to extraordinary events that 1594. See the analysis of taxpayer-initiated compensating adjustments in ch. 15. 1595. Treas. Regs. § 1.482-4(f)(2)(ii)(D).

488



The US periodic adjustment provision

could not reasonably have been anticipated and the rest of the requirements of US Treasury Regulations (Treas. Regs.) § 1.482-4(f)(2)(ii)(B) (pertaining to CUT-based original pricing) or § 1.482-4(f)(2)(ii)(C) (pertaining to the exception for original pricing based on methods other than the CUT method) are satisfied. In order for the exception to be triggered, the following criteria must be met: − due to extraordinary events that were beyond the control of the controlled taxpayers and could not reasonably have been anticipated at the time at which the controlled agreement was entered into, the aggregate actual profits or aggregate cost savings realized by the taxpayer are less than 80% or more than 120% of the prospective profits or cost savings; and − all of the requirements of the second or third exception are otherwise satisfied (see sections 16.3.3.3.-16.3.3.4.). The exception is illustrated by an example in which a foreign parent licenses a new air-filtering process to its US subsidiary. The licence runs for 10 years, and the profits are projected to be 15 per year. The fixed royalty rate is based on an inexact CUT, and the requirements under the CUT-based exception are fulfilled, apart from the +/- 20% criterion.1596 In examining year 4 of the licence, the IRS determines that the aggregate actual profits earned by the US subsidiary through year 4 are 30, i.e. less than 80% of the projected profits of 60. However, the subsidiary establishes that this is due to an earthquake that severely damaged its manufacturing plant. Because the difference between the projected and actual profits is due to an extraordinary event beyond the control of the US subsidiary and could not reasonably have been anticipated at the time at which the licence agreement was entered into, the requirements under the “extraordinary events” exception have been met, and no periodic adjustment is made. Based on the relatively strong language of the exception, requiring “extraordinary events beyond control”, as well as the earthquake example, there is little doubt that the threshold for triggering the “extraordinary events” exception is set very high. Qualifying events must likely be akin to typical force majeure occurrences, such as war and natural disasters. The IRS argues in the aforementioned (see section 16.3.2.) 2007 memorandum 1596. Specifically, the parent and subsidiary have entered into a written agreement that provides for a royalty in each year of the licence, the royalty rate is considered arm’s length for the first taxable year in which a substantial royalty is required to be paid, the licence limits the use of the process to a specified field, consistent with industry practice, and there are no substantial changes in the functions performed by the US subsidiary after the licence agreement is entered into.

489

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

that periodic adjustments should not be made on the basis of actual profits that could not have been reasonably anticipated at the time at which the controlled transaction was entered into, but rather that actual profits provide the IRS with a presumptive basis for making periodic adjustments.1597 Further, taxpayers have the ability to rebut that presumption by showing that the actual results were beyond the control of the taxpayer and could not reasonably have been anticipated at the time of the transaction. On this point, the 2007 memorandum refers to the “extraordinary events” exception.1598 The author finds the 2007 memorandum to be rather speculative, as it seems to present the “extraordinary events” exception as being broader than it actually is. While the author agrees with the IRS that an earthquake certainly is an extraordinary event and beyond the control of even multinationals, he does not agree that such events are the only circumstances that will not be foreseeable for a taxpayer at the time at which a controlled intangibles transfer is agreed to. For instance, a range of market conditions, such as the introduction of new competing products, new competitors or infringement of patent rights, may cause actual results to deviate from the projected results. Yet, the “extraordinary events” exception will likely not encompass the majority of such events. The author’s view is therefore that the ability of the taxpayer to rebut the presumptive basis of the IRS is limited indeed.

16.3.4. Five-year cut-off rule If the requirements of the exception for initial CUT-based pricing or the exception for initial pricing based on methods other than the CUT method are met for each year of the 5-year period, beginning with the first year in which substantial periodic consideration was required to be paid, no periodic adjustment will be made in any subsequent year.1599

16.3.5. Concluding remarks on the exceptions The exceptions to the periodic adjustment rule are rather convoluted, narrow and not particularly practical. The criteria for triggering the exceptions 1597. IRS AM 2007-007, at p. 11 (with further references to the White Paper [Notice 88-123] in its footnote 19). 1598. IRS AM 2007-007, at p. 11 (see also its footnote 20). 1599. Treas. Regs. § 1.482-4(f)(2)(ii)(E).

490



Periodic adjustments to lump-sum IP transfers under US law

are many and strict. Whether the +/- 20% range of allowed profits is suitable is a matter of opinion. The exceptions are, of course, intended to be restrictive, seeing as the commensurate-with-income language in IRC section 482 requires the profit allocation in controlled intangibles transfers to be commensurate with the actual profits allocable to the transferred intangible. In order to attain this alignment of projected and actual profits, the adjustment provision must be broad. Realistically, the exceptions therefore do not seem to encompass scenarios in which there will be any practical need, as seen from the point of view of the IRS, to perform subsequent pricing adjustments to controlled intangibles transfers with fixed-price structures.

16.4. Periodic adjustments to lump-sum IP transfers under US law The White Paper was sceptical towards the use of fixed lump-sum pricing in intangibles transfers, including deployment of intangibles through CSAs (buy-ins). Two problems were identified with respect to periodic adjustments of such transactions. First, an adjustment could be barred by the statute of limitations. Second, if the adjustment was made “mid-stream”, it would not be possible to foresee the last part of the income stream with certainty. Thus, the adjustment could be too high or too low. The solution of the White Paper was to treat the transaction as open. The lump-sum payment was regarded as a pre-payment for the intangible. No adjustment would be carried out before the aggregate of a calculated adjustment amount exceeded the prepayment. Building on the initial thoughts presented in the White Paper, the 1994 regulations include a provision that addresses the use of fixed lump-sum payments.1600 It provides that fixed lump-sum payments are subject to periodic adjustments to the same extent as licence agreements that provide for periodic royalty payments. The regulations determine that if an intangible is transferred in a controlled transaction for a lump sum, that amount must be commensurate with the income attributable to the intangible.1601 This criterion will be met if the equivalent royalty rate in a taxable year is equal to an arm’s length royalty rate. The equivalent royalty rate for a taxable year is the amount determined by treating the lump sum as an advance 1600. The 1992 proposed (57 FR 3571-01) and 1993 temporary (58 FR 5263-02) regulations did not include this rule, but the issue was reserved. 1601. Treas. Regs. § 1.482-4(f)(6).

491

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

payment of a stream of royalties over the useful life of the intangible (or the period covered by the controlled agreement, if shorter), taking into account the projected sales of the licensee as of the date of the transfer. In order to determine the equivalent royalty amount, a present value calculation must be performed, based on the lump sum, an appropriate discount rate and the projected sales over the relevant period. This is illustrated in an example in which a US parent licenses make-sell rights to a patented kitchen appliance to its European subsidiary.1602 The licence covers 5 years, and a single lump sum charge of 500,000 is paid at the outset of the agreement. The projected sales of the subsidiary are as follows: Year

Projected sales

1

2,500,000

2

2,600,000

3

2,700,000

4

2,700,000

5

2,750,000

The equivalent royalty amount for the licence is determined by deriving a rate equal to the lump-sum payment divided by the present value of the projected sales of the subsidiary. Based on the riskiness of the kitchen appliance business, an appropriate discount rate is determined to be 10%. The present value of the year 1-5 sales is approximately 10,000,000, yielding an equivalent royalty rate of 5%. Therefore, the equivalent royalty amounts for each year are as follows: Year

Projected sales

Equivalent royalty amount (5%)

1

2,500 000

125,000

2

2,600 000

130,000

3

2,700 000

135,000

4

2,700 000

135,000

5

2,750 000

137,500

1602. Treas. Regs. § 1.482-4(f)(6)(iii).

492



The OECD periodic adjustment provision

The equivalent royalty amount is subject to periodic adjustments to the same extent as an actual royalty rate would be. No periodic adjustment is made if any of the exceptions from the general periodic adjustment rule (as discussed in section 16.3.3.) apply. Thus, the +/- 20% allowed range between projected and actual profits, as well as the other criteria of the exceptions, apply also in the context of lump-sum payments. Thus, with respect to the above example, if the equivalent royalty amount is determined not to be at arm’s length in any of the 5 taxable years, a periodic adjustment may be carried out. The adjustment will be equal to the difference between the equivalent royalty amount and the arm’s length royalty for that taxable year. The determination of an arm’s length royalty will be carried out by applying the transfer pricing methods. The CPM would likely be applied to determine the arm’s length royalty payment in the example, as only the US parent provides unique value chain inputs. The lump-sum payment provision should therefore be seen as a technical provision pertaining to how one shall benchmark a lump-sum payment against an arm’s length royalty rate in order to assess whether there should be an adjustment of income in any of the taxable years during a licence agreement that applies a fixed lump-sum payment structure.

16.5. The OECD periodic adjustment provision The OECD voiced its opinion on periodic adjustments already in the 1993 Task Force Report, commenting on the 1992 proposed US regulations. The report conceded that there was a need for periodic adjustments in some cases.1603 The position was that they should take into account only profits that could reasonably have been foreseen at the time of the transaction and that the use of actual profits to inform a review of the ex ante controlled pricing could be inconsistent with the arm’s length principle outside of “truly abusive cases”.1604 2 years later, the 1995 OECD Discussion Draft proposed to include guidance on periodic adjustments in the OECD Transfer Pricing Guidelines (OECD TPG),1605 resulting in a slightly more fo1603. Task Force Report, para. 3.64. 1604. Id., at para. 3.65. 1605. Under the heading “periodic adjustments”, the 1995 OECD discussion draft stated that no adjustments should be carried out if independent parties would have agreed to a similar fixed compensation structure without adjustment clauses while facing a comparable level of valuation uncertainty (see para. 39). A periodic adjustment could only be carried out if the tax authorities had “no other recourse to determine an appro-

493

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cused consensus text later that same year.1606 The 2010 OECD TPG made no changes to the 1995 text. The question addressed in the 2010 text was whether a controlled intangibles transfer with a fixed-priced structure, which yielded an arm’s length royalty payment at the outset, could be adjusted in later income periods if the profit allocation then proved not to be at arm’s length. It was recognized that independent enterprises in some cases could deem the projected profits allocable to the transferred intangible sufficiently reliable to fix the pricing at the outset. If this was the situation in the controlled transfer, the 2010 text did not permit periodic adjustments.1607 In other scenarios, the projected profits could be so uncertain at the outset that independent parties either would only have (i) used fixed pricing in short-term agreements; or (ii) in the case of long-term fixed-price licence agreements, included price adjustment or renegotiation clauses. The 2010 text allowed periodic adjustments to be carried out in such cases.1608 The problem was separating the cases in which periodic adjustments were barred from the cases in which they were allowed. For this purpose, two criteria were drawn up. First, if independent enterprises would have “insisted on a price adjustment clause” in comparable circumstances, a tax administration was permitted to determine the pricing based on such an imputed adjustment clause.1609 Second, if independent enterprises would priate transfer price”. The draft argued that the tax authorities should seek to determine a price that would not require future adjustments. The periodic adjustment provision was limited to exceptional cases in which independent parties would have insisted on adjustments; see 1995 OECD discussion draft, para. 40. 1606. Without explanation, the 1995 OECD discussion draft heading “periodic adjustments” was replaced in the 1995 OECD Transfer Pricing Guidelines (OECD TPG) with “arm’s length pricing when valuation is highly uncertain at the time of the transaction”, presumably in order to distance the guidance from the obvious influence of the US regulations, likely making it easier to reach consensus on the final text on this controversial issue. Several of the problematic criteria from the 1995 OECD discussion draft were removed. Focus was on what unrelated parties would have agreed to, given valuation uncertainty at the time of transfer; see 1995/2010 OECD TPG, paras. 6.28 and 6.32. Plainly put, tax authorities were entitled to adjust fixed-price structures if unrelated parties would not have adopted a fixed payment form under comparable circumstances. The guidance provided for this hypothetical assessment was modest. The final 1995 text, as opposed to the 1995 OECD discussion draft, included examples on the application of the periodic adjustment authority. 1607. 1995/2010 OECD TPG, para. 6.32. 1608. 1995/2010 OECD TPG, para. 6.34. 1609. Id.

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have considered “unforeseeable subsequent developments so fundamental that their occurrence would have led to a prospective renegotiation” of the fixed price, a periodic adjustment was allowed.1610 Compared to the US periodic adjustment provision, the 2010 OECD rule was structured in a reverse manner. The point of departure under the US rule is that periodic adjustments shall be carried out in all cases to ensure that the profit allocation is commensurate with the income generated by it, to which specific and narrow exceptions are made. The practical question under US law is not to ascertain whether a periodic adjustment is allowed at the outset, but whether that provision is cut off in a concrete case due to one of the exceptions being triggered. The point of departure under the 2010 OECD rule, on the other hand, was that no adjustment was allowed unless independent enterprises would have “insisted” on including a price adjustment clause in the fixed-price licence or subsequent developments were so “fundamental” that they would have agreed to a renegotiation of the fixed-pricing terms. The OECD rule hinged on a hypothetical assessment, contingent on the degree of uncertainty surrounding the projected profits. It will be very difficult, on an after-the-fact basis, to ascertain the degree of uncertainty that actually surrounded the projected profits at the time at which the agreement was entered into, not to mention what level of uncertainty would entice multinationals to adopt variable pricing structures in the absence of a CUT. The core point of the pricing structure of a controlled licence agreement will normally be to provide the licensee with an arm’s length return, typically determined under the TNMM (e.g. a normal market return to routine entities in the principal model).1611 If the projected profits are so uncertain that it is likely to be difficult to attain the target return for the tested party using a fixed-price structure, it seems sensible to assume that multinationals would not adopt such structures.1612 This logic speaks in favour of a 1610. Id. 1611. See the discussion of the centralized principal model in sec. 2.4. 1612. E.g. if an arm’s length target return for a low-risk distributor subsidiary is set to 5% of the total operating costs, and a fixed royalty rate is set to 40% of sales based on projected sales of 1,000. Only if the actual sales of the subsidiary prove to be 1,000 will the target 5% return be achieved. If it is equally likely that the subsidiary’s sales will be 500, 750, 1,250 or 1,500, it will make little sense to fix the pricing at the outset, as it is likely that the target return of 5% will not be met using a fixed-price structure. Instead, the agreement should include a price adjustment clause so that the royalty rate of 40%

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relatively low threshold for periodic adjustments under the 2010 text. However, this interpretation runs afoul of the restrictive 2010 language, which indicated a high threshold. Regardless of how the 2010 text should be understood with respect to the adjustment threshold, in the end, it seems hard to get around the fact that the best practical indicator of the degree of uncertainty that surrounded the projected profits at the time at which the transaction was entered into is the degree of discrepancy between the projected and actual profits. If it is significant, it will likely provide a convincing argument that the projected profits were surrounded by such a large degree of uncertainty that independent enterprises would not have opted for a fixed-price structure. Contrary to the US regulations, no specific range of allowed discrepancy between the projected and actual profits was indicated in the 2010 text.1613 On that basis, it can be observed that the periodic adjustment provision of the 2010 OECD TPG was ambiguous. While it was clear that periodic adjustments in some cases were allowed, the threshold for triggering the provision was not. Undoubtedly, this was due to the historical resistance among some OECD member countries against periodic adjustments. An obvious problem with the 1995/2010 approach of tying the periodic adjustment provision to an assessment of the degree of uncertainty surrounding projected profits, combined with a lack of guidance on the use of actual profits, is that it would likely be possible to argue convincingly for a wide range of solutions, resulting in a significant potential for controversy. The author would assume that this made the 2010 rule difficult to apply in practice, possibly resulting in double taxation. The 2017 OECD TPG introduce some new language on periodic adjustments while retaining the basic point of departure of the 2010 text. It is recognized that unrelated parties may base the pricing of an intangibles can be adjusted depending on actual sales in order for the subsidiary target return of 5% to be reached. In practice, the taxpayer will often perform year-end adjustments to transactional net margin method (TNMM)-based pricing structures to adjust prices in light of actual results so that the tested party’s target return can be reached; see the analysis of year-end adjustments in ch. 15. There will then, in theory, be no need for a periodic adjustment rule for tax authorities, as the taxpayer will already have adjusted its prices to an arm’s length result. 1613. Further, the relationship between the 2010 OECD periodic adjustment rule and the transfer pricing methods was problematic. The 2010 text did not distinguish the periodic adjustment provision depending on which transfer pricing method was used to set the initial transfer price.

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transfer on profit projections. If these are sufficiently predictable, the parties may choose to fix the pricing at the time of the transaction.1614 However, major unforeseeable events may occur, or events that, in principle, were foreseeable at the time of the transaction, but had low probabilities of materializing. This may justify a renegotiation of the price.1615 Further, in cases in which the financial projections are uncertain, third parties may adapt by choosing short-term agreements, including price adjustment clauses, or basing the price on contingent payment terms in which the quantum or timing of payments rely on future events (progressive royalties, additional payments at pre-determined thresholds, etc.).1616 On this basis, the OECD TPG state that if unrelated enterprises in comparable circumstances would have agreed on the inclusion of a contractual mechanism to address the valuation uncertainty (e.g. a price adjustment or renegotiation clause or a contingent payment structure), the tax administration should be entitled to impute such a mechanism against which to benchmark the controlled pricing. Further, if third parties would have considered subsequent events so fundamental that their occurrence would have led to a renegotiation of the fixed pricing, the tax administration may adjust the price to an arm’s length level following such events. This is essentially in line with the 2010 consensus text, apart from the new reference to contingent payment terms as a mechanism to address valuation uncertainty.1617 The significant new addition in the 2017 text is that the “old” 2010 text is now linked to new guidance on hard-to-value intangibles (HTVIs).1618 1614. OECD TPG, para. 6.182. 1615. OECD TPG, para. 6.184. 1616. OECD TPG, para. 6.183. 1617. The emphasis on contingent payment arrangements is likely influenced by the US intangible property (IP) ownership provisions, pursuant to which the IRS may impute contingent payment arrangements aligned with economic substance to allocate residual profits; see the analysis in sec. 21.3.3. 1618. The examples used in the 2010 text are now, thankfully, scrapped. The examples were ambiguous and did not provide any useful guidance. The first example pertained to a controlled, 3-year licence of proven make-sell rights to a drug with a fixed royalty rate (see 2010 OECD TPG, annex to ch. VI, Example 1). The example did not properly explain why unrelated parties would have insisted on a price adjustment clause, but simply stated that one should “assume there is evidence that independent enterprises would have insisted”. The valuation uncertainty referred to in the example pertained to typical market risks that will normally exist for transfers of unique intangibles. It does not seem entirely obvious that independent parties would have included adjustment clauses due to such typical risks. In the second example, a parent company licensed

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HTVIs are defined as follows: [I]ntangibles or rights in intangibles for which, at the time of their transfer between associated enterprises, (i) no reliable comparables exist, 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, or the assumptions used in valuing the intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of the transfer.1619

Transactions involving HTVIs typically include (i) transfers of partially developed intangibles (R&D); (ii) intangibles that are not expected to be exploited commercially until years after the transfer; (iii) an intangible that is not in and of itself an HTVI but is integral to the development of other intangibles that qualify as HTVIs; (iv) intangibles that are expected to be exploited in a novel manner and lack a track record; (v) an intangible that is transferred for a lump sum; or (vi) an intangible that is contributed to or developed under a CSA. It is the author’s view that the HTVI definition in most cases will encompass all unique and valuable intangibles that are capable of generating residual profits. There will likely be significant uncertainty pertaining to factors such as the useful life of an intangible (risk of technical obsolescence), discount rates, etc. This is amply illustrated in Veritas, which pertained to the transfer of intangibles connected to established, high-selling software. The fact that the definition is intended to encompass a broad range of intangibles is further indicated by the comprehensive listing of typical transactions that fall within the definition. The point of the HTVI guidance is that information asymmetry will exist between multinationals and tax authorities with respect to the valuation of HTVIs. A multinational will possess the technical business knowledge necessary to critically estimate potential profits and associated risks. Tax authorities generally lack this information, placing them in a precarious situation with respect to reviewing the ex ante taxpayer pricing.

make-sell rights to a microchip to its subsidiary for 5 years at a fixed royalty rate of 2% (see 2010 OECD TPG, annex to ch. VI, Example 3). The example was, in the author’s view, unfit to provide guidance on the periodic adjustment provision, as in reality, it pertained to an ordinary transfer pricing review of an agreement that was not at arm’s length at the outset, as opposed to a periodic adjustment. 1619. OECD TPG, para. 6.189. See also Navarro (2017), at p. 242, on this topic.

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The OECD periodic adjustment provision

To compensate for this information asymmetry, the new 2017 guidance entitles tax administrations to use ex post profit data to inform the determination of whether the ex ante controlled pricing was arm’s length.1620 The link between the old 2010 language and the new HTVI guidance is as follows: provided that none of the exceptions from the periodic adjustment provision are triggered, ex post profit data may be used to determine the ex ante pricing pursuant to the new HTVI guidance. The profit allocation result that follows from the reassessed ex ante price is regarded as that which would follow from the price adjustment or renegotiation clauses adopted by third parties pursuant to the old 2010 language. Thus, the new HTVI guidance will, in practice, inform both as to when a periodic adjustment can be carried out (i.e. when the exceptions from the periodic adjustment provision are not triggered) as well as the extent of it (the data on actual profits will, in practice, be determinative of the price). This represents a significant clarification of the threshold for applying the OECD periodic adjustment provision and puts an end to the comprehensive ambiguity that has plagued the periodic adjustment guidance since its inception 2 decades ago.1621 The 2017 text expresses the opinion that the HTVI guidance is consistent with the arm’s length principle, as it does not entail the use of hindsight when ex post financial results are taken into account without considering whether the information could or should reasonably have been known or considered at the time at which the transaction was entered into. This is sought to be ensured through the four exceptions to the HTVI adjustment provision.

1620. OECD TPG, para. 6.192. Ex post actual financial results provide presumptive evidence as to the arm’s length character of the controlled pricing, and may be rebutted by the taxpayer. See the discussion below in this section of the exceptions to the provision to use ex post results to assess ex ante pricing. The OECD released a discussion draft on 23 May 2017 containing proposed guidance on the practical implementation of the hard-to-value intangible (HTVI) language contained in the 2017 OECD TPG. See also Brauner (2016), at p. 109, where he notes that the new guidance on HTVIs does not go beyond the confides of the arm’s length principle. The author agrees. However, see also Fedusiv (2016), at p. 488, where it is argued that the HTVI guidance goes beyond the arm’s length principle and thus may result in double taxation, essentially based on the view that the guidance cannot be reconciled with the wording of art. 9 of the OECD Model Tax Convention. 1621. The HTVI guidance should, in the author’s view, be seen as a success for the OECD. It was a long time coming, being among the last items in the intangibles project to reach consensus. The guidance offers generous authority to perform periodic adjustments.

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First, no adjustment may be made if the taxpayer provides:1622 − details of the ex ante projections used at the time of the transfer to determine the profit allocation (including how risks were accounted for, e.g. probability weighted, the consideration of reasonably foreseeable events and other risks and the probability of occurrence); and − reliable evidence that any significant difference between the financial projections and actual outcomes is due to (i) unforeseeable developments or events occurring after the determination of the price that could not have been anticipated by the associated enterprises at the time of the transaction; or (ii) the playing out of the probability of occurrence of foreseeable outcomes and evidence that these probabilities were not significantly overestimated or underestimated at the time of the transaction. An example is provided in which the controlled pricing was based on sales projections of 100, and actual sales turned out to be 1000. If the higher sales were due to an exponentially higher demand for the products due to a natural disaster or some other unexpected event that was clearly unforeseeable at the time of the transaction or if they were appropriately given a very low probability of occurrence, the ex ante pricing should be recognized as arm’s length.1623 This establishes a comprehensively high, force majeurelike threshold for applying the exception, akin to the US “extraordinary events” exception.1624 Second, no adjustment may be carried out if the transfer of the HTVI is covered by a bilateral or multilateral advance pricing arrangement in effect for the period in question between the countries of the transferer and transferee.1625 Third, no adjustment may be carried out if the actual compensation for the HTVI does not deviate more than +/- 20% from the financial projections that formed the basis for the controlled pricing at the time of the transaction.1626 This exception is akin to the +/- 20% allowed range of discrepancy between the projected and actual profits under the US regulations.1627

1622. OECD TPG, para. 6.193, i). 1623. OECD TPG, para. 6.194. 1624. See the discussion of the US exception in sec. 16.3.3.5. 1625. OECD TPG, para. 6.193, ii). 1626. OECD TPG, para. 6.193, iii). 1627. See the analysis in secs. 16.3.3.3. and 16.3.3.4.

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Fourth, no adjustment may be carried out if a commercialization period of 5 years has passed following the year in which the HTVI first generated unrelated party revenues for the transferee, and during this period, the differences between the projected and actual outcomes were not greater than +/- 20%.1628 In summary, it seems clear that the 2017 revision of the periodic adjustment provision was heavily influenced by the solutions drawn up in the US regulations. As the case is for the US regulations,1629 it may be questioned as to whether the OECD periodic adjustment provision in reality is limited to taking into account actual profits only based on information that could or should reasonably have been known or considered at the time at which the transaction was entered into. Actual profits will be used in all cases in which the deviation from projected profits exceeds +/- 20% and the profits were not caused by force majeure-like events. As the author sees it, this may also encompass information that not necessarily could or should reasonably have been taken into account at the time of the transfer. His view is that this is necessary in order to ensure effective periodic adjustments. A systemic difference is that the OECD exceptions, as opposed to those of the US regulations, are not categorized pursuant to which method the taxpayer applied in order to price the controlled intangibles transfer. A peculiarity is that the OECD exceptions do not include an exception to the pe1628. OECD TPG, para. 6.193, iv). 1629. The key role played by actual profits run through the US regulations as a red thread. When the initial pricing is not based on a “genuine” CUT, a periodic adjustment will be performed if the actual results deviate more than +/- 20% from the profits projected at the time at which the controlled agreement was entered into, given that the “extraordinary events” exception is not triggered. The role of actual profits in the context of periodic adjustments of CSA buy-ins is even more pronounced. Under the current regulations, a periodic adjustment examination will be triggered if the actual profits of a foreign CSA participant exceed 150% of that participant’s CSA investment. The “extraordinary events” exception prevents reallocations here also. See also the 2007 IRS Coordinated Issue Paper (CIP) (LMSB-04-0907-62), at p. 9, which instructs the IRS to “decline to make a periodic adjustment to a royalty on the basis of outcomes that could not be reasonably anticipated at the time the intangible transfer was entered into. The regulations clearly reflect the intent that the IRS exercise restraint in making periodic adjustments based on only the upfront reasonable expectations and not based on subsequent events which could not be reasonably anticipated”. This indicates that the IRS will not take full advantage of the periodic adjustment authority bestowed upon it in the regulations. The author is sceptical of whether this stance will be adhered to in practice if the question is truly put to the test. To do so could, in the author’s view, arguably be contrary to the legislative intent behind the commensurate-with-income standard.

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riodic adjustment provision when the initial controlled pricing is based on a “genuine” CUT. While likely not of significant practical importance due to the general lack of CUTs pertaining to unique and valuable intangibles, it does, in principle, seem unacceptable to perform a periodic adjustment in these cases. The CUT will represent a “guarantee” that third parties would indeed operate with fixed pricing here. In the author’s view, it is clear that an exception to the adjustment provision must apply in these cases. This follows from the overall purpose of the arm’s length principle, i.e. to provide parity in the taxation of related and unrelated parties. Such an exception may also be anchored in paragraph 6.185 of the OECD TPG, as it is clear that in cases in which the taxpayer pricing is supported by a “genuine” CUT, it will be established that third parties would not have agreed on the inclusion of a “mechanism to address high uncertainty in valuing the intangible”. Further, under both the US and OECD provisions, tax authorities will – apart from when the initial pricing is based on a “genuine” CUT (and when there is an advance pricing agreement) – be entitled to perform a periodic adjustment in cases in which there is a discrepancy between projected and actual profits exceeding +/- 20%, unless these are caused by a force majeure-like event (war, natural disasters, etc.). Perhaps the most interesting aspect of the 2017 HTVI guidance is the periodic adjustment exception for cases in which the HTVI transfer is covered by a bilateral or multilateral advance pricing agreement. Such an agreement represents a safe harbour from reassessments. Given the limited scope of the other periodic adjustment exceptions, this will likely be an attractive option for multinationals. It will be interesting to see whether this will lead to “profit bargains” with local tax authorities and how this may affect international profit allocation. For instance, it may be that a jurisdiction in which a purported routine entity is resident will not accept a TNMM-based return at the lower end of the arm’s length range but will require application of the profit split method based on the assertion that there is, for instance, a local marketing intangible. Such source state profit allocation assertions may conflict with typical tax structures employed by multinationals, such as the centralized principal model. This may trigger a dilemma for multinationals: they can either pursue typical “minimum profit allocations” to source states based on the

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Periodic adjustments of buy-in pricing under the US regulations

TNMM and face the risk of potential reassessments, or they can enter into an advance pricing agreement with a more favourable profit allocation to the source state in order to be shielded from the uncertainty associated with potential subsequent periodic adjustments. Multinationals may benefit from utilizing this exception, thereby gaining predictable profit allocations and avoiding potentially protracted controversy over historical transactions, while at the same time being able to advocate their profit allocation assertions in local negotiations. Tax authorities will benefit from advance pricing agreements by avoiding the use of scarce resources to audit and prepare reassessment cases, along with the potential of agreeing to a somewhat higher profit allocation to the source state in exchange for the safe harbour from reassessments that the advance pricing agreement offers to the multinational.

16.6. Periodic adjustments of buy-in pricing under the US regulations 16.6.1. Introductory remarks CSAs have traditionally been popular instruments for migrating US-developed intangibles to jurisdictions with more favourable taxation of intangible income. The contribution of a pre-existing intangible to a CSA, which triggers a buy-in requirement, is substantially similar to a partial sale of the intangible, as significant portions of the ownership of intangibles developed under the CSA is allocated to foreign CSA participants. Thus, when a US entity contributes a pre-existing intangible to a CSA, it relinquishes its right to the parts of the profit potential connected to the new versions of the intangible developed under the CSA that are allocable to the ownership shares of the other CSA participants. It is this loss of profit potential that the buy-in payment shall compensate the US entity for. The commensurate-with-income standard applies to all intangibles transfers, including contributions of pre-existing intangibles to CSAs. However, without detailed guidance on how to apply the standard in the context of CSAs, it would be difficult to enforce the standard, as CSAs are complex instruments and the initial transfer pricing of buy-ins itself may offer plen-

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ty of technical challenges. This emphasizes the need for a periodic adjustment provision tailored to the context of CSA buy-ins. The current cost-sharing regulations have introduced such provisions.1630 The provisions will ensure that the profit allocation dictated by the CSA transfer pricing methods are abided by, in the sense that the actual profit allocation conforms to the allocation pattern intended by the methods. In line with its general stance on periodic adjustments, the IRS has, on several occasions, maintained that the focus of the periodic adjustment authority for CSAs is to ensure that the initial buy-in pricing was at arm’s length and that no adjustment will be made if the under-pricing was not knowable at the outset.1631 Further, if the above-market returns of a foreign CSA participant are due only to uncertainty materializing in a favourable way, no adjustments will be made.1632 In sections 16.6.2.-16.6.5., the author will discuss the periodic adjustment authority for buy-ins under the current cost-sharing regulations.

16.6.2. A periodic adjustment is triggered if the AERR is greater than the PRRR As touched upon earlier, the terminology of the final cost-sharing regulations is highly specific. The author refers to section 14.2.7. for an overview of the essential terminology.

1630. The 2005 proposed CSA regulations (70 FR 51116-01) coupled the introduction of the buy-in investor model with a periodic adjustment provision tailored specifically to buy-in payments. Its preamble referred to the 1986 Congressional scepticism concerning migration of US-developed, high-profit intangibles for relatively insignificant lump sums or royalties, which placed all the development downside risk with the transferring US entity and the upside profit potential with the foreign transferee; see 2005 Prop. Treas. Regs. (70 FR 51116-01) § 1.482-7, preamble, sec. E.3. A tailored buy-in periodic adjustment provision was deemed necessary to enable the IRS to reassess when the controlled pricing did not appropriately reflect the profit potential of the transferred intangible (typically when the actual profits realized indicate that the buy-in was mispriced), thereby realizing the legislative intention behind the 1986 commensurate-with-income standard that controlled profit allocation to “reasonably reflect the relative economic activities undertaken by each”; see 1986 Committee Report, at p. 1015. 1631. See the comments of M. McDonald (international economist at the US Treasury), in Sheppard et al. (2006). 1632. See the comments of M. McDonald (international economist at the US Treasury), in Nadal (2009).

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In terms of context, multinationals may seek to migrate US-developed intangibles by way of contributing them to CSAs for the purpose of further research so that the bulk of the ownership of future versions of the intangibles will be by foreign group entities, enabling allocation of the residual profits to these foreign entities. In these cases, a US group entity may enter into a CSA with a foreign cash-box subsidiary resident in a low-tax jurisdiction that only provides funding to the R&D performed under the CSA. The income method is the go-to method for determining the buy-in amount in these typical, tax-driven CSA cases.1633 Thus, one of the more practical questions pertaining to the application of the periodic adjustment authority in the context of CSAs is likely whether the actual return experienced by a foreign cash-box subsidiary proves to be larger than the CPM-based normal market return intended to be allocated to it under the income method. If so, and provided that no exception to the adjustment provision is available, the periodic adjustment provision will see to it that the foreign entity is stripped of all residual profits. Indeed, the periodic adjustment authority for CSAs is a potent instrument. If no exception is available, periodic adjustments of buy-ins may be carried out if a controlled participant that was obligated to pay a buy-in amount has realized an actually experienced return ratio (AERR) that lies outside of the periodic return ratio range (PRRR).1634 A periodic trigger occurs if the AERR is outside the PRRR. The PRRR consists of return ratios that are not less than 0.667 or more than 1.5.1635

1633. See the discussion of the income method in sec. 14.2.8.3. 1634. Treas. Regs. § 1.482-7(i)(6)(i). 1635. Treas. Regs. § 1.482-7(i)(6)(ii). Alternatively, if the CSA participants do not comply with the CSA regulations’ documentation requirements, the periodic return ratio range (PRRR) will consist of return ratios that are not less than 0.8 or more than 1.25. In the 2005 proposed CSA regulations (70 FR 51116-01), the range was set to actual return ratios of no more than 2 and no less than 0.5, in practice, entailing that an examination would be triggered in all cases in which the foreign transferee experienced an actual return that exceeded a mark-up of 200% of his CSA investment. The only significant change to the periodic adjustment authority in the 2009 temporary CSA regulations (74 FR 340-01) was that the threshold for triggering a periodic adjustment examination was lowered, as the PRRR was set to a range between 0.667 and 1.5, making the periodic adjustment rule stricter. Thus, if the foreign transferee’s profits were larger than 150% of its investment into the CSA, an examination (and likely a reallocation) would be triggered.

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The AERR is the present value of total profits (PVTP) divided by the present value of investments (PVI). The present value of total profits is the present value, as of the CSA start date, of the platform contribution transaction (PCT) payer’s actually experienced “divisional profits or losses” from the CSA start date through the end of the adjustment year. Divisional profits or losses are defined as operating profits before CSA-related expenditures and taxes.1636 The present value of investment is the present value, as of the CSA start date, of the PCT payer’s investment associated with the CSA activity, defined as the sum of its cost contributions and buy-in payments from the CSA start date through the end of the adjustment year.1637 The PVTP and PVI are calculated using the applicable discount rate (ADR) and all information available as of the date of the determination. The ADR is the general discount rate pursuant to Treas. Regs. § 1.482-7(g)(2)(v).1638 In the event of a periodic trigger, the Commissioner is entitled to carry out periodic adjustments with respect to all buy-in payments between all PCT payers and PCT payees for the adjustment year and all subsequent years for the duration of the CSA activity. A periodic adjustment may be made for a particular taxable year without regard to whether the taxable years of the trigger buy-in remain open for statute-of-limitation purposes. Also, the Commissioner may consider whether the outcome as adjusted more reliably reflects an arm’s length result under all of the relevant facts and circumstances, including any information known as of the determination date.

1636. Divisional profits or losses are defined as the operating profits or losses separately earned or incurred by each CSA participant in its division from the CSA activity, determined before any expense (including amortization) on account of cost contributions, operating cost contributions, routine platform and operating contributions and non-routine contributions (including platform and operating contributions), as well as taxes (see Treas. Regs. § 1.482-7(g)(4)(iii)). It is not clear to the author as to which costs are left to deduct from the sales in order to produce an operating profit after all of the CSA-related costs are excluded. 1637. For the purpose of computing the present value of investments (PVI), PCT payments are all platform contribution transaction (PCT) payments due from a PCT payer before netting against PCT payments due from other controlled participants. 1638. Treas. Regs. § 1.482-7(i)(6)(iv)(A). An exception from this rule applies for publicly traded companies, for which the applicable discount rate (ADR) is the PCT payer’s weighted average cost of capital as of the date of the trigger PCT (see Treas. Regs. § 1.482-7(i)(6)(iv)(B)).

506



Periodic adjustments of buy-in pricing under the US regulations

16.6.3. Making a periodic adjustment: Applying the adjusted RPSM The periodic adjustment shall be carried out pursuant to the adjusted RPSM.1639 The adjusted RPSM is the specified RPSM for determining the initial buy-in pricing in Treas. Regs. section 1.482-7(g)(7) applied to determine the present value – as of the date of the trigger buy-in – of the buy-in payments, with some modifications to adapt the method to the periodic adjustment context, which the author will further explain.1640 First, the results projected by the taxpayer at the time at which the buy-in payment was determined are replaced with the actual results up through the determination date. Second, projected results for the remainder of the CSA period, as estimated by the IRS at the time of the reassessment, shall replace the original projected results, as estimated by the taxpayer at the time at which the buy-in payment was determined. Third, the adjusted RPSM, in contrast to the specified RPSM, is applicable even if only one of the parties to the controlled agreement furnishes unique intangibles.1641 However, if only one party contributes unique inputs to the CSA, the adjusted RPSM will allocate the entire residual profits solely to that party. The profit allocation is therefore similar to the CPM and, in particular, the income method. The author therefore finds it rather misleading to label the allocation method as a form of the RPSM. On the other side, if more than one controlled party to the CSA contribute unique inputs, the adjusted RPSM will allocate the residual profits among those participants, thus earning its label as a profit split method. However, as the lion’s share of audited CSAs presumably pertains to migration cases in which the US entity, as the only participant, furnishes preexisting intangibles to a CSA while funding comes from a foreign cashbox entity, the adjusted RPSM can, for practical purposes, be seen as an extension of the income method. This, as the adjusted RPSM reassessment, ensures that the actual returns experienced by the foreign subsidiary are equal to those that the income method would have allocated to it through the discounted-cash-flow-based buy-in amount at the outset of the CSA, had the actual results been known at that time and incorporated into the income-method buy-in calculation.

1639. Treas. Regs. § 1.482-7(i)(6)(v). 1640. Treas. Regs. § 1.482-7(i)(6)(v)(B). 1641. Treas. Regs. § 1.482-7(i)(6)(v)(B)(3).

507

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

A comment on the 2006 temporary regulations included the question as to whether it was consistent with the arm’s length standard to require the use of the adjusted RPSM, as the arm’s length standard calls for the best-method rule to be applied in all circumstances, and the adjusted RPSM may not be the best method in every circumstance. The US Treasury Department and the IRS replied that this issue was sufficiently addressed in the regulations, which require periodic adjustments to be administered in accordance with the arm’s length standard. Specifically, in determining whether to make periodic adjustments, the IRS may consider whether the outcome as adjusted more reliably reflects an arm’s length result under all relevant facts and circumstances. In the author’s view, the question is interesting, but ultimately, not of much relevance. The reason for this is that the adjusted RPSM in reality encompasses the allocation patterns of both the specified CPM and RPSM, as it is applicable regardless of the number of participants that contribute unique contributions to the CSA. It is therefore difficult to imagine a scenario in which the adjusted RPSM cannot be applied to yield an arm’s length result.

16.6.4. The procedure for making a periodic adjustment to a buy-in payment illustrated If it is concluded that a periodic trigger has occurred and that none of the exceptions to the periodic adjustment provision are applicable, the periodic adjustment to a CSA buy-in is determined using the steps below.1642 The list of steps may come across as overwhelming and abstract, but the author will go through an example of their application. (1) determine the present value of the buy-in payments pursuant to the adjusted RPSM, as of the date of the trigger buy-in; (2) convert the first step’s result into a stream of contingent payments on the base of reasonably anticipated divisional profits over the entire duration of the CSA activity, using a level royalty rate. The conversion is based on all information known as of the determination date; (3) apply the second step’s rate to the actual divisional profit for taxable years preceding and including the adjustment year to yield a stream of contingent payments for these years, and convert the stream into a present value as of the CSA start date;

1642. Treas. Regs. § 1.482-7(i)(6)(v)(A).

508



Periodic adjustments of buy-in pricing under the US regulations

(4) convert any actual buy-in payments up through the adjustment year to a present value as of the CSA start date, then subtract such amount from the third step’s result. Determine the nominal amount in the adjustment year that would have a present value as of the CSA start date equal to the present value determined in the previous sentence to determine the periodic adjustment in the adjustment year; (5) apply the second step’s level royalty rate to the actual divisional profit for each taxable year after the adjustment year up to and including the taxable year that includes the determination date to yield a stream of contingent payments for such years. The second step’s rate applied to a loss will yield a negative contingent payment for that year. Then, subtract from each such payment any actual buy-in payment made for the same year to determine the periodic adjustment for such taxable year; (6) for each taxable year subsequent to the year that includes the determination date, the periodic adjustment equals the second step’s rate applied to the actual divisional profit for that year. The second step’s rate applied to a loss for a particular year will yield a negative contingent payment for that year; and (7) if the periodic adjustment for any taxable year is a positive amount, it is an additional buy-in payment owed from the PCT payer to the PCT payee. If the periodic adjustment for any taxable year is a negative amount, it is an additional buy-in payment owed by the PCT payee to the PCT payer. The author will now go through an example of the periodic adjustment provision.1643 It pertains to a US parent that enters into a CSA with a foreign subsidiary to develop mobile phone technology. The parent contributes the rights to an in-process piece of technology, for which compensation is due from the subsidiary. The subsidiary has no platform contributions and no operating contributions. The parent and subsidiary agree to fixed buy-in payments of 40 in year 1 and 10 per year for years 2 through 10. At the beginning of year 1, the weighted average cost of capital of the group is 15%. In year 9, the Commissioner audits years 5 through 7 of the CSA and considers whether any periodic adjustments should be made. The foreign subsidiary experiences the actual results during the first 7 years as shown in table 16.1.1644

1643. Treas. Regs. § 1.482-7(i)(6)(vii), Example 1. 1644. All cash flows are assumed to arrive at the beginning of each year.

509

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

Table 16.1 Year

Sales

Non-CC* CC costs

PCT payments

Investments (PVI)

Divisional profit/loss

AERR 0

1

0

0

15

40

55

0

2

0

0

17

10

27

0

3

0

0

18

10

28

0

4

705

662

20

10

30

46

5

886

718

22

10

32

168

6

1,113

680

24

10

34

433

7

1,179

747

27

10

37

432

PV through year 5

970

846

69

69

138

124

0.90

PV through year 6

1,523

1,184

81

74

155

340

2.20

PV through year 7

2,033

1,507

93

78

171

526

3.09

* CC = cost contribution

All present values in table 16.1 are calculated as of the start date of the CSA. In any year, the present value of the cumulative investment (PVI) represents the present value of the cost contributions and PCT payments. The present value of the cumulative investments into the CSA through year 7 is 171. The present value of the cumulative divisional profit (PVTP) represents the present value of sales minus all costs apart from cost contributions and PCT payments. The present value of the cumulative divisional profit through year 7 is 526. The AERR is the present value of the divisional profit (PVTP) divided by the PVI, which is 526 ÷ 171 = 3.09. This is a periodic trigger, as the AERR for the subsidiary falls outside the PRRR of 0.67 to 1.5.1645 Thus, the PRRR allows a maximum return of 150% on the investments into a CSA before an examination is triggered. At the time of the audit, it is determined that the first adjustment year in which a periodic trigger occurred was in year 6, when the AERR of the subsidiary was 2.20 (340 ÷ 155). The periodic adjustments should therefore be made using year 6 as the adjustment year. The arm’s length buy-in payment from the subsidiary to the parent is determined for each taxable 1645. Treas. Regs. § 1.482-7(i)(6)(ii).

510



Periodic adjustments of buy-in pricing under the US regulations

year using the adjusted RPSM. Periodic adjustments shall be made for each year to the extent that the buy-in payments actually made differ from the arm’s length buy-in payment calculation under the adjusted RPSM. The question then turns to how the buy-in payment calculation is determined under the adjusted RPSM. The cost-shared intangibles will be exploited through year 10. The CPM-based return on the subsidiary’s routine value chain contributions is set to 8% of the non-cost-contribution costs. The residual profit from the cost-shared intangibles is calculated in the manner expressed in table 16.2.1646 Table 16.2 Year 1

Sales

Non-CC costs

0

0

Divisional profit/loss 0

CCs

Routine return

Residual profit

15

0

-15

2

0

0

0

17

0

-17

3

0

0

0

18

0

-18

4

705

662

43

20

53

-30

5

886

718

168

22

57

89

6

1,113

680

433

24

54

355

7

1,179

747

432

27

60

345

8

1,238

822

416

29

66

321

9

1,300

894

406

32

72

302

10

1,365

974

391

35

78

278

Cumulative PV through year 10 as of the CSA start date

3,312

2,385

927

124

191

612

The cumulative present value of the divisional residual profit through year 10 is 612. The periodic adjustments are calculated in a series of steps set out in Treas. Regs. § 1.482-7(i)(6)(v)(A). The first step is to determine a lump sum for the buy-in payment using the adjusted RPSM. Because only the parent made non-routine contributions 1646. Residual profits = sales − non-cost-contribution costs − cost contributions − routine return

511

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

to the CSA, the entire residual divisional profit constitutes the buy-in, allocable to the United States. This strips the entire residual profits from the subsidiary, which only receives an 8% normal market return on its routine contributions to the CSA. The second step is to convert the lump-sum buy-in payment that the subsidiary is obliged to make into a level royalty rate based on the reasonably anticipated divisional profit from the exploitation of the cost-shared intangibles. This is accomplished by selecting a royalty rate that will transfer all residual profits from the subsidiary to the parent over the lifetime of the CSA. The net present value of the divisional profits from the cost-shared intangibles over the 10-year life is 927. As seen in table 16.2, the present value of the residual profits over the 10-year life of the cost-sharing agreement is 612. Thus, in order to extract all residual profits from the total divisional profits, a royalty rate of 66% (612 ÷ 927) is required. The third step is to apply the 66% royalty rate to the actual results achieved by the subsidiary through year 6 and then determine the aggregate present value as of the start date of the CSA, as shown in table 16.3. Table 16.3 Year

Divisional profit

Royalty rate

Nominal royalty due under adjusted RPSM

Nominal payments made

1

0

66%

0

40

2

0

66%

0

10

3

0

66%

0

10

4

43

66%

28

10

5

168

66%

111

10

6

433

66%

286

10

224

74

Cumulative PV as of year 1

Periodic adjustment

302

The present value of the cumulative nominal royalty due under the adjusted RPSM through year 6 is 224. The present value of the cumulative buy-in payments actually made through year 6, as agreed in the controlled transaction, is 74. The difference between the present value of the cumulative nominal royalty and the present value of the actual buy-in payments is 150. This difference, representing a net present value as of the CSA start date, is then converted into a nominal amount as of the adjustment year, using 512



Periodic adjustments of buy-in pricing under the US regulations

the 15% discount rate. That nominal amount is 302,1647 which is also the periodic adjustment in year 6. Thus, through this periodic adjustment, the actual buy-in payments “catch up” to the arm’s length level of payments that should have been made in years 1-6. The next step is to determine the royalties due from the subsidiary to the parent for the years subsequent to the adjustment year, i.e. for year 7 through year 9 (the year including the determination date). These assessments are made for years 8 and 9 after the divisional profit for those years materializes. For each year, the periodic adjustment is a buy-in payment due in addition to the 10 buy-in payment required under the CSA. This periodic adjustment is calculated as the product of the step-two royalty rate and the actual divisional profit, minus the 10 that was otherwise paid for that year, in the manner expressed in table 16.4. Table 16.4 Year

Divisional profit

Royalty rate

Royalty due

PCT payments otherwise made

Periodic adjustment

7

432

66%

285

10

275

8

416

66%

275

10

265

9

406

66%

268

10

258

Under the last step, the periodic adjustment for year 10 (the only year after the year containing the determination date) is determined by applying the step-two royalty rate to the actually experienced divisional profit. This periodic adjustment is a buy-in payment from the subsidiary to the parent and replaces the payment of the 10 otherwise due (see table 16.5). Table 16.5 Year

10

Divisional profit 391

Royalty rate 66%

Royalty due 258

1647. 302 = 150 × 1.155

513

PCT payments otherwise made 10 (not paid)

Periodic adjustment 258

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

The periodic adjustment for year 10 is therefore 258.1648

16.6.5. Exceptions to the periodic adjustment provision 16.6.5.1. Introduction In sections 16.6.5.2.-16.6.5.6., the author will discuss the exceptions from the CSA periodic adjustment authority. No adjustment will be made to a buy-in payment if the taxpayer establishes that one of the exceptions is applicable.

16.6.5.2. Exception: The initial buy-in pricing is based on a CUT involving the same platform contribution The first exception to the periodic adjustment rule applies where the initial buy-in pricing was based on a CUT involving the same platform contribution as in the trigger buy-in, i.e. a “genuine” CUT.1649 Presumably, it will be highly rare that this exception is relevant, as the pre-existing intangible contributed to the CSA then would have to be used as the platform for further research in two parallel and independent R&D processes, i.e. the controlled CSA and an uncontrolled CSA with third parties.

16.6.5.3. Exception: Extraordinary events Second, an exception is made if the periodic trigger is due to extraordinary events beyond the control of the CSA participants that could not reason-

1648. Lastly, the regulations provide an example of a periodic adjustment in which a US parent enters into a CSA with three subsidiaries to develop version 2.0 of a computer program (see Treas. Regs. § 1.482-7(i)(6)(vii), Example 3). Only the parent makes a platform contribution, i.e. version 1.0 of the program, for which compensation is due from the three subsidiaries. The example applies the adjusted residual profit split method to allocate all residual profits from the three subsidiaries to the parent, using the exact same methodology described in the first example (see Treas. Regs. § 1.482-7(i) (6)(vii), Example 1, discussed in sec. 16.6.4.). 1649. Treas. Regs. § 1.482-7(i)(6)(vi)(A)(1). Under this CUT-based exception, the same pre-existing intangible has been contributed to an uncontrolled taxpayer under substantially the same circumstances as those in the controlled CSA and with a similar form of payment, typically a fixed compensation structure. This CUT serves as the basis for applying the CUT method in the first year and all subsequent years in which substantial buy-in payments are required to be paid.

514



Periodic adjustments of buy-in pricing under the US regulations

ably have been anticipated as of the date of the buy-in.1650 An example is provided in the US CSA regulations in which the facts are the same as in the example discussed previously,1651 with the exception that the first adjustment year in which a periodic trigger occurred was year 6, when the AERR of the subsidiary was 2.73.1652 Upon investigation as to what caused the high return in the market of the subsidiary in years 4 through 6, it becomes clear that competitors experienced severe and unforeseen disruptions in their supply chains, resulting in a significant increase in the market share of the controlled parties. Without this unforeseen event, the periodic trigger would not have occurred. It is therefore determined that no adjustments are warranted.

16.6.5.4. Exception: Reduced AERR does not cause a periodic trigger The third exception is rather technical and applies in the scenario in which a reduced AERR is not deemed to cause a periodic trigger. The exception came to life due to comments received on the 2006 temporary regulations, in which the argument was made that the definition of “divisional profits or losses” is overly broad and thus attributes too much value to the concept of the AERR, thereby making the numerator in the periodic adjustment calculation trigger disproportionately large relative to the denominator, and thus too easily triggered.1653 Essentially, the exception states what shall be included in the numerator (PVTP) in the calculation of the AERR. The exception applies when the periodic trigger would not have occurred if the tested parties’ (PCT payers) divisional profits or losses used to calculate its PVTP had taken into account both expenditures for operating cost contributions and routine platform contributions and excluded profits or losses attributable to its routine contributions to the exploitation of costshared intangibles, non-routine contributions to the CSA activity, operating cost contributions and routine platform contributions.1654 While the author finds it clear that operating cost contributions and routine platform contributions shall be deducted from the operating profits, he finds 1650. Treas. Regs. § 1.482-7(i)(6)(vi)(A)(2). 1651. See the discussion in sec. 16.6.4. 1652. Treas. Regs. § 1.482-7(i)(6)(vi). 1653. See the preamble to the final 2011 cost-sharing regulations (76 FR 80082-01). 1654. Treas. Regs. § 1.482-7(i)(6)(vi)(A)(3). With respect to divisional profit or loss, see supra n. 1636.

515

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

it peculiar that “profits or losses attributable to the … routine contributions … non-routine contributions … operating cost contributions and routine platform contributions” shall be excluded. In order to comply with this, profits or losses must be allocated for (i) operating cost contributions; (ii) routine platform contributions; (iii) routine operating contributions; (iv) non-routine platform contributions; and (v) non-routine operating contributions. No guidance is provided on how to separately allocate profits for these items. Even further, if profits or losses due to these items are excluded from the divisional operating profits or losses, it does not seem clear that there would be much left, resulting in a relatively small PVTP, and thus a relatively small AERR. That would again raise the risk of a periodic trigger occurring due to an AERR below the lower threshold of the PRRR. This exception should be clarified on this point, as the current text seems ambiguous.

16.6.5.5. Exception: Increased AERR does not cause a periodic trigger Fourth, an exception is made for the scenario in which an increased AERR is not deemed to cause a periodic trigger. The exception applies when the periodic trigger would not have occurred if (i) the divisional profits or losses of the PCT payer used to calculate its PVTP had included its reasonably anticipated divisional profits or losses after the adjustment year from the CSA activity, including from its routine contributions, operating cost contributions and non-routine contributions to that activity; and (ii) the cost contributions and PCT payments of the PCT payer used to calculate its PVI had included its reasonably anticipated cost contributions and PCT payments after the adjustment year. These reasonably anticipated amounts are determined based on all information available as of the determination date.1655 Information will then be available on the actual results for periods between the adjustment year and the determination date. The author assumes that the aim of the exception is to provide the taxpayer with an opportunity to prevent an adjustment in cases in which the results subsequent to the adjustment year have proven 1655. Treas. Regs. § 1.482-7(i)(6)(vi)(A)(4). The CSA participants may assume that the average yearly divisional profits or losses for all taxable years prior to and including the adjustment year in which there was substantial exploitation of cost-shared intangibles will continue to be earned in each year over a period equal to 15 years minus the number of exploitation years prior to and including the determination year.

516



Periodic adjustments of buy-in pricing under the OECD TPG

to not be as great. This may be relevant when the periodic trigger occurs “mid-stream”. The rationale is likely that the CSA may, over a longer period, yield lower returns that, over the life of the CSA, will bring the overall CSA return down to a level that lies within the PRRR.

16.6.5.6. Exception: Cut-off rule The fifth exception is a cut-off rule. If the AERR is within the PRRR for each year of a 10-year period beginning with the first taxable year in which there is substantial exploitation of cost-shared intangibles resulting from the CSA, there will be no periodic adjustment in the following years. Further, there will be no adjustment if the AERR falls below the lower bounds of the PRRR in any year of a 5-year period beginning with the first taxable year in which there is substantial exploitation of cost-shared intangibles.1656

16.7. Periodic adjustments of buy-in pricing under the OECD TPG The 2017 OECD TPG do not provide any specific guidance on periodic adjustments of CSA buy-in payments, but state that the general HTVI guidance shall be applied analogously.1657 CSAs are complex instruments that historically have been used to migrate unique intangibles of considerable value out of high-tax jurisdictions. It may be difficult to ascertain, on an after-the-fact-basis, whether the initial pricing valuation was at arm’s length. It seems rather obvious that the lack of guidance on how to apply the OECD’s periodic adjustment provision to buy-in payments may cause significant controversy among treaty partners. The core message of the new 2015 CSA guidance is that a cash-box funding entity participating in a CSA should only be allocated a risk-adjusted rate of return on its funding contribution so that the residual profits are allocated to the jurisdiction in which the intangible value was created (where R&D is carried out). In order to enforce this intention, it may be necessary to carry out periodic adjustments to strip the foreign funding entity of any excess profits on top of the risk-adjusted rate of return that may accumulate to it as a result of its actual profits being higher than the profits projected at the time at which 1656. Treas. Regs. § 1.482-7(i)(6)(vi)(B)(1); see also § 1.482-7(i)(6)(vi)(B)(2). 1657. OECD TPG, para. 8.9.

517

Chapter 16 - Periodic Adjustments of Controlled IP Transfer Pricing

the buy-in was calculated. It is not clear how this shall be accomplished by applying the HTVI guidance analogically. It may seem that the only possible solution is to align the buy-in price with the actual profit data in cases in which the discrepancy between the projected and actual profit data exceeds the allowed +/- 20% range. Given the amount of complexity in calculating a buy-in amount and taking into consideration the projected R&D costs and the risk-adjusted rate of return, as well as the time that may pass from the formation of the CSA and recognition of the buy-in amount until the cost-shared intangibles are fully developed and may be exploited, the author questions whether the periodic adjustment authority will be practicable in the context of CSAs without more detailed guidance. There is a risk that a lack of guidance may lead to diverging practices among treaty partners, and thereby double taxation. The OECD should address this issue as soon as possible, as effective operationalization of the buy-in pricing methods is reliant on proper enforcement through periodic adjustment rules, akin to those of the US regulations.

518

Chapter 17 The Allocation of Residual Profits to a Permanent Establishment 17.1. Introduction In order to gain a representative impression of how intangible operating profits are allocated under international tax law, it is imperative that articles 7 and 9 of the OECD Model Tax Convention (OECD MTC) are viewed together, as they express the same allocation norm, i.e. the arm’s length principle. Both articles allocate business profits between two jurisdictions, albeit on different levels within a multinational. More specifically, articles 7 and 9 allocate profits between two parts of the same legal entity and two different group entities, respectively. Article 7 avoids juridical double taxation by way of determining the maximum amount of profits taxable in the source jurisdiction, and thus the maximum amount that a residence state is obliged to provide relief for.1658 Article 9 avoids economic double taxation by way of allocating profits between two residence states. To the extent that an amount of profit is allocable to one of the jurisdictions, the other must make a corresponding adjustment to exclude the same amount from taxation there. In this chapter, the author will discuss how profit allocation issues that arise when a permanent establishment (PE) provides input to an intangible value chain shall be resolved under the OECD MTC.1659 Brief comments will also be tied to the treatment under the UN MTC. The question of how IP ownership shall be assigned to PEs under the OECD MTC, however, will be analysed first in chapter 25 so that the discussion can be seen in light of the analysis of the 2017 OECD Transfer Pricing Guidelines (OECD TPG) on intangible property (IP) ownership in part 3 of the book.

1658. See also the OECD Commentary on Article 7, para. 27. 1659. For fairly recent discussions of the allocation of profits to permanent establishments (PEs), see, e.g. Russo (2005); Schön (2007); and Pereira (2009). See also Edgar (2005); Malherbe (2010); Sharma (2008); Baker et al. (2006); Bennett et al. (2005); and Kobetsky (2011).

519

Chapter 17 - The Allocation of Residual Profits to a Permanent Establishment

17.2. Historical background Even though the PE concept originates from the model agreement developed by the League of Nations in the 1920s, the rules for allocating operating profits among the head office and a PE remained pronouncedly ambiguous and divisive until 2010.1660 No uniform allocation pattern was adhered to in practice. Multinationals likely exploited this ambiguity to support modest profit allocations, resulting in growing discontent among OECD jurisdictions. In light of this, the OECD, in the 1990s, embarked on a project to revise the basic methodology for allocating profits to PEs. This led to a notable discussion draft in 2001,1661 which observed that “there is no consensus amongst the OECD Member countries as to the correct interpretation of Article 7. This lack of a common interpretation and consistent application of Article 7 can lead to double, or less than single taxation”.1662 The project initially embraced the paradigm that the article 7 allocation rules should not be influenced by the transfer pricing concepts developed under article 9. The explanation for this approach is to be found in the historically rooted way of thinking that PEs were markedly different from related group companies, even though both articles 7 and 9 pertain to the allocation of business profits.1663 A significant methodological breakthrough was reached when the OECD acknowledged that the article 9 transfer pricing principles should be applied by analogy for the purpose of allocating profits to a PE.1664 This thinking resulted in the OECD’s landmark 2008 Report.1665 This progressive report diverged significantly from the material content of the allocation rules contained in the Commentary on Article 7 at 1660. For a historical overview, see the 1992 IFA General Report in Maisto (1992), at pp. 62-72. For an informed discussion of the attribution of profits to PEs under the pre2010 article 7 regime with an emphasis on agent schemes, see Vann (2006). 1661. Discussion draft on the attribution of profits to permanent establishments (OECD 2001) [hereinafter the 2001 OECD PE Draft]. 1662. 2001 OECD PE Draft, preface, para. 2. 1663. For the views of a proponent of the historical school of reasoning, see Vann (2003), at p. 163, as well as pp. 143 and 157. 1664. On the gradual gravitation of the OECD towards applying a transfer pricing approach to allocate business profits to PEs, see the (critical) comments in Vann (2003), at pp. 137-139. For critical comments on the authorized OECD approach transfer pricing analogy, see Schön (2010a), at p. 252. 1665. OECD, Attribution of Profits to Permanent Establishments (OECD 2008) [hereinafter 2008 Report]. It was found necessary to amend the commentaries to reflect the new principles drawn up in the Report. This proved problematic, as the wording of art. 7 of the OECD Model Tax Convention (OECD MTC) itself formed a restriction on how far the commentaries could go in adapting the material solutions contained in the Report.

520



Historical background

that time, also with respect to the allocation of residual profits from unique IP. The historical OECD position on IP was that the principles developed under the OECD TPG “cannot be applied in respect of the relations between parts of the same enterprise”,1666 and that “it may be extremely difficult to allocate ‘ownership’ of the intangible right solely to one part of the enterprise and to argue that this part of the enterprise should receive royalties from the other parts as if it were an independent enterprise”. These dismissive statements made it difficult to allocate residual profits to a PE, regardless of the extent to which it had contributed to the development of the IP that generated the profits.1667 Further, the 2008 commentaries seemingly allowed asymmetrical allocations, in the sense that costs – but not income – resulting from IP development could be attributed to a PE. No rationale was provided as to why this should be sensible. The profit allocation result of the 2008 commentaries was likely that residual profits from intra-group-developed IP were more or less always extracted from the source jurisdiction. It goes without saying that this was detrimental to an equitable distribution of operating profits among jurisdictions. In 2010, a new version of article 7 was introduced, allowing full incorporation of the allocation principles developed in the 2008 Report.1668 The report itself was updated in 2010 to incorporate references to the new language of article 7,1669 but its material content was not altered from the 2008 version. 1666. See 2008 OECD Commentary on Article 7 (as it read before the 22 July 2010 revision, available in the 2008 update to the OECD Model Tax Convention), para. 34. 1667. It could be argued that these 2008 commentaries were in conflict with the wording of OECD MTC art. 7(2) itself, expressing the fundamental separate entity approach. It seems fairly obvious that there must be scenarios in which a PE should be entitled to residual profits, as unrelated enterprises would demand compensation for their intangible development contributions. 1668. For the purpose of interpreting tax treaties based on the pre-2010 version of art. 7, the revised 2008 commentaries must be applied. While the 2008 Report serves as a background, there are limits as to how far it may influence the interpretation. Its guidance on IP, services and internal debt (the core of the 2008 Report) is clearly incompatible with the allocation paradigm of the pre-2010 version of art. 7 and the revised pre-2010 commentaries. Over time, this problem will eventually become irrelevant, as new treaties will likely be based on the 2010 version of art. 7. There are new treaties that have adopted the 2010 art. 7 approach to profit allocation, e.g. the Convention between the Kingdom of Norway and the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains (14 Mar. 2013), Treaties IBFD. More will hopefully follow soon. 1669. OECD, Report on the attribution of profits to permanent establishments (OECD 2010) [hereinafter 2010 Report].

521

Chapter 17 - The Allocation of Residual Profits to a Permanent Establishment

The discussion here is limited to the 2010 version of article 7. This is the only version relevant to future treaties based on the OECD model. For this version, the 2010 Report reigns as the supreme source of interpretation.1670 The report emphasizes that its transfer pricing approach is based on applying the OECD TPG by analogy.1671 It is specifically stated that, to the extent that the OECD TPG are modified in the future, the 2010 Report should be applied by taking into account the guidance in the OECD TPG as modified from time to time.1672 This is a key point, in particular with respect to IP, as the 2017 OECD TPG on the issue of IP ownership and transfer pricing of IP depart significantly from the solutions drawn up in the previous 1995/2010 versions of the OECD TPG. Thus, to the extent that there is a conflict between the allocation guidance contained in the 2010 Report and the 2017 OECD TPG (which there is), the latter prevails.

17.3. The relationship between articles 7 and 9 The author would like to point out two noteworthy differences between articles 7 and 9 with respect to profit allocation.1673 First, an article 9 allocation is potentially more attractive for profit shifting purposes than an article 7 allocation. A residence state will normally opt to provide relief under article 7 by way of credit for taxes paid in the source state as opposed to the exemption method. This will effectively ensure that the multinational is only relieved of residence taxation to the extent that is taxed on its sourcestate profits. There is no similar mechanism under article 9. If an amount of profit is allocable to residence jurisdiction 1, there will be a requirement for residence jurisdiction 2 to exclude the amount from taxation, regardless of whether it has been taxed in residence jurisdiction 1. In effect, relief under article 9 is limited to an exemption method. Second, there is a “cliff effect” associated with article 7, which lacks a parallel under article 9. Only if a PE is deemed to exist will allocation under article 7 be triggered. Profit allocation is thus contingent on there being a PE. The PE threshold is due to the fundamental system of the distributive rules of the OECD MTC, which provide exclusive taxation rights for the residence jurisdiction in the absence of a specific exception allowing the source state to tax a particular item of income (in this case, the identifica1670. See OECD Commentaries, art. 7, para. 9. 1671. 2010 Report, preface, para. 10. 1672. Id. 1673. See also Vann (2003), at p. 151, on the relationship between profit allocation under arts. 7 and 9.

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tion of a PE).1674 This two-tiered character of the PE rule has caused tension between article 7(1) (governing whether a PE exists) and article 7(2) (governing the profit allocation) in the sense that a taxpayer will be able to entirely avoid profit allocation to a source state as long as a PE is not deemed to exist. There has been widespread exploitation of this “cliff” by multinationals, as amply illustrated through the use of commissionaire structures to avoid PE status.1675 Thus, now close to a century after the inception of the PE concept in international tax law, it can be observed that the principles for allocating operating profits between a head office and a PE under article 7 of the OECD MTC represent loyal applications of the basic transfer pricing concepts developed under article 9. The substantial difference between the transfer pricing rules under article 9 and the PE rules under article 7 lies not in the material content of the allocation rules, but in the fact that the PE threshold must be surpassed in order to trigger profit allocation to the source jurisdiction under article 7, while no similar threshold applies under article 9.

17.4. The article 7 profit allocation system 17.4.1. Introduction Article 7(2) of the OECD MTC determines the following: [A PE shall be allocated the operating profits] it might be expected to make, in particular in its dealings with other parts of the enterprise, if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the permanent establishment and through the other parts of the enterprise.

To operationalize this approach, the 2010 Report assigns economic ownership of assets, capital and risks to the PE, resulting in income and deduc1674. See art. 1 OECD MTC, which sets out that the model only applies when one of the persons involved is resident in one of the contracting states; and art. 21, para. 1 OECD MTC, which states that any income of a resident that has not specifically been allocated to the source state (through the distributive rules) is taxable only in the residence state. Art. 7 bestows upon the source state the right to tax business profits earned there if the multinational “carries on business … through a permanent establishment situated therein”. 1675. See OECD, Preventing the Artificial Avoidance of Permanent Establishment Status – Action 7: 2015 Final Report (OECD 2015), International Organizations’ Documentation IBFD [hereinafter 2015 Action 7 Report].

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tions. The underlying chain of reasoning is that assets give rise to risks, which then must be allocated capital, parts of which will be interestbearing and give rise to interest deductions in the profit calculation for the PE.1676 Additional profits are allocated on the basis of assigning related and unrelated transactions to the PE, as well as recognizing its dealings with the head office. To frame the discussion of the IP transfer pricing issues for PEs (as well as the IP ownership issue discussed in chapter 25), the author will tie some comments to the 2010 profit allocation system.

17.4.2. Assignment of assets, capital and risk to the PE The concept of “significant people functions” plays a fundamental role in the profit allocation regime drawn up in the 2010 Report.1677 Its primary purpose is to assign economic ownership of assets and risks to a PE, including economic ownership of IP, both internally developed and externally acquired.1678 While it is clear that the significant-people-functions concept pertains to the identification of functions of elevated importance for profit allocation purposes, the 2010 Report ironically makes no attempt to define the term,

1676. 2010 Report, part 1, paras. 21-26. 1677. See also Schön (2007), sec. III.A.1; and Oosterhoff (2008). For critical comments on derivative applications of the concept for the purpose of allocating risk among group entities, see Schön (2014), at pp. 20-22. See also the discussion in sec. 6.6.5.5.2. 1678. 2010 Report, part 1, para. 18. In contrast, the parameter for assigning economic ownership of tangible assets is “use”, i.e. where the asset is physically located (see 2010 Report, part 1, para. 194). The profits allocable to a PE as a result of its ownership of tangibles should, in theory, be unaffected by whether the use or significant people functions comprise the allocation key. Assume, for instance, that an oil platform is used by a PE, while the significant people functions are performed at the head office. If use is the allocation key, the PE is deemed the owner and is allocated depreciation deductions and interests expenses on external debt financing. Conversely, if the significant people functions are applied as the allocation key, the PE will be deemed to lease the platform and will be allowed deductions for lease payments. The view of the OECD was that, over time, the depreciation and interest deductions would equal the deductible lease payments. Nevertheless, the short-term profits allocable to the PE will differ, with more deductions initially in the owner scenario. Both approaches may be difficult to apply in practice. In the ownership scenario, it may be difficult to determine the basis for depreciating relatively “unique” tangibles and attribute capital to the PE. The lease scenario may be challenging with respect to assets that have no clear significant people functions attached, e.g. assets that rely on) “stop/go” orders. Of course, the location where an asset is used may coincide with the place where the significant people functions are performed, as typically will be the case for financial assets; see the 2010 Report, para. 20.

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under the reasoning that the significant functions will vary among business sectors.1679 Nevertheless, the author finds it clear that the core of the concept is to allocate profits to the part of the enterprise where the significant financial risk-taking functions are carried out. Over two thirds of the pages of the 2010 Report pertain to profit allocation to PEs of banks, insurance companies and global trading enterprises. Significant functions for such PEs are referred to as “key entrepreneurial risk-taking” (KERT) functions.1680 These functions “require active decision-making with regard to the acceptance and/or management (subsequent to the transfer) of individual risks and portfolios of risk”.1681 The OECD drafted part 2 of the 2010 Report on profit allocation to PEs of banks before the general guidance in part 1 was penned. An unfortunate consequence of this seems to have been that the KERT-functions concept was uncritically carried over to govern also the assignment of economic ownership of assets to PEs outside the financial sector, even though financial risks do not necessarily drive value creation to the same extent in other sectors as in the financial industry.1682

1679. 2010 Report, part 1, para. 16. 1680. See 2010 Report, part 2, paras. 8-11. See also Vann (2006), at p. 378, on key entrepreneurial risk-taking (KERT) functions. 1681. 2010 Report, para. 8. The OECD Discussion draft on the attribution of profits to permanent establishment – Part I: General considerations (OECD 2004) [hereinafter the 2004 PE draft] applied the term “KERT functions” (as opposed to the concept of significant people functions) to assign economic ownership of assets (including internally developed IP) also outside of the financial, insurance and global trading sectors; see 2004 PE draft, para. 228. It can be observed that the 2004 description of KERT functions in the context of IP development is almost identical to the description of significant people functions in the 2010 Report. The factual pattern in InverWorld, Inc. v. CIR, T.C. Memo. 1996-301 (Tax Ct., 1996), seems to illustrate “typical” KERT functions. At issue was whether a Cayman Islands-incorporated company, Inverworld Limited (LTD), was taxable in the United States through its wholly owned US subsidiary, Inverworld Inc (INC), under US domestic law. LTD was not afforded treaty protection, as there was no tax treaty between the United States and the Cayman Islands. The question was whether LTD was engaged in trade or business within the United States. If so, it would be taxable on income effectively connected to the conduct of such trade according to IRC sec. 882(a)(1) and Treas. Regs. § 1.864-4(c)(5)(i). LTD advised and sold financial services to external clients and received client funds to invest. LTD carried out a range of functions and transactions in the United States through INC, including receiving funds, placing loans, monitoring interest rates, valuing portfolios, dispersing dividends and interests and selling and purchasing financial instruments. LTD also supplied funds to INC, and INC acted almost exclusively for LTD and LTD’s clients. Had the case been assessed under art. 7 of the OECD MTC, the author finds it likely that the KERT functions would indeed have been identified at the level of the US PE. 1682. Precisely why the key functions for being assigned economic ownership of assets for non-financial PEs were renamed from “KERT functions” in the 2004 PE draft to “significant people functions” in the 2010 Report is unclear. Perhaps it was to stress the distinction between financial and non-financial businesses; see Schön (2007), at sec.

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The part of the enterprise that is assigned economic ownership of IP will be entitled to “the income attributable to the ownership of the asset, such as royalties; the right to depreciate a depreciable asset; and the potential exposure to gains or losses from the appreciation or depreciation of the asset”.1683 Thus, in order for a PE to be allocated residual profits, it must first be assigned economic ownership of the IP in question (pursuant to the significant-people-functions doctrine). This IP ownership issue is analysed in depth in chapter 25. At this point, the author will just make one observation that relates to the significant-people-functions doctrine. In the context of assigning economic ownership to internally developed IP, the 2010 Report specifically states that the main risk is losing the research and development (R&D) investment.1684 This point of view originates from the 2004 OECD discussion draft on the allocation of profits to PEs, in which it was stated that “performance of the development function(s) does not of itself determine the legal ownership. Rather the key issue is which enterprise acts as the entrepreneur in deciding both to initially assume and subsequently bear the risk associated with the development of the intangible property”.1685 Aligned with this, the 2010 Report allocates economic ownership to intragroup developed IP to the part of the enterprise that assumes or manages the financial development risks. As the author will revert to in chapter 25, this 2010 position stands in stark contrast to the position taken by the OECD on IP ownership of manufacturing IP in the 2017 OECD TPG.1686 The 2010 focus on R&D-funding facilitated BEPS, as multinationals placed funding risk in low-tax jurisdictions. Also, the 2010 Report ignored that R&D is the dominating IP value driver in a transfer pricing context and should thus be determinative for the allocation of residual profits.1687 Further, once the PE has been allocated economic ownership of IP and other assets, the question will be how much capital should be assigned to the PE. The 2010 Report states that the PE should have “sufficient capital III.A.1. However, as the alteration pertained solely to the “labelling” of the relevant functions as opposed to the underlying material guidance, the author finds that strange. A more likely explanation may be that there were concerns that the “KERT” terminology could influence the interpretation of the PE threshold; see Bell (2007). 1683. See 2010 Report, footnote 4. 1684. 2010 Report, para. 89. 1685. See 2004 PE draft, para. 227. 1686. See the analysis in ch. 22. 1687. See the discussions in secs. 21.2. and 22.2. on value drivers in IP development.

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to support the functions it undertakes, the assets it economically owns and the risks it assumes”.1688 Capital is attributed to a PE based on the value of its assets.1689 The valuation may be based on a variety of parameters, including financial accounting value, R&D costs, purchase price and market value.1690 Valuations of unique IP tend to be subjective and may serve to increase the total amount of assets (and thereby the interest-bearing capital) allocable to the PE. In order to avoid speculative tax planning, the valuation of externally acquired and internally developed IP should arguably be restricted to their purchase price and R&D costs, respectively.1691 The 2010 Report requires additional free capital to be allocated to the PE if it incurs entrepreneurial risks, for instance, through the development of marketing IP in the source state without reimbursement of expenses from the head office.1692 The allocation of capital to the PE cannot, in these cases, be based on asset value alone. The additional free capital requirement applies also in the context of the internal development of manufacturing IP, to support the risk of the R&D efforts failing,1693 as well as for risks connected to the subsequent IP exploitation (e.g. product liability risks). The capital allocated to the PE cannot, in its entirety, be interest-bearing. A portion of it must be “free” so that source-state operating profits are not fully extracted through the payment of interest expenses to a foreign head office.1694 The 2010 Report does not recognize interest expenses on internal debt from the PE to the head office.1695 Thus, the issue of allocating interest-bearing debt to the PE pertains only to the question of how much of the enterprise’s external loans may be allocated to the PE.1696 The 2010 1688. 2010 Report, para. 28. 1689. 2010 Report, para. 109. 1690. 2010 Report, paras. 109-111. 1691. It should be noted that a multinational would likely not want to inflate its IP values in the source jurisdiction for the purpose of maximizing its local interest deductions. A high value may be problematic if it later wants to migrate the IP to a different jurisdiction, as the income tax transfer charge will be bigger. 1692. 2010 Report, para. 111. 1693. 2010 Report, para. 89. Relevant research and development (R&D) costs will be the salaries of the researchers, costs for property and equipment and costs for the use of pre-existing IP owned by unrelated or related parties or by the head office. 1694. See 2010 Report, part 1, para. 32. 1695. See 2010 Report, paras. 157-158. 1696. The fact that deductions for internal “interest payments” are completely cut off under art. 7 is a surprisingly progressive solution. When source states have domestic thin capitalization rules that allow interest deductions on internal debt within certain

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Report provides an ambiguous answer to this question, as the OECD member countries did not reach a clear consensus on the methodology. The 2010 Report accommodates a range of methods.1697 The 2010 Report also leaves considerable leeway for determining the interest rate on the debt portion of the PE’s capital. As this pertains to external loans, the rate itself is at arm’s length. The problem, however, is to determine which of the enterprise’s external loans should be deemed to be included in the debt of the PE.1698 This is a matter of causality, and not a simple one. The multinational and the source state will be incentivized to allocate loans with high and low interest rates to the PE, respectively.

