Transfer Pricing - Intagibles

Unfolding the UnseenUnfolding the UnseenA research paper on one of the most controversial topics in Transfer Pricing, precisely as it involves invisible assets i.e. Intangibles.This paper provides an insight on the various aspects on intangibles,with special emphasis on marketing intangibles and its interplay with the transfer pricing provisions

Author:

Akshay Kenkre, ACAManaging Partner

Solutions LLPTransPrice

1 TransPrice Solutions LLP1

Contents:

Particulars

Introduction to intangibles

Reporting of intangibles assets in the financial statements

Valuation of intangibles- Cost Approach- Income Approach- Market Approach

Intangibles and Transfer Pricing

Benchmarking International Transactions in Intangibles- Comparable Uncontrolled Price (‘CUP’)- Transactional Net Margin Method (‘TNMM’)- Profit Split Method (‘PSM’)

Transfer Pricing and Classification of Intangibles- Trade Intangibles- Marketing Intangibles- Trade vs. Marketing intangibles

Transfer Pricing and Trade Intangibles- Development of Trade Intangibles- Licensing of Trade Intangibles

Transfer Pricing and Marketing Intangibles- Marketing Intangibles – An Overview- Famous case of GlaxoSmithKline – USA- OECD on Marketing Intangibles- Perspective on ‘Revised Discussion Draft on Transfer Pricing Aspects of Intangibles’ released by OECD

- ITAT Special Bench decision- LG Electronics India Private Limited

Key Conclusion and Message

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“What is great about entrepreneurship is that entrepreneurs create the tangible from the intangible.” Robert Herjavec

Robert Herjavec is a Canadian businessman, an investor, and a television personality, with a net worth of $100 million.

Robert’s quote serves as a testimony to the happenings in the practical business world. Most of the businesses that started in the 20th century by investing heavily in tangible assets like land, plant and machinery, etc are driving majority of their present income through intangible assets, they have developed over the past few years. Few such organizations are Coca-Cola, Microsoft, Intel, etc.

With the fall of Berlin wall in the year 1989, the industrial age saw a decline and the age of information saw a new dawn. Since then, with an increase in the worldwide communication and wide spread of internet and e-commerce, information and intangibles became the power. An organization that owned knowhow, information, knowledge of a particular process gained an upper hand in the valuation process and also in the day to day operations.

Global business is primarily driven by intangibles. Intangibles are the major growth drivers for any business or economy. Future potential, matters more than today’s outcome.

Intangibles are anything that generates value that you cannot hold in your hands. Value creation takes place through Innovation, Research & Development (‘R&D’), Brand Building, Relationships and Networks which are all intangible assets.

In the world of business and management accounting little importance is given to the power of intangibles and consequently such assets are undervalued. It is an underlying fact that the difference between the book value of a company and the market value of the company is generally the intangibles that the company possesses.

Before we get in to the further evaluation of the topic, it is important to understand the meaning of terms intangibles.

Intangible Assets = Hidden Assets = Invisible Assets = Means to achieve targets

The Indian Accounting Standard (AS- 26) on ‘Intangible Assets’ define intangible assets as: ‘an Identifiable, non – monetary asset, without physical substance, held for use in production or supplying of goods or services for rentals to others or for administrative purpose’.

The IAS 38 as per the International Financial Reporting Standards defines Intangible Assets as ‘an identifiable, non – monetary asset without physical substance’.

1. Introduction to intangibles

1TransPrice Solutions LLP2

1.1 The main features of intangible assets as per the standard are

• Identifiable

• Non Monetary Asset

• Absence of Physical substance

1.1.1 Identifiable: The asset has to be separate from other assets and should be capable of generating future economic benefits.

1.1.2 Non Monetary Asset: The value to be received against the asset is not fixed. As intangibles are ultimately asset, they are to be controlled by an enterprise and should be a result of past transaction or event and which can be a source of future economic benefit.

1.1.3 Absence of Physical Substance: Intangible assets have no physical substance i.e. they cannot be touched. However, some intangible assets may have physical substance in the form of a compact disk containing licensed software. In such cases, the value of compact disc is negligible as compared to the contents in the same.

Section 32 of The Income Tax Act, 1961 defines intangibles in an inclusive way to include know-how, patents, copyrights, trademarks, licenses, franchises, or any other business or commercial rights of similar nature.

Intangibles provide tremendous value addition to an organization:-

• It provides a competitive advantage over others

• Intangibles like patents act as a barriers to entry for others

• It increases market share (brand or trademark)

• It can lead to fixation of premium pricing ( brand and trade marks)

• It may ultimately lead to enhanced top line for the organization

In the current research note, we will focus our analysis on how intangibles play an important role in the study of transfer pricing and will be more specific on the marketing intangibles that have recently gained importance. In this paper, we will discuss on the intangibles, which may or may not be reflected in the balance sheet of a company. The intangible assets in addition to the assets mentioned in the above definitions, will consider all types of competitive advantages that a company has either through self generated or acquired assets, either through license, purchase or without any consideration.

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TransPrice Solutions LLP

Financial reporting and statements are an important means for understanding and managing the performance of an organization and also acts as an investor and shareholder’s guide. It is a practise often followed to disclose the statutory disclosures as provided by the law; however the organization seldom discloses such voluntary information that may not be provided by the statute but may add tremendous value to the organization. One such information includes information on intangible assets of the Organization.

