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IP migration strategies – pre-and post-BEPS

BEPS aims to prevent aggressive profit-shifting strategies to better align transfer pricing outcomes with value creation. In this paper, Dale Hill, a partner at Gowling WLG, examines BEPS’s application to the transfer pricing aspects of intangibles and the impact on tax-motivated IP migration strategies.

The largest initiative the transfer pricing world has seen, since the introduction of the Organisation for Economic Cooperation and Development's (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Current TP Guidelines), is in its final stages and will result in material changes in the way the global operations of corporate organisations are structured and international transactions are reported.

On October 5 2015, the OECD released the final report of its 15-point Action Plan on Base Erosion and Profit Shifting (BEPS). The BEPS Action Plan was an ambitious project that addressed a number of concerns relating to international corporate tax planning. Actions 8 to 10 and Action 13 deal specifically with transfer pricing concerns and, in addition to the introduction of Country-by-Country Reporting (CBCR), contain significant revised guidance in the form of amendments to the Current TP Guidelines (Amended TP Guidelines).

In brief, the OECD's BEPS initiative, as it pertains to transfer pricing, attempts to prevent aggressive profit-shifting strategies by amending the Current TP Guidelines to better align transfer pricing outcomes with value creation. This is accomplished by placing more emphasis on the allocation of profits to the jurisdiction where substantive functions are performed, including the control functions related to risks assumed and capital employed. The Amended TP Guidelines, intended to be clarifying in nature and not a departure from the arm's length principle as enshrined in the Current TP Guidelines, now provide the tools and support the Canada Revenue Agency (CRA), and presumably other tax administrations, need to successfully challenge tax-motivated transfer pricing strategies where substantive people functions are not transferred with the intangible property (IP).

This paper examines the OECD BEPS initiative as it applies to the transfer pricing aspects of intangibles and the impact on tax-motivated IP migration strategies. It is widely recognised that the primary objective of an MNE is to maximise profits and, as such, MNEs are constantly evaluating their international operations in an effort to maximise revenues and minimise costs, including tax expenses. Historically, where the commercial opportunity existed, companies often adopted IP migration transfer pricing strategies that allocated significant profits to lower-tax jurisdictions. In the most extreme cases, no or minimal functionality (i.e. no employees) was transferred with the IP (e.g. cash box companies). Many of these strategies, and the tax savings that arose from them, whether rightfully or wrongfully, were thought to be legally effective and in line with the arm's length principle as described in the Current TP Guidelines. Such tax-motivated IP migration cases have often come under careful scrutiny by tax administrations. Notwithstanding such scrutiny, there was a lack of clear guidance and policy application by the CRA's Audit Division, Appeals Directorate and Competent Authority. In many cases the CRA accepted these structures as they were generally thought to be tax efficient and in line with the arm's length principle regardless that significant profits were allocated to that lower tax jurisdiction. This is about to change

BEPS changes to current TP guidelines in respect to intangibles

The OECD's BEPS Action Plan was an enormous undertaking covering many areas of international tax and only time will tell what the collective impact will be as a consequence of all the final report recommendations. However, what is widely agreed upon in the international tax community is that the most immediate, and likely most significant, impact from the BEPS project will be in the world of transfer pricing. The new CbCR and the Amended TP Guidelines are reality and are here to stay.

The OECD's work related to transfer pricing under the BEPS Action Plan focused on three key areas. Action 8 looked at transfer pricing issues related to transactions involving intangibles, Action 9 considered the contractual allocation of risks and the resulting allocation of profits to those risks, and Action 10 focused on other high-risk areas including the possibility of re-characterisations where transactions were not commercially rational. The Amended TP Guidelines arising as a consequence of the OECD's work on Actions 8 to 10 are significant and amend several chapters and sections of the Current TP Guidelines. The following is a brief summary of the new guidance dealing with intangibles:

  • Legal ownership of intangibles by an associated enterprise alone does not determine entitlement to returns from the exploitation of intangibles;

  • Associated enterprises performing important value-creating functions related to the development, enhancement, maintenance, protection and exploitation (DEMPE) of the intangibles can expect appropriate remuneration;

