The changing frontiers of transfer pricing for life sciences companies
Life sciences companies, long at the vanguard of international tax planning, are facing particular challenges because of the important role the exploitation of intellectual property (IP) plays in the industry. Aydin Hayri, Keith Reams and Susan Eisenhauer discuss the complex web of tax and transfer pricing regulations that multinational companies have to navigate.
Like many industries, the life sciences industry is going through a period of rapid change, led by a burst of technological innovation and a changing business environment. Globalisation accelerates these trends as companies look to capitalise on their discoveries on an unprecedented scale and search for talent around the world.
This article will touch upon the emerging issues regarding economic ownership of IP, which are rapidly gaining importance in the context of international tax compliance and planning, particularly in light of the Organisation for Economic Cooperation and Development's (OECD) current base erosion and profit shifting (BEPS) initiative, as well as high-profile challenges by tax examiners in various countries.
Two broad themes emerge in this area: tax administrations seem to be increasingly convinced that (1) multinationals have been and are adopting abusive tax structures designed to circumvent the various tax rules they are subject to; and (2) such arguably abusive tax structures lack economic reality and/or are short on substance. The OECD's Working Party 6, made up of representatives from the various member states, has been working diligently for many years now to find consensus around some of the thornier issues. While far from being unanimous in their thinking, the members of the working group published some of their ideas regarding the transfer pricing aspects of intangibles in draft recently. If adopted in the final guidelines and ultimately incorporated into legislation, these concepts could have far-reaching effects on multinationals in the life sciences industry.
IP in the life sciences context tends to consist generally of legally protected IP, such as patents, trademarks, and trade names and copyrights, as well as unpatented technology and other unprotected intangibles. Product IP in the industry, in particular, will include product and/or use patents, technical data from clinical trials, regulatory approvals, manufacturing know-how (including potential patents for manufacturing), and trademarks. Historically, life sciences companies have managed their IP on a product or portfolio franchise basis, which means they usually treat all constituent parts of the IP on a bundle of rights basis, divided according to custom on a geographic or field-of-use basis.
Bundling was particularly meaningful for small-molecule pharmaceuticals, because the economic useful life of a particular small molecule compound typically would come to an abrupt end with the expiration of the fundamental protective patent(s) (or in the case of generic off-patent products, at the end of the typical six-month period of exclusivity). In that sense, there was little need to consider separately the constituent parts of the bundle of rights in the product IP, because all components of IP were seen to have the same useful life.
For more complex large-molecule biopharmaceutical products, however, the situation is somewhat different. First, biopharma products typically have very complex patent protection patterns. For instance, some biopharma patents are used to block competitors from working on certain types of indications, enzymes, genes, proteins, or even biological pathways or mechanisms of action, but may be non- specific as to a particular compound. Those patents may be seen as process or platform patents and have broad reach in terms of protecting a whole class of potential compounds and therapeutic agents for what may be a very difficult to measure and/or uncertain period of time.
Second, and perhaps more important, biopharma products are often the result of bioengineering processes using live organisms, which are more difficult to reproduce in the laboratory compared with the more straightforward chemical synthesis processes used to make small-molecule compounds. As such, the useful life of typical biopharma products may depend on factors beyond the patent protection period, such as manufacturing know-how and trade secrets.
Finally, big pharmaceutical companies have more recently shown the ability to lengthen the economic lives of some products beyond patent expiration, despite the growth of generic competition through significant investments in marketing and brand-building around the branded products they produce and distribute.
Increasingly, the challenge today for international tax planning and transfer pricing for most companies in the industry is to be able to identify and evaluate the different component parts of the product IP separately. Historically, there has been a strong reliance on the wide variety of available information regarding uncontrolled third-party licensing deals in the industry as comparable uncontrolled transaction (CUT) benchmarks for purposes of setting and documenting intercompany arrangements for income tax and transfer pricing purposes. When a more differentiated set of IP rights are involved, the CUT approach is often difficult to apply, because CUTs involving separate components of IP have not generally been readily available. Other methods, therefore, have tended to take precedence in those instances.