17.4.3. Assignment of transactions and dealings to the PE The last part of the article 7 profit allocation system pertains to the assignment of profits from transactions and dealings to the PE.1699 First, a PE shall be allocated operating profits from transactions between the enterprise and unrelated and related enterprises as are properly attributable to the PE.1700 This allocation hinges on the identification of “those of the

limits (e.g. 30% of taxable EBITDA), the source and residence jurisdictions take on more or less burdens in the form of more or less interest deductions, respectively, than intended by the 2010 Report. It is the domestic law prerogative of source states to do so. 1697. The capital allocation approach assigns a portion of the free capital of the enterprise to the PE based on the proportion of assets allocated to the PE relative to the total assets of the enterprise (if the PE is allocated 10% of the assets, it will receive 10% of the free capital); see the 2010 Report, paras. 121-127. The economic capital approach allocates free capital based on a wider range of risks (e.g. R&D risks); see the 2010 Report, para. 128. The thin capitalization approach requires a PE to have the same amount of free capital as a comparable independent enterprise; see the 2010 Report, paras. 129-133. A safe-harbour method is also allowed (and other methods particular to insurance enterprises); see the 2010 Report, para. 139 and part IV. See also the discussion in the 2010 Report in paras. 99-149, as well as the statement in para. 147. There seems to be tension between this methodological freedom and the premise that the PE should have the same creditworthiness as the enterprise as a whole (implying a similar capital structure); see the 2010 Report, part 1, para. 30 and paras. 99-101. 1698. Two basic methods are used to determine the interest rate on PE debt funding. The first is the tracing method, pursuant to which all internal movements of funds between the head office and the PE are traced back to the unrelated lender. The PE is then allocated the same interest rate as the lender charged. The second is the fungibility approach, which disregards the actual movement of funds and allocates a portion of the actual interest expenses on the external debt of the enterprise based on a predetermined allocation key. 1699. 2010 Report, para. 44. 1700. 2010 Report, para. 98.

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enterprise’s transactions with separate enterprises which should be hypothesised to have been entered into by the PE”.1701 The 2010 Report finds that it should be possible to determine this by way of a functional analysis of the enterprise, taking into account the functions, assets and risks of the PE. Second, a PE shall be allocated operating profits from dealings between the PE and other parts of the enterprise, i.e. a form of “deemed transactions”. With respect to dealings in which IP is transferred between the head office and the PE, an analytical challenge will be the lack of a controlled agreement that transfers the rights to the IP. It will therefore not be clear at the outset as to which particular rights are purportedly conveyed to the PE. It is, however, important not to exaggerate the significance of this issue. In substance, the same problem is present in the context of the transfer pricing of IP under article 9, because one cannot take for granted that the specification of transferred rights in a written controlled agreement is aligned with the economic substance of the actual behaviour of the controlled parties. Only a thorough and careful functional analysis will reveal whether that is the case. If it is not, the terms that may be deduced from the actual behaviour will prevail for pricing purposes. For example, it may be possible to observe how the multinational has organized its distribution in other markets and to interpret the dealing in light of this, e.g. it may be that it uses local subsidiaries in common-law countries to distribute, market and sell products, which license rights to marketing intangibles. In civil-law countries, it may use commissionaire structures. To the extent that any PEs are triggered in the civil-law countries, it may logically be assumed that they have similar rights to the relevant marketing intangibles as the local subsidiaries in the common-law countries, provided that the PEs and subsidiaries contribute similar value chain inputs.

17.5. Transfer pricing of the IP transactions and the dealings of a PE The allocation of profits to a PE from its participation in transactions can be computed directly in the case of third-party transactions, and through article 9 of the OECD MTC in the case of related-party transactions.1702 With respect to the dealings of the PE, profit allocation shall, under the authorized OECD approach, be based on “a comparison of dealings between

1701. Id. 1702. Id.

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the PE and the enterprise of which it is a part, with transactions between independent enterprises”.1703 Such benchmarking shall be carried out through analogical application of the OECD transfer pricing methodology set out in the 2017 OECD TPG. The author refers to his earlier discussions of the transfer pricing methods, in particular the transactional net margin method (TNMM) and the profit split method (PSM),1704 for a detailed analysis of how IP income shall be allocated among the related contributors to an intangible value chain. The following discussion is limited to comments on the particular profit allocation issues touched upon in the 2010 Report, with respect to dealings that distribute rights to use IP among different parts of an enterprise. In order to extract as much profit from the source state as possible, multinationals will typically assert that the head office is the economic owner of IP employed in the value chain for a product that is sold in the source state. The key issue will then be to identify which rights to the IP have been made available to the PE. It may, for instance, be that the PE begins to make use of a marketing intangible developed by the head office. If this qualifies as a dealing, it must be priced as a deemed “licence”.1705 An arm’s length notional royalty rate for the licence should then be deducted in the calculation of the profits of the PE.1706 Source-state deduction for such deemed payments from the PE to the headquarters is problematic in the views of some jurisdictions.1707 These states are concerned that such deductions can trigger the issue of whether the source state should be allowed to levy withholding tax on the deemed payments, in order to ensure equal treatment of PEs and subsidiaries and to avoid base erosion. For the purpose of determining the amount of the notional royalty deduction, an important issue will be to determine whether the rights conveyed to the IP are exclusive or not. This will affect the pricing, as an exclusive right will normally be more valuable than a non-exclusive right. The fact that the head office made IP available to a PE does not in itself imply that 1703. 2010 Report, para. 183. 1704. See chs. 8 and 9 for an analysis of the transactional net margin method and the profit split method, respectively. 1705. 2010 Report, para. 206. 1706. 2010 Report, para. 209. The 2010 Report uses the term “might”, but the author cannot see any reason as to why there should be uncertainty surrounding the ability to deduct such royalty payments for the purpose of calculating the profits allocable to the PE, provided that it has been established that the PE should be deemed a “licensee”. 1707. See para. 29 of the OECD Commentaries on the Article 7 of the OECD MTC (2010).

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that the PE has obtained an exclusive right to the IP.1708 In cases in which the PE carries out manufacturing or distribution in the source state and there are no other parties that make or sell the same products in this geographical market, it should likely be assumed that the PE has carried out a dealing with the head office, pursuant to which it “licenses” exclusive rights to make or sell the products through the use of the related manufacturing and marketing intangibles. This will reduce the profits allocable to the source jurisdiction relative to what would be the case if the conveyed rights to the intangible were deemed to be non-exclusive. Conversely, when the PE is deemed to be the economic owner of the IP, it shall be allocated all residual profits from the IP in question. If the intangible economically owned by the PE is being used in a value chain where there are no other unique inputs, the TNMM may be used to allocate a normal market return to the head office and other group entities that provide routine inputs. The residual profits are allocable to the PE. If there are other unique inputs in the value chain, the PSM should be applied to split the residual profits among the intangible owned by the PE and the other unique intangibles, pursuant to their relative values. Further, it may be that the enterprise has licensed an intangible from a third party. The economic ownership to the licensed right may be allocated to one part of the enterprise, which then makes it available to another part. In these cases, the dealing must be priced, either as an outright transfer of the ownership or as a licence.1709 Should the PE be deemed to have acquired the intangible or an interest in it, the PE should be entitled to depreciate the cost base, subject to source country rules on depreciation.1710 Further, the 2010 Report contains guidance on the treatment of dealings akin to cost-sharing arrangements (CSAs) between an enterprise and its PE. Chapter VIII of the 2017 OECD TPG must be applied analogically to allocate profits from such “CSA” dealings.1711 As a PE is not a separate legal entity, the identification through a functional and factual analysis of a “CSA” between the enterprise and its PE will be a purely notional construct for the purpose of aiding in the allocation of profits to the PE.1712 The 2010 Report uses the term “economic CCA” (cost 1708. 2010 Report, para. 207. 1709. 2010 Report, para. 210. 1710. 2010 Report, para. 208. 1711. See 2010 Report, preface, para. 10. 1712. See 2010 Report, para. 213.

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contribution arrangement).1713 A typical situation will be that in which IP that has been developed by one part of the enterprise shall be further developed by the enterprise as a whole.1714 Two relatively clear instructions can be read in the 2010 Report. First, if one part of the enterprise has developed pre-existing IP and contributes it to an R&D arrangement with other parts of the enterprise (the purpose of which is to further develop the pre-existing IP), the other parts must make a buy-in payment.1715 Thus, the other parts of the enterprise are treated as having acquired an interest in the pre-existing IP. The buy-in amount shall be set so that it allocates the residual profits to the part of the enterprise that carries out important R&D functions, and limits the return to the part of the enterprise that only contributes IP development funding to a risk-adjusted rate of return. Second, if the PE is found to have acquired only make-sell rights to the pre-existing IP (as opposed to a beneficial interest in the IP itself), no buyin requirement is triggered. In these cases, a notional royalty paid from the PE to the head office for the use of the IP may be attributed based on applying the transfer pricing methods by analogy. The TNMM should be a likely candidate to allocate a normal market return to the PE in such cases.

17.6. Allocation of operating profits to a dependent agent PE 17.6.1. Introduction A source state will only be entitled to tax the profits of a non-resident enterprise if it has a PE there.1716 A PE will not be deemed to exist if the enter1713. 2010 Report, para. 215. A range of practical issues will necessarily arise in these “deemed” cost-sharing arrangement (CSA) scenarios. As contracts will be absent between parts of the same enterprise, countries may, in order to accept the existence of deemed CSAs, require a multinational to meet a “significant threshold” in order to provide reliable evidence of its position that a notional CSA is established between the head office and a PE; see the 2010 Report, paras. 211 and 214-215. Further, when there is no contemporaneous documentation available to support the claim, an enterprise cannot claim the existence of a notional CSA after the fact. 1714. 2010 Report, para. 211. 1715. Id. 1716. OECD MTC, art. 7(1). The allocation of profits to a PE under US law relies on the “effectively connected” provisions of the IRC; see IRC sec. 882(a)(1). Newer US treaties contain language that allows the profit allocation to be based on the approach taken in the 2008 Report. The United States will likely not allow the approach under older treaties; see Zollo (2011), at p. 764. The question may be raised as to whether a

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prise merely carries on business through an agent of independent status.1717 If, however, a person other than an agent of independent status (i) acts on behalf of the enterprise in the source state and has, and habitually exercises, authority to conclude contracts in its name; or (ii) pursuant to the 2015 BEPS revision of article 5 of the OECD MTC, habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise,1718 a PE will be deemed to exist.1719 Such a PE is known as a dependent agent PE, the allocation of operating profits to which will be the topic of discussion in this section.1720 The author is interested in this for two reasons. First, multinationals have used certain agent schemes for distribution, marketing and sales of products based on unique IP in order to lower the amount of operating profits allocable to the source state.1721 Second, there is a peculiar – and rather ambiguous – relationship between article 9 and article 7 in these cases that must be clarified, as it will often have consequences for the allocation of operating profits from intangible value chains.

17.6.2. A lead-in to the discussion When there is a dependent agent PE, the source country will have taxing jurisdiction over two different entities. The first entity is the dependent agent enterprise. Typically, this is a subsidiary resident in the source state that has contracted to sell products for its foreign parent in return for a local US R&D subsidiary will constitute a PE of the foreign parent. The R&D activity will generally not be seen as preparatory or auxiliary to the business operations of the foreign parent. The subsidiary will also likely not be seen as an agent, as a typical R&D entity will not habitually enter into contracts in the name of the foreign parent; see Zollo (2011), at p. 774. 1717. OECD MTC, art. 5(6). For an interesting and thorough analysis of the historical background of the agency PE, see Lüdicke et al. (2014). 1718. Further, the contracts are in the name of the enterprise, or for the transfer of rights in property owned by the enterprise or that the enterprise has a right to use, or for the provision of services by that enterprise; see OECD MTC, art. 5(5). 1719. OECD MTC, art. 5(5). This requires that the exceptions for preparatory and ancillary activities under art. 5(4) are not triggered. 1720. See, in particular, Vann (2003), at p. 167; and Vann (2006) on this issue (under the pre-2010 art. 7 regime). See also Toro (2009); Gazzo (2003); Kobetsky (2006); Pinto (2006); Sheppard (2006); Russo et al. (2007); Innamorato (2008); Romano et al. (2010); Gouthière (2010); Schoueri et al. (2011); Rosalem (2010); and Goede (2012). 1721. The author refers to the analysis of case law in sec. 25.6. See, in particular, the Norwegian Supreme Court decision in Dell Products v. the State (Utv. 2012, s. 1), where the tax authorities asserted that the local agent had contributed to the development of a marketing intangible (ruling analysed in sec. 25.6.5.).

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commission fee calculated on the basis of its local sales. The fee is subject to article 9 transfer pricing. The second entity is the dependent agent PE of the foreign parent. It must be remunerated under article 7. This “article 5(5) PE” is a deemed PE, not caused by a “fixed place of business” of the foreign parent in the source state,1722 but due to the functions performed by the dependent agent enterprise. The most pronounced “PE risk” will normally be related to this type of PE, as a multinational will usually have more control over whether the PE thresholds in article 5(1)-(4) are breached. In particular, source state tax authorities may be inclined to assert that there is a dependent agent PE subsequent to a business restructuring, e.g. when the source state entity is stripped from a full-fledged manufacturer to a contract manufacturer or from a full-fledged distributor to a buy-sell distributor or commission agent.1723 Such PE assertions will normally aim to recoup the profits associated with the risks that were contractually stripped from the source state in the business restructuring. Dependent agent PE structures are controversial. The Action 7 of the BEPS Action Plan states: [I]n many countries, the interpretation of the treaty rules on agency-PE allows contracts for the sale of goods belonging to a foreign enterprise to be negotiated and concluded in a country by the sales force of a local subsidiary of that foreign enterprise without the profits from these sales being taxable to the same extent as they would be if the sales were made by a distributor. In many cases, this has led enterprises to replace arrangements under which the local subsidiary traditionally acted as a distributor by “commissionaire arrangements” with a resulting shift of profits out of the country where the sales take place without a substantive change in the functions performed in that country. Similarly, MNEs may artificially fragment their operations among multiple group entities to qualify for the exceptions to PE status for preparatory and ancillary activities.1724 1722. See OECD MTC, art. 5(1). 1723. PE assertions from a source state following a “risk strip-down” conversion may be based on the formerly resident group entity having a place of business in the source state pursuant to OECD MTC, art. 5(1) if it maintains a certain amount of space “at its disposal”; see the OECD Commentary on Article 5, para. 4. Alternative arguments are that the formerly resident group entity has a place of management in the source state pursuant to OECD MTC, art. 5(2) a), or that it constitutes an agent PE in the source state under OECD MTC, art. 5(5). 1724. 2015 Action 7 Report.

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Action 7 of the BEPS Action Plan was to “prevent the artificial avoidance of PE status”.1725 As a result, article 5(5) and (6) were amended in the fall of 2015 as part of the BEPS package. The OECD found, as a matter of policy, that when the activities that an intermediary exercises in a country are intended to result in the regular conclusion of contracts to be performed by a foreign enterprise, that enterprise should be considered to have a taxable presence in that country unless the intermediary is performing these activities in the course of an independent business.1726 Article 5(5) and (6), as well as their commentaries, were altered to implement this policy so that commissionaire (and similar) arrangements now trigger the existence of a PE. No changes were made to the profit allocation rules in article 7 as a result of the alterations to article 5.1727 The OECD’s view is that the revision of article 5 does not require substantial modifications to the existing rules on the allocation of operating profits to PEs, but that there nevertheless is a need for some clarifying guidance on how the current profit allocation rules should be applied in light of the revised article 5. The OECD issued a 2017 discussion draft that seeks to address this.1728 The discussion in sections 17.6.3.-17.6.4. should be relevant for the ongoing OECD revision.

17.6.3. The OECD approach for allocating operating profits to a dependent agent PE Some transfer pricing schemes involving dependent agent PEs have resulted in insufficient allocation of income to source states when judged in light of the economic activity carried out there. The allocation approach in the 2010 Report is a reaction to this. Multinationals have traditionally embraced the “single-taxpayer approach” with respect to the allocation of operating profits to a source state.1729 Under this approach, an arm’s length article 9 fee to the dependent agent enterprise “fully extinguishes the profits attributable to the dependent agent 1725. Id. 1726. Subsequent to the 2015 alterations of art. 5(6), a person who acts exclusively (or almost exclusively) on behalf of one or more enterprises to which it is closely related is not considered an independent agent. 1727. Action 7 Report, para. 19. 1728. OECD, BEPS Action 7: Additional Guidance on Attribution of Profits to Permanent Establishments (OECD 2017) [hereinafter 2017DD]. This draft replaces (and takes a new approach to the one adopted in) the July 2016 discussion draft on the same matter. 1729. On this point, see Oosterhoff (2008), at p. 68.

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PE”.1730 The logic is that the article 9 fee appropriately rewards the dependent agent enterprise for all functions performed by it, as well as for assets and risks that are contractually allocated to it. Thus, there should be nothing left for which to remunerate the PE. The 2010 Report asserts that there are three fundamental flaws in the single-taxpayer approach. First, it does not result in a “fair division of taxing rights” between residence and source states.1731 Assets and risks connected to the source state activity are ignored solely on the basis of contractual allocation to the non-resident enterprise. Second, for PEs other than the dependent agent PE, assets that are economically owned and risks created as a result of the PE’s functions will be assigned to it, regardless of contractual allocation.1732 In other words, the single-taxpayer approach would imply differing applications of the authorized OECD approach, depending on which type of PE is involved.1733 The 2010 Report argues that this is incompatible with article 7 and the arm’s length principle. Third, the singletaxpayer approach results in the curious outcome that there are no profit consequences of identifying a dependent agent PE under article 5(5).1734 The 2010 Report finds this problematic in light of the principle of statutory interpretation that provisions should generally not be interpreted in a manner that renders them superfluous.1735 Thus, the single-taxpayer approach remunerates the subsidiary, but not the PE. The OECD position taken in the 2010 Report on the article 7 remuneration of a dependent agent PE is motivated by the desire to “amend” the lack of compensation for assets and risks under the article 9 remuneration. The fundamental rule in the 2010 Report is that a dependent agent PE should be remunerated pursuant to the same principles that are applied under article 7 to attribute profits to other types of PEs.1736 In particular, the dependent agent PE will be attributed profits that stem from the assets it economi1730. 2010 Report, para. 235. 1731. 2010 Report, para. 236. 1732. In these cases, there will not be a subsidiary that performs functions in the source state for the non-resident enterprise, and therefore no transfer pricing under OECD MTC, art. 9. 1733. 2010 Report, para. 237. 1734. The 2010 Report observes that source-state taxing rights will vary significantly depending on whether or not there is a PE; see 2010 Report, para. 227. Otherwise, similar cases may result in widely differing profit allocations, depending on whether the source state activities breach the PE threshold. The 2010 Report, expressing discontent over the PE thresholds, finds that its profit allocation approach may mitigate some of the consequences of this “cliff effect”. 1735. 2010 Report, para. 239. 1736. 2010 Report, para. 228.

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cally owns, the risks it incurs and the capital it is assigned pursuant to the “significant people functions” doctrine.1737 Alternatively, if the dependent agent enterprise performs the significant people functions relevant to the assignment of economic ownership of assets and the assumption and management of risk, the allocation of assets, risks and profits to the PE will be reduced or eliminated.1738 The 2010 Report emphasizes: [The] activities of a mere sales agent may well be unlikely to represent the significant people functions leading to the development of a marketing or trade intangible so that the dependent agent PE would generally not be attributed profit as the “economic owner” of that intangible.1739

While the author agrees that this normally will be the case, there can be no legal presumption for this outcome. A concrete assessment based on a thorough functional analysis must be made in each case.

17.6.4. Is the dependent agent PE relevant? The point of the 2010 Report’s approach is to ensure that the combined allocation of profits under articles 7 and 9 provides the source state with income that is commensurate with the functions carried out, assets used and risks incurred by the multinational there.1740 What typically is at stake here is the size of the normal market return allocable to the source state, normally not residual profits. Of course, it cannot be ruled out that there are unique value chain inputs (IP) provided by the subsidiary or the PE in the source state, in which case the source state should be allocated a portion of the residual profits. The following discussion, however, is geared towards value chain distribution structures that are designed to contractually strip risks from the source state.1741 These are generally aimed at reducing the level of normal return allocable to the source state. The more assets and risks allocated to the source state, the larger the normal return must be. The “default scenario” is that the local subsidiary purchases goods from a foreign group entity, typically resident in a low-tax environment. The subsidiary 1737. Id. 1738. 2010 Report, para. 233. 1739. Id. 1740. On this topic, see also Cottani (2016), in particular, at p. 180. 1741. On the risk-stripping of local marketing and distribution entities, see, in particular, Musselli et al. (2008a). See also Schön (2014); Vann (2003), at p. 153; and Vann (2006). On contractual risk allocations in transfer pricing in general, see, in particular, Schön (2014); and supra n. 752.

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takes title to, stores and sells the goods to local customers in its own name. It incurs a “normal” level of distribution risks, including that it may not be able to sell the number of goods at the prices it targets (inventory risk) and that its customers will not settle their credit purchases fully and on time (credit risk), and may therefore incur a loss.1742 A “normal” distribution subsidiary should earn a net operating margin similar to that earned by comparable unrelated distributors (typically benchmarked under the TNMM). In the long run, this must provide the subsidiary with a sensible return on its capital. A buy-sell distributor scheme contractually strips the local subsidiary of inventory risk. The subsidiary will, in these cases, buy products from a foreign group entity. The subsidiary owns the goods only momentarily, which, in tax-planning vernacular, is known as “flash title”. The foreign group entity warehouses the goods in the source state. This would normally fall under article 5(4)(a), (b) and (f) of the OECD MTC, thus not triggering the existence of a PE.1743 The sales will be carried out in the name of the subsidiary, and it therefore incurs credit risk, but no inventory risk, due to the “flash title”. A buy-sell distribution subsidiary should earn a net operating margin similar to that earned by comparable unrelated distributors. This will be less than the operating margin earned by a “normal” distribution subsidiary, but still more than a pure agent. Two schemes are popular for stripping local distribution subsidiaries of both inventory and credit risk. First, there is the “agent scheme”, in which the goods are contractually owned by the foreign entity and sales are carried out by the local subsidiary in the name of the foreign entity. Second, there is the “commissionaire scheme”, a frequently used variant of the agent scheme, in which sales are formally not carried out in the name the foreign entity, even though the local subsidiary does not take title to the goods.1744 Both schemes allocate a minimum level of operating profits to the source state. The agent will normally be allocated a steady, low-risk return from year to year. Due to the comprehensive contractual stripping of risks, an agent should not incur a taxable loss. The attractiveness of the commissionaire structure relative to the plain agent structure can be found on two levels. First, the former arrangement 1742. On the stripping of inventory and credit risk in particular, see Musselli et al. (2008a). 1743. The 2015 BEPS revision of OECD MTC, art. 5(4) altered this; see 2015 Action 7 Report, paras. 10-13. 1744. On this, see, in particular, Vann (2003), at p. 153. See also further discussions on the commissionaire structure in Verdoner (2011); and Angus (2012).

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could be beneficial for business purposes, as local customers have a contractual relationship only with the commissionaire, and from their point of view, the commissionaire appears as an ordinary buy-sell distributor. Second, the commissionaire scheme is resistant against source-state PE assertions pursuant to article 5(5).1745 Due to the rather categorical language applied in the pre-2015 article 5(5) and its commentaries,1746 it was probable that local courts would be forced to respect commissionaire arrangements based on the formal observation that the local sales agreements were entered into in the name of the local subsidiary, not the foreign principal, even if there was little or no substance to the arrangements. This was the case in Dell (Norway), Zimmer (France) and Boston Scientific (Italy).1747 This second level is now eliminated through the 2015 BEPS revision of article 5(5) and (6), which ensures that commissionaire (and similar) arrangements trigger the existence of a PE. The usefulness for multinationals of the buy-sell distributor and agent schemes as legal vehicles for reducing the allocation of operating profits to source states relies fully on the contractual risk-stripping that is given effect for transfer pricing purposes under article 9. The 2010 Report interprets the 2010 OECD TPG so that the contractual allocation of risks in agent schemes should be respected. It states: [U]nder the “single taxpayer” approach, those risks can never be attributed to the dependent agent PE of the non-resident enterprise, whilst the authorised OECD approach would attribute those risks to the dependent agent PE for tax purposes if, and only if, the dependent agent performed the significant people functions relevant to the assumption and/or subsequent management of those risks. (Emphasis added).1748

1745. See, e.g. Musselli et al. (2008a), at p. 265. 1746. The wording of OECD MTC, art. 5(5) is that the person in the source state must have “authority to conclude contracts in the name of the enterprise”. The OECD Commentary on Article 5(5), para. 32 states that “only persons having the authority to conclude contracts can lead to a permanent establishment”. Further, para. 32.1 requires that the “agent … concludes contracts which are binding on the enterprise”. 1747. Under art. 5(5) b) of the UN MTC, however, a person who has no authority to conclude contracts on behalf of the principal but has a stock of goods that he delivers on behalf of the non-resident enterprise could constitute a PE. Commissionaire structures are reliant on the recognition of indirect representation by local private law. Under common law, a properly authorized agent will bind the principal. Under civil law, however, there is a distinction between direct representation, pursuant to which the agent will bind the principal, and indirect representation, in which the principal is not bound. This is why case law on PE assertions pertaining to commissionaire structures have been limited to continental Europe. 1748. 2010 Report, para. 235.

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Oddly enough, the 2010 Report does not question this treatment of risk. The explanation likely partly lies in the fact that the aim of the Report is to address allocation issues under article 7. However, the lack of critical reflection on the article 9 transfer pricing is still peculiar, as the need for article 7 in the context of a dependent agent PE is only triggered if the local entity is not compensated for assets and risks under article 9. The question is whether, in light of the 2017 OECD TPG on comparability and risk,1749 contractual stripping of a distribution subsidiary’s risks should be given effect for pricing purposes under article 9. A key point of the 2017 guidance is that contractual risk allocations should not be respected if the risks are assigned to an entity that is not in control of them.1750 Control is understood as the capability to make decisions to take on the risk and whether and how to respond to the risk.1751 If there are differences between the terms of the controlled agreement pertaining to the assignment of risk and the conduct of the parties, the latter will generally be taken as the best indication of the actual allocation of risk.1752 For instance, if a foreign associated enterprise assumes all inventory obsolescence risk by written contract, it must be ascertained where inventory write-downs and decisions regarding production volumes and inventory levels are taken. If the local distributor provides market feedback that is used for determining product specifications, the local entity could be deemed to share in the product risk management. Normally in agent schemes, the functions relevant to the assumption of inventory and credit risks will be performed in the source state, simply because distribution, marketing and sales are carried out there. The activities of the local entity will normally be influential on the amount of products sold in the source state, which in turn drives inventory levels and customer receivables. In Zimmer, for instance, the local subsidiary had the authority to accept orders from clients, present offers and quotes, participate in bid processes and negotiate discounts and payment terms. Because inventory and credit risk are directly dependent on local sales functions, it must presumably often be concluded that the local entity is in control of inventory and credit risk, not the foreign principal that is contractually allocated 1749. See the discussion of the 2015 OECD guidance on controlled risk allocations in sec. 6.6.5.5.2. 1750. OECD TPG, para. 1.98. In addition, it is a requirement for accepting controlled risk allocations that the entity assigned the risk has the financial capacity to cover losses, should the risks materialize; see OECD TPG, paras. 1.64 and 1.98. 1751. OECD TPG, para. 1.65. 1752. OECD TPG, para. 1.88.

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these risks.1753 If so, the local subsidiary shall be allocated both inventory and credit risks for the purpose of the transfer pricing of the commission fee agreement with the foreign principal pursuant to article 9.1754 The article 9 remuneration of the local subsidiary must take into account all functions performed, assets used and risks incurred. In particular, it must be determined whether the local entity is in possession of unique IP (e.g. marketing know-how and local goodwill).1755 If so, it shall be allocated the residual profits from the IP. The TNMM (to allocate a normal return to the foreign entity) or the PSM should then likely be applied, depending on whether the IP owned by the local subsidiary is the only unique contribution to the value chain. If the local entity is not in possession of any unique IP, it shall only be allocated a normal market return. If the TNMM is applied for this purpose, the third-party net profit data used must be extracted only from full-fledged distributors that incur both inventory and credit risks. Agents or third-party enterprises that act as buy-sell distributors should be rejected as comparables because they will not reflect the return allocable to an entity that is subject to both inventory and credit risks. Source state tax authorities should be critical of any comparability adjustments made to profit data extracted from buy-sell distributors or agents that allegedly make the risk profile of the uncontrolled transactions purportedly comparable to that of the controlled transaction. In light of the 2017 OECD TPG on risk under article 9, it can no longer be taken for granted that contractual allocations of inventory and credit risk to foreign principal entities will be deemed to be in correspondence with the economic substance of the actual behaviour of the controlled parties. The relevant question is whether the local subsidiary is in control of the inventory and credit risks. If so, it shall be allocated the operating profits connected to these risks as a transfer pricing matter under article 9. The criteria used to establish control in the new 2017 comparability guidance on risk are akin to the “significant people functions” doctrine outlined in the 2010 Report. The author finds it unlikely that these doctrines would allocate inventory and credit risks differently. 1753. A different issue entirely is that no significant inventory risks will necessarily exist in the value chain. The group may, for instance, have a “just-in-time” logistics system in place, designed to minimize inventory risks and costs. 1754. OECD TPG, paras. 1.88 and 1.98. 1755. This was the position of the Norwegian tax authorities in Dell Products v. the State, Utv. 2012, s. 1 (ruling analysed in sec. 25.6.5.). The allocation issue was not assessed by the Norwegian Supreme Court, as it held that the commissionaire scheme used by Dell in Norway did not trigger the existence of a PE under art. 5(5).

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If the local subsidiary is assigned a normal market return for its contributions of functions, assets and risks under article 9, this will be full compensation to the source state, making the “dependent agent PE” assertion superfluous. The end result for the source state of applying only article 9 pursuant to the 2017 OECD TPG on risks should be the same as the combined application of (i) article 9 to remunerate the commission fee pursuant to the 2010 OECD TPG on risk; and (ii) the authorized OECD approach under article 7 to remunerate inventory and credit risk. In light of this, the dependent agent PE under article 5(5) should no longer be relevant for the purpose of allocating operating profits to a source state. Thus, there should be no profit allocation consequences of identifying a dependent agent PE. This is a curious result. One would assume that there would be consequences for identifying a PE under article 5(5). Nonetheless, viewed in the context of the relationship between article 7 and article 9, as described in the 2010 Report, the primary purpose of the authorized OECD approach was to “fix” the problem raised by the article 9 transfer pricing under the old (1995/2010) OECD TPG on comparability and risk, pursuant to which the dependent agent enterprise was often not allocated profits connected to inventory and credit risks if these risks were contractually assigned to a foreign entity. As the 2017 OECD TPG on comparability and risk refuses to accept such formal risk allocations with effect for transfer pricing, there is no longer any problem to fix. The 2017 OECD discussion draft on the allocation of profits to PEs reaches a similar conclusion, as it states the following: [W]here a risk is found to be assumed by the intermediary under the guidance in Section D.1.2 of Chapter I, such risk cannot be considered to be assumed by the non-resident enterprise or the PE for the purposes of Article 7. Otherwise, double taxation could occur in the source country through taxation of the profits related to the assumption of that risk twice, i.e. in the hands of both the PE and the intermediary.1756

Further, the discussion draft states: In particular, when the accurate delineation of the transaction under the guidance of Chapter I of the TPG indicates that the intermediary is assuming the risks of the transactions of the non-resident enterprise, the profits attributable to the PE could be minimal or even zero.1757

1756. 2017DD, at para. 18. 1757. 2017DD, at para. 19.

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Thus, the core point of the OECD, as expressed in the 2017 discussion draft, is that the source state shall be allowed to tax an arm’s length amount of total income that reflects the return attributable to the functions performed, assets used and risks incurred in the source state, regardless of whether it is attributable to the dependent agent enterprise or the dependent agent PE. The total income shall only be taxed once, and the draft allows it to be taxed at the level of the dependent agent enterprise.1758 It can, in light of the above, be observed that the PE threshold under article 5(5) becomes irrelevant with respect to whether the source state shall be allocated the “additional profit” connected to inventory and credit risk, as the income will be attributable to the local subsidiary (dependent agent enterprise). In the author’s view, this result is appropriate. The relaxed position of the pre-2017 OECD TPG on controlled contractual risk allocations was highly unsatisfactory. Third parties would not assume risks that they had no control over.1759 Further, giving effect to controlled allocations that dislocate risks from the group entities responsible for the operational risk-generating business activities could, in the long run, be damaging to the international consensus on the separate entity approach and arm’s length pricing. Source states could lose faith in the ability of the prevailing system to distribute operating profits in an equitable manner that is aligned with economic reality and value creation.

17.7. The UN approach for allocating profits to a PE 17.7.1. Introduction In sections 17.7.2.-17.7.3., the author will tie some comments to the allocation of operating profits between a residence and source state pursuant to article 7 of the 2011 UN MTC. The material content of the UN rule may diverge significantly from article 7 of the OECD MTC, as the former is based on the pre-2010 article 7 of the OECD MTC. The limited aim of this discussion is merely to briefly indicate the main differences, as this may provide an inter-

1758. See 2017DD, paras. 26, 31 and 35. 1759. OECD, BEPS Actions 8, 9 and 10: Discussion draft on revisions to Chapter I of the Transfer Pricing Guidelines (including risk, recharacterisation and special measures) (OECD 2014), at sec. D2, para. 38.

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esting perspective on how intangible profits are allocated to the developing countries that tend to use the UN MTC as a basis for their treaties.

17.7.2. The allocation norm under article 7 of the 2011 UN MTC The UN rule for allocating operating profits earned by an enterprise in a source state between that state and the jurisdiction where the enterprise is resident is expressed in article 7(2) of the UN MTC. It states that the profits attributable to a PE are “the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment”. The provision is a reiteration of the pre-2010 version of article 7 of the OECD MTC. The main focus of article 7 of the UN MTC is to limit the expenses that are deductible in the calculation of the PE’s profits. The first sentence of article 7(3), which is identical to the pre-2010 version of article 7(3) of the OECD MTC, limits deductible items to “expenses which are incurred” for the purposes of the business of the PE. Further, the provision specifically excludes a range of income and expense items.1760 Article 7(3) denies deductions for payments from the PE to the head office for “royalties, fees or other similar payments in return for the use of patents or other rights”, “commission” and “interests”.1761 Non-recognition of these items applies symmetrically to the income side of the PE profit calculation. In other words, the PE may not charge the head office for “royalties, fees, or other similar payments”, “commission” or “interests”.1762 The reason why deemed royalty payments to and from a PE are not recognized is,1763 according to the sparse commentaries on article 7(3), that it 1760. These limitations were formulated by the former Group of Experts in 1980. Some developing countries were of the opinion that UN MTC, art. 7(3) should clearly reflect the treatment of relevant items in order to assist the application of the provision and that a highlighting the exclusion of certain deductions would be instructive for taxpayers; see para. 16 of the UN Commentary on Article 7. 1761. Only the first two items refer to the operating profits of the PE. Interests are financial items that will not affect the operating profits as such (but will, of course, influence the net taxable income of the PE). 1762. UN MTC, art. 7(3). 1763. The pre-2010 version of art. 7 of the OECD MTC also does not recognize deemed royalty payments to or from a PE. While this is not explicitly indicated in the wording of the provision, its commentary (see para. 34) is identical to that of art. 7(3)

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would be difficult to assign IP ownership and IP development costs among different parts of an enterprise.1764 Also, if deductions for deemed royalty payments were to be allowed for the purposes of determining the profits of the PE, this would trigger the issue of whether the source state should be allowed to levy withholding tax on the deemed payments in order to ensure equal treatment of PEs and subsidiaries and to avoid base erosion.1765 The UN Committee of Experts rejected the article 7 authorized OECD profit allocation approach in 2009, partially due to this problem. It is not entirely clear to the author what the consequences of this are. For instance, assume that there is a PE that distributes a pharmaceutical product in the source state. The product is based on unique patents and trademarks owned by the enterprise. The PE “purchases” the products from the head office and incurs some operating expenses to distribute, market and sell the products locally. All sales are made to unrelated customers. The PE realizes a significant residual profit in the source state. The question is how this profit should be allocated between the residence state of the enterprise and the source state of the PE under article 7 of the UN MTC.1766 This issue would have been relatively straightforward to resolve had transfer pricing principles akin to the authorized OECD approach been applicable. If the economic ownership of the unique IP had been assigned to the head office, the TNMM would likely have been applied to allocate a normal return on the routine distribution activities performed by the PE. The operating profits of the PE after deduction for the normal return would be allocable to the residence state as a deemed royalty payment for the unique IP used by the PE. This solution is likely unavailable because it results in the deduction of a deemed royalty payment in the calculation of the profits of the PE in the of the UN MTC. This is important because the 2008 revision of the OECD MTC art. 7 commentary (the amendment text is included as an appendix in the 2008 Report) set out to include the profit allocation aspects of the 2008 Report that did “not conflict with previous Commentary”; see the 2008 Report, preface, para. 8. Thus, the fact that the commentaries on the point of deemed royalties were not altered in 2008 is a clear indication that the OECD approach for allocating operating profits from intangibles cannot be applied under the old art. 7. 1764. See the Commentary on Article 7, of the UN MTC, para. 34. The focus seems to be that the actual development costs should be allocated among all parts of the enterprise without any mark-up for profit or royalty. 1765. Compare para. 29 of the OECD Commentary on Article 7 of the OECD MTC (2010). 1766. Or the pre-2010 OECD MTC, for that matter.

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source state.1767 This conclusion, however, is far from certain. The wording of article 7(3), or its commentaries for that matter, does not contribute much to the interpretation. It is mentioned that administrative costs and a share of IP development costs may be deducted, but such elements are normally allocated to and included in the cost of goods sold (COGS) or operating expenses. The irony, as the author sees it, is that it will be easy to achieve the same TNMM result simply by reclassifying the “deemed royalty” payment. For instance, if an application of the TNMM indicates that the PE should make a net operating margin of 5%, this can be achieved by adjusting the price for the goods sold by the head office to an amount that would yield the desired profit margin for the source state. This technique was, for instance, used by the taxpayer in the Norwegian Vingcard Elsafe AS v. Skatt Øst case in the context of article 9.1768 The economic result of an upward adjustment of the COGS to the PE would be the same as charging a deemed royalty payment to the PE, i.e. the residual profits are extracted from the source state. Alternatively, the COGS of the PE could be determined using the resale price method. Given that it will normally be possible to reclassify a deemed royalty to increased COGS or possibly also to operating expenses allocable to the PE, it is not clear what the actual consequences of the cut-off rule for deemed royalty payments in article 7(3) are. In the author’s view, there is no question as to what the result should be in the pharmaceutical distribution PE example used in this section. The PE contributes only routine inputs to the value chain. The residual profits should therefore not be taxable in the source state. It should not matter whether the residual profits are classified as a deemed royalty payment or as increased COGS. However, this obviously does matter under article 7(3). The decisive question therefore seems to be whether article 7(3) accepts the extraction of residual profits from the source state as long as these payments to the head office are not classified as royalty payments.

1767. Neither the wording of UN MTC art. 7(3) or the UN Commentaries contribute much to the interpretation. It is mentioned that administrative costs and a share of intangible development costs may be deducted, but such elements are normally allocated to and included in the cost of goods sold or operating expenses (see the analysis of the concept of operating profits in sec. 6.2.). 1768. Ruling by Borgarting Appellant Court Ruling, dated 18 June 2012 (Utv. 2012 p. 1191), reversing in part the ruling by Oslo City Court, dated 29 Nov. 2010 (Utv. 2010 p. 1690). See the analysis of the case in sec. 15.6. in the context of taxpayer-initiated year-end adjustments.

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The UN approach for allocating profits to a PE

On the one hand, it will be easy to circumvent the cut-off rule if this is allowed. On the other hand, there cannot be any question that the price for which the products are sold from the head office to the PE would, at arm’s length, reflect the value of the unique intangibles embedded in the products if there was no separate licence agreement between the parties. Thus, the extraction of residual profits from the source state through an increase in the COGS yields an arm’s length result in the author’s example, which is the overarching requirement indicated by the language in article 7(2). On this basis, the author finds it unclear as to which extent article 7(2) of the UN MTC allows the extraction of residual profits from source states due to the cut-off rule for deemed royalty payments in article 7(3). There are likely differing opinions on this matter among treaty partners. Nevertheless, the decisive factor should, in the author’s view, be that the language in article 7(2) requires an arm’s length allocation of profits between the residence and source states. This will simply not be possible to achieve without making sure that residual profits are allocated to the part of the enterprise that is deemed to be the economic owner of the unique IP used in the value chain. If this were not adhered to, article 7(3) of the UN MTC would represent a serious impediment to the allocation of intangible business profits between residence and source states in a manner that is aligned with value creation, third-party behaviour and fundamental economic reasoning.

17.7.3. The relationship between articles 7 and 9 of the UN MTC A curiosity is that article 9(1) and (2) of the UN MTC are reproductions of articles 9(1) and (2) of the OECD MTC. The OECD TPG are used as the basis for applying article 9 of the UN MTC.1769 This means that the international allocation of business profits under UN MTC-based treaties may potentially follow two bizarrely disconnected patterns, depending on whether the multinational has organized its presence in the source country through a PE or a subsidiary.1770 If organized through a PE, article 7 governs the profit allocation. The allocation rules are ambiguous and do not recognize deemed royalty payments to and from the PE. If, however, the source country’s presence is organized through a subsidiary, article 9 will govern the 1769. UN Commentary on Article 9, para. 3. 1770. This is also the situation for tax treaties based on the pre-2010 version of the OECD MTC.

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allocation of business profits. The calculation of the source state’s profits should then follow the 2017 OECD TPG, including the important functions doctrine for assigning economic ownership of IP, the guidance on risk and comparability, revised guidance on the pricing methods, cost savings, location-specific advantages, etc. This lack of neutrality opens the door for tax planning and represents a clear potential for BEPS. The author is not convinced that the asserted practical advantages of the cut-off rule in article 7(3) for tax administrations in developing countries can outweigh the obvious shortcomings of this rule. Further, it may be that developing countries are missing out on income due to this provision. For instance, if a PE has developed profitable unique IP, the source state may not be entitled to tax the residual profits under article 7 of the UN MTC.

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Chapter 18 Introduction to Part 3 The topic for discussion in part 2 of the book was how operating profits from intangible value chains shall be allocated among the different value chain inputs under the transfer pricing methodology in US law and the OECD Model Tax Convention (OECD MTC). The author will again refer to the example used in the introduction to part 2, in which a Norwegian subsidiary of a US-based multinational performs routine distribution functions and licenses a patent from an Irish group entity in connection with its local sales of a blockbuster drug. The role of the transfer pricing methods here is to allocate the profits from the Norwegian sales among the value chain inputs, i.e. the routine distribution functions and the foreign-owned patent. Assume that the Norwegian profits are 100 and that the transactional net margin method (TNMM) indicates that an arm’s length return to the subsidiary is 20. The residual profits of 80 are thus allocable to the foreign patent. The next step is to allocate the residual profits. This is governed by the intangible ownership provisions in the US regulations and the 2017 OECD Transfer Pricing Guidelines (OECD TPG), which provide a link between the determined residual profit amount and the group entities to which the amount is to be allocated. The ownership rules are relevant for intangibles developed within a multinational1771 when more than one group entity was involved in the development.1772 The purpose of the rules is to ensure 1771. Conversely, when intangible property (IP) is externally acquired, the group will control to which of its entities ownership is assigned. The acquisition will be carried out by third parties. The price paid will thus be at arm’s length. To choose which group entity – and thereby, which jurisdiction – the acquired intangible shall be assigned to is the prerogative of the group, much analogous to the freedom a multinational has with respect to where it wants to allocate its external debt financing. A nuance here is the allocation of assets among the residence and source jurisdictions when there is a permanent establishment under art. 7 of the OECD Model Tax Convention (OECD MTC). The allocation rules may entail that the assets and debt of the enterprise are allocated to the source jurisdiction, even if they are legally owned by the enterprise in the residence state; see the discussion in ch. 25. 1772. If all functions, assets and risks connected to the research and development (R&D) (including enhancement and maintenance) of an item of IP are contributed by one group entity alone and the development is carried out within its residence jurisdiction, all income from the developed IP will be allocable there; see OECD Transfer Pri­ cing Guidelines (OECD TPG), para. 6.71. The issues analysed in this part of the book are not relevant in this (pronouncedly theoretical) scenario.

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that intangible profits are allocated to the group entities that took part in the intangible development in proportion to their value contributions, and thereby to the jurisdictions where the intangible value was created. These provisions will be analysed in this part of the book.1773 The analysis of the ownership rules should also be seen in the context of the “principal model”.1774 In order for the model to work (i.e. yield an optimally low effective tax rate for the multinational), ownership of internally developed unique intangibles must not be assigned to the group entity resident in the (typically high-tax) jurisdiction in which it was created through research and development (R&D), but to a group entity in a foreign (typically low-tax) jurisdiction. It is no secret that multinationals historically have often been successful in doing so. The 2017 OECD TPG on intangible property (IP) ownership are designed to eliminate these BEPS practices and ensure that residual profits are allocated to the jurisdictions where the intangible value was created (i.e. mainly to the R&D jurisdictions).1775 The ownership rules are, in principle, equally applicable to manufacturing and marketing intangibles. The allocation assessments will, however, vary among the two groups, because the respective development processes differ markedly. Manufacturing IP is created through a combination of R&D, funding, pre-existing intangibles and the use of tangible assets, normally emanating from only a few jurisdictions.1776 1773. For discussions of IP ownership under US law and the OECD MTC, see, e.g. Wittendorff (2010a), at pp. 625-629; and Markham (2005), at pp. 48-53. On the US rules, see, in particular, Andrus (2007), at pp. 634-637; and Levey et al. (2010), at pp. 117120. For less recent but relevant contributions, see Boykin (1996); Mentz (1999); Mentz et al. (1997); Ossi (1999); and Przysuski et al. (2004a). 1774. See the discussion of the principal model in sec. 2.4. 1775. Assume that a functional analysis reveals that the Irish entity in the example holds legal title to the patent and financed its development. All R&D necessary to create the intangible was, however, performed by a US group entity. The new 2017 OECD ownership provisions require that the group entity that financed the R&D efforts receive a risk-adjusted rate of return on its investment; see the analysis of intangible R&D funding remuneration in sec. 22.4. The residual profits shall go to the group entity that performed the important R&D functions; see the analysis of the “important functions doctrine” in sec. 22.3. This may entail that the 80 in profits are divided so that, for instance, 3 is allocated to the Irish entity as compensation for its administrative and legal services in connection with its holding of legal title and 15 as a risk-adjusted rate of return on its R&D financing contribution. The remaining residual profits of 62 are allocated to the US R&D entity. 1776. For example, say that pre-existing IP is contributed by a group entity resident in jurisdiction 1, ongoing R&D comes from an entity in jurisdiction 2 and R&D funding comes from an entity in jurisdiction 3. The residual profits from the developed IP shall be split among jurisdictions 1 and 2, while jurisdiction 3 is allocated a risk-adjusted rate

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In contrast, marketing IP (e.g. the value of a global trademark) must be developed in each single market through local marketing activities. Thus, from a causality perspective, every market jurisdiction is involved in the development of the local value of a marketing intangible.1777 More jurisdictions may therefore feel entitled to a stake in the residual profits from marketing IP than what is the case for manufacturing IP. Further, it will normally be straightforward to distinguish between the development and exploitation of R&D-based manufacturing IP. The same cannot often be said for marketing IP, as promotional activities will both develop and exploit it. The ownership rules are, in this respect, more problematic for internally developed marketing IP than they are for manufacturing IP. While the 2017 BEPS revision of the OECD IP ownership provisions was geared towards internally developed R&D-based manufacturing intangibles, it is important not to lose sight of the fact that the allocation of profits of return on the funding contribution. This entails that the residual profits generated through the worldwide exploitation of the IP are extracted from all market jurisdictions in which the product based on the IP is sold, and they are allocated to jurisdictions 1, 2 and 3. There is a solid rationale (behind this allocation. As the IP value was created in jurisdictions 1, 2 and 3 only, it seems reasonable that the profits should be allocated there. 1777. Logically, this observation should indicate that the residual profits from the marketing IP should at least partially be retained at source so that the value is taxed where it is created. This reasoning is, however, too rudimentary when it comes to marketing IP. The development of global marketing IP is, in contrast to R&D-based manufacturing IP, mainly linked to one type of development contribution: marketing expenses. A multinational is free to choose where to draw its funding from. Local marketing expenses may therefore be reimbursed by a foreign funding entity, removing some of the causality connection between the IP development and the source state. Nevertheless, while such reimbursements may facilitate foreign ownership of the local value of marketing IP, and thereby extraction of the residual marketing profits from the source state, they will come at a cost for the multinational, i.e. it will not be able to deduct the expenses at source (as the local entity does not bear the expenses due to the reimbursement). This may be problematic, for instance, if significant marketing expenses are required to establish a new product in a competitive market. The risks involved may be high, as the marketing may fail to yield the intended results. In these cases, it will likely be essential to ensure local deductibility. If the marketing expenses deducted at source are high enough, there is a risk both under the US and OECD rules that the source state may claim entitlement to the profits. See the analysis of the US and OECD rules on profit allocation in the context of internally developed marketing IP in ch. 23 and ch. 24, respectively. Further, the assignment of residual profits from internally developed marketing IP is complicated by the possibility that the local distribution subsidiary may have developed unique marketing IP that is distinct from the local value of the foreign-owned trademark (goodwill, know-how, etc.). There may also be local market characteristics (proximity to market, consumer preferences, etc.) that are separate from marketing IP, but may yield incremental profits that must be allocated; see the analysis of market-specific characteristics in ch. 10.

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from internally developed marketing intangibles is an equally important subject. The author has sought to reflect this in his analysis as he provides extensive discussions of the ownership rules in the context of both types of IP. The outline of part 3 is as follows: − the historical development of the US and OECD IP ownership rules is discussed in chapter 19; − a lead-in to the determination of IP ownership under the current US and OECD rules is provided in chapter 20; − the determination of IP ownership for intra-group-developed manufacturing IP under US law and the OECD MTC is analysed in chapter 21 and chapter 22, respectively; − the determination of IP ownership for intra-group-developed marketing IP under US law and the OECD MTC is analysed in chapter 23 and chapter 24, respectively; − the determination of IP ownership in the context of permanent establishments (PEs) (i.e. among the head office and PE of an enterprise under article 7 of the OECD MTC) is analysed in chapter 25; and − concluding remarks are provided in chapter 26.

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Chapter 19 The Evolution of the US and OECD Approaches to Intangible Ownership 19.1. Introduction This chapter examines the structure and material content of the historical US and OECD intangible property (IP) ownership rules, i.e. the rules that determine how residual profits generated through the exploitation of IP developed intra-group shall be allocated among group entities. This analysis will provide a valuable background for the interpretation of the current US and OECD provisions governing IP ownership, which will be examined in the following chapters. The significance of IP ownership rules in transfer pricing has increased over the years, as the profits of global enterprises have gradually become more IP-driven. In the 1960s, many of the largest enterprises operated within the car and oil industries, while they now can be found within typical IP sectors, such as the high-tech, software, pharmaceutical and retail industries. In the 2015 BEPS revision of the OECD Transfer Pricing Guidelines (OECD TPG), IP ownership issues were among the most challenging to reach consensus on, in particular with respect to intra-group-developed manufacturing IP. The United States introduced advanced and substance-based IP ownership provisions already in the 1968 Internal Revenue Code (IRC) section 482 regulations. The OECD, however, was late to the party. The IP ownership provisions of the historical OECD TPG were only moderately developed. The main focus of this chapter will therefore lie on the historical US rules, which have been a great influence on later thinking around IP ownership in transfer pricing law. The author will analyse the IP ownership provisions of the 1968 US regulations in section 19.2., the 1992 proposed and 1993 temporary US regulations in section 19.3. and the 1994 US regulations in section 19.4. Brief comments will thereafter, in section 19.5., be tied to the approach of the 1995 and 2010 OECD TPG.

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19.2. Determination of IP ownership under the 1968 US regulations 19.2.1. Introduction The 1968 regulations implemented a two-branched approach to the determination of intangible ownership, which was based on whether the joint development efforts were organized through a cost-sharing arrangement (CSA).1778 If a CSA was entered into, the controlled parties could share ownership of a jointly developed intangible, given that certain criteria were fulfilled.1779 The operating profits generated by this intangible would then be split among the CSA participants pursuant to their respective shares of the intangible development costs. If a CSA was not entered into, the allocation of operating profits from a jointly developed intangible was governed by the so-called “developer-assister” rule (DA rule).1780 Its purpose was to protect the integrity of the CSA institute by not allowing a split of residual profits in joint development arrangements that did not satisfy the criteria set out in the 1968 regulations for qualifying CSAs.1781 The DA rule was in effect for almost 3 decades and has influenced international transfer pricing jurisprudence on intangible ownership significantly.1782 It forms an important backdrop for analysing the current ownership provisions of both the United States and OECD. The author will therefore comment on the material content of the rule in section 19.2.2. and discuss some possible limitations of the rule in sections 19.2.3. and 19.2.4. Two notable transfer pricing cases in which the application of the DA rule to determine IP ownership was at issue will be discussed in section 19.2.5.

1778. The predecessor to the 1968 regulations was Revenue Procedure 63-10, which only addressed transactions between US-based multinationals and their Puerto Rican subsidiaries. The rule was that such subsidiaries should be allocated profits from manufacturing intangibles that they owned, but not profits from marketing intangibles (trademarks, trade names and goodwill) used to distribute products in the United States; see Revenue Procedure 63-10, sec. 4.01. 1779. 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(4). 1780. 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(1)(ii)(a). 1781. See Ossi (1999), at p. 993. 1782. For a discussion of the 1968 developer-assister (DA) rule, see, e.g. Wittendorff (2010a), at p. 632.

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19.2.2. The DA rule The DA rule distinguished the developer of an intangible from other group entities that assisted in the development. For the developer, “no allocation with respect to such development activity” was to be made.1783 In other words, the developer was not entitled to compensation for contributing to the development of his own intangible, but was, as the owner, entitled to the residual profits from subsequent exploitation of the intangible. Under the DA rule, there could only be one developer. Only if the developed intangible later would be made available by the developer to other group entities through the transfer of complete or limited rights to it would a transfer pricing allocation be justified.1784 Group entities that rendered assistance to the intangible development were to receive an arm’s length compensation on a concurrent basis throughout the development phase.1785 However, the DA rule was silent with respect to the specifics of how this compensation should be determined.1786 Nevertheless, the author finds it reasonably clear that the 1968 US regulations did not afford the assister any residual profits, regardless of the extent to which he contributed to the intangible value creation. The determination under the DA rule of which group entity was the developer relied on a broad assessment of the specific facts and circumstances.1787 The greatest weight, however, was placed on which group entity bore the largest amount of the IP development costs (and incurred the connected risks),1788 as well as the relative values of any intangibles made available without compensation that were likely to substantially contribute to the development. Other relevant factors included the location of development, the capabilities of the various members to carry on the project independently and the degree of control over the research and development (R&D) project exercised by the respective group entities. The DA rule assessment was il1783. 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(1)(ii)(c) (see (a)). 1784. 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(1)(ii)(a). 1785. 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(1)(ii)(b). 1786. Id. It only stated that “the amount of any allocation that may be appropriate with respect to such assistance shall be determined in accordance with the rules of the appropriate paragraph”. 1787. 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(1)(ii)(c). 1788. Id. A group entity was not allocated the intangible development costs and risks if the costs were not carried by the entity contemporaneously with their incurrence and without regard to the success of the project. Thus, the recharging of, or contingent liability for, development costs was insufficient.

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lustrated in an example in the 1968 regulations that pertained to company X, which developed a product through a 4-year R&D process, in which it invested USD 1 million each year, in addition to employing a valuable intangible it owned.1789 Midway into the process, company Y contributed four researchers who worked on the project at the facilities of X, at a cost of USD 100,000, funded by Y. The example deemed X as the developer. Further, X was deemed to have transferred the developed intangible to Y when the latter registered the patent for the intangible upon completion. Thus, the DA rule disregarded legal ownership for the purpose of determining which group entity should be regarded as the developer. Most of the factors relevant in the DA assessment are efficient barriers against profit shifting. Factors such as contributions of intangibles without proper compensation, the location of the development activity, independent capabilities to carry on the development and the degree of control over the R&D project are all, albeit to varying degrees, challenging to circumvent. The DA rule assessment bears similarities to the analogous determination of which group entity is entitled to the residual profits from a jointly developed intangible under the 2017 OECD TPG.1790 However, in spite of the comprehensive description of relevant factors, the DA rule was, in practice, interpreted so that the greatest weight was placed on the entity that incurred concurrent R&D costs, mitigating the significance of the other factors.1791 This separates the DA rule from the current OECD guidance, 1789. See 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(1)(ii)(d), third example. Two additional examples were also included. In the first, company X developed a new machine to be used by company Y. The funding and intangibles required for the development were provided by Y, which was deemed to be the developer. The example did not provide guidance on the pricing of the assistance efforts of X. The second example was a modification of the first, with the twist that company Y provided contingent development funding, in the sense that Y would reimburse X for its development costs if the machine was successfully developed. The example deemed X the developer. Later access for Y to the new machine was made possible through a transfer from X, which warranted a transfer pricing allocation. 1790. See the analysis of the OECD Transfer Pricing Guidelines (OECD TPG) on the ownership of manufacturing intangible property (IP) in ch. 22. 1791. The factual pattern of Nestlé Co., Inc. v. CIR, T.C. Memo. 1963-14 (Tax Ct., 1963) is interesting with respect to the DA rule (see the discussion of the ruling in sec. 5.2.3.). The US sales of Nestlé grew rapidly in the 1940s, due to both the quality of the Nestlé products and the significant marketing efforts by the US entity. In fact, the marketing expenses incurred by the US licensee in the period under review of 1947-1952 were approximately 33% larger than the royalties paid in the same period. Had the case been tried under the 1968 DA rule, the US entity would likely have been regarded as the developer of the US rights to the Nestlé trademark. The main reason is that the US entity, over a longer period of time, incurred substantial marketing expenditures, as well as

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pursuant to which there is a pronounced focus on restricting the amount of profits allocable to intangible development-funding contributions in order to limit profit shifting to “cash-box” group entities resident in low-tax jurisdictions (see the discussion in section 22.4.).

19.2.3. The DA rule was geared towards, but not limited to, manufacturing IP It has been claimed that the DA rule was mainly intended to determine the entitlement to residual profits generated by manufacturing IP developed through joint R&D efforts as opposed to where a local distributor increased the value of marketing IP legally owned by a foreign group entity.1792 The author does agree that the rule was geared towards R&D. For instance, when the rule spoke of assistance, an example pertaining to the lending of laboratory equipment was used.1793 In principle, however, the development of marketing IP was also encompassed by the broad wording of the provision. Nevertheless, the focus on R&D entailed a link to the CSA provision of the 1968 regulations,1794 pursuant to which a US CSA participant would be allocated residual profits from the subsequent exploitation of the developed intangible in proportion to its share of the development costs. On the contrary, if the US entity was deemed developer under the DA rule, it would be allocated the entirety of the residual profits from the jointly developed intangible. The author therefore assumes that the DA rule may have functioned as an incentive to organize joint R&D activities through a CSA so that part of the residual profits could be shifted abroad for lower taxation. For example, if a pharmaceutical product was developed through US R&D while the funding came from a foreign subsidiary, the DA rule would likely deem the foreign entity the developer. From the perspective of the multinational, this would be positive in the sense that the potential residual profits from a successfully developed and commercialized drug would be allocated in full to the foreign entity and taxed at a lower rate. The problem with this would be that none of the the associated risk. The US entity should then have been entitled to the profits generated through the exploitation of the US rights to the trademark, necessitating a downward US Internal Revenue Code (IRC) sec. 482 adjustment of the outbound royalties. 1792. See Ossi (1999). 1793. 1968 Treas. Regs. (33 Fed. Reg. 5848) § 1.482-2(d)(1)(ii)(b). 1794. 1968 Treas. Regs. § 1.482-2(d)(4).

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R&D expenses could be deducted in the United States. For large and genuinely risky R&D projects, this would likely be problematic from the point of view of the multinational. Alternatively, had the R&D been organized through a CSA, the US entity would be able to deduct its share of the R&D expenditures, with the drawback being that a commensurate portion of the residual profits would be taxable in the United States. This relationship between the DA rule and the CSA provision likely meant that it was more attractive for multinationals to organize relatively high-risk R&D projects as CSAs and relatively low-risk projects as non-CSA joint development efforts governed by the DA rule.

19.2.4. Was the DA rule limited to the development of entirely new IP? It has been asserted that the DA rule was intended for cases in which an entirely new intangible was developed, as opposed to where the value of a pre-existing intangible was increased, through joint efforts.1795 This assertion is based on the view that the Tax Court in Ciba purportedly distinguished the development of a new intangible from the exploitation of a pre-existing intangible.1796 In this case, a US distribution subsidiary made and sold herbicides based on make-sell rights that it licensed from its Swiss parent. The US Internal Revenue Service (IRS) disallowed deductions for outbound royalty payments by asserting that the subsidiary should be deemed the owner of the patent pursuant to an imputed CSA. The Tax Court rejected this assertion and stated that “it is upon the development of the triazine compounds, and not the exploitation of the U.S. market for them, that we must keep our attention focused”. The significant R&D functions were performed in Switzerland by the parent, which was also the legal owner of the patent. The US distribution subsidiary only carried out some auxiliary R&D functions connected to the products it sold. In the absence of evidence on the relative intangible development costs and risks borne by the controlled parties, the Tax Court in Ciba focused its DA rule assessment on the group’s R&D functions. It found that the parent planned, performed, supervised and controlled the significant R&D 1795. See Ossi (1999). 1796. Ciba-Geigy Corp. v. CIR, 85 T.C. No. 11 (Tax Ct., 1985), acquiescence recommended by AOD-1987-21 (IRS AOD, 1987), and acq. 1987 WL 857882 (IRS ACQ, 1987); see the analysis of the case in sec. 5.2.3.4.

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functions. Further, only the parent was capable of carrying on this R&D independently. The routine R&D functions of the subsidiary, which were characterized as “peripheral at best”, could have been outsourced to third parties at a low cost. Also, the subsidiary had neither the required personnel nor the facilities to carry out any significant R&D. The parent was deemed the developer. It was not at issue before the Court as to whether the marketing and sales activities of the subsidiary contributed to or increased the value of a separate marketing intangible. Thus, there is no merit to the assertion that the Court distinguished the development of a new intangible from the exploitation of a pre-existing intangible. In the author’s view, the DA rule was applicable in all cases in which intangible value was created by the joint efforts of group entities outside of CSAs.

19.2.5. Case law on the DA rule 19.2.5.1. Introduction In sections 19.2.5.2. and 19.2.5.3., respectively, the author will tie some comments to two fairly recent cases in which the DA rule was applied to determine IP ownership, namely GlaxoSmithKline Holdings (Americas) v. CIR1797 and DHL Corporation v. CIR.1798 The factual patterns of these cases, as well as the principal transfer pricing problems triggered by them, are also highly relevant under the current US IP ownership rules (analysed in chapters 21 and 23), as well as the current OECD IP ownership rules (analysed in chapters 22 and 24).

19.2.5.2. GlaxoSmithKline Holdings v. CIR (2006) 19.2.5.2.1.  Introductory comments The UK-based multinational GlaxoSmithKline (GSK), one of the largest pharmaceutical groups in the world, had a long-running dispute with the IRS pertaining to the allocation of profits to its US distribution subsidiary

1797. GlaxoSmithKline Holdings (Americas), Inc. v. CIR, 117 TC 1 (Tax Ct. Docket No. 5750-04, 2004). See Musselli et al. (2007a) for comments on the case. 1798. DHL Corp. v. CIR, T.C. Memo. 1998-461 (Tax Ct., 1998), affirmed in part, reversed in part by 285 F.3d 1210 (9th Cir., 2002). Several other problems apart from the ownership issue were assessed in the case, e.g. the determination of common control and valuation of a trademark.

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for the income years 1989-2005. The case was docketed in the US Tax Court, scheduled for a February 2007 trial, but was settled in 2006.1799 Even though the case never reached trial and ruling, the problems it raised are so significant that a discussion is warranted.1800 The main issue was how much of the business profits generated by the US distribution subsidiary, GSK US, owned by the UK parent, GSK UK, should be taxable in the United States. One of the problems was whether GSK UK or GSK US should be deemed owner of the US marketing intangibles and allocated the residual profits from their exploitation.1801 The author will tie some comments to this in sections 19.2.5.2.3.-19.2.5.2.5. However, in order to do so, it is necessary to first draw up the background for the case. 19.2.5.2.2.  A lead-in to the case The UK parent was the legal owner of both patents and trademarks for numerous pharmaceutical products, including Zantac, a global bestselling ulcer drug. Zantac was the result of lengthy and costly R&D carried out in the United Kingdom from the mid-1970s to the early 1980s. The global marketing strategy for Zantac was developed by the parent. The drug was introduced in the United States in 1983 by the local marketing and distribution subsidiary, GSK US, which licensed the relevant patents and trademarks from the parent. It performed marketing and sales functions and secondary manufacturing and provided assistance for approval by the Food and Drug Administration. It grew rapidly by retaining and investing its substantial earnings. By 1994, it was the second-largest US pharmaceutical company, with annual sales of USD 3.7 billion and 6,500 employees.1802

1799. GSK agreed to pay the US Internal Revenue Service (IRS) approximately USD 3.4 billion to resolve the dispute. The payment was the largest settlement ever in a US tax case. See the 2006 IRS press release, IR-2006-142. As the case did not result in a ruling, not all details are available. The author based his discussion mainly on information contained in the 2 April 2004 petition (which also contained the notice of deficiency as an appendix) filed by GSK with the US Tax Court (available at Tax Analysts, doc. 2004-7600). 1800. For comments on the case, see, e.g. Fris et al. (2006). 1801. There were two other main issues: (i) whether GSK could carry out year-end adjustments (which is discussed in sec. 15.10.); and (ii) how the total US residual profits (from the exploitation of both the UK manufacturing and US marketing intangibles) should be split among the US subsidiary and the UK parent (which is discussed in sec. 19.2.5.2.5.). 1802. 2 April 2004 petition (available at Tax Analysts, doc. 2004-7600), at p. 11.

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The transfer pricing dispute began during an IRS audit of GSK US in the early 1990s, which GSK sought to resolve in 1999 by requesting relief from the US IRS and Her Majesty’s Revenue and Customs (HMRC) in the United Kingdom. Supposedly, negotiations between the United States and United Kingdom collapsed, as the United Kingdom took the position (also held by GSK) that no additional taxes were due to the United States.1803 In 2004, the IRS issued a notice of deficiency covering 1989-1996 for approximately USD 2.7 billion in taxes,1804 followed by additional notice in 2005 covering the income years 1997-2000 for a further USD 1.9 billion.1805 The reassessment covered the transfer pricing of a range of pharmaceutical products sold by the US subsidiary, but the significant portion of the adjustments pertained to sales of Zantac. The lion’s share of the adjustments was carried out by adjusting the cost of goods sold (COGS). Of the total increase in income, approximately 58% was due to downward adjustments of COGS on inputs purchased from the UK parent. The notice of deficiency did not explain its calculation of the adjusted COGS. However, the author takes it that the COGS were adjusted so that the parent could recoup its costs plus a profit margin of 30%.1806 Even though it was not the most significant aspect of the case from a fiscal point of view (of the total increase in income, approximately 25% was due to downward adjustments of royalties paid to the UK parent), the matter of determining the arm’s length royalty for intangibles licensed from the parent to the subsidiary has certainly been the most debated. 19.2.5.2.3.  The principal IRS argument that the US subsidiary was the developer In addition to charging the US subsidiary for royalties pertaining to its deployment of manufacturing intangibles, the UK parent also charged for marketing intangibles it legally owned. The IRS disallowed full deductions claimed by the US subsidiary for royalty payments with respect to the UK1803. See the press release from GlaxoSmithKline dated 7 January 2004 (available at Tax Analysts, doc. 2004-363). 1804. Available at Tax Analysts, doc. 2004-7600. 1805. See the description of the 2005 notices in GSK’s 12 April 2005 petition, at pp. 4-6, available at Tax Analysts, doc. 2005-8873. See also the press releases from GlaxoSmithKline dated 7 January 2004 and 26 January 2005 (available at Tax Analysts, doc. 2004-363 and doc. 2005-1656, respectively). 1806. Based on information stated on p. 6 of the 2 April 2004 petition (available at Tax Analysts, doc. 2004-7600).

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owned marketing intangible. In the opinion of the IRS, the subsidiary was not entitled to deduct royalties paid for trademarks and other marketing intangibles, as it was “the owner for tax purposes of the trademarks and marketing intangible purportedly licensed”.1807 The logic behind this assertion was that the US subsidiary was deemed to be the “developer of said intangibles and because the economic substance of … dealings … at the time the licensed drugs were first sold in the United States establishes the existence of an imputed royalty-free license or other transfer of the … marketing intangibles”.1808 In other words, the IRS held that the subsidiary was entitled to all residual profits from the US exploitation of the marketing IP.1809 19.2.5.2.4.  The secondary IRS argument that the US subsidiary was the assister Further, as a secondary argument, the IRS asserted that the subsidiary was entitled to compensation for assistance rendered to the developer of the marketing IP, i.e. a normal market return. In terms of context, it should be mentioned that before Zantac was introduced, the drug Tagamet was the largest-selling ulcer drug in the world. Tagamet was manufactured and sold by the UK-based SmithKline Beecham, a competitor of GSK. In 2000, GSK merged with SmithKline Beecham. This likely gave GSK access to an advance pricing agreement (APA) that Smithkline Beecham had entered into with the IRS in 1993 pertaining to the allocation of income to the US distribution subsidiary that marketed Tagamet for the income years 1991-1993. In that APA, the IRS accepted an application of the resale price method in which the US subsidiary was the tested party and allocated a gross profit margin based on what comparable distributors earned.1810 Concretely, the APA deemed it sufficient that the US subsidiary was allocated a 28% (gross) margin from its sales of Tag-

1807. See the 2004 notice of deficiency (available at Tax Analysts, doc. 2004-7600), attachment: explanation of adjustments, point b). 1808. Id. 1809. Thus, the IRS asserted a profit split, with the residual profits from the manufacturing and marketing intangibles being allocable to the United Kingdom and United States, respectively. On the IRS profit split assertion, see Musselli et al. (2008a), at p. 270. 1810. For comments on this pricing, see Roberge (2013), at p. 225.

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amet.1811 That margin was consideration for all promotional and distribution functions carried out by the subsidiary. Additional margins of 5% and 3% were allocated to the subsidiary as returns on the Tagamet trademark and the SmithKline Beecham trade name, which the US subsidiary was deemed to own under a CSA. GSK applied for an APA for the transfer pricing of US sales of Zantac 1 year after SmithKline Beecham received its favourable APA. In the GSK application, the US subsidiary was described as “a marketer of pharmaceutical products”.1812 GSK requested approval of the resale price method for allocating income to the US subsidiary as compensation for its promotion and distribution functions. The application asserted that all significant intangibles were developed and owned by the UK parent and other foreign group entities, including the principal marketing intangibles for Zantac.1813 The IRS denied GSK’s application to use the resale price method, or any other transfer pricing method under which the US subsidiary was treated as the tested party.1814 Apparently, the IRS was not willing to issue an APA unless the profit split method (PSM) was used for allocating income to the subsidiary. GSK argued that not only had the IRS applied the solution of the 1991-1993 SmithKline APA for an additional year, but the transfer pricing method applied in that APA was also accepted for two other SmithKline products for years 1999-2000. GSK further asserted that the IRS had concluded at least one other APA for an inbound pharmaceutical blockbuster product in which the US distribution subsidiary was treated as the tested party and remunerated based on comparable data on operating profits. It was, however, mentioned that the result of that APA was supported by a profit split determination, purportedly consistent with the SmithKline APA. Even though an APA given to another taxpayer clearly was not relevant for determining the allocation of income pursuant to IRC section 482 to GSK US (an APA is the result of individual negotiations between the IRS and a taxpayer and thus not relevant for profit allocation for other taxpayers),1815 GSK’s 2005 memorandum did provide interesting insights into the functions performed by the US subsidiary. The 2005 memorandum 1811. See GSK’s memorandum dated 22 February 2005 in opposition to the IRS motion for partial summary judgment (available at Tax Analysts, doc. 2005-3635), at p. 13. 1812. Id., at p. 15. 1813. Id., at p. 16. 1814. Id., at p. 18. 1815. See also Verbeek (2005).

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claimed that the marketing and distribution functions of GSK US were “substantially similar” to those performed by the US distribution subsidiary in the SmithKline APA. Both relied primarily on brief, in-person presentations to doctors, advertising in professional journals, seminars, etc. The capabilities and qualifications of the sales staff of both companies were also purportedly similar. 19.2.5.2.5.  How would the case have been assessed under the DA rule? Had the case gone to trial, it would have been decided partly on the basis of the 1968 regulations and partly on the 1994 regulations.1816 Key elements in the 1968 DA rule assessment would have been (i) the incurrence of significant, non-refundable marketing costs by the US subsidiary; (ii) the use of local know-how, marketing expertise and relationships used to market Zantac; (iii) the fact that the marketing was carried out in the United States; and (iv) the fact that such marketing could not have been carried out by the parent from abroad. Before the subsidiary became so profitable that it was capable of finan­ cing the US marketing expenditures through its own earnings in 1986, the UK parent reimbursed “substantial amounts of … marketing and launch expenses”.1817 However, the subsidiary itself paid for all of the US marketing costs for the years under review. The subsidiary therefore bore the financial risk of the marketing activities. Further, it seems likely that the US subsidiary developed unique marketing intangibles in the form of customer relationships, marketing infrastructure and goodwill that were separate from the US value of the trademark. If so, such unique intangibles were undoubtedly owned by the subsidiary and likely contributed positively to the value-building process for the Zantac trade name in the United States. As far as the author can see, this makes it likely that the US subsidiary would have been deemed developer of the US value of the licensed trademark under the 1968 DA rule. Thus, for the income years 1989-1994, all residual profits from the licensed marketing intangibles should have been allocated to the US subsidiary. For the subsequent income years 19951996, the subsidiary would have likely, for the same reasons, been deemed owner of the US marketing intangibles, either pursuant to the “economic 1816. The 1968 regulations (33 Fed. Reg. 5848) would apply to income years 19891994, and the 1994 regulations (59 FR 34971-01) would apply to subsequent years under review. 1817. 2 April 2004 petition (available at Tax Analysts, doc. 2004-7600), at p. 16.

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substance” exception or the “multiple owners” exception of the 1994 regulations.1818 It then also, for the last 2 years encompassed by the reassessment, would have been entitled to all residual profits generated by the developed marketing intangibles. Thus, under US law, the UK parent should not have been allocated any residual profits from the licensed marketing intangibles. The question would then be of whether article 9 of the 1975 UK-US tax treaty would accept the US allocation.1819 The 1979 OECD report contained no useful guidance with respect to the allocation of residual profits from marketing IP.1820 The 1995 OECD TPG, which would have been relevant at least for the last few of the reassessed years, contained only limited guidance. Ultimately, the key issue for these last years would likely have been, as indicated by the 1995 OECD TPG, whether the US distribution subsidiary incurred marketing costs that exceeded the level of costs that would have been incurred by an unrelated distributor in comparable circumstances. If so, the US allocation of residual profits from the locally developed marketing intangibles should be acceptable under article 9 of the 1975 UK-US treaty.