Tangible information about an organization’s financial information for e.g. profit and loss, fixed assets, and current liabilities shows past performance of a company. Intangibles very often say something about the potential or ability of an organization that may have edge over the others and may lead to substantial increase in the value of an organization. Hence, knowledge of intangibles is very essential for understanding the future performance of the organization.

Intangible may exceed all the physical assets of an organization in terms of value as well as contribution to the growth of an organization. Most of the time such efforts to develop intangibles are expensed out to the profit and loss account in the year of accrual and they ultimately do not find place in the balance sheet of the organization. For e.g. marketing efforts and business development expenses incurred for development and growth of brand are expensed out in the year of incurrence. Such expenses may not be linked directly to the sales of the year in which the expenses are incurred and may contribute to the top line of the organization for many future years to come.

Disclosure of intangibles in the financial statements will enumerate a greater transparency in providing information and enabling decision making. What gets measured gets monitored and managed. Measuring an intangible makes the management realize its value and accordingly they can then pay attention to the growth of the organization linked with the performance of the intangibles.

Information on Intangibles may be instrumental in increasing the market value of the shares of the company/ organization. Intangibles unlike tangibles assets take time to build and recognized after a through R&D or persistent value development like in case of brands. Thus, it is difficult for a competitor to clone the intangible in his business for growth of such competitor company, unlike in case of a fixed asset where the competitor by one time investment can purchase a fixed asset similar or same to what has been employed by the other organization. However there are exceptions to this principle when the competitor may get in to malpractices of brand infringement or patent theft.

It should be noted that intangibles are also secrets of an organization. If such secrets are shared in public, there may be a risk of erosion of intangibles. Thus it is important to understand and then disclose the intangibles in the financial statements that will only add value to the intangibles and does not go against the organization itself.

2. Reporting of Intangible Assets in the Financial Statements:

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Like any other asset, an intangible asset results in some benefit to an organization and hence increases its value. Such an asset can add value to an organization, if it

• Benefits the customers

• Provides a competitive edge

• Offers potential for future

• Is sustainable for several years

Therefore, it becomes important to value an intangible asset. Such a valuation is independent of whether the same is recognised in the books of account or not. As mentioned above, ‘what gets measured, gets monitored and managed’; it is imperative to value a known intangible asset to multiply the benefits from the same.

There are several methods of valuing an intangible asset, most of which can be classified under 3 basic approaches to valuation.

- Cost approach

- Income approach

- Market approach

3.1 Cost Approach

It is possible to value an intangible asset on the basis of ‘cost to create’ or cost to recreate similar assets for commercial utility. This may include valuing a brand with reference to the cost that has been incurred on various marketing activities and business development activities, valuing a patent with the cost that has been incurred on research and development of such patent. In the case of information technology (‘IT’), cost includes development and implementation of the IT software.

The advantage of such method is that it is simple to compute the value of an intangibles and many of the accounting standards also recognize such method of accounting of intangibles.

However, the main drawback of ‘cost to create’ approach is that it fails to account for the economic benefits that the asset owners will enjoy through its use. There may be little or no correlation between the development cost and its impact on the financial performance. Once created, the value of the asset to its owner may be significantly higher than the cost to create it. This approach may therefore understate the price at which the asset is recognized.

3.2 Income Approach

Income approach is used to estimate the value of intangible by considering the Net Present Value (‘NPV’) of the future cash flows / benefits that will accrue due to such intangible asset.

This approach considers income and expenses relating to the assets and arrives at the value of the intangibles through a capitalization process. The process may consider multiples of profits, yield or discounting rates or combination of these.

3. Valuation of Intangibles:

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Advantages of this method is that it identifies the income that is generated from an intangible asset and then values the asset on the basis of such income which ultimately leads to best judged value of an intangible in correlation with the benefits accrued or to be accrued from the same.

The downfall of this method is that there are variables used in the method which make this method subjective. Variables like identification of income from intangibles, discounting factor, profit earnings multiples may be very subjective and these assumptions may vary from person to person.

In spite of the above short comings, this is one of the widely used methods for valuation, due to near approximation correlation between the value of intangible asset and the income derived from the same. This method may not be used by an accountant to value an asset.

There are many methods in the Income Approach to determine the value of an intangible. Out of these, there are two methods that are widely used. They are as follows:

- Market Capitalization method

- Discounted Cash Flow method

3.2.1 Market Capitalization Method

It is “top down approach” that arrives at a value of intangibles for a given organization. In this approach it is assumed that the difference between the book value and market value of the share is a competitive advantage in form of intangibles which is perceived by the general market. In simple terms, market value of the shares is the factor of the current earnings of the company plus the future potential earnings of the company given the level of risk, assets and functions. Theoretically, an organization’s market value should be the present value of its expected future earnings.

The method starts with the organization’s total market capitalization plus the liabilities. From such amount, the value of the tangible assets plus the value of recognized/ booked intangibles is reduced. The result is lump-sum value of intangibles (competitive advantage) of the organization. Then such lump-sum value is allocated across a set of intangibles.

One of the major drawbacks of market capitalization method is that the stock prices are volatile. They can fluctuate from time to time and may impact the computation of intangibles. One way to overcome such issue is to use average value instead of single stock price. Also there might be market bubbles due to some rumours in the market which may not have factual backing. Under this circumstances adjustments can be made however, it is difficult to get the exact correct price.

