When the internet emerged as a potentially dominant medium for conducting business transactions, many business managers and financial analysts predicted that it would create a new business paradigm in which the traditional rules of business no longer applied – thus, the "New Economy" was born. Many expected "New Economy" companies to vastly outperform and ultimately displace "Old Economy" businesses. Some observers went so far as to predict that the business world would become dominated by internet portals. These New Economy portals would use the internet to coordinate all of the complex business processes involved in getting products from producers to consumers and would totally replace traditional product delivery channels.
These sky-high expectations came back to earth in the aftermath of last year's precipitous fall of the technology-heavy NASDAQ stock index. The business world is still dominated mostly by Old Economy companies. However, Old Economy companies themselves have undergone considerable transformation. The most successful have incorporated e-commerce components (ie using the internet to facilitate coordination of suppliers, partners and customers) into their business models, refining and improving the competitiveness of their operations. Thus, instead of replacing the Old Economy businesses, the internet has been ushered into service to revitalize them.
The evolution of Old Economy businesses into new-Old Economy businesses has profoundly altered the form and substance of intercompany transactions within multinational corporations. Businesses, national tax authorities and international organizations such as the OECD are all working to address emerging transfer pricing issues and it is likely that the internet will also lead to an evolution of transfer pricing rules and enforcement rather than a wholesale change in the environment.
TRANSFER PRICING FOR E-COMMERCE
No special transfer pricing rules for e-commerce
There are no specific transfer pricing rules (enacted or promulgated) to govern e-commerce transactions. Instead, an e-commerce transaction is characterized under normal tax principles and traditional transfer pricing rules apply to determine the amount of income the respective controlled parties must earn. A controlled transaction will be arm's length if the results of the transaction are the same as would have been realized by uncontrolled taxpayers engaged in a comparable transaction in comparable circumstances. Furthermore, in the US, transfer prices must be set according to the method that, under the facts and circumstances, provides "the most reliable measure" of an arm's length result. Notwithstanding the lack of new transfer pricing rules, as discussed below, e-commerce transactions can have a significant impact on the application of the existing transfer pricing rules and pricing methodologies.
Governmental differences
National tax authorities are concerned with the emergence of the internet as the dominant medium for business transactions, and its potential for facilitating the structuring of e-commerce transactions to create income in low tax jurisdictions. The OECD has recognized the internet's potential to drastically alter the enforcement of international tax and transfer pricing laws and has been active in studying its implications. The OECD Committee on Fiscal Affairs has concluded, however, that the tax principles that guide governments in relation to conventional commerce should also guide them in relation to e-commerce.
The OECD issued several reports and discussion papers in February 2001 with the goal of reaching an international consensus on the tax treatment of e-commerce. These documents focus on three areas: direct tax issues (permanent establishment, treaty characterization, profit attribution and business profits), consumption tax issues and tax administration issues.
Based on the material differences of opinion among OECD member countries as to the tax treatment of common fact patterns, however, it is still unclear whether an effective international consensus on the fundamental points of international e-commerce taxation will emerge, even among OECD member countries. Even if OECD members agree on the broad rules to govern the transfer pricing treatment of e-commerce transactions, questions surrounding the application of those rules by the various governments will persist for years to come. Taxpayers with intractable e-commerce issues will need to pursue bilateral resolution through either the competent authority process or advance pricing agreement procedures.
Characterization
The preliminary issue for all e-commerce transactions is how the transactions will be characterized for tax purposes (ie whether the transaction is a sale of tangible goods, a service or a transfer of intangible property). Tax characterization sets in motion a number of other tax issues, but the main impact on transfer pricing issues is the determination of the applicable transfer pricing methodology and the selection of comparable transactions or companies. Additional complexities may arise in transactions that bundle the transfer of intangible property with the sale of tangible goods or the provision of services (so-called "embedded intangibles").
TRANSFER PRICING FOR TANGIBLE GOODS
Types of transactions
One of the first commercial applications of the internet was to facilitate the sale of tangible goods. The internet's role in this respect can be as simple as posting a product catalogue on a web site or as complex as a comprehensive distribution system with links to manufacturers, individual purchasers and customer support staff. Because of its inherent capacity to automate and centralize functions, the internet may actually reduce the number of intercompany transactions as distribution functions that were once performed by multiple entities become automated and centralized within one or a few entities. Regardless of how the internet is used to facilitate the sale of tangible goods, determining transfer prices for such sales is based on product similarity and the relative functions and risks borne by the parties involved in the transaction. In this respect, setting transfer prices for sales of tangible goods via the electronic medium is no different than setting transfer prices for sales through conventional channels.