  • An associated enterprise assuming risk in relation to the DEMPE of the intangibles must exercise control over the risks and have the financial capacity to assume the risks including the very specific and meaningful control requirement;

  • Entitlement of any member of the MNE group to profit or loss relating to differences between actual and expected profits will depend on which entity or entities assume(s) the risks that caused these differences and whether the entity or entities are performing the important functions in relation to the DEMPE of the intangibles;

  • An associated enterprise providing funding and assuming the related financial risks, but not performing any functions relating to the intangible, could generally only expect a risk-adjusted return on its funding; and

  • If the associated enterprise providing funding does not exercise control over the financial risks associated with the funding, then it is entitled to no more than a risk-free return.

An example of the new approach

To see how the allocation of profits from IP transfers differ between a pre- and post-BEPS world, consider example 17 from the Amended TP Guidelines. In the example, the following facts/assumptions are assumed:

  1. Parent is a large pharmaceutical company.

  2. Parent conducts its operations in country X.

  3. Parent regularly retains independent (unrelated) contract research organisations (CROs) for research and development (R&D) activities, including designing and conducting clinical trials.

  4. CROs are not engaged in the blue sky research to identify new compounds.

  5. When retained, Parent actively participates with CRO engaged in clinical research activities.

  6. CROs are paid a negotiated fee for services and do not have an ongoing interest in the profits.

  7. Parent transfers patents related to Product to Subsidiary operating in country Y.

  8. Product is early stage pharmaceutical drug (high risk, low probability of commercialisation).

  9. Payment based on anticipated future cash flows – expected cash flow discounted by appropriate discount rate.

  10. Subsidiary has no technical personnel for ongoing research activities.

  11. Subsidiary contracts with Parent to carry out research related to Product.

  12. Subsidiary funds all Product research, assumes risk, and pays Parent based on cost plus margins earned by similar CROs.

The fact pattern given above is the classic example of an early stage pharmaceutical company wanting to realise future profits in a low-tax jurisdiction. In the pre-BEPS world, a significant portion of the profits would have moved to country Y. It was generally recognised that given the Subsidiary was the legal owner, it was entitled to any excess profit or loss after paying routine amounts for the R&D activities, even where the important value-creating functions of the IP did not take place in the Subsidiary's country. The transfer of the IP would have been done at a low value (although arm's length) as the prospects of successful commercialisation were very uncertain at the time of the transfer. In regards to future development of the intangible property, Parent, as a service provider, would have been entitled to a cost plus mark-up on costs incurred.

In a post-BEPS world, less emphasis is placed on legal ownership and more on economic aspects of substance. In the example above, Parent controls functions and manages patent risks owned by Subsidiary and is entitled to compensation. The Amended TP Guidelines, including the analysis to example 17, will support that Parent's compensation is not appropriately recognised by the profits earned by a CRO. Parent's transactions with CROs are not comparable to the Subsidiary/Parent arrangement given that the functional profiles differ, i.e. parent is in control of function and is the more appropriate party to assume the risks of success or failure. While Subsidiary legally owns the patents it lacks the capability to control research risks while Parent performs key decision making functions and thus should be appropriately compensated.

Clearly there has been a fundamental shift in the way we look at the division of profits due to the introduction of BEPS. In a pre-BEPS environment, Subsidiary would be better able to keep profits given it legally owned the intangibles and paid arm's length prices for development functions. Post-BEPS, it is clear this will change with an emphasis on functions, including control of those functions and risks.

Moving intangible property offshore in a transfer pricing setting – pre-BEPS & post-BEPS

Intangibles are becoming an increasingly valuable component of a company's value. Intangibles often account for a larger stake in an enterprise's value than traditional tangible assets. When you factor in the mobility of these assets, it is not a surprise that IP migration strategies have frequently been relied upon to move profit-generating assets to lower tax jurisdictions. However, there are other legitimate reasons for migrating intangibles, including:

  • Protection of intangible property

  • Capital funding

  • Sharing in intangible development risks

  • Tax credit issues

From a tax perspective, during both the pre-BEPS and post-BEPS era, moving IP from one jurisdiction to another, including lower tax jurisdictions, can be justified and legally tax effective if the corresponding functions, assets and risks are moved with the IP. Historically, the legal owner took all, or a material portion of, the residual profits after routine profits were paid to entities that performed functions related to the DEMPE of the intangibles and the management of the risk. In the post-BEPS environment however, a shift has occurred in that people functions, particularly controlling functions related to the DEMPE of the intangibles and controlling functions regarding the assumption and mitigation of risk, have far greater value than legal ownership, direct funding and contractual assumption of risk.