3.2.2 Discounted Cash Flow method (‘DCF’)

The DCF method relates to valuation of intangibles based on the expected future income. First, forecast income and expenditure is determined. Then the NPV of future cash flows is calculated using an appropriate discounting factor reflecting the risk of investment for the organization. The drawback of such method is that the financial projections are not always reliable and estimating income attributable to intangibles and its economic life and the discounting factor is judgmental and subjective.

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3.3 Market Approach

This approach deals with arriving at the value of intangibles by finding the Fair Market Value (‘FMV’) of such intangible. The intangible assets are compared with other assets in the market on the basis of actual sales of comparable intangible assets.

Although not impossible, it is quite uncommon for an intangible asset to be sold in piecemeal to the buyer. Generally there is a purchase of a business and not just intangible. Even though there is a purchase of intangible, such a data may not be available in the public database.

This approach being the most reliable in theoretical terms fails to test the practicality of the method. Many valuable intangibles are unique and unless there is transaction in the specific asset under consideration, any comparison of prices may not be helpful or require significant adjustments.

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As discussed above, in today’s business, intangibles are the main value creators. Invisible value creators that is difficult to find in the financials of a tax payer. From a tax perspective, there is a risk of mis – pricing or overlooking an intangible in a transaction. There is a possibility that such a transaction may have occurred at a significant value but there is no visible trail of such transaction. The Indian tax authorities are focusing more on the intangible transactions first by applying withholding tax provisions, amending and clarifying the definition of royalty, and applying transfer pricing provisions to protect the tax base.

As per Indian Transfer Pricing Law, the following transactions are included in the definition of International Transactions in case of intangibles:1. Purchase or Sale of an Intangible Property2. Transfer, Lease, Use of an Intangible property3. Transfer of ownership or the provision of use of rights regarding: Brand, Commercial secret, copyrights, customer list, any type of design, franchises, industrial property rights, knowhow, land use, licenses, marketing channel, patents, trademarks, any other business or commercial rights of similar nature

Hence, in transfer pricing, there can be three broad categories of international transactions that can be treated as intangible• Transfer of Intangibles or Intellectual property (IP) • Lease or licensing of IP• Cost contribution for development of IP

<a> Transfer of Intangibles or Intellectual property (IP) When an IP is transferred, the tax laws of most of the countries require the developer/ owner of the intangible to receive fair market remuneration for the intangible developed or owned. The valuation methods discussed above play a vital role in determining the value of the intangible. The remuneration arrived by a ‘cost approach’ may be low and not at arms length as it may not link directly with the benefits that the purchaser may get out of such purchase. For such type of deals, income approach or market approach should be used for valuation.

<b> Lease or licensing of IPThis is the most widely used method for transferring of rights between parties through use of exclusive or non exclusive license arrangements. Generally, the licensor and the licensee enter in to a licensing agreement, whereby licensee agrees to pay royalty for the rights that he gets to use the intangibles owned by the licensor.

<c> Cost contribution for development of IPCost sharing is based on an idea that the group of companies come together and share the experience and costs for development of Intangibles through R&D process. By contributing knowledge and cost, each of the group companies my then exploit the developed intangible at if it belonged to them or for a very minute royalty that is computed after taking in to consideration the cost already contributed by such group companies. For the analysis of transfer pricing for intangibles, we will focus on the first two types of transactions and cost contribution/ sharing being a mammoth concept in itself, would be covered separately.

4. Intangibles and Transfer Pricing

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When two or more group companies enters into a transaction with each other, the terms of contract and the prices can be affected by their close relationships. When two or more independent entities enter in to a transaction, the commercial and financial terms are determined by market force and dynamics. The principle of Arm’s length (benchmarking) helps compare the transfer prices between the related entities and independent organisations.

This approach treats each and every entity in the multinational group of company as a separate legal entity rather than as a group. Such legal entity is then compared with a similar set of companies having transactions in an independent nature determined by the market forces

The process of comparing the international transactions within the group to the independent transaction is called as benchmarking and it revolves around finding the best possible comparable transactions that are entered into the with similar conditions

A comparable always does not mean that all the conditions and situations are same as entered in to with the controlled transactions. To be a comparable it means that any difference between the conditions of the controlled party and independent transaction can be duly adjusted to suit the requirements of controlled transactions or the differences does not materially affect the comparability between these transactions.

As any other international transaction, transactions involving intangibles also needs to be benchmarked as per the most appropriate method out of the five methods prescribed.

The Cost Plus Method (‘CPM’) and Resale price method (RPM) are generally used for computation of tangible property and hence that cannot be directly applied to value intangibles.

5.1 Comparable Uncontrolled Price Method (CUP)

CUP method is based on finding the exact comparable data that is same or similar to the transaction that the tax payer has entered into. In the case of transfer of intangibles and licensing of intangibles (charge of royalty) it can be one of the most preferred methods as it can provide direct comparables in the same or similar conditions and contractual relations. Such method can be applied when the intangible is not unique and the data of comparable is available in the public database. Any non material functional differences can be adjusted for. Hence, an organization dealing with development and selling of intangibles to third parties as well as related parties can be considering Internal CUP for such transfer of intangible. When an organization involves transfer or licensing of unique intangibles, exact comparable are rarely found. The unique intangible transfer may have some strict confidential and secret clauses that may not be available in any third party agreements. This method, although being reliable, fails in these instances.

