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BEPS challenges for the automotive industry will include matching intangible development contributions to profit allocation |
Among the many novelties presented to international companies by the OECD's BEPS project, one particular challenge will come in relation to intangible contributions in the automotive industry. In effect the new OECD guidelines will mean that all companies that contribute to the development of intangibles should earn some pursuant profits. Creating a transfer pricing system that is both manageable and takes these multiple contributions into account is challenging, but can be done.
The issue arises because the OECD has vastly broadened the concept of 'intangibles', such as informal know-how and best practices. The income from intangibles will be attributed to those entities that exercise 'control'. Many contract R&D structures will face serious challenges, as the principal company often does not exercise sufficient control over the development; on the other hand, local developers have some level of authority and local know-how.
The transfer pricing system has to take into account that the intangibles are created by many entities with vastly different contributions, such as personnel, financing, labs, or contributions at different times and of varying significance. Taxpayers may shun the perceived complexity of a license system between many companies.
We addressed these issues in a recent case of the development of new electronic devices in the automotive industry. The electronic devices will be used by group companies of the MNC for manufacturing the devices, and will also be licensed to third-party companies.
The hardware was developed by several European, American, and Brazilian entities. The development was led by the European group parent company, and conducted by the development departments in these countries. The parent company registered the patents for the hardware. The developers got the right to manufacture the devices over the coming years.
On the other hand, the sophisticated software for the devices had been developed in the US, Europe, and India through an interactive and iterative process.
We analysed the case and found that the parent company did indeed have effective control over the hardware development. The other entities that were involved had followed clear development plans, which were set, checked, and actively managed by the parent. We could demonstrate that this aspect was actual contract development.
On the other hand, the various entities had shown significant levels of personal initiative for the software development, and contributed pre-existing platform intangibles. Therefore the local entities developed some 'economic ownership' in the software intangibles and should earn some pursuant profit.
We evaluated the various contributions (including know-how and effectiveness) on the basis of staff and other costs and used a series of surveys for further refinement. We translated the facts into a residual profit split system, which was then converted into a simple mark-up system for the price setting so that:
The remuneration is principally centred on the parent company, which acts as the payment center. Third-party licenses are exclusively paid to the principal, and are considered in the overall pricing system.
The contribution of most companies is implicitly remunerated through the right to use the devices, and through favourable terms and conditions for parts and finished goods bought from the parent. We demonstrated that the benefit from this approach matches the value of the contributions.
A few companies that contributed to, but do not sell, products to the principal company are explicitly remunerated through a sub-license fee arrangement. In some cases, they are remunerated through netting with other licenses when this was more tax efficient due to withholding tax issues.
We then created an Excel tool that calculated these effects; the tool is used by the client for future price setting. The system could be implemented easily and should be accepted by all tax authorities, including those in India.