The old transfer pricing adage of "functions, assets and risk" is now misleading as functionality seems to be highly relevant in all three of those factors. In other words, if transfer pricing is supposed to be based on economic reality, does economic reality support allocation of residual profits to purely functions (e.g. labor) rather than ownership (e.g. capital)? This is one of the main reasons there is debate in the international tax community, and particularly in the Canadian tax community, regarding whether the Amended TP Guidelines are clarifying in nature or whether they constitute a fundamental change to the arm's length principle. Unfortunately, this debate is a moot point because the opinion of the OECD and tax administrations, which ultimately prevails over that of the taxpayer, is that the revised guidelines are clarifying in nature and not a fundamental departure from the arm's length principle. The CRA has confirmed its view that the revisions are clarifying in nature.

In the post-BEPS world, if tax-motivated IP migration strategies are to be carried out in an acceptable manner, it is imperative that substantive functions be transferred with the intangibles. From the OECD's perspective, its BEPS initiative successfully eliminates the tax benefits behind cash box companies and other structures that were pushing the envelope with respect to lack of functionality in the lower tax jurisdiction.

Rectifying pre-BEPS structures that are inconsistent with the amended TP guidelines

Many enterprises are concerned about how taxing authorities, such as the CRA, will treat existing tax structures involving IP migration that were created before BEPS. As mentioned above, the Amended TP Guidelines are considered by the OECD and the CRA to be clarifying in nature and are, for all intent and purpose, retroactive in effect. If taxpayers believe that their existing structures are not consistent with the Amended TP Guidelines and make no attempt to rectify them, they run the risk of being exposed to transfer pricing adjustments should they be audited by the CRA. In the event taxpayers decide to rectify the situation on a prospective basis only (e.g. by amending their transfer pricing documentation to reflect the Amended TP Guidelines for future years), this could red flag problems and deficiencies to the CRA with respect to their filed taxation years.

To date, the CRA hasn't made public statements regarding possible relief for taxpayers trying to rectify existing IP migration structures that have been reported in a manner that is inconsistent with the Amended TP Guidelines. In the author's view, this silence, or lack of concern, is unfortunate considering the significance of the changes which are, arguably, beyond clarifying in nature. What is more troublesome is the CRA's position that these changes are clarifying in nature and retroactive in effect despite having agreed to countless audit, appeal and mutual agreement settlements over the years on IP migration structures, supposedly on a "principled" analysis of the arm's length principle, in a manner that is not consistent with the Amended TP Guidelines. In other words, tax administrations have routinely settled transfer pricing cases in a manner that is not consistent with the Amended TP Guidelines and have allowed varying degrees of profits to be reported in lower-tax jurisdictions where little functionality has taken place.

In the absence of guidance from the CRA on this matter, taxpayers should proceed with caution before deciding on a rectification strategy. Canadian taxpayers can file amended tax returns for those open taxation years where their reported transfer prices are inconsistent with the Amended TP Guidelines. However, if the taxpayer's pending upward transfer pricing adjustments for filed taxation years are significant and subject to possible penalties, taxpayers may consider the CRA's voluntary disclosure program (VDP). The CRA has little experience in its VDP with respect to transfer pricing cases and the waiver of transfer pricing penalties, so there is some uncertainty in this avenue of recourse. Also, Canada's VDP has stringent conditions for eligibility that often prohibit taxpayers from applying, particularly those taxpayers who are under constant audit activity by CRA. Taxpayers could also consider applying for an Advanced Pricing Agreement (APA) which assists taxpayers in determining transfer pricing methodologies for prospective years (generally three to five years). One of the benefits of the CRA's APA program is the ability for taxpayers to ask to apply the terms and conditions of an APA retroactively to non-statute-barred taxation years (i.e., an APA rollback). Where APA rollbacks are accepted, the taxpayer will not be subject to transfer pricing penalties.