19.2.5.3. DHL Corporation v. CIR (1998) A key question in DHL was whether a US entity within the DHL group should be considered the developer of, and thus entitled to the residual profits from the exploitation of, international rights to the DHL trademark, pursuant to the 1968 DA rule.1821 DHL’s international delivery business was built up gradually from the 1970s from a domestic US business into a substantial international opera1818. The economic substance exception was contained in the 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(ii)(A), and the multiple owners rule in the 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(i). See the discussions in secs. 19.4.5. and 19.4.6., respectively. 1819. Convention between the Government of the United States of America and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains (31 Dec. 1975), Treaties IBFD. 1820. See the comments in sec. 19.5. 1821. DHL Corp. & Subsidiaries v. CIR, T.C. Memo. 1998-461 (Tax Ct., 1998), affirmed in part, reversed in part by 285 F.3d 1210 (9th Cir., 2002). For comments on the case, see, e.g. Brauner (2008), at p. 151; Schön et al. (2011), at pp. 202-204; Wittendorff (2010a), at p. 659; Andrus (2007), at p. 637; Levey (2000); and Levey et al. (2002). See also Casley et al. (2011), at p. 167.

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tion. The company DHL US carried out the courier business in the United States, while the company DHLI carried out the international side of the business through a network of local operating subsidiaries that functioned largely autonomously. In the early 1990s, a consortium of international investors, including Japan Airlines and Lufthansa, acquired a controlling interest in DHLI. In connection with the acquisition, DHL US transferred all rights to the DHL trademark to DHLI for a separate consideration. The DHL trademark was the significant intangible asset in the DHL group and was highly valuable. The IRS issued a reassessment premised on DHL US owning the DHL trademark, increasing the transfer price. It was not contested that DHL US owned the US rights to the trademark; the question was whether it also, under the 1968 DA rule, owned the international rights. DHL US stood as the legal owner of the trademark in a licence agreement with DHLI. Other agreements and correspondence between the parties also indicated that DHL US was the legal owner, but the agreements were informal and imprecise. Also, in negotiations with investors, DHL US was presented as the owner. However, the trademark was registered to DHLI in all countries apart from the United States, and DHLI incurred all marketing costs with respect to the international rights. The IRS asserted that, in the absence of a CSA, all rights to the trademark were owned by DHL US. The arguments were that DHL US was the legal owner of the trademark and that DHL’s marketing expenses were not above an arm’s length level.1822 DHL, on the other side, argued that legal ownership was irrelevant under the 1968 DA rule, And further that DHLI should be regarded as the owner of the international rights because DHLI incurred all marketing costs connected to those rights. The Tax Court ruling was, in the author’s view, unfortunate for several reasons. First, the court misguidedly focused on the licence agreement between DHL US and DHLI. It found that, under US intellectual property law, a licenser was entitled to the value of a trademark even if that value had been created through the efforts of a licensee.1823 Further, the validity of a trademark licence was contingent on sufficient control by the licenser

1822. On this last aspect of the Tax Court ruling (i.e. on the “bright line test” with respect to whether the marketing expenses exceeded an arm’s length level), see, in particular, Levey et al. (2006), at p. 3. 1823. See Cotton Ginny, Ltd. v. Cotton Gin, Inc., 691 F.Supp. 1347 (S.D.Fla., 1988).

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Determination of IP ownership under the 1968 US regulations

over the quality of services sold under the trademark by the licensee.1824 The Court found that the “unique relationship of the corporate entities” was an adequate indication of the required control, even though there was no legal basis in the agreement to constitute such control. The Court, in the author’s view, disregarded the separate entity approach under IRC section 482, not to mention the fact that this entire problem was not relevant under the 1968 DA rule. Second, the Tax Court assessed the question of ownership and the determination of the developer under the 1968 DA rule separately. The two questions are the same and should have been determined as one under the DA rule. In essence, the Court framed the issue under the DA rule as whether the marketing efforts of DHLI justified joint ownership of the marketing intangible, a notion contrary to the fundamental point of the DA rule, which distinguishes a developer, who is entitled to residual profits, from assisters, who are not. There could only be one developer under the 1968 DA rule. Third, the Tax Court rejected DHL’s argument that the substantial marketing costs incurred by DHLI for establishing the DHL brand internationally entitled DHLI to a stake in the value of the DHL trademark. The Court dismissively stated: [I]n answering the question of whether the ownership of the DHL trademark was bifurcated between DHL and DHLI, we do not look to the section 482 regulations cited by petitioners. Although those regulations may have some effect on our allocation decision, they are not relevant in deciding the ownership of the trademark rights as a predicate for valuing the trademark.1825

Obviously, the 1968 regulations were not only relevant, but decisive.1826 Fourth, the Tax Court rejected that DHLI should be assigned ownership to the worldwide trademark rights on the basis of its marketing expenditures, as “there has been no showing that the costs incurred for registration and/ or enhancement of the trademark were more than a licensee would have expended at arm’s length”.1827 1824. See 15 U.S.C. § 1055 and § 1127; and Haymaker Sports, Inc. v. Turian, 581 F.2d 257 (C.C.P.A., 1978). See also McCarthy (1996), at sec. 18.42, pp. 18-66. A lack of control provisions could entail that the licenser’s rights to the trademark are abandoned; see Stanfield v. Osborne Industries, Inc., 839 F.Supp. 1499 (D.Kan., 1993), order affirmed by 52 F.3d 867 (10th Cir., 1995), certiorari denied by 516 U.S. 920 (U.S., 1995). See also McCarthy (1996), at sec. 18.48, pp. 18-75. 1825. See T.C. Memo. 1998-46, at p. 43. 1826. See also Ossi (1999). 1827. See T.C. Memo. 1998-46, at p. 55.

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This was clearly not a relevant factor under the 1968 DA rule. The question was simply that of which entity incurred the lion’s share of the development costs. The author suspects that the Court’s erroneous interpretation of the law on this point was influenced by the somewhat contradictory arguments from the DHL group with respect to the significance of marketing expenditures. On the one side, it was important for DHL to clearly convey that DHLI incurred substantial worldwide marketing expenditures (worth approximately USD 340 million) in order to substantiate its claim that DHLI should be considered the developer under the DA rule. On the other side, DHL sought to defend its modest USD 20 million valuation of the trademark transfer as an arm’s length price, a number grossly incommensurate with the marketing expenditures incurred to build the value of the trademark. The Tax Court’s opinion was, however, immoderate; DHLI was not even afforded the status of assister under the DA rule. On appeal, the Ninth Circuit reversed the Tax Court’s ruling on the issue of the ownership of the international rights to the DHL trademark. The Ninth Circuit found no legal basis to require DHL to demonstrate that DHLI’s marketing expenditures exceeded the level that would have been incurred in arm’s length dealings. It was found that the Tax Court had mistakenly applied a rule in the 1994 regulations that governed the allocation of income to assisters that stated that assistance did not include expenditures of a routine nature that an unrelated party dealing at arm’s length would be expected to incur under similar circumstances.1828 Of course, the 1994 provisions did not apply to the reassessed income years (1982-1992). The Ninth Circuit found that even if it had been applicable, it would have been difficult to apply, as there was no clear line between the development and exploitation of a trademark. Further, DHLI, through its marketing efforts, had developed the DHL trademark outside the United States, and it was the service network of DHLI that was the basis for the value of the trademark.1829 The Ninth Circuit found that the Tax Court’s reliance on legal ownership for determining the allocation of profits was in conflict with the wording of the DA rule. The Ninth Circuit found support for its interpretation in the preamble of the 1994 regulations, where it was made clear that the 1968 regulations disregarded legal ownership for the purpose of determining which entity was the developer under the DA rule. 1828. See 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(iii). 1829. See Levey (2000) for a discussion of the divide between the exploitation and development of a trademark.

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Determination of IP ownership under the 1992 proposed and 1993 temporary US regulations

Further, the Ninth Circuit Court assessed the four factors listed in the DA rule.1830 It found that the first factor, pertaining to the relative development costs and risks borne by each controlled party, clearly indicated that DHLI was the developer of the foreign rights to the trademark. DHLI undertook registration of the trademark in all foreign jurisdictions and bore the related expenses, it paid for all marketing campaigns (totalling USD 340 million), it bore costs for protecting the trademark against infringement and handled all disputes. Further, all market-development activities outside of the United States were carried out by DHLI, and DHLI was found to be better situated to carry on the development independently, given its connections in international market jurisdictions. Finally, DHLI exercised control over the advertising and development of the international rights to the DHL trademark. Conversely, DHL US had not incurred any expenses with respect to the foreign rights to the trademark. The Ninth Circuit thus held that DHLI was the developer of the international rights to the DHL trademark under the 1968 DA rule or, alternatively, that DHLI provided assistance to DHL US’s development. If DHLI was regarded as the developer, there would be no basis for allocating any value from the worldwide rights to the trademark to DHL US. Alternatively, if DHLI was regarded as an assister, DHL US would be obliged to pay a consideration for that assistance, thereby completely setting off the USD 50 million transfer pricing increase that followed from the IRS’s reassessment. Thus, under both solutions, there would be no profit allocation to DHL US with respect to the value of the worldwide rights to the DHL trademark.

19.3. Determination of IP ownership under the 1992 proposed and 1993 temporary US regulations The 1992 proposed regulations carried over the DA rule, but added the so-called cheese example, which would soon become infamous.1831 In the period from the mid-1970s to the early 1990s, the IRS had garnered experience with the allocation of operating profits to US distribution subsidiaries of foreign-based multinationals. The “cheese” example expressed the IRS’s position on how such allocations should be performed.

1830. See the analysis of the 1968 DA rule in sec. 19.2.2. 1831. 1992 Prop. Treas. Regs. (57 FR 3571-01) § 1.482-2(d)(8)(iv), Example 4.

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Chapter 19 - The Evolution of the US and OECD Approaches to Intangible Ownership

The example pertained to a foreign parent that owned an established and valuable trade name connected to a particular brand of cheese. The trade name was not known in the United States prior to its introduction by a newly established US distribution subsidiary. The subsidiary incurred marketing expenses of USD 5 million, which were not reimbursed by the parent company, and supervised local marketing efforts. The example deemed the subsidiary the developer of the US rights to the trade name pursuant to the DA rule. Some commentators argued that the example augmented the DA rule,1832 but the IRS’s position was that it merely clarified it.1833 A problem with this initial version of the cheese example was, in the author’s view, its description of marketing expenses. No indication was provided as to the relative significance of the USD 5 million. Depending on the size of the multinational in question and the relevant marketing budget, the amount could be relatively large or small and lie below or above the level of expenses that a comparable unrelated distribution company would be obliged to incur without reimbursement, for instance, under a thirdparty franchisee agreement. Thus, given that it would not be possible to determine whether the expenditures were at arm’s length, the author finds it speculative that the example nevertheless deemed the subsidiary the developer, thereby entitling it to the residual profits.1834

19.4. Determination of IP ownership under the 1994 final US regulations 19.4.1. Introduction The 1994 US regulations introduced new rules for determining which group entity should be assigned ownership, and thereby the residual profits, from jointly developed intangibles. A key aspect of the 1994 IP ownership approach was the partial relinquishment of the DA rule. The 1994 IP ownership provisions were heavily modified when the new intra-group service rules were introduced in 2009, but the basic structure put in place in 1994 1832. It was also asserted that the “cheese” example was not compatible with the guidance provided in the regulations for the application of the resale price to tangible transactions. 1833. See the preamble to the 1993 regulations (58 FR 5263-02). 1834. The 1992 proposed regulations (57 FR 3571-01), including the “cheese” example, were carried over to the 1993 temporary regulations (58 FR 5263-02) without substantial changes. The DA rule was contained in § 1.482-4T(e)(3), and the cheese example in § 1.482-4T(e)(3)(iv), Example 4.

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Determination of IP ownership under the 1994 final US regulations

remains intact in the current IP ownership rules. In this sense, it can be said that the 1994 provisions formed the foundation for the current US rules on IP ownership that are analysed in chapter 21 and chapter 23. A thorough understanding of the 1994 provisions will aid in the interpretation of the current rules. The author therefore finds an analysis of the 1994 IP ownership rules necessary. The discussion is organized as follows. In order to properly frame the context in which the 1994 IP ownership provisions were introduced, in sections 19.4.2. and 19.4.3., the author will comment on two key reasons for why the United States replaced the DA rule. Further, the point of departure for assigning IP ownership under the 1994 regulations will be discussed in section 19.4.4. The “economic substance” exception is discussed in section 19.4.5. The “multiple owners” exception is discussed in section 19.4.6. Concluding remarks are provided in section 19.4.7.

19.4.2. Reason 1 for replacing the DA rule: Criticism against its treatment of the legal owner The DA rule was criticized for not giving effect to legal ownership for profit allocation purposes. As far as the author can gather, this was founded on the basic observation that the group entity deemed to be the developer under the DA rule would not necessarily hold legal title to the IP. In this direction, the preamble to the 1994 regulations stated that “at arm’s length, the legal owner could transfer the rights to the intangible to another person irrespective of the developer’s contribution to the development of the intangible”.1835 This wording is ambiguous. Only the developer could transfer the intangible at arm’s length under the DA rule. Another thing entirely is that the group entity that held the legal title to the IP could legally transfer it to another entity. The author therefore interprets the preamble to express that practical complications could arise when the group entity that held the legal title was not the entity deemed to be the developer under the DA rule. While the author does not contest this assertion as such, his view is that it 1835. See the preamble to § 1.482-4(f)(3) in the 1994 regulations (59 FR 34971-01). The sentence following the quote is as follows: “On the other hand, it would be unlikely that at arm’s length an unrelated party would incur substantial costs adding value to an intangible that was owned by an unrelated party, unless there was some assurance that the party that incurred the expenses would receive the opportunity to reap the benefit attributable to the expenses.”

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should have no bearing on the usefulness of the DA rule. In principle, there should be no significant pricing consequences connected to controlled transfers of the legal title alone. Realistically, the true core of the criticism likely emanated from the desire of multinationals to extract residual profits – particularly from marketing IP – from the source by way of allocating them to a foreign legal owner, regardless of the extent to which a US distribution subsidiary had contributed to the intangible’s development. Multinationals were presumably behind a 1994 draft of replacement provisions for the DA rule, penned by some Washington lawyers.1836 The draft claimed that a legal owner in third-party relationships would control the IP that it owned and therefore be entitled to the income from it. The draft argued that the same should apply among related entities. Closely connected to this was the comparable profits method (CPM)-akin pricing argument that US distribution entities that only contributed routine inputs to the value chain should not be entitled to residual profits, but should be compensated with a normal market return (e.g. on a cost-plus basis). The author does not find this chain of reasoning to be convincing. Intellectual property law is concerned with the protection of a group’s IP from third-party infringement, not with how the group decides to arrange the registration of ownership of its IP internally among its own entities. The allocation of operating profits among jurisdictions would be disconnected from intangible value creation if it were to hinge on legal form. To claim, as the draft did, that the allocation of operating profits pursuant to legal title alone would comport with economic reality is, in the author’s view, without merit. Further, the draft claimed that there was inconsistency between the 1968 DA rule and the 1993 proposed regulations for tangible property. In particular, the allocation of operating profits described in an example in the proposed regulations (Example 9),1837 illustrating the application of the resale price method, was not compatible with the DA rule. Example 9 pertained to a US distribution subsidiary that sold a product manufactured by its foreign parent. The product brand name at the outset was not widely known in the United States and did not command a premium price. The 1836. The draft was written by W.P. McClure and four other lawyers with McClure, Trotter & Mentz and was sent to the International Tax Counsel at the Department of the Treasury in a letter dated 14 March 1994. See McClure (1994) for the letter and draft in full. 1837. See 1993 Temp. Treas. Regs. (58 FR 5263-02) § 1.482-3T(c)(4), Example 9.

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Determination of IP ownership under the 1994 final US regulations

subsidiary and parent agreed that local US marketing should be carried out to develop the brand name. The subsidiary incurred the marketing expenses and supervised the marketing efforts. The parent bore the marketing costs by reducing the transfer price of the product sold to the subsidiary for local resale. Thus, the subsidiary effectively recharged its marketing expenses to the parent. As a result of the marketing efforts, the product began to command a premium price in the United States. The example stated that this “value should inure to the benefit of P since there has been no transfer to S of any intangible rights in the brand name”. In other words, the residual profits due to the US marketing intangible should be allocated fully to the parent. A fundamental criterion under the 1968 DA rule and the 1993 “cheese” example (see section 19.3.) was that the developer bore the intangible’s development costs.1838 This was not the case in Example 9. Thus, this assertion also lacked merit.

19.4.3. Reason 2 for replacing the DA rule: OECD conformity In the early 1960s, outbound foreign direct investment (FDI) from the United States was approximately five times the amount of inbound FDI.1839 By the mid-1990s, the United States imported roughly the same amount of capital as it exported. The increase in inbound FDI triggered transfer pricing disputes.1840 Trade between the United States and Japan – at the time, the two largest economies in the world measured by GDP – represented one of the most significant commercial relationships globally.1841 A notable 1838. See 1993 Temp. Treas. Regs. (58 FR 5263-02) § 1.482-4T(e)(3), § 1.482-4T(e)(3) (iv), Example 4. 1839. In the wake of the attention paid to roundtrip transactions in the late 1970s, the IRS began investigating import transactions by foreign-based multinationals, focusing on taxable losses due to marketing expenses. For an example of a case pertaining to Japanese distribution subsidiaries in the United States, see US v. Toyota Motor Corp., 569 F.Supp. 1158 (C.D.Cal., 1983); and U.S. v. Toyota Motor Corp., 561 F.Supp. 354 (C.D.Cal., 1983). 1840. The IRS issued audit statistics in the early 1990s. Total understatements for the ten largest trading partners of the United States amounted to USD 1.3 billion. This figure included understatements in the tax returns of 314 US subsidiaries of Japanese multinationals, to which USD 507.8 million in adjustments were proposed. See Wartzman (1993); Polinsky (1993); Haas (1991); Turro (1990); and Dworin (1990). 1841. When negotiations for the revised Japan-United States treaty commenced in the late 1960s, Japanese multinationals carried out relatively modest trade in the United States. In the 1990s, that trade increased significantly. See Miyatake et al. (1994), footnote 25 for further references.

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disagreement arose between the competent authorities of the United States and Japan with respect to the allocation of operating profits to US distribution subsidiaries of Japan-based multinationals.1842 The IRS asserted that the profits of US distribution subsidiaries were reduced as the result of profit shifting. Apparently, it was unofficially held that Japanese multinationals used entities in low-tax treaty jurisdictions (e.g. Singapore) to push US profits back to Japan without incurring tax. These alleged schemes were made possible through a combination of aggressive transfer pricing strategies, including the utilization of Singapore tax holidays and the tax-sparing credit benefits of the 1971 Japan-Singapore treaty.1843 The Japanese tax authorities held that Japanese enterprises made relatively less operating profits than their US counterparts, and that the profit margins of US distribution subsidiaries of Japanese multinationals therefore could not meaningfully be compared to the margins of solely domestic entities.1844 Japan held that its argument was supported by the fact that the corporate income tax rate in Japan was higher than in the United States and that it therefore did not make sense to shift taxable profits from the United States to Japan.1845 Japan represented a resounding voice within the OECD, urging the United States to conform its transfer pricing rules to the OECD consensus.1846 The OECD’s views, as expressed in the 1992 and 1993 Task Force Reports, caused movement on the US side towards moderation on several of the positions taken in the 1992 proposed US regulations.1847

1842. For a thorough discussion of the Japan-US relationship, see Miyatake et al. (1994). There were over 20 cases of competent authority negotiations between the United States and Japan in 1996; see Yoost (1996), in some of which, there allegedly were problems with obtaining effective double taxation relief due to reluctance from both Japan and the United States to provide necessary refunds. 1843. See art. 21, nos. 1 and 4. See also Deloitte (2000); Tan (2001); and Miyatake et al. (1994), footnote 82. Pursuant to art. 21 of the treaty, Japan was obliged to provide credit for Japanese tax for tax paid on the same income in Singapore. The Japanese tax credit included relief for the amount of Singapore tax that would have been payable if not for a tax exemption or reduction under the special incentive provisions designed to enhance the economic growth in Singapore. 1844. See also the comments on international reactions to the 1988 White Paper in sec. 5.3.3., in particular, supra n. 524. 1845. See Turro (1992). 1846. See the reported comments by officials of the Japanese Ministry of Finance and National Tax Administration in Tax Management Transfer Pricing Report (TMTPR) (1992). 1847. See supra n. 910 on the objections raised in the reports against the cost-plus method.

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The author assumes that the US relinquishment of the DA rule may have been seen by the United States as a reasonable compromise, given the OECD controversy over other provisions in the proposed regulations, in particular the CPM and the periodic adjustment provision. The main US concern was likely the avoidance of asymmetrical allocation of income and expenses connected to US-developed IP, and in particular that US distribution subsidiaries of foreign-based multinationals should not be entitled to deduct substantial marketing expenses if the resulting residual profits were allocated to foreign group entities.

19.4.4. The point of departure under the 1994 IP ownership rules: The legal owner (of IP subject to legal protection) and the developer (of IP not subject to legal protection) are entitled to residual profits The 1994 regulations took a two-branched approach to the determination of which group entity should be considered the owner of an intangible, depending on whether the relevant intangible was subject to legal protection or not. With respect to legally protected intangibles,1848 the legal owner of a right to exploit such an intangible would “ordinarily” be considered the owner, and thus entitled to the residual profits.1849 This is regardless of how and to which extent other group entities contributed to the intangible development.1850 Legal ownership included ownership acquired through law or contract. The 1994 regulations provided two exceptions to this rule. First, the IRS was entitled to impute an agreement pursuant to which the residual profits from the US exploitation of a foreign-owned intangible would be allocated to the US entity if this aligned with the economic substance of the actual conduct of the controlled parties.1851 Second, the right to exploit an intan1848. The intangibles of most significance in transfer pricing practice tend to fall within this category. The lion’s share of the case law analysed in this book pertains to the allocation of profits from patents and trademarks. The author therefore assumes that the profit allocation consequences of the legal ownership rule (and its exceptions) were relatively more significant than those of the ownership rules for intangibles not subject to legal protection. 1849. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(ii)(A). 1850. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3). 1851. See the analysis in sec. 19.4.5.

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gible could be disaggregated into discrete legal units capable of separate ownership.1852 If triggered, the exceptions would entitle a US group entity, under the rationale of deemed ownership, to the residual profits from an intangible that it had contributed to the creation of, but did not hold legal title to. Further, with respect to intangibles not subject to legal protection (e.g. trade secrets and goodwill), the developer was considered the owner.1853 The regulations specifically stated that, outside of CSA contexts, when two or more group entities jointly developed an intangible, only one of the entities would be regarded as the developer, with the remaining entities considered to be assisters.1854 Thus, for intangibles not subject to legal protection, the DA rule in effect prevailed under the 1994 US regulations. The 1994 regulations prescribed a broad facts-and-circumstances-based assessment to determine which group entity should be deemed developer, akin to that of the 1968 regulations. Key factors continued to be which entity carried the largest portion of the development costs and which entity contributed IP without adequate compensation. If this could not be determined, the location of the development activities, the capacity of the involved parties to carry on the development activities independently, the extent to which each involved party controlled the development project and the actual conduct of the parties had to be taken into account. An assister was entitled to an arm’s length compensation “determined in accordance with the applicable rules under section 482”.1855 However, expenditures of a routine nature that an unrelated party dealing at arm’s length would be expected to incur without compensation under circumstances similar to those of the controlled taxpayer would not command remuneration.1856 An interesting question is whether an assister could be entitled to a portion of the residual profits from the fully developed intangible pursuant to the PSM, provided that it contributed unique inputs to the IP development process. This may immediately seem somewhat counterintuitive. After all, 1852. See the analysis in sec. 19.4.6. 1853. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(ii)(B). 1854. Id. Assistance included loans, services and the use of tangibles or intangibles as contributions to the intangible’s development. 1855. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(iii). 1856. Id.

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if assisters could also be entitled to residual profits, why bother to separate the developer from the assisters in the first place? Nevertheless, the 1994 US regulations did refer to the transfer pricing methods for determining the amount of operating profits allocable to an assister, thereby, in principle, leaving the door open for applying the PSM. The IP ownership provisions of the 1994 regulations were geared towards marketing IP.1857 The second “cheese” example pertained to a US distribution subsidiary that incurred excessive marketing costs, but was deemed to be an assister. It was allocated operating profits equal to “the fair market value of the services” provided by it.1858 The wording could, at first glance, seem to indicate that the subsidiary was entitled only to a normal market return pursuant to the one-sided methods, but it does not rule out the possibility that the subsidiary could be entitled to a portion of the residual profits.1859 In conclusion, the author’s impression is that assisters – if they contributed unique development inputs – in principle could be allocated residual profits under the 1994 regulations, as their remuneration was governed by the pricing methods. However, if only marketing expenses were contributed, the point of departure should be that a normal market return would suffice. Thus, if a distribution subsidiary possessed local marketing intangibles (e.g. goodwill, know-how or customer relationships) that it contributed to the development of new, or to the enhancement of the value of existing, marketing IP, the potential for a profit split could be triggered. 1857. The most significant contributions to the development of marketing intangibles are marketing expenses. At least at the outset, marketing expenses should not be regarded as unique contributions that attract residual profits, but should rather be allocated a risk-adjusted return. Compare the analysis of research and development (R&D) funding remuneration under the OECD TPG in sec. 22.4. 1858. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(3)(iv), Example 3. 1859. Langbein (2005), at p. 1076 noted that the regulations did not directly answer the question of whether an assister should be allocated only a normal market return or a portion of the residual profits. He found little support for either direction in the 1994 Treas. Regs. (59 FR 34971-01) § 1.482-2(b)(3), which governed profit allocation for intra-group services, or in the provision pertaining to tangible rental in the 1994 Treas. Regs. (59 FR 34971-01) § 1.482-2(c)(2). However, on the basis of the former provision, Langbein concluded that “the best argument would seem to be that this provision implies that the allocation should involve a ‘share’ of the profit, not just a marginal return”. Further, he found that if the assister were to receive a portion of the residual profits, it should be calculated on the basis of the assister’s intangible development costs. The author take it that this implied that the residual profits should be allocated among the legal owner of the intangible and the assister in relation to the intangible’s development costs incurred by them.

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19.4.5. The first exception to the legal ownership rule: Economic substance The 1994 regulations authorized the allocation of profits from the exploitation of legally protected IP to a group entity different from that which held legal title to it, provided that the actual conduct of the parties indicated that the former entity, in economic substance, was the owner.1860 The economic substance imputation provision was illustrated in an example pertaining to a US distribution subsidiary that sold products under an initially unknown trade name, which was legally owned by a foreign parent.1861 The subsidiary incurred expenses in years 1-6 to promote the trade name that were substantially larger than the marketing expenses incurred by unrelated parties in comparable transactions. By year 7, the trade name was established in the United States, and the product generated residual profits. The contractual relationship between the entities was then structured so that the subsidiary became a commission agent, allowing it to earn a normal market return only. The example deemed it unlikely that the subsidiary, at arm’s length, would incur such incremental expenses in years 1-6 without benefitting in year 7 onwards. It therefore allocated an “appropriate portion of the price premium” attributable to the trade name to the subsidiary.1862 The quoted wording may be interpreted as to allow a split of the residual US marketing profits. That is somewhat peculiar, as the construction is that the subsidiary, in economic substance, is deemed the owner. It therefore seems more natural that the subsidiary would be entitled to the entirety of the profits. However, a profit split would likely result in most of the profits being allocated to the subsidiary in any case. The reason for this is that the allocation would likely have to be based on an analogical application of the PSM, under which the profits would be split pursuant to the relative value of the respective intangible development contributions.1863 The legal owner

1860. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(ii)(A), last two sentences; see also § 1.482-1(d)(3)(ii)(B). 1861. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-1(d)(3)(ii)(C), Example 3. 1862. Langbein (2005), at p. 1074 noted that it was unclear as to at which point the distributor would be deemed owner. The author agrees, in principle, but it may be that, in practice, residual profits are generated subsequent to a relatively lengthy development process, after which it could be clear that the distributor should be deemed owner. 1863. See the analysis of the US profit split method in ch. 9.

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would likely not “contribute” anything apart from being registered as the legal title holder, while all of the marketing functions and risks would be provided by the subsidiary.

19.4.6. The second exception to the legal ownership rule: The multiple owners rule (1994 cheese examples) The 1994 regulations found that because the right to exploit an intangible can be “subdivided in various ways”, a single intangible may have “multiple owners” under IRC section 482.1864 For instance, if the owner of an intangible licensed exclusive exploitation rights for a specific geographical area for a set period of time to a related entity, “both the licensee and the licensor will be considered owners” with respect to their discrete exploitation rights. This rule applied to both legally protected and non-protected intangibles, but would likely be relevant mostly in the former context. The author therefore views it as an exception to the legal ownership rule. He will refer to this as the “multiple owners rule”. The notorious 1992 cheese example (see the discussion in section 19.3.) was now expanded into three variants in an attempt to illustrate both the legal ownership rule and the multiple owners exception.1865 The examples shed light on the degree to which the new approach yielded results that deviated from the 1968 DA rule. In all three variants, the US subsidiary incurred concurrent marketing expenses that were not refunded by its foreign parent.1866 In the base example,1867 the US subsidiary incurred marketing expenses on a level comparable to that of uncontrolled distributors that marketed similar products in the United States under a foreign trade name. In this situation, no profits would be allocated to the subsidiary for its marketing activity, as it would have incurred the same level of expenses, had it been unrelated to its parent.

1864. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(i). 1865. For an informed discussion of the “cheese” examples, see Culbertson et al. (2003), at p. 118. See also the comments in Levey et al. (2006), at p. 2. 1866. The 1994 cheese examples were controversial. The IRS would remain focused on clarifying them. See Bureau of National Affairs (BNA)(1998), reporting comments by Associate Chief Counsel International Michael Danilack; and BNA (1999). 1867. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(iv), Example 2.

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In the second variant,1868 the marketing expenses were significantly larger than those incurred by independent distributors under similar circumstances. The expenditures were considered separate services rendered by the subsidiary, which required fair market value compensation. The author interprets the example to require only a normal market return (typically cost-plus-based) to be allocated to the subsidiary, as opposed to residual profits.1869 In the third variant,1870 the US subsidiary, while incurring marketing expenses significantly above an arm’s length level, operated under a longterm contract with its parent, pursuant to which it had the exclusive right to resell cheese purchased from the parent at arm’s length. In this case, the regulations simply regarded the subsidiary as the owner of the trademark for US exploitation purposes. Consequently, the excess marketing efforts of the subsidiary were not seen as services rendered for the benefit of the foreign parent that should be compensated on a separate basis. The subsidiary was entitled to a significantly greater reward: the entire US residual marketing profits.1871 The same result would likely have followed from the DA rule, had it been applicable. The author is not convinced that the multiple owners rule was well founded. First, its threshold for application seemed rather artificial. Both the second and third cheese examples pertained to a situation in which the US distribution subsidiary incurred marketing expenses significantly above an arm’s length level. In the second example, the foreign legal owner prevailed, resulting in extraction of the residual US marketing profits from the source. Conversely, the US subsidiary was allocated the residual profits in the third example. The author does not find any substantial differences between the factual patterns in these two examples. Yes, the third example specified that there was a long-term and exclusive licence agreement in place. However, at least ostensibly, that description could, in substance, fit just as well in the second example. Controlled distribution structures are often exclusive in substance, regardless of whether they are formalized. 1868. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(iv), Example 3. 1869. See also Jie-A-Joen et al. (2007), under the section entitled “Arm’s length compensation for (incremental) marketing activities”. 1870. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(iv), Example 4. 1871. See Langbein (2005), at p. 1076, who seemed to disagree. He questioned whether the allocation of income to the US entity in this third example, in which the entity is deemed the owner, would be significantly different from the allocation that it would have received had it been seen only as a service provider (as the case was in the second cheese example).

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Determination of IP ownership under the 1994 final US regulations

Second, when viewed as a profit allocation rule, the multiple owners provision seemed to break with the rationale behind the CPM and PSM methodology introduced in the very same 1994 regulations. These new pricing methods dictated that the allocation of operating profits should be founded on an analysis of the functions performed, assets used and risks incurred, and in particular, that only unique contributions should attract residual profits. The multiple owners rule, however, instead allocated residual profits based on a narrower assessment, focused on the incremental marketing costs incurred by the local distribution subsidiary. If these costs were high enough, the subsidiary could be deemed the owner, provided that a long-term, exclusive licence agreement was in place. In other words, the subsidiary could be allocated residual profits even if it did not contribute any unique development inputs. A possible explanation for this inconsistency may lie in the basic observation that the multiple owners exception targeted marketing intangibles, the development of which is mainly cost-driven1872 and less reliant on unique inputs than what typically will be the case for R&D-based manufacturing intangibles. Also, a distribution subsidiary that develops a local marketing intangible may, in practice, own other unique intangibles (e.g. goodwill or know-how) that are used in its marketing development. If so, the result of the multiple owners rule may be easier to reconcile with the logic of the new pricing methods. Professor Langbein seemed to be wary of the consequences for the US tax base of rules that attract residual profits based on costs (including the economic substance exception and the multiple owners rule).1873 His point seemed to be that outsourcing could place such costs outside the United States, thereby extracting profits that otherwise would have been allocable to the United States. The author agrees, in principle, but the point of departure for determining IP ownership, both under the US regulations and the OECD MTC, was legal ownership. Had there been no economic substance exception and the multiple owners rule, multinationals would be free to assign legal ownership, and thus residual profits, to the group entity of choice in the first place. This is a theoretical observation, as it is difficult to imagine that a legal ownership rule without exceptions could realistically be implemented. The multiple owners rule was geared towards inbound transactions, where the 1872. See also 1979 OECD Report, para. 126. 1873. Langbein (2005), at p. 1078.

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practical concern was to attract residual profits to the United States when a local distribution subsidiary incurred, and deducted, excessive marketing expenses. The multiple owners rule likely sought to protect the US tax base through a substance view akin to that of the 1968 DA rule, while also accommodating the OECD to some extent by moving towards the more commonly accepted platform of legal ownership. Conversely, the new pricing methods (at least the CPM) were more geared towards outbound contexts, focused on taxing intangible value created in the United States. Ultimately, however, there should, in principle, be no difference in the fundamental logic applied for allocating operating profits, regardless of whether the context is inbound or outbound. The concern in both scenarios is to provide appropriate remuneration for intangible development contributions.

19.4.7. Concluding remarks on the 1994 US approach to intangible ownership The 1994 replacement of the 1968 DA rule for legally protected intangibles with the legal ownership rule was not as dramatic as one immediately could assume, due to the economic substance and multiple owners exceptions. The replacement was, however, in the author’s view, largely a step backwards, from an outright substance assessment towards giving effect, at least at the outset, to legal formalities for pricing purposes. As discussed in sections 19.4.1.-19.4.6., the author suspects that the reason behind the change was to accommodate the historical view of the OECD that residual profits from intangibles should accrue to the legal owner. The 1994 revision likely entailed a certain relaxation compared to the results that would have followed from the DA rule in that less operating profits would be allocable to the United States in some contexts. For instance, a US distribution subsidiary could incur excessive marketing expenditures, only to be remunerated on a cost-plus basis as a service provider under the 1994 regulations,1874 while the same would normally not be possible under the DA rule.1875 This was likely a dilemma for foreign multinationals with US 1874. See the comments on the second cheese example in sec. 19.4.6. 1875. This, however, did not mean that a foreign-based multinational could just remove the exclusivity clause from its distribution agreement with its US subsidiary and thereby enable the extraction of US residual profits free of consequences under the 1994 regulations. The IRS apparently took the audit position that a US entity would not, at arm’s length, have incurred incremental marketing expenses without being an exclusive distributor. Unless there was an exclusive distribution agreement, the marketing costs would not be incurred to the benefit of the US subsidiary, and therefore would not be deductible. See Boykin (1996).

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Determination of IP ownership under the historical OECD TPG

sales. On the one side, they could opt for exclusive distribution agreements, but that would likely attract residual profits to the US subsidiary under the multiple owners rule.1876 Alternatively, if the multinational opted for non-exclusive US distribution, it would likely suffice to allocate a normal market return to the US entity, but income tax deductions would then be denied for marketing costs above an arm’s length level. The choice between exclusive or non-exclusive distribution arrangements was therefore likely puzzling when substantial marketing expenses over consecutive income periods were expected to be necessary, followed by sizable residual profits from US sales. This could, for instance, be practical when a new, high-profit-potential product had to be introduced in a competitive market through extraordinary marketing activities in the initial sales years.

19.5. Determination of IP ownership under the historical OECD TPG The 1979 OECD Report did not provide much guidance on how residual profits generated through exploitation of intra-group-developed IP should be allocated among the group entities that contributed to the IP development process. With respect to manufacturing IP developed through joint R&D, it offered only a brief description of relevant contractual structures, but no guidance on profit allocation was to be found. On marketing IP, it noted that “the value for the licensor may increase as the result of efforts and expenditure by the licensee”.1877 However, no guidance was offered on how the arm’s length royalty rate should be established when the licensee contributed to the intangible value. It merely indicated that the costs incurred by the licensee would affect the determination.

1876. Not only that, but the US subsidiary would then be regarded as owner of the US marketing intangible. A buy-out charge could possibly be triggered on the value of the intangible if the US subsidiary in a business restructuring later was contractually stripped of assets and risks in order to accommodate a low-risk distributor classification aimed at allocating less profits to the United States. As the 1994 regulations were issued around the time during which multinationals were becoming interested in the possibilities offered by tax-driven business restructurings to establish centralized principal models (see supra n. 185), the author assumes that this was a relevant consideration. 1877. 1979 OECD Report, para. 136.

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The rule of the 1995 and 2010 OECD TPG was that the legal owner should be allocated the residual profits.1878 No particular guidance was offered with respect to the allocation of residual profits from intra-group-developed manufacturing IP. With respect to marketing IP, however, the position was that the distributor would not be “entitled to share in any return attributable to the marketing intangible” if the foreign legal owner reimbursed the marketing costs.1879 The same would not necessarily be the case if the costs were not refunded. A distributor under a long-term, exclusive distribution agreement could receive sufficient “benefits from its investments in developing the value of a trademark” from increased sales. The author interprets this to entail that the distributor would not be entitled to separate remuneration for his marketing activities. The logic was likely that this scenario was analogous to franchising agreements, in which the distributor is expected to incur marketing costs that benefit the value of a trademark owned by the franchiser without any specific remuneration. The 1995 OECD discussion draft was seemingly more lenient on this point. It stated that the problem could be approached by looking at the “functions that each party performs”.1880 This wording was scrapped in the consensus text of the final 1995 OECD TPG and was replaced with a reference only to the “substance of rights”.1881 The 1995 OECD discussion draft further assumed that the distributor, in an arm’s length dealing, normally would be entitled to “some additional profits” if those activities were successful.1882 The author interprets this as possibly entailing that the distributor was to receive some share of the residual profits generated through the exploitation of the intangible. The 1995 OECD discussion draft further stated that, to the extent that the distributor incurred greater expenditures than unrelated parties would have incurred in similar circumstances, an appropriate compensation should be received.1883 It is not clear whether this wording intended to convey that a cost-plus remuneration would be sufficient for the incremental costs or whether the distributor should be entitled to share in the residual profits. 1878. Conversely, see the 1995 OECD TPG, para. 3.36. See the discussion in sec. 19.4.3. on how the material content of the US IP ownership rules gravitated towards this OECD consensus approach. 1879. 1995 OECD TPG, para. 6.37. 1880. See the 1995 OECD discussion draft, para. 43. 1881. See the 1995 OECD TPG, para. 6.38. 1882. See the 1995 OECD discussion draft, para. 44. 1883. Id.

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Determination of IP ownership under the historical OECD TPG

The OECD position taken in the final 1995 consensus text on this profit allocation issue for when a distributor incurred “extraordinary marketing expenditures” without reimbursement from the owner of the marketing IP was hesitant.1884 It is noted that the distributor “might” be allocated a portion of the residual profits from the marketing intangible, “perhaps” either through a decrease in the purchase price for the product or a reduction in the royalty rate.1885 It is apparent that the OECD in reality was unable to reach clear consensus on this issue.1886

1884. 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(3)(iv), Example 3. The discussion is clearly inspired by the cheese examples of the 1994 US regulations, which, in comparison, applied the similar terminology of “significantly larger than the expenses” incurred by unrelated distributors. 1885. 1995 OECD TPG, para. 6.38. 1886. The guidance pertaining to the treatment of extraordinary marketing expenditures was a delayed issue in the process towards the final 1995 consensus text. There was no wording covering this issue in the 1995 OECD discussion draft.

587

Chapter 20 A Lead-In to the Determination of IP Ownership under the US Regulations and OECD TPG: A Story about Legal Ownership, Control and Economic Substance 20.1. Introduction This chapter will serve as a lead-in to the topic of which group entity should be deemed owner of, and thereby entitled to the residual profits from, intangibles developed internally within a multinational under the current US regulations and the OECD Transfer Pricing Guidelines (OECD TPG).1887 The group entity that holds legal ownership of an intangible will, in practice, be the entity that actually receives royalty payments from other group entities that license the intangible, simply because the group has structured its agreements like this. The legal owner therefore forms a practical point of departure for identifying which entity should be allocated the residual profits. If it is not possible to identify a legal owner, typically because the intangible in question is not subject to legal protection, the group entity that controls the intangible will form this point of departure. Neither the US regulations nor the OECD TPG place decisive relevance on legal ownership in and of itself for profit allocation purposes. In the context of transfer pricing, legal ownership should be seen as a formality that is comprehensively unsuitable to guide the allocation of operating profits among jurisdictions. Instead, the United States and OECD rely on substance-based rules to align the allocation of operating profits from internally developed intangibles with the underlying development contributions to intangible value. Nevertheless, some aspects of the US and OECD provisions on legal ownership require clarification. The author will therefore comment on the provisions in sections 20.2. and 20.3., respectively, before some brief common remarks on the use of control as a criterion for ownership are made in section 20.4. The substance-based ownership rules that are decisive for profit allocation under both the US and OECD regimes are ana1887. See also Pankiv (2017), at p. 80, who emphasizes that the concept of ownership for transfer pricing purposes functions as a “label” for a group entity’s entitlement to intangible property (IP) profits.

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lysed in depth in chapters 21-25 of the book. The author will introduce them in section 20.5., as they may be seen as exceptions to the “legal ownership rule”.

20.2. The US regulations 20.2.1. Introduction The current US regulations give effect to legal ownership for profit allocation purposes only if doing so is compatible with the economic substance of the controlled transaction.1888 The author will briefly comment on the legal ownership rule in section 20.2.2. before discussing the treatment of licensees in section 20.2.3.

20.2.2. Legal ownership The legal owner of an intangible is the group entity designated as the owner pursuant to the intellectual property law of the relevant jurisdiction, or as the holder of the rights constituting an intangible under contractual terms or other legal provisions.1889 This entity is considered the “sole owner” of the respective intangible, and is thereby entitled to the residual profits from the intangible. This will, in practice, be the entity that is registered as the owner in a central government registry, for instance, the US Patent and Trademark Office, or designated as the legal owner in controlled agreements.

1888. Treas. Regs. § 1.482-4(f)(3)(i)(A). The rule was proposed in 2003 (68 FR 5344801), affirmed in 2006 (71 FR 44466-01) and adopted without changes in the final 2009 service regulations (74 FR 38830-01). See also Treas. Regs. § 1.482-4(f)(3)(i)(B), which delimits the scope of the legal ownership rule vis-à-vis intangibles developed through cost-sharing arrangements (CSAs) that are governed by Treas. Regs. § 1.482-7. Wittendorff (2010a), at p. 625 states that “Section 482 does not govern the ownership of intangibles for transfer pricing purposes”. He also states, at p. 629, that “Article 9 (1) does not govern the tax ownership of intangibles”. The author finds these assertions to be ambiguous. There is no doubt that the intangible ownership provisions of the US regulations and OECD TPG are decisive for the allocation of operating profits from internally developed intangibles among the group entities that contributed to the development process. See Brauner (2008), at p. 125 for reflections on the US IP ownership provisions. 1889. Treas. Regs. § 1.482-4(f)(3)(i)(A).

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20.2.3. The treatment of licensees The US legal ownership rule conceals a convoluted legislative stance with respect to the treatment of specific rights to an intangible in particular licences. It states that “the holder of rights constituting an intangible property pursuant to contractual terms (such as the terms of a license) … will be considered the sole owner of the respective intangible property”.1890 In other words, a licensee is considered the legal owner of the licence. In this section, the author refers to the quoted provision as the “discrete owner rule”.1891 Its implications for how operating profits from the US exploitation of a licensed (unique) intangible should be allocated between a foreign licenser (the legal owner of the intangible as such) and the US licensee (the legal owner of the limited rights, i.e. the licence) are ambiguous.1892 The 1968 developer-assister (DA) rule took the position that a subsidiary that was deemed owner of the licensed US rights should not be obligated to pay any royalties.1893 In other words, the subsidiary was entitled to keep the entirety of the residual profits from the locally developed trademark. This was also the stance in the third 1994 “cheese” example (see the analysis in section 19.4.6.). The question is whether the 2009 discrete owner rule takes the same position.1894 First, the preamble to the 2003 proposed regulations stated that a purpose of the new ownership provision was to replace the “multiple owners rule” in the 1994 cheese examples with the identification of “a single owner for each discrete intangible”. This gives the impression that the new approach was to differ from the 1994 result. One would also logically assume this 1890. Id. 1891. The rule may conceivably also encompass other rights than those conveyed through a licence agreement, but this is likely not practical. In any case, the regulations focus solely on licence agreements in the context of the discrete owner rule. 1892. The problem is, in particular, relevant when a US subsidiary licenses a marketing intangible and incurs an above-arm’s length level of marketing expenses to build the local value of the trademark. See the analysis of this issue in sec. 23.4.3. 1893. See the analysis of the 1968 developer-assister (DA) rule in sec. 19.2. 1894. In terms of context, a foreign third-party licenser of a unique trademark may be in a bargaining position that makes it possible to extract most of the residual profits from a licensee’s local exploitation of the trademark. However, if the licensee contributes non-routine inputs to the value chain (goodwill, know-how, etc.), the licenser may be placed in a relatively weakened bargaining position and forced to surrender more of the residual profits to the licensee. It is apparently typical in third-party licensing structures (e.g. franchising agreements) to oblige the licensee to perform a certain level of marketing activities without remuneration.

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to be the case, as there should be no reason to replace the 1994 multiple owners rule otherwise. However, the replacement of a rule pertaining to multiple legal owners of the same intangible with one identifying a single legal owner for each legally protected facet of a single intangible does not immediately seem to make much of a difference. The ambiguity of the preamble makes it difficult to deduct arguments in either direction. Further, the preamble specifically stated that it intended to replace the multiple owners rule with a rule that gave effect to the legal ownership of an intangible. The motivation behind this was that the application of the notion of ownership under the 1994 regulations as an analytical tool for allocating residual profits had been criticized.1895 The US Internal Revenue Service (IRS) resented “black or white” income allocation patterns, as they typically would not properly reflect the dynamic of the varying underlying contributions to intangible development from the group entities involved. The solution was to discard the idea behind the 1968 DA rule that only one of the contributing entities should be entitled to the residual profits. A goal of the 2009 approach was therefore to more clearly distinguish between ownership and transfer pricing rules. The fact that a licensee was not deemed owner of an intangible that it contributed to the creation of did not necessarily entail that it would not be entitled to a portion of the residual profits, as such remuneration could result from an application of the transfer pricing rules. Thus, the 2009 regulations abandoned the perceived “all or nothing” approach of the 1968 and 1994 regulations. For the 2009 approach to be meaningful, the first step, pertaining to the determination of legal ownership, should not be clouded by allocation-motivated and disaggregated constructions, such as the one indicated by the discrete owner rule. In fact, the author finds it difficult to reconcile the purpose stated in the 2003 preamble with the discrete owner rule. After all, if the aim were to distinguish between ownership and transfer pricing rules, then why use the construction of discrete ownership at all? In the author’s view, the logical step towards realizing the stated purpose would be to say that, as the point of departure, the legal owner is allocated the residual profits, while group entities that contribute to the intangible’s development are entitled to an arm’s length consideration, which could – but not necessarily would – attract a portion of the residual profits.

1895. 2003 Prop. Treas. Regs. (68 FR 53448-01), preamble, explanation of provisions, no. 2.

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Second, the wording of the provision indicates that a licensee is deemed owner of the licensed rights. In order for the wording to have meaning, one would assume that the owner is entitled to the operating profits generated by the licensed rights. The wording of the discrete owner rule is so broad, however, that the author takes issue with a literal interpretation. For instance, shall a US trademark licensee be deemed owner of the US rights even if it does not incur incremental marketing costs?1896 If so, the licensee would likely be treated more favourably than comparable thirdparty licensees that are obliged to pay an arm’s length royalty. This would deviate from the arm’s length notion that there should be parity in the tax treatment of controlled and third-party transactions. The author’s impression is therefore that an application of the discrete owner rule in cases in which a US licensee incurs only an arm’s length level of marketing expenditures is contrary to the arm’s length principle. Nevertheless, the wording of the provision seems to also encompass these scenarios. This touches upon a greater issue. What if the US licensee were not involved in the intangible development at all? For instance, if a US subsidiary licenses a proven patent from a Norwegian research and development (R&D) performing parent, the generous wording of the discrete owner rule may lend support to an argument that the subsidiary should be deemed owner of the rights to exploit the patent in the United States. The next logical step would be to claim entitlement to the residual profits generated through the US exploitation. Such a solution seems disconnected from the prevailing US Internal Revenue Code (IRC) section 482 transfer pricing principles. In spite of the broad wording, the 2009 examples focus on marketing intangibles, for which a US licensee does contribute to the value of the trademark by carrying out local marketing. Further, the ownership provisions are fundamental norms that assign entitlement to profits to group entities because they were involved in the intangible development and thus took part in the creation of intangible value. In the author’s example, the US licensee played no part in the development of the Norwegian patent. It therefore pertains to a pricing issue, not the determination of ownership. Third, the 2009 regulations provide two examples on the discrete owner rule, which are relevant here. The first example pertains to a foreign 1896. See the analysis of the remuneration of intangible development contributions in this context in sec. 23.4.2.

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parent that holds legal title to the worldwide rights to a trademark and is also registered as the legal owner in the United States.1897 It licenses exclusive US rights to the trademark to a local subsidiary. The example identifies the parent as the owner of the trademark pursuant to intellectual property law, and the US subsidiary is identified as the owner of the “license pursuant to the contractual terms of the license, but not the owner of the trademark”. The example provides no indication as to the income allocation consequences of deeming the US licensee the owner of the licence. The second example pertains to a foreign parent that carries out advertising for trademarked athletic gear in the Olympics,1898 which also enhances the value of the licensed US trademark rights. The example obligates the subsidiary to remunerate the parent for the services provided to increase the value of the US rights, regardless of the fact that the parent is the legal owner of the trademark as such. It seems reasonably clear that the example deems the subsidiary the owner of the US trademark rights. After all, if it were not, there should be no reason to compensate the parent. The example does not precisely state that the subsidiary shall be allocated the entire residual profits from its US exploitation of the licensed trademark rights, but this is the logical consequence of the obligation to remunerate the parent. This does not offer much clarification, as it is not indicated as to which transfer pricing method the parent’s remuneration shall be based on. If the marketing efforts of the parent are seen as routine contributions, the cost-plus method or the transactional net margin method (TNMM) will likely be applied to allocate a normal market return to the parent. Alternatively, if the marketing efforts are deemed unique contributions, the profit split method (PSM) will likely be applied, resulting in a split of the US profits from the exploitation of the US trademark rights. Thus, both examples are ambiguous with respect to the extent to which the US subsidiary, as the legal owner of the licence, is entitled to the residual profits from the US exploitation of the licensed intangible, and therefore do not lend much support to the interpretation of the discrete owner rule. Fourth, if one were to interpret the discrete owner rule as allocating the entire residual profits from the US exploitation of a licensed intangible to the 1897. Treas. Regs. § 1.482-4(f)(3)(ii), Example 1. 1898. Treas. Regs. § 1.482-4(f)(3)(ii), Example 6. See also the discussion under sec. 23.4.3.4.

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licensee, this would, of course, be intrusive on the controlled allocation of profits. As opposed to the owner of an intangible, a licensee is obligated to pay royalties for its use of the licensed rights. This basic distinction makes the construction of a licensee as the legal owner inherently problematic. If the US licensee were deemed owner of the licensed US rights, one would logically assume the result to be that the licensee should not pay any royalties. This could be a sensible solution when the US subsidiary incurs incremental marketing costs, but then based on the view that the subsidiary should be deemed owner of the US rights pursuant to economic substance, not legal ownership.1899 For these reasons, the author’s conclusion is that the discrete owner rule should likely be interpreted as having no bearing on the allocation of residual profits from a licensed intangible. A US licensee, as the holder of limited rights to an intangible, may, however, be entitled to some of the residual profits, but then as a result of the provisions on economic substance or the transfer pricing methods.1900 It seems to the author that the notion of legal ownership here has been “stretched” to include an artificial construction of licensees as deemed owners of licensed rights. Why this has been done, when the 2009 ownership provisions on economic substance and the transfer pricing methods offer rich possibilities for allocating residual profits to the United States when the facts and circumstances of a case make such an allocation appropriate, is unclear. An explanation of the discrete owner rule is likely to be found in the historical development of the ownership provisions. The 1968 DA rule professed a largely substance-driven assessment as to which entity was to be regarded as the owner. In this light, the 1994 legal ownership rule represented a somewhat formalistic approach, but was supplemented with the third cheese example, likely in order to at least ensure a substance-based approach to a specific and practical factual pattern. The distinct owner rule seems to be a continuation and further development of the multiple owners rule of the third cheese example. Compared to the 1994 approach, however, there is a significant difference in the legal context in which the discrete owner rule is to be applied. 1899. See the discussion in sec. 23.4.3.2. 1900. See the discussion of incremental marketing contributions to IP value in sec. 23.4.3.

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The 2009 ownership provisions on economic substance offer a far more substance-driven set of rules than the 1994 regulations. The IRS has substantial authority in these provisions to allocate income when a US licensee contributes to the development or value of a licensed intangible. Thus, there should be no need or place for the discrete owner rule. The current wording of the discrete owner rule should, in the author’s view, either be clarified or taken out.

20.3. The OECD TPG The legal owner of an intangible is the entity designated as such pursuant to the applicable law or governing contracts.1901 The 2017 intangibles guidance states that legal ownership by itself does “not confer any right ultimately to retain returns derived by the multinational group from exploiting the intangible, even though such returns may initially accrue to the legal owner as a result of its legal or contractual right to exploit the intangible”.1902 The amount of profits allocable to the group entity that holds legal title to an intangible developed intra-group depends on its intangible development contributions in the form of functions, assets and risks.1903 Further, the current OECD guidance deems a licensee the legal owner of its licence agreement. This provision seems to be a rather direct import of the 2009 US regulations’ discrete owner rule.1904 The author sceptical of the usefulness of viewing a licence agreement as a separate intangible for profit allocation purposes. He refers to the discussion of the US discrete owner rule in section 20.2.3.

1901. OECD TPG, para. 6.40. 1902. OECD TPG, para. 6.42. 1903. This is illustrated through an example that strips the legal owner of residual profits when it does not contribute to intangible value creation; see OECD TPG, annex to ch. 6, Example 1 (Premiere). The example allocates the residual profits to the parent alone on the basis of its functions performed, assets used and risks assumed. The subsidiary is allocated an arm’s length consideration for the patent administration services and nothing more. The guidance contains two extensions of this example; see OECD TPG, annex to ch. 6, Examples 2 and 3. 1904. Treas. Regs. § 1.482-4(f)(3). See also the discussion of the “discrete owners” rule in sec. 20.2.3.

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20.4. The determination of ownership of intangibles not subject to legal protection If the intangible in question is not subject to legal protection, the group entity that controls it is considered the sole owner under both the current US regulations and the OECD TPG.1905 This rule may be a practical point of departure for assessing ownership of intangibles such as know-how and local goodwill. The US regulations’ use of control as a criterion for ownership represents a departure from the 1994 approach, pursuant to which the DA rule was applied for determining ownership of intangibles not subject to legal protection, with intangible development costs being the key parameter. Thus, the last remnant of the 1968 DA rule is now removed. The control provision is illustrated in an example in the US regulations, in which a US manufacturing and distribution subsidiary developed a valuable customer list.1906 The example deems the subsidiary the owner of the list, as it “has knowledge of the contents of the list, and has practical control over its use and dissemination”.

20.5. Ownership and economic substance The fact that a group entity holds legal title to an intangible is, in itself, not relevant for the determination of whether it should be allocated residual profits generated by the exploitation of the intangible under the US regulations and the OECD guidance.1907 Profit allocation hinges on substance, not legal formalities.1908 The residual operating profits from the exploitation of 1905. Treas. Regs. § 1.482-4(f)(3)(i)(A); and OECD TPG, para. 6.40. The OECD TPG describe control as the ability to make decisions concerning the use and transfer of the intangible and the practical capacity to restrict others from using the intangible. 1906. See Treas. Regs. § 1.482-4(f)(3)(ii), Example 2. 1907. See also Pankiv (2017), at pp. 82 and 165; and Pankiv (2016), at p. 472. See also Wilkie (2012); Wilkie (2014a); Lagarden (2014); and Schwarz (2015). Further, the substance requirements for IP ownership under the OECD TPG must be held completely separate from the “beneficial owner” substance requirements for royalties under art. 12 of the OECD MTC, as the material content of the provisions differ substantially. On this point, see Pankiv (2017), at p. 171. See also Monsenego (2014), at p. 17, where a comparative analysis of the two concepts are carried out. 1908. See also Brauner (2016), at p. 106, with respect to the current OECD IP transfer pricing provisions. See also Brauner (2015), at p. 78. See, however, seemingly opposing viewpoints presented in Navarro (2017), at p. 230. In that direction, see also Kane (2014), at pp. 311 and 314. For a recent, general and comparative overview of the “economic sub-

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IP allocable to a group entity that purports to own the IP must reflect the value of the functions, assets and risks contributed by it to the development of the IP in question.1909 This is highlighted in the new IP ownership guidance of the 2017 OECD TPG, which states that in order for the legal owner to retain all residual profits generated through the exploitation of an intangible developed within the multinational, the group entity holding legal title must have performed and controlled all functions, provided all assets and bore and controlled all risks related to the development.1910 The logic behind this approach is that multinationals could easily shift their operating profits anywhere if the allocation depended on legal ownership. Intangible profits would then likely not be distributed to the jurisdictions where intangible value was created. Because legal ownership in and of itself does not determine the allocation of residual profits from the exploitation of unique IP under the US regulations and the OECD TPG, it is not immediately clear to the author how the relationship between the provisions on legal ownership (as discussed in sections 20.2.-20.3.) and the substance-based profit allocation rules (which are the topic of discussion in chapters 21-24) should best be portrayed. On the one side, there is no doubt that legal ownership played a more central role in transfer pricing in the past. It still serves as a “reference point” for the profit allocation assessment.1911 Seen in this light, the substance-based allocation rules could be viewed as exceptions from the “legal ownership provisions”. This characterization would also align with the fact that the stance” approach to IP ownership, see Rocha (2017), at p. 213. See also Wilkie (2016), at p. 66, where the legal nature of the economic substance assessment is emphasized. 1909. In this sense, “IP ownership” can be seen as a label on a profit allocation result. See also, in this direction, Wilkie (2012), at p. 238, where it is stated: “‘[O]wnership’[is used] to connote what is necessary to explain the outcome of a functional analysis […].” 1910. OECD TPG, para. 6.71. This entails that if more than one group entity contributes to the creation of IP, the residual profits from the exploitation of that IP shall be split among these group entities, i.e. there may be more than one “owner” of the IP for transfer pricing purposes; see, e.g. Storck et al. (2016), at p. 217. See also Schwarz (2015), where it is argued that the 2017 OECD TPG place too little weight on the legal ownership of IP. Schoueri (2015), at p. 715 argues that the stripping of residual profits from a group entity that only funds research and development (R&D) and holds legal ownership of the developed manufacturing IP under the current OECD TPG is contrary to the arm’s length principle. For the reasons expressed in the analysis in ch. 22, the author does not agree. 1911. OECD TPG, para. 6.43.

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substance-based rules may, but will not necessarily, allocate the profits to a group entity different from that which holds legal title. Alternatively, the substance-based allocation rules may be seen as prerequisites for giving effect to legal ownership for profit allocation purposes, as the legal owner of IP developed intra-group will only be allocated the residual profits if its intangible development contributions in the form of functions, assets and risks justify such an allocation. Of course, this debate is only relevant for terminological purposes. Regardless of the perspective chosen, the substance-based allocation rules are decisive. For the purpose of further discussions, the author chooses to characterize the substance-based allocation rules as “exceptions” to the legal ownership provisions. This is in spite of the fact that there really is no such thing as a clear point of departure under the current US regulations or the OECD TPG dictating that the legal owner should be allocated the residual profits. The author does, however, find that his choice of terminology facilitates subsequent discussions in a straightforward manner. Moving on, what are these “substance-based allocation rules”? Both the US regulations and the OECD TPG have traditionally (and still do) distinguished rules for determining which group entity should be considered the owner of an intangible from rules that allocate operating profits for the IP in question (i.e. transfer pricing methods that price subsequent transfers of the intangible).1912 Both sets of rules are necessary in order to carry out a complete profit allocation. While the rules on ownership determine which group entities should be deemed entitled to the residual profits from the exploitation of unique IP to which they have contributed the development of, the transfer pricing rules govern the allocation of operating profits among the different intangible value chain inputs (and thus also for the unique IP in question). For instance, assume that the problem is to allocate a Norwegian distribution subsidiary’s operating profits of 100 from its local sales of a mobile phone. A functional analysis reveals that there are two main value chain inputs: (i) a patent licensed from a UK group entity; and (ii) routine sales functions performed by the subsidiary. The transfer pricing rules (methods) determine how the profits of 100 shall be allocated among the value chain inputs, i.e. the UK patent and the Norwegian sales functions. Assume 1912. The pricing rules are analysed in part 2 of this book.

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that the TNMM is chosen to remunerate the subsidiary, and that an arm’s length return is 10. That leaves a residual profit of 90 allocable for the UK patent. The ownership rules determine which group entities are entitled to the 90. Assume that a functional analysis determines that legal ownership is held by a UK entity, while the patent was developed fully through R&D carried out by a US entity and financed by an Irish entity. An application of the 2017 OECD TPG on IP ownership determines that (i) the UK entity is entitled to 5 as compensation for administrative and legal services connected to holding legal title; (ii) the Irish entity is entitled to 20 as a risk-adjusted rate of return on its financing contribution; and (iii) the US R&D entity is entitled to the residual profits of 65. Even though the transfer pricing methods and the rules on intangible ownership are clearly distinct, serve different purposes and pertain to different stages of the life of an intangible (namely the exploitation and development phases, respectively), there is an undeniable convergence between these two classes of provisions in the current generation of the US regulations and the OECD TPG. The ownership provisions are now essentially applications of the transfer pricing methods in the specific context of intangible development. The overarching idea is that a group entity should be allocated operating profits generated by internally developed IP commensurately with the value of its development contributions to that IP. This bears resemblance to the profit split transfer pricing method,1913 albeit applied in the context of development (as opposed to the context of subsequent exploitation, for which the methodology was originally designed). Thus, there is no longer a significant difference between the core material content of these two classes of rules. This convergence can be explained as follows. The US provisions on intangible ownership were revised in connection with the introduction of new transfer pricing methods for intra-group service transactions in 2009.1914 These new methods were meant to ensure that (i) the pricing 1913. See the analysis of the US and OECD profit split method (PSM) in ch. 9. 1914. The 2009 service methods mirror the general methods. See (i) the comparable uncontrolled services price method in Treas. Regs. § 1.482-9(c), mirroring the comparable uncontrolled price and comparable uncontrolled transaction methods; (ii) the gross services margin method in Treas. Regs. § 1.482-9(d), mirroring the resale price method; (iii) the cost-of-services-plus method in Treas. Regs. § 1.482-9(e), mirroring

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of intra-group services was harmonized with the commensurate-with-income framework of the 1994 regulations for the transfer pricing of tangible and intangible transactions; and (ii) economically similar transactions were treated similarly for transfer pricing purposes, regardless of their formal classification. For example, if the effect of a service transaction was to transfer an intangible, the profit allocation should not differ from the allocation that would have been carried out had the transaction been structured as an intangibles transfer. Pricing methods tailored to intragroup service transactions had been a long time coming in the United States.1915 The 2009 intra-group service pricing methods clearly influenced the content of the revised ownership rules. This is not surprising, as the allocation of residual profits from unique and valuable IP developed intra-group, on the one side, and the remuneration of controlled services that contribute to the IP development, on the other side, are highly interrelated issues that are not readily distinguishable.

the cost-plus method; (iv) the comparable profits method for services in Treas. Regs. § 1.482-9(f), mirroring the general CPM; and (v) the PSM in Treas. Regs. § 1.4829(g), mirroring the residual profit split method. The 2009 regulations also introduced the services cost method in Treas. Regs. § 1.482-9(b), a safe harbour rule for routine and low-yield “back office” services, pursuant to which the service transaction may be priced at cost plus, and the US Internal Revenue Service (IRS) may only reassess if the mark-up equals or exceeds 6%. 1915. Prior to the 1968 regulations (33 Fed. Reg. 5848), the courts applied a discretionary, facts-and-circumstances-based approach for pricing controlled service transactions. The author refers to Plumb et al. (1963) and Surrey (1968). The 1968 regulations did not contain specified pricing methods for service transactions (thus forcing taxpayers and the IRS to apply the methods for tangibles and intangibles analogically), but set out the rule that reassessments could be made to reflect an arm’s length charge for marketing, managerial, administrative, technical or other services performed by one group entity for the benefit of, or on behalf of, another group entity; see 1968 Treas. Regs. § 1.482-2(b)(1). The charge should be the amount that would have been charged for similar services in unrelated transactions under similar circumstances (see 1968 Treas. Regs. § 1.482-2(b)(3)), in practice, deemed to be equal to the costs incurred by the renderer in performing such services, unless the renderer established a more appropriate charge for services that were not an “integral part of the business activity” of either the renderer or the recipient of the services. The 1994 regulations introduced no new pricing methods for controlled services. The 1968 transfer pricing rules for services were therefore first replaced by the 2009 services regulations. For further on the services regulations, see IFA (2004). See also Kirschenbaum et al. (2003); PG (2003); ACC (2003); API (2003); B&M (2003); TEI (2003); SIA (2004); TEI (2004a); TEI (2004b); TEI (2004c); Wolosoff et al. (2004); ABA (2004); Birnkrant (2004); CIB (2004); Deloitte (2004); EY (2004); FW (2004); MBRM (2004); MBRM (2005); Stewart (2009); and Murphy (2010).

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The influence of the 2009 service regulations is evident in the economic substance IP ownership provisions,1916 as well as in provisions that govern concurrent remuneration of group entities that contribute to IP development.1917 The message of these provisions is that group entities that render IP development contributions may be allocated a portion of the residual profits if necessary to reflect an arm’s length charge. Further, for a long time, the OECD guidance on IP ownership remained conservative and sparse.1918 The new 2017 guidance seems heavily inspired by the 2009 US service regulations in its sweeping demand that group entities that contribute functions, assets and risks to the development of an intangible must be remunerated commensurately with the value of their development inputs, possibly entailing a portion of the residual profits.1919 The substance-based IP ownership rules that allocate residual profits among group entities, which the author refers to in the following discussions in chapters 21-24 as exceptions to the legal ownership rule, are systemically arranged as follows: – The US regulations: Two groups of provisions should be seen as one coherent set of rules for the purpose of allocating residual profits from the exploitation of unique and valuable IP developed intra-group. The first group encompasses the comparability provisions on economic substance.1920 The second group encompasses the provisions on the remuneration of group entities that contribute to the value of intangibles owned by other group entities.1921 The similarity with respect to

1916. Treas. Regs. § 1.482-4(f)(3). See also Treas. Regs. § 1.482-1(d)(3)(ii)(B), in particular, the examples in (C). 1917. Treas. Regs. § 1.482-4(f)(4). 1918. As discussed in sec. 19.5., the 1995 OECD TPG only provided modest guidance. There were no changes from the 1995 OECD TPG to the 2010 OECD TPG with respect to intra-group allocation of residual profits. In the aftermath of the 2007-2008 financial crisis, however, the development of the OECD TPG on this point picked up considerable speed. 1919. On a more general level, while the OECD’s focus traditionally has been on avoiding double taxation, the new 2017 guidance on ownership is pronouncedly geared towards avoiding BEPS, i.e. ensuring that intangible profits are taxed where they are created. 1920. Treas. Regs. § 1.482-4(f)(3). See also Treas. Regs. § 1.482-1(d)(3)(ii)(B), in particular, the examples in (C). 1921. Treas. Regs. § 1.482-4(f)(4).

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the material content of these two groups is underlined by the fact that certain examples pertain to similar factual patterns.1922 – The OECD TPG: Reference here is made to the section pertaining to intangible ownership (with the core paragraphs being 6.47-6.68), describing the significance of IP development contributions from different group entities in the form of functions, assets and risks for the purpose of allocating residual profits from unique and valuable IP developed intra-group. The author’s analysis of these substance-based exceptions is divided into two main blocks on the basis of the type of intangible developed. He will discuss the allocation of residual profits generated through the exploitation of intra-group-developed IP as follows: – manufacturing IP in chapter 21 and chapter 22 for the US regulations and the OECD TPG, respectively; and – marketing IP in chapter 23 and chapter 24 for the US regulations and the OECD TPG, respectively. The author finds it necessary to emphasize that the economic substance exceptions of the US regulations and the OECD TPG in principle apply equally to manufacturing and marketing intangibles. The reason why the author has chosen to separate the discussions is that the factual patterns relevant to the substance rules differ quite significantly, depending on whether the internally developed intangible in question is a manufacturing or marketing intangible. This is reflected in the fact that both the US regulations and the OECD TPG, to a large degree, discuss the treatment of the two types of intangibles separately. Further, he would like to add that while there are strong similarities between the approaches taken by the United States and the OECD with respect to the allocation of residual profits from marketing intangibles, their approaches differ considerably when it comes to internally developed (R&D-based) manufacturing intangibles. More specifically, the reader will note that while the US economic substance provisions are heavily geared towards marketing intangibles and inbound structures, they are conspicuously sparse with respect to manufac1922. These are the infamous “wristwatch” and “athletic gear” examples, which the author will revert to in depth in chs. 21 and 23.

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turing intangibles and outbound structures. This stands in contrast to the IP ownership provisions of the 2017 OECD TPG, which are heavily geared towards manufacturing intangibles developed intra-group and may be said to constitute the core of the new anti-BEPS guidance on intangibles. This is an important structural difference between the US and OECD approaches to IP ownership. The explanation behind it is not immediately apparent, as the allocation of residual profits from internally developed manufacturing intangibles is, of course, highly practical, also in the United States. The answer to this riddle likely lies in the fact that internal development of manufacturing intangibles within a multinational is often – and particularly in the United States (historically at least) – structured through specific legal vehicles, such as contract R&D arrangements and, most importantly, cost-sharing arrangements (CSAs). The US substance exceptions (as well as the transfer pricing methods for services and IP) are relevant for addressing contract R&D arrangements, but the guidance on this particular issue is modest.1923 With respect to CSAs, however, the US regulations offer expansive, innovative and aggressive guidance. This takes “pressure” off of – as well as relevance away from – the substance-based ownership rules. Thus, in order to form a representative view of how the US regulations address profit allocation in the context of internally developed manufacturing intangibles, it is crucial that the substance-based exceptions to the legal ownership rule are seen in light of the CSA regulations. When viewed in isolation, the substance exceptions provide a misleading picture of the depth and reach of the US regulations pertaining to the allocation of residual profits from internally developed manufacturing IP. In contrast, while the new 2017 OECD guidance on intangible ownership – in particular with respect to internally developed (R&D-based) manufacturing intangibles – is genuinely substance-driven and geared at effectively putting a stop to the current profit-shifting practices of multinationals, the new OECD guidance on CSAs, while certainly a step in the right direction, pales in comparison to the potent and sophisticated US rules. This triggers the question of what the consequences will be of these differing US and OECD approaches to IP ownership on this point.

1923. See the discussion in sec. 21.3.7., with further references.

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A multinational’s internal R&D will often be based on pre-existing intangibles, R&D results and other relevant resources controlled by it (such as R&D teams in place). The US regulations have therefore taken the position that the allocation of profits from manufacturing intangibles developed through CSAs is mainly a transfer pricing problem, in the sense that as long as the contribution of the pre-existing intangible (normally developed in the United States) to the CSA is priced at arm’s length, the “profit shifting” with respect to the income generated through the subsequent exploitation of future (second generation) intangibles developed through the CSA to foreign group entities should be respected. While this, on the surface, may seem as a comprehensively different approach to the OECD’s substance-driven ownership assessment, focusing on the functions, assets and risks contributed to the intangible development, it is not.1924 The US pricing of the pre-existing intangibles contributed to CSAs is highly substance-based. Normally, the pricing will be based on the income method, which represents an application of the principle of the best realistic options available.1925 The author would therefore say that the difference between the US and OECD approaches lies more in the methodologies applied than in the material content of the rules (with respect to the required profit allocation patterns). While it is not possible to gauge the extent to which the two approaches ultimately may yield differing profit allocation results, there is no question that the ultimate aim of both paradigms is the same, i.e. to allocate residual profits to the jurisdiction where the intangible value was created. The US rules on CSAs were discussed in chapter 14 as a part of the transfer pricing analysis. CSAs are clearly important for the purpose of allocating profits from internally developed manufacturing intangibles, and could therefore just as well have been a component of this “ownership” part of the book. This disposition was chosen, however, because the material content of the CSA provisions is more geared towards the issue of pricing than of ownership. In particular, the main purpose of the US cost-sharing regulations 1924. The author will add that it might be questioned as to whether the OECD approach to determining ownership of internally developed manufacturing intangibles places too little weight on traditional pricing assessments. The author will revert to this issue when discussing the treatment of other unique intangible development contributions under the current OECD guidance in sec. 22.5. 1925. See the discussion of the income method in sec. 14.2.8.3.

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Chapter 20 - A Lead-In to the Determination of IP Ownership under the US Regulations and OECD TPG: A Story about Legal Ownership

is to provide guidance on the pricing of the contribution of pre-existing intangibles to the CSA. A necessary consequence of this disposition is that the reader should bear in mind, when going through the discussion of the US economic substance exceptions pertaining to internally developed manufacturing intangibles,1926 that the CSA provisions lurk in the background.1927

1926. The US economic substance rules that are applied in the context of internally developed manufacturing intangibles are discussed in ch. 21. 1927. The US CSA regulations are analysed in ch. 14.

606

Chapter 21 The Distribution among Group Entities of Residual Profits Generated through Exploitation of Internally Developed Manufacturing IP under the US Regulations 21.1. Introduction The question in this chapter is how the intangible property (IP) ownership rules of the current US regulations allocate profits generated through the exploitation of internally developed manufacturing IP among the group entities that contributed to the development. The core aspect of that question is – as always with respect to the determination of IP ownership for transfer pricing purposes – which group entity shall be deemed entitled to the residual profits generated by the intra-group-developed IP. As discussed in chapter 20, the point of departure under the US regulations for determining which group entity should be entitled to the residual profits generated through the exploitation of IP developed intra-group is legal ownership. Nevertheless, legal ownership will not be given effect for transfer pricing purposes if it is not consistent with the economic substance of the actual behaviour of the controlled parties (the economic substance exception).1928 The US regulations are sparse and fragmented with respect to the application of the economic substance exception to intra-group-developed manufacturing IP, in contrast to their relatively extensive economic substance exception provisions for internally developed marketing IP (which are analysed in chapter 23). The author attributes this to two main factors. First, intra-group development of manufacturing intangibles has historically often been organized through cost-sharing arrangements (CSAs), which are now governed by the comprehensive CSA regulations discussed in chapter 14. CSAs specify that each participant in the agreement shall be entitled to a portion of the residual profits that corresponds to the participant’s fraction of the intangible development costs.1929 Thus, the agreements themselves resolve the profit allocation issue. Second, the transfer pricing methods, applied to a controlled transaction that is properly delineated to align with the econom1928. Treas. Regs. § 1.482-4(f)(3)(i)(A). 1929. Treas. Regs. § 1.482-7(b).

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Chapter 21 - US Distribution among Group Entities of Residual Profits from Exploitation of Internally Developed Manufacturing IP

ic substance of the actual conduct of the controlled parties, will ensure that a group entity that contributes to the development of an intangible receives an arm’s length compensation.1930 As the author will revert to, the US approach to determining ownership of internally developed manufacturing IP is different from that of the OECD.1931 The latter relies on a holistic substance approach, while the US regulations are focused on some specific profit allocation aspects. This chapter is divided into three sections. In section 21.2., the author discusses the value drivers behind manufacturing IP development. The bulk of the chapter is dedicated to an analysis of the US economic substance exception applied to manufacturing IP in section 21.3. Lastly, in section 21.4., the author discusses the US stance on profit allocation in contract research and development (R&D) arrangements in light of the new 2015 provisions on the application of the arm’s length standard and the best-method rule under US Internal Revenue Code (IRC) section 482, along with other code provisions.