Separating manufacturing know-how
In uncontrolled deals, the licensor typically licences out the product IP before approval. While all technical data and manufacturing know-how are typically included under the licence grant, full-scale manufacturing typically would not start for a possibly extended period of time. Uncontrolled license deals for the full-scale exploitation of compounds/treatment regimes in later phases of development are rather few and typically take the form of a distribution agreement (whereby the licensor also supplies the product). This is quite often the case when the manufacturing of the product is complex and, therefore, the contribution of the manufacturing know-how is likely to be more important. The value of this contribution can often be measured by attempting to quantify the difference between the typical wholesale supply price for the finished product and the typical licence rate (that is, the difference between what the IP owner might earn as the supplier compared to being just a pure licensor). This difference would generally include the routine manufacturing return, as well as any product liability risk associated with the supply (that is, the IP owner would normally assume the manufacturing defect risk as the supplier, but often not as the licensor). While there are large variations in the industry, an IP owner might typically earn between 40% and 60% of the resale price, whereas the licence rate for an approved (or a late-stage) product rarely exceeds 30% of the net sales price.
Another approach for assessing the contribution of manufacturing know-how might be to analyse transactions involving solely manufacturing know-how, or analogous IP (such as the delivery system licensing rates). Although such agreements may involve a significant degree of complexity, the prevailing licencing royalty rates observed in the industry for pure manufacturing know-how – even for an important well-known and accepted product – are typically about 4% of net sales.
When there are few industry benchmarks for assessing the contribution of the manufacturing know-how in a particular instance, an approach to consider may be the "replacement cost" method, depending on the facts and circumstances and the general availability of specific development cost data.
Indicia of beneficial ownership of IP
IP is so central to value creation in the life sciences industry that arguably the most important international tax and transfer pricing questions revolve around the identification of the developer and owner of the IP. To this end, it is not sufficient to simply look to the registration of the patents and trademarks. For income tax purposes, it is necessary to establish the "beneficial" or "economic" owner; that is, the entity, group, or organisation responsible for undertaking the funding and risk of development of the IP. Until the recent OECD discussion draft on intangibles, the established practice in this area looked for four indicia of beneficial ownership:
1) Cash – Which entity or group assumed upfront responsibility for the IP development or acquisition costs? Did the presumptive owner incur specific expenses to develop or acquire the IP?
2) Capital – Did the presumptive owner have appropriate capitalisation upfront to withstand the potential failure of the development effort? Would it make economic sense for a company with the presumptive owner's resources to have attempted such an IP development project?
3) Conduct – Did the presumptive owner secure the proper legal rights to the IP and memorialise the intended course of conduct? Follow-through with respect to the implementation of that course of conduct is also important. While the ultimate legal registrations may not be in the name of the beneficial owner, there should be some documentation of the initial intent regarding which party would be the beneficial owner. Did the presumptive owner make arrangements upfront and conduct development and commercialisation efforts in a consistent manner?
4) Control (Executive) – Did the presumptive owner of the IP exercise managerial control over the business activities that directly influence the amount of income or loss realised from the IP or its development? Did the presumptive owner set the budget, and make the strategic decisions for development, protection and value preservation? These questions are consistent with the guidance provided in Paragraph 79 of the OECD's Revised Discussion Draft on the Transfer Pricing of Intangibles.
While these four indicia have been in the guidance for a long time and have been generally accepted by many taxpayers, the OECD working party representatives, as part of the more recent BEPS initiative, appear to be trying to add a fifth indicium, which hitherto has not been deemed a strict requirement, but "good to have":
5) Control (Operational) – Did the presumptive owner exercise operational control over the IP development and/or commercialisation? Did the presumptive owner design the development programme and make most of the critical operational decisions?
The income tax regulations promulgated by the US Treasury (Treas. Reg. §1.482-1(d)(3)(iii)(B)(3)) suggest either managerial or operational control as an important factor: "[E]xercise managerial or operational control over the business activities that directly influence the amount of income or loss realized." The OECD draft chapter VI of the transfer pricing guidelines goes beyond executive or managerial control, and appears to suggest that to secure all beneficial rights to IP, the presumptive IP owner must have operational or functional control over the IP development, perhaps directly through its employees.