Transfer pricing methodologies
A taxpayer has various methods available for determining taxable income from the transfer of tangible property:
Comparable Uncontrolled Price Method (CUP): The CUP method evaluates whether the amount charged in a controlled transaction is arm's length by reference to the amount charged in a comparable uncontrolled transaction. An uncontrolled transaction is considered comparable if the tangible property and contractual terms are substantially the same as those of the controlled transaction and, if any minor differences exist, they either have no effect on the price or have a definite and reasonably ascertainable effect on price.
Resale Price Method (RPM): The RPM measures an arm's length price by subtracting the appropriate gross profit from the applicable resale price for the property involved in the controlled transaction. The RPM is ordinarily used in cases involving the purchase and resale of tangible property in which the reseller has not added substantial value to the tangible goods (ie by physically altering the goods or through the use of an intangible) before resale.
Cost Plus Method: The cost plus method determines an arm's length charge by comparing the gross profit markup realized in controlled and uncontrolled transactions. The cost plus method is ordinarily used in cases involving the manufacture, assembly or other production of goods that are sold to related parties.
Profit Split Method: The profit split method compares the allocation of the combined operating profit or loss attributable to controlled transactions to the relative value of each controlled taxpayer's contribution to that combined operating profit or loss. The profit split method is not commonly used for tangible property transfers.
Comparable Profits Method (CPM): The CPM evaluates whether the amount charged in a controlled transaction is arm's length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances. In practice, the operating margin is the most prevalent profit level indicator.
Application difficulties
As indicated above, the transfer pricing methodologies for tangible goods transactions are premised on product similarity and the relative functions and risks borne by the parties involved in the transaction. The most basic methodology – the CUP method – relies heavily on product similarity. Because there would be no difference between tangible goods sold over the internet and the same goods sold through traditional distribution channels, the search for potential CUPs is made easier. Nevertheless, other factors, including functions and risks assumed by the parties, contractual terms, level of the market (eg wholesale or retail), geographic market in which the transaction takes place, date of the transaction, intangible property associated with the sale, foreign currency risks and alternative commercial arrangements realistically available to the buyer and seller also affect the application of the CUP method. (These other factors also affect other transfer pricing methodologies, such as the RPM and CPM, the reliability of which are most dependent on a similarity of functions performed, risks borne and contractual terms.)
All of these non-product factors can be affected by the use of the internet and may affect price and, therefore, require adjustments. For instance, an Old Economy distributor may use telephone customer sales representatives to take customer orders whereas a new Old Economy company may use a computer server to automate many of its distribution activities in a low tax jurisdiction. Consequently, these companies are likely to incur significantly different levels of fixed (office space, computer and telephone equipment) and variable (employees) costs that must be taken into account in applying a methodology. In this case, it may be more difficult to apply the RPM or CPM.
INTERCOMPANY SERVICES
Types of transactions
The internet has spawned two types of new services-related transactions: truly new e-commerce services and traditional services provided over the internet. Examples of new services include:
Application hosting (with separate license): The user owns a license to use a software product and enters into a contract with a host entity in which the host entity loads the software on servers owned and operated by the host and provides technical support. The user can remotely access, execute and operate the software application either at a customer's computer or remotely on the host's server. This type of arrangement could apply to financial management, inventory control, human resource management or other enterprise resource management software applications.
Application hosting (with bundled contract): For a single, bundled fee, the provider (also the copyright owner) allows access to one or more software applications, hosts the software applications on a server owned and operated by the host and provides technical support. The user can remotely access, execute and operate the software application either at a customer's computer or remotely on the host's server.
Application service provider (ASP): The provider obtains a license to use a software application in the provider's business as an ASP. The ASP gives the customer access to a software application hosted on servers owned and operated by the ASP. For example, the software might automate sourcing, ordering, payment and delivery of goods or services. The customer has no right to copy or use the software, other than on the ASP's server, and does not have possession of a software copy.
Web site hosting: The provider offers space on its server to host web sites. The provider obtains no rights in the copyrights created by the developer of the web site content. The owner of the copyrighted material on the site may remotely manipulate the site, including modifying the content.
The new e-commerce services also might involve the use of embedded intangibles. For example, application hosting involves the payment of a single, bundled fee for the service and use of certain software intangibles.