In the recently ruling of Indian Tax Court (ITAT), in case of Tally Solutions Private Limited, use of Excess Earning Method (EEM) for valuation of unique intangibles has been upheld. Similar guidance is also found in the US Transfer Pricing Regulation.

5. Benchmarking International Transactions for Intangible Assets:

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The Indian law has also incorporated Rule 10BA which explains that any other method for determination of ALP in relation to an international transaction can be used in such a way that the price that could have been charged or paid for same or similar transaction between non associated enterprises , under similar circumstances. This gives options to the tax payer as well as the revenue department to use many valuation methods in the analysis of transfer pricing.

5.2 Transactional Net Margin Method (TNMM)

TNMM compares the net margins relative to appropriate profit level indicator (Operating profits/ sales or cost or assets) between the tested party and the comparable companies in the similar business. This method can be used when royalty is charged for licensing of intangibles. Many a times the organization/ tested party may not make immediate profits and in such cases it may be advisable to charge royalty to the organization only after a few years of gestation or after the breakeven point. The usage of net profit margins for comparison enables to eliminate the functional differences between the companies that are compared. However this being an indirect method to justify the royalty payments, the Transfer Pricing Authorities (‘TPA’) may not accept this argument and require the tax payer to justify the commercial and economic benefits from the use of such intangible.

5.3 Profit Split Method (PSM):

PSM is used when two and more organizations are dealing with each other’s intangibles. Typically in the profit split method, the total profitability from an international transaction is determined. Those profits are split between the associated enterprises on an arms length basis without considering any additional returns from intangibles (routine profits). The residual profits arising out of high value, unique intangible that remains after deduction of such routine profits is then allocated between the parties who have contributed significantly to the development of the intangibles under consideration in the ratio of functions performed and risks assumed.

Where it is difficult to find any comparables, then the PSM method is restored to. The focus of PSM lies on determining the allocation of appropriate profits rather than selection of comparables and determining the correct arms length price (‘ALP’). In other words, the focus is on profits actually earned rather than what should have been earned.

The downside of the method is that the profits made by the entire group have to be disclosed and declared in a tax jurisdiction and accordingly allocation has to be done. The Multi National Enterprises (‘MNE’) may not be very comfortable disclosing such group profitability to a tax authority of a jurisdiction. However, with increase in unique intangible deals, the use of profit split method will only rise rather than diminish.

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The ‘OECD Transfer Pricing Guidelines for Multinational and Tax Administration’ has beautifully categorized the intangibles in to two broad categories

• Trade Intangibles

• Marketing Intangibles

6.1 Trade Intangibles:

Trade Intangibles include patents, know-how, and designs, models that are directly used or are instrumental for production of goods or the provision of services or rights or licenses that itself are business assets that are transferred to customers for e.g. Software

Trade intangibles are generally created through a risky and expensive R&D process and the economic benefits to the generator flows in after the R&D stage when the product can be manufactured or service can be provided by using such outcome of the R&D. Such a R&D process can be undertaken in-house by the developer or can be given to the external service providers to perform such R&D on behalf of the principal in exchange of a consideration to develop such intangibles. The output of R&D is then registered and protected by the developer to enjoy future economic benefits.

Such trade intangibles can be directly used by the developer in a production process or service provision or can possibly license the same to a licensee for use in the business in return of a license fee.

<a> Patents:

A patent does not give right to the inventor of a product or process to produce, use or sell the invention; however it provides a right to exclude others from producing, making use, and selling the invention for a specified period of time. Such a right helps the inventor to produce goods or provide services in a monopoly or monopolistic market thereby recovering the cost of its invention and also make profits on such inventions before others can enter and enjoy the benefits in the market.

<b> Knowhow and Trade Secrets:

Knowhow and Trade secret are important information regarding an industrial application, manufacturing process, commercial or scientific nature which has operational value to an enterprise and with use of the same economic benefits can be derived. Knowhow and trade secrets may or may not be covered by a patent. Any process that is indigenously applied by an organization can also become knowhow and trade secret for producing the goods or service meeting the quality standards.

6.2 Marketing Intangibles:

Marketing intangibles include Trademark, Trade names, brand, and symbols, pictures that help to commercially exploit the product or services. The marketing intangibles may or may not be protected by law (some marketing intangibles like Trademarks are registered under the local laws of the country). The value of marketing intangible depends upon the reputation of a brand or trade mark, number of year of existence in the market, quality of products produced or services rendered by the company, the marketing and distribution channel of the company, the promotional

6. Classification of Intangibles for Transfer Pricing

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expenditure incurred in order to familiarize the product with the market. Such an intangible asset can be any type of competitive advantage that the company may have over other market players.