Taxpayers would be well advised to seek tax counsel before deciding on first, whether self-rectification of unaudited filed years is advisable and, if so, what specific course of action to take.

Post-BEPS – is there now more uncertainty?

As a consequence of the BEPS project and the resulting Amended TP Guidelines, profits must be aligned with the location of value creation. There is no ambiguity in the OECD's message to the tax community on this issue. However, the guidance from the OECD, including example 17, does not provide much in the way of how the actual intercompany transfer prices should be documented. In a typical IP migration strategy, there is often only two intercompany transactions taking place: i) the initial transfer of the IP to the subsidiary located in the lower tax jurisdiction; and ii) the intercompany R&D service contract. The final sale of the IP or the ultimate exploitation of the IP by the foreign subsidiary will be done with arm's length parties (i.e. customers). In the event the CRA decides not to recharacterise the transaction, the first intercompany transaction will simply involve valuation issues. With regards to the second intercompany transaction, the OECD expects future revenues to be properly allocated to the parent company for its efforts in contributing to the value of the IP. However, in the absence of guidance from the OECD and tax administrations on how this should be documented, taxpayers are left in the dark.

From a practical point of view, profits should be set such that the simpler of the two parties be given a routine return while the more complex party receives the residual profits/losses if such profits materialise. The profits attributable to each party will depend on the functions performed, assets utilised, and risks assumed by each party. If the subsidiary is simply the holder of IP with no corresponding functions, it may only be entitled to an unadjusted return on capital. If the subsidiary performs routine functions in addition to holding the IP, a risk adjustment return on capital may be warranted.

The decision to allocate excess profits/losses to the parent may cause audit controversy for a number of reasons. It is the author's experience that governments are risk averse and want to see some level of compensation in the immediate term even though they may only be entitled to larger atypical profits or losses when the intangibles are fully utilised. Consider the possibility that, in the example above, the IP generated large losses in the initial post transfer years. Will the CRA allow the parent company, performing and controlling key functions and risks, to report the losses even though it did not own the IP and is simply a service provider according to the intercompany R&D service contract? It's doubtful.

Tax authorities such as the CRA may have difficulty accepting that a service provider should not receive at least a cost plus mark-up on services it renders (in addition to some share of the profits if they materialise). It is very likely that setting intercompany pricing on an intercompany service agreement such that the parent company service provider incurs losses will trigger an audit. The guidance, in our view, does not shed sufficient light on the mechanics of profit allocation and seems to add more confusion to an already uncertain landscape. Example 17 of the Amended TP Guidelines is a common IP migration structure but it is highly likely that the annual reporting of the service contract during the start-up years where no profits are being realised will be treated differently between taxpayers and tax administrations until further guidance is developed.

The Amended TP Guidelines will likely result in fewer companies carrying out IP migration strategies, which was one of the unwritten goals of the BEPS initiative. Consequently, the OECD and tax authorities may not be overly concerned about its lack of guidance on reporting issues during the start-up years where the legal ownership of IP was in fact transferred offshore. This is unfortunate because some IP migration strategies involving low-tax jurisdictions may still be carried out, regardless of the Amended TP Guidelines, without the initial movement of functions. This could, for example, be an acceptable strategy where a start-up company wants to keep its options open (e.g. relocate the appropriate DEMPE functions to the jurisdiction that holds legal title of the intangibles) once it has a better idea of the potential value and income earning capacity of the intangible. Even though the Amended TP Guidelines will need to be considered regarding the lack of functionality in the low tax jurisdiction in that initial start-up period, there could be future departure tax savings by transferring ownership of the intangibles at the earliest stage possible.


The BEPS initiative was designed to ensure multinational corporations report profits in jurisdictions based on actual functions, assets and risks and to combat aggressive tax planning structures. The new guidance moves away from placing significant emphasis on legal ownership and towards economic substance and control. The introduction of the Amended TP Guidelines will provide taxing authorities, such as the CRA, more tools to raise and support transfer pricing adjustments. Consequently, taxpayers must be aware of this new guidance before carryout out any IP migration planning.