In addition to new services, continually decreasing telecommunications costs and increasing competitive pressures encourage multinational corporations to move traditional functions to a single location to create operational efficiency. Examples of opportunities to provide traditional services over the internet include the following:
replacing traditional distribution activities with a web server in each country tied to a centralized order-processing center;
moving headquarters and technical support functions for global operations to a single low tax jurisdiction; and
transferring all currency risk to be managed from a single location.
Transfer pricing methodologies
The arm's length charge for intercompany services is the amount that was charged or would have been charged for the same or similar services in independent transactions with or between unrelated parties under similar circumstances considering all the relevant facts. The transfer prices for services are usually charged out at either cost (for non-integral services) or cost plus a markup (for integral services). In either case, the relevant costs include all direct and indirect costs of providing such services.
Application difficulties
Comparability is key to any transfer pricing determination, and comparables may be particularly hard to find in the case of services provided over the internet. First, the types of services offered over the internet still may be novel enough that comparable uncontrolled transactions with internet service companies may be challenging to locate. Further, the profitability of internet service companies may be extremely volatile: many internet service providers endure years of start-up losses before achieving even minimal profits.
On the other hand, it may difficult to make a reliable comparison between internet and non-internet providers of services. For example, a multinational corporation could replace its country-wide distribution network with a server tied to a centralized order-processing center. A transfer pricing determination for the new server-based approach based on non-internet distribution comparables gives rise to challenging comparability issues. Adjustments should be made for differences in the levels of service offered to the customer; however, these adjustments are difficult to quantify reliably. Further, the tax authorities of the host country might assert that an intangible is transferred to the parent corporation in the restructuring transaction. The comparability of non-internet and internet services can be expected to diverge further each year as e-commerce business models continue to evolve and adapt.
Transactional methods are difficult to apply because of lack of comparable transactions and the difficulty of making appropriate adjustments. Under profit-based methods, it may be difficult to attribute the profit to individual transactions and to value the relative contributions of the parties. Further, a profits-based approach may rely on internal data that may be unreliable because the services are provided by a large number of participants and different transactions are handled simultaneously.
The global formulary apportionment method applied by certain US states treats a multinational engaged in a controlled transaction as a single business entity and allocates the multinational's global profits among the associated enterprises on the basis of a predetermined formula. This method is arbitrary because profits would be allocated without reference to market conditions, unique facts surrounding the transaction and ownership of intangible property. It will generally lead to double taxation by reaching profits earned by foreign multinationals in foreign countries, profits already taxed by foreign jurisdictions.
INTANGIBLE PROPERTY
Types of transactions
New and Old Economy companies have spent considerable time, money and energy developing business models, software and systems to conduct business through the internet. This is readily apparent from the increasing proportion of market capitalization of quoted companies not explained by the value of their tangible assets. Having developed intangible property, a company will optimize its return by making it available to new or existing businesses overseas. Examples of e-commerce transactions involving intangible property include:
Taking a successful US e-business (perhaps a marketplace) and creating a European equivalent;
Expanding a successful national e-broking business to include foreign customers (and their liquidity); and
Replicating a successful e-commerce clothing retail business overseas to sell local fashions to local customers.
These transactions raise significant transfer pricing questions regarding the existence, ownership and value of intangibles.
Transfer pricing methodologies
Determining an arm's length value on a related party license is very simple in theory but usually difficult in practice. In theory, the value of the intellectual property (IP) is the capitalization of the discounted cash flow added to the business by having access to the IP. The license is then the price that willing unrelated parties would pay to obtain that increased discounted cash flow. In practice, there are several methodologies for valuing that license, but only three are worthy of further comment:
CUP (CUT) Method: If there are no internally generated CUP(T)s, public data can be used to establish the likely license rate. In practice, public data is limited, both in the number of examples and the detail available for each example. By its very nature, IP is unique and its value is dependent upon the industry in which it is used. One might expect the license to use the name of a well-known and popular university on apparel to generate a higher license rate than a less well-known name, or, indeed, the same name applied to a financial product (which has lower margins). In practice, therefore, it is difficult to show more than the broad range in which one might expect the license fee to be found, and another methodology is needed to zero in on the particular license rate.
Market Capitalization Method: In theory, the value of capital (shares plus long-term debt) committed to the business is equal to the value of tangible and intangible assets of the business. The value of shares in publicly traded companies is set by independent investors, so this figure can be used as a point of departure. Thus, it is possible to add long-term debt and deduct the fair market value of tangible assets to identify the value of all intangibles. Some tax authorities (notably the IRS) strongly favour this methodology when valuing IP. Unfortunately, two key issues are commonly overlooked. First, looking at one well-known dot.com, although the value of tangible assets in the business remained largely constant over the period, the market method predicted that, from 1997-2001, the value of intangibles would rise meteorically between 1998 and late 1999, and then fall dramatically between late 1999 and early 2001. In hindsight, the price of internet companies in the market was distorted and the underlying value did not bear any close relation to the share price. If the share price is not a measure of the true value of the company, then the key principle of the methodology is broken and the methodology is not applicable.