6. 3 Trade vs. Marketing Intangibles

It has to be understood that every R&D expenditure does not create a trade intangible and every marketing activity does not create marketing intangible. It is generally difficult to evaluate which activities does contribute to both these intangibles. However, one can figure out by the nature of the activities whether to categorise them as trade or marketing intangibles. A snapshot of difference between Trade and Marketing intangible is given below

Particulars

Nature of Intangibles

Importance in Supply Chain

Time limit for economic benefit

Cost attached for creation

Cost attached for maintenance

Risk Involved

Trade Intangibles

Creates Monopoly

Production Stage

Limited

Expensive

Not expensive

Risky

Marketing Intangibles

Creates market

Marketing and Sales

Indefinite

Not expensive

Expensive

Less risky

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7.1 Issue 1: At the time of development of Intangible

We discussed above that the trade intangibles are created through a risky R&D process and involves a lot of time, efforts and money. Due to such characteristics of R&D, the MNE group tends to set up contract R&D centres at various locations in the world which will help contribute to the creation of intangible. Generally the MNE group set up such centres where it can get cost benefits on the investments in R&D. Ideally such R&D works on a model of Cost plus mark up, where the principal entity bears all the cost of the R&D centres plus provides an arms length mark up on such cost to remunerate the efforts of R&D centres.

Most of the R&D centres assume more functions than simple back office R&D centres. They seek to employ best brains in the industry to perform the R&D, owns research labs, equipments, technology to perform such R&D. They seek to assume performance risk and also employ functions that are performed by a high risk independent R&D centre, rather than a low or no risk R&D centre.

In such a case, it can be held that India performs significant functions and create intangibles in India which are freely transferred to overseas Associated Enterprise (AE).

To avoid confusion and to clear off the litigation the Central Board of Direct Taxes (CBDT) issues Circular no 3 of 2013, providing factors to be considered in determining centre that can be treated as contract R&D service providers with insignificant risks.

CBDT clarified that the R&D centres set up by foreign AE can be classified in to following 3 categories:

1. Centre which are entrepreneurial in nature;

2. Centre which are based on cost-sharing arrangements; and

3. Centre which undertake contract research and development.

For a contract R&D centres bearing insignificant risk following factors are to be complied:

1. Economically significant functions to be carried on by the foreign AE principal, the Indian R&D centre will just act on the direction and concept provided by the foreign AE.

2. The contract R&D needs to be entirely funded by the foreign AE.

3. Indian R&D centres should not assume any risk. The contract and conduct should talk the same language.

4. When the foreign AE is situated in a low tax or no tax jurisdiction, it may be assumed that Indian AE is a risk bearing entity. The burden to prove otherwise is on the tax payer.

5. The Indian contract R&D should have no ownership of the intangibles, legal or economic.

In the case of GE India technologies Centre P. Ltd v DDIT and ST Microelectronics P. Ltd v CIT it was held that although the contract with the foreign AE provides for a low risk R&D, the tax payers were engaged in high end R&D and therefore it was held that they are high risk bearing entities and needs to be compensated appropriately

7. Transfer Pricing and Trade Intangibles

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7.2 Issue 2: At the time of licensing of trade intangible

The common method to benchmark royalty payments was under the CUP method wherein the tax payer compared the rates to the permissible rates under the exchange control regulations and accordingly concluded at arms length. However, such an approach has not been accepted by the Transfer Pricing Authorities as these approvals were under the exchange control regulations and the limits set are the maximum possible royalty pay out, where as the arms length price of a royalty pay out may be lesser than the maximum limit specified in such exchange regulations.

The other approach used by the tax payer is to use TNMM, and the justification given by the tax payer is that after considering the royalty as an operating expenditure the operating profit ratios as derived from the controlled transactions vis a vis the comparable companies is higher and hence the royalty payment is at arms length. However, such an approach is also challenged by the TPA’s by asking the tax payer to justify the economic and commercial benefits derived from the use of such intangible.

Some guidelines to overcome such issues:

Payment of royalty and fixing up a percentage of royalty along with model is a very subjective exercise, for the precise reason that royalty is linked directly with the value that is added by the intangible which cannot be seen upfront.

Few considerations to be kept in mind while fixing the model and percentage:

• What does the licensing of intangible bring on to the table for e.g. increase in sales, reduction in cost, increase in productivity or increased visibility

• The unique factor under consideration for e.g sales in case of increase in sales needs to be evaluated

• The expected increase in sales due to use of such intangible, needs appropriate documentation

• The payment of royalty needs to be based on such unique factor, it can be Sales

• It has to be proven that the benefits that the entity is enjoying from such use is more than the royalty pay out that is made by the tax payer

• Such an agreed rate needs to be benchmarked with the industry rates

• The preferred method can be CUP, where publically available similar contracts can be scanned and average rates of royalty can be applied to decide the royalty percentage

• All the negotiations for such royalty payout needs to be documented

• Group transfer pricing policy will definitely act as a guidance to prove how the royalty rates are determined and in general guidance for other intangibles

• Ultimately such a royalty rate can be benchmarked via CUP ( as mentioned above) corroborated with TNMM analysis

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“Every Advertisement should be thought of as a contribution to the complex symbol which is brand image” – David Ogilvy, founder of Ogilvy & Mather

Advertisement and Brand are the two sides of the same coin. A sustained effort to maintain the quality and other competitive advantage of a product or service gives rise to a brand. Advertisements help the brand to grow stronger by reaching out to the target audience and persuading the prospective customer the need to buy such product or service. One can call it as providing information or creating a need in the eyes of the customer.

Branding is one of the differentiating factors in the competitive market. Brand helps to create a monopolistic market, create an upper hand in the competition and therefore most of the distributors and manufactures would like to market and sell branded products rather than unbranded ones.