21.2. The value drivers in manufacturing IP development Both the US and OECD rules on IP ownership fundamentally seek to allocate the profits generated by the exploitation of internally developed intangibles according to the relative values of the underlying development contributions from the involved group entities. The idea is that intangible profits should be taxed where the intangible value was created. This focus is particularly pronounced in the 2017 OECD TPG (discussed in chapter 22),1932 but also underlies the US rules. In terms of causality, three main development inputs are, in general, assumed to drive intangible value. First, the primary force behind the cre-

1930. Outside of cost-sharing arrangements (CSAs), the relevant methods will, in particular, be the comparable profits method and profit split method (PSM); see the analysis in ch. 8 and ch. 9, respectively. In the context of CSAs, the relevant methods are, in particular, the income method and the PSM; see the analysis in secs. 14.2.8.3. and 14.2.8.6., respectively. 1931. See the analysis of the new 2017 OECD Transfer Pricing Guidelines (OECD TPG) on the ownership of manufacturing intangible property (IP) in ch. 22. 1932. The author further develops his viewpoints on IP development value drivers in the context of the OECD TPG in sec. 22.2.

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The value drivers in manufacturing IP development

ation of unique manufacturing intangibles is R&D.1933 This is the work of clever, specialized and experienced minds, often working in concert. These R&D functions represent relatively unique IP development inputs that are not easily replaced. They are also pronouncedly immobile. There are normally deep ties between a person and his home, and the typical high-tax jurisdictions where these researchers work tend to be safe societies with good infrastructure. Thus, a multinational cannot easily motivate its researchers to relocate to low-tax jurisdictions, even if generous compensation packages are offered.1934 Second, unique manufacturing intangibles tend to be the result of lengthy, costly and risky R&D processes that are entirely dependent on sufficient access to risk-willing capital. Only a small fraction of R&D efforts achieve commercially viable results, while fewer still generate residual profits. However, projects that are successful may generate such extraordinary profits that they not only sustain their own R&D costs, but also the R&D costs of unsuccessful projects, in addition to providing satisfactory returns on the total capital invested. Capital is highly mobile. Thus, it is easy for a multinational to place R&D funding in a low-tax jurisdiction for profit shifting purposes. Third, the R&D carried out by a multinational often draws upon its historical research results, typically embodied in pre-existing unique intangibles, such as when version 1 of a successful piece of software forms the basis for ongoing R&D of version 2. In the context of IP development, pre-existing intangibles should likely be viewed as relatively immobile development inputs, as a transfer from the jurisdiction of origin may trigger a transfer pricing charge equal to their full value. Due to this “lock-in” effect, a multinational may be unable to effectively shift the profits associated with the pre-existing intangible abroad. For instance, if the buy-in amount for the 1933. This discussion focuses on the forces behind the creation of manufacturing IP specifically. It should be remembered, however, that in order to create a successful product based on manufacturing IP, significant marketing efforts (and marketing IP) will normally also be necessary; see, in particular, Roberge (2013), at p. 228. 1934. This picture may, however, to some extent, be evolving. Many otherwise hightax jurisdictions are now offering IP regimes (the freedom to offer such regimes going forward is restricted by the 2015 OECD nexus approach; see the analysis in sec. 2.5.) or low general tax rates, in combination with local infrastructure normally not found in typical low-tax jurisdictions. In combination with the current reliance of the OECD allocation rules on substantial “core value” research and development (R&D) functions may, over time, lead multinationals to base their “tax planning” on strategic human resources (hiring polices etc.), in the sense that core R&D departments are located in jurisdictions that offer favourable IP taxation, in order to ensure that residual profits are not attracted to high-tax jurisdictions.

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Chapter 21 - US Distribution among Group Entities of Residual Profits from Exploitation of Internally Developed Manufacturing IP

contribution of a pre-existing intangible to a CSA captures the entire value of the intangible for future R&D purposes, there should be no tax gain in migrating it.

21.3. The economic substance exception applied to manufacturing IP 21.3.1. Introduction In sections 21.3.2.-21.3.7., the author will analyse how the US economic substance exception shall be applied to determine ownership of internally developed manufacturing IP, i.e. how the exception can be used to ensure an arm’s length profit allocation to the group entities that contributed to the development of the IP. An important aspect of the economic substance exception is that it can be applied to impute contingent payment terms that are consistent with the economic substance of the controlled transaction.1935 This authority is highly practical in the context of intra-group-developed manufacturing IP – in particular, with respect to contract R&D arrangements – and the profit allocation effects of applying the provision will therefore be the main focus in the following sections. Before the author begins that analysis, however, he will tie some comments to the relationship between the economic substance exception applied to manufacturing IP and the transfer pricing methods.

21.3.2. The economic substance exception should not replace the transfer pricing methods The economic substance exception can be applied to determine ownership of intra-group-developed manufacturing IP, i.e. to determine how group entities that contributed to the IP development shall be remunerated for their efforts. In cases in which it will be meaningful to apply the economic substance exception in this manner, there will be more than one group entity that has contributed to the IP’s development. If, however, the IP has been developed by only one group entity (that has contributed all functions, assets and risks necessary for the development), the ownership issue will be 1935. Treas. Regs. § 1.482-9(h)(i)(3) and § 1.482-1(d)(3)(ii)(B). See also the comments on the general economic substance imputation authority in sec. 6.6.5.2.3.

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The economic substance exception applied to manufacturing IP

clear: this entity is owner. However, if the developer entity then transfers the completed IP to another group entity, the transfer pricing methods – not the IP ownership rules – must be applied to ensure arm’s length pricing. The current US regulations contain an example that touches upon this, in which the legal ownership of internally developed manufacturing IP is registered to a group entity that did not contribute to its development.1936 The example pertains to Company X, which performs R&D over a 4-year period, resulting in a compound. In year 4, the data is made available to Company Y, which uses it to register patents. Company Y, as the legal owner of the patents, then enters into licence agreements with other group entities using royalty rates, which enables it to extract all of the residual profits from the local exploitation of the patents.1937 The example shows that the performance of R&D and the transfer of results by Company X is inconsistent with the registration and subsequent exploitation of the patent by Company Y. An agreement consistent with the economic substance of the controlled transaction is therefore imputed, pursuant to which an “appropriate portion of the premium return from the patent rights” is allocated to Company X.1938 It should be noted that this example applies the economic substance exception, as opposed to the transfer pricing methods, to remunerate the developer (Company X) for its IP transfer. The author takes issue with this profit allocation approach, as well as the allocation result as such. 1936. Treas. Regs. § 1.482-1(d)(3)(ii)(C), Example 6. See also Langbein (2005), at p. 1086. This example is one of three examples illustrating the application of the economic substance exception in the context of intangible ownership, and the only example that pertains to manufacturing IP. The other two examples pertain to marketing IP (in cases in which both controlled parties actually played some part in the IP development) and are analysed in secs. 23.3. and 23.3.3. 1937. In the initial version of the example contained in 2003 Treas. Regs. (68 FR 53448-01) § 1.482-1(d)(3)(ii)(C), Company X performed R&D over a 4-year period, resulting in a compound. A different group entity, Company Y, was registered as the legal owner of the patent. In the final version of the example, company X, in year 4, made a large amount of R&D data available to Company Y, which the latter used to register patents. The 2003 version found it unlikely that Company X would have engaged in R&D in the absence of contemporaneous compensation or a reasonable anticipation of receiving a future benefit from the R&D activities. The example imputed an agreement under which a portion of the residual profits from the patent was allocated to Company X, either as a deemed service agreement or as a transfer of the developed compound. The 2006 version of the example, found in Temp. Treas. Regs. (71 FR 44466-01) § 1.482-1T(d)(3)(ii)(C), Example 6, was adopted without changes in the final regulations. 1938. This example seems influenced by the developer-assister rule example discussed in sec. 19.2.2.

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Chapter 21 - US Distribution among Group Entities of Residual Profits from Exploitation of Internally Developed Manufacturing IP

Company X fully developed the intangible by itself. The example therefore, in principle, does not pertain to the allocation of profits to group entities that contributed to the development of the IP, but rather to the appropriate transfer pricing treatment when a sole developer transfers a fully developed intangible to another group entity. Thus, the arm’s length charge for the transfer of R&D data should be governed by the transfer pricing methods, not the IP ownership provisions. This will likely necessitate an application of the cost-plus method or comparable profits method (CPM) to allocate a normal market return to Company Y. As the IP was developed solely by Company X, it alone should be allocated the residual profits. The example, however, states that Company X should be allocated an “appropriate portion” of the residual profits. If this is to be taken as an indication that a profit split is deemed appropriate, the author would take issue with the allocation result. He does not see any basis in the transfer pricing methods for allocating residual profits to Company Y, as Company X alone rendered all intangible development inputs. It is the author’s view that the example should be revised to make it clear that the application of the economic substance exception to determine IP ownership should be reserved for cases in which more than one group entity has contributed to the development of the IP. If one group entity alone has developed the IP and then later transfers it to another group entity, the profit allocation should be governed by the transfer pricing methods, not the IP ownership provisions.

21.3.3. Imputation of contingent payment terms: A lead-in The transfer pricing methods normally require concurrent compensation in each income period. This point of departure has been relaxed in order to make room for controlled pricing structures akin to those commonly applied among unrelated enterprises in business sectors in which significant up-front high-risk investments are required, often long before the potential super-profit rewards materialize (e.g. in the pharmaceutical, extractive and software sectors). The current US regulations recognize the use of controlled contingent payment terms, as long as the terms are consistent with the economic substance of the controlled transaction.1939 When the 1939. Treas. Regs. § 1.482-9(h)(i)(2)(ii). The regulations contain a comparability provision dealing with market penetration strategies; see Treas. Regs. § 1.482-1(d)(4)(1); and the comments in sec. 6.6.5.4.4. of this book. Temporarily increased expenses or lower prices than charged in comparable uncontrolled transactions (CUTs) in the same market will not lead to a reassessment, provided that an uncontrolled taxpayer would

612



The economic substance exception applied to manufacturing IP

acceptance of such terms was proposed in 2003,1940 it was deemed to provide sought-after flexibility for the pricing of high-risk R&D that stretches across multiple income years.1941 The recipient of a service will not pay the service provider on a concurrent basis in contingent payment arrangements. Payment is only due if and when the specified contingency occurs. The US regulations only accept controlled contingent payment terms when the payment basis reflects the recipient’s benefit from the service and the risks borne by the renderer.1942 The author interprets this to mean that non-payment on a concurrent basis for services rendered in the context of IP development will normally only be acceptable under the US regulations if the service provider is allocated a portion of the subsequent residual profits.1943 The flip side of the recognition of taxpayer contingent payment terms is that the US Internal Revenue Service (IRS) may impute such terms if necessary to reflect the economic substance of the controlled transaction.1944 This is particularly relevant when a US group entity incurs intangible development risks through R&D (or incremental marketing efforts) without receiving

have engaged in a comparable strategy under the same circumstances. The market penetration provision can be seen as a parallel to the recognition of contingent payment arrangements, in the sense that both rules tolerate the absence of concurrent compensation in anticipation of future benefits. Both sets of rules may be particularly relevant in the context of intra-group-developed marketing IP, for which significant expenses must be incurred in order to establish a trademark in a new market. 1940. The 2003 proposed regulations (68 FR 53448-01) set, as a condition for recognizing controlled contingent payment terms, that “it is reasonable to conclude that such payment would be made by uncontrolled taxpayers that engaged in similar transactions under similar circumstances”, at § 1.482-9(i)(1), indicating that a CUT that demonstrated third-party use of a similar contingent payment term was necessary. This led to questions from commentators, resulting in an omission of the language in the 2006 temporary regulations (71 FR 44466-01). It is therefore clear that there is no requirement for a CUT in order to trigger recognition of a controlled contingent payment structure. Additional requirements for the recognition of contingent payment arrangements are set out in the regulations (including written contract and specified contingency); see Treas. Regs. § 1.482-9(h)(i)(2)(i). 1941. See Terr (2004), at p. 565. 1942. Treas. Regs. § 1.482-9(h)(i)(2)(i)(C). 1943. See the analysis of the examples illustrating the imputation authority in sec. 21.3.5. 1944. Treas. Regs. § 1.482-9(h)(i)(3). See also the discussion in sec. 21.3.5. Terr (2004), at p. 566 finds that the power of the US Internal Revenue Service to impute contractual terms may arguably exist independently of the US Internal Revenue Code (IRC) sec. 482 regulations to the extent authorized by common law doctrines, such as substance over form and economic substance.

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Chapter 21 - US Distribution among Group Entities of Residual Profits from Exploitation of Internally Developed Manufacturing IP

concurrent compensation.1945 In these cases, there will be an asymmetry between the burdens and benefits associated with the intangible development. The US subsidiary incurs costs and risks, while the upside in the form of potential subsequent residual profits are allocated to the foreign entity. The imputation provision will aim to correct this. In sections 21.3.4.-21.3.6., the author will analyse the examples drawn up by the US regulations on the contingent payment terms imputation provision before concluding remarks are made in section 21.3.7.

21.3.4. Imputation of contingent payment terms base example: Successful contract R&D arrangement with contingent profit split payment structure The base example pertains to a contract R&D arrangement, under which ompany X shall perform R&D for Company Y.1946 Any patents or other rights resulting from the R&D will be owned by Company Y alone. Further, Company X will receive payment only if the research leads to commercial sales of derivative products. If so, Company Y is obliged to pay Company X a percentage of its gross worldwide sales of the derivative products for a period of 7 years. At the time at which the agreement is entered into, the possibility that the R&D will result in new products is highly uncertain. Further, the potential markets for any new products are unknown and cannot be reliably estimated. R&D is carried out by Company X in years 1-4, resulting in a compound. Company Y registers patents for the compound in several jurisdictions in year 4. Products based on the compound are sold by Company Y in year 6 and continue through year 9. As agreed, Company Y pays a percentage of its gross sales to Company X. The first question pertains to the recognition of the contingent payment terms. The actual behaviour of the controlled parties is found to be consistent with the contractual risk allocation.1947 Further, Company X had the financial capacity to bear the risk that the R&D could be unsuccessful, and that it therefore would not receive any compensation. Also, Company X exercised managerial and operational control over its own R&D activities, which made a contractual allocation of the R&D risks to Company X rea1945. See the analysis of the economic substance imputation authority applied to marketing IP in sec. 23.3. 1946. Treas. Regs. § 1.482-9(h)(i)(5), Example 1. 1947. See the analysis of risk as a comparability factor in sec. 6.6.5.5.

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The economic substance exception applied to manufacturing IP

sonable. On this basis, the example deems the contingent payment terms to be consistent with the economic substance of the arrangement. The second question is whether the remuneration paid by Company Y in years 6-9 was at arm’s length. The example takes into account that Company X bore the risk that it possibly would not receive any compensation for its services. Further, the realistic alternative available to Company X was to undertake the R&D activities on its own behalf and license out the rights to exploit any successfully developed intangibles.1948 The relevance of this alternative is accentuated by the demonstrated willingness of Company X to incur, and its ability to bear, the R&D expenses and risks. On this basis, the example finds that the IRS is entitled to consider royalties charged for comparable intangibles. The example is ambiguous on the further specifics of the profit allocation. Given the focus on the realistic alternatives of the US entity, however, the author deems it likely that the IRS, in this situation, would demand a contingent payment that effectively would put the US entity in a position equal to that which would have been the result if it had performed R&D on its own behalf and subsequently licensed out its own intangible. In other words, the lion’s share (or all) of the residual profits generated by the patent would likely be allocated to the US subsidiary (analogous to an application of the CPM, and the income method in the context of CSAs). Company Y will then only receive a normal market return for its contributions to the value chain, if any.1949

21.3.5. Imputation of contingent payment terms example: Unsuccessful contract R&D arrangement with contingent profit split payment structure The factual pattern of the second example is the same as in the base example in section 21.3.4., apart from the twist that the R&D proves un1948. The “realistic alternatives available” concept is central in current transfer pricing methodology. See the comments in the context of unspecified methods in sec. 12.2., the new 2017 OECD guidance on valuation in sec. 13.5. and the income method for pricing buy-ins in CSAs under the US cost-sharing regulations in sec. 14.2.8.3., with further references. The “realistic alternatives” valuation principle was codified in the last sentence of IRC sec. 482 in the December 2017 tax reform; see the discussion in sec. 1.7. 1949. The 2017 OECD TPG take essentially the same stance, as they finds that “reimbursement of costs plus a modest mark-up” will not sufficiently remunerate the R&D entity under a controlled contract R&D agreement; see OECD TPG, para. 6.79.

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Chapter 21 - US Distribution among Group Entities of Residual Profits from Exploitation of Internally Developed Manufacturing IP

successful.1950 Pursuant to the controlled agreement, Company Y did not provide Company X with any compensation for the year 1-4 R&D efforts. The example deems the contingent payment term to be consistent with the economic substance of the actual conduct of the parties, and the resulting non-payment in the examined years is deemed arm’s length. In other words, it is accepted that the US subsidiary bears all R&D costs and risks without being allocated any profits. The regulations ensure symmetry. If successful, the US entity enjoys the residual profits. If unsuccessful, it may deduct its R&D expenses without being allocated any income.

21.3.6. Imputation of contingent payment terms example: Successful contract R&D arrangement with cost-plusbased contingent payment structure The facts in this last example are the same as in the base example in section 21.3.4., apart from the twist that the contingent payment arrangement does not provide Company X with a percentage of the worldwide revenues of the derivative product, but instead reimburses its R&D costs with the addition of a normal return mark-up.1951 In year 6, Company Y makes the single payment to Company X as required under the contract. The cost-plus reimbursement is not deemed to reflect the recipient’s benefit and the renderer’s risk. It is therefore not consistent with the economic substance of the transaction. This triggers the IRS’s authority to impute contingent payment terms. It is found that one possible basis of payment that will reflect the recipient’s benefits and the renderer’s risks is a charge equal to a percentage of the commercial sales of the derivative products. The example takes into account the alternatives realistically available to the parties for the purpose of determining an appropriate royalty rate. As in the base example, the realistic alternative available to Company X was to undertake the R&D activities on its own behalf and license out the rights to exploit any successfully developed intangibles. As in section 21.3.4., the author deems it likely that the IRS, in similar factual patterns, would impute contingent payment terms that allocated the residual prof1950. Treas. Regs. § 1.482-9(h)(i)(5), Example 2. This example was introduced in the 2006 temporary regulations (71 FR 44466-01), in response to requests from commentators for guidance on the scenario in which the R&D efforts are unsuccessful. 1951. Treas. Regs. § 1.482-9(h)(i)(5), Example 3. The mark-up is within the range of mark-ups on costs of independent contract researchers that were compensated under concurrent remuneration terms.

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The economic substance exception applied to manufacturing IP

its to the US subsidiary, analogous to an application of the CPM and the income method.1952

21.3.7. Concluding remarks on the application of the economic substance exception to impute contingent payment terms The US guidance on contingent payment terms should be seen as a clear rejection of contingent cost-plus-based payment structures. In essence, this is the same message as conveyed by the athletic gear example for marketing IP (discussed in section 23.3.3.), which rejects a solution in which the US subsidiary is reimbursed incremental marketing costs with a mark-up after the marketing has proved to yield residual profits. On the flip side, however, the examples discussed in sections 21.3.4.-21.3.6. provide, rather surprisingly, support for the argument that concurrent costplus-based compensation of a US R&D entity that contributes to the development of IP is sufficient, regardless of the extent of the contribution. The R&D entity will then not be entitled to any of the residual profits. It will produce a steady stream of net income equal to the cost plus mark-up on the R&D costs incurred throughout the development phase, entailing that there are no effective tax deductions for the development costs in the United States. In this sense, the United States has no stake in the subsequent residual profits, as no risk has been assumed, from a fiscal point of view. The US contingent payment term imputation authority presents multinationals with a dilemma: if concurrent cost-plus remuneration is provided, the multinational will not be able to receive effective US tax deductions for the R&D expenses, as the US entity is reimbursed for its expenses with an arm’s length mark-up. The entity will therefore report a normal return profit throughout the R&D project, and the subsequent residual profits from the exploitation of the developed intangible are allocated to the foreign ownership entity. If, however, concurrent cost-plus remuneration is not provided, the multinational will be able to effectively deduct the R&D expenses in the United States, but is faced with the risk that the entire residual profits from subsequent exploitation of the developed intangible will be taxed in the United States. 1952. See also the comments on the athletic gear example in sec. 23.3.3., pertaining to the determination of ownership of co-developed marketing intangibles, pursuant to the economic substance exception.

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Chapter 21 - US Distribution among Group Entities of Residual Profits from Exploitation of Internally Developed Manufacturing IP

On this basis, the author assumes that when the R&D risk is relatively low, combined with a relatively high likelihood that the R&D results will generate residual profits, a multinational will opt to remunerate the US R&D service provider on a concurrent cost-plus basis. One could argue that the United States, in this situation, is allocated a level of income that does not sufficiently reflect the value of the intangible development contributions from the US entity. In essence, the cost-plus allocation will depart from the paradigm that intangible profits should be allocated to the jurisdiction where the value was created. Nevertheless, R&D projects with such risk profiles tend to be based on pre-existing intangibles connected to commercially established products. The contribution of such pre-existing intangibles to the R&D process (in practice, typically through CSAs) should be taxed pursuant to the pricing methods, as the author will revert to in section 21.4.1953 This will ensure that intangible value is taxed where it was created, in spite of the cost-plusbased remuneration of the ongoing “second-generation” R&D efforts. If the R&D is truly “blue sky” research in the sense that it does not build upon any pre-existing intangibles or established products, concurrent costplus remuneration of a US R&D provider will ensure that only a normal return is allocated to the United States, while the residual profits, if any, are allocated to the foreign funding entity. In these cases, at least, intangible value is not allocated to the jurisdiction where it is created. The author is somewhat surprised that the United States accepts this. Perhaps this should be seen as an indication that such cases are not very practical and that contract R&D arrangements in which the US entity is the R&D provider are normally based on pre-existing intangibles and organized through CSAs. Further, in cases in which the R&D risk is relatively high, combined with significant uncertainty as to whether the R&D will provide successful results and generate residual profits, the author assumes that it will be more relevant for a multinational to not remunerate the US R&D service provider on a concurrent basis in order to effectively deduct the R&D costs in the United States. Again, such R&D will normally be organized through CSAs. When it is not, however, the imputation authority for contingent payment arrangements is relevant. The potential subsequent profit allocation to the US entity will be the same as if it were deemed to own the developed intangible. It will attract the entire residual profits. Thus, non-concurrent 1953. The realistic alternatives available to the controlled parties will underlie the application of the transfer pricing methods; see supra n. 1948.

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The US stance on contract R&D arrangements in light of the 2015 provisions on the arm’s length standard and best-method rule

payment of a US R&D group entity is a risky tax-planning strategy, seen from the point of view of a multinational. At the same time, the United States will have a significant stake in the R&D development in these cases, due to concurrent tax deductions for R&D expenses. Any income resulting from the research should then be allocated to the United States in order to ensure symmetry. Also, it would simply not make sense for the US entity, on the basis of its realistic alternatives, to contribute unique inputs to the intangible’s development and in return receive no concurrent remuneration or future residual profits. The rule, as it stands now, is therefore, in the author’s view, logical and must be assumed to correspond to what third parties would have agreed in similar circumstances, i.e. that significant risks should be followed by an opportunity to earn significant profits.

21.4. The US stance on contract R&D arrangements in light of the 2015 provisions on the arm’s length standard and best-method rule The result expressed in section 21.3.7. that concurrent cost-plus-based compensation of a US R&D entity that has contributed to the development of an intangible is seemingly sufficient, regardless of the extent of the IP development contribution, is unexpected. It also marks a pronounced deviation from the approach of the current OECD Transfer Pricing Guidelines (OECD TPG), which allocate the residual profits to the group entity that performs the important R&D functions.1954 From this, it could possibly be inferred that the migration of intangible ownership pursuant to popular contract R&D schemes in which the R&D provider, located in a hightax jurisdiction (here, the United States), is remunerated on a concurrent cost-plus basis, while a foreign IP holding or funding entity, located in a beneficial tax environment with respect to intangible income, is assigned ownership to any intangibles resulting from the R&D, and thus the residual profits, is acceptable under US law, while it is not under the OECD TPG. The US economic substance exception provisions (including the contingent payment terms imputation authority) must, however, be read in light of the transfer pricing methods. Contract R&D projects will normally build upon pre-existing intangibles, know-how and the experience of the 1954. See the analysis of the current OECD approach for determining the ownership of manufacturing IP in ch. 22.

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research team providing the R&D services. In these cases, a proper arm’s length charge for the contribution of the pre-existing unique inputs to the intangible development process by the R&D provider will ensure that the intangible value is allocated to the jurisdiction in which it was created. If the R&D arrangement qualifies as a CSA, the income method will be the go-to method for pricing the pre-existing intangibles.1955 Alternatively, if the arrangement does not qualify as a CSA, the pricing will likely be based on an unspecified method, in which the alternatives realistically available to the controlled parties are the key factors for determining the arm’s length charge, along with an analogical application of the income method.1956 Thus, where contingent payment terms are imputed, it is likely that the minimum amount of royalties allocated to the US entity will be equal to the amount of operating profits that it would have received under its best realistically available alternative. In most cases, this will be carrying out the R&D on its own behalf, as the owner, and then licensing out the fully developed intangibles to other group entities at a royalty rate that extracts the residual profits from local entities’ exploitation of the completed intangible. In other words, a multinational’s risk connected to not remunerating a US R&D service provider on a concurrent basis will be significant. New provisions on the application of the arm’s length standard and the best-method rule under section 482 with other tax code provisions were introduced into the regulations in September 2015.1957 These are relevant to the tax treatment of controlled contract R&D arrangements and require that the entire controlled arrangement must be considered in order to ensure arm’s length compensation of all intangible value transferred intragroup.1958 The new provisions include an example that pertains to US Company P, which has developed product X through R&D carried out by its own R&D team. Company P enters into a contract R&D arrangement with a foreign subsidiary, under which it shall provide R&D services to create a new line of products that build upon the product X platform.1959 Any IP developed 1955. See the discussion of the income method in sec. 14.2.8.3. 1956. See supra n. 1948. 1957. T.D. 9738. See the comments in the context of (i) the relationship between IRC secs. 367 and 482 in sec. 3.5.8.; (ii) the best-method rule in sec. 6.4.; and (iii) aggregated valuation in sec. 6.7.2. 1958. Treas. Regs. § 1.482-1T(a)(i)(A). 1959. Treas. Regs. § 1.482-1T(f)(2)(i)(E), Example 10.

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under the arrangement is to be owned by the foreign subsidiary. Company P has not transferred the product X platform or its R&D team, but is providing value associated with the use of the platform and know-how through its rendering of the R&D services. The example requires that this value must be compensated under IRC section 482 through an aggregated valuation that reflects the interrelated value of the services and the embedded value of the platform and know-how.1960 The example is ambiguous with respect to the profit allocation consequences of the required arm’s length charge. The author nevertheless finds that it likely requires a significant portion of the residual profits from the IP developed under the contract R&D agreement to be allocated to the US R&D entity. The end allocation result should thus be similar to that yielded by the income method in the context of CSA buy-ins. Given the ambiguity of the new 2015 provisions, there will likely be diverging allocation assertions from multinationals and the IRS. A noteworthy aspect of the example is that the US R&D entity was reimbursed for its R&D costs (on a concurrent basis) by the foreign subsidiary. In other words, the US entity did not incur any of the financial risks associated with the R&D, and the United States had no stake in the development, as there were no concurrent US tax deductions for the R&D expenses. Even still, an arm’s length charge for the interrelated value of the services and the platform and know-how is imposed. As there are clear similarities between a simple reimbursement of R&D costs without any mark-up and a cost-plus remuneration for R&D services, the new 2015 provisions introduce significant uncertainty as to whether concurrent cost-plus remuneration for R&D expenses throughout the development phase still should be considered a possible safe harbour from the US entity being allocated any residual profits generated through the subsequent exploitation of intangibles developed through the contract R&D agreement.

1960. The example also contains an extension, in which the facts are otherwise the same, but Company P assigns all or a portion of the R&D team and the rights to the product X platform to the foreign subsidiary. The taxpayer assertion is that the transferred platform rights must be compensated, but that the transferred know-how is not compensable, as it is purportedly not encompassed by the intangibles definition in IRC sec. 936(h)(3)(B). The example requires compensation for all value transferred to the foreign subsidiary, apparently including the value of the know-how, based on an imputed agreement.

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The author’s impression is that there might be a conflict between the allocation results dictated by the economic substance provisions on imputed contingent payment terms and the new 2015 provisions. It may be argued that the former provisions are clearer than the latter, and that the possible concurrent cost-plus safe harbour therefore should prevail until the economic substance provisions are altered to reflect otherwise. This would, however, in the author’s view, contradict the fundamental requirement under the arm’s length principle that there should be parity in the taxation of related and unrelated enterprises. There cannot be any serious doubt that third parties must pay full value for unique development inputs such as know-how, pre-existing intangibles, goodwill and workforce in place. In order to realize this fundamental principle, the new 2015 clarification that there should be an arm’s length charge for all intangible value provided in controlled transactions must be decisive. Thus, in cases in which the contract R&D builds upon pre-existing resources, the arm’s length charge should, as indicated above, be based on an aggregated valuation approach, akin to an analogical application of the income method. This will ensure that the residual profits are allocated to the R&D entity. When the contract R&D is pure “blue sky” research that does not build upon any specific pre-existing resources, the R&D will still, in itself, be the primary value driver behind the creation of unique intangibles.1961 The arm’s length charge for the R&D services should reflect the best realistic alternatives available to the R&D entity. This will normally entail that the residual profits should be allocated to the R&D entity, based on the position that it alternatively could have developed the IP itself outside of the contract R&D arrangement and reaped the entire residual profits through licensing out the fully developed intangible to other group entities. Further, regardless of whether the R&D is based on pre-existing resources or is pure “blue sky” research, the foreign group entity that funds the R&D should, in principle, be allocated an arm’s length return. There is currently, however, no legal basis in the US regulations to impose such an allocation for funding contributions. The funding entity is simply cut off from profit allocation. Also on this point, the US regulations provide a markedly different outcome than the current OECD TPG, which afford a group entity

1961. See the discussion of IP value drivers in sec. 21.2.

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that funds R&D efforts a risk-adjusted rate of return on the funding contribution.1962 In conclusion, a US R&D entity should, under the current regulations, be allocated the entire residual profits from the exploitation of IP developed through controlled contract R&D arrangements. The foreign funding entity, however, will not be entitled to any remuneration for its R&D funding contribution.

1962. See the analysis in sec. 22.4.7.

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Chapter 22 The Distribution among Group Entities of Residual Profits Generated through Exploitation of Internally Developed Manufacturing IP under the OECD TPG 22.1. Introduction The question in this chapter is how the intangible property (IP) ownership rules of the current OECD Transfer Pricing Guidelines (OECD TPG) allocate profits generated through the exploitation of an internally developed manufacturing IP among the group entities that contributed to the development.1963 The OECD rules governing this problem have been significantly revised in the 2017 OECD TPG. The predecessor rules contained in the 2010 OECD TPG were underdeveloped and allowed controlled pricing structures that resulted in BEPS. Tightening those rules was a focus point in the latest revision of the OECD TPG. The core aim of the revised rules is that the residual profits generated by unique and valuable manufacturing IP shall be allocated to the jurisdictions in which the real intangible value creation took place.1964 As will be shown in this chapter, the new OECD rules make up a relatively complex profit allocation system that divides the IP profits among the group entities that contributed to the development of the IP. The key IP development contributions that must be remunerated are functions, R&D financing (funding) and pre-existing IP.

1963. With respect to terminology, it should be noted that the new 2017 OECD ownership guidance applies the comprehensive wording of “development, enhancement, maintenance, protection and exploitation” (the so-called “DEMPE functions”) to describe intangible development contributions; see OECD TPG, para. 6.50. The terminology seems unnecessarily broad. For instance, the word “development” overlaps with “enhancement”, and “maintenance” overlaps with “protection”. For the sake of simplicity, and because the guidance is geared towards the research and development (R&D) of manufacturing intangibles, the author will only use the word “development”. Unless otherwise stated, this also encompasses the enhancement, maintenance and protection of intangibles. 1964. As illustrated by the critical comments made in Brauner (2014a), at p. 99, it will likely not always be straightforward to determine in which jurisdictions the significant intangible property (IP) value creation in fact takes place.

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The author discusses the allocation of profits for functions in section 22.3., funding in section 22.4. and pre-existing IP in section 22.5. First, however, he provides a lead-in to the profit allocation issue at hand in section 22.2.

22.2. A lead-in to the profit allocation problem for internally developed manufacturing IP For a general discussion of the value drivers behind the creation of manufacturing IP, the author refers to section 21.2., which forms the background for the following comments. The goal of the OECD TPG on intangible ownership is to ensure that residual profits are allocated to the jurisdiction(s) in which intangible value was created. The rules thus fundamentally seek to allocate profits based on causality. As research and development (R&D), capital and pre-existing intangibles are the main forces behind intangible value creation,1965 it may logically be inferred that the residual profits should be split among the jurisdictions in which the multinational: – carried out ongoing R&D (often high-tax jurisdictions); – drew R&D funding from (often low-tax jurisdictions); and – created unique pre-existing intangibles (often high-tax jurisdictions). As will be analysed extensively in the rest of this chapter, however, the new 2017 ownership guidance does not accept an outright split of the profits among the IP development contributions in this manner. Even though there is unquestionable causality between funding and intangible value creation, this development input is not afforded residual profits, but a separately determined return. This stands in contrast to the contributions of both ongoing R&D and pre-existing intangibles, which are allocated residual profits. The reason for this discrimination is likely twofold. First, capital is a more generic development input than “high-level” R&D.1966 A genuinely disruptive technology in early-phase R&D with

1965. See the discussion in sec. 21.2. 1966. See, however, Musselli et al. (2017), at p. 337, where it is argued that the OECD, through the 2017 OECD TPG, places too much weight on functions (and too little on capital) for profit allocation purposes, with the result that profit allocation will not be aligned with the underlying value creation. The author does not agree (for the reasons stated in his analysis in secs. 22.3.2.-22.3.3.).

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blockbuster potential will likely not struggle to raise funding, but it will be difficult to find such investment opportunities, even if the capital is available.1967 Second, if IP development contributions in the form of funding were to attract residual profits, it would essentially be up to the multinational to choose whether or not to tax those profits, as it is free to locate its capital in any jurisdiction. The balancing of these factors with the acknowledgement that there indeed is causality between funding contributions and intangible value creation has proven severely difficult for the OECD, as the author will revert to in his discussion on R&D funding.1968 Further, on a more concrete level, the new 2017 OECD ownership guidance may be seen as a response to controlled transactions designed by multinationals to shift intangible profits away from high-tax “R&D jurisdictions” to low-tax “funding jurisdictions”.1969 In this respect, two main culprits have emerged: (i) contract R&D arrangements that shift residual profits from ongoing R&D; and (ii) cost-sharing arrangements (CSAs) that shift profits from pre-existing intangibles as well as ongoing R&D. The hallmark of contract R&D arrangements is that the group entity that contributes R&D efforts is remunerated with a normal market return for its ongoing R&D, normally on a cost-plus basis, while the residual profits are assigned to the group funding entity (which pays the cost-plus consideration). CSAs work differently, but yield similar results. For instance, say that valuable and unique pre-existing IP (e.g. version 1 of a piece of software) created in a high-tax R&D jurisdiction is contributed to a CSA for the purpose of further development. While version 1 was

1967. See also Brauner (2010), at p. 17 with respect to the buy-in issue under the US cost-sharing arrangement (CSA) regulations. 1968. See sec. 22.4. 1969. See, e.g. Navarro (2017), at p. 230. See also Musselli et al. (2017), at p. 331, where it is argued that the new OECD approach to IP ownership (which focuses on important functions) places too much weight on labour relative to capital, and thus favours highly industrialized (and high-tax) jurisdictions with large pools of educated workforces over developing (and low-tax) jurisdictions with respect to tax base allocation. In this direction, see also Rocha (2017), at p. 243. See also Milewska (2017), in particular at p. 54, for an interesting perspective from the Mexican side, where it is noted that employees in developing countries (while often numerous) generally perform only routine functions and follow strategic decisions made by the (foreign) parent company. The new OECD rules will indeed allocate the residual profits from intra-group-developed manufacturing IP only to the jurisdictions in which important development functions were carried out. However, it should, in the author’s view, also be taken into account that such functions may very well also be carried out in developing (and low-tax) jurisdictions. See also Fichtner et al. (2016), at pp. 27-28; and the discussions in secs. 11.2. and 26.6.

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100% owned by the R&D entity resident in the high-tax jurisdiction, version 2 will be mainly owned by a foreign group entity that provides the bulk of the R&D funding. Thus, through the CSA, most of the residual profits from version 2 (and subsequent versions) of the IP have been shifted from the high-tax R&D jurisdiction to the low-tax funding jurisdiction. Thus, the implicit assertions underlying the profit allocation results of such controlled R&D arrangements and CSAs is that intangible value is mainly created through funding, not R&D. This conflicts with the position taken in both the current US and OECD transfer pricing regimes. While both the United States and OECD end up with the same profit allocation result, the regimes have selected somewhat different methodological approaches to attain this result. The OECD approach is to deal with contract R&D agreements through substance requirements, while the new 2015 US regulations apply a pricing approach to address the same problem.1970 With respect to CSAs, both the US and the OECD regimes apply a “realistic alternatives”-based pricing approach to value contributions of pre-existing intangibles to IP development (so-called “buy-in pricing”), although the US methodology is more developed and sophisticated than its OECD counterparty.

22.3. Profit allocation for IP development contributions: Functions 22.3.1. Introduction The question in this section is of how operating profits derived from the exploitation of internally developed manufacturing IP shall be allocated among the group entities that contributed to the development of the IP the most immobile and important development inputs of all: R&D. It is no exaggeration to claim that this issue is one of the most problematic in today’s international transfer pricing. It is also one of the most significant issues, as it directly pertains to which jurisdiction may claim entitlement to tax residual profits from unique and valuable IP. The discussion is organized in two parts. The author will first tie some comments to the new OECD guidance on functions in section 22.3.2.

1970. See the discussion in sec. 21.4.

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Then, he will discuss how this guidance can be applied to controlled contract R&D arrangements in section 22.3.3.

22.3.2. The “important functions” doctrine The new OECD guidance on IP ownership requires that all group entities that contribute certain key functions to the development of IP are compensated with an arm’s length amount of operating profits.1971 The profit allocation to such entities should reflect the relative value of the functions they contributed to the IP development.1972 The guidance singles out a group of functions that “usually make a significant contribution to intangible value”, including control over R&D strategy, design, budgets, protection and quality control.1973 These strategic R&D control decisions should command relatively more profits than other (and more “generic”) functional IP development contributions. The author will refer to this as the “important functions” doctrine. This point is also reflected in the revised intra-group services chapter of the OECD TPG, which makes it clear that R&D services cannot be regarded as low-value services.1974 As there no comparable uncontrolled transactions (CUTs) will exist upon which to benchmark the allocation of profits to these important R&D functions, the use of profit splits may become necessary.1975 The new guidance specifically states that a group entity that performs important R&D functions should not be remunerated as the tested party under a one-sided method.1976 As the one-sided methods only afford the tested party a normal market return, it must be concluded that the new guidance requires residual

1971. OECD TPG, para. 6.50. See Andrus et al. (2017), at p. 92 on the DEMPE functions. See also Navarro (2017), at pp. 232-233, where critical remarks on the OECD DEMPE approach are presented, and the conclusion is drawn that the OECD approach is “not in line with the arm’s length principle”. The author strongly disagrees with this reasoning (which seems to elevate the relevance of legal ownership in transfer pricing to unrealistic heights). 1972. OECD TPG, para. 6.55. 1973. OECD TPG, para. 6.56. See the discussion of the DEMPE concept in Monsenego (2014), at p. 17 (based on the 2013 OECD intangibles discussion draft). For critical comments, see Musselli et al. (2017), at p. 340, where the argument is that the determination of whether a function qualifies as a DEMPE function will entail subjective assessments, possibly resulting in disagreements among taxpayers and jurisdictions. In this direction, see also Heggmair (2017), at p. 265. 1974. OECD TPG, paras. 7.49 and 7.41. 1975. OECD TPG, para. 6.57. 1976. OECD TPG, para. 6.58.

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profits to be allocated to group entities contributing important functions to the development of the IP. Thus, the important-functions doctrine can, in essence, be regarded as a peremptory profit split requirement.1977 The doctrine instructs that some specific development inputs, shall, in all cases, be deemed the main drivers of IP value creation, and thus capable of attracting residual profits. Historically, it is unusual for the OECD TPG to provide such detailed profit allocation instructions. The logic behind the important-functions doctrine is convincing. Routine R&D, such as clinical studies and trial support, is widely outsourced among unrelated parties on a cost-plus basis, while non-routine R&D is not.1978 It would be contrary to third-party behaviour, and thus the arm’s length principle, to allocate only a normal market return to group entities that contribute unique R&D functions to the development of IP.1979

22.3.3. Outsourcing: Contract R&D arrangements 22.3.3.1. Introduction In this section, the author discusses how the important-functions doctrine will govern the allocation of profits in controlled contract R&D arrangements. He begins his analysis by commenting on the historical OECD guidance for contract R&D arrangements in section 22.3.3.2. before discussing how the current important-functions doctrine can be applied to contract R&D arrangements in section 22.3.3.3. Lastly, some comments are made on the use of geographically dispersed employees in section 22.3.3.4. 1977. In this general direction, see also Wilkie (2016), at p. 87. For critical comments, see Musselli et al. (2017), at pp. 339-340, where it is argued that the split of residual profits based on important functions will entail highly subjective (and thus problematic) assessments. The author does not share this concern. Subjective assessments are nothing new in transfer pricing. The important point here is that the residual profits from unique and valuable IP are allocated only to jurisdictions from which significant IP value creation contributions emanated from (as opposed to the generally low-tax R&D funding jurisdiction, which Musselli argues should still be able to claim the residual profits). 1978. A multinational will likely never outsource unique, core-value-creating R&D; see the discussion on foreign direct investment in sec. 2.3. 1979. In this direction, see also Brauner (2010), at p. 17 with respect to the buy-in issue under the US CSA regulations.

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22.3.3.2. The relationship between the 2015 OECD importantfunctions doctrine and the historical 2009 business ­restructuring and intra-group services guidance In 2016, the OECD reached consensus on new wording on the treatment of cross-border business restructurings in the OECD TPG, replacing the 2009 predecessor text. The new 2016 text was designed to align with the material profit allocation positions taken in the new OECD guidance on intangibles. Thus, there are no inconsistencies between the current OECD texts on business restructurings and intangibles. In this section, however, the author will discuss the relationship between the current text on intangibles and the historical 2009 text on business restructurings. He does so because the discussion provides valuable insight into how the important-functions doctrine has altered the profit allocation positions historically taken by the OECD with respect to contract R&D arrangements, and thereby also insight into the practical significance of the important-functions doctrine. It is no secret that the OECD TPG, until just recently, have been lenient on the widespread use by multinationals of controlled contract R&D arrangements to shift profits from internally developed manufacturing IP out of high-tax jurisdictions.1980 Acknowledgement of this historical preBEPS backdrop is necessary in order to gauge the significance of the 2015 important-functions doctrine. The 2009 business restructuring guidance was written before the financial crisis led to increased focus on declining public finances, which again led to a political will among OECD member countries to address such profit-shifting practices. The 2009 text took the position that a group entity that only funded R&D could be allocated residual profits, as long as it incurred the financial risks connected to the IP development.1981 It was not required that the funding entity performed or controlled core R&D activities. This was clearly illus1980. In this direction, see also Schön (2014), at p. 4. See also Musselli et al. (2017), at p. 337, where it is argued that the OECD should have retained the pre-BEPS solution that a group entity that solely funds IP development could end up being allocated the residual profits from later exploitation of the IP (see also Musselli (2006); and infra n. 1998). The author does not share this view. He suspects that, in the long run, it could have been damaging to the international consensus on the arm’s length principle as the legal foundation for allocating taxing rights to business profits if the OECD would have continued to accept controlled profit allocations based on legal formalities akin to the pre-BEPS contract R&D agreements, which no doubt have resulted in the extraction of residual profits from the jurisdictions in which the intangible values were created (and the injection of those profits into tax havens). 1981. See also Brauner (2016), at p. 102; and Brauner (2015), at p. 75.

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trated in an example pertaining to a contract R&D arrangement in which the funding entity compensated the R&D entity on a concurrent cost-plus basis and was allocated the residual profits from the developed IP.1982 This was accepted, as long as the funding entity made relevant decisions in order to control its “risk of failure of the research”. Thus, the view of the 2009 guidance was that the incurrence of financial risk alone was enough to justify allocating residual profits to a funding entity. In order to accept that the funding entity incurred financial risks, however, it had to make the following decisions: – “hiring” and “firing” the R&D entity; – determining the type of research to be carried out and the objectives of it; – determining the R&D budget; – setting out reporting obligations for the R&D entity; and – assessing the outcome of the R&D activity. These are high-level decisions. They are, however, of an administrative character and may likely be performed by non-technical personnel with business or legal backgrounds. This interpretation is supported by the emphasis of the 2009 business restructuring guidance that the core operational R&D risk was “distinct from the failure risk borne” by the funding entity, which justifies allocating residual profits to it.1983 The same reasoning was applied in the previous intra-group services guidance on contract R&D arrangements. The OECD TPG here stated, in unambiguous wording, that when the R&D entity “has discretion to work within broadly defined categories … involving frontier research”, which can be a “critical factor in the performance of the group”, an application of the “cost plus method may be appropriate”.1984 Of course, this pricing method will treat the R&D entity as the tested party and allocate only a normal market return to it, while the residual profits can then be extracted from the R&D jurisdiction and allocated to a foreign funding entity (often in a low-tax jurisdiction). Again, the justification offered by the OECD TPG for this profit allocation solution was that the R&D entity was “insulated from financial risk”, as its expenses were reimbursed regardless of whether the research was 1982. 2010 OECD TPG, para. 9.26. 1983. Id. 1984. 2010 OECD TPG, para. 7.41.

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successful or not.1985 The implication of this position was that the residual profits were allocated to the funding jurisdiction, not the R&D jurisdiction. Intangible income would then not be allocated to the jurisdiction where intangible value was created.1986 This pre-BEPS reasoning of the historical business restructuring and intragroup service guidance conflicts with the 2017 important-functions doctrine. The former guidance required, in order to accept an allocation of residual profits to a funding entity, that the entity incurred the financial risks associated with the R&D project. Little or no involvement was required by the funding entity with respect to the “core R&D” activities performed by the R&D entity. In contrast, the important-functions doctrine requires that the funding entity perform some important R&D functions in order to claim entitlement to any residual profits. The question of how much “R&D substance” the important-functions doctrine requires from a foreign funding entity before it may be allocated residual profits is the topic for discussion in section 22.3.3.3. In conclusion, it is clear that the previous generation of OECD guidance on business restructurings and intra-group services allowed group entities that performed core R&D functions – and thus, in reality, were responsible for IP value creation – to be compensated with only a normal market return on a concurrent basis throughout the IP development phase under a one-sided pricing method (typically cost-plus) without being entitled to any of the later exploitation “fruits” of the IP that they had contributed so significantly to the development of.1987 This OECD position has now been discarded. The new guidance explicitly prohibits an R&D entity being treated as the tested party and only allocated a normal market return under a one-sided

1985. The guidance also added that the funding entity, as the owner of the developed IP, would assume the commercial exploitation risks. This argument is clearly inappropriate. Any risks connected to subsequent exploitation should have no bearing on how group entities that contributed to the IP development (i.e. the pre-exploitation phase) should be remunerated for their efforts. 1986. In this direction, see also Brauner (2016), at p. 121, where it is stated that “no research company would enter into an agreement under which it shares its crown jewel intangibles with another company that brings nothing to the table but cash”. See also supra n. 1206; and Durst (2012b), who argues that R&D agreements in which the R&D provider relinquishes all rights to residual profits (from unique and valuable IP that it creates) likely do not exist among third parties. 1987. In this direction, see also Schön (2014), at p. 4.

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method.1988 Group entities that contribute important functions to the development of IP must now be allocated residual profits from subsequent exploitation of the IP. Thus, the important-functions doctrine has taken the opposite profit allocation position to the one historically embraced by the OECD, and has thus significantly altered how IP profits must be allocated intra-group.1989

22.3.3.3. The important-functions doctrine and contract R&D ­arrangements If the important-functions doctrine entailed that the R&D entity’s own employees must carry out R&D functions physically on site in the entity’s residence jurisdiction in order for it to be allocated residual profits, it would put a brutal stop to contract R&D schemes designed to shift profits. Only a 1988. OECD TPG, para. 6.58. See also Pankiv (2016), at p. 467, where cost-plus remuneration of an R&D entity is rejected. However, Navarro (2017), at pp. 240-241 (and also p. 286) seems to blatantly disregard the position of the OECD TPG on this point. The author argues – based on the circular and unrealistic premise that the taxpayer can demonstrate that the cost-plus method (or TNMM) will result in an arm’s length profit allocation – that the legal owner of the IP may compensate other group entities that perform DEMPE functions on a cost-plus basis, with the apparent result that the legal owner (i.e. the funding entity) ends up with the residual profits. The reasoning offered for this solution is that the OECD’s 2017 DEMPE approach “impl[ies] the disregard of the ownership (i.e. an implicit transactional adjustment) not in accordance with the arm’s length principle”. The author strongly disagrees. Navarro’s reasoning (i) disregards the manifest OECD position on the issue (2017 OECD TPG, para. 6.58); (ii) seems to be based on an unfounded conception of the relevance of legal ownership in transfer pricing; and (iii) uses an ill-conceived “best method”-like line of argumentation to support the use of one-sided pricing methodology to remunerate group entities performing DEMPE functions. With respect to this last part, Navarro seems to be under the impression that the important-functions doctrine (i.e. the key element of the 2017 OECD IP ownership provisions) represents an application of the specified profit split method (which it does not), and thus that the one-sided methods could be preferred if better suited to the circumstances. The author’s take on this is that both the reasoning and the conclusion of Navarro on this point represent an unfounded interpretation of the OECD TPG and should thus be disregarded. It is clear that group entities that contribute DEMPE functions shall, under the 2017 OECD TPG, attract residual profits, and thus cannot be remunerated under one-sided pricing methodologies. 1989. See also, in this direction, Brauner (2016), at p. 110, where it is noted that the current OECD TPG have “reduced the importance of (financial) risk taking in transfer pricing”. See also Musselli et al. (2017), at p. 332, where this BEPS revision of the OECD TPG is described as follows: “This is a Copernican revolution … the OECD has progressed from a model where intangibles are owned by funding capital necessary for intangibles development and assuming the risk of a negative research outcome to a model where intangibles are owned by companies performing important functions related to the same intangibles development, enhancement, maintenance, protection or exploitation (DEMPE).”

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“true” R&D entity, which both performs and controls its own R&D, would then qualify for residual profits. While this, at an early stage of the BEPS Project, may have been the OECD’s ambition,1990 it is clear that the important-functions doctrine does not go this far.1991 The final consensus text now expressly states that the group entity claiming entitlement to residual profits does not have to “physically [perform] all of the functions related to the development … through its own personnel… to retain or be attributed a portion of the return”.1992 The question is to which extent R&D may be performed in one jurisdiction while the residual profits are allocated to a group entity resident in another jurisdiction, typically a funding (cash-box) entity.1993 The guidance on this important issue is ambiguous and convoluted, as may be expected for an issue this controversial.1994 This question was a key part of the intangibles (and the larger BEPS) project. It was debated extensively and was among the last points on which to reach consensus. The criterion is that that the funding entity must control the R&D functions outsourced to other group entities in order to attract residual profits.1995 Thus, a group funding entity in jurisdiction X may, in principle, be allocated the residual profits from IP developed by a group R&D entity in jurisdiction Y, if the R&D can be said to have been controlled by the financing entity. If the financing entity did 1990. For a debate comment on this in the relatively early phase of the BEPS revision of the intangibles guidance, see Durst (2012b), at p. 1124; and Durst (2012d). 1991. The wording contained in the 2012 OECD Discussion draft Revision of the special considerations for intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions (2012D) more directly indicated a requirement to have competent “white coat” employees on the ground locally. It read: “It is expected, however, that where functions are in alignment with claims to intangible related returns in contracts and registrations, the entity claiming entitlement to intangible related returns will physically perform, through its own employees, the important functions related to the development, enhancement, maintenance and protection of the intangibles” (see 2012D, para. 40). For comments on the 2012 OECD intangibles draft, see Wittendorff (2012d); and Helderman et al. (2013). 1992. OECD TPG, para. 6.51. 1993. On outsourcing, see also Swaneveld et al. (2004). 1994. In this direction, see also Brauner (2016), at p. 110, where it is noted: “Even though the cash-box is targeted by these rules, they state that the taxpayer does not have to perform the functions of controlling the risk itself; paying for them suffices. This is quite vague and would likely result in many interpretation conflicts and litigation but perhaps would eliminate the most egregious cases where one party is a true cash-box or an empty shell solely owning the intangible.” 1995. This criterion has been criticized for being open to tax planning (placement of R&D control functions in “cash boxes” to attract residual profits); see, e.g. Ballentine (2016). See also Osborn et al. (2017), under sec. I.C, and the practical example of a tax planning design in sec. IV.A-C.

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not control the R&D, the residual profits will be allocated to jurisdiction Y, where intangible value was created. First, it is clear that if the funding entity retains all important control functions over the outsourced R&D, it will be entitled to all residual profits. This interpretation is supported by the first “Shuyona” example, which pertains to a multinational with two R&D centres.1996 One is operated by the parent in country X and is responsible for all R&D within the group. It designs R&D programmes, develops and controls budgets, decides where R&D is to be carried out and monitors progress on R&D projects. The second centre is subordinated to the first, is operated by a subsidiary in country Y and carries out specific projects assigned by the parent R&D centre. It needs approval for modifications to the R&D programme and for budget increases, and reports its progress on a monthly basis to the parent. The parent funds the subsidiary’s R&D through a concurrent service provider remuneration, while the residual profits are allocated to the parent. The example accepts this allocation, as the parent performs the important functions. Second, it is clear that if the funding entity does not perform any of the important R&D control functions, it will not be entitled to any residual profits. This interpretation is supported by the second Shuyona example, which modifies the factual pattern of the first with the twist that the group now sells two lines of products.1997 R&D for product lines A and B is carried out and funded autonomously by the parent and the subsidiary, respectively. In particular, the subsidiary R&D centre now develops its own programmes, establishes its own budgets, determines which projects to go for, hires its own staff and does not report to the parent R&D centre. The example concludes that the residual profits from the product line B intangibles should be allocated to the subsidiary, as it performed the important 1996. OECD TPG, annex to ch. VI, Example 14. The language contained in the 2013 OECD Revised discussion draft on transfer pricing aspects of intangibles (2013 RDD) was not as clear as the final 2017 version. It entitled the subsidiary to remuneration “reflecting the anticipated contribution to intangible value”. This could, in the author’s view, be interpreted as requiring the allocation of (some) residual profits to the subsidiary. This was likely an unintended ambiguity, as the rest of the 2013 example indicated that a concurrent normal market return allocation to the subsidiary would suffice. 1997. OECD TPG, annex to ch. VI, Example 15. Some additional wording was introduced in the final version of this example, emphasizing that it would be “inappropriate to treat Company S as the tested party in an R&D service agreement”, as the subsidiary performs all of the important functions. The author, of course, agrees with this. If the subsidiary was remunerated as the tested party under a one-sided method, this would entail that the residual profits were allocated to the parent, contrary to the result of the important-functions doctrine.

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R&D functions for these intangibles. The parent did not control any of these functions. These examples address “polar” situations. In the first example, the R&D entity is both controlled and funded by another group entity. In the second, it acts completely autonomously in both respects. The important-functions doctrine leads to obvious one-sided allocations of residual profits in these scenarios: there is no profit split, as all residual profits are allocated to the group entity that contributed the important R&D functions. These two Shuyona examples just reiterate the OECD’s position that important R&D functions attract residual profits. The examples do not convey useful guidance for more nuanced factual patterns. Cases that lie between these polar situations will likely trigger challenging assessments. What if the entity claiming entitlement to residual profits outsources some important R&D functions while retaining others? For instance, what if strategic R&D decisions and quality control for the development of a pharmaceutical product’s IP are outsourced, while control over budgets and some design aspects of the research are retained? In the obvious absence of CUTs, the author sees no other alternative than to apply a profit split. In principle, the split should be based on an assessment of the relative value contribution from each type of important R&D function contributed to the IP development. It will likely be unrealistic to identify clear causal relationships between the specific types of important R&D functions and the creation of intangible value. This may leave no other alternative than to split the residual profits equally among the entities performing important R&D functions. Does this entail that the important-functions doctrine is more restrictive than the pre-BEPS allocation guidance contained in the 2010 OECD TPG? At least one thing is clear. The “black-or-white” allocation patterns described in the 2009 business restructuring and intra-group services texts discussed in section 22.3.3.2. are no longer acceptable. As mentioned, in typical contract R&D arrangements, a mere funding entity could, under the 2010 OECD TPG, be allocated all residual profits on the basis of financial risk alone, while the entity performing R&D could be remunerated on a separate, cost-plus basis. The important-functions doctrine flips the table completely, allocating all residual profits to the R&D entity. The tax-planning contract R&D arrangements of the future will likely place some important R&D functions in the low-tax funding entity while 637

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the remaining R&D functions are performed by the high-tax R&D entity, resulting in a profit split. In these cases, the important-functions doctrine will at least reject the allocation of all residual profits to the funding entity. Tax authorities in R&D jurisdictions should carry out a thorough functional analysis of the separation of functions in R&D projects when a foreign funding entity asserts entitlement to a portion of the residual profits. It must be clarified whether the foreign entity actually performs the functions it asserts to perform and whether the functions can be deemed important R&D functions in the context of the specific project at hand. If they can, the significance of those functions relative to the functions performed in the R&D jurisdiction should be determined. In order to realize the purpose behind the important-functions doctrine, relatively more residual profits should, in the author’s view, be allocated to “core” R&D functions than to more auxiliary functions, such as budgeting. To sum up, the important functions doctrine should be seen, in the context of international transfer pricing, as a considerable leap towards aligning the allocation of intangible profits with value creation.1998 As opposed to the pre-BEPS (2010) OECD TPG, financial risk alone is no longer sufficient to attract residual profits. The result will likely be a smoother profit allocation, with the residual profits allocable only to the jurisdictions where actual R&D functions are carried out. It remains to be seen how multinationals will adapt their controlled R&D structures to the importantfunctions doctrine. There is no reason to entertain illusions in this respect. The author’s guess is that they will turn their focus towards combining elements of important R&D functions with funding in a low-tax entity. If some R&D functions (e.g. control over design aspects and budgets) are placed in a low-tax funding entity, this will attract a split of the residual profits. Due to the absence of clear causality, it may prove difficult for 1998. For an opposing view, see Musselli et al. (2017), at p. 331 and pp. 337-338, where the 2017 OECD approach based on the allocation of residual profits to important functions is highly criticized. Musselli argues that the OECD should have upheld the preBEPS position that residual profits could be allocated to a group entity that only funds the R&D efforts, possibly combined with stricter ex post valuation adjustment rules, as well as anti-“cherry-picking” rules. This argument seems largely to be based on the belief that third parties actually enter into agreements in which an R&D enterprise that is in possession of resources capable of generating superprofits (IP residual) willingly would surrender this profit potential in return for only a normal market profit (concurrent cost-plus remuneration during the development phase). The author does not share this belief. His clear impression is that such third-party “comparables” in fact do not exist. He finds Musselli’s argument (which claims support in loose references to economic theory and empirical research) to carry little persuasive power.

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source-jurisdiction tax authorities to challenge the specific profit split applied. If one adds to this that the funding entity is entitled to a risk-adjusted return on its R&D funding,1999 a multinational may, in practice, come very close to achieving full extraction of the residual profits from the jurisdiction where the bulk of the important R&D functions are carried out. This will bring the allocation of intangible profits in international transfer pricing back to square one, with the same result as that yielded by the preBEPS guidance.

22.3.3.4. Performance of important R&D functions through ­geographically dispersed employees The question in this section is whether a funding entity may be allocated residual profits if it performs important R&D control functions through employees that live and work in a country different from its residence jurisdiction. For instance, assume that a low-tax funding entity enters into a contract R&D agreement with a high-tax R&D entity, pursuant to which it is allocated the residual profits from the developed intangibles in exchange for the payment of a concurrent cost-plus remuneration to the R&D entity. All R&D is carried out in the R&D jurisdiction. The funding entity, with no technical personnel in its residence jurisdiction, employs key senior members of the research team to control the R&D, while they continue to live and work in the R&D jurisdiction. Viewed in isolation, this structure should satisfy the important-functions doctrine, as the funding entity performs the important R&D control functions. Nevertheless, as the performance of the R&D control functions will form an essential and significant part of the business activities of the funding entity, they may trigger a permanent establishment (PE) in the R&D jurisdiction.2000 In determining the allocation of income between the head office in the low-tax jurisdiction and the PE in the high-tax jurisdiction, functions, assets and risks shall be attributed to the PE pursuant to the “significant people functions” doctrine of the authorized OECD approach (AOA).2001 The important-functions doctrine described in the new OECD TPG on IP ownership should, in the author’s view, normally qualify as

1999. See the discussion on R&D funding profit allocation in sec. 22.4. 2000. OECD Model Tax Convention (OECD MTC), at art. 5. 2001. See sec. 25.2. for a discussion of the concept of “significant people functions” in relation to art. 7 of the OECD MTC. See also the OECD Commentary on Article 7, at paras. 20 and 21; and the OECD 2010 Report, at para. 16.

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significant people functions in the context of intangible development.2002 Thus, it is likely that the economic ownership of the developed intangible will be attributed to the PE, thereby attracting the residual profits from the developed intangible to the source state where the employees carry out their work and intangible value is created.2003 The author reverts to the allocation of profits to a PE in chapter 25.

22.4. Profit allocation to IP development contributions: Funding 22.4.1. Introduction The question in this section is the extent to which IP development funding contributions should be allocated operating profits generated through the subsequent exploitation of the developed IP under the new 2017 OECD TPG. This is one of the most important – and problematic – issues in the international transfer pricing of intangibles. It was one of the key issues in the 2015 revision of the TPG on intangibles, and among the last to be reached consensus on.

22.4.2. A lead-in to the issue The remuneration of IP development funding can be regarded as the “flip side” of determining which group entity should be entitled to the residual profits. IP development may span over several years, require significant funding and entail high risks. Because of this, the return allocable for the funding may be considerable. This return will come out of the operating profits from the subsequent exploitation of the developed IP. Therefore, the larger the funding return, the less will be left as residual profits for the “owner” of the IP that contributed the important R&D functions. 2002. This is not to say that the opposite (i.e. that significant people functions normally will be equal to the important functions) is true; see the discussion in sec. 25.2. 2003. This will have several consequences. First, the residual profits will, of course, likely be taxed at a much higher rate than in the low-tax jurisdiction. Second, as the permanent establishment (PE) is assigned ownership to the developed intangible for profit allocation purposes, a subsequent migration of it from the PE jurisdiction will likely trigger a charge. Third, if the funding entity provided the R&D entity with concurrent remuneration, this may have generated a taxable loss in its residence state throughout the development phase, which may prove difficult to utilize, as the funding entity is not allocated the subsequent residual profits.

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This highlights a central aspect pertaining to the relationship between the important-functions doctrine and the guidance on IP development funding remuneration. When the important-functions doctrine strips a foreign funding entity of residual profits, the entity goes from being in an “equity” position in the IP development project to a “creditor” position. In other words, it goes from being entitled to a negatively defined amount (the residual profits) to a positively defined amount (the arm’s length return for the funding provided). Because it is not very simple for a multinational to relocate its talented researchers to other jurisdictions, the important-functions doctrine may turn out to be successful in hampering a great deal of common profit-shifting schemes, typically contract R&D agreements and CSAs. The doctrine may, however, entice multinationals to extract IP profits from the source jurisdiction under the “label” of funding remuneration. It was therefore crucial for the OECD to impose legal restrictions on the allocation of profits for funding. Otherwise, a funding entity might be able to extract a return so high that it in reality could be treated as the “owner” of the developed intangible for profit allocation purposes. That would be detrimental to the new OECD approach to IP ownership, which is centred around the important-functions doctrine. The OECD has, in the current OECD TPG, taken a two-tiered approach to the remuneration of IP development funding. The main rule is that if the funding entity controls the financial risk associated with its funding contribution, it will be entitled to a risk-adjusted rate of return on the invested capital.2004 It can be noted that there is an inconsistency between this new OECD position and the historical position taken by the OECD in the 2009 business restructuring guidance. The 2009 guidance requires, in order to give effect to a contractual allocation of risk, that the entity allocated the risk also, in substance controls, it.2005 It defines control as “the capacity to make decisions to take on the risk (decision to put the capital at risk) and decisions on whether and how to manage the risk, internally or using an external provider”.2006 (Emphasis added) However, it is unclear as to what extent this is actually a requirement. The guidance, on several points, states that the alignment of control in 2004. See Andrus et al. (2017), at p. 94 on this point. 2005. 2010 OECD TPG, paras. 9.22-9.28. 2006. 2010 OECD TPG, para. 9.23; see also 2010 OECD TPG, para. 1.49.

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substance and contractual allocation of risk is simply “a relevant factor”, and a “relevant, although not determinative” factor.2007 Thus, when the 2009 guidance spoke of risk, it focused on financial risk.2008 The author draws support for this interpretation from an example in paragraph 9.26 of the 2010 OECD TPG, pertaining to a straightforward contract R&D agreement. The example accepts a significantly lesser degree of functions being performed by a funding entity than required under the new 2017 OECD TPG in order to assign the residual profits to it. The ratio­ nale behind the 2009 stance is that the funding entity is deemed to bear the “failure risk”, i.e. the financial risk. The example indicates that the mere selection by the funding entity of a party to perform the R&D, the decision of what type of research is to be carried out, as well as a reporting obligation for the R&D entity in combination with its funding will constitute sufficient control to allocate the financial risk, and thereby the residual profits, to the funding entity. Thus, there is a crucial difference between the concept of control in the 2009 business restructuring guidance and the new intangibles guidance, as control over financial risk alone could entitle a funding entity to the residual profits under the 2009 text.2009 In contrast, financial risk will only entitle the funding entity to a risk-adjusted rate of anticipated return on its capital invested under the new guidance, but not more. An opposite conclusion would contradict the important-functions doctrine. Further, the current OECD TPG limit this remuneration to a funding entity that does not control the financial risk to a risk-free rate of return on the invested capital.2010 The new two-tiered OECD approach to IP development funding remuneration was revealed in the draft texts leading up to the final 2017 consensus text.2011 There was, however, no indication in the drafts that the OECD was willing to allocate any profits to a funding entity that did not even control the financial risk associated with its funding. Under the 2014 draft, such an entity was completely cut off from funding remuneration, while it rather surprisingly is entitled to a risk-free rate of return in the current consensus text. The difference between a “risk-adjusted” and “risk-free” rate of return on the R&D funding capital may be significant. How the risk-adjusted rate 2007. 2010 OECD TPG, para. 9.22; and the illustration in 2010 OECD TPG, para. 9.33. 2008. See also, in this direction, Monsenego (2014), at p. 13. See also the discussion of significant people functions in the context of art. 7 of the OECD MTC in sec. 25.2. 2009. On the contractual shifting of risks, see Schön (2014). 2010. See Andrus et al. (2017), at p. 93 on this. 2011. See 2013 RDD, at para. 84; and 2014D, at para. 6.61.

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shall be determined under the current OECD TPG is not entirely clear, as the author will revert to in the discussion in sections 22.4.4.-22.4.11. A riskfree rate is easier to determine. At the time of writing, this rate is low, with US treasury bonds of 3 months’, 5 years’ and 10 years’ maturity offering yields of 0.06%, 1.51% and 2.14%, respectively.2012 In essence, this entails that a group entity that is not in control of the financial risk associated with its R&D funding, and is therefore only entitled to a risk-free return, will incur a “loss” on its funding, as the risk-free return will be below the return that it could have received on an alternative R&D investment of similar risk. Nonetheless, this “loss” will not be as dramatic as it would have been had the OECD gone through with its initial plan of entirely cutting off funding entities that do not control the financial risks associated with their R&D funding.

22.4.3. Control over financial risk A group funding entity must control the financial risk connected to its IP development funding contribution in order to qualify for profit allocation equal to a risk-adjusted rate of return.2013 If it is not in control, it will only attract a risk-free rate of return.2014

2012. See http://www.bloomberg.com/markets/rates-bonds/government-bonds/us (accessed 4 Sept. 2015). 2013. OECD TPG, para. 6.61 (see also paras. 1.98 and 1.65). See also Andrus et al. (2017), at p. 94 on the control threshold. 2014. OECD TPG, para. 1.103. See also the example in OECD TPG, para. 1.85, where the funding entity does not have the capacity to make decisions to take on or decline the financing opportunity. It is therefore not deemed to be in control of the financial risk, and is thus only allocated a risk-free rate of return on its funding; see OECD TPG, para. 1.103. See also OECD TPG, annex to ch. VI, Example 16, where company T does not control the financial risk and is only entitled to a risk-free return on its R&D funding (see OECD TPG, annex to ch. VI, para. 58). See also OECD TPG, annex to ch. VIII, Example 5, where company A does not control the funding risk, and is therefore not allocated any operating profits. Even though not entirely clear, the example does not seem willing to allocate a risk-free return to the funding entity. The author finds that comprehensively strange. Such a solution would depart significantly from the positions taken in the guidance on risk contained in the OECD TPG, which is applicable also to CSAs (see OECD TPG, paras. 8.9 and 6.59), and would represent an unjustified discrimination of IP development funding, depending on the contractual mechanism through which it is rendered, as funding through contract R&D would be allocated a risk-free return, while funding through CSAs would not. The author therefore finds that the example must be interpreted as allocating a risk-free return to a funding entity that is not in control of the financial risk.

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At least in theory, financial risks are distinguishable from operational R&D risks.2015 The latter is the risk that the R&D will not be successfully completed and commercialized, while financial risk is risk that the funder will not recover the principal investment amount together with a risk-adjusted rate of return. Intangible development funding, however, is project-specific financing, where the financial risk is derived from the operational R&D risks. A return on investment is contingent on the project being successful so that it will generate operating profits sufficient to pay the risk-adjusted rate of return to the funding entity. The divide between operational and financial risk for project-specific R&D funding is therefore rather artificial. Nevertheless, the approach of the current OECD TPG to IP ownership is built on this distinction. In light of this, it comes as no surprise that the guidance on control in the context of IP development funding is relatively ambiguous. After all, the issue of allocating operating profits to a funding entity will typically arise because the important functions doctrine has stripped the entity of all residual profits since it does not control the important R&D functions. This entails that the entity will likely have very little influence (if any) on the substantial R&D operating decisions and the operational risks. Given the close relationship between operational R&D risks and financial risks, the author finds it somewhat illogical to require that the funding entity be in control of financial risks when the important R&D functions are performed by a different group entity that also generates the operational R&D risks. It is unclear precisely what type of control is required over the financial risks. “Control” in general is defined in the OECD TPG as the “the capacity to make decisions to take on the risk and decisions on whether and how to respond to the risk”.2016 Thus, the group entity purporting to control the relevant risk must be able to assess potential risk outcomes and their effects on business.2017 The funding entity must also have competent and experienced people in place that are able to assess the creditworthiness of the group entity receiving funds, the R&D risks, whether it is likely that additional funding is required, etc.2018 The extent of required control activities increases with the amount of R&D financing and the R&D risk.2019 2015. See OECD TPG, para. 6.61. 2016. OECD TPG, para. 1.65. See Monsenego (2014), at p. 15, on financial capacity (under the 2010 OECD TPG); and Bullen (2010), at pp. 496-506, on the control of risk under the historical 1995/2010 OECD TPG text. 2017. OECD TPG, para. 1.66. 2018. OECD TPG, para. 6.64. 2019. OECD TPG, para. 6.63.

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The author’s interpretation of the control criterion’s wording in the current OECD TPG is that it requires the funding entity to be capable of: – assessing the commercial prospects of the R&D project in order to decide whether and how much to invest; – assessing the relative profitability of the R&D investment against other realistic investment opportunities; and – monitoring the progress of the R&D project and revising its investment analysis accordingly, e.g. to halt funding if the prospects of the project change.2020 Nevertheless, there is no getting around the fact that there is tension between this general OECD guidance on the control criterion and some specific examples included in the OECD TPG on IP development funding. The examples indicate a lower threshold for establishing control over financial risks than follows from the above interpretation of the general control guidance.2021 The examples fall into two categories: those that do not accept that the funding entity is in control of the financial risk and those that do. The first group of examples describes the funding entity as doing nothing apart from channelling funds, with no technical personnel capable of supervising R&D.2022 Further, the examples that accept that the funding entity is in control of the financial risk offer little in the way of intuition for their conclusions. One example indicates that the funding entity must be capable of “analys2020. This issue is distinguishable from whether the funding entity must, at least to some extent, be in control of the R&D entity’s use of the funding in order to be assigned the financial risk. An interesting point here is that the 2013 RDD allowed the allocation of operating profits for intangible development funding, even if the funding entity did not have “any control over the use of the contributed funds or the conduct of the funded activity”; see 2013 RDD, at para. 84. The quoted wording was omitted in the 2014 draft text and in the final 2017 text. The author finds it doubtful as to whether third-party investors would be willing to contribute funds to an R&D project for which they had no control over the spending. However, if the R&D team is talented and has a proven track record and the project is likely to be highly profitable, that may not be the case. Also, the R&D activity will, in itself, drive the use of the contributed funds, and the new guidance clearly does not demand that the funding entity be capable of exercising any control over R&D functions. The author therefore finds that control over the use of contributed funds should not be required. Had the entity controlled the important R&D functions, it would have been entitled to residual profits, not just a risk-adjusted return on its funding. 2021. The author discusses these examples more thoroughly, including their profit allocation consequences, in sec. 22.4.6. 2022. See the first example in OECD TPG, paras. 1.85 and 1.103; the second example in OECD TPG, annex to ch. VI, para. 58; and the third example in OECD TPG, annex to ch. VIII, Example 5. See also OECD TPG, annex to ch. VI, Example 16 (Shuyona).

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ing” the intangible at stake and making some profit estimates.2023 Another example simply states that the funding entity is in control without elaborating.2024 In both of the examples that accept that the funding entity is in control of the financial risk, however, the funding entity only contributes funding to the IP development, while all R&D and pre-existing intangibles are contributed by other group entities. There is no indication that the funding entity is capable of performing any technical assessments of the potential of the R&D project. In conclusion, the examples apparently deem only pure “post-box” entities – which are comprehensively stripped of all relevant decision-making capacity – to not be in control of the financial risks associated with their IP development funding. The examples provide a solid basis for asserting that as long as there is some capability in the funding entity with respect to making a financially informed investment decision, the threshold for establishing control over financial risk will likely be passed. In the author’s view, this is where the line generally must be drawn under the current OECD TPG. This interpretation is compatible with the fact that a funding entity will not perform the important R&D functions, and will therefore not control the operational R&D risks. The required investment decisions may likely be carried out by experienced, non-technical personnel with managerial, business and legal backgrounds with insight into project financing within the relevant business sector. It will probably not be demanding for a multinational to ensure that such functions are in place in a foreign (low-tax) funding entity. It will therefore likely be rare that the profit allocation to a group funding entity must be limited to a risk-free return on the R&D funding amount. Normally, the funding entity will be entitled to a riskadjusted rate of return.

22.4.4. The point of departure for determining the riskadjusted rate of return The guidance on how the rate of return allocable to a group entity that provides IP development financing (and is in control of the associated financial risks) shall be determined is comprehensively ambiguous.2025 2023. OECD TPG, annex to ch. VI, Example 6. 2024. OECD TPG, annex to ch. VIII, Example 4. 2025. The core provisions encompass OECD TPG, paras. 6.59-6.62.

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Nevertheless, two main directions can be made out. First, the remuneration must mirror that of “similar funding arrangements among independent entities”.2026 This is problematic for the “usual” reason, i.e. the absence of CUTs. The author will elaborate on this in section 22.4.5. Second, the remuneration is restricted to a “risk-adjusted” rate of return.2027 This is a separately determined arm’s length return to the funding contribution, and stands in contrast to the residual profits typically allocated to the funding entity in the controlled pricing subject to review. As discussed in section 22.4.3., due to the low threshold for constituting control over financial risk, the funding entity will normally be entitled to a risk-adjusted rate of return. This makes the determination of this rate an important transfer pricing issue. Ironically, the current OECD TPG on IP ownership – a main point of which is to restrict the allocation of profits to foreign, low-tax funding entities – provides precious little guidance on how to arrive at an appropriate risk-adjusted rate of return. The only indication provided is that the rate may be “based on the cost of capital or the return of a realistic alternative investment with comparable economic characteristics”,2028 and that it is “important to consider the financing options realistically available to the party receiving the funds”.2029 It is clear that these parameters are not exhaustive. The author will discuss how the risk-adjusted rate of return shall be determined in sections 22.4.6.22.4.11.

22.4.5. Uncontrolled transaction analogy for determining the risk-adjusted rate of return: Venture capital financing The basic point of departure for allocating profits for IP development funding under the current OECD TPG is, as mentioned in section 22.4.4., that the remuneration must mirror that of “similar funding arrangements among independent entities”.2030 A problem is that there will normally be

2026. OECD TPG, para. 6.59. 2027. OECD TPG, para. 6.62. 2028. OECD TPG, para. 6.62. 2029. Id. 2030. OECD TPG, para. 6.59.