From a Canadian perspective, an unfortunate aspect of the BEPS project is the lack of guidance provided by CRA with respect to these new guidelines. In the author's opinion, now that the CRA has endorsed these changes as clarifying in nature, having both retroactive and prospective effect, it is inappropriate for the CRA to remain silent on self-rectification and contemporaneous documentation issues.

The jurisprudence is clear that legal form prevails in Canadian transfer pricing cases. The Supreme Court of Canada has on many occasions addressed the doctrine of economic substance and significantly limited the CRA's ability to ignore the facts and circumstances, and substitute economic fiction.

Two recent transfer pricing cases heard by the Tax Court of Canada (TCC) also comment on the CRA's discretion to substitute legal reality with economic theory. In McKesson (2013 TCC 404)), the TCC concluded that the CRA can only recharacterise the legal reality under paragraph 247(2)(b), a special GAAR-like anti-avoidance rule in the Canadian taxing statute. In the absence of a reassessment under this recharacterisation provision, "[a] reassessment under [paragraphs] 247(2)(a) and (c) does not permit a recharacterisation of the transactions entered into by non-arm's length parties, nor can another different transaction entirely be substituted therefore." In Marzen (2014 TCC 194), the TCC agreed with the respondent's reference to the Current TP Guidelines in support of respecting legal reality which states "[a] tax administration's examination of a controlled transaction ordinarily should be based on the transaction actually undertaken by the associated enterprises as it has been structured by them." Both these transfer pricing cases are consistent with the earlier Supreme Court of Canada decisions concerning the appropriate use of the doctrine of economic substance.

With Canada's tax system having such a strong emphasis on legal form, one might question how a Canadian court would view a transfer pricing adjustment made by the CRA to an R&D service contract as per example 17 above, once CRA has chosen not to recharacterise any of the transactions. That is, the OECD's approach under its Amended TP Guidelines is to reward the company that forms the value creating function while ignoring the traditional entrepreneurial principle of rewarding legal ownership with all or at least a portion of residual profits. In other words, the OECD seems to want to treat the company that contributes to the value creation of the IP as the beneficial owner of the IP in cases where they do not feel they have the grounds to recharacterise the transaction. However, issues will arise in the absence of further guidance on how to properly document these transactions in those early years where no revenues are generated. It will be interesting to see how these cases will play out in a Canadian court.



Dale Hill

Partner, Tax Services – National Leader, Transfer Pricing & Competent Authority Group

Gowling WLG

Office: +1 (613) 786 0102

Fax: +1 (613) 788 3473

Dale Hill is a partner in Gowling WLG's Ottawa office and is the national leader of the Gowling WLG's Transfer Pricing and Competent Authority team. Dale works in conjunction with the firm's national tax practice group to help organisations optimise their global tax position and reduce exposure to unfavourable audit assessments through proper tax planning and implementation strategies. Dale's specialty is audit defence and dispute resolution with many countries around the world.

In addition to Dale's audit defence work, he also oversees the group's transfer pricing documentation and Advanced Pricing Agreement (APA) practice and is actively involved in providing litigation advice to the firm clients from a tax perspective. Dale has worked in a variety of industries including, but not limited to, pharmaceuticals, auto, construction, consumer durables and computer software industries.

Dale's ability to solve contentious issues stems from his vast experience working at the Canada Revenue Agency (CRA) at a senior level. Prior to joining Gowling WLG in 2005, Dale was involved in international transfer pricing and tax avoidance with the CRA for 16 years. During his tenure as a senior manager with the CRA's International Tax Directorate, he participated in more than 40 APAs with numerous countries, as well as hundreds of Competent Authority requests relating to international transfer pricing adjustments involving a vast array of issues. He is also experienced in a number of other international tax areas, including interest deductibility, guarantee fees, imputed interest, notional expenses, penalties and appeals. Dale has been successful in resolving a number of controversial audit issues through negotiations with various tax authorities in a number of countries around the world.

Dale's expertise has been recognised many times by various institutions. In particular, his group was awarded with Canada Transfer Pricing Firm of the year award by International Tax Review for the years 2011, 2013, and 2015. He acquired his CPA and CFP designations in 1991 and 1995, respectively, and completed the CICA in-depth tax course in 1999.

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