As rightly said by David Ogilvy in his quote; advertisement of a product along with the brand helps to build an image of the brand. Advertisement can be a powerful means to grow a brand’s network thereby contributing to the development of marketing intangibles of an MNE group.

Transfer pricing over the years have evolved and gone beyond trade intangibles to recognize efforts of an associated organization to develop marketing intangibles as transactions subject to the arms length principle.

Such a transaction is subject to transfer pricing, when the legal ownership of Brand, Trademark is with one associated enterprise and the economic ownership of the brand lies with another associated enterprise. Any efforts made by the associated enterprise having economic ownership of the brand, towards development of the brand contributes to increase in the value of the brand, legally owned by another enterprise, then such a transaction would be subject to transfer pricing.

The flow of explanation for marketing intangibles is provided in the following sections:

Global guidance on Marketing Intangibles: Sets out most discussed Glaxo case, that is one of the biggest case in marketing intangibles, highlights relevant points on marketing intangibles as provided by the OECD Transfer Pricing guidelines, 2010 and snapshot of the revised draft discussion paper on the Transfer Pricing aspects involving Intangibles assets.

Indian Special bench case law and the guidance on applicability of transfer pricing to marketing intangibles: Analysis of the case having far reaching effects on the Indian industry

Key messages and plausible solutions: outlines the areas that are to be of key concerns to MNE and provides suggestion on potential risk mitigation strategies.

8.1 Marketing Intangibles – An overview:

A marketing intangible will generally arise where a subsidiary of a global MNE (generally a sales and distribution entity) assumes responsibility of strategic marketing decisions and performs

8. Transfer Pricing and Marketing Intangibles

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significant level of marketing activities and incurs substantial expenditure on advertisement for the development of brand or trade mark of which it is not a legal owner. In such a case the transfer pricing authorities can argue that the sales and distribution entity is the economic owner of the intangible in the local market and developing the brand not legally owned by it.

For a MNE group it is advisable and preferable to determine appropriate profitability in the value chain with reference to the functions employed, assets owned and risk undertaken on an ongoing basis rather than wait for the tax authorities to review and audit and then conclude that the distributor is under compensated. Hence, it is important to regard the creation of marketing intangible in a jurisdiction and accordingly arrive at the compensation model.

8.2 The famous case of GlaxoSmithKline against U.S Tax Authorities

8.2.1 Facts of the case:

The products challenged by the Investigation of Internal Revenue Service (‘IRS’) included 20 products out of which Zantac (a blockbuster product for treatment on peptic acid disease) accounted for 70% in value terms on the adjustment. Zantac was a second entrant in the market after a product named as Tagamet, manufactured by SmithKlineBeecham (a competitor of Glaxo in 80s and early 90s). Since 1986 Zantac has been one of the best sellers for Glaxo all over the world.

Glaxo U.S was the distributor of the products, discovered and patented by Glaxo U.K.

The functional profile of Glaxo U.K and Glaxo U.S was explained as follows:

Glaxo U.K

• Discovered all products through Research

• Patented the products

• Conducted the Clinical Trials and Drug Developments

• Invented the technology for manufacturing the active ingredient and undertook manufacturing of such active ingredient

• Obtained regulatory approvals all over the world

• Designed worldwide marketing platforms and strategy

• Determined the co- promotion strategy for Zantac’s launch in the U.S, using the sales force of Hoffman-LaRoche to supplement Glaxo U.S inadequate sales force

• Reimbursed all development expenses including covering FDA approvals of Zantac, among other products

Glaxo U.S functions:

• Provided Development Assistance for FDA Approvals

• Performed Secondary manufacturing (Formulation)

• Applied to the U.S market the strategy and platform provided by Glaxo U.K

• Introduced products in US

• Conducted distribution and selling activities

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Glaxo U.S used a resale price methodology (RPM) for pricing the products, under which Glaxo U.S was left back with a gross profit of 55% for the years at issue

8.2.2 Dispute:

The years under consideration were 1989 till 2005. It took 14 years for the negotiations between Glaxo U.S and IRS to arrive at the solutions. It is one of the most long drawn case and one of the biggest in the history of US taxation.

Glaxo U.S after an attempt for entering in to an Advance Pricing Arrangements in 1994 and other proceedings ultimately filed against the deficiency notice issues by the IRS with the tax court in 2004. Glaxo challenged that IRS has erred in increasing its income by USD 4.5 Billion for the cost of goods sold, USD 1.9 Billion for royalties and USD 1.4 Billion for the interest income involving intercompany transactions. The company in fact stated that it had to be granted a refund of USD 1 Billion, for discriminating its case and granting its competitor SmithKline and APA for Tagamet.

IRS in it deficiency note argued that Glaxo U.S is not eligible for the deduction on the payment of royalties it paid for trademark and other marketing intangibles because it was the owner of such marketing intangibles for tax purpose, which were licenses from Glaxo U.K. To determine the arms length price, the IRS used a profit split method and re-assessed the contribution between Glaxo U.S and Glaxo U.K. In the total over all split of around 30:70 between U.S and U.K, the proposed adjustment from the IRS lead to the split to 80:20 in favour of U.S.