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no CUTs to the typical R&D contract agreements or CSAs used by multinationals to extract residual profits from source jurisdictions. There are several reasons for this. First, an unrelated party that possesses a valuable and unique resource will normally be in a bargaining position that makes it unwilling to surrender its “equity” position in the potential future profits to a party that only brings funding to the table. It will simply have better realistic alternatives available, such as self-financing or external loan financing. In very earlystage R&D for particularly innovative products, when the risk is extreme and considerable amounts of capital are required to further develop and commercialize the project, however, that bargaining position may be severely challenged. Nevertheless, even in such circumstances, the entrepreneur will rarely give up all residual profits to an investor. There will normally be an equity split so that the entrepreneur owns part of the company, with the rest being owned by investors. Also, the farther the entrepreneur gets along the IP development cycle, the more bargaining power he will command, and the less residual profits he will be willing to part with.2031 Conversely, the hallmark of controlled R&D agreements and CSAs is that the group entity in the best bargaining position, i.e. that which contributes R&D and unique pre-existing intangibles, relinquishes its residual profits to a foreign funding entity that “only” brings cash to the table. Second, early-stage, high-risk investment opportunities in specific projects are not publicly available to just any investor, in particular, not to passive financial investors. Commercial R&D is normally carried out by multinationals. A new, early-stage project may be carried out as part of a larger R&D portfolio. An unrelated financial investor who buys shares in a listed multinational will implicitly buy into its entire R&D project portfolio, consisting of a range of projects, with some at the initial idea phase and others far developed, and some with large profit potentials and others that will fail. The investor will likely have severely restricted information on the R&D conducted by the company, including future strategies to be pursued. Thus, the investor must accept the whole R&D portfolio as such. It cannot “cherry-pick” only the R&D projects that it finds most alluring.

2031. On the use of the bargaining power concept in transfer pricing, see Blessing (2010b). See also supra n. 1125.

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Conversely, related parties normally enter into R&D contract arrangements or CSAs only for specific projects. Given the perfect flow of information between the controlled parties, this triggers an obvious cherry-picking risk, which lacks a direct parallel among unrelated parties. To the extent that third parties even have access to investments in specific, early-phase, promising, high-risk R&D projects, this will normally pertain to start-up companies – often consisting of a few talented individuals with technical backgrounds – that seek funding. Investment opportunities in these projects will normally only be available and relevant for a limited circle of investors, entirely different from the financial investors that trade in noted financial instruments. Such early-stage investors are known as venture capitalists, i.e. active investors that provide capital for extremely risky, pre-commercialized projects.2032 In exchange, they require a significant return. Such investments are organized through contractual structures vastly different from the R&D contract schemes and CSAs that frequently appear in related-party transfer pricing structures. Nevertheless, venture capital investment practices could provide a sound point of departure for determining the risk-adjusted return allocable to a controlled funding contribution to early-phase R&D. The author will therefore provide an overview of the relevant aspects of venture capital (VC) investments.2033

2032. Private equity capital may also contribute, but is normally reserved for investments that are carried out with the purpose of restructuring an existing company, with existing products and cash flows, to optimise its financial performance. These investments typically come at a later stage in the life cycle of a project or company than venture capital (VC) investments, which typically concern projects that have not yet resulted in any concrete marketable products or associated revenues, or are even not yet incorporated. Private equity investments are typically triggered by the identification of underutilized assets and optimization potential, as opposed to VC investments, which may be triggered by the early-phase potential of certain individuals, teams, innovations or projects. 2033. Very few early-stage projects attract funding from VC funds; see National Venture Capital Association Yearbook 2013 (NVCA, YB 2013), at p. 27. In 2012, software projects received 31% of VC funding in the United States, life sciences projects received 26% and renewable technology received 10.5%. The few that are picked are illiquid investments. Considerable amounts of capital may be “locked in” for a long development period before an exit opportunity is available. There is also a high probability of failure for single projects, without any option for recovery of the invested capital. For instance, in the United States, only approximately 16% of VC projects become listed companies, and 33% are acquired. The two main exit opportunities available to VC funds are public offerings and acquisitions.

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A VC fund is typically organized as a limited partnership.2034 The ownership structure of a VC fund consists of a general partner (GP) and several limited partners (LPs). The relationship between a GP and an LP with respect to remuneration in a VC project provides a useful analogy for the relationship between a group entity that contributes important R&D functions to IP development and one that merely contributes funding. The GP is a professional VC enterprise responsible for organizing the legal structure of the VC fund, marketing the project towards institutional investors2035 and picking the projects to be included in the fund’s project portfolio. A GP is actively involved with the day-to-day management of the selected start-up companies and exercises a significant amount of control over their development activities. While the GP contributes a significant amount of human capital (in the form of functions) to a VC fund, it normally only provides a relatively modest portion of the invested funds.2036 Conversely, an LP is a passive, risk-willing investor. An LP has no active involvement in the projects of the VC fund, but will provide the lion’s share of the funding.2037 The author will illustrate this with an example.2038 Let us say that a VC fund, in total, raises capital of 1,000, to be gradually invested into promising ideas for software development over a period of 5 years. The GP invests 1% of the capital, while the remaining 99% comes from LPs. The VC fund successfully develops a few of the selected start-up projects and sells them for a total of 1500. Under the VC fund agreement, the GP is entitled to an annual management fee of 1% of the invested capital, in addition to a carried interest (carry) of 20% of the profits realized when exiting an individual project.2039 Under 2034. NVCA, YB 2013, at p. 8. A limited partnership is a form of partnership similar to a general partnership, except that in addition to at least one general partner with unlimited liability for the limited partnership’s obligations, there are one or more limited partners with liability limited to their capital contributions. Limited partnerships are recognized, for instance, under the company law of Germany, Japan, New Zealand, the United Kingdom and the United States. 2035. Such investors include pension funds, insurance companies, foundations and high-net-worth individuals. 2036. In the United States, this portion is generally around 1% of the invested capital, while it is larger in, for instance, Norway, with portions ranging from 1-10% of the invested capital. 2037. Often as much as 99% of the capital invested. 2038. The example is inspired by Breslin (2013), at p. 4. 2039. In this example, profits are simply calculated as the difference between the exit price for all sold companies minus the total invested capital on all projects, regardless

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these assumptions, the GP is entitled to a management fee of 50,2040 in addition to the 100 in carry,2041 for a total of 150.2042 The remaining 350 will be distributed to the LPs, who will then realize a return on their investment of 35%.2043 If one calculates the return on investment for the GP, it will be an immense 1500%. It is, however, a mistake to interpret this as a return on the financing contribution of the GP.2044 In fact, it is clear that the GP and the LPs realize the same 35% return on their funding. The extraordinary excess return of the GP is remuneration for its functions, in particular, for its talent in selecting promising start-up projects and for leading those projects towards commercial maturity.2045 If one were to apply this typical VC structure for allocating profits among functions and funding analogously to a transfer pricing scenario in which the important R&D functions are performed by one group entity while another provides funding, the result would be that the funding entity should receive only a financial return on its funding contribution. That return should be set relatively high, however, due to the risks connected with early-phase R&D investment. Venture capitalists in 2011 generally required a return, often referred to as the “target rate of return”, on their investments of 30-70%.2046 This rate certainly should not be persuasive for the remuneration of funding entities for transfer pricing purposes in general. Nonetheless, it should of success. 2040. 1,000 × 0.01 × 5 = 50 2041. 500 × 0.2 = 100 2042. The management fee is calculated as 1,000 × 1% × 5 = 50. The vested interest is calculated as (1500 − 1000) × 20% = 100. 2043. The return on investment to limited partners (LPs) is calculated as the distributed profits divided by their total investment, which, in this case, is (350 ÷ 1000) × 100 = 35.35%. LPs will also be entitled to an annual interest on the capital invested (hurdle rate), for instance, 8%, which the author disregards for the purpose of this example. 2044. See also Breslin (2013), p. 5. 2045. The classification of carried interests in VC and private equity has also proven problematic in tax contexts apart from international transfer pricing. For instance, the Norwegian Supreme Court, on 12 November 2015, ruled in favour of the taxpayer in a case pertaining to the domestic income tax treatment of carried interests (Rt. 2015 s. 1260). The question was whether the carried interest was to be regarded as income on capital (in which case it would be tax-exempt under the Norwegian participation method) or as income from employment (which, in addition to a marginal tax rate for the personal taxpayer of 47.8%, would trigger employer social security contributions of 14.1% of the carried interest for the VC fund). 2046. Damodaran (2012), p. 647. The target rate of return is the internal rate of return required by venture capitalists.

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be recognized that the general rate of return achieved by financial investors in VC funds represents the return to investors that (i) do not exercise direct control over the R&D that they invest in; and (ii) incur high levels of risks. Likely, this will be the closest one can get to a CUT for benchmarking the operating profits allocable for intangible development funding of earlyphase, high-risk R&D. It is the author’s view that the VC financial investor returns are, in general, helpful for determining the profit allocable to group entities that fund genuinely high-risk, early-phase R&D projects. This will ensure that the funding remuneration mirrors that of “similar funding arrangements among independent entities”.2047 The VC target rate of return, however, of course does not qualify as a CUT under the specified CUT method of the OECD TPG, and there are obvious comparability concerns connected with the use of this rate as a reference point. It is therefore crucial that the profit allocation assessment also takes into account the specific economic characteristics relevant to the controlled transaction.

22.4.6. Do the OECD TPG examples contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? The OECD has, in several of the examples contained in the current OECD TPG, addressed the allocation of profits to a group entity that funds R&D. Some of them provide unusually concrete indications of the level of remuneration envisioned by the OECD as an arm’s length return. This clarification was a long time coming. The 2012, 2013 and (albeit to a lesser extent) 2014 drafts of the new intangibles chapter were rather ambiguous on this point. While there are still “blank spots” in the final 2017 consensus text, there is now at least some guidance pertaining to the relatively low-risk R&D scenarios addressed (i.e. the funding of second-generation R&D). The first example pertains to company B, which performs R&D through experienced staff and owns valuable pre-existing IP that is used in the development.2048 It enters into a contract R&D agreement with related company A, pursuant to which it shall perform and control all activities related to 2047. OECD TPG, para. 6.59. 2048. OECD TPG, annex to ch. VI, Example 6. The example was not included in either the 2012D or 2013 RDD texts, but surfaced for the first time in the 2014D, where it was bracketed, indicating that it was not a consensus text.

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the development, maintenance and exploitation of the intangible. Company A funds the development with 100 annually in years 1-5 and is assigned legal ownership of any intangibles developed. It is estimated that worldwide exploitation of the developed intangibles will generate operating profits of 550 annually in years 6-15. The controlled profit allocation assigns 200 of the annual profits to company B and 350 to company A. Company A is deemed to be in control of the financial risks associated with its funding contribution, and is therefore allocated a risk-adjusted rate of return. With respect to the amount, the example just assumes that the funding entity should receive 110 annually. Thus, of the global annual profits of 550, 110 is allocated to company A, with the residual profits of 440 allocable to company B. This equals an internal rate of return on company A’s funding investment of approximately 11%,2049 which apparently is the rate that the OECD is willing to allocate for funding contributions in projects akin to the relatively low-risk R&D described in the example. The second example pertains to companies A and B, which enter into a CSA to develop an intangible.2050 Company B provides a pre-existing intangible, which forms the basis for the development, as well as the R&D team, while company A funds the R&D with an annual 100 in years 1-5. Company A is deemed to be in control of the financial risk associated with its funding contribution to the CSA, and therefore entitled to a return on its funding contribution. The exploitation of the cost-shared IP is estimated to generate global profits of 550 per year in years 6-15.2051 The controlled pricing allocates 330 in operating profits to company A in each year. This pricing is benchmarked against the best realistic alternative of company A, which is to receive a risk-adjusted rate of return on its funding capital. This return is determined 2049. The final 2017 version of the example explicitly states that the return equals 11%, while the draft version in 2014D did not do so (but did, nevertheless, contain the same information on investment and profit amounts so that it was possible to calculate the internal rate of return). The fact that the OECD has specified the 11% rate in the final text adds to the impression that the intention of the example is to pinpoint a concrete arm’s length remuneration for intangible development funding of relatively low-risk R&D ventures. 2050. OECD TPG, annex to ch. VIII, Example 4. The funding contribution is, according to the author’s calculations, afforded a rate of return of 11.64% in this example. Thus, the OECD affords the same amount of return to a funding contribution regardless of whether the funding is contributed through a contract research agreement or a CSA. See the discussion of the example in the context of CSAs in sec. 14.3. 2051. With 60% of the profits generated in the market of Company A and 40% in the market of Company B.

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to be 110 per year in years 6-15, equal to an internal rate of return of 12%. Thus, in order for the pricing to be at arm’s length, company A must surrender (through balancing payments) 220 per year to company B so that the profits allocable to company A in each year is 110, equal to its best realistic alternative.2052 Both of the above examples indicate a risk-adjusted rate of return of approximately 11%. A profit allocation that results in this level of return now seems to be the OECD-endorsed arm’s length profit allocation for similar cases.2053 This is undeniably interesting, both because it offers concrete guidance and because it seems relatively restrictive. 11% is a far cry from the VC rate of return of 30-70% suggested in the discussion in section 22.4.5. The explanation for this is likely that the described R&D projects entail relatively low risks. All projects are based on pre-existing IP, developed by experienced staff, and are expected to be highly profitable. In the author’s view, this rate of return should be viewed as a minimum rate that should only be appropriate in cases in which there is no genuine uncertainty connected to the R&D project. The rate is clearly inappropriate for analogical application in the context of high-risk R&D projects, typically when the R&D is not based on pre-existing and valuable intangibles. It would therefore be comprehensively inappropriate for tax authorities in R&D jurisdictions to use this as a go-to rate for remunerating a foreign

2052. The OECD TPG include a third example in the annex to ch. VI, Example 17. One would assume that the funding entity in this example, Company S, should be deemed as not being in control of the financial risk. The example is, however, ambiguous. It simply states that the entity is entitled to a “financing return”, the level of which depends on whether it is in control of the funding risk. The author cannot comprehend why the example does not dismiss the possibility that the funding entity controls the financial risk. Clearly, it should have done so, as there is no indication that the funding entity is capable of controlling this risk, and should therefore only be entitled to a risk-free rate of return. This ambiguity renders the example impotent. Irrespective of the extent of the funding remuneration, the residual profits are allocated to Company A. For comments on the example, see Musselli et al. (2017), at p. 333. 2053. It should be noted that footnote 1 of the new CSA guidance (see OECD TPG, annex to ch. VIII, para. 20) does not explain how the 110 in annual income from the funding investment in years 6-15 is derived. It is just assumed that this level of profit represents an arm’s length level of return. It is further stated that this result is shown just to demonstrate the principles of the example and is not meant to offer any “guidance as to the level of arm’s length returns to participants in [cost contribution agreements]”. While the author recognizes this reservation, he finds it difficult to see that the rate of return used in the example should have no relevance in cases pertaining to “pure cash-box” entities. After all, the rate of return selected is used to illustrate an arm’s length return.

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funding entity without first establishing that the funded R&D project indeed is a low-risk venture.

22.4.7. Do the US CSA regulations contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? The OECD’s funding guidance applies generally, irrespective of whether the IP development is carried out through an R&D contract agreement, a CSA or a different legal vehicle.2054 Comparatively, the US cost-sharing regulations determine the allocation of profits only when the IP development is organized through a qualifying CSA. Nevertheless, within this scope of application, the US CSA rules also face the issue of how to remunerate (normally foreign) R&D funding contributions. The author therefore finds it interesting to investigate whether the US solution may provide any arguments for the interpretation of the OECD’s guidance on the determination of the risk-adjusted return. A typical scenario under the CSA regulations is where a US group entity performs R&D, owns valuable, pre-existing IP and enters into a CSA with a foreign group funding entity to develop new versions of the pre-existing IP, pursuant to which the lion’s share of the residual profits from the exploitation of IP developed under the CSA are assigned to the foreign entity. The CSA regulations strip the foreign funding entity of the residual profits by way of determining a buy-in payment. This is a deemed payment from the foreign entity, as consideration for the pre-existing IP and other unique resources (e.g. know-how) contributed by the US entity to the CSA. In these scenarios, where only one of the parties to the controlled agreement contributes unique inputs to the IP development process, the income method will likely be applied to determine the buy-in amount.2055 That amount will, based on the best alternatives realistically available to the US entity, be set so high that the US entity is taxed for all residual profits from the IP developed under the CSA.2056

2054. OECD TPG, paras. 6.59 and 8.9. 2055. See the discussion of the income method in sec. 14.2.8.3. 2056. Normally, it will be a realistic option for the US entity to continue its ongoing R&D and develop the intangible by itself by way of self-funding the project, thereby reaping all residual profits from the developed intangible itself. Thus, the income meth-

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An important result is that this methodology, when applied in the generic profit-shifting scenario described, will allocate only a comparable profits method (CPM)-like normal return to the funding entity. The residual profits are allocated to the US parent.2057 In other words, the US CSA regulations do not allocate any operating profits for IP development funding contributions.2058 The result is surprising in light of the fact that the 2005 proposed US CSA regulations offered relatively generous compensation for IP development funding. Under the CPM application of the income method in the 2005 proposed regulations, funding contributions were compensated with a portion of the residual profits through a so-called “cost contribution adjustment”.2059 The residual profit split method also allocated a portion of the residual profits to IP development costs through the so-called “cost contribution share” of the residual profits.2060

od requires that, if the total present value for the US entity from participating in the CSA is less than the total present value it alternatively could have derived from the realistic option of self-funding and licensing out the developed intangible, the difference in value must be allocated to the US entity through a deemed buy-in amount. 2057. Treas. Regs. § 1.482-7(g)(4)(iii)(B). 2058. This is illustrated in an example on the income method pertaining to a US parent that performs R&D through an experienced team and has developed version 1 of an established piece of software. It enters into a CSA with a foreign subsidiary to develop future versions of the software. The CSA assigns exclusive exploitation rights to the developed intangible for the United States and for the worldwide market to the parent and the subsidiary, respectively. On the basis that the subsidiary does not provide any unique contributions to the intangible development, it is allocated only a normal market return on its routine functions pursuant to the CPM, set to 14% of its revenues. It is not allocated any operating profits that are consideration for its intangible development funding contribution. 2059. See 2005 Prop. Treas. Regs. (70 FR 51116-01) § 1.482-7(g)(4)(iv)(B)(4), if the calculation were to be performed on the basis of sales); or § 1.482-7(g)(iv)(C)(3), if the calculation were to be performed on the basis of profits. Funding returns would also be allocated to external routine contributions; see § 1.482-7(g)(4)(iv)(D)(v). This was illustrated through an example in § 1.482-7(g)(4)(iv)(D), pertaining to a US pharmaceutical parent that entered into a CSA with a foreign funding entity to further develop a partially researched vaccine. The development costs were 100, of which the subsidiary funded 50. The return allocated for that investment was 50 (in other words, a 100% return on the funding). The example does not provide information on how many income periods there were under the CSA investment, but this is not relevant, as the return is stated on a present value basis. 2060. 2005 Prop. Treas. Reg. (70 FR 51116-01) § 1.482-7(g)(7)(iii)(C)(2). An example illustrated this, pertaining to a CSA in which both the US and foreign entities contributed unique pre-existing intangibles to the R&D; see § 1.482-7(g)(7)(v). The intangible development costs were 10 billion, of which the subsidiary funded 6. The return allocated to that funding was 6 (in other words, a 100% return).

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After the 2005 proposed CSA regulations, the US approach changed. The 2007 CIP, while indicating that CSA funding should be remunerated, was markedly ambiguous on how the return should be determined.2061 Without offering any explanation, the 2009 temporary US CSA regulations did not allow any return on IP development funding contributions. One would expect such a significant change from the proposed regulations to be commented on.2062 The effects of the US position are particularly pronounced in generic cases in which the foreign subsidiary contributes solely funding, which is priced under the income method. The R&D funding contribution is simply ignored, with the subsidiary only being allocated a normal market return on its routine functions. The effects of the US stance will not be so pronounced under the profit split method (PSM), as no single entity here will be left completely stripped of residual profits. In conclusion, the US CSA regulations simply do not remunerate IP development funding. This is an aggressive – and likely effective – approach. As the US and OECD regimes differ significantly on this issue,2063 it is clear that the US CSA regulations provide no argument for the interpretation of the OECD’s guidance on the determination of the risk-adjusted return. The US solution, however, is most noteworthy from a de lege ferenda perspective. The author will revert to this in his concluding comments in section 22.4.11.

2061. See the discussion of the 2007 IRS Coordinated Issue Paper (CIP) in sec. 14.2.3. 2062. Precisely why the final 2011 CSA regulations (76 FR 80082-01) ended up not remunerating funding is unclear. The preamble states, with respect to the residual profit split method, that “market returns are not assigned to cost contributions because, under this method, resources, capabilities, and rights that benefit the development of cost shared intangibles (and thus make such development more valuable its costs) are compensated as platform contributions”; see TD 9568, Explanation of provisions, E, 4. In other words, the argument is that because operating profits are allocated to unique development contributions (R&D, pre-existing intangibles, etc.), funding should not receive any. The author struggles to see the logic. The fact that one particular type of intangible development contribution is remunerated is obviously not an argument for refusing to remunerate another type. It is unfortunate that this was not challenged. Perhaps the complex nature of the CSA regulations allowed for this issue to “fly under the radar” in the process towards the final regulations. 2063. Thus, double taxation may occur when the US enters into a treaty based on the OECD model and the foreign jurisdiction claims entitlement to tax an arm’s length funding remuneration.

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22.4.8. Does the cost of capital contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? The current OECD TPG state that the risk-adjusted rate of return may be determined by reference to the “cost of capital”.2064 The author will briefly comment on this. The determination of a return on risky R&D investments is not a mechanical exercise. There is no financial method available that will yield an objectively “correct” result. When unrelated parties (e.g. VC funds) value investments in early-phase, high-risk, single R&D projects for the purpose of assessing whether they should invest or not, they normally do not base their valuations on discounted cash-flow methodology, but rather on the likelihood of the project being successfully developed and commercialized. Often, the so-called “venture capital method” is used,2065 which consists of five steps, as follows: (1) the operating result of the project for a future year is estimated. The future year will typically be the year in which the venture capitalists expect that they can sell their participation in the project through an initial public offering or mergers and acquisitions; (2) on the basis of the market pricing of comparable companies in the same line of business, an earnings multiple is extracted; 2066 (3) the exit value is estimated by multiplying the estimated future earnings by the market multiple; 2067 (4) the exit value is discounted to the present value, using the “target rate of return” as the discount rate; and (5) the net present value of the project is found by subtracting the IP development investments from the present value of the exit value.

2064. OECD TPG, para. 6.62. 2065. Damodaran (2012), p. 646. See also Metrick (2010), at p. 178. 2066. An earnings multiple is extracted by dividing the market price of a project or company by its earnings. E.g. if a company has a price-to-earnings ratio of 10, this implies that it has a market value (equity) ten times its annual earnings. 2067. For instance, a VC fund invests in an early-phase, high-risk software development project that is expected to be successfully exited in an initial public offering in 5 years. If the expected earnings from the project are estimated to be 4 in year 5 and the market multiple extracted from comparable software companies is 25, the estimated exit value will be 100.

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The target rate of return is normally set at a significantly higher rate than a conventional cost-of-equity discount rate, or a weighted average cost of capital (WACC) for that matter. Leading financial literature suggests 3070%, depending on the stage of development.2068 In contrast, a traditional risk-and-return model will rarely produce discount rates above 20%. The target rate of return is determined through historical experience and plain guesswork.2069 In conclusion, the cost of capital does not offer any firm benchmarks for remunerating IP development funding contributions. The methodology, however, does correspond to (and support) the above analogy (in section 22.4.5.) to VC financing, as well as the fact that a return of 30-70% may be appropriate for high-risk projects.

22.4.9. Do the financing alternatives realistically available contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? The current OECD TPG state that the “financing options realistically available to the party receiving the funds”, as well as the return that the funder could get from a “realistic alternative investment with comparable economic characteristics” should be taken into account when determining the risk-adjusted rate of return allocable to IP development funding.2070 The wording is ambiguous on several points. First, the logic behind taking into account the perspectives of both parties in this particular context is not immediately apparent. The whole point behind the approach of the new OECD guidance on IP ownership – in which the R&D entity performing the important development functions is allocated the residual profits and the funding entity a risk-adjusted rate of return – is to restrict the extraction of intangible profits from the jurisdic2068. Damodaran (2012), p. 647. 2069. Id. The target rates of return are high due to a combination of risk factors: (i) stand-alone, early-phase projects are more exposed to macroeconomic risks than the rest of the market; (ii) venture capitalists are often focused on particular sectors, such as biotechnology and software, and thus are not diversified between business sectors, and therefore demand a premium return for project-specific risks; (iii) the target rate of return takes into account that the project may fail; And (iv) target rates of return for venture capitalists may also be influenced by the fact that a high rate of return will provide a better bargaining position when entering into negotiations with an entrepreneur for an equity stake in the project. 2070. OECD TPG, para. 6.62.

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tion where IP value creation takes place. Thus, the problem is seen from the point of view of the borrowing entity, i.e. the R&D entity resident in the high-tax jurisdiction. Why should the realistically available alternative return of the funding entity matter in this assessment? One would assume that in third-party contexts, the price that a borrowing entity will be willing to pay should not be directly influenced by the lending entity’s investment options. Nevertheless, there is no getting around the fact that the guidance requires the alternative return of the funding entity to be taken into account in determining the risk-adjusted rate of return allocable to it. It will be important to clarify the risk of the R&D project being funded. It will, in the case of contract R&D agreements and CSAs, often be that the R&D pertains to the further development of established and successful products with relatively low risk (second-generation R&D). In these cases, it will be natural to use the “11% examples” (see section 22.4.6.) as the point of departure for determining the realistically available return allocable to the funding entity. In more impractical, high-risk R&D scenarios, it must be assessed whether the funding entity actually has an alternative investment available with a similar risk profile. That may very well not be the case. If so, one should, in the author’s view, use the 11% “low-risk” return, as that may provide the best estimate of the return of a realistically available R&D investment. Further, for the reasons stated above, it is the author’s view that the determination of the risk-adjusted rate of return on IP development funding should mainly be framed from the point of view of the borrowing entity. This aligns with the way the realistic alternatives principle typically is applied in other transfer pricing contexts, such as IP valuation. In these other applications, the pronounced focus lies on the point of view of the entity performing R&D and contributing unique functions, as this party normally will have a superior bargaining position vis-à-vis an entity that only contributes funding. The interests of the funding entity are normally well catered to, as long as the end allocation result ensures that it is not put worse off by entering into the funding transaction.2071 Second, the wording quoted at the beginning of this section does not indicate whether the realistically available financing alternatives of the borrowing en2071. The author refers in particular to the discussion of the Pervichnyi example in sec. 13.5.

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tity should be based solely on the borrowing ability embodied in the specific R&D project being funded, or whether also the income, projects, functions and assets connected to other business activities of the borrowing entity can be taken into account. The realistic options available for procuring funding will vary depending on this premise. If the assessment is restricted to solely taking the commercial prospects of the specific IP development project into consideration, disregarding all other income and assets of the borrowing entity, that would likely lead to the conclusion either that funding simply was unavailable for a project that was particularly risky or that the cost of financing would be set relatively high, typically on par with a VC target rate of return. This could lead to a scenario in which the funding entity would, more or less, always be allocated a relatively high return on its funding contribution, regardless of whether the borrowing entity is highly liquid and solvent and easily could have commanded a relatively low market interest rate on third-party loans on its own. Such a result would be contrary to the arm’s length principle, as there would not be parity in the prices applied between related and unrelated parties. The author therefore concludes that the determination of the return allocable to a funding entity should be based on the realistic options available to the borrower entity, also taking into consideration the business income and assets of that entity that are not connected to the specific R&D project being funded. Third, and as an extension of the above, the OECD guidance on this point does not provide any direction as to whether the realistic funding alternatives available should encompass those that are contingent on the borrowing entity’s affiliation with its group, i.e. whether funding alternatives that rely on the business income and assets owned and controlled by other group entities are relevant. An inherent feature of the arm’s length principle is, of course, the separate entity approach. Each entity within a group should, for transfer pricing purposes, be treated as if it were not a member of the group. This paradigm, however, has been relaxed in some contexts. For instance, the OECD TPG take the position that a controlled service transaction should not be deemed to have occurred – with the result that compensation is not required – when a group entity obtains “incidental benefits attributable solely to its being part of a larger concern, and not to any specific activity being performed”.2072 2072. See OECD TPG, para. 7.13, which distinguishes passive association that is not compensable from active promotion that is. See also Treas. Regs. § 1.482-9(l)(3)(v),

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Further, synergistic benefits that arise purely as a result of group membership without the deliberate concerted action of group members or the performance of any functions are not required to be separately compensated or specifically allocated among members of the group.2073 This rule is illustrated in an example pertaining to a subsidiary that is able to procure external financing on better terms than it would have been able to on its own, purely as a result of its consistently AAA credit-rated parent.2074 The subsidiary borrows an amount from a third-party lender on the beneficial terms. It then borrows an identical amount from a group entity. The interest rate on the latter loan is deemed to be at arm’s length because it is the same rate charged by an unrelated party in a comparable loan transaction, as well as because the synergistic benefit of the low interest rate is a result of the “group membership alone and not from any … concerted action” of the group members.2075 In this, the author finds a solid basis for asserting that the borrowing capacity indicated by the business and assets of other group entities should be taken into account. If this would not be the case, there would be inconsistency between the provisions for pricing funding agreements in general and those pertaining to funding in the specific context of IP development. Synergetic benefits would then be persuasive for the pricing in the former category of transactions, but not the latter. The author finds no good reason to accept such inconsistency. This imposes a severe limitation on the returns allocable for funding contributions. For instance, it may be that a borrowing entity alone, and based solely on the commercial merits of the specific R&D project being funded, would only be able to procure financing on VC terms, for instance, with an which states that a taxpayer is not considered to obtain a benefit when the benefit results from passive association with a group. See also § 1.482-9(l)(5), Examples 15-19. 2073. OECD TPG, para. 1.158. 2074. OECD TPG, para. 1.164. 2075. OECD TPG, para. 1.166. The example is unclear in the sense that it does not specifically state whether the low interest rate would be deemed a compensable benefit for the subsidiary if there was no CUT. E.g. if the subsidiary had beneficial third-party financing readily available but no transaction was actually entered into with the third party, would the interest rate on a controlled loan arrangement that corresponded to the interest rate available on third-party financing be considered a compensable benefit if it were clear that the interest rate was lower than the subsidiary would have been able to procure had it not been a member of the group? The general OECD TPG position that benefits that arise solely due to group affiliation are not compensable clearly indicates a negative conclusion. However, due to the specific inclusion of the comparable uncontrolled loan agreement in the example, that conclusion cannot be regarded as certain.

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annual rate of 70%. If, however, the entity (taking its group affiliation into consideration), would be able to borrow for 10% from unrelated parties, the latter rate should be decisive.

22.4.10. Does the financial risk assumed contribute to the determination of the risk-adjusted rate of return allocable to the funding entity? The 2014 OECD TPG intangibles chapter draft text mentioned that “the financial risk assumed by the funding entity” should be taken into account to determine the risk-adjusted rate of return allocable to IP development funding.2076 Even though this parameter is not positively listed in the final consensus text of the current OECD TPG, the author finds it clear that it may nevertheless be taken into account, as the list is not exhaustive. It is not immediately clear to the author what the 2014 draft meant by “financial risk”. The OECD TPG describe several types of risks that, in general, are important in a functional analysis of controlled IP transfers, including those pertaining to R&D, infringement, product obsolescence and liability.2077 The key risk here must be that the R&D efforts prove unsuccessful, with the consequence that the investment is lost, along with the potential returns. This will be the relevant risk for the funding entity and is the same risk faced by unrelated VC investors. The return attributable to the funding entity must be commensurate with the degree of this risk.2078 The author will tie some reflections to this. Consistent with his stance above, he will use the target rate of return of 30-70% for unrelated passive financial investors in VC funds as a point of reference for the upper limit for funding remuneration, relevant only for relatively high-risk investments. Alternatively, if the funding should be seen as a relatively low-risk investment, this could indicate that the funding entity should be allocated a return significantly lower than a typical VC financial investor return, e.g. the 11-12% return indicated by the new OECD examples.2079 It goes without saying that this assessment should be carried out with a sceptical frame of mind, as there is an obvious danger that R&D

2076. 2014D, para. 6.61. 2077. OECD TPG, para. 6.65. 2078. It will not, however, affect the deemed obligation of the borrower entity to repay the principal amount. 2079. See the discussion in sec. 22.4.6.

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jurisdictions, on the one side, and funding jurisdictions and multinationals, on the other, will default to low and high-risk assertions, respectively. Although not exhaustive, the following factors should be relevant for the determination of whether particular R&D funding should deemed as a relatively high or low-risk investment: (i) the funding entity’s control over early-phase, high-risk R&D; (ii) the inherent risk of the particular R&D project; and (iii) whether the funding is a single project investment or part of a portfolio. With regard to factor (i), a pure funding entity will not be in control of the important R&D functions.2080 This is, to a certain degree, parallel to limited partners in VC funds that are not involved in the active day-to-day management or control of the backed projects. Nevertheless, the general partner of a VC fund has a custodial responsibility towards the limited partners with respect to choosing the right projects and supervising their progression. LPs in VC funds are therefore indirectly in some control over the important decisions pertaining to the further development of each supported project. More importantly, the limited partners in VC funds decide whether they want to contribute more funds to the development of the supported projects on a concurrent basis as the need for additional cash flow arises. If they deem the risk to be too high in relation to the possible benefits, they will simply halt funding. Investments in early-phase, high-risk IP development would likely never be undertaken by third parties without a severe degree of control over how the investments were spent, combined with concurrent monitoring of the progress made and results achieved. The author would therefore assert that the mere existence of a pure funding entity is an argument for restricting its funding remuneration to a relatively low-risk return. The logic behind this is that this entity has no true basis for exercising control over its investment. No rational third-party investor would likely be willing to enter into such an agreement unless it pertained to a relatively low-risk investment. Therefore, the existence of group fund2080. It will, in principle, depend on the controlled agreement between the funding entity and the entity incurring intangible development costs as to whether the funding entity has the authority to exercise control over the development process. If the funding entity has such authority, however, it will likely also perform some of the important development functions and thus be entitled to a portion of the residual profits. For the purpose of this discussion, the author therefore assume that the funding entity has no such authority.

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ing entities with no control or influence over the R&D processes they are funding should logically indicate that the underlying R&D risk is in fact relatively low. With regard to factor (ii), an opinion on the inherent R&D risk must be formed in order to uncover the derivative financial risk. The 2014 draft accentuated the importance of the timing of the funding for the level of financial risk.2081 How far the research has been developed (and in particular, how close it is to commercialization), combined with its profit potential, will be important for the chance of attracting third-party funding. Even VC funds tend to avoid investing in research without immediately apparent practical applications, regardless of how promising it may seem. If the controlled R&D is genuine, high-risk, early-stage, “blue sky” research, this will justify deeming the funding a relatively high-risk investment. Typical transfer pricing structures in the form of contract R&D and CSAs, however, will often not pertain to such “made from scratch” projects. The multinational’s experience, know-how and pre-existing IP form the basis for a continuum of gradually developing knowledge, where succeeding products often are improvements on the previous ones, such as the case is for Apple’s line of iPhone mobile phones. Over time, gradual improvements may collectively alter the core product, but that is not likely to happen from version to version. Xilinx, Veritas and BMC all pertained to factual patterns in which the cost-shared IP development processes, in reality, were nothing other than straightforward continuations of established, US-based R&D for existing and profitable products.2082 In such cases, the R&D risk will likely not be comparable to that of earlyphase, high-risk IP development, and these instances should therefore be classified as relatively low-risk investments. The return attributable to the 2081. 2014D, at para. 6.60. This text was added first in the 2014 draft version of the guidance. 2082. In Xilinx Inc. and Subsidiaries v. CIR, 125 T.C. No. 4 (Tax Ct., 2005), affirmed by 598 F.3d 1191 (9th Cir., 2010), recommendation regarding acquiescence AOD-201003 (IRS AOD, 2010), and acq. in result, 2010-33 I.R.B. 240 (IRS ACQ, 2010), pre-existing IP in the form of rights to integrated circuits and development software systems were transferred to a CSA with an Irish manufacturing and distribution subsidiary for the European market. In Veritas Software Corporation & Subsidiaries v. CIR, 133 T.C. No. 14 (U.S. Tax Ct. 2009), IRS nonacquiescence in AOD-2010-05, a US parent contributed pre-existing IP in the form of existing storage management software to a CSA with an Irish distribution subsidiary. Finally, in BMC Software Inc. v. CIR, 141 T.C. No. 5 (Tax Ct., 2013), reversed by 780 F.3d 669 (5th Cir., 2015), a US parent entered into a CSA with a European holding subsidiary with respect to existing software solutions owned by the parent.

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funding of further R&D for mature “milk cow” products should be significantly lower than the general return to financial VC investors. It might also be that a contract R&D arrangement or CSA is entered into for which there is no existing commercialized product based on pre-existing IP, but for which the know-how and unique skills of an experienced R&D team in place with a good track record will be an obvious value driver. It is the author’s view that investments into such projects also should be seen as relatively low-risk investments. In such cases, the return attributable to the funding should be lower than the general return to financial VC investors. With regard to factor (iii), it must be ascertained whether the funding pertains to a portfolio of “diversified” R&D projects or to a single project. VC investors invest in funds that contain a range of start-up projects at different stages of development, pertaining to different products with different growth potential and risk profiles. In this respect, a diversification benefit is achieved. The investment risk connected to a single project is mitigated, to some extent at least, by the inclusion of other projects in the investment portfolio. Conversely, contract R&D arrangements and CSAs are normally entered into for specific projects.2083 As a point of departure, one would logically expect an investor to demand a higher return on an investment in a specific early-phase, high-risk project than for a portfolio of such projects, due to the lack of diversification and the resulting increase in risk. This logic, however, is founded on the premise that there is asymmetrical information between the transacting parties. The author is sceptical of applying such reasoning for the purpose of allocating income among related parties. Due to the perfectly symmetrical information between the parties to a controlled arrangement, there will be an obvious risk of cherry-picking high-profit-potential R&D projects for structuring through contract R&D arrangements and CSAs in order to extract residual profits from the source jurisdiction. The question should, in the author’s view, therefore be reversed. Does the fact that the controlled arrangement includes only a specific project not indicate that its funding risk is lower than the typical VC-financed, early-phase, high-risk projects? The economic substance of such controlled schemes may be that only the most promising research is selected for the purpose of profit shifting. If such an observation can be made and it is sup2083. See, e.g. Treas. Regs. § 1.482-7(d)(1)(i) on the definition and scope of the intangible development activity covered by the CSA.

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ported by the analysis of the inherent R&D risks, the funding should likely be seen as a relatively low-risk investment and be remunerated accordingly. The return attributable to the funding entity in such cases should be lower than the general return to financial VC investors.

22.4.11. Concluding comments on IP development funding In this section, the author will summarize his interpretation of the OECD’s guidance on the allocation of profits for IP development funding and tie some de lege ferenda reflections to the rule. The allocation of financial risk to a funding entity will be respected if it controls the risk. The low threshold for establishing control will likely result in only foreign “post-box” funding entities being cut off from a riskadjusted rate of return. These will nevertheless receive a risk-free rate of return. In the vast majority of cases, group-funding entities will be entitled to a risk-adjusted rate of return. The extent of this return depends on a two-fold assessment: the return must (i) mirror that of “similar funding arrangements among independent entities”; 2084 and (ii) be restricted to a “risk-adjusted return”.2085 The author has argued that the remuneration required by passive thirdparty financial investors in VC structures, ranging from 30-70% of the invested amount, could form a meaningful point of departure for determining the operating profits allocable to the funding of early-phase, genuinely high-risk R&D. Contrary to such relatively high-risk investments, the projects selected by multinationals for development through contract R&D schemes and CSAs often pertain to the further development of IP connected to established and successful products, with the R&D based on pre-existing IP and carried out by the same experienced and proven R&D team that developed the first-generation IP. The funding of such projects should be seen as relatively low-risk investments. The examples included in the current OECD TPG suggest that such investments could be remunerated with a rate of approximately 11% of the invested amount. The question then becomes how to distinguish between relatively high and low-risk funding endeavours. The author argues that the degree of financial 2084. OECD TPG, para. 6.59. 2085. OECD TPG, para. 6.62.

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risk is driven by (i) the funding entity’s control over the R&D risk; (ii) the inherent risk of the particular R&D project; and (iii) whether the funded project is part of a portfolio of R&D projects or should be assessed on a stand-alone basis. The author finds that factors (i) and (iii), in the context of typical contract R&D arrangements or CSAs, should lead to the conclusion that IP development funding is a relatively low-risk investment. The same goes for factor (ii), except for in cases in which it is clear that the funded R&D project in fact pertains to genuinely high-risk, early stage, “blue sky” research. Further, the author has argued that the realistic alternatives available, in particular to the R&D entity being funded, often should entail that the funding is seen as a relatively low-risk investment. Thus, the author’s interpretation of the current OECD TPG entails that IP development funding should normally be seen as a relatively low-risk investment and remunerated accordingly. While the specific level of profit allocation must be assessed concretely, it is the author’s view that the 11% rate indicated by the OECD examples should be guiding. Due in particular to the restriction imposed on the profit allocation by the realistic alternatives of the controlled parties, the author is not convinced that it will be practical to remunerate funding on the premise that it is a relatively highrisk investment. Should it, in specific and narrow circumstances, be appropriate to do so, the third-party VC remuneration level of 30-70% ought to be guiding in the absence of true CUTs. In the end, however, the wording contained in the current OECD TPG on the risk-adjusted rate of return allocable to a funding entity is ambiguous, leaving room for divergent interpretations.2086 It has likely been difficult to achieve consensus on more specific directions.2087 Conflicting views on the allocation of profits to IP development funding could lead to double taxation. R&D jurisdictions will likely default to low-risk characterizations of funding, while the funding jurisdiction and the multinationals will default to high-risk characterizations. Even if there is agreement on the risk charac2086. See also Andrus et al. (2017), at p. 104, where it is recognized that the current IP development funding rules are too unclear and that further work to clarify the rules will be necessary. In this direction, see also Storck et al. (2016), at p. 217. 2087. An indication of this is that the generic “11%” example was introduced late in the BEPS process. It first emerged, in bracketed form, in 2014D. Substantially the same example was used in the Public Discussion Draft, BEPS Action 8: Revisions to Chapter VIII of the Transfer Pricing Guidelines on Cost Contribution Arrangements (OECD 2015) [hereinafter 2015 OECD CSA draft], also in bracketed form.

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terization, it will likely be problematic to agree on an appropriate level of remuneration. For instance, the VC third-party target rate of return represents an extremely large interval, stretching from 30% to 70%. Further, is the 11% rate indicated by the OECD in the 2015 examples truly appropriate for the generic scenarios? Unfortunately, no objectively correct answer exists.2088 Having said this, the author finds that the negative sides of the guidance on the remuneration of IP development funding contained in the current OECD TPG must not be exaggerated. First, ambiguity and inherent imprecision with respect to the amount of operating profits allocable is not specific to the guidance on IP development funding. It is a recurring theme in all transfer pricing, fundamentally due to the lack of CUTs for the type of transactions carried out by multinationals. Realistically, this is just a problem one must live with. Second, the OECD approach to funding is sound in theory. It requires that funding, in principle, should be treated equally as all other IP development contributions, in the sense that such inputs should also qualify for an arm’s length allocation of profits. Third, the OECD approach attempts to remunerate IP development funding separately, based on a tailored analysis of the profit potential and risks in each R&D project. This will likely yield a more reliable result than if the funding entity were remunerated through, for instance, a profit split.2089 Fourth, the inherent feature that the funding return must be calculated on the basis of a nominal investment amount will, to some extent, mitigate the negative effects of the ambiguity pertaining to the determination of an arm’s length, risk-adjusted rate. For instance, assume that 100 is invested in

2088. This problem is largely analogous to domestic law attempts to apply the general arm’s length standard to benchmark controlled interest rates on the internal debts of multinationals, which has resulted in widespread adoption of domestic mechanical thin capitalization rules. 2089. It would be difficult to assess the relative value of pre-existing intangibles and R&D against funding in order to perform a profit split. Such a comparison would be akin to comparing apples and oranges. Draft versions of Examples 16 and 17 indicated that a profit split approach should also be adopted to remunerate a funding entity (see 2013D, Example 13, para. 274; 2013D, Example 14, para. 278; 2014D, Example 17, para. 60; and 2014D, Example 18, para. 64), but this was fortunately scrapped in the final 2017 consensus text.

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a risky R&D project over 5 years and that the arm’s length return is determined to be 30%. The funding entity will not be entitled to any more after it has been allocated 30 on top of the invested amount. This is important, as the value of unique IP will often not be correlated with the investment costs necessary to create it. Thus, the residual profits may be significantly larger than the return allocable to funding and may be generated long after the funding remuneration has been completed. This in itself entails that the funding guidance offers some resistance against profit shifting. The big question, however, is whether the current OECD approach to IP development funding remuneration offers a sustainable solution for avoiding BEPS. The core ambition of the 2017 OECD approach to IP ownership is to align the allocation of intangible profits with intangible value creation. This is operationalized through the important-functions doctrine, assigning residual profits from internally developed IP to the R&D jurisdiction. The route taken by the OECD on funding may prove detrimental to the realization of this ambition. Risk-willing capital is necessary to create intangible value. While they are not as scarce or unique development inputs as, for instance, the patent for a blockbuster drug or the Apple logo, risk-willing capital must be remunerated with a clearly higher rate of return than the normal market return allocable to pronouncedly generic inputs, such as administrative or fiduciary functions. This is the crux of the current OECD approach to IP ownership. In the author’s view, there is no doubt that the primary purpose behind multinationals’ use of foreign funding entities, regardless of whether the controlled structure is organized as a contract R&D arrangement or a CSA, is to extract operating profits from taxation at source. The author doubts that it will be onerous for a multinational to set up a foreign funding entity with enough substance to be allocated financial risk and to channel IP development funding through it.2090 Thus, even if the important functions doctrine allocates the residual profits to the R&D jurisdiction, much of these profits can be extracted by way of a risk-adjusted return to the foreign funding entity, significantly impairing the effect of the doctrine.

2090. See also Osborn et al. (2017), under sec. IV.A-C, for a practical example of a tax-planning package designed to “fill” up a cash-box entity with enough substance not only to attract a risk-adjusted rate of return for its funding of R&D, but also some residual profits from the IP developed, by way of ensuring that the cash box controls financial risks and some R&D risks.

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Given that the goal is to allocate IP profits to the jurisdiction in which they were created, it could be argued that (i) the shifting of profits out of an R&D jurisdiction to a funding jurisdiction by way of funding remuneration is unworthy of protection; and (ii) the best would be to disallow it entirely, as the United States has done in the context of CSAs. The basic idea that all IP development inputs should receive appropriate compensation, however, lies at the very heart of the arm’s length principle. This is reflected in the design of the OECD’s profit allocation rules. It would contradict this system to single out one particular type of IP development input for which remuneration is refused. To do so would be to take a big step away from a coherent and logical profit allocation system. The reason why the United States, with all of its experience with the transfer pricing of IP, has chosen to cut off funding remuneration in the context of CSAs is probably twofold. First, reductions of the domestic tax base through what is, realistically, outright profit shifting by multinationals, simply will not be tolerated. Second, the United States likely views unique development inputs (in the form of pre-existing IP, R&D results, talented R&D teams in place, etc.) as the true intangible value drivers. Regardless of what motivates it, it is clear that the US position conflicts with the basic notion that all IP development inputs should be remunerated at an arm’s length level. In this light, the OECD’s solution represents a compromise. In cases in which the economic substance of the controlled transaction does not support the assignment of financial risk to the funding entity, the OECD does not (contrary to the US regulations) cut off funding remuneration entirely, but restricts it to a meagre risk-free rate of return. Outside of these narrow “post-box entity” cases, however, a risk-adjusted return must be provided, leaving the door open for profit shifting. The result is a rule far less restrictive than its US counterpart. Nevertheless, the author finds the OECD compromise to be well founded. After all, the OECD has managed to stand its ground and uphold the integrity of the arm’s length transfer pricing system by affirming that all IP development inputs should receive an arm’s length return. Only time will tell as to whether it is possible in practice to uphold such a principled stance while at the same time realizing the allocation intention of the importantfunctions doctrine. With that said, the author finds it likely that the OECD position may, in practice, prove too lenient, allowing for BEPS, and that it will need to be revised in the future. If so, what then? 671

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As the author sees it, there are two main alternative routes available. First, the OECD could, as the US CSA regulations have done, cut off the funding entity entirely, regardless of whether the entity incurs financial risk. That would, in the author’s view, breach the arm’s length principle, resulting in an incoherent transfer pricing system. However, it would be an effective weapon against BEPS. Second, the OECD could – as some suspected they would do already in the latest revision round – mechanically “cap off” the funding remuneration at a specific and restrictive level (for instance, at 3, 5 or 7%) of the funded amount, regardless of the risk of the R&D efforts. The author favours this alternative. Such a rule would be rather analogous to domestic thin capitalization rules for intra-group financing transactions, which have proven effective. It would strike a reason able balance between the need to respect the arm’s length transfer pricing system by remunerating all IP development inputs and ensuring that the extent of IP profit extraction by multinationals from R&D jurisdictions is contained at sustainable levels. Not to mention, the problems associated with applying the current ambiguous OECD funding guidance would become a thing of the past. The main problem with this type of allocation rule would be its lack of flexibility. All R&D projects would be remunerated with the same rate of return, irrespective of inherent risk. That would not align well with how third parties price analogous investments, and therefore would not reflect a “true” arm’s length rate. In the author’s view, however, this would be a relatively modest price to pay for a more effective profit allocation system.

22.5. Profit allocation for IP development contributions: Pre-existing unique IP 22.5.1. Introduction In sections 22.4.10.-22.4.11., the author discussed the provisions of the current OECD TPG with respect to the remuneration of IP development contributions in the form of important functions and funding, which govern the allocation of residual profits and a risk-adjusted return, respectively. In cases in which the IP development is truly “blue sky” research, in the sense that it is not based on any existing R&D results, know-how, etc., the focus will be on these two development inputs. Nonetheless, R&D carried out by multinationals will often not start from scratch, but will build upon and enhance current R&D results (embodied in patents, know-how, etc.).

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Thus, a third development input is introduced: pre-existing unique IP. The question then becomes of how much of the profits from the subsequently developed IP shall be allocated to this IP development contribution, taking into account that the two other development inputs (important functions and funding) also shall be ensured their share of the profits (residual profits and a risk-adjusted rate of return, respectively).

22.5.2. The point of departure for pricing the contribution of the pre-existing IP The wording contained in the OECD TPG on the contribution of assets to IP development is geared towards funding.2091 Contributions of other types of assets are hardly discussed. Nevertheless, it is, in principle, clear that all assets contributed to IP development should receive an “appropriate compensation”.2092 The wording indicates that the transfer pricing methods should be used. This will likely result in the application of unspecified versions of either the transactional net margin method or the PSM, as the specified methods cannot be applied directly in the context of IP development. The latter methods are designed to allocate operating profits among the inputs to the intangible value chain (as discussed in part 2 of the book), not among the contributions to the development of a specific value chain input (in this case, unique IP).2093 For instance, it could be that the pre-existing IP and ongoing R&D are contributed by one group entity, while another provides funding. The latter entity could then be treated as the tested party and allocated a return on 2091. OECD TPG, paras. 6.59-6.61. 2092. OECD TPG, para. 6.59. As indicated, the author’s discussion is limited to the contribution of unique pre-existing IP. Routine assets (laboratory gear, plant and equipment, generic software applications, etc.) should be remunerated with a normal return pursuant to the one-sided methods, likely the cost-plus method. In other words, these assets, as opposed to unique pre-existing IP, will not be allocated residual profits, simplifying the remuneration of them to some extent. 2093. The TNMM allocates a normal market return to the tested party based on the operating margins realized by comparable enterprises. Because it will not be possible to find such margins that include IP funding remuneration, an unspecified version of the method must be used (this was also the problem with applying the CPM directly to allocate income to the funding entity in a CSA prior to the introduction of the US income method; see the discussion of the 2007 CIP in sec. 14.2.3.). Its aim will be to allocate the risk-adjusted rate of return for the funding contribution, in addition to the normal TNMM margin as compensation for routine functions, to the tested party. The same will apply for the first step of the residual profit split method. See the analysis of the TNMM and OECD PSM in ch. 8 and ch. 9, respectively.

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its funding contribution. The residual profits are allocable to the former entity alone. The challenge is to determine a reliable funding remuneration. Alternatively, the pre-existing IP could be contributed by entity 1, ongoing R&D by entity 2 and funding by entity 3. In this case, the PSM could be applied, resulting in the allocation of a “normal return” to entity 3 for its funding and a split of the residual profits between entities 1 and 2. Both steps will likely be problematic to carry out reliably. A practical scenario is that the R&D is organized through a CSA. The CSA wording in the current OECD TPG supplements the intangibles and services chapters.2094 It provides no detailed guidance on the pricing of pre-existing IP contributed to a CSA. Instead, the basic position is that the pricing should be “based on [the pre-existing IP’s] value … in order to be consistent with the arm’s length principle”.2095 Further, the fact that the controlled R&D process is organized through a CSA does “not affect the appropriate valuation of the separate contributions of the parties”.2096 This provides a firm basis for asserting that the pricing of pre-existing IP contributed to the development of a new intangible should be the same regardless of whether the R&D is organized through a CSA or other structures, typically an R&D contract research agreement. One will ultimately end up in the intangibles chapter of the OECD TPG in any case.2097 Both the important-functions doctrine and the guidance on funding remuneration look towards current R&D and financing. Conversely, the transfer pricing methods applied to price the contribution of pre-existing IP will allocate profits to the group entities that created the pre-existing intangible. The author will tie some comments to the coordination of these rules in the following sections. He will discuss the allocation of profits for when the group entity that performs the current important R&D functions is the same as or different from the entity that contributes the pre-existing intangible in sections 22.5.3. and 22.5.4., respectively.

2094. OECD TPG, para. 8.9. 2095. OECD TPG, para. 8.25. 2096. OECD TPG, para. 8.7. 2097. The absence of detailed instructions on how to price the contribution of a preexisting intangible to a CSA stands in stark contrast to the US CSA regulations. While this principled OECD stance was likely necessary in order to achieve consensus, the author suspects that it may prove difficult to apply the ordinary transfer pricing methods uniformly in the context of intricate CSAs. He refers to his discussion of CSAs in ch. 16 for further comments.

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22.5.3. The pre-existing IP is contributed by the same group entity that carries out the ongoing R&D functions In this scenario, it will be easy to identify which jurisdiction should be allocated the residual profits, as both unique development inputs (preexisting IP and ongoing R&D) are contributed by the same group entity. Still, it must be distinguished between the residual profits allocable to the pre-existing IP and the ongoing R&D because the timing of their profit allocation will differ, and it must be ensured that the R&D jurisdiction is not allocated the residual profits allocable for the pre-existing IP twice. These problems can be illustrated through two examples outlined in the OECD TPG. The first example pertains to a parent (Shuyona), which performs important R&D functions and controls the R&D carried out by its foreign subsidiary S in jurisdiction Y.2098 The parent transfers valuable, self-developed IP to foreign subsidiary T in jurisdiction Z for an arm’s length fee and enters into a contract R&D arrangement under which subsidiary T funds ongoing R&D and is assigned all residual profits from the developed IP. The parent and subsidiary S continue their R&D activities as before the transfer. The 2014 draft version of the example found that (i) the parent was entitled to compensation for its important R&D functions; (ii) subsidiary S was entitled to compensation for R&D (as a service provider); and (iii) subsidiary T was entitled to compensation for its investment in the acquired intangibles and for funding on-going R&D. The example concluded: [I]t may be extremely difficult or impossible to identify comparable transactions with such a structure and use of profit split methods, valuation techniques, or other methods may be necessary to identify the appropriate level of compensation to Shuyona for its functions, assets and risks.

Thus, the 2014 draft version provided no clear direction for the profit allocation. The quoted text was omitted in the final 2017 consensus version of the example (included in the current OECD TPG), which focuses solely on

2098. OECD TPG, annex to ch. VI, Example 16. The text in the 2013 and 2014 draft versions of the example is identical. The example was bracketed in the 2014 version, indicating that there was no consensus on the text. The example was also included in the 2014 discussion draft on the use of profit splits in the context of value chains. The final 2015 version of the example focuses on the remuneration of the intangible development funding contributions. The author discusses this example in sec. 22.3.3.3. on the important-functions doctrine and contract R&D.

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the remuneration of the IP development funding contribution.2099 The question is how the contribution of the pre-existing IP shall be remunerated. The factual pattern is significantly complicated by the transfer of the preexisting IP. Without it, the analysis would be relatively straightforward. All pre-existing IP was created by the parent, which also performs the ongoing important R&D functions. Thus, the residual profits should be allocable to it alone under the rationale that the intangible value was created in its jurisdiction. Subsidiary S should be allocated a normal return, likely based on the cost-plus method, while subsidiary T should receive a risk-adjusted return for its funding contribution, provided that it is in control of the financial risk.2100 This is the result of a direct application of the OECD guidance on important functions and funding. The end allocation result cannot be altered by the fact that there is a transfer of the pre-existing IP. After all, the substance of the controlled transaction remains the same: all important R&D functions, past and present, are carried out by the parent. The transfer, however, entails that the parent, through the price paid by the subsidiary, is allocated the estimated value of the transferred IP at the time of the transfer. Thus, it should not also be allocated the residual profits that later are realized through the exploitation of the transferred IP based on the argument that it performs the concurrent R&D functions. To do so would mean that it would be allocated the same value twice. That would be nonsensical and contrary to the arm’s length principle.2101 Further, the example states that the transferred IP rights include the right to use the pre-existing IP for the purpose of further research. This is distinct from the exploitation rights and must be priced separately.2102 Let us say that the transferred IP forms the basis for R&D of a new version. Further, 40% of the estimated value from the exploitation of the new intangible is due to the predecessor IP. The 40% will be the arm’s length price for the transfer of the pre-existing IP. When these 40% later materialize, they must be allocated to subsidiary T, or otherwise the parent would get double pay for the transfer of the same rights. 2099. See the discussion in sec. 22.4.3. on control over financial risk. 2100. The final 2017 version of the example concludes that subsidiary T is not in control of the financial risk and therefore should be allocated a risk-free return only. 2101. See also Ballentine (2016), where the conclusion is reached that “T cannot pay Parent a price equal to the present value of all future cash flows and then also share those same cash flows with Parent. The result is a negative expected present value to T, which it would not accept at arm’s length”. 2102. In practice, the exploitation rights and the right to use the intangible for the purpose of further R&D would most likely be priced together.

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The second example pertains to a similar scheme.2103 A parent carries out R&D and transfers patents and other IP connected to an existing product to a foreign cash-box entity without technical personnel for an arm’s length fee. A contract R&D agreement is then entered into, under which the parent is to carry out R&D as before. R&D funding comes from the subsidiary, which is also assigned the residual profits from the exploitation of the developed IP. In the author’s view, there cannot be any doubts as to the end allocation result. Only the parent performs important R&D functions. The R&D jurisdiction should therefore be entitled to the residual profits, while a risk-adjusted return on the funding contribution is allocated to the “funding jurisdiction”.2104 The allocation of profits to the transferred pre-existing IP is complicated by the fact that they are only partially developed and not yet commercialized. The example emphasizes that the fee relates “strictly to the existing intangibles and does not include compensation for future R&D services” of the parent.2105 Nevertheless, this is, in principle, the same type of assessment as in the first example. The point is to single out the transfer of the pre-existing IP and remunerate this separately from the ongoing R&D. Nevertheless, when the transferred IP is only partially developed, this line becomes blurry.

22.5.4. The pre-existing IP is contributed by a group entity different from that which carries out the ongoing R&D functions In this scenario, the residual profits will be split between two jurisdictions, as the unique development inputs (the pre-existing intangible and 2103. OECD TPG, annex to ch. VI, Example 17. The text in the 2013 and 2014 draft versions of the example is identical. The example was bracketed in the 2014 version, indicating that there was no consensus on the text. The example was also included in the 2014 discussion draft on the use of profit splits in the context of value chains. The final 2017 version of the example remains largely the same as the draft versions, but focuses on the remuneration of IP development funding, and the reference to a possible profit split solution is now removed. For comments on Example 17, see Musselli et al. (2017), at p. 333. 2104. Also here, “double counting” must be avoided. Thus, when the estimated value paid for later materializes through the exploitation of the developed IP, it must be allocated to the funding jurisdiction so that the same value is not taxable twice in the R&D jurisdiction. 2105. This clarification was introduced in the version of the example contained in the 2014 draft, which was otherwise similar to the 2013 version.

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the R&D) are contributed by different group entities.2106 Thus, in addition to the timing and double-counting factors discussed in section 22.5.3., the allocation takes on an additional dimension. The difficult-to-assess line between intangible value caused by the pre-existing intangibles and the ongoing R&D is decisive for the amount allocable to the R&D jurisdictions. The jurisdiction in which the pre-existing IP was created will likely argue that most of the value of the intangible developed through the CSA or contract R&D arrangement comes from the pre-existing IP. The other (R&D) jurisdiction will likely claim that ongoing R&D is the main value driver. The assessment will be pronouncedly difficult if the pre-existing IP is only partially developed.2107 For instance, assume that a US entity, through its own R&D and funding, has developed an innovative and successful software program. A Norwegian group entity, operating autonomously, overtakes the software development functions, building extensively on the original version. The US entity is not involved in further R&D. The structure is set up so that the US entity enters into a CSA with an Irish subsidiary and the Norwegian company. All three entities contribute ongoing R&D funding in proportion to the benefits they expect to derive. The residual profits from the new version are allocated accordingly. In addition to its part of the funding, the US entity contributes the pre-existing software code to the CSA. Let us assume that 90% of the value of the new version is attributable to the pre-existing software. How should the residual profits from the new version be allocated pursuant to the current OECD TPG? A proper allocation, in the author’s view, may only be attainable through a layered analysis. First, it must be ascertained as to which group entities are entitled to the residual profits from the pre-existing IP. This assessment should – in parallel to an application of the PSM – take into consideration all functions, assets and risks contributed to the development of the pre-existing IP. The US entity alone developed the original software in the example. Had other 2106. A premise for this discussion is that the group entities are resident in different jurisdictions. 2107. With respect to the profit split assessment under the specified OECD PSM, the author argues that in cases in which more than one unique input has caused the intangible value and these inputs were necessary components of the value creation, the best solution might be to divide the residual profits equally among them in the absence of reliable evidence on causality indicating that a different allocation would be more appropriate; see the discussion of the residual profit split under the OECD PSM in ch. 9. The author does not rule out that the same approach could be useful in this context.

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Profit allocation for IP development contributions: Pre-existing unique IP

group entities resident in different jurisdictions also contributed unique development inputs, additional complexity would have been added to the assessment (as they would have then also been entitled to compensation). Second, it must be estimated how much of the value of the developed intangible is caused by the pre-existing IP versus the ongoing R&D. This is an essential determination, as it divides the estimated net present value of the residual profits from the developed intangible into two parts: one allocable to the jurisdiction where the pre-existing IP was created, and the other allocable to the jurisdiction where the ongoing R&D is carried out. This valuation will likely be challenging, and ultimately subjective. Key premises include assumptions concerning the extent to which the new intangible builds upon the pre-existing IP, the useful life of the pre-existing IP, as well as the life of the new intangible.2108 Again, the above example is simplified, as the value of the original software is assumed to account for 90% of the value of the new version. The third step is to ascertain which group entities are entitled to the remaining residual profits from the developed intangible due to the ongoing R&D. In the example, the Norwegian entity alone performs R&D. The allocation is then straightforward: the entire 10% should be allocated to the Norwegian entity. Had other group entities also performed important R&D functions, as the case may be in practice, the assessment would become more complicated. The Irish entity is allocated a risk-adjusted return on its funding contribution. The above should apply also to other controlled R&D structures in which pre-existing IP is contributed to IP development, including contract R&D agreements.

22.5.5. Concluding remarks on the contribution of ­ pre-existing IP to intangible development processes When pre-existing IP is contributed to the development of an intangible, it is paramount that the guidance on important functions and funding is not applied in isolation based solely on the current stage of development, but in conjunction with an application of the transfer pricing methods to price the contribution of the pre-existing IP. Only then will the profit alloca2108. See the analysis of CSA buy-in pricing in ch. 14, in particular, secs. 14.2.8.14.2.8.7.

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tion reflect the intangible value creation made by different group entities throughout all development phases. For instance, in the example in section 22.5.4., had the Norwegian tax authorities asserted that the entire residual profits from the new software developed should be allocated to Norway, based on the argument that the Norwegian entity performs the important ongoing R&D functions, this clearly should be rejected. Such an allocation would fail to reflect that only 10% of the intangible value creation was carried out in Norway. It is therefore somewhat ironic that the current OECD TPG on IP ownership is so preoccupied with ensuring that ongoing R&D and funding contributions are appropriately remunerated that sight is nearly lost of the fact that a proper arm’s length profit allocation may also require compensation to group entities that contribute pre-existing IP to the development process.

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Chapter 23 The Distribution among Group Entities of Residual Profits Generated through Exploitation of Internally Developed Marketing IP under the US Regulations 23.1. Introduction A marketing intangible developed within a group may generate residual profits when it is exploited in a marked jurisdiction. The typical set-up is that a distribution subsidiary in the market jurisdiction licenses the intangible property (IP) from a group entity resident in a foreign (often low-tax) jurisdiction and builds the local value of the IP through marketing efforts. The question in this chapter is how the current US regulations allocate residual profits that are generated through exploitation of such marketing IP in the United States among the group entities that contributed to the development of the intangible. As discussed in chapter 20, the point of departure is that the group entity that holds legal title to an item of IP is entitled to the residual profits. The US regulations, however, are not willing to give such pricing effect to legal ownership unless there is enough economic substance underlying it. Section 23.3., is dedicated to a discussion of this issue. If there is enough economic substance underlying the foreign legal ownership of the internally developed marketing IP, the legal ownership will be given pricing effect, and the residual profits will thus be allocated to the foreign group entity that holds legal title to the IP. The question then turns to how other group entities, in particular the local US distribution entity that has developed and exploited the IP, shall be remunerated for its efforts. This issue is discussed in section 23.4. Concluding comments are provided in section 23.5. First, however, the author will present a high-level introduction to the profit allocation problem for internally developed marketing IP in section 23.2.

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23.2. A lead-in to the profit allocation problem for internally developed marketing IP A multinational is generally free to register which group entity it desires to hold legal title to particular marketing IP it controls.2109 The focus of IP law is on protecting IP rights against third parties, not on how legal title is allocated among the legal entities within the same economic group. This freedom, combined with the historical point of departure under international tax law that the group entity that holds legal title to an item of IP should be entitled to the residual profits, provides multinationals with an incentive to register legal ownership of their unique and valuable marketing intangibles to group entities resident in jurisdictions that offer beneficial tax treatment of IP profits. This incentive effect is amplified by the fact that a multinational will normally develop and exploit its valuable marketing intangibles in every jurisdiction where it sells its products and services, as marketing IP must be promoted locally in order to have value there. In contrast, the development of manufacturing intangibles will normally involve vastly fewer jurisdictions. R&D, and the funding of it, will typically source from just a couple jurisdictions (where the R&D and financing centres of the group are located).2110 Thus, as opposed to the case for marketing intangibles, almost all jurisdictions in which a manufacturing intangible is exploited will have no factual basis to assert that they should be entitled to a portion of the residual profits (because the intangible was not developed there). Marketing activities are intangible development contributions. Where such contributions are rendered by a local distribution entity, fundamental profit allocation issues are triggered. On the one side, the US Internal Revenue Code (IRC) section 482 regulations (and the new 2017 OECD Transfer Pricing Guidelines (OECD TPG) on intangibles) in principle aim to ensure that intangible profits are allocated among jurisdictions in a manner that reflects where the intangible value creation takes place. Applied in the 2109. There may, however, in some jurisdictions, be intangible property (IP) law restrictions requiring that a local legal entity is registered as title holder to trademarks and the like. The factual pattern in DHL Corp. & Subsidiaries v. CIR, T.C. Memo. 1998-461 (Tax Ct., 1998), affirmed in part, reversed in part by 285 F.3d 1210 (9th Cir., 2002), provides an illustration of how global trademark registrations are carried out by multinationals in practice. See the discussion in sec. 19.2.5.3. 2110. See the discussions on the value drivers in IP development with respect to manufacturing IP in sec. 21.2. for the US regulations and sec. 22.2. for the OECD Transfer Pricing Guidelines (OECD TPG). On the risk aspects of developing manufacturing IP through research and development (R&D) versus marketing IP through marketing expenditures, see Roberge (2013), at p. 220.

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A lead-in to the profit allocation problem for internally developed ­marketing  IP

context of locally developed marketing intangibles, this basic reasoning provides an argument for allocating the residual profits to the source state. Source state tax authorities would likely advocate this position. On the other hand, it is clear that unrelated enterprises do enter into distribution agreements in which one party licenses a marketing intangible and must contribute to the local value of the intangible in the form of marketing expenditures without being allocated any residual profits.2111 Multinationals tend to advocate that controlled profit allocations should correspond to such third-party behaviour. In other words, the local market jurisdiction should allow the group distribution entity to deduct its marketing (IP development) costs without being allocated any of the residual profits that are subsequently generated by the IP in the local market jurisdiction. The challenge faced by the US and OECD is to design allocation rules that strike a reasonable balance between these two axioms. A related issue is how incremental operating profits due to specific market conditions should be allocated between the local group entity that performs marketing and sales, on the one side, and a foreign group entity that holds legal title to the marketing intangible, on the other side. While, in principle, it is clear that profits caused by the local exploitation of foreign-owned marketing IP and local market characteristics are two different notions entirely (that also follow different profit allocation norms),2112 the two types of profits tend to be connected, as both stem from the marketing and sales part of the value chain.2113 The allocation of residual profits from a locally developed marketing intangible is not a problem particular to developing countries. The GSK case, involving the United States as the market jurisdiction and the United Kingdom as the residence jurisdiction of the legal owner of the marketing intangible, illustrates the relevance of the issue among developed countries.2114 Ulti2111. It is, however, unclear how profitable such third-party distributors indeed are. It has been asserted in the literature that such distributors make low, stable returns; see, e.g. Allen et al. (2006), at sec. 5.2. 2112. See the discussion of the new OECD allocation rules for profits from local market characteristics in ch. 10 and on the corresponding US rules (on comparability with respect to economic conditions) in sec. 6.6.5.4. 2113. Separation of residual profits generated through local exploitation of a foreignowned marketing intangible from incremental profits due to specific market characteristics may be challenging, as experienced by tax authorities in developing countries when multinationals extract all local marketing (residual) profits based on the assertion that they are caused solely by locally exploiting a foreign-owned marketing intangible. 2114. See the discussion of GlaxoSmithKline Holdings v. CIR (2006) in sec. 19.2.5.2.

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mately, however, the author’s impression is that the problem is pronounced when the market jurisdiction is a developing country, due to the existence of local market characteristics that generate incremental operating profits.

23.3. When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance? 23.3.1. Introduction In sections 23.3.2.-23.3.8., the author will discuss the application of the US “economic substance” exception for internally developed marketing intangibles. The point of departure is that the US regulations will respect controlled pricing agreements that allocate residual profits from local US exploitation of marketing IP to a foreign group entity that holds legal title to the IP as long as there is sufficient economic substance supporting the legal ownership. The question then becomes: what is the threshold for applying the economic substance exception in order to alter the controlled profit allocation so that the local distribution entity is allocated a portion of the residual profits? While the US regulations provide no general guidance for this problem, two extensive examples are drawn up that illustrate the application of the economic substance exception. These examples will be discussed in sections 23.3.2.-23.3.4. Thereafter, the author will discuss three different aspects of the threshold for the economic substance exception: (i) concurrent compensation throughout the development phase as a safe harbour (discussed in section 23.3.5.); (ii) the “incremental marketing” criterion (discussed in section 23.3.6.); and (iii) that the economic substance exception should only be relevant for incoherent pricing structures (discussed in section 23.3.7.). Lastly, in section 23.3.8., the author will briefly compare the current economic substance exception to its 1994 predecessor.

23.3.2. The wristwatch example: US distributor incurs incremental marketing expenditures to build local value of foreign-owned trademark The first example on the application of the economic substance exception for internally developed marketing IP addresses the allocation of a US distribution subsidiary’s operating profits generated through US exploitation of 684

 When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance?

a marketing intangible for wristwatches, where legal title to the intangible is held by a foreign manufacturing parent.2115 The US subsidiary purchases the watches from the parent at a fixed, arm’s length price per watch. The parent and subsidiary together undertake (without separate compensation) carrying out US marketing activities to establish the trademark (comparable uncontrolled transactions (CUTs) contain similar marketing obligations). In years 1-6, the subsidiary also undertakes incremental marketing, for which it is not compensated. In year 7, the sale of watches begins generating residual profits. The controlled pricing allocates the residual profits to the foreign parent, on the basis that it holds legal title to the trademark. The mismatch between the subsidiary’s incremental marketing activities in years 1-6 and the subsequent allocation of residual profits to the parent in year 7 is deemed inconsistent with the economic substance of the actual conduct of the controlled parties. The logic is that an unrelated party would not have carried out incremental marketing to develop the value of marketing IP that it did not own unless it received contemporaneous compensation or otherwise had reasonable anticipation of receiving a future benefit.2116 The example therefore rejects the controlled profit allocation that allocated all residual profits to the foreign title-holding entity, and instead prescribes a split of the residual profits. This new allocation is achieved through the imputation of an agreement that, consistent with the economic substance of the behaviour of the controlled parties, affords the US subsidiary “an appropriate portion of the premium return”.2117

23.3.3. The athletic gear base example: US subsidiary incurs incremental marketing expenditures to build local value of foreign-owned trademark The second example addresses the allocation of operating profits that a US subsidiary has earned through exploiting exclusive US rights to athletic 2115. Treas. Regs. § 1.482-1(d)(3)(ii)(C), Example 3. 2116. Id., at (iii). 2117. The current regulations offer separate guidance for the imputation of contingent compensation structures. See the discussion in sec. 21.3.3. The imputation of any specific type of agreement is not required, as long as the prescribed profit allocation is achieved. For example, the imputed agreement may be (i) a service agreement that affords the subsidiary contingent payment for its incremental efforts in years 1-6; (ii) a long-term, exclusive distribution agreement that allows the subsidiary to benefit from its incremental marketing activities; or (iii) that the parent compensates the subsidiary for terminating its imputed long-term distribution agreement.

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gear manufacturing and marketing IP that it licensed from its foreign parent (which holds legal title to the IP).2118 Both the subsidiary and parent are obligated to undertake specific US marketing activities without separate compensation (similar obligations are applied in CUTs). The subsidiary, however, also performs incremental marketing activities without compensation. In year 7, US sales begin generating residual profits. A separate services agreement is then entered into, pursuant to which the parent agrees to compensate the subsidiary on a cost basis for its incremental marketing expenditures incurred in years 1-6 and forward. The royalty rate is increased so that all residual profits from US sales are allocated to the parent. This example also rejects the controlled profit allocation that allocates all residual profits to the foreign entity,2119 and prescribes instead a split of the residual profits, thereby allocating a portion of the residual profits to the US subsidiary.2120

23.3.4. The athletic gear example: The 2006 extension An extension of the athletic gear example was introduced in 2006 to clarify that the economic substance exception should not be applied simply if the US Internal Revenue Service (IRS) disagrees with the taxpayer’s transfer pricing,2121 as “normal” mispricing should be corrected by way of the transfer pricing methods. Only if the mispricing is “substantial” should application of the economic substance exception be considered. The factual pattern in the extension is the same as in the base example (discussed in section 23.3.3.) with respect to years 1-6, apart from the twist that in year 1, the parent agrees to compensate the subsidiary quarterly for its incremental marketing activities on a cost-plus basis, regardless of whether the marketing proves successful. For year 4, it is determined that the mark-up on costs is outside the arm’s length range. A reassessment is 2118. Treas. Regs. § 1.482-1(d)(3)(ii)(C), Example 4. 2119. Id., at (iii). 2120. Langbein (2005), at p. 1086 comments on the 2003 proposed regulations (68 FR 53448-01), stating that he finds the allocation of residual profits to the subsidiary to rest on a “nebulous and discretionary identification of a return on ‘services’” rather than a more concrete, cost-based allocation for IP. As above in the first example (Treas. Regs. § 1.482-1(d)(3)(ii)(C), Example 3, as discussed in sec. 23.3.2.), there is no requirement as to the imputation of any specific type of agreement, as long as the resulting allocation of income is as envisioned by the example. See the discussion on contingent compensation structures in sec. 21.3.3. 2121. Treas. Regs. § 1.482-1(d)(3)(ii)(C), Example 5.

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 When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance?

made, requiring compensation based on the median of the interquartile range of the arm’s length mark-ups charged by uncontrolled parties. The example emphasizes that the fact that the mark-up in year 4 was outside the arm’s length range does not indicate that the economic substance exception should be triggered, as the subsidiary did not bear the risks associated with the incremental marketing activities. Thus, the transfer pricing methods – and not the economic substance exception – should be applied to correct the controlled pricing. The example is, however, ambiguous with respect to whether a mark-up significantly outside the arm’s length range could trigger the economic substance exception.2122 The author will revert to this issue in the discussion in section 23.3.7.