The second problem relates to the tax authorities' application of this method in practice. Not all intangibles are made available to the overseas affiliate; branding may be a good example. In a successful company, the brand will account for a significant proportion of the total value of intangibles. However, even if the trademark, logo, name and other items associated with the brand are made available to the overseas affiliate, in many cases the parent brand value cannot be made available. Hence, it is necessary to identify and value any intangible assets not made available to the overseas affiliate and to deduct those to establish the true value of intangibles made available to that affiliate.
Cost-Based Methods: Cost-based methods fall into two categories – historic or replacement cost. The former looks at the costs incurred in generating the intangibles, plus the cost of maintenance, a reasonable rate of return and the usage to calculate the license fee. There is, however, no causal relationship between historic cost and value. One party might spend millions pursuing an idea whilst a competitor reaches the same result through a flash of inspiration. The idea that there ought to be a return for the effort of creating IP is fatally flawed.
The replacement cost method looks at the cost of generating the particular IP today, rather than licensing the existing item. This approach is useful for certain IP, such as software, if it is feasible to estimate the cost of generating the IP anew. The replacement cost approach, however, is not applicable to all IP; for example, brands are so individual that it is impossible to say that one could create the brand at all, let alone within a certain cost.
Application difficulties
In an ideal world, the same IP will also be licensed to an unrelated party under comparable circumstances and the CUP (or CUT) method can be used. More commonly, the IP is so valuable that it is not licensed outside the group and internally generated comparables are not available. In such circumstances, external data must be used. It is important to remember that, in applying any methodology based on decapitalzing total value, no third party licensee will pay an amount equal to the total value it expects to generate from access to the intangible – at that price, a business person would be ambivalent about the opportunity as there is no profit for him. In the real world, the value of exploiting the asset must be shared between the owner and the licensee.
COST SHARING ARRANGEMENTS
Many groups have looked to cost sharing arrangements as an alternative to a mere transfer of intangibles from one affiliate to another. For some, cost sharing has been of considerable benefit in promoting sound commercial practice (information sharing), reducing administration and minimizing withholding taxes. However, there are disadvantages to cost sharing (such as multiple ownership of an intangible that is later sold to a third party), and, therefore, cost sharing is not necessarily the solution. In addition, the administrative burden is often no easier, only different. Further practical issues arise when one or more parties to the cost sharing arrangement already have IP in the subject matter and a "buy-in" payment has to be considered. Care must be taken in structuring the buy-in: valuation of the pre-existing rights can be expensive and time consuming, inadvertent capital gains tax exposure might be created, and the solution might not be immune from tax-audit challenge. In summary, the decision of whether or not to cost share must be taken on a case-by-case basis having considered all potential ramifications of that decision.
CONCLUSION
Multinational businesses continue to redesign their operations to adapt to the new efficiencies offered by the internet. Although this trend is driven first and foremost by business factors, tax and transfer pricing factors also must be taken into consideration. Companies are facing the task of modifying their transfer pricing policies to account for their business changes. This evolution of business operations and transfer pricing policies creates opportunities for businesses to reconsider their global tax planning. It remains to be seen to what extent these companies will take advantage of this opportunity.
John Henshall is a partner in the London International Tax Practice, and a member of the Transfer Pricing Group. In this role, he is responsible for service to clients on all aspects of cross-border pricing arrangements, including providing assistance to major multinational companies in their dealings with the UK Inland Revenue and foreign tax authorities in transfer pricing compliance matters, as well as reviewing companies' cross-border pricing arrangements for planning. Henshall is a leading expert in the transfer pricing of intellectual property. Email: jhenshall@deloitte.co.uk
Steven Wrappe is a partner with the Transfer Pricing Group in Washington, DC. Prior to joining Deloitte & Touche, he was with IRS APA Program, with direct involvement in over 50 APAs and oversight responsibility for all North American APAs. Email: swrappe@deloitte.com
Kerwin Chung is a senior manager with the Transfer Pricing Group in Washington, DC. He advises multinational clients in the areas of APAs, competent authority, transfer pricing documentation, permanent establishment, cost sharing and examination issues. Email: kechung@deloitte.com