Glaxo U.S ultimately agreed to pay USD 3.4 Billion to settle the case. The dispute involving Glaxo U.S and the IRS and its settlement establishes a landmark case in the modern history of Transfer Pricing, notably because it is the largest case in the IRS history. The following conclusions can be derived from the case

• The case demonstrated the important of marketing intangibles in par with any other trade intangibles.

• Demonstrated the importance of Functional and Risk analysis to speak the same language that is in practice. Substance over form principal applies here.

• It demonstrated the need for an innovative approach in terms of functional and economic analysis during the time of involvement of intangibles.

• Also highlighted the need for a common guidance globally to apply such principals consistently rather than being affected by the perception of the MNE or the tax authorities in a jurisdiction.

8.3 View of OECD on marketing activities undertaken by enterprises not owning intangibles:

The guidance on treatment of marketing intangibles from a transfer pricing perspective is provided in the ‘OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’. Chapter VI point number 6.36 to 6.39 details out the guidance laid by the OECD

The OCED acknowledges that difficulties might arise in pricing a transaction when the marketing activities are undertaken by controlled enterprises not owning Trademarks, Brands or Trade names that a controlled enterprise is promoting. There are two main issues in such a case

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1. Whether the marketer should be compensated for such additional service provided as a service provider (advertising and branding on behalf of the principal) or whether the entity owning the intangibles should share an additional return attributable to the marketing in tangible

2. Further, the computation and identification of return attributable to the marketing intangible

Regarding the issue of whether the marketer/ distributor should be compensated for the activities will depend on the rights and obligation enumerated in the arrangement/ agreement between the marketer and the principal.

Where the distributor acts merely as an agent where he gets reimbursement of the marketing activities perform from the principal, the return to the distributor should be equal to any other distributor now promoting a brand.

Where the distributor actually bears the cost of marketing activities without reimbursement, the marketing activities should be compared to the independent distributor and its profit margins. If the distributor performs marketing activities substantially higher than the independent distributor then such additional efforts can be compensated by the owner of the trademark (principal) in 3 ways:

• Payment by the Principal to payment covering the marketing activities with appropriate mark up

• Decrease in the purchase price of the distributor

• Decrease in the royalty rates

The second question still remains about the identification and computation of returns attributable to the marketing activities. Any marketing activities obtain a value from the advertising and promotional activities performed by the distributor entity. However, it is difficult to relate how much of advertisement has actually contributed to the increase in the sales of the distributor and the related MNE group. The value of the marketing intangible will also depend on how effectively the product has been marketed and promoted than only making expenditure. It might also be possible that the trade intangibles may be high quality and unique nature than the advertisement and promotional expenses. In such a case the actual conduct of parties over the years and the legal terms entered between them will add significant value in determining the return from intangibles.

8.4 Guidelines in ‘Revised Discussion Draft on Transfer Pricing Aspects of Intangibles’:

The OECD has recently released a revised discussion draft on the aspects of intangibles which was earlier released on 6th June 2012.

On 6th July 2012, the OECD released an interim discussion draft on the intangibles. Based on the comments receive in public consultation, the OECD released revised draft on Transfer Pricing aspects of intangibles.

The proposed guidelines has appropriately worded the definition of intangibles (earlier was an inclusive definition). The proposed guidelines mentions that there will be difficulties if a narrow or a broad definition of intangibles is considered and hence the definition of intangibles with restrictive meaning for Transfer Pricing purposes should be considered as per the mentioned guidelines.

The definition states “intangibles” is intended to address something which is not a physical asset or a financial asset, which is capable of being owned or controlled for the use in commercial activities and whose use or transfer, would be compensated had it occurred in a transaction between independent parties in comparable circumstances

For the purpose of these guidelines the categorization of intangibles has been kept the same as (1) Trade intangibles and (2) Marketing intangibles

The proposed guidelines define marketing in tangibles as ‘An intangible used in the business operations that are customer facing’. It may include trademarks, trade names, customer relationships, customer data and other marketing and consumer data that can be used in marketing and selling the goods or services to the customers.

The guidelines provide detail guideline on the ownership of intangibles and basis that legal ownership does not confer any right to retain the returns from the intangibles. The entitlement of return from the intangible will depend on the control exercised and functions performed for development, enhancement, maintenance and protection of the intangible.

The guidance provided in the proposed guidelines is not too much different than what is already included in the existing guidelines. It states that whether the distributor should be entitled to compensation on the marketing activities depends on the following conditions:

(i) The obligations and rights implied by the legal registrations and the agreements between the parties

(ii) The functions performed, risks assumed and the assets employed and the cost incurred by the parties

(iii) The value created by the marketer/ distributor

(iv) Compensation provided for the distribution activities

The guidelines further provide that if an independent distributor performs functions that are additional to the normal conduct of distribution then it will typically require additional remuneration from the trademark owner. Such remuneration could take form of

(i) Higher distribution profits

(ii) Reduction of royalty rates

(iii) Share of profits associated with the enhanced value of the trademark or other marketing in tangibles

The revised guidelines have also provided illustration of the various scenarios that are similar to that released by the Australian Tax Office (ATO). One can find the examples on the website of ATO i.e www.ato.gov.au, under the topic of business and in that Tax topics. Such illustration shows an important roadmap to the tax payer and the tax administration on the treatment of intangibles under various scenarios.