23.3.5. Concurrent remuneration during the IP development phase as a safe harbour from the economic substance exception The current US regulations, through the wristwatch and athletic gear examples discussed in sections 23.3.2.-23.3.4., seek, more clearly than their 1994 predecessor, to induce vigilant transfer pricing behaviour when a US group entity contributes to the domestic value of foreign-owned marketing IP. The economic substance exception turns on the lack of contemporaneous compensation for incremental marketing expenses. While the regulations do not elaborate on what is meant by concurrent compensation, the author’s interpretation is that the language refers to an arm’s length compensation for the incremental marketing contributions, typically determined under the cost-plus method or the comparable profits method (CPM). Provided that the US subsidiary is allocated such remuneration throughout the development phase, there should be no legal basis to apply the economic substance exception (to split any US residual profits generated in the exploitation phase). Concurrent normal market return compensation to the United States will thus provide the multinational with a safe harbour from the economic substance exception. This conclusion corresponds to the author’s observations on the economic substance exception applied to internally developed manufacturing IP (see the discussion in section 21.3.7.). Multinationals are given the choice of either (i) reimbursing excessive marketing expenditures with a steady cost-plus margin income to the US entity 2122. It is stated that the mark-up being outside the arm’s length range does not “without more” trigger the economic substance imputation authority.

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on a concurrent basis throughout the IP development phase; or (ii) risking a residual profit split further down the line when the IP is exploited. The likely problem with this safe harbour, seen from the perspective of a multinational, is that it will effectively result in the marketing costs not being deductible in the United States (as the costs are reimbursed by the foreign parent with a mark-up). This may be problematic when significant marketing expenses are necessary to establish a new product and there is a risk that the marketing may prove unsuccessful, typically because there is fierce competition in the marketplace.

23.3.6. A premise for triggering the economic substance exception: “Incremental” marketing expenditures The economic substance exception is triggered in both the wristwatch and athletic gear examples (discussed in sections 23.3.2. and 23.3.3., respectively) because the US subsidiary incurs “incremental” marketing expenditures without compensation during the IP development phase (before the product begins generating residual profits).2123 The effect of triggering the economic substance exception could be serious: the entire residual profits from US exploitation of the marketing intangible may be split between the US subsidiary and the foreign group entity that holds legal title to the marketing IP. Unfortunately, the regulations provide no guidance as to what constitutes incremental marketing. Those who commented on the 2003 proposed regulations requested clarification of the term.2124 The IRS responded, rather 2123. The term “incremental marketing” was likely adopted as a response to the criticism of the Ninth Circuit in DHL Corp. & Subsidiaries v. CIR, T.C. Memo. 1998-461 (Tax Ct., 1998), affirmed in part, reversed in part by 285 F.3d 1210 (9th Cir., 2002), pertaining to the determination of intangible ownership based on the incurrence of relative marketing expenditures under the 1968 regulations (33 Fed. Reg. 5848). See the discussion of DHL in sec. 19.2.5.3. See also Levy (2002); and Terr (2004), at p. 564. Langbein (2005), at p. 1085 notes that the new terminology weakens the link to intangible development expenses, without being clear on the implications of that. The incremental marketing concept is also significant for determining an arm’s length remuneration for intangible development contributions rendered by other group entities than the entity assigned ownership. See the discussion under sec. 23.4.3. Terr (2006), at p. 881 also finds that the examples contain insufficient guidance on the question of whether and to what extent a contribution to intangible development shall be remunerated. See also Wittendorff (2010a), at p. 637 on incremental marketing expenses. 2124. See the preamble to the 2006 regulations (71 FR 44466-01), at sec. B.2. See also Terr (2004), at p. 564.

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 When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance?

obtusely, in the preamble to the 2006 temporary service regulations that incremental marketing activities refer to “activities … quantitatively greater (in terms of volume, expense, etc.)” than activities undertaken by third parties in comparable transactions.2125 The incremental marketing threshold therefore remains ambiguous. Whether the threshold is surpassed can, in the author’s view (in line with the statement in the 2006 preamble), only be assessed in a meaningful manner if there is a third-party “reference level” of marketing expenditures, incurred under similar terms and conditions, that the controlled level of marketing expenses can be compared to.2126 Apparently, it is common in third-party distribution and franchising agreements that the local franchisee is obliged to perform a certain level of marketing without reimbursement from the franchiser. For valuable international marketing IP, the franchiser will likely have a strong bargaining position vis-à-vis local unrelated franchisees that only provide fairly routine inputs to the value chain. Presumably, the more valuable the licensed IP is, the more burdens (e.g. marketing expenses) will be placed on the licensee.2127 2125. The author agrees with Terr (2006), at p. 881, who found little comfort in the statement of the 2006 preamble that consideration was being given to discounted cashflow analysis as a method to analyse non-owner contributions to intangible value, with respect to avoiding subjective evaluations of contributions. 2126. See also, in particular, Levey et al. (2006), at p. 7 for a strong analysis of this “bright line test” (i.e. whether the related distributor’s marketing expenses exceed an arm’s length level, thereby going from being “routine” to “non-routine” marketing expenses and thus creating local marketing IP). Levey criticizes the mere notion of there being a clear industry standard in the first place against which to benchmark a related distributor’s marketing expenses, and emphasizes that there are serious problems connected to attaining reliable information at all on third-party distributors’ marketing expenses in publicly available financial statements. This is due to a lack of disaggregated and properly categorized cost data, as well as accounting timing issues (some marketing expenses may be booked on the balance sheet for expensing in later periods). Further, if the related distributor nonetheless is guaranteed a normal return on its marketing expenses, Levey argues that it should not be relevant as to whether its expenses exceed an arm’s length level. See also Helderman et al. (2013), at p. 365 and p. 368, with respect to the incremental marketing expenses issue (discussed in relation to the US Glaxo case). 2127. For example, Apple would likely have no struggle in outsourcing local distribution of its products for a normal market fee to unrelated distributors. It may be, however, that third-party outsourcing is not a realistic alternative for the multinational due to its need to (i) ensure quality control over each step in the value chain of its products so that its marketing intangibles maintain their value; or (ii) make sure that know-how and business processes remain secret from competitors. See the discussion of foreign direct investment in sec. 2.3.

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Logically, one would nevertheless assume that there are limits as to the level of marketing expenses that an unrelated distributor would be willing to incur, even when negotiating with a powerful franchiser for the licence of an attractive marketing IP. An unrelated licensee would presumably, in general, reject conditions that could put it worse off than it would have been under its best realistic alternative, for instance, when the estimated present value of the marketing efforts is negative.2128 Also, a local thirdparty distributor may control unique intangibles (local goodwill, marketing know-how, etc.) that may have synergetic effects with the licensed marketing intangible. It seems unlikely that such a distributor (with a relatively strong bargaining position) would accept incurring incremental marketing expenditures without assurance that its efforts would be profitable. Further, it may be that the foreign licenser’s trademark is successfully established and valuable in foreign jurisdictions, but unknown in the United States. If so, that might indicate that the franchiser is in a lesser bargaining position than it would have been had the brand already been established and highly valuable in the United States. Given the wide range of possible bargaining constellations between unrelated licensers and licensees, the author does not find it realistic that, in most cases, it will be possible to identify any “normal” third-party level of marketing expenditures. If it is not possible, on the basis of CUTs, to determine whether the controlled level of marketing expenses is “incremental”, the point of departure should be that a related distribution entity that provides only routine inputs to the value chain should be able to incur marketing expenses at a level that is not incompatible with a normal market return operating margin. Thus, if the US subsidiary, concurrently throughout the IP development phase, experiences a level of operating profits that corresponds to the amount that would be allocated to it under the CPM, there should be no basis for an application of the economic substance exception. Further, if its operating margin lies outside the arm’s length range, the natural approach would, in the author’s view, be to perform a transfer pricing adjustment, as opposed to imputing new pricing terms based on the economic substance exception. If, however, the incurrence of incremental marketing expenditures results in an operating margin that lies significantly outside the arm’s length range, it may be appropriate to resort to the economic substance exception. 2128. It is, however, conceivable that a licensee would be willing to incur short-term losses if there are prospects of higher future returns as a result of the licence arrangement.

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 When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance?

Due to the blatant lack of guidance on the “incremental” marketing criterion, the author suspects that, in practice, it will prove challenging to determine whether there indeed is a legal basis on which to apply the economic substance exception.2129 Future revisions of the US regulations should seek to clarify the incremental marketing expenses threshold.

23.3.7. The economic substance exception should be relevant only for incoherent pricing structures The wristwatch and athletic gear examples illustrate that the economic substance exception is reserved for rather extreme scenarios. Comments on both the 2003 proposed and the 2006 temporary service regulations expressed a concern that the economic substance exception could be used to impute new pricing terms if the IRS took issue with the taxpayer’s transfer pricing.2130 Even though the author certainly agrees that the threshold for applying the economic substance exception is ambiguous, he does not share this concern. The essence of the factual patterns of the wristwatch and athletic gear examples is that a US group entity takes the entrepreneurial role in an intragroup marketing IP development process and assumes the associated risks without receiving a commensurate benefit in return. It is difficult to see such arrangements as anything other than schemes constructed for the purpose of achieving concurrent tax deductions for IP development expenses (in a high-tax jurisdiction), combined with the shifting of residual profits to the foreign group entity that holds legal title to the intangible (often resident in a low-tax jurisdiction). Take the wristwatch example (discussed in section 23.3.2.), for instance, in which the US subsidiary incurs incremental marketing costs over a 6-year period. Even if the marketing efforts prove successful (in the sense that the local brand value is increased), the subsidiary has no prospect of reaping any of the residual profits. It is not even reimbursed for its costs. To accept this pricing structure would be contrary to the realistic options available to the controlled parties. The subsidiary would simply be significantly better off by not entering into the licensing structure. 2129. See also Vincent (2006), p. 28:10. 2130. See the preamble to the 2006 proposed regulations (71 FR 44466-01), sec. C; and the preamble to the 2009 final regulations (74 FR 38830-01), sec. C. See also the discussion of the 2006 extension of the second example illustrating the economic substance provision in sec. 23.3.4.

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Further, in the athletic gear example (discussed in section 23.3.3.), the US subsidiary is reimbursed for its incremental marketing costs plus a normal return mark-up only after the IP development process proves successful. All residual profits are allocated to the foreign parent. While less extreme than the wristwatch example, it must be assumed that a rational third-party enterprise would not enter into such an agreement, as the risk-adjusted return of the incremental marketing investment would likely lie significantly below a normal market return. After all, there is a pronounced risk at the outset that the subsidiary will not even be able to recover its incremental marketing expenses. In the author’s view, the wristwatch and athletic gear examples establish a high threshold for applying the economic substance exception. These factual patterns do not pertain to marginal transfer pricing misstatements, but to incoherent pricing structures. The author is therefore surprised by the introduction of the 2006 extension of the athletic gear example (discussed in section 23.3.4.), as it may be interpreted as placing the threshold for applying the economic substance exception up for discussion. There, the US subsidiary is reimbursed for its incremental marketing costs on a concurrent basis (with the addition of a mark-up) regardless of whether the intangible development proves successful, and therefore assumes no risk. Comparatively, in the wristwatch and athletic gear base examples, the US entity assumes the entire development risk. The problem in the extension is simply that the mark-up lies outside the arm’s length range, for which an adjustment is made.2131 The extension states that a mispriced mark-up “does not, without more, support imputation of additional contractual terms”.2132 Thus, even though the extension does make it clear that the economic substance exception is inapplicable, it manages, by way of the wording “not, without more”, to introduce uncertainty with respect to how far from qualifying for imputed pricing terms the factual pattern really lies. The problem with the 2006 extension is that it can now be questioned whether the economic substance exception truly requires as relatively extreme scenarios as indicated by the wristwatch and athletic gear examples, or whether a fairly “normal” mispricing will be sufficient to trigger the imputation authority.2133 2131. See the discussion of the arm’s length range in sec. 6.5. 2132. Treas. Regs. § 1.482-1(d)(3)(ii)(C), Example 5, at (iv). 2133. The answer to this question may have significant profit allocation implications. If treated as a transfer pricing issue, the effect will be to adjust the normal market return

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 When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance?

The original wording proposed in 2006 for the extension contained an additional reservation: [H]ad the compensation paid to USSub been significantly outside the arm’s length range, that might lead the Commissioner to examine further whether, despite the contractual terms that require cost-plus reimbursement of USSub, the economic substance of the transaction was not consistent with [foreign patents] bearing the risk associated with promotional activities in the United States market. (Emphasis added) 2134

This wording was removed in the final 2009 version of the service regulations, as the US Treasury and the IRS agreed that it did not convey the intended meaning.2135 To the author, the removal does not seem to entail much reality, as at the same time, it was made clear that the imputation authority would be relevant “where the economic substance of the transaction is consistent with such terms”.2136 Also, the current text contains the “without more” reservation. In the author’s view, the 2006 extension failed its mission to clarify the boundaries of the economic substance exception. Instead, the extension, as it currently reads, seems to indicate almost an overlap of the scope of application for the economic substance exception and the ordinary transfer pricing methods. The author finds that there are compelling reasons to interpret the economic substance exception in accordance with the ordinary meaning of the wording “inconsistent with the economic substance of the underlying transactions” of the economic substance provision in the 2009 Treas. Regs. § 1.482-4(f)(3)(i)(A), and to rely significantly on the wristwatch and athletic gear base examples. These sources of law indicate a high threshold for allocable to the routine inputs provided by the US subsidiary (e.g. adjustment of the cost plus mark-up). However, if the imputation authority is used to establish pricing terms comparable to the ones used in the wristwatch and athletic gear examples (see secs. 23.3.2.-23.3.4.), the US entity could be allocated residual profits, which, of course, can be significantly greater than the normal return resulting from an application of a one-sided pricing method. The author would object to such an allocation. Even if the IRS should impute new pricing terms on the basis of the economic substance exception, the income allocation results achieved thereby must lie within the boundaries set by the transfer pricing methods. The pricing solution must be at arm’s length. This is a severe restriction on the imputation authority. See also Terr (2006), at p. 884, who notes that “if the shortfall is significant”, the US Internal Revenue Service (IRS) could impute terms that supported an adjustment of that shortfall. 2134. 2006 Temp. Treas. Regs. (71 FR 44466-01) § 1.482-1-T(d)(3)(ii)(C), Example 5. 2135. See the preamble to the final 2009 regulations (74 FR 38830-01), at sec. C. 2136. Id.

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applying the economic substance exception. Further, the inherent lack of clarity in the 2006 extension, the initial intention behind it to clarify that the economic substance exception is inapplicable if the problem simply is that the IRS disagrees with the taxpayer’s pricing, as well as the obvious problems associated with using similar thresholds for applying the economic substance exception and the transfer pricing methods provide further support for the author’s interpretation. The economic substance exception should be reserved for cases in which the US subsidiary incurs the intangible development risks and it is not possible to determine a proper allocation of operating profits without the imputation of additional terms. This is in line with the wristwatch and athletic gear base examples, where there are no arrangements in place to remunerate the US subsidiary, either on a concurrent cost-plus basis or a contingent residual profit basis. In such cases, the transfer pricing methods cannot readily be applied, as there are no pricing terms to adjust. Application of the economic substance exception should therefore be justified. Where there is a pricing mechanism in place, however, as is the case in the 2006 extension, income adjustments should be based on ordinary pricing adjustments. The basic reason for this is that the US entity does not bear the risks of incremental marketing in these latter cases. The question is simply as to which extent the US entity should profit. That is, of course, a transfer pricing matter, not an issue of rejecting a controlled contractual risk allocation on the basis that it does not align with the economic substance of the controlled transaction (and replacing it with new imputed pricing terms).

23.3.8. The economic substance exception is balanced relative to its 1994 predecessor It has been debated as to whether the current economic substance exception is more far-reaching than its 1994 predecessor.2137 As illustrated by the 1994 economic substance example,2138 the authority was already significant. It has therefore been speculated as to whether the new guidance was introduced to replace the previous “excess marketing expenditures” terminology with “incremental marketing activities” due to criticism levied by the Ninth Circuit in DHL,2139 or whether the new economic substance 2137. See Terr (2004), at p. 567. 2138. See the discussion in sec. 19.4.5. 2139. See supra n. 2123.

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 When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance?

exception guidance could allow the IRS to circumvent the statute of limitations.2140 The author’s impression is that the coordination of the economic substance exception with the imputation authority for contingent payment terms (see the discussion in section 21.3.3.) necessitated more elaborate guidance and that the combined authority likely is more far-reaching than the 1994 rule. The current economic substance exception offers more aggressive and lenient solutions than its 1994 predecessor, in the sense that it – in specific contexts – allocates more or less operating profits to the United States. On the aggressive side, the current regulations require allocation of residual profits to a US distribution entity, whereas the 1994 regulations did not. For instance, in cases of incremental marketing expenditures incurred under non-exclusive licences, the second cheese example of the 1994 regulations allocated the entire residual profits to the foreign group entity (that held legal title to the marketing IP) under the rationale that the US subsidiary was an “assister”. The US entity was only afforded a cost-plus remuneration.2141 The wristwatch example discussed in section 23.3.2. also pertains to a nonexclusive licence in which the US subsidiary incurs incremental marketing costs, but it splits the residual profits between the subsidiary and the foreign parent that holds legal title to the marketing IP. Had the factual pattern of the wristwatch example been assessed under the 1994 regulations, the result would, in the author’s view, likely have been to allocate the entire residual profits to the foreign legal owner of the IP. Thus, the current regulations allocate more income to the United States, relative to the 1994 regulations, when incremental marketing efforts are carried out under nonexclusive licence agreements. The athletic gear example (discussed in sec. 23.3.3.) provides a different result than the “multiple owners rule” of the third cheese example in the 1994 regulations. Pursuant to the latter rule, the US entity was allocated all residual profits from the US exploitation of the intangible. This differs from the allocation pattern professed by the athletic gear example, in which the profits from the US exploitation of the trademark are split between the US entity and the foreign parent. Thus, in the context of exclusive licence arrangements, the current regulations allocate less profits to the United States than the 1994 regulations. 2140. See Terr (2004), at p. 567. 2141. See the discussion of the 1994 “cheese” examples in sec. 19.4.6.

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The author finds that the wristwatch and athletic gear examples together offer a coherent and balanced alternative to the 1994 cheese examples. As discussed in the analysis of the 1994 regulations,2142 the author does not find any convincing reason as to why the treatment of the factual patterns in the second and third cheese examples should differ as drastically as they did. The 1994 threshold for allocating residual profits to the US entity seemed somewhat arbitrary. The current regulations instead use a profit split approach in cases in which the US entity, under the 1994 regulations, was not entitled to any of the residual profits, as well as in cases in which it was entitled to all of it. Thus, the rough edges of the 1994 regulations are now smoothed, offering an approach that, on average, likely will be more acceptable, both from a US and treaty partner perspective.

23.4. Remuneration of a US distribution entity when the economic substance exception is not triggered 23.4.1. Introduction The premise for the following discussion is that the controlled assignment of legal title to the marketing IP (that is developed and exploited in the United States) to a foreign group entity is respected and given transfer pricing effect under the legal ownership rule, as it is supported by sufficient economic substance. In other words, the economic substance exception (discussed in under section 23.3.) has not been triggered. The residual profits from US exploitation of the intangible should therefore be allocated to the foreign group entity that holds legal title to the IP. The question then turns to how the US distribution subsidiary should be remunerated for its IP development contributions that increased the US value of the licensed marketing intangible. This will, in principle, depend on an application of the transfer pricing methods.2143 The US regulations, through guidance provided in two base examples, split the treatment of this issue into two main categories. The first is where the US distribution entity has incurred an arm’s length level of marketing expenses, and the second is where it has incurred an incremental level of marketing expenses. The author will discuss this guidance in sections 23.4.2. and 23.4.3., respectively. Thereafter, in section 23.4.4., he will tie some com2142. See the discussion of the “multiple owners” exception in sec. 19.4.6. 2143. Treas. Regs. § 1.482-4(f)(4)(i).

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 When are the US regulations unwilling to give pricing effect to foreign legal ownership of marketing IP due to a lack of economic substance?

ments to the selection of an appropriate pricing methodology to remunerate the “assister” entity that contributed to the development of the marketing IP.

23.4.2. Arm’s length marketing expenditures are incurred The question is of how much profit shall be allocated to a US group entity that has developed the US market value of a trademark owned by a foreign group entity by incurring an arm’s length level of marketing expenditures. In the first example, a foreign manufacturing parent is registered as the owner of a trademark for wristwatches.2144 Its US subsidiary is given the right to resell watches in the US market under an exclusive 5-year agreement. Both entities are obligated to carry out specified types and levels of US marketing. The subsidiary purchases watches from the parent at a fixed price per watch, which entails (i) compensation for the exclusive US resale rights; (ii) the right to use the trademark in the United States; and (iii) the marketing activities of both parties. The question is whether the wristwatch transfer price should be adjusted in order to provide the subsidiary with an arm’s length return. The example is ambiguous with respect to the required profit allocation. On a stand-alone basis, it may possibly be interpreted to invite the application of the profit split method (PSM), based on the observations that both entities perform marketing and that the CUT method likely will be inapplicable due to comparability concerns.2145 Such arguments are not convinc2144. Treas. Regs. § 1.482-4(f)(4)(ii), Example 2. 2145. The original version of the example, as it read in the 2003 proposed regulations (68 FR 53448-01), stated that if it were not possible to identify comparable uncontrolled transactions (CUTs) that incorporated a similar range of integrated elements and if there were non-routine contributions from both the parent and the subsidiary, “the most reliable measure of the arm’s length price for the wristwatches may be the residual profit split method”, pursuant to which “an appropriate allocation of the combined operating profits from the sale of wristwatches and related activities” could be carried out. See also 2003 Prop. Treas. Regs. § 1.482-9(g)(1), which stated that “the profit split method is ordinarily used in controlled services transactions involving highvalue services or transactions that are highly integrated and that cannot be readily evaluated on a separate basis”. The sentence was removed in the 2006 temporary regulations [71 FR 44466-01], “thus eliminating any implication that the profit split method is a ‘default’ method for controlled services transactions that have value significantly in excess of cost”; see the 2006 preamble, sec. A.6. The final 2009 regulations [74 FR 38830-01] version of § 1.482-9(g) was modified in order to make it consistent with the § 1.482-7 cost-sharing regulations, clarifying that the residual profit split method (RPSM) is inapplicable to arrangements in which only one of the controlled parties make “significant non-routine contributions”. The reference was criticized by commentators, who interpreted it to imply a preference for the PSM in all cases pertaining to

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ing. First, the US subsidiary does not seem to contribute any unique inputs to the value chain. The PSM should therefore be inapplicable (likely, the CPM should be applied to remunerate the US entity). Second, the subsidiary does not incur any incremental marketing expenditures. Third-party distributors will presumably be willing to provide the same level of marketing for a normal market return. It is therefore difficult to see why the US subsidiary should demand any part of the residual profits. The author’s interpretation is supported by the new examples on the best-method rule.2146 The second example on this issue pertains to a scenario in which a foreign group entity holds legal title to the AA trademark for athletic gear and licenses exclusive US make-sell rights to a local subsidiary in return for an annual royalty.2147 Both entities are obliged to perform specified types and levels of US marketing without compensation, apart from that embedded in the royalty rate. The question is whether an allocation is warranted with respect to the royalty rate in order to provide the subsidiary with an arm’s length return. In this example, it is also unlikely that a CUT is available, rendering the CUT method inapplicable. The US entity does not provide any non-routine contributions to the value of the trademark. It should therefore likely be compensated based on either the cost-plus method or the CPM.2148 The author’s interpretation is supported by the new examples on the best-method rule.2149 In conclusion, it is the author’s view that the above examples do not provide any legal basis for allocating residual profits to a US distribution subsidiary that does not provide any non-routine IP development inputs and incurs only an arm’s length level of marketing expenditures to build the local value of marketing IP owned by a foreign group entity. The residual profit intangible development contributions; see the 2006 preamble, at sec. A.6. The 2006 temporary regulations therefore removed the reference. This may seem to be a considerable revision. It was, however, offset by the inclusion of strict comparability requirements, rendering the CUT method inapplicable in most cases. Thus, even though the pronounced preference for the RPSM is removed in the final 2009 regulations, it will, in practice, be the go-to method in cases in which both parties contribute unique inputs to the intangible’s development. 2146. The author refers to the discussion of the cost-plus method and comparable profits method (CPM) in sec. 23.4.4. 2147. Treas. Regs. § 1.482-4(f)(4), Example 3. 2148. Terr (2006), at p. 881 seems to suggest that Example 12 on the application of the RPSM in § 1.482-8(b) of the current regulations (for a discussion of the example, see sec. 23.4.4.) could advise on the allocation of income in this scenario. For the reasons stated in this section, the author disagrees. 2149. The author refers to the discussion of the cost-plus method and CPM in sec. 23.4.4.

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should, in these cases, be allocated to the foreign group entity that holds legal title to the IP. The US distribution subsidiary shall, in these cases, be treated as an “assister”.

23.4.3. Above-arm’s length marketing expenditures are incurred 23.4.3.1. Introduction The question then turns to the compensation of a US distribution subsidiary that contributes incremental marketing efforts to increase the US value of marketing IP that it licenses from a foreign group entity that holds legal title to the IP.2150 The guidance on this issue distinguishes between scenarios in which (i) the US subsidiary is deemed owner of a licence; (ii) the US subsidiary is remunerated for its marketing efforts under a separate service agreement; and (iii) the foreign group entity that holds legal title to the marketing IP is remunerated under a separate service agreement. The discussion will follow this structure.

23.4.3.2. Scenario 1: The US subsidiary is deemed owner of a licence The question in this first scenario is that of how much of the operating profits earned by a US subsidiary from exploitation of foreign-owned marketing IP shall be retained by it when it contributed to developing the local value of the IP by incurring an above-arm’s length level of marketing expenditures when it is deemed owner of the licence. The US regulations provide guidance for this problem in the form of an extension of the athletic gear base example (discussed in section 23.4.2.).2151 The factual pattern for the first year is the same as in the base example. In year 2, however, the subsidiary undertakes marketing efforts above the level required in the licence agreement, but the agreement is of sufficient duration that it is reasonable to expect that the subsidiary could obtain benefits from its incremental marketing activities by way of increased US sales. 2150. It has been asserted in the literature that this problem is highly practical, as most group distribution entities incur more marketing expenses than third-party distributors; see Allen et al. (2006), at sec. 5.3. For an analysis of the corresponding problem under the (2010 version of the) OECD TPG, see, in particular, Roberge (2013). 2151. Treas. Regs. § 1.482-4(f)(4), Example 4.

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The example concludes that if it is reasonable to anticipate that the incremental marketing activity will increase the value of only the US rights to the trademark (and not add to the value of the trademark in other jurisdictions),2152 it will not be necessary to compensate the US entity for the incremental marketing. The entire residual profits from the US exploitation of the marketing IP may then be allocated to the foreign group entity that holds legal title to it. The author’s impression is that the example, at least at the outset, forms a solid basis for treating the US subsidiary as an assister that will only be entitled to a normal market return for its contribution to the development of the local value of the marketing IP (and thus not any of the residual profits subsequently generated by the IP). It is, however, doubtful as to whether this conclusion can be upheld, as the example deems the subsidiary the owner of “intangible property (that is, USSub’s license to use the AA trademark for a specified term)”. (Emphasis added) 2153 Thus, even if the foreign parent (that holds legal title to the IP) is seen as the owner of the trademark as such, the subsidiary is deemed owner of the licensed US exploitation rights. The “discrete owner rule” (see the discussion in section 20.2.3.), although ambiguous, will likely allocate a portion of the US residual profits to the subsidiary based solely on the fact that it is the legal owner of the licence, even if the intangible as such is owned by a foreign group entity.2154 The question is if the US subsidiary, on top of this, should be allocated a separate remuneration for its incremental marketing costs. As mentioned, the position taken in the example is that if the incremental marketing costs only increase the value of the US rights to the foreignowned marketing IP, no additional profits should be allocated to the US subsidiary (with respect to its contribution to the development of the local value of the IP). The rationale behind this is likely that the subsidiary will, under the terms of the licence agreement, reap its portion of the residual profits from increased US sales due to the additional marketing. If the incremental marketing costs also increase the value of the foreign rights to the marketing IP, however, it will be necessary to compensate 2152. The 2003 proposed regulations (68 FR 53448-01) referred to these rights as “USSub’s intangible”. 2153. See Treas. Regs. § 1.482-4(f)(4), Example 4, at (ii). 2154. The author refers to the analysis of the “discrete owners rule” in sec. 20.2.3., which forms the backdrop for the discussion in this section.

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the US subsidiary. The author assumes that the rationale simply is that the United States will not tolerate deductions for incremental marketing costs that the subsidiary will not benefit from.2155 No guidance is provided as to the extent of the required additional remuneration of the US subsidiary or on how to determine whether the incremental marketing costs actually increased the value of the foreign rights to the marketing IP. It is unclear whether the subsidiary should be entitled to additional residual profits. The result is similar to that of the multiple owner rule of the third cheese example of the 1994 regulations,2156 in which a US subsidiary that incurred incremental marketing expenditures was entitled to the residual profits from the US rights to a trademark legally owned by a foreign entity. The fact that a purpose of the current regulations was to move away from the criticized solutions of the 1994 cheese examples further enhances the lack of clarity surrounding this example. There are, however, more fundamental problems at issue here. First, had the example instead chosen to focus on applying the ordinary transfer pricing methods to determine an arm’s length compensation for the incremental marketing services provided by the subsidiary, the author finds it unlikely that any additional residual profits would have been allocated to the United States. The reason for this is that even though the subsidiary certainly assumes financial risk in funding the marketing, the marketing services themselves should likely be regarded as routine services, entitled only to a normal rate of return (typically cost-plus based). Second, and most importantly, it could be argued that the US subsidiary’s incurrence of incremental marketing expenditures itself may indicate that there is not sufficient economic substance supporting the foreign legal ownership of the US rights to the marketing intangible. A rational solution would then be to apply the economic substance exception (discussed in section 23.3.) and treat the US subsidiary as the economic owner of the US intangible as opposed to the licence, and assert that the entire residual profits from US exploitation of the marketing IP should be allocated to the US subsidiary. Instead, the regulations have ended up with an unclear add-on to the already unclear “discrete owner rule” for cases in which a US

2155. See also the discussion in sec. 20.2.3. on the legal ownership rule with respect to a licence. Terr (2004), at p. 564 seems to be of the opinion that the example does not take a stance with respect to whether the US licensee should be compensated for its contribution. For the reasons stated in this section, the author does not agree. 2156. See the discussion of the “cheese” example in sec. 19.4.6.

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subsidiary incurs incremental marketing costs that also increase the value of the foreign rights to the relevant marketing intangible. Thus, the conclusion is that the US subsidiary in these cases will receive (i) remuneration pursuant to its licence agreement, likely entailing a small portion of the residual profits (pursuant to the discrete owner rule); and (ii) a return for increasing the value of the foreign rights to the marketing IP, likely entailing a normal return fee (on the basis of the cost-plus method or the CPM). Whether this intricate mix of profit allocation to a US subsidiary based on a combination of the discrete owner rule and the (one-sided) transfer pricing methods applied to remunerate intangible development contributions at all is practicable remains to be seen. The author’s impression is that the ambiguity associated with the profit allocation consequences of deeming a US licensee the legal owner of the licence adds unnecessary uncertainty to cases that could have been dealt with in a satisfying manner through the economic substance exception (allocating all residual profits from the US exploitation of the foreign-owned marketing IP to the US subsidiary) and the (one-sided) transfer pricing methods (compensating the US subsidiary for increasing the value of foreign rights to the marketing IP).

23.4.3.3. Scenario 2: The US subsidiary is compensated under a separate service agreement The question in this second scenario is how much of the operating profits earned by a US subsidiary from exploitation of a foreign-owned marketing IP shall be retained by the subsidiary when it contributed to developing the local value of the IP by incurring an above-arm’s length level of marketing expenditures when the marketing efforts of the subsidiary are compensated through a separate agreement. The guidance provided for this problem here is also in the form of an extension of the athletic gear base example (discussed in section 23.4.2.).2157 The factual pattern for the first year is the same as in the base example, but in year 2, a separate service agreement is entered into, pursuant to which the subsidiary shall carry out incremental US marketing activities. It is made clear that the subsidiary will not be entitled to any of the residual

2157. Treas. Regs. § 1.482-4(f)(4), Example 5.

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Remuneration of a US distribution entity when the economic substance exception is not triggered

profits from US sales, as it does not provide any non-routine contributions to the value of the foreign-owned trademark. Comparatively, the previous regulatory profit allocation solution for this scenario (under the developer-assister (DA) rule and the 1994 third cheese example) used the incurrence of US incremental marketing costs as the key benchmark for determining whether the US entity should be entitled to residual profits, based on the position that it was the deemed owner of the US rights. Nevertheless, as the incremental marketing services in this context are subject to separate compensation, their remuneration should naturally be seen as a transfer pricing matter as opposed to questioning whether there is sufficient economic substance supporting the assignment of legal ownership to the foreign group entity. The fundamental reason for this is that when incremental marketing services are separately compensable, the US subsidiary will ultimately be reimbursed for its costs, with the addition of a profit margin. Thus, the incurrence of incremental marketing costs by the US subsidiary no longer represents a form of behaviour that is contrary to the practices of comparable unrelated distributors. The author therefore fully agrees with the example in that the US subsidiary should not attract residual profits in this case, as the services provided seem to be of a routine nature. The US entity will be entitled to a normal market return (typically cost-plus or CPM-based).2158

23.4.3.4. Scenario 3: The foreign legal owner is compensated ­under a separate service agreement The question in this third scenario is of how much of the operating profits earned by a US subsidiary from the exploitation of foreign-owned marketing IP shall be retained by the subsidiary when it contributed to developing the local value of the IP by incurring an arm’s length level of marketing expenditures when the incremental marketing efforts of the foreign group entity (that holds legal title to the IP) are compensated through a separate agreement. Also here, guidance is provided in the form of an extension of the athletic gear base example (discussed in section 23.4.2.).2159 The factual pattern 2158. Also here, the proposed 2003 regulations (68 FR 53448-01) contained a preference for the RPSM, which is removed in the current 2009 regulations (74 FR 38830-01) and replaced with a reference to the best-method rule and the new examples. See the discussion on the cost-plus method and CPM in sec. 23.4.4. 2159. Treas. Regs. § 1.482-4(f)(4), Example 6.

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for the first year is the same as in the base example, but in year 2, the parent and subsidiary now enter into a separate service agreement that obligates the parent to perform incremental marketing activities in the form of advertising the AA trademark in international sporting events (e.g. the Olympics). The separate service agreement obligates the subsidiary to compensate the parent for the benefit that it could anticipate to reap as a result of the parent’s marketing efforts (an increase in the US value of the marketing IP). The question is with regard to the extent of the payment. The example sees the subsidiary as the owner of the US rights to the trademark under the discrete owners rule (see the discussion in section 20.2.3.). While the profit allocation consequences of that rule are, in general, ambiguous,2160 it seems clear that this particular example takes the position that the US subsidiary should be allocated a portion of the US residual profits. The author is not convinced by this reasoning. The point of departure is that the foreign parent owns the marketing IP, as the economic substance exception has not been triggered. Pricing effect should thus be given to the foreign legal ownership of the IP, and the foreign parent should therefore be allocated the residual profits from the US exploitation of the IP. As the US subsidiary only contributes routine inputs to the value chain, it should be compensated based on a one-sided pricing method. However, the example does not adhere to this logic due to the discrete owners rule. Instead, the point of departure is turned “upside-down”, as the basic assumption is that the US subsidiary owns the US rights and thus should reap the residual profits yielded through their exploitation. The question then becomes whether the US subsidiary must surrender some of those residual profits because the foreign parent incurs incremental marketing expenses. The answer to this question will depend on the transfer pricing mechanism applied in the separate service agreements. Normally, marketing should be viewed as a routine contribution that alternatively could be outsourced to third parties for a normal market fee, and should be remunerated under the one-sided methods (typically on a cost-plus basis). This will lead to the 2160. See the analysis of the remuneration of a US licensee that incurs incremental marketing expenditures without separate compensation in sec. 23.4.3.2.

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Remuneration of a US distribution entity when the economic substance exception is not triggered

conclusion that a foreign group entity that owns the US rights to a marketing intangible will not be allocated the residual profits from the rights, even when it incurs incremental marketing expenditures to increase their value. Instead, the foreign owner will simply be compensated under a one-sided method. The author is not convinced that this result reflects an allocation of operating profits that corresponds to what would have resulted from third-party behaviour under similar terms and conditions. Ideally, the profit allocation guidance contained in the US regulations for this scenario should be revised so that the foreign group entity that holds legal title to the marketing IP will be entitled to the residual profits from the US exploitation. After all, the economic substance exception is not triggered here. Legal title should therefore be respected for profit allocation purposes. At the very least, a profit split should be mandatory so that the foreign group entity gets a portion of the US residual profits, even if it only contributes routine marketing efforts. Such a result cannot, however, be based on the transfer pricing methods, as they will only allocate a normal market return to routine value chain inputs.2161 To achieve this result, the guidance on the economic substance exception must be revised.

23.4.4. What is the appropriate transfer pricing methodology to remunerate an assister? Here, the author will tie some comments to the position of the US regulations on appropriate transfer pricing methodology to remunerate a US group entity that contributes to the US value of marketing IP that it licenses from a foreign group entity that holds legal title to the IP. As discussed in sections 23.4.2. and 23.4.3., the US entity will, in most cases, be entitled only to a normal market return for its marketing IP development contributions. Exceptions to this are only made when the US subsidiary is deemed to own the licence of the US rights to the foreignowned marketing IP under the discrete owners rule, or in the rare cases in which a profit split is deemed appropriate. It is in this light that the US service regulations introduced three new examples in 2009 that illustrate the application of the best-method rule to select transfer pricing methodologies to deal with these scenarios. The core focus of the examples is on 2161. Only in the presumably rare cases in which the foreign entity performs particularly valuable marketing (e.g. advertising in the Olympics) may a profit split be relevant

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applying the one-sided methods in the service regulations to provide the US subsidiary with a normal market return, thereby in effect allocating the residual profits from US exploitation of the foreign-owned marketing IP to the foreign group entity that holds legal title to it. The first of the new examples pertains to the application of the cost-plus method for services when the US subsidiary is remunerated for its marketing efforts through a separate agreement.2162 The example discusses the relationship between the cost-plus method and the CPM, and finds that if sufficiently disaggregated third-party accounting data had been available, the CPM would likely be the most reliable method. The cost-of-servicesplus method is found to be the most reliable method only because the subsidiary is in possession of CUTs.2163 The second of the new examples pertains to the application of the CPM for services, in which the US subsidiary is remunerated for its marketing efforts through a separate agreement that applies (also here, the cost-plus method).2164 The example finds the CUT and cost-plus methods inapplicable due to the lack of CUTs. As it is possible to find third-party advertising companies that perform similar marketing activities, their accounting data can be used as CUTs under the CPM to benchmark the operating margin of the US subsidiary with respect to its marketing efforts.2165 The CPM is therefore deemed the most reliable method.2166 The last example illustrates an application of the PSM, where the question is of how much of the residual profits from the exploitation of foreign-

under the transfer pricing methods, then based on the rationale that such efforts are non-routine IP development contributions. 2162. Treas. Regs. § 1.482-8(b), Example 10. 2163. See the cost-of-services-plus method in Treas. Regs. § 1-482-9(e). While the author does not analyse the general cost-plus method as such in depth in this book, he does comment on the relationship between the gross and net profit methods in sec. 6.3., in particular with respect to the classification of costs. 2164. Treas. Regs. § 1.482-8(b), Example 11. 2165. The accounting treatment by the unrelated marketing companies of material items (e.g. the classification of costs of goods sold and administrative expenses) could differ from the treatment applied by the subsidiary. The example deems such inconsistencies less important when using the ratio of operating profits to total service costs under the CPM for services. The author agrees, as the classification of expenses will not influence this profit measure (all costs are included in the operating profits and in total service costs). See the analysis of operating profits in sec. 6.2., in particular, the discussion on the classification of expenses in sec. 6.2.4., with further references. 2166. See the CPM for services in Treas. Regs. § 1.482-9(f). See also the general CPM in Treas. Regs. § 1.482-5, and the discussion in ch. 8.

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owned marketing IP can be kept by the local US distribution entity when both it and the foreign IP owner entity contribute unique marketing IP development inputs.2167 The presence of unique contributions renders the CUT method, cost-plus method and CPM inapplicable. The PSM is deemed to yield the most reliable result,2168 entailing a residual profit split pursuant to the relative value of the unique IP development contributions.2169 In conclusion, a local US group distribution entity that contributed to the value of foreign-owned marketing IP that it exploits will rarely be entitled to any of the residual profits generated by the IP, and will thus generally be remunerated through the one-sided methods (typically cost-plus or CPM). The PSM will only be appropriate if the local entity contributes something relatively unique to the marketing IP development (e.g. advertisements in the Olympics, promotional contracts with famous athletes or highly beneficial distribution arrangements).

23.5. Concluding remarks Multinationals can generally extract residual profits generated in the United States from the local exploitation of marketing IP to the foreign group entity that holds legal title to the IP. As discussed in section 23.2., the intangible value behind marketing IP has to be created locally in each marked jurisdiction in order to have value there. Thus, a US distribution subsidiary that carries out marketing will contribute to creating the intangible value that later manifests in US residual profits. In this light, it would only seem fair if the US subsidiary would be entitled to a portion of the residual profits that it contributed to the creation of. Nevertheless, if the owner of valuable marketing IP can license it to an unrelated distribution company without surrendering any part of the residual profits from the exploitation of the IP, it will not be meaningful to put a related US distribution subsidiary in a better position, as the arm’s length principle fundamentally aims for parity in taxation between related and unrelated parties. From the discussions in this chapter, it can be observed that this axiom is respected under US law to a large extent, as the threshold 2167. Treas. Regs. § 1.482-8(b), Example 12. See the RPSM for services in Treas. Regs. § 1.482-9(g); and the analysis of the general US PSM in ch. 9. 2168. See the RPSM for services in Treas. Regs. § 1.482-9(g). 2169. The relative values may be difficult to measure. See the discussion of the use of an unspecified residual profit split under the US PSM in sec. 9.3.2., where this is developed further.

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for not giving pricing effect to foreign legal ownership of marketing IP indeed is set high. The US economic substance exception applied in the context of internally developed marketing intangibles will only look past legal ownership if the US subsidiary carries out incremental marketing efforts without being entitled to concurrent (normal return) compensation (typically cost-plus-based) or to a portion of the potential future residual profits. Thus, the economic substance exception will only be available for application in the relatively extreme scenarios in which the US subsidiary deducts high marketing costs without there being any link to potential future income. The current economic substance exception was meant to distinguish more clearly between the rules on intangible ownership and transfer pricing.2170 That ambition has, in the author’s opinion, not been realized (quite the contrary). The intangible ownership rules are now heavily influenced by the transfer pricing methods. This is illustrated clearly by the fact that the income allocation effect of applying the economic substance exception to determine IP ownership is consistently highlighted in the wristwatch and athletic gear examples (see sections 23.3.2. and 23.3.3.). The focus is on whether the US entity receives “an appropriate portion of the premium return”. How this is achieved seems secondary, as long as the allocation result itself is acceptable.2171 Also, the lack of guidance for determining the “appropriate” profit spilt under the economic substance exception will, in practice, make it necessary to resort to analogies to the transfer pricing methods, in particular, to the PSM.2172 This further reduces the degree to which it is meaningful to distinguish between the rules for determining ownership of internally developed intangibles and the transfer pricing methods. As opposed to the 1968 DA rule, the current economic substance exception will likely not identify only one group entity that should be allocated all residual profits from the co-developed intangible, but rather allocate the residual profits among the group entities that were involved in the intangible value creation, which, in typical scenarios, will be the US distri2170. It can be noted that the economic substance exception is systemically a part of the general provisions on transfer pricing comparability, and therefore inherently part of the transfer pricing provisions. The comparability provisions of the US regulations are placed in Treas. Regs. § 1.482-1(d), with the economic substance exception in § 1.482-1(d)(3)(ii)(B). See also the legal ownership rule in § 1.482-4(f)(3)(A); and the discussion of comparability in the context of transfer pricing in sec. 6.6. 2171. This is underlined by the fact that the examples leave the door open for the IRS to “impute one or more agreements … consistent with the economic substance”. See Treas. Regs. § 1.482-1(d)(3)(ii)(C), Examples 3, 4 and 6. 2172. Treas. Regs. § 1.482-6.

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bution subsidiary and the foreign group entity that holds legal title to the marketing IP. This is, in the author’s view, a significant shift, as it rejects the traditional DA-rule construction that a single group entity (the “developer”) is entitled to the residual profits, while the other entities involved in the development (the “assisters”) are remunerated on a separate (normal return) basis. The fact that the current US regulations do not distinguish clearly between rules on intangible ownership and transfer pricing should be seen as a mere consequence of the fact that both categories of rules fundamentally seek to allocate operating profits among the controlled parties in an arm’s length manner. A sharp divide between the categories would be rather artificial in any case. Further, as discussed in section 23.4., if the economic substance exception is not triggered – as it normally will not be due to its high threshold for application – the foreign legal owner of the marketing IP will be entitled to the residual profits. The question then turns to how the US subsidiary should be remunerated for its IP development contributions. There will be no legal basis under US transfer pricing law to allocate a portion of the residual profits to the US distribution subsidiary when it only incurs an arm’s length level of marketing expenditures (as discussed in section 23.4.2.). The real question is whether the situation will be different if it incurs marketing expenses above an arm’s length level. As discussed in section 23.4.3., when a US subsidiary develops a foreign-owned marketing intangible by incurring incremental marketing expenditures that are not compensated separately, the picture becomes blurry.2173 The subsidiary will likely be entitled to a portion of the residual profits under the discrete owner rule. In addition, it will be allocated an arm’s length return for its incremental marketing efforts, likely under the cost-plus method or the CPM. As seen from the above, the current US regulations, in some instances, afford the US subsidiary a portion of the residual profits. Thus, assisters may now be allocated a portion of the residual profits under the current regulations.2174 This departs from the “black and white” allocation pattern of the 1968 DA rule, which allocated the residual profits to the developer, 2173. See the discussion in sec. 23.4.3.2., as well as the analysis of the discrete owner rule in sec. 20.2.3. 2174. For this reason, the author does not agree with Terr (2004), at p. 564, who argues that the changes from the 1968 regulations (33 Fed. Reg. 5848) to the proposed 2003 regulations (68 FR 53448-01) regarding intangible ownership were changes more of

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while the assisters were left with a normal market return, regardless of the extent to which their development inputs contributed to the creation of the intangible value. The 1968 DA rule method for compensating assisters is thus finally abandoned, at least in principle.2175 Nevertheless, the cases in which a US distribution subsidiary may be allocated residual profits are few. Normally, the foreign legal owner of the marketing IP will be able to extract the entire residual profits. Thus, the purpose behind the new 2009 provisions on intangible ownership and remuneration of IP development contributions to move away from the “black and white” allocation patterns under the DA rule seems, in practice, to have been realized only to a very limited extent. The author’s impression is that it is still very much decisive for the allocation of residual profits from internally developed marketing IP as to which group entity is assigned legal title to it. A multinational will presumably be inclined to assign legal title to USdeveloped marketing IP to foreign group entities (in low-tax jurisdictions) and focus on establishing sufficient economic substance to substantiate that this assignment should be given pricing effect in the United States. If there is a high degree of uncertainty as to whether significant marketing efforts will succeed, the multinational will likely prefer to deduct the marketing expenses at the level of the US subsidiary to receive income tax deductions in a high-tax jurisdiction (i.e. no concurrent cost plus remuneration during the IP development phase). The current regulations deliver a clear message for such cases: foreign legal ownership of marketing IP will not be given pricing effect unless the US subsidiary is allocated a portion of the future residual profits.

terminology and emphasis than of substance. The author does, however, sincerely agree with Terr’s expectation that the new regulations do not appear more likely than the 1968 and 1994 approaches (59 FR 34971-01) to avoid the challenging facts-and-circumstan­ ces-based assessment akin to that which was assessed in DHL Corp. & Subsidiaries v. CIR, T.C. Memo. 1998-461 (Tax Ct., 1998), affirmed in part, reversed in part by 285 F.3d 1210 (9th Cir., 2002). 2175. See also Langbein (2005), at p. 1087 on the corresponding rule of the 2003 proposed regulations (68 FR 53448-01).

710

Chapter 24 Distribution among Group Entities of Residual Profits Generated through Exploitation of Internally Developed Marketing IP under the OECD TPG 24.1. Introduction A marketing intangible developed within a group may generate residual profits when it is exploited in a market jurisdiction. The typical set-up is that a distribution subsidiary in the market jurisdiction licenses the intangible property (IP) from a group entity resident in a foreign (often low-tax) jurisdiction and builds the local value of the IP through marketing efforts. The question in this chapter is of how the 2017 OECD Transfer Pricing Guidelines (OECD TPG) allocate residual profits from such marketing IP among the group entities that contributed to the development of the intangible. For a general overview of the profit allocation problem for internally developed marketing intangibles, the author refers to the discussion in chapter 23, under section 23.2. As discussed in chapter 20, the point of departure is that the group entity that holds legal title to an item of IP is entitled to the residual profit. The 2017 OECD TPG go far in accepting this in most situations with respect to marketing IP.2176 Nevertheless, three scenarios are singled out in which the remuneration of the local distribution subsidiary is up for discussion.2177 These scenarios represent a sliding scale with respect to the level of risks incurred by the subsidiary in rendering development contributions to the local value of the foreign-owned marketing IP: (1) first scenario: the subsidiary’s marketing expenses are reimbursed on a cost-plus basis. It therefore incurs no marketing risks. This is analysed in section 24.3.;

2176. OECD Transfer Pricing Guidelines (OECD TPG), para. 6.77. On the legal ownership of marketing intangible property (IP), see, in particular, Roberge (2013), at p. 216. See also Musselli et al. (2008a). 2177. These scenarios are described in the OECD TPG, paras. 6.77 and 6.78. On the economic ownership of marketing IP, see Roberge (2013), at p. 217.

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Chapter 24 - OECD Distribution among Group Entities of Residual Profits from Exploitation of Internally Developed Marketing IP

(2) second scenario: the subsidiary sustains an arm’s length level of marketing costs, and therefore incurs relatively low marketing risks. This is discussed in section 24.4.; and (3) third scenario: the subsidiary sustains marketing costs above an arm’s length level, and therefore incurs relatively high marketing risks. This is analysed in section 24.5. Concluding comments on the profit allocation positions taken in the 2015 OECD TPG are provided in section 24.6. First, however, the author will, in section 24.2., clarify as to which kind of marketing profits the discussions in this chapter will pertain to.

24.2. The 2017 OECD TPG require differentiation of market-based super profits The 2017 OECD TPG on the ownership of internally developed marketing IP focuses on how residual profits generated through the local exploitation of a foreign-owned marketing intangible (e.g. trademarks and trade names) should be allocated between the local distribution subsidiary and the foreign group entity that holds legal title to the marketing IP. Such marketing IP is normally the primary source for marketing-related super profits. Nevertheless, such profits may also encompass profits from local marketing IP that the subsidiary owns (e.g. goodwill and know-how), as well as profits from local market characteristics. Assume, for the sake of argument, a theoretical scenario in which a large multinational distributes the latest version of its globally best-selling smartphone in China through a local subsidiary. Residual profits from local sales will likely be due to both the unique manufacturing IP and marketing IP associated with the device. Let us disregard the profits that are due to the manufacturing intangibles and focus on the profits that are marketing-related. These latter profits may stem from three distinguishable elements: (1) foreign-owned marketing IP (trademarks and trade names). Such profits will, under the 2017 OECD TPG, normally be allocated to the foreign group entity that holds legal title to the IP. As will be discussed in sections 24.3.-24.6., the OECD has struggled to reach clear consensus with respect to when the local distribution subsidiary shall be allocated a portion of the residual profits that are due to the marketing IP; 2178

2178. See the discussion in sec. 24.5.

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 The 2017 OECD TPG require differentiation of market-based super profits

(2) unique intangibles owned by the local distribution entity (e.g. goodwill and know-how). For instance, the local subsidiary may have developed unique and valuable customer relationships over a longer period, its employees may be highly qualified and possess special know-how and its business may have reputational value (goodwill). The source jurisdiction alone should be entitled to tax profits from such intangibles, as they are owned there; and (3) location-specific advantages (e.g. local purchasing power, product preferences, growing market and good infrastructure). Such profits will normally be extracted from the source state under the 2017 OECD TPG.2179 The profits from these three elements may be allocable to different group entities, as the profit allocations are governed by different transfer pricing norms.2180 To ensure a true arm’s length allocation of marketing-based super profits, it is therefore crucial that a thorough functional analysis is performed in order to identify the extent to which the marketing-related super profits of the local subsidiary stem from these three elements. If it is automatically assumed that the entire marketing profits are due to the foreign-owned marketing IP, the result may be that the allocation of operating profits among the contracting jurisdictions are distorted. Thus, it must be clarified as to whether the marketing-related super profits of the local subsidiary, in addition to the profits generated through the exploitation of the foreign-owned IP, also stem from a unique intangible owned by the subsidiary (e.g. goodwill and know-how). The profits from such locally owned IP must be allocated to the source state. The widespread use of the transactional net margin method (TNMM) to remunerate source jurisdictions may be interpreted as an indicator that multinationals and source-state tax authorities have not identified unique local marketing intangibles in many cases. The author finds that puzzling. The emphasis of the 2017 OECD IP guidance on the profit split method (PSM) could, at least partially, be seen as a reaction to the likely unrealistic assumption that local distribution entities do not own any unique marketing intangibles.2181 Lastly, it must be clarified as to whether parts of the marketing-based su2179. The author refers to the analysis of the allocation of incremental operating profits due to location-specific advantages in sec. 10.7. 2180. See the discussion of the new OECD allocation rules for profits from local market characteristics in ch. 10, and on the corresponding US rules (on comparability with respect to economic conditions) in sec. 6.6.5.4. 2181. See the comments in ch. 11 on the transfer pricing of intangibles under the OECD TPG in the post-BEPS era.

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per profits stem from local market characteristics. If so, the allocation of the latter profits must be carefully considered when choosing comparables under the appropriate transfer pricing method. There should be great potential, both for multinationals and source-state tax authorities, for achieving profit allocations that more reliably ensure that intangible value is allocated to the jurisdiction where it was created through differentiation of the local entity’s marked-based super profits into the above-mentioned three categories. The discussions in sections 24.3.-24.6. below will address only the allocation of market-based super profits that stem from one of the three elements mentioned above, namely from foreign-owned marked IP (e.g. trademarks and trade names). The reason for this is that the IP ownership rules of the 2017 OECD TPG with respect to marketing IP focus only on this. For other unique marketing IP that the local subsidiary has developed by itself (e.g. goodwill), there will be no allocation discussion. The profits from such IP shall be taxed in the source state, as the local subsidiary owns it. With respect to the allocation of profits from local market characteristics, the author refers to the analysis in chapter 10.

24.3. Scenario 1: The local group distribution entity is reimbursed on a cost-plus basis The question in this first scenario is whether the 2017 OECD TPG, based on economic substance considerations, will deny controlled profit allocations that extract the residual profits that a local distribution subsidiary has generated through the exploitation of marketing IP (that it licenses) to the foreign group entity that holds legal title to the IP in cases in which the subsidiary, throughout the development phase, is reimbursed by the foreign group entity for its marketing costs to build the local value of the IP.2182 The historical 1995 OECD TPG position was that the subsidiary would only be entitled to a normal market return on its distribution and marketing services, as opposed to a stake in the subsequent residual profits.2183 The 2010 consensus text is identical.2184 Seemingly in line with the historical position, the new 2017 guidance states that the local subsidiary will only 2182. OECD TPG, para. 6.77. 2183. 1995 OECD TPG, para. 6.37. 2184. 2010 OECD TPG, para. 6.37.

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Scenario 1: The local group distribution entity is reimbursed on a cost-plus basis

be entitled to a normal market return “where a distributor acts merely as an agent, being reimbursed for its promotional expenditures and being directed and controlled in its activities by the owner of the trademarks and other marketing intangibles”.2185 The rationale behind this position is that the subsidiary should not be entitled to any additional profits above a normal market return when it does not “assume the risks … with the further development of the … intangibles”.2186 The application of this rule is illustrated in an example (the “Primair” example, which is clearly inspired by the US regulations; see the discussion in section 23.4.2.) pertaining to a newly established subsidiary in jurisdiction Y, which markets and sells watches purchased from its parent in jurisdiction X under the trademark and trade name R.2187 The marketing intangibles are owned by the parent and are widely known and valuable in country X, but not in country Y. An exclusive, long-term, royalty-free marketing arrangement is entered into, pursuant to which the subsidiary shall build the local value of the licensed marketing IP. The purchase price per watch paid to the parent is at arm’s length (apparently determined on the basis of comparable uncontrolled transactions (CUTs)) and provides the subsidiary with sufficient remuneration for its distribution activities. The question is of how the subsidiary should be remunerated for its marketing development contributions to the local value of the R watch intangibles. The example highlights that the foreign parent “develops the overall marketing plan based largely on its experience in other countries, it develops and approves the marketing budgets, and it makes final decisions regarding advertising designs, product positioning and core advertising messages”.2188 The subsidiary executes the global marketing strategy locally under the direction of its parent and provides feedback on the local effectiveness of the marketing. In doing so, it incurs marketing expenses, which are reimbursed through a concurrent cost-plus remuneration, with the mark-up determined on the basis of the mark-ups experienced by independent advertising agents that are deemed comparable.2189 The example concludes that the foreign 2185. OECD TPG, para. 6.77. 2186. Id. 2187. OECD TPG, appendix to ch. VI, Example 8, at para. 22. The wording in the final version of the example is identical to that used in the 2013 and 2014 drafts. The example contains elaborate and specific premises and is likely inspired by the US “wristwatch” examples; see the analysis in secs. 23.3.2., 23.3.6. and 23.4.2. 2188. OECD TPG, appendix to ch. VI, Example 8 (Primair), at para. 22. 2189. Normally, the author would object to such comparables; see the discussion of the US Treas. Regs. § 1.482-8(b), Example 11 on the comparable profits method in sec. 23.4.4. In the US example, marketing was only an auxiliary part of the subsidiary’s

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parent, because it owns the licensed marketing IP, “is entitled to retain any income derived from exploiting the R trademark and trade name in the country Y market that exceeds the arm’s length compensation”.2190 Thus, the controlled cost-plus remuneration of the subsidiary’s marketing efforts is accepted, with the result that the residual profits are extracted from the market jurisdiction and allocated to the foreign parent. In order to avoid any residual profits being allocated to the distribution subsidiary, it must – in addition to being reimbursed for its marketing expenses with an arm’s length mark-up – be “directed and controlled in its activities” by the foreign group entity that holds legal title to the licensed marketing IP so that it acts “merely as an agent”.2191 This requirement is clearly based on the new OECD comparability guidance on risk and economic substance,2192 and forms a parallel to the “important functions” doctrine for internally developed manufacturing IP.2193 In terms of context, multinationals tend to centralize high-level marketing decisions, ensuring that local sales entities pursue a uniform global marketing pattern. That was the case in GSK, and was one of the main taxpayer arguments for allocating the residual profits from the US exploitation of the trade name Zantac in the United Kingdom.2194 Thus, a local subsidiary will rarely perform all important marketing functions, but may nevertheless have a significant amount of freedom with respect to how it chooses to approach local marketing within the global framework of the group. This may entail that some important functions are performed locally in the source state.2195 business. The author finds it inappropriate to compare its operating margins on the marketing activity to the margins realized by specialized third-party marketing enterprises in the absence of suitable comparability adjustments. In this example, however, country Y’s subsidiary is newly established, with distribution and marketing of the watches sold under the R trademark as its only activities. The marketing carried out by the subsidiary should therefore likely not be deemed auxiliary. Experienced and specialized third-party marketing enterprises would likely realize higher operating margins on their promotional activities than a newly established company that only markets one type of product. Comparability adjustments should therefore be implemented to make the third-party margins more reliable, and the interquartile range should be used. 2190. OECD TPG, appendix to ch. VI, Example 8 (Primair), at para. 25. 2191. OECD TPG, para. 6.77. 2192. See the analysis on comparability and risk in sec. 6.6.5.5. 2193. See the analysis of the important-functions doctrine in sec. 22.3.2. 2194. The group entity that held legal ownership to the trade name was resident in the United Kingdom. See the discussion of the GSK case in sec. 19.2.5.2. 2195. For instance, it has been asserted that the Canadian subsidiary in the Glaxo case (see the discussion in sec. 6.7.4.) had a large degree of autonomy with respect to local marketing efforts; see Roberge (2013), at p. 229.

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Scenario 1: The local group distribution entity is reimbursed on a cost-plus basis

The wording “directed and controlled” and “merely as an agent” lends support to the interpretation that the control of the foreign owner must be relatively intense and encompass all local activities that pertain to the licensed marketing IP in order for the foreign group entity to retain entitlement to the entire residual profits. Clearly, all high-level decisions pertaining to the local marketing efforts must be governed by the foreign owner (e.g. marketing strategy design and budget determination). The question is whether important local day-to-day operating decisions (e.g. localization of global marketing material and advertising media purchases) must also be controlled by the foreign owner. The 2017 OECD TPG do not provide any specific direction for this question. The answer must therefore be based on ordinary transfer pricing considerations. First, if the subsidiary makes substantial local marketing decisions, it could arguably retain sufficient autonomy to not qualify as “merely an agent”, even if its decisions are within the boundaries of the global marketing strategy of the group. Second, marketing activities performed in the source state should be seen as IP development contributions that enhance the local value of the licensed marketing IP. It could be argued, on the basis of causality, that because the development activities that create the local value are carried out by the subsidiary, it should be entitled to reap some of the residual profits that may result from its contributions. Third, it could be argued that the subsidiary incurs the IP development risks. The day-to-day operational decisions it makes influence whether its marketing efforts are successful or not, and thus whether the local value of the licensed marketing IP increases. It could be questioned as to whether it would align with the economic substance of the actual behaviour of the controlled parties if the intangible development risks (and the residual profits) were allocated to the foreign group entity that holds legal title to the IP in such circumstances. Let us say, for the sake of argument, that a distribution subsidiary makes significant day-to-day decisions pertaining to local marketing strategies and design that fit within the multinational’s global marketing programme, and, within the upper limits established by the foreign owner, it is entitled to determine the amount of marketing expenses to be incurred. The expenses are reimbursed on an arm’s length, cost-plus basis. If one were to assess this factual pattern based on the interpretation of the current guid717

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ance suggested above, the residual profits would likely be split between the local subsidiary and the foreign group entity that holds legal title to the marketing IP, as the former would not qualify as a “mere agent”. Would such an allocation yield an arm’s length result? The allocation result would then be that a group entity that does not incur the financial risks associated with the IP development is allocated a portion of the residual profits. This, in itself, should not be seen as a controversial position, as the same result may follow from an application of the importantfunctions doctrine to internally developed manufacturing IP.2196 Further, it could be argued that third-party licensers of unique and valuable marketing intangibles do generally not accept terms that allocate residual profits to a local licensee. The licenser would likely have better realistic alternatives available, because only he contributes unique inputs to the value chain.2197 The basic reason for this is that the services provided by the local distributor would likely be relatively generic, and could be outsourced to third parties for a normal market return fee. Thus, the argument is that such a licenser would generally be in a superior bargaining position vis-à-vis a local distributor that only brings routine inputs to the table. The licenser supplies the necessary rights to the unique marketing IP, the capital necessary to build its local value and the high-level instructions for how the marketing should be carried out, and therefore also bears all risks connected to the IP development. It seems unrealistic to assume that an unrelated licenser in this case would not demand all residual profits from the developed intangible. The author finds this decisive. An arm’s length profit allocation must align with the realistic alternatives available to the controlled parties. This result will normally not be attained if a local distribution subsidiary, which is reimbursed for its marketing expenses with the addition of an arm’s length markup margin, is allocated a portion of the residual profits, even if it does make some significant marketing decisions on a relatively independent basis.2198 Also, the new “directed and controlled” add-on (to the wording carried over from the 1995/2010 OECD TPG) is, as touched upon above in this section, influenced by the new 2017 guidance on risk and economic substance, as well as the important-functions doctrine for manufacturing IP. 2196. For instance, the residual profits are allocated to the group entity that performs research and development (R&D), even though the intangible development was funded by a foreign “cash-box” entity or IP holding company. 2197. See the discussion of foreign direct investment (FDI) in sec. 2.3. 2198. See also Barbera (2003), at p. 71 on royalty structures based on the reimbursement of marketing expenses.

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 Scenario 2: The local group distribution entity bears an arm’s length level of marketing costs

Understandably, the OECD also wanted to apply the important-functions doctrine to the development of marketing IP. An obvious problem with this is that the distinction between risk and intangible development funding is more meaningful in the context of manufacturing intangibles. The value of unique manufacturing IP is driven by research and development (R&D) carried out by talented researchers. Such talent represents scarce resources, and is therefore highly valuable. This has no direct parallel in the context of marketing IP, as the increase in local marketing value will often rely directly on the amount of, for example, local media exposure, as well as the quality of the underlying product being promoted. The important-functions doctrine is not fit for the internal development of marketing intangibles due to the absence of unique development contributions on the side of the local distribution subsidiary. In conclusion, it is the author’s view that the wording of the current 2017 guidance should be interpreted narrowly. The local subsidiary should be deemed to act “merely as an agent” even if it is free to decide on local marketing matters on a day-to-day basis, as long as its actions align with the global marketing framework indicated by the foreign owner of the marketing IP.2199 A more liberal interpretation would result in an allocation of operating profits among jurisdictions that would be contrary to third-party behaviour and the realistic alternatives available to the controlled parties. Thus, there will be no legal basis under the 2017 OECD TPG to allocate any residual profits to a local distribution subsidiary that is reimbursed for its arm’s length IP development contributions (in the form of marketing expenses) on a concurrent cost-plus basis throughout the IP development phase. The material content of the OECD TPG here is in line with the US Internal Revenue Code (IRC) section 482 regulations, which provide the same result for this scenario (see the discussion in section 23.3.5.).

24.4. Scenario 2: The local group distribution entity bears an arm’s length level of marketing costs 24.4.1. The subsidiary must earn a normal market return throughout the IP development phase The question in this second scenario is whether the 2017 OECD TPG, based on economic substance considerations, will deny controlled profit al2199. Such a framework should include the overall marketing strategy and country-bycountry marketing budgets.

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locations that extract the residual profits that a local distribution subsidiary has generated through the exploitation of marketing IP (that it licenses) to the foreign group entity that holds legal title to the IP in cases in which the subsidiary is not reimbursed for its arm’s length marketing costs incurred to build the local value of the marketing IP under a long-term distribution agreement.2200 The point of departure for this problem under the 1995 (and identical 2010) OECD TPG consensus text was that “the ability of a party that is not the legal owner of a marketing intangible to obtain the future benefits of marketing activities that increase the value of that intangible will depend principally on the substance of the rights of that party”.2201 Thus, if there were no basis in the controlled pricing agreement between the foreign group entity that held legal title to the IP and the local distribution entity that the latter should be allocated a portion of the residual profits, there would be no legal basis for such allocation under the 1995/2010 OECD TPG. Nevertheless, the 1995/2010 OECD TPG recognized that the local subsidiary should be allocated a normal market return for its IP development contributions in the form of increased local sales when the controlled distribution agreement provided for long-term and exclusive distribution rights for the trademarked product. The distributor’s (normal return) share of benefits should then be determined with reference to the operating profits earned by independent distributors in comparable circumstances (typically TNMM-based).2202 While the new 2017 OECD TPG clearly retain this point of departure,2203 it is also added that the “distributor’s efforts may have enhanced the value of its own intangibles, namely its distribution rights”.2204 This addition seems to draw heavily on the US discrete owner rule (see the discussion in section 20.2.3.). Unfortunately, it also suffers from similar ambiguities with respect to the extent that the local distribution subsidi2200. OECD TPG, para. 6.78. 2201. 1995 and 2010 OECD TPG, para. 6.38. 2202. Id. 2203. OECD TPG, para. 6.78. It is added that the residual profits would be the result of the subsidiary’s “functions performed, assets used, and risks assumed currently or in the future”. The 2013 OECD Revised discussion draft on transfer pricing aspects of intangibles (2013 RDD) also emphasized the costs incurred by the local subsidiary (see paras. 95 and 96), but this wording was taken out in the final consensus text. This particular revision is, in the author’s view, inconsequential. 2204. OECD TPG, para. 6.78.

720

 Scenario 2: The local group distribution entity bears an arm’s length level of marketing costs

ary should be entitled to residual profits from its local exploitation of the licensed marketing IP. The 2017 OECD TPG include an example on the application of this “US discrete owner”-influenced rule, which uses the factual pattern in the example discussed in section 24.3. as its base (the Primair example; see the discussion in section 24.3.), and adds the twist that the subsidiary now develops, funds and executes its own market plan.2205 The foreign group entity that holds legal title to the marketing IP exercises a lesser degree of control over the subsidiary’s marketing efforts. The differences between the controlled transfer pricing structures applied in the (Primair) base example and this extension example relevant to the current problem are as follows: – In the base example, the subsidiary is compensated in two ways: (i) it receives separate cost-plus remuneration for its marketing activities on a concurrent basis throughout the IP development phase; and (ii) the purchase price for the R watches is set to a level that enables the subsidiary to realize an arm’s length operating margin on its sales activities. – In the extension example relevant to the current problem, the subsidiary is remunerated only through a lowered purchase price for the R watches, which must be low enough to provide it with an operating margin large enough to yield an arm’s length compensation for both its marketing and sales activities. In other words, there is no concurrent compensation to the subsidiary with respect to its IP development contributions throughout the IP development phase. The subsidiary bears its (arm’s length) marketing expenses itself. The question is how the profit margin allocated to the subsidiary through the lowered purchase price for the watches shall be determined. There is no doubt that the subsidiary should be allocated “a greater anticipated total profit” than in the base (Primair) example (in which it was reimbursed for its marketing expenses) because of its additional functions and risks, because it now bears its own marketing expenses.2206 The question is of how much more profit (than cost plus) shall be allocated to the subsidiary. 2205. OECD TPG, annex to ch. VI, Example 9. 2206. OECD TPG, annex to ch. VI, Example 9, para. 26, second bullet point. The wording used in the 2013 RDD, annex, Example 6, was “earning a greater total profit”. The author does not attach any particular consequence to the revised wording in the final text.

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Since the subsidiary bears the marketing costs, it experiences high operating expenditures and modest margins in years 1-3.2207 CUTs indicate that the functions performed, the level of marketing expenditures incurred and the operating profits realized by the subsidiary in these years are similar to those of independent distributors bearing the same types of risks and costs in the initial years of comparable long-term marketing and distribution agreements for similarly unknown products. Unfortunately, the example offers little guidance on the specifics of how the subsidiary should be remunerated. It essentially just refers to its own premise that the allocation of profits between the subsidiary and the foreign owner entity corresponds to the allocation indicated by the CUTs. An underlying point, however, seems to be that the exclusive, long-term distribution agreement should offer the subsidiary an “opportunity … to benefit (or suffer a loss)” from its marketing efforts, akin to what would be the case for comparable third-party distributors.2208 The author interprets this wording to entail that the subsidiary should be entitled to a normal market return profit margin for its marketing and distribution activities (typically determined on the basis of the TNMM). This, however, is where the guidance becomes problematic. Logically, one would assume that if the subsidiary were to benefit from its marketing activities based on the view that it has “enhanced the value of its own intangible, namely its distribution rights”,2209 one would stop here and say that the subsidiary should be entitled to keep its net profits, or at least a healthy portion of it. Provided that the subsidiary’s purchase price for the R watches is at arm’s length, this would, in effect, be the same as saying that the subsidiary is entitled to the residual profits generated by the local exploitation of the marketing intangible. The basic problem with this reasoning is that the example at the same time instructs that the profits allocable to the subsidiary should be determined by reference to the profits made by comparable unrelated enterprises. Of course, third-party enterprises that carry out marketing and sales for products trademarked by unique intangibles that they do not own must pay royalties to the licensers. How much of the licensee’s operating profits are allocated to the unrelated licensers will depend on the bargaining posi2207. OECD TPG, annex to ch. VI, Example 9, at para. 27. 2208. Id., at para. 28. 2209. See OECD TPG, para. 6.78.

722

 Scenario 2: The local group distribution entity bears an arm’s length level of marketing costs

tions of the parties, in particular on whether the licensee brings any unique inputs to the table. Normally, when the licensed intangible is unique and valuable and the licensee only provides routine marketing and distribution functions, it should be presumed that the licensee would likely not retain any residual profits.2210 This results in the basic observation that the operating profits of unrelated distributors (as reflected in the operating profits in the financial statement) are the profits they retain after deductions have been made for royalties paid to the licensers. Thus, even though the new guidance states that the subsidiary should have the “opportunity … to benefit (or suffer a loss)” because it “enhanced the value of its own intangible”, its profits will be benchmarked, likely under the TNMM, against the post-royalty profits of unrelated comparable distributors. In this light, the author fails to see that there is any substance to the impression that one might immediately get from the wording of the new 2017 OECD guidance that the subsidiary should be entitled to some of the residual profits because it acts relatively independently and incurs risks. Further, as the example stands, it should be regarded as fairly certain that a cost-plus-based remuneration rendered after the IP has been developed will not be sufficient when the subsidiary bears its own marketing expenditures. Such cost-plus remuneration will not compensate the subsidiary sufficiently for the risks it incurs through its marketing expenditures throughout the IP development phase. In conclusion, the 2017 OECD TPG should be read as requiring concurrent allocation of a normal market return (likely TNMM-based) throughout the IP development phase to a distribution subsidiary that incurs an arm’s length level of marketing expenses in order to uphold the controlled pricing that allocates the residual profits to the foreign group entity that holds legal title to the marketing IP. Reimbursement of the subsidiary’s marketing expenses on a cost-plus basis after the IP development is completed and the marketing IP begins generating residual profits should not be regarded as sufficient. The material content of the profit allocation solution offered by the OECD for this scenario is the same as that drawn up by the US IRC section 482 regulations (see the discussion in section 23.4.).

2210. See the discussion on FDI in sec. 2.3.

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24.4.2. The first twist: The duration of the distribution agreement is shortened; can residual profits then be allocated to the subsidiary? The 2017 OECD TPG provide two twists to the exclusive long-term distribution (Primair) example discussed in section 24.4.1. The first extension alters the factual pattern so that the distribution agreement is a short-term, royalty-free agreement, which spans over 3 years with no option to renew.2211 The distribution subsidiary is now unable to benefit from the arm’s length marketing costs it incurs. The example assumes that third parties enter into short-term distribution agreements only when “they stand to earn a reward commensurate with the functions performed, the assets used, and the risks assumed within the time period of the contract”.2212 Further, the short-term nature of the distribution agreement makes it “unreasonable to expect” that the subsidiary may obtain “appropriate benefits under the contract within the limited term of the agreement”, as it incurs substantially higher risks – without compensation – than would have been the case in a long-term agreement.2213 On this basis, the OECD TPG conclude that the subsidiary is entitled to compensation for its risk contribution to the value of the marketing IP. However, the example is ambiguous with respect to the extent of this remuneration. It states that the compensation could take the form of either “direct compensation … for the anticipated value created through the marketing expenditures and … functions”, or a “reduction in the price paid … for R watches during Years 1 through 3”.2214 While the second alternative merely pertains to form, the first alternative does seem to provide a hint as to the level of the required profit allocation. It links the compensation to the anticipated increase in value of the marketing IP. The author interprets this wording as requiring that the subsidiary, 2211. OECD TPG, annex to ch. VI, Example 11. On short and long-term distribution agreements and the effects for transfer pricing purposes, see Roberge (2013), at p. 217, where doubt is expressed with respect to the common assumption that most intra-group distribution agreements are long-term. See also Becker (2008), at p. 461, who argues that not updating the royalty rate in long-term distribution agreements creates risk for the distributor. 2212. OECD TPG, annex to ch. VI, Example 11, at para. 36. 2213. Id., at para. 37. 2214. Id., at para. 38.

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 Scenario 2: The local group distribution entity bears an arm’s length level of marketing costs

over the 3-year term of the agreement, shall be allocated operating profits equal to the net present value of the expected residual profits from the local exploitation of the trademark in future income years. This may trigger the allocation of substantial amounts of operating profits to the subsidiary. It will likely be necessary to resort to the 2017 guidance on valuation in order to estimate the net present value.2215 This result is somewhat surprising. After all, the foreign parent is the owner of the valuable marketing IP, and therefore provides a unique value chain input. The subsidiary certainly provides marketing functions and expenses and assumes associated risks, but these inputs should likely be deemed as rather generic. From this perspective, it is difficult to argue that the allocation of the residual profits to the subsidiary would be aligned with the realistic alternatives of the controlled parties. Nevertheless, even if the licenser has a superior bargaining position, it must at least provide the licensee with an arm’s length normal market return on a concurrent basis. That has not been done. The example therefore bears resemblance to the imputation authority under the economic substance exception of the US regulations, where the lack of concurrent normal return compensation may trigger a claim for the subsequent residual profits (see the discussion in section 23.3.).2216 Ultimately, the example seems to treat the subsidiary as the owner of the local rights to the marketing intangible, and thus entitled to the residual profits from their exploitation. In conclusion, it can be observed that the OECD is unwilling to give pricing effect to foreign legal ownership of internally developed marketing IP in cases in which the local distribution subsidiary incurs (what is at the outset) an arm’s length level of marketing expenditures when the distribution agreement is of such limited duration that the subsidiary will be unable to reap any reasonable benefit from its efforts. In these cases, the OECD guidance seems to provide a legal basis for allocating the residual profits from the local exploitation of the marketing IP to the subsidiary.