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8.5 Special bench of ITAT (Tax Court of India) in the case of LG Electronics India Private Limited (LG India)

LG India is a wholly owned subsidiary in India of LG Korea, which was engaged in the business of manufacturing, sale and distribution of electrical products

LG India entered in to an agreement with LG Korea for technical assistance and royalty payment, under which LG India in capacity of Licensee acquired rights for manufacturing, marketing, sale and service of the agreed products from LG Korea, Licensor. The royalty payment was determined as 1% on the sale of products. LG Korea allowed using the brand name (LG) on an exclusivity basis without any restriction of use.

The TPA observed that the marketing and promotion expenses including trade discounts and volume discounts (AMP expenses) were 3.85% of its sale at INR 6553.36 crores. The average of comparable companies vis Videocon and Whirlpool was at 1.39% of their sales amount. It was inferred that LG India is promoting a foreign brand not owned by LG India and the foreign company should adequately compensate LG India for the additional efforts contributed by LG India to promote the brand in India. The TPA adjusted LG India’s income taxable by INR 161.22 crores which is excess of marketing expenditure over the market average ( 3.85% - 1.39%). At the second stage of appeal to the Dispute Resolutions Panel (‘DRP’), the DRP held that the taxpayer has not charged any mark up on the reimbursement and therefore enhanced the addition to INR 182.71 crores ( mark up @13%)

There were two main questions to be answered by the Special bench of ITAT

(i) Whether transfer pricing adjustment is justified in relation to advertisement, marketing and sales promotion

(ii) Whether a mark up on the adjustment in respect of AMP expenses is justified

It was held as follows:

• All 3 necessary conditions under Section 92B are fully satisfied i.e (1) there is a transaction of creating and improving the marketing in tangibles by the taxpayer on behalf of its AE ,(2) The AE is a foreign enterprise and non – resident, (3) such transaction is in nature of service

• The retrospective amendment in the powers of the TPA under Section 92CA(2B) to determine the ALP of transactions not referred to the TPA is upheld by the special bench

• LG India has not only promoted the products in India but also the foreign brand not registered in India. Special Bench accepts various evidence submitted by the TPA

• Higher advertisement expenses is not the only conclusive evidence, promotion of brand owned by the foreign AE is necessary condition

• Economic ownership of brand is not recognized by the IT Act. In the context of the IT Act, only the legal owner is recognized. Hence any efforts made by LG India will lead to enhancement of the brand of the foreign AE who is the legal owner

• To apply the transfer pricing provisions, it is fore most important to find the cost of international transaction. The TPA has applied a ‘bright line method’, which in simple terms means comparing the level of AMP expenses of the taxpayer to the AMP expenses of other domestic companies not owning/ using international brand to ascertain the cost of international transaction and it is not used to benchmark and determine the ALP under the transfer pricing regulations

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• Expenses in connection with the sales which does not lead to brand promotion cannot be brought in the ambit of AMP for determining the cost of the transactions

• Mere conclusion that the import of goods from the AE is at ALP does not justify higher brand promotion expenses on behalf of its foreign AE as every transaction is separate and needs to be benchmarked separately

• Expenses to promote a brand to be considered as AMP expenditure, expenditure on selling and distribution which helps selling a product not to be considered to determine the AMP expenditure

• DRP and TPA right in applying the cost plus method but wrong in arbitrarily determining the cost plus mark up of 13% without suitable benchmarking

• Non applicability of appropriate benchmarking does not make the whole proceedings void

• The case has been remanded back to the files of TPA to determine the ALP as per the provisions of transfer pricing

8.6 Key Conclusions and Message:

In view of the above discussions, following is the summary message to tax payers:

1) MNE with significant global operations need to review on regular basis the allocation of profits. It has to be analysed that every transaction in the value chain gets an appropriate remuneration with regard to the ALP for the transaction.

2) Although the concept of economic ownership is not recognized by the Indian courts, the principle that understates is that the entity that adds value (by incurring expenditure or trough its rights and obligations) to the intangibles owned by the legal owner should be compensated on an arms length basis.

3) For computation of ALP the service provider can be benchmarked on a cost plus basis and accordingly either reduction in purchase price or royalty or service fees needs to be received by the marketer/ distributor.

4) For computing the ALP where the marketer/ distributor adds significant value to the brand/ intangible that it does not own, the marketer or distributor can be said as having an equal participation in development, enhancement, maintenance and/ or protection of intangible. In this case a profit split methodology can be applied where the additional profits over and above the normal profits can be allocated to the marketer and the legal owner in the ratio of functions performed by both the parties.

5) One of the method to apply profit split computation to value the brand in the country of economic ownership and legal ownership and accordingly allocate the profits to both the tax jurisdiction. Care should be taken that the value of brand only from the supply chain between the country of economic ownership and country of legal ownership should be considered.

We strongly advise the taxpayers to seek appropriate advice and prepare documentation to back the Arms length nature of all intangible transaction. The documentation may include transfer pricing policy for transfer of intangibles, regular reviews of the profits margin around the global operations, comparing the profit margins to the domestic industry and analysis and documenting the contribution of each and every MNEs contribution for the development, enhancement, maintenance and/ or protection of intangibles.

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Transfer Pricing - Intagibles

Economy & Finance

Transcript of Transfer Pricing - Intagibles