2215. See the analysis of the new guidance on valuation in ch. 13. 2216. The fact that the example should be seen as an application of the economic substance doctrine is further strengthened by the premise that “evidence derived from comparable independent enterprises” shows that they do not enter into short-term agreements with no hope of benefitting from their investments; see OECD TPG, annex to ch. VI, Example 11, para. 36. See also the analysis of the US imputation authority under the economic substance exception in the context of manufacturing and marketing intangibles in secs. 21.3.3. and 23.3., respectively.

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24.4.3. The second twist: A royalty payment is introduced; can residual profits then be allocated to the subsidiary? The second extension of the exclusive, long-term distribution (Primair) example (discussed in section 24.4.1.) introduces a royalty payment at the end of the third year when the brand has been successfully established in the local market.2217 Without this royalty payment, the subsidiary would have been allocated the residual profits due to the combination of higher margins and an unaltered purchase price for the R watches sold from the foreign parent. The example makes two assumptions. First, the marketing activities and expenses of the subsidiary from year 4 are consistent with those of comparable unrelated distributors. Second, there is no evidence that such distributors would have agreed to pay royalties in similar circumstances. This factual pattern is relatively similar to that discussed under the economic substance exception in the US regulations,2218 pertaining to a US distribution subsidiary that incurs marketing costs during the first 6 years of a long-term distribution agreement. Once the product is successfully established, all residual profits are allocated to the foreign legal owner. The US regulations take the position that this controlled allocation of operating profits contradicts the economic substance of the transaction. It is found unlikely that an unrelated distributor would enter into a long-term marketing and distribution agreement unless it received concurrent remuneration or had an expectation of deriving some future benefit. Thus, the foreign legal owner may only extract the subsequent residual profits if it remunerates the subsidiary for its marketing on a concurrent basis. A significant difference between the factual pattern discussed in the US regulations and that of the current OECD example is that the local distribution subsidiary incurs incremental marketing costs in the former, while it does not in the latter. Thus, the US guidance pertains to a more aggressive transfer pricing structure in which the local subsidiary is put even worse off.

2217. OECD TPG, annex to ch. VI, Example 12. The renegotiated agreement is another long-term agreement, similar in all respects to the original agreement, apart from the royalty. 2218. See Treas. Regs. § 1.482-1(d)(3)(ii)(C), Example 3; and the discussion in sec. 23.3.2.

726

 Scenario 2: The local group distribution entity bears an arm’s length level of marketing costs

The position taken by the OECD example, in surprisingly clear language, is that a transfer pricing adjustment disallowing the royalty payments should be carried out. The basis for this conclusion is two-fold. First, a royalty would generally not be expected when “a marketing and distribution entity obtains no rights for transfer pricing purposes in trademarks and similar intangibles other than the right to use such intangibles in distributing a branded product supplied by the entity entitled to the income derived from exploiting such intangibles”.2219 The author is far from convinced by this reasoning. In his view, there seems to be no principal basis as to why a royalty payment could not be appropriate in such circumstances. After all, the purpose of the royalty would be to allocate the residual profits to the foreign group entity that holds legal title to the marketing IP, and the OECD does, in the quoted wording, admit that the owner is “entitled to the income derived from exploiting such intangibles”.2220 Whether the income is extracted from the market jurisdiction through (i) the sales price for the distributed products from the owner of the intangible to the local distributor; or (ii) through a royalty should be beside the point. Second, and considerably more persuasive, is the argument that the operating margins of the subsidiary in year 4 and on are “consistently lower than those of independent enterprises with comparable functions performed, assets used and risks assumed during the corresponding years of similar long-term marketing and distribution agreements”.2221 In other words, there is a mismatch between the operating margins that the transfer pricing methods (e.g. the TNMM) indicate should be allocated to the subsidiary and its reported income. Thus, given that the guidance on temporary pricing strategies cannot be applied to justify the subsidiary’s low returns, there must be an adjustment.2222 However, the example disallows the royalties entirely. A more appropriate result would, in the author’s view, be to adjust the subsidiary’s income as indicated by the applicable transfer pricing method so that it falls within the arm’s length range of the operating margins of the comparable 2219. OECD TPG, annex to ch. VI, Example 12, at para. 41. 2220. Id. 2221. Id. 2222. Temporary pricing strategies are discussed in sec. 6.6.5.4.4. The guidance, in the author’s view, is not relevant, as the trademark is established and generates residual profits in year 4 onwards.

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unrelated enterprises. It should be perfectly clear that this does not necessarily require the disallowance of the entire royalty amount. The royalty payments could be partially upheld as long as the subsidiary’s operating margins align with the results of the transfer pricing method. Even though it is categorically stated in the OECD example that the entire royalty payments should be disallowed, the author finds that his interpretation is reconcilable with the message provided by the example. After all, the point is that the royalty payments should be disallowed because the subsidiary’s profit margins are “consistently lower than those of independent enterprises”.2223 Thus, if the controlled margins are adjusted so that they align with those of the unrelated distributors, there should be no justification in the OECD transfer pricing methodology for disallowing the exceeding royalties, if any. The author therefore finds it likely that this extension example envisions the TNMM-based profit allocation of the base example to be continued from year 4 and on, entailing that the residual profits remaining (after upwards TNMM adjustment of the subsidiary’s profit margin) are extracted from the market jurisdiction. In light of the fact that the extension pertains to a distribution subsidiary that incurs an arm’s length level of marketing expenditures, the OECD’s stance is more restrictive towards allocating residual marketing profits to a foreign group owner than the US regulations (see the analysis of the parallel problem under the US regulations in section 23.4.2.). Nevertheless, the author finds it unlikely that a conflict may arise between the two sets of rules. As the US regulations are concerned with the allocation of residual profits to a US distribution subsidiary, it will only support the view that the OECD seems to go further in the same direction. In conclusion, the author finds no legal basis in the “second twist” OECD (Primair) example on which to allocate any portion of the residual profits from the local exploitation of foreign-owned marketing IP to the local subsidiary. The residual marketing profits should be allocated to the foreign owner of the IP. Only a normal market return shall be allocated to the subsidiary under the one-sided methods (likely the TNMM). This may necessitate additional (normal return) profit allocation to the subsidiary, but this allocation should not include a portion of the residual profits. 2223. OECD TPG, annex to ch. VI, Example 12, at para. 41. The 2013 draft of the example (2013 RDD, annex, Example 9) emphasized this even further, as it, in addition to the current wording, stated that “Company S’s profit margins are consistently lower than the profit margins of independent enterprises during the corresponding years of similar long-term marketing and distribution agreements because of the royalty”.

728

 Scenario 3: The local group distribution entity bears an above-arm’s length level of marketing costs

24.5. Scenario 3: The local group distribution entity bears an above-arm’s length level of marketing costs 24.5.1. Introduction The question in this third scenario is whether the 2017 OECD TPG, based on economic substance considerations, will deny controlled profit allocations that extract from the market jurisdiction the residual profits that a local distribution subsidiary has generated through the exploitation of marketing IP (that it licenses) to the foreign group entity that holds legal title to the IP in cases in which the subsidiary incurs marketing expenditures exceeding those that an unrelated comparable distributor would have agreed to.2224 This is a classic transfer pricing problem that has been the subject of repeated OECD negotiations and is analogous to the issue discussed in the context of the US IRC section 482 regulations in section 23.4.3.2225 The analysis of this problem is divided into two sections. The author discusses the threshold set out in the 2017 OECD TPG for applying economic substance considerations to the controlled pricing in section 24.5.2. Thereafter, in section 24.5.3., he discusses the material content of the profit allocation that should be applied in cases in which the economic substance threshold has been breached.

24.5.2. The OECD TPG threshold for additional profit allocation to the source-state distribution subsidiary In this third scenario, the local subsidiary incurs marketing expenditures and risks that go beyond what normal low-risk distributors (LRDs) would be willing to assume. Such high levels of marketing may be necessary to establish an unknown product in a competitive market. As a result of concurrent income tax deductions for such marketing costs (combined 2224. OECD TPG, para. 6.78. It has been asserted in the literature that this problem is highly practical, as most group distribution entities incur more marketing expenses than third-party distributors; see Allen et al. (2006), at sec. 5.3. On this issue, see thorough reflections (based on the 2010 version of the OECD TPG) in Roberge (2013). 2225. This problem pertains to the so-called “bright line test”, where the question is whether it can be accepted that the local group entity performs marketing on a serviceprovider basis (and is thus only entitled to a normal market return), or if the entity should be deemed to own the local marketing value it has created (and thus be entitled to residual profits). The “service provider” classification is normally contingent on the local entity only incurring a “routine” level of marketing expenses, while the “owner” classification is contingent on a “non-routine” level of marketing expenses. See, e.g. Musselli et al. (2008a), at p. 263.

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with the allocation of income premised on an LRD characterization), the distribution entity may fail to report a net taxable position. This scenario has proven to be particularly relevant when multinationals distribute their products in developing countries. India has a substantial body of case law pertaining to local distribution entities incurring significant advertising expenditures coupled with low returns, resulting in tax losses.2226 China has had similar experiences.2227 Such taxpayer loss return positions may be difficult to reconcile with the classification of the local subsidiary as an LRD. Herein lies the heart of the matter. An LRD is expected to earn a modest (but steady) market return on the low-risk, routine functions it performs. When it does not, the question arises as to whether the economic substance of the transaction is such that a low-risk characterization of the distribution entity should not be accepted for pricing purposes, i.e. whether the entity should be remunerated with a (higher) normal market return pursuant to the one-sided methods, or even be entitled to a split of the residual profits. The point of departure in the 1995 and 2010 OECD TPG was, as mentioned in sections 24.3.-24.4., that residual profits yielded through the local exploitation of foreign-owned marketing IP should be allocated to the foreign group entity that holds legal title to the IP (i.e. extraction of residual profits from the source), while the source-state group distribution entity should be remunerated on a separate basis to provide it with a normal mar2226. See, e.g. Maruti Suzuki India Ltd v. CIT, W.P.(C) 6876/2008 (Delhi High Court, 2010); Aztec Software & Technology Services Limited v. CIT, 2007 107 ITD 141 Bang (Income Tax Appellate Tribunal – Bangalore, 2007); Rolls Royce Plc v. Dy. Director Of Income-Tax, (2008) 113 TTJ Delhi 446 (Income Tax Appellate Tribunal – Delhi, 2007); Sony India (P.) Ltd. v. CBDT, (2006) 206 CTR Del 157 (Delhi High Court, 2006); Amadeus Global Travel Distribution v. CIT, 113 TTJ Delhi 767 (Income Tax Appellate Tribunal – Delhi, 2007); UCB India (P) Ltd. v. CIT, 30 SOT 95 (Income Tax Appellate Tribunal – Mumbai, 2009); Global Vantedge Pvt. Ltd. v. CIT, ITA Nos. 116 & 323/Del/2011 (Income Tax Appellate Tribunal – Delhi, 2010); Intel Asia Electronics Inc. v. Asstt Director Of Income Tax, ITA No. 131/Bang/2010 (Income Tax Appellate Tribunal – Bangalore, 2009); Amadeus India Pvt Ltd v. CIT, ITA 938/2011 (Delhi High Court, 2011); and Symantec Software Solutions Pvt Ltd v. CIT, ITA No. 7894 (Income Tax Appellate Tribunal – Mumbai, 2010). With respect to India’s position on the allocation of operating profits generated through marketing intangibles, see the UN Transfer Pricing Manual (UN TPM), paras. 10.4.8.5, 10.4.8.7 and 10.4.8.12-10.4.8.18. See also Levey et al. (2011). For insightful comments on the Maruti case, see, in particular, Casley et al. (2011). For further information on India’s approach to the transfer pricing of IP, see Lagarden (2014), at p. 344. 2227. China will likely assert the application of a profit split approach in such cases; see UN TPM, paras. 10.3.5.10-10.3.5.11. See also Bell (2012) on this issue; and Lagarden (2014), at p. 345 on China and IP transfer pricing.

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ket return for its development contributions.2228 Additional operating profits could, however, be allocated to the source state if the local distribution entity incurred (without being reimbursed) “extraordinary marketing expenditures beyond what an independent distributor with similar rights might incur for the benefit of its own distribution activities”.2229 In these cases, the local subsidiary “might obtain an additional return from the owner of the trademark, perhaps through a decrease in the purchase price of the product or a reduction in royalty rate”.2230 This wording was, in the author’s view, ambiguous both with respect to the “extraordinary marketing expenditures” criterion for triggering additional source-state compensation2231 as well as the profit allocation consequences indicated by an “additional return”. The absence of clarity was likely due to difficulties in reaching consensus on sharper criteria in 1995.2232 The 2017 OECD TPG retain the point of departure of the 1995 and 2010 text, but add some modifications.2233 There now seem to be two cumulative criteria for triggering this particular allocation rule. First, the 1995 reference to “extraordinary marketing expenditures” is replaced with the following: “[A] distributor may perform functions, use assets or assume risks that exceed those an independent distributor with similar rights might incur or perform.”2234 Thus, while the 1995 text focused solely on the level of marketing expenditures incurred by the subsidiary, the new wording seems to demand a broader perspective, encompassing the entire spectrum of the local subsidiary’s IP development contributions. This does not, however, alter the fact that the value of marketing IP generally is correlated with the level of marketing expenditures. Also, the more marketing costs the subsidiary incurs, the more likely it will be 2228. 1995 and 2010 OECD TPG, para. 6.37. 2229. In contrast, the wording of the 1994 cheese examples was more reserved than that of its 1995 OECD TPG counterparty. The second cheese example referred to “significantly larger [expenses] than the expenses incurred by independent distributors under similar circumstances”; see 1994 Treas. Regs. (59 FR 34971-01) § 1.482-4(f)(3)(iv), Example 3; and the discussion in sec. 19.4.6. 2230. 1995 and 2010 OECD TPG, para. 6.37. 2231. See the discussion of the parallel criterion for “incremental” marketing expenditures under the US regulations in sec. 23.3.6. 2232. The author takes it that the 1995 OECD TPG text was inspired by the 1994 US cheese examples, which distinguished between cases in which the local distribution subsidiary incurred an arm’s length level of marketing expenditures, and the expenditures were incremental. See the discussion of the 1994 cheese examples in sec. 19.4.6. 2233. See OECD TPG, para. 6.78. 2234. Id.

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that additional functions, assets and risks are utilized in the process. The new 2017 OECD guidance could therefore be seen as clarifying the 1995 predecessor text (with respect to the required marketing expenses) rather than conveying entirely new concepts. The level of marketing expenditures will, in the author’s view, remain the key factor for determining whether a distribution subsidiary’s marketing IP development contributions exceed those of comparable third-party distributors. Nevertheless, the new wording emphasizes, to a stronger degree than the 1995 OECD TPG, that the risks incurred by the subsidiary should factor into the assessment of the amount of operating profits allocable to the source state.2235 It will likely not be straightforward to establish whether the marketing expenditures incurred by the subsidiary “exceed those an independent distributor” would incur.2236 The author refers to the discussion on “incremental marketing expenditures” with respect to the US regulations in section 23.3.6. Second, the new 2017 OECD guidance adds that the subsidiary’s incremental development inputs must create “value beyond that created by other similarly situated marketers/distributors”.2237 The interpretation of this new wording is not straightforward. It seems to require a determination of whether the value yielded by the subsidiary’s incremental development inputs goes beyond the (likely theoretical and supposedly comparable) value created by similarly situated third-party distributors. The author suspects that this comparison may be challenging to carry out in practice. Given that the subsidiary has incurred a level of marketing costs that goes beyond what unrelated distributors would be willing to bear, it may be questioned as to what the resulting value should be compared with. Should it be benchmarked against the intangible value created by an unrelated distributor that provides only a “normal level” of development contributions? That would be tantamount to comparing apples and oranges, as the value created by the larger cost base of the controlled subsidiary then would be compared to the value created by the smaller cost base of the otherwise comparable third-party distributor. Indeed, the author would be surprised if the former 2235. The author reverts to the significance of risk below in this section. 2236. See also Vincent (2006), at 28:10; and, in particular, Levey et al. (2006), at p. 7 (see supra n. 2126). See, however, Roberge (2013), at p. 230, where it is suggested (with respect to the pharmaceutical industry) that the level of marketing assistance provided to the distribution subsidiary by the owner of the marketing IP (e.g. in the form of free goods or marketing samples) could be of aid in determining whether the subsidiary carried out incremental marketing efforts. 2237. OECD TPG, para. 6.78.

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value did not go “beyond” the latter. Of course, even if there should be differences in terms of absolute value, the relative return might still be the same. In summary, such a comparison seems comprehensively inappropriate. Alternatively, should it be compared to the value created by unrelated distributors that also provide “incremental” development contributions, in particular, marketing costs? That would be problematic, as third parties, by definition, will not incur such a level of costs.2238 The author finds neither of the two interpretation alternatives satisfying. The solution to this conundrum is, in the author’s view, to see the wording of “functions … assets [and] risks that exceed” and “create value beyond” as one collective criterion rather than two separate criteria. The point of the 2017 OECD guidance seems to be that the local subsidiary here contributes intangible development inputs to an extent that is incompatible with a normal market return remuneration for low-risk routine value chain contributions. The basic justification for a low-risk distribution classification is ignored where the local subsidiary bears excessive marketing costs during the marketing IP development phase, combined with the allocation of the entire residual profits to the foreign group entity that holds legal title to the marketing IP when the marketing efforts start to pay off in later income periods. The author finds it unclear whether the “create value beyond” wording should be deemed to have any independent significance. Let us, for the sake of argument, suppose that the subsidiary incurs incremental marketing costs that result in an unsuccessful marketing campaign. Should this failure to “create value beyond that created by other similarly situated marketers/distributors” entail that the subsidiary, in spite of its above-arm’s length level of marketing costs during the IP development phase, is not entitled to any additional income on top of the profits it earns as a low-risk distributor? The answer to this must clearly be negative. The failure to create value is due to the additional risks associated with the incremental mar2238. Let us, for the sake of argument, say that, in theory, it would be possible to identify unrelated comparable distributors that provide “incremental” development contributions. The question is then whether the value created by the “incremental” contributions of the local distribution subsidiary goes beyond that created by the third-party distributors. This question does not, in the author’s view, adhere to logic. One would assume that related and unrelated parties derive the same amount of utility from each additional unit of marketing expenditures. Also, it does not seem reasonable to demand that the value created by a related distributor should go “beyond” the value created by a comparable unrelated distributor when these entities incur the same amount of marketing expenditures. The subsidiary should be remunerated in the same way as these “incremental” third-party risk-takers.

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keting expenditures materializing. At arm’s length, it cannot be expected that third parties would be willing to incur such incremental risks without receiving a commensurate reward. The author therefore does not see the “create value beyond” wording as an additional threshold. The decisive criterion under the current OECD TPG must – as was the case under the 1995 text – be that if the local subsidiary has incurred incremental marketing expenditures, it should not be compensated as an LRD. On this basis, the author concludes that the 2017 OECD TPG have not, in substance, altered the 1995/2010 OECD TPG threshold for triggering additional profit allocation to a distribution subsidiary in cases in which it incurs incremental marketing expenditures. The essence still remains whether the subsidiary has incurred extraordinary marketing expenditures (absent of concurrent normal return compensation throughout the marketing IP development phase) without being entitled to any of the potential future residual profits. If so, there is a legal basis in the OECD TPG to set aside the controlled profit allocation (which assigns all of the residual profits to the foreign group entity that holds legal title to the marketing IP) and allocate more profits to the local distribution subsidiary. The extent to which the subsidiary in this scenario should receive additional profits will be discussed in section 24.5.3.

24.5.3. The material content of the profit allocation The premise for the following discussion is that the local subsidiary has incurred above-arm’s length marketing expenditures to build the local value of marketing IP that it licenses from a foreign group entity that holds legal title to the IP. In such cases, the OECD TPG allow additional profits to be allocated to the subsidiary (see the discussion in section 24.5.2.). The question in the following is of how much more profit can be allocated to it. The 1995 and 2010 OECD texts stated that the subsidiary, in cases in which it incurred incremental marketing expenditures, “might obtain an additional return from the owner of the trademark, perhaps through a decrease in the purchase price of the product or a reduction in royalty rate”.2239 The author finds it unclear whether this wording entitled the subsidiary to a normal market return remuneration on a separate basis (e.g. cost-plus or 2239. 1995 and 2010 OECD TPG, para. 6.38.

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TNMM) or to a portion of the residual profits (which would otherwise be allocable to the foreign IP owner). The guidance in the current OECD TPG entails a similar degree of ambiguity,2240 but presents several suggestions as to the manner in which additional compensation may be allocated to the subsidiary. These are (i) a “decrease in the purchase price of the product”; (ii) a “reduction in royalty rate”; or (iii) a “share of the profits associated with the enhanced value of the trademark or other marketing intangibles”. The first two alternatives merely pertain to the form of the additional remuneration. They do not convey clear positions on the material content of the profit allocation. The third alternative, however, does provide material direction. It indicates that the subsidiary could be allocated a portion of the residual profits. This lends support to the interpretation that the preceding two alternatives require only a normal market return, as it would be unnecessary to include them in the guidance if their meaning were simply to convey that the subsidiary could be entitled to a portion of the residual profits (which is explicitly indicated by the third alternative). Thus, the new guidance basically says that the subsidiary can be compensated for its incremental IP development contributions either through a separate normal market return (typically cost-plus or TNMM) or through a portion of the local residual profits. As the wording reads, the three profit allocation alternatives are equal in priority. A rule that encompasses such a wide selection of profit allocation patterns of equal standing would be disconcerting. The patterns offer the subsidiary significantly varying degrees of operating profits, thus creating the potential for irreconcilable profit allocations. A multinational (and the residence jurisdiction of the foreign group entity that holds legal title to the marketing IP) would likely always opt for the first or second alternative so that a minimum amount of profits could be allocated to the source state, while the source-state tax authorities would likely, in practice, always opt for the residual profits alternative to allocate a maximum amount of profit there.

2240. The 2017 guidance states that “an independent distributor … would typically require additional remuneration from the owner of the trademark … in order to compensate … for its functions, assets, risks, and anticipated value creation” before referring to the new examples for further guidance; see OECD TPG, para. 6.78. Again, it is unclear as to whether this additional remuneration should be a normal market return for the incremental development contributions or a portion of the residual profits.

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The conflict would be difficult to resolve, as the rule accommodates both positions. Thus, the general guidance contained in the 2017 OECD TPG does not determine a specific profit allocation method that should be applied to remunerate a local distribution subsidiary that incurs an above-arm’s length level of marketing expenditures, but leaves the door open for both a normal market return and a portion of the residual profits from the local exploitation of the marketing IP. The question in the following is whether an extension of the Primair example included in the 2017 OECD guidance, which pertains to this scenario (above-arm’s length marketing expenditures), provides further direction. The example pertains to a distribution subsidiary that, under a long-term, exclusive distribution agreement, carries out marketing to build the local value of foreign-owned marketing IP.2241 In doing so, it incurs marketing expenses in year 1-5 that “far exceed” those of comparable third-party distributors.2242 It is expected that the marketing will result in higher local prices and margins for the R watches. The subsidiary expects to benefit from its promotional activities in the form of increased profits from sales. The marketing expenses in years 1-5 (the IP development phase), however, drive the subsidiary’s profits in this period significantly below those realized by comparable third-party distributors, leading to the observation that the subsidiary has not been “adequately compensated by the margins it earns on the resale of R watches”.2243 The example concludes that the subsidiary should be remunerated consistently with what independent enterprises would have earned in comparable transactions. Aligned with the general guidance discussed above, the example lists three main profit allocation options (seemingly of equal legal rank): (i) adjustment of the purchase price for R watches through the resale price method or the TNMM; (ii) application of the residual profit split method; 2244 or (iii) direct compensation for the subsidiary’s incremental marketing expenditures on a cost-plus basis.

2241. OECD TPG, annex to ch. VI, Example 10. 2242. Id., at para. 31. 2243. Id., at para. 33. 2244. Its application will consist of two steps (see the analysis of the OECD profit split method in ch. 9): (i) a normal market return is allocated to the parties for their routine contributions to the development; and (ii) the residual profits are split pursuant to the relative values of the parties’ intangible development contributions.

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The first alternative is to adjust (downwards) the subsidiary’s purchase price for the R watches by applying the resale price method or the TNMM.2245 The methods, consistent as they are, will extract the entire residual profits from the market jurisdiction to the foreign group entity that owns the marketing IP. In other words, they will “stop” the lowering of the purchase price at a level that affords the subsidiary only a normal market return on its marketing and distribution activities (corresponding to the profit level earned by comparable third-party distributors).2246 It will not lower the price beyond this point. An illustrative example of the use of the TNMM to determine a purchase price is the taxpayer’s transfer pricing in the Norwegian case Wingcard (the author refers to the analysis of this ruling in section 15.6.). Further, the resale price method and TNMM will compensate the subsidiary as if it only provided low-risk distribution activities.2247 That premise will not be fitting when it incurs incremental marketing expenses and thereby, in reality, has an entrepreneurial role in the development of the local value of the foreign-owned marketing IP. The subsidiary will also have financed the incremental marketing efforts on a concurrent basis without reimbursement or a promise of a part of the potential future residual profits. The author therefore cannot fathom why a low-risk characterization

2245. OECD TPG, annex to ch. VI, Example 10, para. 33, first bullet point. 2246. Also, an application of the resale price method and transactional net margin method (TNMM) may raise significant comparability concerns here. The third-party comparables must be assumed to have incurred only a “normal” level of marketing expenses, while those of the tested party “far exceed” this level. The profit data will therefore not be immediately comparable. It may be difficult to carry out proper comparability adjustments if aggregated financial statements are the only accounting data available on the third-party comparables, which almost always will be the case. See the discussions on aggregated financial accounting data in secs. 6.2.4. and 6.2.5., with further references. See also the discussion on comparability in sec. 6.6. 2247. This result (if accepted) is confounding. The resale price method and the TNMM provide the subsidiary with an arm’s length return only if it incurred an arm’s length level of marketing expenditures and risks, which precisely is not the case here. Perhaps it could be argued that the application of some “custom-made” version of the resale price method or the TNMM, pursuant to which a normal return was calculated on the incremental marketing cost base of the subsidiary, could remunerate it sufficiently. In effect, this would be equal to applying the cost-plus method. For the reasons stated below in this section (comments on the third profit allocation alternative described by the 2017 OECD example), however, the author does not see this as providing an arm’s length result. Also, such “custom-made” versions must be regarded as unspecified transfer pricing methods; see the discussion of unspecified transfer pricing methods under the OECD TPG in sec. 12.3. The author finds it unlikely that the 2015 guidance envisioned the application of such methods. Had it done so, it likely would not have specifically indicated that the resale price method and the TNMM could be applied.

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of the subsidiary should be acceptable, as this would be contrary to the economic substance of the controlled transaction.2248 The author would also argue that an application of the resale price method or the TNMM to adjust the purchase price would be contrary to the options realistically available to the subsidiary.2249 In the author’s view, it cannot be presumed that an unrelated distributor would be willing to enter into an arrangement pursuant to which it was obliged to incur marketing expenditures significantly above the market level (with the additional risks that such costs entail), with the best-case scenario being that it could possibly earn a profit margin equal to that which it could have earned had it not incurred such incremental marketing costs. Such an investment will likely have a negative net present value. The subsidiary would be better off by not entering into it. In conclusion, with respect to this profit allocation alternative, given the extent of the subsidiary’s IP development contribution, the extraction of the residual profits from the source by the foreign owner (which is the implication of the example’s reference to the resale price method and TNMM) seems to violate the stated purpose of the new 2017 OECD IP guidance stating that intangible profits should be allocated to the jurisdiction in which the intangible value was created.2250 This profit allocation alternative should therefore not be used. The second profit allocation alternative suggested by the 2017 OECD example is the PSM.2251 While it may be relatively straightforward to identify which controlled parties contributed the most valuable development inputs in the context of internally developed manufacturing IP (typically R&D and unique pre-existing intangibles), it may prove more problematic to identify similarly unique contributions in the context marketing intangibles, as the values of the latter IP tend to be mainly cost-driven. The relative significance of functions is therefore diminished.2252 A distribution 2248. See the discussion of the 2017 OECD TPG on risk in sec. 6.6.5.5. 2249. OECD TPG, para. 6.139. See the discussions of the realistic options available in the context of unspecified methods in sec. 12.3., and in the context of valuation in sec. 13.5. 2250. OECD TPG, paras. 6.2 and 6.3. 2251. OECD TPG, annex to chapter VI, Example 10, para. 33, second bullet point. 2252. Multinationals will likely argue otherwise. The taxpayer in GSK argued that more income should be allocated to the foreign legal owner of the trademark even though the US distribution subsidiary performed local marketing. See the discussion of GlaxoSmithKline Holdings (Americas), Inc. v. CIR, 117 TC 1 (Tax Ct. Docket No. 5750-04, 2004) in sec. 20.2.4.2. The reason for this is that purportedly key marketing

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subsidiary that incurs incremental marketing expenditures to build the local value of the IP should be allocated a significant portion of the residual profits under the PSM, aligned with the stated purpose of the 2017 OECD guidance on intangibles to allocate profits in accordance with where the intangible value was created. This PSM approach should, in the author’s view, be the preferred allocation method, as it will take into account both parties’ contributions of functions to (and, in particular, risks borne in respect of) the intangible’s development.2253 The third profit allocation alternative described by the 2017 OECD example is to reimburse the subsidiary’s incremental marketing costs with the addition of a mark-up (in other words, to apply the cost-plus method).2254 The guidance pertaining (also) to this alternative is somewhat ambiguous. One possible interpretation is that the foreign group entity that holds legal title to the IP – at the end of year 5 – is entitled to extract all future residual profits from the exploitation of the locally developed marketing intangible simply by, at this point in time, reimbursing the subsidiary on a cost-plus basis. The subsidiary has, in this case, assumed all risks associated with the incremental costs, while the foreign legal owner of the IP is allocated the fruits thereof. The latter group entity will have the benefit of knowing whether the marketing investments were successful before deciding whether or not to compensate. If the investments were unsuccessful, there will be no future residual profits, and the legal owner will not be interested in reimbursing the local subsidiary. It is a win-win situation for the foreign owner and a lose-lose situation for the subsidiary. During the first 5 years of developing the local trademark, the subsidiary has no chance of receiving concurrent arm’s length remuneration, nor is it promised a portion of the potential future residual profits. In fact, the best conceivable outcome functions were performed centrally (e.g. the designing of a global marketing strategy and preparation of budgets). That argument did not seem to have much impact on the final settlement with the US Internal Revenue Service (IRS) and, in general, is not very convincing. Marketing content will normally not be created by the employees of the legal owner of the marketing intangible, but will rather be outsourced by the group to specialized third-party advertising firms. Also, high-level marketing decisions will often result from relatively generic upper management functions, as opposed to the specialized R&D functions necessary for the creation of manufacturing intangibles. Reliance on relatively generic functions for profit allocation purposes might entail that the legal owner easily could extract profits from the source state. 2253. In this direction, see also Roberge (2013), at p. 236, with regard to the result under the 2010 OECD TPG. 2254. OECD TPG, annex to ch. VI, Example 10, para. 33, third bullet point.

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for the subsidiary is to be reimbursed for its incremental marketing expenses at the end of the development phase (of course, only if the promotion efforts prove successful). Such an investment will likely have a negative net present value. The subsidiary would be better off by not entering into it. This cost-plus alternative should therefore not be used, as it will not adhere to the pricing boundaries dictated by the best realistic alternatives of the controlled parties. From a comparative viewpoint, it can be noted that the economic substance provisions of the 2009 US IRC section 482 regulations also reject such controlled pricing structures.2255 To summarize the above discussion in a question, which alternatives for allocating additional profits to a distribution subsidiary that has incurred above-arm’s length marketing expenses does the 2017 OECD guidance offer? Apparently, all bets are off. Both the general guidance and the specific example indicate that the entire spectrum of specified transfer pricing methods (apart from the CUT method) are acceptable alternatives for allocating profits to the source jurisdiction. The author attributes this unfortunate lack of direction to the likely inability of the OECD to reach consensus on an appropriate allocation pattern. As argued above, the wording of the 2017 example cannot be read in isolation from the rest of the OECD TPG on intangibles. In particular, the allocation patterns suggested by the 2017 example based on applying the resale price method, cost-plus method and TNMM would, in the author’s view, conflict not only with the overarching purpose of the new guidance on the allocation of residual profits from unique and valuable IP that residual profits should be allocated to the jurisdictions in which the intangible value was created, but also with the economic substance of the controlled transaction, which would result in pricing that is contrary to the realistic alternatives of the subsidiary. These approaches should therefore be rejected. The new guidance should be interpreted so as to allow only the profit split method to remunerate a subsidiary that has incurred incremental marketing expenses. This is consistent with the economic substance of the controlled transaction, which is that the subsidiary alone incurs all risks connected to the IP’s development (and performs all necessary functions).2256 2255. See the discussion in sec. 23.3.3. 2256. An extension is provided for the example in OECD TPG, annex to ch. VI, Example 13, pursuant to which, at the beginning of year 4, (i) the foreign owner outsources the manufacturing of the watches to a third party, from which the subsidiary purchases them directly at arm’s length prices; and (ii) the distribution agreement is renegotiated into a new, long-term agreement with terms similar to the initial agreement, apart from obliging the subsidiary to pay a royalty for its right to process, market and distribute the

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24.5.4. The profit allocation reservation The example discussed in section 24.5.3. contains a potentially potent reservation, which may incapacitate the authority to allocate additional income to the source-state subsidiary all together. The example states that if the subsidiary “could expect” to obtain an arm’s length return on the incremental marketing costs during the remaining term of the distribution agreement then “a different outcome could be appropriate”.2257 The author interprets this to entail that if it can be established, at the end of year 5, that the subsidiary has the potential to earn an arm’s length return on its investment for the next 5 years (the distribution agreement had a duration of 10 years), the source-state tax authorities will not be entitled to reassess. No guidance is provided on how to determine whether the distribution subsidiary could expect to receive an arm’s length return for its incremental marketing efforts during the remaining term of the distribution agreement. Nevertheless, as concluded in section 24.5.3., it would be contrary to the economic substance of the controlled transaction and the realistic alternatives available to the subsidiary to remunerate it on the basis of the onesided methods. Thus, an arm’s length result will only be possible to attain in this situation if the subsidiary, from and including year 5, is allocated a portion of the residual profits generated through the local exploitation of the foreign-owned marketing intangible that it licenses. This portion should likely be the lion’s share of the profits. If the controlled agreement does not give such remuneration to the subsidiary, it should not be deemed at arm’s length. The controlled allocation of profits to the subsidiary should then be reassessed. Thus, in conclusion, it can be observed that the reservation will only bar source-state tax authorities from reassessing the income of the distribution subsidiary when the controlled pricing structure is based on a profit split. watches. For years 1-3, the adjustment should be the same as in the main example. The author found there that a profit split approach should be adopted. The guidance states that the same allocation should be performed in the following years, but also allows compensation of the subsidiary for the renegotiated agreement pursuant to the business restructuring guidance in ch. IX of the OECD TPG. Such an adjustment cannot, however, possibly come in addition to the other adjustments suggested above in this section. Otherwise, the subsidiary would, in effect, be compensated twice for the same income item. See the discussion in sec. 22.5. of the somewhat parallel problem of allocating residual profits from pre-existing intangibles by way of substance views and transfer pricing charges. 2257. OECD TPG, annex to ch. VI, Example 10, para. 34.

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When the pricing is based on a one-sided pricing method (e.g. cost-plus or TNMM), the reservation will not be relevant, and the source-state tax authorities may reassess.

24.6. Concluding comments As shown in this chapter, the OECD has traditionally taken the position that the group entity that holds legal title to internally developed marketing IP shall be allocated the residual profits that it generates.2258 This approach is highly susceptible to tax planning, as a multinational is generally free to designate whichever group entity it may choose to hold legal title to IP that is controlled by the group. This “restrictive” OECD profit allocation approach has only afforded local distribution entities (and their residence jurisdictions) a portion of the marketing-based super profits in very narrow circumstances, if at all.2259 It was therefore interesting to see whether the 2017 BEPS revision of the OECD TPG on intangible ownership induced the OECD member countries to agree on a clear and progressive stance on this issue. Based on the analysis in this chapter, the author concludes that this did not turn out to be the case. Precisely why is an open question. As the author sees it, the BEPS revision targeted abusive profit-shifting structures pertaining to manufacturing intangibles. The more “ordinary” problem of allocating marketingbased super profits took a backseat position in the OECD debates leading up to the 2017 consensus text. As the current OECD TPG now read, it will be easy for a multinational to set up a structure with legal ownership of the marketing IP in a foreign group entity (resident in a low-tax jurisdiction), license the IP to a local distribution subsidiary (resident in a high-tax jurisdiction) and extract the residual profits by way of royalty payments. As long as the multinational ensures that the distribution subsidiary does not incur excessive marketing expenses (see the discussion in section 24.5.2.) during the marketing IP development phase, the source-state tax authorities will have no legal basis in the OECD TPG on which to downwardly adjust outbound royalty payments that extract the entire marketing-based super profits from the 2258. See also the comments on the historical OECD position in sec. 19.5. 2259. In such circumstances, however, where the local group entity is allocated residual marketing profits, it will be deemed to own a local value of the marketing IP in question. If the local entity is later stripped down, this may trigger exit compensation for the transfer of the local marketing IP; see Musselli et al. (2008a), at p. 262.

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Concluding comments

source jurisdiction. The “excessive marketing expenses exception” to profit allocation to the (foreign) legal owner of the marketing IP is now an old approach to transfer pricing that calls back to the 1979 OECD Report and the first “cheese” example of the 1992 proposed US regulations that sought to modify the 1968 developer-assister rule,2260 and should now be regarded as highly overdue for rethinking and revision. In respect of allowing profit allocation of marketing-based super profits, to hinge on legal formalities in this manner is contrary to a clear aim behind the OECD BEPS Project that intangible value should be taxed where it is created. As the current OECD TPG now stand, the foreign group entity that holds legal title to the marketing IP may extract the entire residual profits from the marketing jurisdiction without providing much in the form of functions, assets and risks, apart from legal ownership, to the value chain. It may be questioned as to whether such profit allocation indeed should be regarded as being at arm’s length. The OECD should, in the author’s view, seek to revise the guidance on intangible ownership of marketing IP so that it will ensure a more balanced profit allocation that takes into account the functions, assets and risks provided by both the licenser and the licensee in marketing IP structures.

2260. See the comments on the IP ownership approach of the 1979 OECD Report in sec. 19.5., and on the proposed 1992 first “cheese” example in sec. 19.3.

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Chapter 25 The Allocation of Residual Profits from Unique and Valuable IP to Permanent Establishments 25.1. Introduction This chapter will address two questions. The first is how intangible property (IP) ownership shall be assigned under article 7 of the OECD Model Tax Convention (OECD MTC) 2261 – more specifically, whether the head office or the permanent establishment (PE) shall be assigned economic ownership of an item of IP, and thereby also the residual profits generated by it. As this issue is relevant both for internally developed and externally acquired manufacturing and marketing IP, the author will analyse it separately for each type of IP. The discussion of this problem should be read in light of the introduction to the “significant people functions” concept in chapter 17. Here, the author will focus on interpreting the concept for the particular purpose of assigning ownership of IP among the head office and the PE of an enterprise. The second question that will be discussed in this chapter is of whether the PE threshold under article 7 of the OECD MTC may have a distortive effect on the allocation of business profits compared to allocations that are carried out under article 9.

25.2. Assigning economic ownership to internally developed manufacturing IP The question is whether the head office or the PE shall be assigned economic ownership of internally developed manufacturing IP, and thereby also the residual profits generated by it. The performance of research and development (R&D) functions and their funding may be rendered by different parts of the enterprise, typically with R&D being performed by a research centre PE that is funded by the head office. The question then becomes whether the assignment of economic IP ownership requires that the relevant part of the enterprise performs the

2261. The transfer pricing issues that arise when a permanent establishment (PE) contributes to an intangible property (IP) value chain are analysed in ch. 17.

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important R&D functions or whether it is enough that it funds the R&D efforts.2262 The 2010 OECD PE Report (the 2010 Report) applies the significantpeople-functions concept to assign economic ownership of IP, pursuant to which the key functions are “those which require active decision-making with regard to the taking on and management of … risk … associated with the development of the intangible”.2263 The Report indicates that such functions will include the active management of individual R&D programmes, the testing of specifications, the determination of the research framework, review and evaluation of data, the setting of milestones for specific R&D projects and the determination of whether a project should be continued or abandoned.2264 Such R&D functions lie close to the important functions described in the 2017 OECD Transfer Pricing Guidelines (OECD TPG) on IP ownership.2265 The 2010 Report, however, also makes clear that the performance by one part of the enterprise of “most or all of the functions by which a trade intangible, e.g. a complex software operation, has been created” does not necessarily entail that it should be deemed economic owner of the developed IP.2266 It is also stated in the 2010 Report that “under the authorised OECD approach the ‘developer’ of the assets would have to bear such losses”.2267 The term “developer” in this context should be read as a reference to established transfer pricing terminology based on the long-standing 1968 US developer-assister (DA) rule, under which the entity that bears R&D costs shall be entitled to the residual profits.2268 Thus, the 2010 Report seemingly accepts dealings that, in substance, are similar to contract R&D arrange2262. It is, however, clear that it does not suffice for economic ownership that one particular part of an enterprise has the necessary capital available to assume the research and development (R&D) risks (but has not actually assumed the costs); see the OECD 2010 Report, at para. 91. With respect to the cost side of the IP development, this could be the case if the R&D project fails (and does not generate income), and “ownership” of the project is assigned to the PE, resulting in a loss position (for the PE); see Schön (2014), at p. 9; and Schön (2008), where it is argued that the source state will not be obliged under international tax law to provide a deduction for the loss, and that this OECD MTC art. 7 treatment differs from what would be the case under art. 9 (if the R&D investment were carried out through a subsidiary in the source state instead). 2263. 2010 Report, para. 85. 2264. 2010 Report, paras. 87 and 88. 2265. See the analysis of the “important functions doctrine” in sec. 22.3.2. 2266. 2010 Report, para. 83. 2267. 2010 Report, para. 89. 2268. See the analysis of the historical 1968 US developer-assister rule in sec. 19.2.

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ments in which the R&D entity is remunerated on a cost-plus basis while the residual profits are allocated to the funding entity.2269 The author finds that the 2010 Report must be interpreted as accepting the assignment of economic ownership to the part of the enterprise that renders R&D funding, and thus incurs the financial risks associated with the R&D efforts, even if this part of the enterprise does not perform any of the R&D functions connected to the developed IP. This result is incompatible with the allocation pattern dictated by the 2017 OECD TPG on important functions, which requires that residual profits are allocated to group entities that contribute important R&D functions. Remuneration of R&D funding is restricted under the 2017 OECD TPG to a separately determined risk-adjusted return.2270 As the 2010 Report must be applied by taking into account the OECD TPG as modified from time to time,2271 the important-functions doctrine must be applied analogically to assign economic ownership. The result will be that all residual profits from the developed IP must be allocated exclusively to the part of the enterprise that performs the important R&D functions.2272 The part of the enterprise that only renders a “funding contribution” will merely be entitled to a risk-adjusted return.2273 If important R&D functions are performed by both the head office and the PE, the residual profits from the developed IP must be split between the residence and source states. The allocation of residual profits under article 7 of the OECD MTC will then – as is the case under article 9 – reflect where IP value creation takes place.

25.3. Assigning economic ownership to internally developed marketing IP The question is whether the head office or the PE shall be assigned economic ownership of internally developed marketing IP, and thereby also the residual profits generated by it. 2269. 2010 Report, paras. 84 and 85. 2270. See the analysis of the remuneration of IP development funding contributions in sec. 22.4. 2271. 2010 Report, preface, at para. 10. 2272. This follows from an analogical application of the 2017 OECD TPG instruction that a group entity that contributes important R&D functions cannot be remunerated as the tested party under a one-sided method; see OECD TPG, para. 6.58. 2273. OECD TPG, para. 6.62; and the analysis in sec. 22.4. of this book.

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The 2010 Report is ambiguous with respect to which specific significant people functions shall be determinative for the IP ownership assessment. The 2010 Report merely reiterates the point of departure that the relevant functions are those that are “associated with the initial assumption and subsequent management of risks of the marketing intangibles” and indicates that this may include the creation of and control over branding strategies, trademark and trade name protection and the maintenance of established intangibles.2274 These are typical head office functions, as the marketing efforts of multinationals tend to be coordinated through centralized, high-level management. The specific application and localization of the marketing strategy may, however, be determined in the source state where the marketing efforts are actually carried out. For example, the decision to invest in a marketing campaign may be taken at the head office, while the more specific marketing content is determined in the source state. Even though the 2010 Report, to some extent, recognizes the “creative” day-to-day marketing functions performed at the PE level, the author finds that the functions that directly affect the financial risk connected to the marketing IP development (investment decisions, design of the marketing strategy, IP protection, etc.) must prevail, as such functions lie at the core of the significant-people-functions concept. If these functions are performed at the head office, economic ownership of the local marketing IP should be allocated to the residence state.2275 A transfer pricing problem closely related to the ownership issue arises where the head office is assigned IP ownership, but the PE incurs incremental marketing expenditures to develop the local value of the marketing IP in the source state.2276 In this context, the PE is deemed to license exploitation rights to the marketing IP through a dealing with the head office. The question is whether the PE in such cases should be allocated a portion of the residual profits generated through its local exploitation of the IP. This 2274. 2010 Report, para. 97. See the comments in Levey et al. (2006), at p. 4, on the key entrepreneurial risk-taking functions criterion for determining the ownership of marketing IP. 2275. Even if the head office is assigned economic ownership of the marketing IP developed in the source state, it cannot be taken for granted that all source-state marketing profits are due to this IP. It may be that the PE, by itself, developed other local marketing IP (e.g. goodwill or know-how) that is separate from the marketing IP owned by the head office. The residual profits from such other IP may be allocable exclusively to the PE. 2276. With respect to the cost side of the IP development, see supra n. 2262.

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is the article 7 parallel to the allocation of profits to a local distribution subsidiary that incurs incremental marketing expenditures under article 9 (see the discussion in section 24.5.). There is irony to this scenario, as the basis for allocating economic ownership to the residence jurisdiction is that the “financial risk” functions are performed there, while the incremental marketing expenses that cause the financial risk are deducted in the source jurisdiction. This does not, however, entail that there is a lack of reality in the head office’s economic ownership. The financial risk functions may very well in substance be performed in the residence state, while the costs themselves are deducted at source. A PE will be wholly comparable to a distribution subsidiary in the parallel situation under article 9 with respect to the functions performed, assets used and risks incurred to develop the marketing IP. To ensure neutrality in the international tax law treatment of business profits, a PE should be entitled to a portion of the residual profits from local marketing IP to which it has contributed incremental marketing expenditures to develop its value. An unrelated distributor would simply not be willing to incur incremental marketing expenditures without a stake in the potential super profit returns. A different result would thus conflict with the arm’s length principle.

25.4. Assigning economic ownership of acquired manufacturing IP The question is whether the head office or the PE shall be assigned economic ownership of acquired manufacturing IP, and thereby also the residual profits generated by it. This depends on which part of the enterprise performs the significant people functions connected to the acquired intangible, i.e. the active decision-making functions relating to the taking on and management of financial risks.2277 The 2010 Report indicates that relevant functions include the evaluation of whether the IP should be purchased, the performance of follow-up R&D, as well as the management of risks pertaining to deployment of the IP.2278 If this ambiguous guidance should be understood as assigning economic ownership of the acquired manufacturing IP to the part of the enterprise that “funds” the IP (through the investment decision) as opposed to the part of the enterprise that carries out R&D functions relevant to the IP 2277. 2010 Report, at para. 92. 2278. 2010 Report, at para. 94.

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(further development, maintenance R&D, etc.), the 2010 Report, on this point, will arguably be incompatible with the important-functions doctrine of the 2017 OECD TPG. As the 2010 Report requires that the OECD TPG be applied by analogy to allocate profits among the head office and PE, there is no question that ownership of the acquired IP must be assigned to the part of the enterprise that performs the important R&D functions. Only then will the allocation pattern dictated by the 2017 OECD TPG be respected. If important R&D functions are performed by both the head office and the PE, the residual profits must be split between the residence and source states. Application of the 2017 important-functions doctrine is unproblematic when the enterprise actually carries out R&D. The people responsible for ongoing R&D will then typically also be the ones that were qualified to assess whether the acquired IP would be useful for the business and whether it would be more rational to acquire it than to develop a similar intangible internally.2279 It may, however, also be that the enterprise does not carry out any R&D, or at least not any R&D relevant to the acquired intangible. For example, this could be the case if competing software is acquired for the purpose of letting it “wither on the vine” without further development. Ownership of the acquired manufacturing IP should then be allocated to the jurisdiction where the people performing the financial risk decisions (decisions on whether to acquire the IP, to use equity or debt financing, whether the investment should be hedged or insured, etc.) are located. This will tie the profit allocation directly to the closest proxy that there is to intangible development value creation in this scenario, namely the decision to purchase the IP.

25.5. Assigning economic ownership of acquired marketing IP The question is whether the head office or the PE shall be assigned economic ownership of acquired marketing IP, and thereby also the residual profits generated by it. The financial risks will vary depending on the value of the acquired marketing IP, which again will depend on whether the IP is new and untested or established and well known. If it is a new trademark, the enterprise will need to invest in marketing subsequent to the acquisition to develop the value of the IP. The profit allocation must then adhere to the rules discussed in section 25.3. for internally developed marketing 2279. 2010 Report, at para. 93.

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IP. If the trademark is established, however, these rules will not be useful, as the value of the acquired marketing IP already has been developed by the seller. The following discussion pertains solely to this latter scenario. The 2010 Report does not indicate which particular significant people functions are relevant for the “taking on and management of risks” with respect to acquired marketing IP.2280 The 2010 Report’s guidance on the corresponding issue for acquired manufacturing IP (discussed in section 25.4.) may aid in the interpretation. The relevant risk-assuming function will, in particular, be the decision to purchase the IP. Thus, economic ownership of acquired established marketing IP should be assigned to the part of the enterprise that performs the financial risk functions related to the acquisition, typically the purchase decision.2281

25.6. The cliff effect under article 7 of the OECD MTC and the important-functions doctrine 25.6.1. Introduction In this section, the author will discuss the potential impact of the PE threshold of article 7 on the allocation of residual profits from unique and valuable IP under the 2017 important-functions doctrine, using recent case law as an illustration in the analysis. In a range of recent cases on controlled distribution structures involving products based on foreign-owned IP, source-state tax authorities have 2280. 2010 Report, at para. 94. 2281. The author finds it fair to ask whether it is useful to base the assignment of economic ownership on the financial-risk-centred significant-people-functions concept. As ownership here largely hinges on a one-time event, the multinational could arrange for this single decision to be taken in the jurisdiction of its choice. The ownership assignment has added importance in this context, as the “incremental marketing expenses exception” will not be triggered, because the acquired marketing IP is established. The PE will thus likely only need to incur a “normal” arm’s length level of marketing expenses to maintain the already established value of the acquired marketing intangible, in contrast to when the value of new and unknown marketing IP must be built from scratch, which will likely require intensive marketing efforts in the initial years. Once the ownership issue has been solved, it is unlikely that there will be any basis on which to assign profits to the PE. Ultimately, however, there may be no better allocation parameter available than the financial risk functions relied upon by the significant-peoplefunctions doctrine.

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claimed taxing jurisdiction over residual profits based on PE assertions. The lack of a thorough profit allocation analysis is a common factor in these rulings. Typically, the PE assertion was rejected by the courts, leaving the allocation issue untried.2282 If it was found that there was a PE, the source-state allocation assertion was accepted or adjusted without a proper analysis. Some cases were settled before or during the proceedings.2283 This case law therefore does not contain much useful guidance on the profit allocation issue. As the factual patterns pertain to popular distribution structures, however, it may be fruitful to gain insight into how the 2017 important-functions doctrine would allocate profits to the source state (if there is a PE), and thereby how much profit is at stake in these common scenarios. This is particularly relevant in the current post-BEPS climate, as the OECD has now adjusted the PE threshold of article 7 so that there no longer is a “commissionaire safe harbour” (as discussed in section 17.6.). If there is no PE, the source state will be cut off from these profits (the socalled “cliff effect” of article 7). Even though it will no longer be possible to avoid PE status through commissionaire structures, the PE threshold remains relevant for profit allocation cut-off purposes in a host of other situations. The article 7 cliff effect is interesting because, as the author argued in sections 17.1. and 17.3., the material content of the allocation patterns under articles 7 and 9 is similar. Contrary to article 7, however, article 9 does not contain a threshold that must be breached before profit allocation kicks in. The analysis aims to provide an impression of the possible distortion effect on the international allocation of operating profits caused by this threshold.2284 2282. The author’s impression is that the combination of a restrictive PE threshold in OECD MTC, art. 5 with the ambiguous pre-2010 OECD MTC, art. 7 profit allocation guidance may have enticed multinationals to favour a fight regarding the PE threshold over the allocation issue. In this sense, art. 5 may have served as an “all or nothing” allocation proposal. If the multinational succeeded in convincing source-state courts that there was no PE, no additional profits would be allocable to the source state. Conversely, if a PE were found, it would likely prove challenging to convince the courts to significantly alter the tax authority’s profit allocation assertion due to the ambiguity of the pre-2010 allocation rules, typically resulting in an allocation of the reassessed income to the source state, or at least substantial parts of it. 2283. E.g. the General Motors dispute between the United States and Canada, in which the United States did not agree on the allocation of profits to a Canadian PE of General Motors, and thus refused to provide credit relief under the 1980 Canada- United States treaty. The case was settled. This dispute is apparently one reason as to why the United States is unwilling to interpret art. 7 of its existing treaties on the basis of the 2010 authorized OECD approach. 2284. The analysis is limited to the 2010 version of the OECD MTC, art. 7. The comments should not be perceived as positions on how the allocation issues should have been resolved in these specific cases under the pre-2010 version of art. 7.

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25.6.2.  Philip Morris (Italy, 2001) In the 2001 Phillip Morris case, the Italian Supreme Court reviewed a reassessment based on the assertion that the Phillip Morris group had a PE in Italy.2285 The profit allocation issue was not addressed.2286 The Italian tax authorities allocated intangible business profits from local cigarette sales to the PE. The profits were consideration for make-sell rights to manufacturing and marketing IP associated with the cigarettes, in the form of royalty payments from the Italian tobacco monopoly.2287 As the author understands the facts of the case, the intangibles were legally owned by, and licensed from, a German group entity.2288 The group had a subsidiary in Italy, which made and distributed cigarette filters and controlled whether the monopoly’s cigarette distribution satisfied the quality criteria of the licence agreement with the German entity. Further, its employees participated in licensing negotiations between the German entity and the monopoly. How should the operating profits be allocated, provided that there is a PE and the issue is assessed under the important-functions doctrine of the 2017 OECD TPG? Only fragments of the relevant information are offered in the ruling, but the author will provide some thoughts based on what is known. The question was not whether the royalty payments were at arm’s length, as the licence agreement was between the German entity and the unrelated Italian tobacco monopoly, but whether they were allocable to the PE (in other words, whether the economic ownership of the Italian make-sell rights to the IP should be assigned to Italy). The author will assume that the important people functions necessary for the creation of the manufacturing IP were performed by the German entity. This entity should then be regarded as the economic owner under article 7 and should be allocated the profits from the exploitation of the manufactur-

2285. Ministry of Finance (Tax Office) v. Philip Morris (GmbH), Case No. 7682/05 (Supreme Court of Italy, 2002). 2286. The case was reversed and remitted to the Court of Appeal of Lombardy for renewed assessment and was ultimately settled. The author suspects that the allocation issue would have been the crux of the case, had it gone forward. 2287. Under Italian law, the monopoly was obliged to perform tasks such as transportation, distribution, conservation and diffusion of tobacco products. 2288. See the judgment in IT: Supreme Court, 2002, Case No. 7682/05, Ministry of Finance (Tax Office) v. Philip Morris (GmbH), at para. 3.7.

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ing IP in Italy. This should also be the point of departure for the marketing IP. The only basis for allocating a portion of the marketing royalties to the PE would be if it incurred incremental marketing costs (see the discussion in section 25.3.). The facts referred to in the ruling provide no basis for assuming so. Even if they did, it would likely not justify an allocation of the entire residual profits.2289 The author’s impression is that none of the intangible profits are allocable to Italy. Nevertheless, it is clear that the PE did perform functions and incur risks for which it should be remunerated. In particular, it performed manufacturing, distribution, control and negotiation functions. These are rather generic services, the performance of which alternatively could have been outsourced to third parties for a normal fee. Thus, the PE should be remunerated as a routine service provider under a one-sided method. A point here is that, while not clear from the ruling, the subsidiary was likely remunerated for a range of routine functions performed in Italy, at least for the manufacturing and distribution functions. Functions compensated at the level of the subsidiary should not also be compensable for the PE (see the analysis in section 17.6.4.). It may be that the only element not compensated at the level of the subsidiary was the royalty payments. Since these should not be allocated to the PE under the important-functions doctrine, there will be no cliff effect here, as all routine functions are compensated in the source state under the article 9 compensation of the local subsidiary.2290 Thus, two observations can be made. First, there is a significant discrepancy between the source state profit allocation assertion, which allocated the entirety of the royalties to the PE, and the normal market return afforded to the PE by the important-functions doctrine. Second, there is likely no cliff effect in this case, as the source state should not lose out on any income if there is no PE, since the local subsidiary is remunerated for the routine services performed.

2289. See the discussion in sec. 25.3. on profit allocation for when the PE incurs incremental marketing expenditures. 2290. This was not the case under the 2010 OECD TPG, which allowed separation of inventory and credit risk from the local distribution subsidiary with effect for the art. 9 pricing, thus resulting in a “cliff effect” if there were no dependent-agent PE under art. 7 to which the profits associated with these risks could be allocated. The author refers to his analysis of these transfer pricing issues in sec. 17.6.4., and of the new OECD guidance on risk in sec. 6.6.5.5.

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25.6.3.  Rolls Royce (India, 2007) The 2007 ruling of the Indian Income Tax Appellate Tribunal (ITAT) in the case of Rolls Royce PLC v. Dy. Director of Income Tax pertained to whether the UK company Rolls Royce Private Ltd had a PE in India through its local subsidiary, Rolls Royce India Ltd.2291 The Rolls Royce group sold aero-engines and spare parts to the Indian Navy and Air Force. The subsidiary performed local support functions, including business development, public relations and technical support, and was remunerated on a cost-plus basis. The UK parent reimbursed all marketing costs. R&D and manufacturing were done in the United Kingdom. Employees of the UK parent frequently visited the local subsidiary’s offices for marketing and sales purposes. Based on a PE assertion,2292 the Indian tax authorities allocated 100% of the local business profits to the PE for 2 of the reassessed years, and 75% for the remaining years. The ITAT affirmed the assessment on the PE issue, but reduced the profit allocation to 35%.2293 The logic behind the 35% allocation was that these profits were due to marketing efforts carried out in India. The remaining 65% were allocated to the United Kingdom.2294 How should the operating profits be allocated, provided that there is a PE and the issue is assessed under the important-functions doctrine of the 2017 OECD TPG? First, it is clear that economic ownership of the manufacturing IP should be assigned to the UK parent, as R&D was carried out in the United Kingdom. The residual profits from sales of aero-engines and spare parts in India are therefore allocable in their entirety to the United Kingdom.2295 Even though the 65/35 ITAT allocation may seem conservative and in favour of the United Kingdom, it cannot be ruled out that an even larger portion of the total profits should be due to manufacturing IP connected to specialized, high-tech products with narrow customer bases, such as the aero-engines in this case. 2291. Rolls Royce Plc v. Dy. Director of Income Tax, 125 ITD 136, Delhi, 2007. 2292. See Kapoor (2008) for critical comments on the PE issue. 2293. The ruling does not devote much attention to the allocation issue. 2294. 50% to UK manufacturing and 15% to UK R&D. 2295. It may be questioned as to whether the technical support performed by the PE in India could be seen as follow-up R&D for the manufacturing intangibles or as technical know-how separately owned by the PE, which would attract a portion of the residual profits. The limited information in the ruling provides no basis for assuming so.

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Second, the ruling does not provide any information on the marketing IP relevant to the aero-engines and spare parts sold in India or which group entity owned them. There is, for instance, no mention of whether international trademarks or trade names were involved. Due to the worldwide familiarity of the Rolls Royce name, however, the author would assume that this was the case. He will further assume that the marketing IP was legally owned by the UK company. As the marketing costs were reimbursed, the UK head office should be assigned economic ownership of the marketing IP. Thus, as the point of departure, there is no legal basis for allocating any of the residual marketing profits to the Indian PE.2296 The ITAT conversely argued that marketing profits were allocable to India because marketing was performed there. This is irrelevant under the 2010 Report, as the allocation of residual marketing profits hinges on economic ownership, not the performance of marketing functions. The functions performed in India seem rather generic, possibly apart from the technical support functions, and likely possible to outsource to third parties for a normal market fee. Only a normal market return should therefore be allocable to India, while the residual profits are allocable in their entirety to the United Kingdom. Thus, two observations can be made. First, there is a significant discrepancy between the source-state profit allocation assertion, pursuant to which the entire Indian operating profits were allocable to the PE, and the normal market return indicated by the important-functions doctrine. Second, there realistically does not seem to be a cliff effect in this case, as no additional profits on top of the article 9 remuneration would be allocable to the source state if there were a PE.

25.6.4.  Zimmer (France, 2010) In the 2010 Zimmer ruling, the French Supreme Administrative Court rejected a reassessment premised on the UK orthopaedic enterprise Zimmer 2296. The PE performed a range of local marketing functions (including business development, public relations and conferences). It cannot be ruled out that this activity created local marketing intangibles (e.g. goodwill, marketing know-how, etc.) that should be economically owned by the PE alone. If so, the residual marketing profits should be split between the marketing intangibles owned by the UK head office and the Indian PE. The author will, however, assume that there were no local marketing intangibles, as there is no indication of this in the ruling and it was not asserted by the Indian tax authorities.

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Limited, having a PE in France.2297 How should the operating profits be allocated, provided that there is a PE and the issue is assessed under the important-functions doctrine of the 2017 OECD TPG? The profit allocation issue was addressed by neither the first-tier judges nor the Paris Court of Appeals, which simply accepted the tax authority’s assertion. Key information relevant to the allocation is absent. For instance, it is not clear as to which group entity owned the manufacturing and marketing IP used in the locally sold products. As far as the author can gather, the point of the reassessment was to “reverse” the restructuring so that the profit attributed to the PE plus the controlled allocation of income to the local subsidiary in total equalled the pre-restructuring operating margin of the local subsidiary.2298 Had there been a PE, it should likely not have been allocated any residual profits, as the head office economically owned the manufacturing and marketing intangibles. This seems to be in line with the controlled pre and post-restructuring allocation of profits.

2297. Société Zimmer Limited v. Ministre de l’Économie, des Finances et de l’Industrie, Nos. 304715 and 308525 (Supreme Administrative Court, 2010), reversing No. 05-2361 (Administrative Court of Appeals of Paris, 2007). The case was determined on the PE issue, as Zimmer Limited was not found to have a dependent-agent PE in France under art. 4 of the 1968 France-United Kingdom treaty. The Zimmer group restructured its French orthopaedic distribution operation prior to the reassessment, going from a fullfledged buy-sell distributor to a limited risk commissionaire structure. Similar restructurings were common in France at the time; see Gelin et al. (2007); and Gelin et al. (2010). The 2012 Spanish Supreme Court ruling in Roche Vitamins Europe Ltd. v. Administración General del Estado, Case No. STS/202/2012, also pertained to a strippeddown local distribution subsidiary. The Spanish tax authorities asserted that the Swiss parent had a PE in Spain through the local subsidiary pursuant to the Spain-Switzerland treaty (1966). The Supreme Court, as in the 2008 ruling of the National Court, ruled in favour of the tax authorities. The case is somewhat peculiar, in the sense that it is really an art. 9 case, and the terms of the local manufacturing and marketing agreements were regarded as being at arm’s length. It is not clear whether the tax authorities asserted that the entire business profits from the sales in Spain were allocable to the PE. For further discussions, see Calderón (2012); and Wittendorff (2012e). 2298. Prior to the restructuring, the subsidiary purchased medical device products from its UK parent for local resale, thus incurring both inventory and credit risk. Its pre-restructuring profits reflected this, and were likely comparable to the level of profits achieved by French third-party distributors of medical devices (typically benchmarked through the transactional net margin method (TNMM)). By contractually stripping these risks from the subsidiary, through a commissionaire structure, the Zimmer group was able to allocate less profits to France; see the analysis of dependent-agent PE structures in sec. 17.6.4. The cost-plus method was likely applied to remunerate the subsidiary.

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Thus, two observations can be made. First, there is no real discrepancy between the source-state profit allocation assertion and the allocation indicated by the important-functions doctrine. Second, the question in this case pertains only to the level of normal return profits allocable to the source state, in particular, whether the PE should be allocated profits associated with inventory and credit risk on top of the cost-plus remuneration earned by the subsidiary. This is no longer relevant under the new OECD guidance on risk, as the article 9 remuneration of the subsidiary will include compensation for these risks.2299 Thus, there is no cliff effect.

25.6.5.  Dell (Norway, 2011) The 2011 Norwegian Supreme Court ruling in Dell Products v. the State pertained to a reassessment in which 60% of the business profits from sales of Dell computers in Norway were allocated to an asserted Norwegian PE of an Irish entity in the Dell group.2300 The reassessment was upheld in the first-tier Oslo City Court and the Norwegian Appellant Court.2301 The allocation issue was argued before the Appellant Court, but the arguments were not particularly developed, as the focal point was on the PE issue. It played an even lesser role before the Supreme Court, which rejected the reassessment on the basis that there was no dependent-agent PE.2302 The Dell group used commissionaire distribution structures in European markets.2303 As opposed to in Zimmer, however, the Norwegian set-up was not the result of a restructuring, but, as far as the author can tell, put in place from the very start. From a total sales revenue in Norway in 2003 of NOK 1.4 billion, the Norwegian subsidiary reported a taxable income of approximately NOK 10 million (0.7% of its revenue) under the logic that it acted as a commissionaire agent for its parent. The legal basis upon which 2299. See the analysis of these transfer pricing issues in sec. 17.6.4., and of the new OECD guidance on risk in sec. 6.6.5.5. 2300. Ruling by the Norwegian Supreme Court, Utv. 2012, at p. 1, reversing ruling by Borgarting Appellant Court, Utv. 2011, at p. 807. 2301. Ruling by Oslo City Court, Utv. 2010, at p. 107. 2302. See art. 5, no. 5 of the Ireland-Norway (2000) treaty. 2303. The Norwegian subsidiary, Dell AS, acted as a commission agent for its Irishresident parent company, Dell Products. The parent was incorporated in the Netherlands and had no employees. The computer products sold in Norway were purchased by Dell Products from its parent, Dell Products (Europe) BV (also a company resident in Ireland, but established in the Netherlands, with approximately 4,000 employees, which manufactured computers in Ireland), which was controlled by the ultimate parent, Dell Computer Corporation, in the United States.

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The cliff effect under article 7 of the OECD MTC and the important-­ functions doctrine

the tax authorities allocated 60% of the Norwegian profits to the asserted PE is ambiguous.2304 How should the operating profits be allocated, provided that there is a PE and that the issue is assessed under the 2017 important-functions doctrine? The international computer hardware industry is competitive, as illustrated in Sundstrand.2305 Information technology companies must therefore distinguish themselves through proprietary features. The computers sold in Norway were likely based on manufacturing and marketing IP owned by the Dell group, but the ruling provides no details. The following comments are thus based on factual assumptions and common knowledge. First, any unique manufacturing IP used in the computers were likely owned by foreign group entities.2306 Second, it is highly likely that economic ownership of the relevant marketing IP, including the Dell trademark, was attributable to a foreign group entity. Thus, the PE must be seen as licensing the right to use the trademark and other relevant IP in Norway through a dealing with the relevant entity, for which it must pay a deemed royalty. Dell is among the largest international PC vendors, and the Dell trademark is established worldwide. Thus, the foreign group entity assigned ownership of the marketing IP exploited in Norway would have a dominating bargaining position vis-à-vis the Norwegian PE, which was a routine service provider. This would likely make it feasible for the owner to impose a royalty high enough to extract the residual profits generated in Norway. 2304. The allocation was based on the pre-2010 art. 7, no. 4 (apportionment method), as the accounting records of Dell did not provide disaggregated transactional information. The Appellant Court, without scrutinizing, agreed in full with the allocation. Essential factual premises for the allocation issue, including which group entities developed and owned the manufacturing and marketing intangibles, the level of marketing expenses incurred in Norway and the remuneration of the Norwegian subsidiary under the commissionaire agreement are not clarified. 2305. For comments on Sundstrand Corp. and Subsidiaries v. CIR, 96 T.C. No. 12 (Tax Ct., 1991), see the discussion in sec. 5.2.5.3. 2306. The intangibles were most likely owned by Dell Products (Europe) BV, from which Dell Products BV purchased the computers for resale. The latter company functioned as a distribution hub, taking credit and inventory risk and selling the products in local market jurisdictions through commissionaire entities. Most of the profits earned by it were likely extracted through the prices it paid for the computers, leaving it with a normal return for a distributor that takes on credit and inventory risk. It therefore seems likely that neither the head office nor the PE owned the relevant manufacturing intangibles.

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There could be two possible grounds for allocating residual profits to the Norwegian PE. The first would be if the PE incurred incremental marketing costs. There is no indication that this was the case. Also, the Dell trademark was well known in Norway in the mid-2000s, so it is counterintuitive that the Norwegian PE should have had to incur incremental marketing expenditures. Further, the sales in Dell were to large Norwegian businesses and the Norwegian public sector. These customers are likely not as susceptible to marketing as consumer clients. The second possible ground would be if the Norwegian PE had developed any unique local marketing IP distinguishable from the Dell trademark, such as goodwill or know-how.2307 The author does not see any basis in the ruling on which to assume that there were local marketing intangibles. His impression is that the PE should not be entitled to any of the residual profits from the marketing IP. The Norwegian tax authorities argued that the combination of the PE’s exploitation of the Dell trademark with its performance of sales functions and incurrence of related risks was the primary value driver, and that the lion’s share of the profits therefore should be allocated to Norway.2308 This is not convincing. The fact that the PE exploited the Dell marketing intangible obviously does not entail that it should be able to reap the residual profits. It would likely not be difficult for the Dell group to find an unrelated distributor in Norway that would be willing to distribute Dell computers to large businesses and the public sector for a normal market fee. The same result must apply when the distribution is carried out by a related party. The author would assume that Dell based its remuneration of the Norwegian subsidiary on the cost-plus method under the argument that it did not incur inventory or credit risk,2309 resulting in a lesser amount of profits compared to what would have been allocable to Norway had the remuneration been based on the TNMM, under the premise that these risks should be included (in order words, the same set-up as in Zimmer; see section 25.6.4.).

2307. If so, the profits from the marketing intangibles should be split between the foreign-owned Dell trademark and the locally developed intangibles economically owned by the PE. The author does not find it doubtful that the relative significance of the Dell trademark would be greater than any potential local marketing intangibles developed by the PE. The lion’s share of the marketing profits should therefore not be allocable to the PE in any case. 2308. This is similar to the argument of the Indian tax authorities in Rolls Royce; see the discussion in sec. 25.6.3. 2309. Such pricing structure cannot be upheld under OECD MTC, art. 9, pursuant to the 2017 OECD TPG on risk. See the analysis in secs. 17.6.4. and 6.6.5.5.

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The cliff effect under article 7 of the OECD MTC and the important-­ functions doctrine

Nevertheless, while the French tax authorities only increased the level of the normal market return to reflect the inventory and credit risks, the Norwegian reassessment went further by also claiming residual profits. The correct allocation would, in the author’s view, be to allocate a normal market return to Norway that is adjusted for inventory and credit risk, but no residual profits (in other words, some more profits than allocated by Dell, but far less than the Norwegian tax authorities claimed).2310 In conclusion, two observations can be made. First, there is significant discrepancy between the source-state profit allocation assertion and the allocation indicated by the important-functions doctrine. Only a normal market return – and no residual profits – should be allocable to Norway as compensation for the routine distribution functions carried out there. Second, there should be no cliff effect, as the source state should not lose out on the incremental normal return premium for inventory and credit risk if there is no PE, since the local subsidiary should be remunerated for these risks.2311

25.6.6.  Boston Scientific (Italy, 2012) At issue in the 2012 Italian Supreme Court ruling in Boston Scientific was also whether a local distribution subsidiary, acting as a commissionaire for its Dutch parent for medical device products, could be regarded as a PE in Italy.2312 The Italian subsidiary, similarly to the Norwegian subsidiary in Dell (see section 25.6.5.), took the return position that the only income allocable to it was the commission fee agreed upon in the distribution

2310. The pre-2010 art. 7, no. 4 apportionment method used as the basis for the 60% reassessment allocation is similar to the profit split method applied under art. 9 and under the 2010 version of art. 7 by analogy; see the analysis of the OECD profit split method in ch. 9. Based solely on the information available in the ruling, the author struggles to see why such a significant portion of the profits should be attached to Norway. 2311. See the analysis of these transfer pricing issues in sec. 17.6.4., and of the 2017 OECD TPG on risk in sec. 6.6.5.5. 2312. Ministry of Finance (Tax Office) v. Boston Scientific, Case No. 3769 (Supreme Court of Italy, 2012). The structure, akin to the ones used in Zimmer and Dell, was set up as follows: the Dutch company, BSI BV, owned 99% of the Italian subsidiary, Boston Scientific SpA, with the remaining 1% owned by the US Boston Scientific Corp. The US entity sold medical device products to the Dutch entity, which had a commissionaire distribution contract with the Italian subsidiary. The Dutch entity functioned as a hub, having similar distribution contracts with local subsidiaries in several European market jurisdictions.

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agreement. The PE assertion-based reassessment allocated an additional EUR 50 million of income to Italy.2313 How should the operating profits be allocated, provided that there is a PE and the issue is assessed under the 2017 important-functions doctrine? The ruling is devoid of allocation-relevant information. There is no way of knowing whether the EUR 50 million reassessment included residual profits. There is no indication that the PE should be deemed the economic owner of any unique IP. Perhaps quite on the contrary, the functions performed by it seem routine, including sales, leasing equipment to hospitals and factoring receivables. For this, it should be allocated a normal return. The author assumes that the subsidiary was stripped of inventory and credit risks, and thus remunerated under the cost-plus method.2314 In conclusion, there is no basis on which to make an informed assumption of whether there is a discrepancy between the source-state profit allocation assertion and the allocation indicated by the important-functions doctrine. Nevertheless, there should be no cliff effect, as the local subsidiary should be remunerated for inventory and credit risks regardless of whether there is a PE.

25.6.7. Concluding comments The cases encompassed by the cursory analysis in this chapter all pertain to distribution structures for established value chains in which the unique IP exploited in the source state was owned by foreign group entities. In none of the cases were the intangibles created in the source state through the performance of important R&D functions. The residual profits should thus be extracted from source under the 2017 OECD TPG. Another notable aspect is that source-state tax authorities have a tendency to issue ambitious reassessments. In the cases discussed in this chapter, in Morris, 100% of the royalties were allocated to the PE; in Rolls Royce, 2313. The taxpayer prevailed in the Regional Tax Court, which decided the case solely on the PE issue. The Supreme Court, while leaning heavily on the Regional Court arguments, rejected the appeal of the Italian tax authorities on procedural grounds. See Sprague (2012) for further comments. 2314. It is unlikely that this could be upheld as the basis for transfer pricing under art. 9, pursuant to the 2017 OECD TPG on risk; see the discussions in secs. 6.6.5.5. and 17.6.4.

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The cliff effect under article 7 of the OECD MTC and the important-­ functions doctrine

between 100% and 75% of the profits from the Indian sales were allocated to the PE; and in Dell, 60% of the profits from sales of computers in Norway were allocated to the PE.2315 While the author finds the source-state profit allocation in Zimmer to be temperate, the allocations in Morris, Rolls Royce and Dell seem poorly founded and aggressive (and would have no legal basis in the 2017 OECD TPG). A contributing factor to this tendency may have been that the tax authorities focused their efforts on establishing that there was a PE under article 5, thereby accentuating the factual elements relevant to that assessment, at the cost of a more thorough profit allocation analysis.2316 If one disregards the unfounded source-state claims for residual profits, one is left with the core issue in these cases, i.e. whether a profit allocation based on a “low-risk distributor” characterization of the local subsidiary is sufficient remuneration to the source state. Under the 2010 OECD TPG and the 2010 Report, the incremental profits due to the risks contractually stripped from the local subsidiary (normally inventory and credit risk) could only be allocated to the source state if there were a dependent-agent PE, as the stripping was accepted for the purposes of the article 9 remuneration of the subsidiary. Thus, if there were no PE, these incremental profits would be extracted from the source.2317 The cliff effect of the PE threshold in the context of these distribution structures 2315. The actual results were also a far cry from the original reassessments. The remanding ruling on the PE issue in Morris likely provided the taxpayer with strong arguments in the settlement that was reached. Even though the Indian Income Tax Appellate Tribunal recognized the existence of a PE in Rolls Royce, it modified the allocation to 35% of the Indian profits. The Norwegian tax authorities lost the case on the PE issue in Dell, resulting in no allocation of residual profits to Norway. 2316. The PE issue was dominating in all cases. Profit allocation was not discussed at all in Morris. Only 1.5 pages of a 29-page ruling in Rolls Royce were devoted to the allocation issue. The Norwegian Appellant Court in Dell touched upon the allocation issue, but the Supreme Court ruled on the PE issue alone. The author’s point is illustrated by the reasoning of the Appellant Court in Dell, which stated that “value creation occurs primarily through sales, and the sale is first and foremost carried out by [the Norwegian subsidiary]”. There is no legal basis in the OECD TPG to assert this view on IP value creation. Nevertheless, it is striking how similar the quoted wording is to the theme for assessment under OECD MTC, art. 5(5), with respect to the question of whether the Norwegian agent entered into sales in the name of the head office. If this observation is justified, the Court simply failed to properly recognize the distinction between the PE threshold under art. 5 and the profit allocation issue under art. 7. 2317. This problem was likely particularly irritating for source states when the local subsidiary, prior to a business restructuring, were taxed on the “full profits”, which included compensation for these risks, as the case was in Zimmer.

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therefore, in essence, equalled these incremental profits. This cliff effect should no longer be of much significance, however, as the article 9 remuneration of the local subsidiary under the 2017 OECD TPG on risk should include compensation for inventory and credit risk.2318 Also, the “cliff” in itself will not be as relevant as before, due to the 2015 OECD removal of the commissionaire safe harbour.2319 Nevertheless, this lack of relevance will typically only pertain to distribution structures in which foreignowned IP is exploited in the source state through the sale of products in established value chains. A more problematic side of article 7 becomes evident when the source state was involved in intangible value creation. It is clear that the R&D carried out by multinationals will not always be performed exclusively on site at its R&D centres. It is practical, for instance, within the software industry, that research employees travel abroad to work for certain periods. During these travels, they may create significant intangible value. Assume, for instance that the core code of a pioneering piece of software is developed by the employees of a foreign-resident enterprise during a stay in a source state. The code is refined and further developed in the residence state when the employees return. It goes on to become a success, generating residual profits. For the sake of argument, let us say that it is possible to determine that 60% of the final intangible value of the software was due to the core code created in the source state. What would the cliff effect of article 7 be here? First, if one starts by addressing the allocation issue, it is clear, under the 2017 important-functions doctrine, that significant R&D functions were carried out in the source state. This intangible development contribution should therefore, in principle, be assigned the 60% of the profits. Second, the question is now whether there is a legal basis for the source state to claim entitlement to the 60% of the profits. That will only be the case if there is a PE there. If the software engineers were in the source state only for a temporary visit, for instance, for a month or two, and they moved around, visiting customers and attending conferences, there would be no sufficient link between the activities performed by the foreign-resident enterprise in the source state and a specific geographical point to establish a

2318. See the analysis of these transfer pricing issues in sec. 17.6.4., and of the 2017 OECD TPG on risk in sec. 6.6.5.5. 2319. See the discussion in sec. 17.6.2.

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PE.2320 There will also be no degree of permanency to the activity,2321 as the R&D employees are only in the source state for a temporary visit.2322 Thus, the enterprise will have no taxable presence in the source state, excluding the intangible profits (that otherwise would have been allocable) from local taxation. This example is, of course, arranged, but the author doubts that such scenarios are wholly impractical. Let us look at the likely implications of this. The PE threshold prevents the source state from claiming the 60% of the profits. The profits are therefore allocated to the residence jurisdiction.2323 This entails that the purpose of the 2017 OECD TPG on IP is not realized because the profits are not allocated to the jurisdiction where they were created. More precisely, the allocation rules under article 7 in and of themselves do allocate the income to the source state, but article 5 does not. This would not have been the result if the source state R&D alternatively had been organized through a subsidiary. Article 9, which has no “trigger” akin to the PE threshold, would then have governed the profit allocation, and the 60% of the profits would have been taxable at source. There is no sound justification for assigning intangible profits due to the same development contributions so fundamentally differently depending on the legal form in which the multinational organized its source-state activities.2324 The author is, for this reason, sceptical of the usefulness of the PE threshold in the context of IP development contributions. The historical origin of the threshold stems from the late 1920s, and its principal structure has remained largely unaltered since then. Even though the threshold clearly is susceptible to tax planning, as amply illustrated by the commissionaire structures discussed in sections 17.6.4. and 25.6.1.-25.6.6. and Action 7 of 2320. This does not, however, necessarily entail that there is no link between the content of the IP value created and the source state. For instance, it may be that the local visit enabled the software engineers to tailor the code to the specific needs of a local customer. 2321. See the OECD Commentary on Article 5 of the OECD MTC, at para. 5. 2322. Id., at para. 6. 2323. The residence state will not be obliged to exclude any profits taxed there through the provision of treaty relief. 2324. See also Schön (2010a), at p. 260, where an argument is made for the assertion of taxing rights for any form of cross-border business activities, regardless of formal thresholds (such as the PE threshold). One may also argue for parity between arts. 7 and 9 on the basis of non-tax-law regulations. See Schön (2007), where he discusses the question of whether there must be equal treatment of a subsidiary and a PE under EU law, and concludes that EU law does not affect the allocation of taxing rights between EU Member States.

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the BEPS Action Plan on the prevention of artificial avoidance of PE status, it cannot entirely be ruled out that it may be useful in some contexts. Otherwise, one could, in theory, risk source states claiming taxation rights over profits made by a foreign enterprise that solely exports goods to the source state. Nevertheless, in a global economy in which significant intangible value (e.g. in the form of software, films, music and technical R&D) may be created as “one-shot” occurrences over a short period and largely independent of location, it may prove unwise to cling on to this “blackand-white” borderline that obviously was not designed to deal with such scenarios. While the comments here touch upon the greater debate of whether the PE threshold represents an equitable trigger for releasing source-state entitlement to tax business profits earned there, it would fall outside the scope of the book to engage in it. The author merely observes that the PE threshold, in the context of IP development contributions, may have the potential to create a cliff effect, one that is of an entirely different scale than the “normal market return cliffs” at stake in the distribution cases discussed in sections 25.6.1.-25.6.6. This may distort the international allocation of residual profits under article 7, in the sense that they will not be taxed where they were created, in contrast to the operating profits that are allocated under article 9 according to the 2017 OECD TPG.

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Chapter 26 Concluding Remarks 26.1. Introduction Throughout this book, the author analysed the most important profit allocation problems connected to intangible value chains, both with respect to how profits shall be allocated among value chain inputs (see the transfer pricing analysis in part 2 of the book) and among group entities that contribute to the development of a unique intangible (see the intangible property (IP) ownership analysis in part 3 of the book). In this final chapter, the author will tie some closing comments to issues that he finds to be of particular relevance going forward. These topics are also ripe for further academic research.

26.2. The methodology for the transfer pricing of IP The analysis of the historical and current US and OECD transfer pricing rules reveals that more emphasis is consistently being placed on aligning profit allocation results with economic substance. Perhaps the best example of this is the inclination to move away from comparables-based IP pricing (the comparable uncontrolled transaction method) towards pricing assessments guided by the realistic options available to the controlled parties and the application of (aggregate) valuation techniques. This is forcefully illustrated by the 2017 OECD TPG on risk and valuation, the 2009 US cost-sharing regulations and the 2017 codification in US Internal Revenue Code (IRC) section 482 of the aggregated valuation principle, based on the best realistic alternatives of the controlled parties. The well-established residual profit split method, pursuant to which residual profits are allocated according to the relative values of the unique value chain contributions, is also a prominent example of an inherently substance-based pricing approach. Applications of the comparable profits method and transactional net margin method (TNMM) may also be in accordance with the realistic options available, provided that the tested party is a genuine routine input provider (i.e. not in possession of unique IP). Periodic adjustments and taxpayer-initiated compensating adjustments ensure that transfer pricing outcomes in each income period are reflective 767

Chapter 26 - Concluding Remarks

of the relative values of the controlled value chain inputs. The emphasis on economic substance in transfer pricing, in the author’s view, is not merely appropriate, but it may also be entirely necessary if the existing paradigm founded on the separate entity approach and arm’s length pricing is to prevail. Future revisions of the US and OECD transfer pricing rules should, in the author’s view, take into consideration three aspects in particular. First, in order to qualify as arm’s length, all profit allocations should, in the author’s view, be aligned with the realistic alternatives of the controlled parties. Thus, it should be considered whether it would be appropriate to further emphasize this in the form of a formal requirement to always crosscheck the results of the transfer pricing methods against the allocation that follows from the realistic alternatives of the controlled parties. The 2017 US codification in IRC section 482 of the realistic-alternatives pricing principle will ensure that the United States takes this route. Second, there should be stricter control with respect to whether the most appropriate transfer pricing method has been chosen. In particular, it should be a requirement that the taxpayer provides a convincing justification for its application of one-sided methods to remunerate local (purported) routine input providers, typically contract manufacturers and distribution subsidiaries. It is crucial that the application of these methods is founded on a thorough functional analysis that, beyond doubt, clarifies that the tested party is not in possession of any unique value chain inputs (goodwill, know-how, etc.). Third, there should be increased focus on the delineation of the sources of residual profits. The 2017 OECD TPG on local market characteristics is a big step in the right direction, but there is, in the author’s opinion, considerable room for improvement with respect to the delineation of the sources of marketing profits, as he will elaborate on in section 26.5.

26.3. Remuneration of IP development funding Intra-group development of manufacturing IP has historically presented multinationals with rich opportunities to shift profits out of high-tax research and development (R&D) jurisdictions through cost-sharing arrangements (CSAs) and contract R&D arrangements. Both the United States and the OECD have recently expensed considerable resources to address 768



Remuneration of IP development funding

this problem. The US approach is geared towards CSAs and buy-in pricing, while the OECD focuses on the performance of concurrent important R&D functions. Both regimes allocate residual profits to the jurisdiction by which the unique development inputs are contributed. In the author’s view, however, there is good reason to question the role that IP development financing plays in both regimes. The remuneration of ongoing R&D contributions under the US regulations is focused on the relationship between risk and reward, and the message is that residual profits should follow financial risk.2325 The logic behind this approach is alluring, as it reflects the economic axiom that higher returns should follow higher risks. In the world of transfer pricing, however, it is comprehensively ill-suited, as it will extract the residual profits from the R&D jurisdiction and move them to the funding jurisdiction. For instance, if a US R&D entity contributes ongoing research services to a foreign funding entity for a concurrent cost-plus fee, the subsequent residual profits may be allocated to the foreign owner alone. This means that a multinational can choose to which jurisdiction it wants to allocate the residual profits. If it wants to allocate them to the United States, it will simply not reimburse the concurrent development costs of the local entity. This stands in contrast to the US approach for CSA buy-ins, which allocates the residual profits to the group entity that contributes the unique pre-existing IP and other unique development contributions (R&D team in place, know-how, etc.).2326 No profits are allocated to funding contributions. The result is an allocation aligned with value creation and the material content of the transfer pricing rules. The lack of funding remuneration, however, ignores the requirement of the arm’s length principle that all development contributions should receive compensation. The author cannot see a convincing rationale as to why there should be such differing allocation principles depending on whether the contribution is a stand-alone R&D service (typically rendered through a contract R&D arrangement) or pre-existing IP contributed to a CSA in which it will serve 2325. See the discussion in sec. 21.3.6. The US position is, in reality, akin to that of the 2009 OECD business restructuring guidance, pursuant to which the residual profits could be extracted from the research and development (R&D) jurisdiction, as long as the foreign funding entity assumed the financial risk, typically by remunerating the R&D entity on a cost-plus basis; see the discussion in sec. 22.3.3.2. 2326. This result is ensured through the application of the US cost-sharing arrangement (CSA) income or profit split methods; see the analysis in secs. 14.2.8.3. and 14.2.8.6., respectively.

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as the basis for ongoing R&D. Both types of contributions are non-routine and drive intangible value.2327 Comparatively, the important-functions doctrine of the OECD applies regardless of how the IP development is organized and funded, and is therefore more coherent and neutral than the US approach.2328 While the doctrine strives to align profit allocation with value creation and the principles of the transfer pricing methods, the treatment of IP development financing provides significant room for profit shifting and dilutes the realization of its purpose.2329 The allocation of profits to IP development funding under the US and OECD rules can be summarized in table 26.1.2330, 2331 Table 26.1 United States

OECD

“Plain” contract R&D arrangements

Risk/reward approach: Funding entity is allocated the residual profits

Important-functions doctrine: Funding entity is allocated a risk-adjusted rate of return2330

CSAs

CSA buy-in pricing methods: Funding is not allocated a return

Important-functions doctrine: Funding entity is allocated a risk-adjusted rate of return2331

2327. The new CSA regulations, and in particular, the income method, represent a significant hurdle for multinationals that seek to shift intangible profits out of the United States by way of CSAs. This may increase the attractiveness of contract R&D structures in cases in which CSA structures previously would have been adapted. The author doubts that this strategy will be effective; not all contract R&D arrangements pertain to “start-from-scratch”, blue-sky R&D efforts. There will likely often be pre-existing intangible property (IP) (R&D results, know-how, etc.) that are contributed by the R&D entity. If so, they must be priced at arm’s length by applying an aggregated valuation approach based on the best realistic alternatives of the controlled parties; see US Internal Revenue Code (IRC) sec. 482, last sentence. 2328. Nevertheless, the OECD CSA rules lack the refinement of the US cost-sharing regulations. No detailed guidance is provided on the buy-in of pre-existing intangibles, making it difficult to price them in a uniform manner under the OECD regime, likely resulting in diverging and equally justifiable valuations, and possibly double taxation. 2329. See the analysis in sec. 22.4.11. 2330. Provided that the funding entity is deemed to be in control of the financial risk, otherwise it will only be allocated a risk-free return on its funding contribution. 2331. Id.

770



Allocation of profits for foreign-owned marketing IP

It can be observed that a considerable amount of profits are “leaked” to funding contributions under both regimes. The transfer pricing reality is that these profits represent extracted residual profits. It is necessary to restrict funding remuneration to a level that ensures that IP profits are allocated pursuant to value creation. Neither the US nor the OECD solutions are, in the author’s view, balanced. The “all or nothing” approach of the United States, depending on whether the development is carried out through a contract R&D arrangement or a CSA, seems inappropriate. The author fails to see a sensible justification for allowing the allocation of residual profits to funding contributions in the contract R&D scenario and denying funding remuneration in the CSA scenario. This is too much and too little, respectively.2332 A more principled approach would be to allow funding remuneration in both scenarios, but to cap it at a pre-determined rate of return. This would considerably decrease the profits allocable for funding in the contract R&D scenario, and would increase them in the CSA scenario. While the OECD approach is principled, the author’s view is that the prescribed risk-adjusted return may easily become too large, and therefore represents a threat to the ambitions of the important-functions doctrine and also should be capped at some predetermined level, akin to a thin capitalization rule.2333 This would be a realistic and effective way of balancing the need to address profit shifting with the need to respect the arm’s length principle by remunerating all IP development contributions while aligning the allocation of IP profits with value creation.

26.4. Allocation of profits for foreign-owned marketing IP The point of departure under both the US and OECD regimes is that the residual profits from the local exploitation of a foreign-owned marketing IP can be extracted from the source and allocated to the foreign group entity holding IP ownership (which is often located in a low-tax jurisdiction). Further, both regimes are open for exceptions to this point of departure in narrow circumstances, depending on the level of marketing expenses in2332. The residual profits should be allocated to the R&D jurisdiction where it was created in the first scenario, and funding remuneration should not be completely cut off in the second scenario, as funding is a genuine development contribution that must be remunerated at arm’s length. 2333. See sec. 22.4.11.

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Chapter 26 - Concluding Remarks

curred by the local subsidiary. Essentially, if the expenses are high enough, there will be a risk that the source state can claim that the local entity should be deemed owner of the local value of the marketing intangible. This represents a “safe bet” for multinationals. As long as the local distribution subsidiary either incurs no (reimbursed) or only an arm’s length level of marketing expenses, there will be no risk for the multinational that the residual marketing profits cannot be extracted from the source. These rules have been left relatively unchanged over the last decades. It is ironic that the OECD, in its comprehensive 2015 BEPS revision of the Transfer Pricing Guidelines (OECD TPG) on intangibles, left the principles in the 1995 OECD TPG for the allocation of residual profits from internally developed marketing IP largely untouched. Both the US and OECD approaches are, in essence, risk/reward-based. The logic is that an unrelated distribution entity would not have agreed to incur incremental marketing costs without a promise of a stake in the potential residual profits. Again, this economic axiom does not fit well in the context of transfer pricing, simply because a multinational is free to place its funding in any jurisdiction, and can therefore easily extract residual profits if the allocation hinges on funding alone. The most problematic aspect of the current rules is that the allocation of marketing profits likely will not align with value creation. The author finds it fairly obvious that the local value of a global trademark is developed in the market jurisdiction. That is, in the author’s view, a forceful argument for allocating at least some of the residual marketing profits there. The author questions the usefulness of the current US and OECD approaches. As they stand, it will be fully possible in the lion’s share of cases for a multinational to develop the local value of its global trademark inside a market jurisdiction and fully exclude the subsequent profits from the local exploitation of the intangible from taxation at source.2334 A better solution would, in the author’s opinion, be to apply a profit split between the ownership jurisdiction and the market jurisdiction. This would cater to both the fact that marketing value is cost-driven and that IP value creation takes place in the market jurisdiction.2335 2334. It is mainly just in the presumably narrow circumstances in which incremental marketing expenditures have been incurred locally that the profits cannot be extracted from the source state. 2335. To this, it could be objected that a profit split should not be applied if comparable uncontrolled transactions (CUTs) can be identified in which third-party distributors

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Is the OECD arm’s length standard heading towards formulary ­apportionment?

26.5. The identification of local marketing IP Residual marketing profits are, in practice, typically presumed to be generated solely by foreign-owned marketing IP. This assumption may often be unreasonable. A local distribution subsidiary is present in the market and develops relationships with its suppliers and customers and expertise through its local sales. This may give rise to the development of local unique marketing IP (e.g. goodwill and know-how) distinct from the local value of a foreign-owned trademark. As they stand, the US and OECD rules seem underdeveloped with respect to the allocation of profits from marketing IP. There should be a much stronger focus on the identification and delineation of local marketing IP. Both the US and OECD rules should be revised to better reflect where intangible marketing value is created.2336 This issue is of great importance, as it has the potential to influence global transfer pricing practices profoundly. The reason is that if local marketing IP is identified, the widespread practice of remunerating local distribution entities under the one-sided methods (in practice, the TNMM) with a normal market return for routine contributions should no longer be accept­ able.2337

26.6. Is the OECD arm’s length standard heading towards formulary apportionment? As discussed in chapter 9, the profit split method has gained increased status as a methodology for allocating operating profits among group entities, in particular within the OECD regime, both through an expansion of its

incur a similar level of marketing expenses without being allocated any residual profits, typically based on the transactional net margin method (TNMM). If such CUTs are available, the author would agree that there is no justification for allocating a portion of the residual profits to the market jurisdiction. He suspects, however, that it will be rare to find genuine CUTs in these cases. 2336. While the identification of local unique marketing intangibles is an ownership issue, the division of the total residual marketing profits among these and the foreignowned trademark is, in principle, a transfer pricing issue. The split should follow the principles developed under the profit split method, which distributes the profits according to the relative values of the unique contributions. The identification of local marketing IP must be kept separate from local market characteristics, as incremental profits from the latter shall not be allocated fully to the market jurisdiction (see the analysis in ch. 10), as opposed to residual profits due to the former. 2337. The method should not be used when the tested party is in possession of unique value chain contributions; see sec. 8.3.

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scope of application as well as by way of incorporation of the methodology’s core material content into the OECD IP ownership provisions. A relevant question is whether this can lead to more evenly distributed operating profits among jurisdictions, avoiding the typical BEPS-driven “centralized principal model” structures that result in the extraction of residual profits from source states (and the injection of those profits into low-tax IP holding companies) and thereby enabling “smoother” profit allocations, akin to those that would result from formulary apportionment. If the expanded OECD profit split method is applied to remunerate a group entity that renders relatively “routine” value chain contributions, the entity could possibly receive more profits than what would have been the case had it been remunerated under a one-sided method in the traditional way (e.g. TNMM-based). More returns to local “routine” entities equals less extraction of residual profits from source states, and thus less residual profits for centralized IP holding companies in low-tax jurisdictions. This, however, will not entail that the arm’s length principle is moving towards formulary apportionment, but only that the amount of residual profits allocable for unique IP value chain contributions can possibly become reduced. A core feature of the arm’s length principle, operationalized through the IP ownership provisions, is that the residual profits from IP value chains shall be allocated according to intangible value creation, i.e. to the group entity that is deemed to own the unique and valuable IP employed in the value chain. Thus, even if the newly expanded OECD profit split method may result in a lesser amount of residual profits, the IP ownership provisions of the 2017 OECD TPG will nevertheless ensure that these residual profits are distributed only to jurisdictions in which intangible value creation took place.2338 This allocation result is the opposite of “smooth” international profit allocation. Formulary apportionment would, in contrast, spread the amount of residual profits across all jurisdictions in which the multinational does business, as pre-determined allocation formulas would determine the split.2339 This 2338. The same result is generally attained under US law, with respect to outbound transactions, through the income method for CSAs and the application of the aggregated valuation principle based on the realistic alternatives of the controlled parties. 2339. A parallel can be drawn here to Schön’s observation on the treatment of individual group members’ risk profiles under formulary apportionment. See Schön (2014), at p. 15, where it is stated that “any “formulary” approach to the taxation of multinational enterprises would indeed disregard the different risk profiles of the involved members

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would, in an economic sense, overcompensate most jurisdictions, as they would be allocated more operating profits than the routine value chain inputs provided by group entities resident in them were worth. The few jurisdictions in which IP value was created would then be undercompensated by not being allocated the entire residual profits. Thus, the key difference between profit allocation based on the arm’s length principle and formulary apportionment really lies in how residual profits are allocated among jurisdictions under the two systems.2340 The arm’s length standard, by way of the OECD IP ownership provisions, gives taxing rights to residual profits only to the few jurisdictions in which IP value creation took place, while a formulary apportionment system would give taxing rights to all jurisdictions in which the multinational does business. The OECD, in the latest BEPS revision of the OECD TPG, has further developed and strengthened its IP ownership provisions, precisely to ensure that residual profits are allocated according to intangible value creation (i.e. only to jurisdictions that had a role in IP development). Thus, there are no signs indicating that the arm’s length principle is heading towards formulary apportionment. Even if the material content of the 2017 revised OECD IP ownership provisions now draw more on the profit split methodology, the residual profits are still just split between the few jurisdictions that were involved in IP development efforts (R&D, funding, etc.). The only way in which the OECD arm’s length principle truly could move towards a formulary apportionment system would be if the IP ownership provisions were removed, thereby eliminating the requirement that residual profits shall be allocated to the group entity that is deemed to own the unique and valuable IP.2341 To do so, however, would remove the heart of the arm’s length principle. The result would be a formulary apportionment system that would contradict economic reasoning, because it would of the group”, and further, that “formulary apportionment would basically level out the individual risk profiles of the involved taxpayers and activities”. See also de lege ferenda views in Hafkenscheid (2017), at p. 24, where it is argued that art. 9 of the OECD MTC should be amended so that all group entities are seen as having the same risk profiles (in order to ensure that profits cannot be shifted within the multinational enterprise by way of contractual risk transfers). 2340. For de lege ferenda viewpoints on how taxing rights over residual profits can be allocated in a new tax order, see Schön (2010a), at p. 260, where he discusses the possible allocation of such profits among four categories of jurisdictions: (i) where the R&D is performed; (ii) where the (legal) owner of the IP is resident; (iii) where manufacturing takes place; and (iv) where marketing and sales take place. 2341. See Brauner (2010), at p. 18, where it is recognized (in the context of US cost sharing) that the allocation of residual profits based on the notion of IP ownership has played a key role in tax-planning structures.

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be based on the underlying assumption that all value chain inputs – both routine and non-routine – are worth the same. The system would be unable to emulate the profit allocation results of transactions among third-party enterprises with genuinely conflicting interests, the hallmark of which is that competition will drive the prices for routine value chain contributions down to a level at which the providers only reap a normal market return. Whether such an alternative system would provide more equitable international profit allocation results is, in the end, a political question. It does, however, seem clear that such an alternative formulary apportionment system would fail to realize a key purpose of the current, arm’s length-based international standard for profit allocation: to provide parity in the tax treatment of unrelated and related parties.

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Wittendorff, Jens, “Valuation of intangibles under incomebased methods – Part II”, 17 International Transfer Pricing Journal 6 (2010), p. 383.

Wittendorff (2010d)

Wittendorff, Jens, “International skatteret” 2010, S R – Skat. (2010).

Wittendorff (2012a)

Wittendorff, Jens, “U.N. Transfer Pricing Manual – The Choice Between International Consistency and Conflict”, 68 Tax Notes Int’l (2012), p. 569.

Wittendorff (2012b)

Wittendorff, Jens, “Darkness Descends on Danish Tax Law: Supreme Court Decision in Swiss Re”, 19 International Trans­ fer Pricing Journal 3 (2012), p. 217.

Wittendorff (2012c)

Wittendorff, Jens, “Transfer Pricing Timing Issues Revisited”, 68 Tax Notes Int’l (2012), p. 87.

Wittendorff (2012d)

Wittendorff, Jens, “‘Shadowlands’: The OECD on Intangibles”, 67 Tax Notes Int’l (2012), p. 935.

Wittendorff (2012e)

Wittendorff, Jens, “Triangular Cases: The Interaction Between Transfer Pricing and PEs”, 66 Tax Notes Int’l (2012), p. 545.

Wittendorff (2013)

Wittendorff, Jens, “Aggregation of Transactions in Transfer Pricing: Glaxo and Other Cases”, 69 Tax Notes Int’l (2013), p. 183.

Wittendorff (2016)

Wittendorff, Jens, “BEPS Actions 8-10: Birth of a New Arm’s-Length Principle”, 81 Tax Notes Int’l (2016), p. 331.

Wolosoff et al. (2004)

Wolosoff, Todd; Ryan, James; Eisenhauer, Susan, “The proposed Section 482 Regs: A path to confusion, uncertainty, and endless controversy”, 34 Tax Notes Int’l (2004), p. 625.

Wu (2005)

Wu, Tim, “Intellectual Property, Innovation, and Decentralized Decisions”, 92 Virginia Law Review 1 (2005), p. 101.

Yamakawa (2007) Yamakawa, Hiroki, “A Practical Analysis of Transfer Pricing Methodologies for Bilateral Advance Pricing Arrangements” (2007), Part 250, available at https://core.ac.uk/download/ pdf/27288414.pdf. Yoost (1996)

Yoost, Dean A., “Dealing with Japan’s tax administration”, 13 Tax Notes Int’l (1996), p. 1837.

Zammit (2015)

Zammit, Ivan, “Centralized Intellectual Property Business Models – Tax Implications of EU Patent Box Regimes”, 69 Bulletin for International Taxation 9 (2015), p. 540.

808

References

Zollo (2010)

Zollo, Thomas M., “Clarification or Modification? The Tax Treatment of the Outbound Transfer of Goodwill, Going Concern Value, and Workforce in Place to a Foreign Corporation”, 39 Tax Mgmt. Int’l J. 2 (2010).

Zollo (2011)

Zollo, Thomas M., US Chapter in “Cross-border business restructuring”, Cahiers de droit fiscal international, Vol. 96a (2011), p. 757.

Zuurbier (2016)

Zuurbier, Niels, “Transfer Pricing in a Post-BEPS World – Transfer Pricing Aspects of Intangibles” (2016), available at http://arno.uvt.nl/show.cgi?fid=141892.

Case law Australia Roche Products Pty Ltd v. FCT (2008) AATA 639; 2008 ATC 10-036.

Canada GlaxoSmithKline Inc. v. R., 2008 TCC 324 (T.C.C., 2008), reversed by 2010 CAF 201 (F.C.A., 2010), application/notice of appeal filed in 2010 CarswellNat 4089 (S.C.C., 2010), and leave to appeal allowed by 2011 CarswellNat 682 (S.C.C., 2011), and affirmed by 2012 SCC 52 (S.C.C., 2012). GSW Appliances Ltd. v. R., 1985 CarswellNat 346 (T.C.C., 1985). Koffler Stores Ltd. v. R., 1975 CarswellNat 336 (Fed. T.D., 1975), affirmed by 1976 CarswellNat 200 (Fed. C.A., 1976). McClurg v. R., 1984 CarswellNat 369 (T.C.C., 1984), reversed by 1986 CarswellNat 244 (Fed. T.D., 1986), affirmed by 1987 CarswellNat 556 (Fed. C.A., 1987), leave to appeal allowed by 1988WL876606 (S.C.C., 1988), and affirmed by 1990 CarswellNat 520 (S.C.C., 1990). Shell Canada Ltd. v. R., 1997 CarswellNat 401 (T.C.C., 1997), reversed by 1998 CarswellNat 170 (Fed. C.A., 1998), leave to appeal allowed by 1998WL1727462 (S.C.C., 1998), and leave to appeal allowed by 1999WL33183768 (S.C.C., 1999), and reversed by 1999 CarswellNat 951 (S.C.C., 1999), additional reasons in 1999 CarswellNat 1808 (S.C.C., 1999).

809

References

Singleton v. R., 1996 CarswellNat 1816 (T.C.C., 1996), reversed by 1999 CarswellNat 1009 (Fed. C.A., 1999), leave to appeal allowed by 2000 CarswellNat 653 (S.C.C., 2000), and affirmed by 2001 SCC 61 (S.C.C., 2001). Alberta Printed Circuits Ltd. v. The Queen (2011 TCC 232).

Denmark H1 A/S v. Skatteministeriet, SKM2010.455.VLR (Vestre Landsret, 2010). H1.1.1 A/S v. Skatteministeriet, SKM2012.92.HR (Supreme Court of Denmark, 2012). See also lower court rulings in SKM2010.134.ØLR (Østre Landsret, 2010), and SKM2008.975.LSR (Landsskatteretten, 2008).

France Société Zimmer Limited v. Ministre de l’Économie, des Finances et de l’Industrie, Nos. 304715 and 308525 (Supreme Administrative Court, 2010); reversing No. 052361 (Administrative Court of Appeals of Paris, 2007).

India Ahmed Bhain Umar Bhai & Co. v. CIT, 18 ITR 472 (Supreme Court of India, 1950). Amadeus Global Travel Distribution v. CIT, 113 TTJ Delhi 767 (Income Tax Appellate Tribunal – Delhi, 2007). Amadeus India Pvt Ltd v. CIT, ITA 938/2011 (Delhi High Court, 2011). Annamalais Timber Trust And Co. v. CIT, 1961 41 ITR 781 Mad (Madras High Court, 1960). Aztec Software & Technology Services Limited v. CIT, 2007 107 ITD 141 Bang (Income Tax Appellate Tribunal – Bangalore, 2007). Global Vantedge Pvt. Ltd. v. CIT, ITA Nos.116 & 323/Del/2011 (Income Tax Appellate Tribunal – Delhi, 2010). Intel Asia Electronics Inc. v. Asst Director Of Income Tax, ITA No. 131/Bang/2010 (Income Tax Appellate Tribunal – Bangalore, 2009).

810

References

M/S. Carborandum Co v. CIT, 1977 AIR 1259 (Supreme Court of India, 1977). Maruti Suzuki India Ltd v. CIT, W.P.(C) 6876/2008 (Delhi High Court, 2010). Rolls Royce Plc v. Dy. Director Of Income-Tax, (2008) 113 TTJ Delhi 446 (Income Tax Appellate Tribunal – Delhi, 2007). Sony India (P.) Ltd. v. CBDT, (2006) 206 CTR Del 157 (Delhi High Court, 2006). Symantec Software Solutions Pvt Ltd v. CIT, ITA No. 7894 (Income Tax Appellate Tribunal – Mumbai, 2010). UCB India (P) Ltd. v. CIT, 30 SOT 95 (Income Tax Appellate Tribunal – Mumbai, 2009).

Italy Ministry of Finance (Tax Office) v. Boston Scientific, Case No. 3769 (Supreme Court of Italy, 2012). Ministry of Finance (Tax Office) v. ITCO, Case No. 11949 (Supreme Court of Italy, 2012). Ministry of Finance (Tax Office) v. Philip Morris (GmbH), Case No. 7682/05 (Supreme Court of Italy, 2002).

Norway Dell Products v. the State, Utv. 2012 s. 1 (Norwegian Supreme Court, 2011), reversing Utv. 2011 p. 807 (Borgarting Appellant Court, 2011). Norsk Agip AS v. the State, Rt. 2001 p. 1265 (Norwegian Supreme Court, 2001). Norske Conocophillips AS and ConocoPhillips Skandinavia AS vs. the State, Utv. 2008 p. 889 (Oslo City Court, 2008). Tore Rynning-Nielsen, Sverre Morten Blix, Gert Wilhelm Munthe and Herkules Capital I AS v. the State, Rt. 2015 p. 1260 (Norwegian Supreme Court, 2015). Vingcard Elsafe AS v. the State, Utv. 2012 s. 1191, (Borgarting Appellant Court, 2012), reversing in part Utv. 2010 p. 1690 (Oslo City Court, 2010).

811

References

Spain Roche Vitamins Europe Ltd. v. Administración General del Estado, Case No. STS/202/2012 (Supreme Court of Spain, 2012).

United States Introduction The categorization of US case law is based on which first-tier court assessed the case. The author has included references to subsequent appeal rulings. Using this system, the author avoids “double counting” in the sense that the first and second-tier court assessments of the same case are not listed twice (once under the first-tier court and once under the second-tier court). The author has only listed a few “outlier” cases separately under the US Appellant Court (e.g. a case brought directly from the US Board of Tax Appeals to the Appellant Court). The author has also included references to the court documents referred to in the book pertaining to the settled case GlaxoSmithKline Holdings (Americas), Inc. v. CIR, 117 TC 1.

US Tax Court Altama Delta Corp. v. CIR, 104 T.C. 424 (Tax Ct., 1995). Amazon.com Inc. v. CIR, Tax Court Docket No. 31197-12. Bausch & Lomb Inc. v. CIR, 92 T.C. No. 33 (Tax Ct., 1989), affirmed by 933 F.2d 1084 (2nd Cir., 1991). Bergersen v. CIR, T.C. Memo. 1995-424 (Tax Ct., 1995), affirmed by 109 F.3d 56 (1st Cir., 1997). Black Industries v. CIR, 38 T.C.M. 242 (Tax Ct., 1979). BMC Software Inc. v. CIR, 141 T.C. No. 5 (Tax Ct., 2013), reversed by 780 F.3d 669 (5th Cir., 2015). Boe v. CIR, 35 T.C. 720 (Tax Ct., 1961), affirmed by 307 F.2d 339 (9th Cir., 1962).

812

References

Boston Scientific Corporation & Subsidiaries v. CIR, Tax Court Docket No. 26876-11. Cardiac Pacemakers, Inc. v. CIR, Tax Court Docket No. 5990-11. Charles Schwab Corp. v. CIR, 122 T.C. No. 10 (Tax Ct., 2004), supplemented, clarified and superseded in part by 123 T.C. No. 18 (Tax Ct., 2004), affirmed by 495 F.3d 1115 (9th Cir., 2007). Ciba-Geigy Corp. v. CIR, 85 T.C. No. 11 (Tax Ct., 1985), acquiescence recommended by AOD-1987-21 (IRS AOD, 1987), and acquiescence 1987 WL 857882 (IRS ACQ, 1987). Citizens and Southern Corp. v. CIR, 91 T.C. No. 35 (Tax Ct., 1988), affirmed by 900 F.2d 266 (11th Cir., 1990), published in full at 919 F.2d 1492 (11th Cir., 1990). Coca-Cola Co. and Includible Subsidiaries v. CIR, 106 T.C. 1 (Tax Ct., 1996). Computing & Software, Inc. v. CIR, 64 T.C. 223 (Tax Ct., 1975), acquiescence 1976 WL 175506 (IRS ACQ, 1976). DHL Corp. & Subsidiaries v. CIR, T.C. Memo. 1998-461 (Tax Ct., 1998), affirmed in part, reversed in part by 285 F.3d 1210 (9th Cir., 2002). Differential Steel Car Co. v. CIR, 16 T.C. 41388 (Tax Ct., 1951). Dittler Brothers, Inc. v. CIR, 72 T.C. 896 (Tax Ct., 1979), affirmed by 642 F.2d 1211 (5th Cir.(Ga.), 1981). Eaton Corporation and Subsidiaries v. CIR, Tax Court Docket No. 5576-12. Edwards v. CIR, 67 T.C. 224 (Tax Ct., 1976), acquiescence recommended by AOD-1977-155 (IRS AOD, 1977), and acquiescence, 1977 WL 185611 (IRS ACQ, 1977), and acquiescence, 1977 WL 185630 (IRS ACQ, 1977). Electronic Arts, Inc. v. CIR, 118 T.C. 226 (Tax Ct., 2002). Eli Lilly and Company and Subsidiaries v. CIR, 84 T.C. No. 65 (Tax Ct., 1985), affirmed in part, reversed in part by 856 F.2d 855 (7th Cir., 1988). Essex Broadcasters, Inc. v. CIR, 2 T.C. 523 (Tax Ct., 1943). Exxon Corp. v. CIR, T.C. Memo. 1993-616 (Tax Ct., 1993), affirmed by 98 F.3d 825 (5th Cir., 1996), certiorari denied by 520 U.S. 1185 (S.Ct., 1997). First Data Corp. v. CIR, Tax Court Docket No. 007042-09, case settled. 813

References

G.D. Searle & Co. v. CIR, 88 T.C. 252 (Tax Ct., 1987). GlaxoSmithKline Holdings (Americas), Inc. v. CIR, 117 TC 1 (Tax Ct., Docket No. 5750-04, 2004), settled 2006. Granberg Equipment, Inc. v. CIR, 11 T.C. 70479 (Tax Ct., 1948). Guidant LLC v. CIR, Tax Court Docket No. 5989-11. Hospital Corporation of America v. CIR, 81 T.C. No. 31 (Tax Ct., 1983), nonacquiescence recommended by AOD-1987-22 (IRS AOD, 1987), and nonacquiescence 1987 WL 857897 (IRS ACQ, 1987). InverWorld, Inc. v. CIR, T.C. Memo. 1996-301 (Tax Ct., 1996). Ithaca Industries, Inc. v. CIR, 97 T.C. No. 16 (Tax Ct., 1991), affirmed by 17 F.3d 684 (4th Cir., 1994), certiorari denied by 513 U.S. 821 (S.Ct.,1994). Kraft Foods Company v. CIR, 21 TC 513 (Tax Ct., 1954). Lufkin Foundry and Mach. Co. v. CIR, T.C. Memo. 1971-101 (Tax Ct., 1971), reversed by 468 F.2d 805 (5th Cir., 1972), and acquiescence in part and nonacquiescence in part recommended by 1974 WL 36323 (IRS AOD, 1974). Massey-Ferguson, Inc. v. CIR, 59 T.C. 220 (Tax Ct., 1972), acquiescence, 1973 WL 157476 (IRS ACQ, 1973). Medchem (P.R.), Inc. v. CIR, 116 T.C. 308 (Tax Ct., 2001), affirmed by 295 F.3d 118 (1st Cir., 2002). Medtronic, Inc. & Consolidated Subsidiaries v. CIR, (Tax Court Docket No. 694411). Microsoft Corp. v. CIR, T.C. Memo. 1998-54 (Tax Ct., 1998). National Securities Corp. v. CIR, 46 B.T.A. 562 (B.T.A., 1942), affirmed by 137 F.2d 600 (C.C.A.3, 1943), certiorari denied by 320 U.S. 794 (S.Ct., 1943). Nestlé Co., Inc. v. CIR, T.C. Memo. 1963-14 (Tax Ct., 1963). Nissho Iwai American Corp. v. CIR, T.C. Memo. 1985-578 (Tax Ct., 1985), affirmed by 812 F.2d 712 (2nd Cir., 1987). Perkin-Elmer Corp. and Subsidiaries v. CIR, T.C. Memo. 1993-414 (Tax Ct., 1993).

814

References

Philip Morris Inc. v. CIR, 96 T.C. No. 23 (Tax Ct., 1991), affirmed by 970 F.2d 897 (2nd Cir., 1992). Polak’s Frutal Works, Inc. v. CIR, 21 T.C. 953 (Tax Ct., 1954), acquiescence, 1955 WL 45485 (IRS ACQ, 1955), and acquiescence withdrawn, nonacquiescence., 1972 WL 124383 (IRS ACQ, 1972). PPG Industries Inc. v. CIR, 55 T.C. 928 (Tax Ct., 1970). R. T. French Co. v. CIR, 60 T.C. 836 (Tax Ct., 1973), distinguished by 1977 WL 191022 (IRS TAM, 1977), and distinguished by 1979 WL 56002 (IRS TAM, 1979), and distinguished by 1992 WL 1354859 (IRS FSA, 1992). Rollman v. CIR, 25 T.C. 481 (Tax Ct., 1955), acquiescence, 1956 WL 56488 (IRS ACQ, 1956), reversed by 244 F.2d 634 (4th Cir., 1957), on remand to T.C. Memo. 1957-182 (Tax Ct., 1957). Ross Glove Co. v. CIR, 60 T.C. 569 (Tax Ct., 1973), acquiescence in part recommended by 1974 WL 36011 (IRS AOD, 1974), and acquiescence, 1974 WL 172643 (IRS ACQ, 1974). Seagate Technology, Inc. v. CIR, 102 T.C. No. 9 (Tax Ct., 1994), acquiescence in result only recommended by AOD-1995-09 (IRS AOD, 1995), and acquiescence, 1995-33 I.R.B. 4 (IRS ACQ, 1995). Seminole Flavor Co. v. CIR, 4 T.C. 1215 (Tax Ct., 1945), nonacquiescence recommended by 1972 WL 32906 (IRS AOD, 1972), and acquiescence withdrawn, nonacquiescence, 1972 WL 124385 (IRS ACQ, 1972). South Texas Rice Warehouse Co. v. CIR, 43 T.C. 540 (Tax Ct., 1965), affirmed by 366 F.2d 890 (5th Cir., 1966), certiorari denied by 386 U.S. 1016 (S.Ct., 1967). Southern Bancorporation v. CIR, 67 T.C. 1022 (Tax Ct., 1977). Sundstrand Corp. and Subsidiaries v. CIR, 96 T.C. No. 12 (Tax Ct., 1991). Taisei Fire and Marine Ins. Co., Ltd. v. CIR, 104 T.C. No. 27 (Tax Ct., 1995), acquiescence, 1995-44 I.R.B. 4 (IRS ACQ, 1995), and acquiescence recommended by AOD-1995-12 (IRS AOD, 1995). U.S. Steel Corp. v. CIR, T.C. Memo. 1977-140 (Tax Ct., 1977), reversed by 617 F.2d 942 (2nd Cir., 1980), and nonacquiescence recommended by AOD-1980-179. Veritas Software Corporation & Subsidiaries v. CIR, 133 T.C. No. 14 (U.S. Tax Ct. 2009), IRS nonacquiescence in AOD-2010-05.

815

References

VGS Corp. v. CIR, 68 T.C. 563 (Tax Ct., 1977), acquiescence recommended by AOD-1978-186 (IRS AOD, 1978), and acquiescence in 1979 WL 194041 (IRS ACQ, 1979). Xilinx Inc. and Subsidiaries v. CIR, 125 T.C. No. 4 (Tax Ct., 2005), affirmed by 598 F.3d 1191 (9th Cir., 2010), recommendation regarding acquiescence AOD2010-03 (IRS AOD, 2010), and acquiescence in result, 2010-33 I.R.B. 240 (IRS ACQ, 2010).

US Court of Claims Bell Intercontinental Corp. v. US, 1967 WL 156523 (Ct.Cl., 1967), report and recommendation Adopted by 180 Ct.Cl. 1071 (Ct.Cl., 1967). E.I. Du Pont de Nemours and Co. v. US, 1978 WL 3449 (Cl.Ct., 1978), adopted by 221 Ct.Cl. 333 (Ct.Cl., 1979), certiorari denied by 445 U.S. 962 (S.Ct., 1980), and judgment entered by 226 Ct.Cl. 720 (Ct.Cl., 1980). E.I. Du Pont de Nemours and Co. v. US, 296 F.Supp. 823, (D.Del., 1969), affirmed in part, reversed in part by 432 F.2d 1052 (3rd Cir., 1970). Eli Lilly & Co. v. US, 372 F.2d 990 (Cl.Ct, 1967). Hooker Chem. & Plastics Corp. v. US, 1978 WL 21534 (Ct.Cl. Trial Div., 1978), affirmed by 219 Ct.Cl. 161 (Ct.Cl., 1979), supplemented by 221 Ct.Cl. 988 (Ct.Cl., 1979). Keene Corp. v. US, 17 Cl.Ct. 146 (Cl.Ct., 1989), reversed by 911 F.2d 654 (Fed.Cir., 1990), modified on rehearing by 920 F.2d 916 (Fed.Cir., 1990) and opinion withdrawn on grant of rehearing by 926 F.2d 1109 (Fed.Cir., 1990), and on rehearing 962 F.2d 1013 (Fed.Cir., 1992), certiorari granted by 506 U.S. 939 (U.S., 1992) and judgment affirmed by 508 U.S. 200 (U.S., 1993). Merck & Co., Inc. v. US, 24 Cl.Ct. 73 (Cl.Ct., 1991). National Westminster Bank, PLC v. US, 58 Fed.Cl. 491, 92 A.F.T.R.2d 2003-7013, 2004-1 USTC P 50,105 (Fed.Cl. 14  November 2003) (NO. 95-758T), affirmed, National Westminster Bank, PLC v. U.S., 512 F.3d 1347, 101 A.F.T.R.2d 2008-490, 2008-1 USTC P 50,140 (Fed.Cir. 15 January 2008) (NO. 2007-5028), rehearing en banc denied (21 April 2008). Richard S. Miller & Sons, Inc. v. US, 537 F.2d 446 (Ct.cl., 1976).

816

References

US District Court Bank of America v. US, 1978 WL 1257 (N.D. Cal., 1979). Cotton Ginny, Ltd. v. Cotton Gin, Inc., 691 F.Supp. 1347 (S.D.Fla., 1988). Frank v. International Canadian Corp., 1961 WL 12345 (W.D.Wash., 1961), affirmed by 308 F.2d 520 (9th Cir., 1962). Houston Chronicle Pub. Co. v. US, 339 F.Supp. 1314 (S.D.Tex., 1972), affirmed by 481 F.2d 1240 (5th Cir., 1973), certiorari denied by 414 U.S. 1129 (S.Ct., 1974). Massey Motors, Inc. v. US, 156 F.Supp. 516 (S.D.Fla., 1957), reversed by 264 F.2d 552 (5th Cir., 1959), and affirmed by 364 U.S. 92 (S.Ct., 1960). Metropolitan Nat. Bank v. St. Louis Dispatch Co., 36 F. 722 (C.C.E.D.Mo., 1888), affirmed by 149 U.S. 436 (S.Ct., 1893). Newark Morning Ledger Co. v. US, 734 F.Supp. 176 (D.N.J., 1990), reversed by 945 F.2d 555 (3rd Cir., 1991), reversed by 507 U.S. 546 (S.Ct., 1993). Northwestern Nat. Bank of Minneapolis v. US, 1976 WL 1016 (D.Minn. 1976), affirmed by 556 F.2d 889 (8th Cir.[Minn.], 1977). Stanfield v. Osborne Industries, Inc., 839 F.Supp. 1499 (D.Kan., 1993), order affirmed by 52 F.3d 867 (10th Cir., 1995), certiorari denied by 516 U.S. 920 (S.Ct., 1995). Toyota Motor Corp. v. US, 561 F.Supp. 354 (C.D.Cal., 1983). United States of America v. Microsoft Corporation, W.D. Wash., Docket No. 2:14-mc-00117-RSM, motion filed 18 Dec. 2014. US v. Merrill, 258 F.R.D. 302 (E.D.N.C., 2009). US v. Toyota Motor Corp., 569 F.Supp. 1158 (C.D.Cal., 1983). Waterman v. MacKenzie, 29 F. 316 (1886), affirmed by 138 U.S. 252 (Circuit Court, S.D. New York, 1891).

US Court of Customs and Patents Appeals Haymaker Sports, Inc. v. Turian, 581 F.2d 257 (C.C.P.A., 1978).

817

References

US Court of Appeal Donrey, Inc. v. US, 809 F.2d 534 (8th Cir., 1987). Northern Natural Gas Co. v. US, 470 F.2d 1107 (8th Cir., 1973), certiorari denied by 412 U.S. 939 (S.Ct., 1973). Russello v. US, 648 F.2d 367 (5th Cir.[Fla.], 1981), on reconsideration in part, 650 F.2d 651 (5th Cir.[Fla.], 1981), and on rehearing 681 F.2d 952 (5th Cir.[Fla.], 1982), and judgment affirmed by 464 U.S. 16 (S.Ct., 1983). U.S. Indus. Alcohol Co. (West Virginia) v. CIR, 42 B.T.A. 1323 (B.T.A., 1940), affirmed in part, reversed in Part by 137 F.2d 511 (C.C.A.2, 1943).

US Supreme Court Mayo Found. v. US, 562 US (2011). Chevron USA Inc. v. Natural Resources Defence Council Inc., 467 US 837.

Case documents The following documents filed with the US Tax Court are referred to in the discussions of GlaxoSmithKline Holdings (Americas), Inc. v. CIR, 117 TC 1 (Tax Ct., Docket No. 5750-04, 2004). Year

Description

Reference

2004

GlaxoSmithKline’s 7 January 2004 court documents.

Available at Tax Analysts (www. taxanalysts.com); Doc 2004-363.

2004

Press release from GlaxoSmithKline.

Available at Tax Analysts (www. taxanalysts.com); Doc 2004-363.

2004

2 April 2004 GlaxoSmithKline Tax Court petition (contained the notice of deficiency as an appendix).

Available at Tax Analysts (www. taxanalysts.com); Doc 2004-7600.

2005

GlaxoSmithKline’s 22 February 2005 memorandum in opposition to the IRS motion for partial summary judgment.

Available at Tax Analysts (www. taxanalysts.com); Doc 2005-3635.

818

References

2005

GlaxoSmithKline’s 26 January 2005 court documents.

Available at Tax Analysts (www. taxanalysts.com); Doc 2005-1656.

2006

IRS press release.

IR-2006-142

 omestic statutes, preparatory works, regulations, D administrative guidelines and decisions, etc. US Code Year

Description

Reference

1913

Tariff Act of 1913

38 Stat. 166

1917

War Revenue Act of 1917

40 Stat. 300

1918

Revenue Act of 1918

40 Stat. 1058

1921

Revenue Act of 1921

42 Stat. 260

1924

Revenue Act of 1924

43 Stat. 288

1926

Revenue Act of 1926

44 Stat. 46

1928

Revenue Act of 1928

45 Stat. 806

1933

Securities Act of 1933

48 Stat. 74

1954

Internal Revenue Code of 1954

68 Stat. 1112

1954

Industrial Incentive Act of 1954

P.R. Laws Ann. tit. 13, Sections 241-251

1963

Industrial Incentive Act of 1963

P.R. Laws Ann. tit. 13, Sections 252-252j

1976

Tax Reform Act of 1976

90 Stat. 1834

1982

Tax Equity and Fiscal Responsibility Act of 1982

96 Stat. 324

1984

Deficit Reduction Act of 1984

98 Stat. 494

1986

Tax Reform Act of 1986

100 Stat. 2085

1993

The Omnibus Budget Reconciliation Act of 1993

107 Stat. 312

1997

Taxpayer Relief Act of 1997

111 Stat. 788

2009

US Freedom of Information Act

5 U.S.C.A. § 552

2012

Regulation S–K (Standard Instructions for Filing Forms Under Securities Act of 1933) Regulation S–K

17 CFR Part 229

2017

Tax Cuts and Jobs Act, Pub. L. 115–97, title 131 Stat. 2219 I, §  14221(b)(2), 22 Dec., 2017 819

References

US Treasury Regulations The US regulations under IRC section 482 are comprehensive and have undergone several revisions. In order to make the references to this material more accessible, the author has sorted the different documents (proposed, temporary and final regulations) in chronological order with respect to each main revision of the regulations. Year

Description

Reference

1918

T.D. 2694, 20 Treas. Dec. Int. Rev. 294, 321 (1918). Regulations to War Revenue Act of 1917, Ch. 63, 40 Stat. 300 (1917).

1935

Reg, 86, Art. 45 (1935). Regulations to Section 45 of the Revenue Act of 1928. The 1968 regulations

1965

Allocation of Income and Deductions Among Taxpayers, proposed regulations (1 April 1965).

30 Fed. Reg. 4256

1966

Allocation of Income and Deductions Among Taxpayers; Determination of Sources of Income, proposed regulations (2 August 1966).

31 Fed. Reg. 10394

1968

Allocation of Income and Deductions Among Taxpayers, final regulations (16 April 1968).

33 Fed. Reg. 5848

1992

Intercompany Transfer Pricing and Cost Sharing Regulations Under Section 482, proposed regulations (30 January 1992).

1993

Intercompany Transfer Pricing Regulations Under 58 FR 5310-01 Section 482, Notice of proposed rulemaking (21 January 1993).

1993

Intercompany Transfer Pricing Regulations Under 58 FR 5263-02 Section 482, temporary regulations (21 January 1993).

1994

Intercompany Transfer Pricing Regulations Under Section 482, final regulations (8 July 1994).

The 1994 regulations 57 FR 3571-01

59 FR 34971-01

The cost-sharing regulation 1992

Intercompany Transfer Pricing and Cost-Sharing Regulations Under Section 482, proposed regulations (30 January 1992).

820

57 FR 3571-01

References

Year

Description

Reference

1995

Section 482 Cost-Sharing Regulations, final regulations (20 December 1995).

60 FR 65553-01

1996

Revision of Section 482 Cost-Sharing Regulations, final regulations (13 May 1996).

61 FR 21955-01

2003

Compensatory Stock Options Under Section 482, final regulations (26 August 2003).

68 FR 51171-02

2005

Section 482: Methods To Determine Taxable Income 70 FR 51116-01 in Connection With a Cost-Sharing Arrangement, proposed regulations (29 August 2005).

2009

Section 482: Methods To Determine Taxable Income 74 FR 340-01 in Connection With a Cost-Sharing Arrangement, temporary regulations (5 January 2009).

2011

Section 482: Methods To Determine Taxable Income 76 FR 80082-01 in Connection With a Cost-Sharing Arrangement, final regulations (22 December 2011).

2013

Use of Differential Income Stream as an Application of the Income Method and as a Consideration in Assessing the Best Method, final regulations (27 August 2013).

78 FR 52854-01

The services regulations 2003

Treatment of Services Under Section 482; Allocation of Income and Deductions From Intangibles, proposed regulations (10 September 2003).

68 FR 53448-01

2006

Treatment of Services Under Section 482; Allocation of Income and Deductions From Intangibles; Stewardship Expense, temporary regulations (4 August 2006).

71 FR 44466-01

2009

Treatment of Services Under Section 482; Allocation of Income and Deductions From Intangible Property; Stewardship Expense, final regulations (4 August 2009).

74 FR 38830-01

2015 best-method rule and valuation regulations 2015

Clarification of the Coordination of the Transfer Pricing Rules With Other Code Provisions, temporary regulations (16 September 2015).

821

80 FR 55538-01

References

Year

Description

Reference

Outbound section 367 transfers and relationship to section 482 regulations 2013

Certain Outbound Property Transfers by Domestic Corporations; Certain Stock Distributions by Domestic Corporations.

78 FR 17024-01

2015

Treatment of Certain Transfers of Property to Foreign Corporations, proposed regulations (16 September 2015).

80 FR 55568-01

2016

Treatment of Certain Transfers of Property to Foreign Corporations (final regulations).

T.D. 9803

2017

Transfers of Certain Property by U.S. Persons to Partnerships with Related Foreign Partners.

T.D. 9814

US “check the box” regulations 1996

Simplification of entity classification rules.

61 FR 66584-01

IRS documents Year

Description

1963

Guidelines for cases involving the allocation of inRev. Proc. 63-10 come and expenses between United States companies and their manufacturing affiliates in Puerto Rico.

Reference

1968

Rev. Proc. 68-23 IRS Revenue Procedure with guidelines regarding certain transactions involving foreign corporations requiring an advance ruling under Section 367 of the Internal Revenue Code of 1954.

1974

IRS revenue ruling on the depreciation of insurance expirations, customer and subscription lists, and similar assets.

Rev. Rul. 74-456

1975

Revenue procedure with respect to conditions for issuing favorable rulings pursuant to Section 375 of the Internal Revenue Code of 1954.

Rev. Proc. 75-29

1976

Revenue procedure explaining the effect of Rev. Rul. 75–561, 1975–2 C.B. 129, on transactions described in Section 3.03(1)(c) of Rev. Proc. 68–23, 1968–1 C.B. 821, 827.

Rev. Proc. 76-20

822

References

Year

Description

Reference

1977

On issuing rulings under Section 367 of the Code.

Rev. Proc. 77-17

1980

On guidelines that will be used by the IRS in considering requests for rulings under Section 367(a)(1) of the IRC.

Rev. Proc. 80-14

1991

IRS Coordinated Issue Paper on Amortization of Assembled Workforce.

91 TNT 90-35

1996

IRS issue paper on the amortization of assembled workforce.

96 TNT 49-27

2003

Ruling publishing a list of previously published rulings that have been identified as no longer determinative with respect to future transactions.

Rev. Rul. 200399

2005

IRS guidance on Section 936 termination.

Notice 2005-21

2006

Procedures for requesting competent authority assistance under tax treaties.

Rev. Proc. 200654

2007

Industry Director Directive No. 1 on Section 936 Exit Strategies.

L M S B - 0 4 - 0107-002

2007

Coordinated Issue Paper on IRC Section 482 CSA buy-in adjustments.

LMSB-04-090762

2007

IRS advice memorandum on taxpayer use of Section 482 and the commensurate with income standard.

IRS AM 2007007

2008

IRS industry directive on IRC Section 936 exit strategies.

LMSB-04-0108001

2009

IRS Generic Legal Advice Memorandum (GLAM) on lending in the US by foreign person giving rise to effectively connected income.

IRS AM 2009010

2012

Internal Revenue Bulletin containing 2011 final cost-sharing regulations (T.D. 9568).

IRB 2012-12

2012

Internal Revenue Bulletin on outbound transfers of intangibles in certain asset reorganizations.

Notice 2012-39

2015

Updates to the procedures for requesting assistance from the U.S. competent authority.

Rev. Proc. 201540

2017

U.S. Treasury Department, Second Report to the President on Identifying and Reducing Tax Regulatory Burdens, Executive Order 13789, 2 October 2017.

TNT Doc 201772131

823

References

US legislative preparatory works, reports, etc. Year

Description

1921

H.R. Rep. No. 350, 67th Cong., 1st Sess. 1 (1921), 1939-1 C.B. (Part 2) 168, 174.

Reference

1932

H.R. Rep. No. 708, 72d Cong., 2d Sess. (1932), 1939-1 (Part 2) C.B. 471.

1962

H.R. Rep. No. 87-1447 (1962).

1962-3 CB 405

1984

House Ways and Means Committee Report on the Tax Reform Act of 1984.

H.R. Rep. No. 98-432, Pt. 2 (1984)

1984

General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, H.R. 4170, 98th Congress, Public Law 98-369 (Joint Committee on Taxation).

JCS-41-84

1984

Senate Finance Committee Report on the Deficit Reduction Act of 1984.

S. Rep. 98-169, Vol. 1 (1984)

1985

H.R. Rep. No. 426, 99th Cong., 1st Sess. 424 (1985).

1985 House Report

1986

H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-638 1986 Committee (1986). Report

1988

A study of intercompany pricing under Section 482 of the Code, 5 December 1988.

Notice 88-123 (White Paper)

2009

Description Of Revenue Provisions Contained In The President’s Fiscal Year 2010 Budget Proposal Part Three: Provisions Related To The Taxation Of Cross-Border Income And Investment (The Joint Committee on Taxation).

JCS-4-09

2009

General explanations of the Administration’s Fiscal Year 2010 Revenue Proposals (US Department of the Treasury).

FY 2010 Greenbook

2010

Joint Committee on Taxation Report: Present law and background related to possible income shifting and transfer pricing, 20 July 2010.

JCX-37-10

2011

Description of revenue provisions contained in the President’s fiscal year 2012 budget proposal (Joint Committee on Taxation).

JCS-3-11 No. 11

2013

General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals (US Department of the Treasury).

FY 2014 Greenbook

2017

Description of the Chairman’s mark of the “Tax Cuts JCX-51-17 and Jobs Act”. 824

References

Norwegian Tax Act Year

Description

Abbreviation

1999

Lov om skatt av formue og inntekt (skatte­loven), LOV-1999-03-26-14.

NTA

Official international documents Model treaties for the avoidance of double taxation Year

Description

Abbreviation

2011

United Nations Model Double Taxation Convention between Developed and Developing Countries.

UN MTC

2014

OECD Model Tax Convention on Income and on Capital.

OECD MTC

OECD documents Year

Description

Abbreviation

1963

Draft Double Taxation Convention on Income and Capital, Report of the OECD Fiscal Committee (1963).

1979

Transfer Pricing and Multinational Enterprises (1979).

1979 OECD Report

1984

Transfer Pricing and Multinational Enterprises: Three Taxation Issues (1984).

1984 OECD Report

1987

Issues in International Taxation, No. 2, Thin capitalisation, Taxation of Entertainers, Artistes and Sportsmen (1987).

1987 OECD Report

1993

Attribution of Income to Permanent Establishments (1993).

1993 OECD Report

1993

Intercompany transfer pricing regulations under US Section 482 temporary and proposed regulations (1993).

825

References

Year

Description

Abbreviation

1993

Tax aspects of transfer pricing within multinational enterprises – The United States proposed regulations: A report by the committee on fiscal affairs on the proposed regulations under section 482 IRC (1993).

Task Force Report

1993

Intercompany transfer pricing regulations under US Section 482 temporary and proposed regulations (1993).

2nd Task Force Report

1994

Issues in International Taxation 5: Model Tax Convention: Attribution of Profits to Permanent Establishments (1994).

1994

Transfer pricing guidelines for multinational enter1994 OECD prises and tax administrations, Part 1: Principles and discussion draft methods, discussion draft (1994).

1995

Transfer pricing guidelines for multinational enterprises and tax administrations, Draft text of Part II (1995).

1995

OECD Transfer Pricing Guidelines for Multinational 1995 OECD Enterprises and Tax Administrations (1995). TPG

1997

Report on cost contribution arrangements, adopted by the Committee on Fiscal Affairs on 25 June 1997.

1998

Harmful Tax Competition: An emerging global issue (1998).

2001

Discussion draft on the attribution of profits to permanent establishments (2001).

2001 OECD PE Draft

2004

Discussion draft on the attribution of profits to permanent establishments – Part I: General considerations (2004).

2004 OECD PE draft

2005

OECD tax policy studies, e-commerce: Transfer pricing and business profits taxation, No. 10 (2005).

2006

Report on the Attribution of Profits to Permanent Establishments, Part I: General Considerations (2006).

2006

Report on the Attribution of Profits to Permanent Establishments, Part II: Special Considerations for Applying the Authorized Approach to Permanent Establishments (PEs) of Banks (2006).

826

1995 OECD discussion draft

References

Year

Description

Abbreviation

2006

Comparability: Public invitation to comment on a series of draft issue notes (2006).

2006 OECD comparability report

2008

Attribution of Profits to Permanent Establishments (2008).

2008 OECD Report

2008

Transfer pricing aspects of business restructurings: Discussion draft for public comment (Paris, 2008).

2008

Transactional profit methods, discussion draft for public comment (2008).

2008

The 2008 update to the OECD Model Tax Convention (2008).

2008

OECD Benchmark Definition of Foreign Direct Investment, 4th ed. (2008).

2009

Chapter 1 Proposed revision of Chapters I-III of the Transfer Pricing Guidelines (2009).

2009

Chapter 2 Proposed revision of Chapters I-III of the Transfer Pricing Guidelines, discussion draft (2009).

2010

2010 Report on the attribution of profits to permanent establishments (2010).

2010 OECD Report

2010

Model Tax Convention on Income and on Capital, condensed version (2010).

OECD Commentaries

2010

OECD Transfer Pricing Guidelines for Multinational 2010 TPG Enterprises and Tax Administrations (2010).

2011

Tackling aggressive tax planning through improved transparency and disclosure, report on disclosure initiatives (2011).

2012

Discussion draft Revision of the special considerations for intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions (2012).

2012

OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Dealing Effectively with the Challenges of Transfer Pricing (2012).

2012

Draft on timing issues relating to transfer pricing (2012).

2012 OECD timing draft

2013

Action Plan on Base Erosion and Profit Shifting (2013).

OECD BEPS Action Plan

827

2008 OECD discussion draft

2009 OECD proposed revisions

2012D

References

Year

Description

Abbreviation

2013

Revised discussion draft on transfer pricing aspects of intangibles (2013).

2013 RDD

2013

Addressing Base Erosion and Profit Shifting (2013).

2013

A step change in tax transparency, OECD Report for the G8 Summit Lough Erne (2013).

2014

Guidance on Transfer Pricing Aspects of Intangibles, OECD/G20 Base Erosion and Profit Shifting Project, Action 8: 2014 Deliverable (2014).

2014D

2014

Public discussion draft BEPS Action 10: Discussion Draft on the use of profit splits in the context of global value chains (2014).

PSMDD

2014

Public discussion draft, BEPS Actions 8, 9 and 10: Discussion draft on revisions to chapter I of the Transfer Pricing Guidelines, including risk, recharacterisation, and special measures (Paris, 2014).

2014 OECD risk draft

2015

Explanatory Paper Agreement on Modified Nexus Approach for IP Regimes 2015 (2015).

2015

Addressing the Tax Challenges of the Digital Economy, Action 1: 2015 Final Report (2015).

2015

Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, Action 4: 2015 Final Report (Paris, 2015).

2015

OECD/G20 Base Erosion and Profit Shifting Project, Action 5: Agreement on Modified Nexus Approach for IP Regimes (2015).

2015

Countering Harmful Tax Practices More Effectively, 2015 Action 5 Taking into Account Transparency and Substance, Report Action 5: 2015 Final Report (2015).

2015

Preventing the Artificial Avoidance of Permanent Establishment Status, Action 7: 2015 Final Report (2015).

2015 Action 7 Report

2015

Aligning Transfer Pricing Outcomes with Value Creation, Actions 8-10: 2015 Final Report (2015).

2015TPR

2015

Measuring and Monitoring BEPS, Action 11: 2015 Final Report (2015).

2015

Developing a Multilateral Instrument to Modify Bilateral Tax Treaties, Action 15: 2015 Final Report (2015).

828

2015 Action 4 Report

BEPS Action 15: 2015 Final Report

References

Year

Description

Abbreviation

2015

Public Discussion Draft, BEPS Action 8: Revisions to Chapter VIII of the Transfer Pricing Guidelines on Cost Contribution Arrangements (2015).

2015 OECD CSA draft

2016

Document for public review, Conforming Amendments to Chapter IX of the Transfer Pricing Guidelines (2016).

2016

Public discussion draft, BEPS Action 7, Additional Guidance on the Attribution of Profits to Permanent Establishments (2016).

2016

Public discussion draft, BEPS Actions 8-10 Revised Guidance on Profit Splits (2016).

2016

Public Discussion Draft, BEPS Action 8, Implementation Guidance on Hard-to-Value Intangibles (2017).

2016

Public discussion draft, BEPS Action 7, Additional Guidance on Attribution of Profits to Permanent Establishments (2017).

2016

Public discussion draft, BEPS Action 10, Revised Guidance on Profit Splits (2017).

2017

OECD Transfer Pricing Guidelines for Multinational 2017 OECD Enterprises and Tax Administrations (Paris, 2017). TPG

2018

Report, Additional Guidance on the Attribution of Profits to a Permanent Establishment under BEPS Action 7 (2018).

UN documents Year

Description

Abbreviation

2011

United Nations Model Double Taxation Convention between Developed and Developing Countries.

UN MTC

2013

United Nations Practical Manual on Transfer Pricing UNTPM for Developing Countries.

2015

World Investment Report 2015: Reforming International Investment Governance (United Nations Conference on Trade and Development).

2017

United Nations Practical Manual on Transfer Pricing UN PMTP 2017 for Developing Countries.

829

UNCTAD (2015)

References

EU documents Year

Description

Reference

2011

Member States’ responses to questionnaire on compensating adjustments/year-end adjustments (EU Joint Transfer Pricing Forum).

JTPF/019/ REV1/2011/EN

2013

Report on Compensating Adjustments (EU Joint Transfer Pricing Forum).

JTPF/009/FINAL/2013/EN

2014

Communication from the Commission to the European Parliament, the Council and the European Economic and Social Committee on the Work of the EU Joint Transfer Pricing Forum in the Period July 2012 to January 2014 (European Commission).

COM(2014) 315 Final

2015

Communication from the Commission to the European Parliament, the Council and the European Economic and Social Committee on the Work of the EU Joint Transfer Pricing Forum in the Period July 2012 to January 2014 – Council Conclusions (Council of the European Union).

7249/15

2016

European Commission Study on the Application of Economic Valuation Techniques for Determining Transfer Prices of Cross Border Transactions between Members of Multinational Enterprise Groups in the EU

Treaties and conventions Treaties for the avoidance of double taxation Year

Description

Abbreviation

1966

Convention between the Swiss Confederation and Spain for the Avoidance of Double Taxation with Respect to Taxes on Income and Fortune, entered into 26 April 1966. (In force. Amended by subsequent protocols.)

SpainSwitzerland treaty (1966)

830

References

Year

Description

Abbreviation

1968

1968 FranceConvention between the Government of the United Kingdom of Great Britain and Northern Ireland and United Kingdom France for the Avoidance of Double Taxation and the treaty Prevention of Fiscal Evasion with Respect to Taxes on Income, entered into 22 May 1968. (Not in force. Current France-United Kingdom treaty was entered into in 2008.)

1971

Convention between the Government of the Repub- 1971 Japanlic of Singapore and the Government of Japan for the Singapore treaty Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, entered into 29 January 1971. (Not in force. Current Japan-Singapore treaty was entered into in 1994, and amended by subsequent protocols.)

1975

United Convention between the Government of the United States of America and the Government of the United Kingdom-United States treaty Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, entered into 31 December 1975. (Not in force. Current United Kingdom-United States treaty was entered into in 2001, and amended by subsequent protocols.)

1978

Convention between the Government of the United Kingdom of Great Britain and Northern Ireland and the Government of Canada for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and Capital Gains, entered into 8 September 1978. (In force. Amended by a 2013 protocol.)

1980

Convention between the United States of America 1980 Canadaand Canada with Respect to Taxes on Income and on United States Capital, entered into 26 September 1980. (In force.) treaty

2000

Ireland-Norway Convention between Ireland and the Kingdom of treaty (2000) Norway for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital, entered into 22 November 2000. (In force.)

831

Canada-United Kingdom treaty

References

Year

Description

Abbreviation

2013

Convention Between the Kingdom of Norway and the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains, entered into 14 March 2013. (In force.)

Norway-United Kingdom treaty (2013)

Conventions Year

Description

1969

Vienna Convention on the Law of Treaties, conclud- VCLT ed in Vienna on 23 May 1969.

Abbreviation

Financial accounting standards Year

Description

2001

International Accounting Standard 1: “Presentation of IAS 1 Financial Statements” (available at http://www.ifrs.org/).

Abbreviation

2001

International Accounting Standard 2: “Inventories” (available at http://www.ifrs.org/).

IAS 2

2001

International Accounting Standard 18: “Revenue” (available at http://www.ifrs.org/).

IAS 18

2001

Statement of Financial Accounting Standards No. 142: “Goodwill and Other Intangible Assets” (available at http://www.fasb.org/).

FAS 142

2004

International Financial Reporting Standards 3: “Business Combinations” (available at http://www.ifrs.org/).

IFRS 3

2007

Statement of Financial Accounting Standards No. 141: (revised 2007) “Business Combinations” (available at http://www.fasb.org/).

FAS 141

2010

International Financial Reporting Standards Conceptual Framework (available at http://www.ifrs.org/).

2014

International Financial Reporting Standards 15: “Revenue from contracts with customers” (available at http://www.ifrs.org/).

832

IFRS 15

Other Titles in the IBFD Doctoral Series Vol. 1 – The Concept of Income: A Multi-Disciplinary Analysis by Kevin Holmes Vol. 2 – Taxing Portfolio Income in Global Financial Markets by Doron Herman Vol. 3 – Free Movement of Persons and Income Tax Law: The ­European Court in Search of Principles by Servaas van Thiel Vol. 4 – Advance Tax Rulings and Principles of Law: Towards a ­European Tax Rulings System? by Carlo Romano Vol. 5 – Arbitration under Tax Treaties: Improving Legal Protection in International Tax Law by Mario Züger Vol. 6 – E-Commerce and Source-Based Income Taxation by Dale Pinto Vol. 7 – Interpretation of Tax Treaties under International Law by Frank Engelen Vol. 8 – Taxation of Investment Funds in the European Union by Tomi Viitala Vol. 9 – Taxation of Cross-Border Partnerships: Double Tax Relief in Hybrid and Reverse Hybrid Situations by Jesper Barenfeld Vol. 10 – Taxation of International Performing Artistes: The Problems with Article 17 OECD and How To Correct Them by Dick Molenaar Vol. 11 – Dispute Resolution under Tax Treaties by Zvi Daniel Altman

Vol. 12 – Income from International Private Employment: An Analysis of Article 15 of the OECD Model by Frank Pötgens Vol. 13 – Taxation of Investment Derivatives by Antti Laukkanen Vol. 14 – International Tax Planning and Prevention of Abuse by Luc De Broe Vol. 15 – EC Law Aspects of Hybrid Entities by Gijs Fibbe Vol. 16 – The EU VAT System and the Internal Market by Rita Aguiar de Sousa e Melo de la Feria Vol. 17 – Formulary Apportionment for the Internal Market by Stefan Mayer Vol. 18 – Cross-Border Consumption Taxation of Digital Supplies by Pernilla Rendahl Vol. 19 – EC Law and the Sovereignty of the Member States in Direct Taxation by Mathieu Isenbaert Vol. 20 – Arm’s Length Transaction Structures – Recognizing and ­Restructuring Controlled Transactions in Transfer Pricing by Andreas Bullen Vol. 21 – Optimization of Tax Sovereignty and Free Movement by Sjoerd Douma Vol. 22 – Taxation of Foreign Business Income within the European Internal Market – An Analysis of the Conflict between the Objective of Achievement of the European Internal Market and the Principles of Territoriality and Worldwide Taxation by Jérôme Monsenego Vol. 23 – The Missing Keystone of Income Tax Treaties by Joanna Wheeler

Vol. 24 – The Principle of Non-Discrimination in International and European Tax Law by Niels Bammens Vol. 25 – A VAT/GST Model Convention by Thomas Ecker Vol. 26 – The Interface of International Trade Law and Taxation – ­Defining the Role of the WTO by Jennifer Emma Farrell Vol. 27 – The Structure and Organization of EU Law in the Field of Direct Taxes by Marcel Schaper Vol. 28 – Taxpayer Participation in Tax Treaty Dispute Resolution by Katerina Perrou Vol. 29 – Triangular Cases: The Application of Bilateral Income Tax Treaties in Multilateral Situations by Emily Fett Vol. 30 – Taxation of International Sportsmen by Karolina Tetłak Vol. 31 – On the Legitimacy of International Tax Law by Cees Peters Vol. 32 – The Sources of EU Law and Their Relationships: Lessons for the Field of Taxation by Rita Szudoczky Vol. 33 – Multilingual Tax Treaties: Interpretation, Semantic Analysis and Legal Theory by Paolo Arginelli Vol. 34 – VAT Grouping from a European Perspective by Sebastian Pfeiffer Vol. 35 – European Capital Movements and Corporate Taxation – From Transaction-Based Origins to More Principle-Based Capital and Taxation Policies by Nana Šumrada Slavnić

Vol. 36 – European Value Added Tax in the Digital Era: A Critical Analysis and Proposals for Reform by Marie Lamensch Vol. 37 – Taxing Cross-Border Services: Current Worldwide Practices and the Need for Change by Angharad Miller Vol. 38 – Cooperative Compliance: A New Approach to Managing Taxpayer Relations by Katarzyna Bronżewska Vol. 39 – Taxation of Services in Treaties between Developed and ­Developing Countries: A Proposal for New Guidelines by Fernando Souza de Man Vol. 40 – Transactional Adjustments in Transfer Pricing by Aitor Navarro Vol. 41 – Nexus Requirements for Taxation of Non-Residents’ Business Income: A Normative Evaluation in the Context of the Global Economy by Stjepan Gadžo Vol. 42 – Dispute Resolution in the EU: The EU Arbitration ­Convention and the Dispute Resolution Directive by Harm Mark Pit Vol. 43 – The Interpretation of Tax Treaties in Relation to Domestic GAARs by Eivind Furuseth Vol. 44 – The Tax Sparing Mechanism and Foreign Direct Investment by Na Li