An appropriate analysis of executive control should focus on the corporate governance of the presumptive IP owner, and should be analysed under a hypothetical scenario of independence. Such a hypothetical analysis under presumed independence should not focus on the actual decision-making process within the multinational enterprise, but whether the presumptive IP owner has the capacity and ability to make executive decisions related to the IP development. In the life sciences sector, that capacity is generally focused on the financial and business wherewithal to direct the development efforts, with support from at least some scientific knowledge. In the current environment, however, it is not implausible that tax authorities may begin questioning the frequency and extent of reviews by the presumptive IP owner of the development programme, and impose changes if actions taken by others are determined to be inconsistent with the objectives and parameters of the development programme.
The determination of beneficial ownership for tax purposes may be affected by the existence of contract research and development (R&D) arrangements, which are common in the life sciences industry, both in the uncontrolled and related-party settings. For many decades, taxpayers viewed a cost plus 10% margin as a de facto safe harbour for contract R&D. For many taxpayers that have had such a policy in place for a long time and have had such arrangements accepted in multiple US or foreign audits, this may well be a low-risk issue. In contrast, for taxpayers that are just entering into such arrangements, or restructuring them, we would like to highlight a few considerations around each of the 5-Cs indicia of beneficial ownership.
1) Cash – Cash needs and expenditures can vary widely with respect to R&D, and careful consideration should be given to each item of cost. For instance, some types of R&D require highly specialised facilities, often necessitating substantial upfront cash outlays. In those cases, and for other expenditures that have an extended period of utilisation, it may be necessary to undertake a broad-based and thoughtful analysis of how such items should be accounted for in the cost base. For instance, the amortisation of those expenditures or an arm's-length lease or rental rate can be used to match expenditures with benefits to the contract R&D arrangement or, perhaps, a decision may be made to treat those expenses separately from other contract R&D services altogether.
2) Capital – The capital structure of the presumptive IP owner in a multinational enterprise may sometimes be an afterthought, but care should be exercised to confirm that the presumptive IP owner has the resources to see through whatever research programme it is funding.
3) Conduct – Some taxpayers take a blanket approach and claim that the benefits of any and all R&D conducted by the contract R&D service provider belong to the service recipient. This result is often assumed to be automatic because of the contractual terms governing the arrangement. The US transfer pricing regulations state, in more than one place, that contractual terms may be overridden if inconsistent with economic substance. Further, the contract R&D activities, in and of themselves, may create intangible assets in the form of non-specific know-how or other capabilities the contractor may develop over time in the normal course of performing its business. Such business process IP may not be related per se to the specific contracted R&D activity, but rather are a separate outcome from the IP being developed through the contract R&D arrangement. Over time, it is that business process R&D, often referred to as going concern value that the contract R&D service provider relies on for efficient and productive functionality. In those cases, it may become necessary and even beneficial to identify this non-specific benefit separately for purposes of future income tax and transfer pricing planning.
4) Control (Executive) – Control of the contract R&D relationship may often require more than just tracking contractual provisions set out in the original contract R&D arrangement. An accepted practice in this area has evolved to include periodic (say, quarterly) budget and programme reviews, including the undertaking of critical decisions and their resolutions. As part of such periodic reviews, the officers and/or the board of the presumptive IP owner that engages a related-party contract R&D service provider would be well advised to exercise and document a substantial level of vigilance regarding the activities of the contract R&D service provider.
5) Control (Operational) – If the presumptive IP owner does not have the facilities or personnel to be involved in the research programme on a day-to-day basis, it may be advisable to include in the upfront contracting process detailed provisions relating to the operational aspects of the contracted R&D program. Such provisions would intentionally limit the discretion of the contract R&D service provider to prevent any perceived dilution of the presumptive IP owner's rights in the IP created under the contract R&D arrangement.
Collaborations and R&D funding
Because of the high costs and substantial risks involved in developing and commercialising products in the life sciences industry, in recent years there has been an upsurge of alliance and collaboration arrangements among different players in the industry. For instance, big pharma, with its armies of detailers and distribution capabilities, has entered into joint development arrangements with small entrepreneurial start-ups with innovative technologies and/or ideas to leverage each other's capabilities. Such arrangements, though increasingly common, are quite complex and distinctive, reflecting a vast array of possibilities.
Collaborations may create complexities for income tax and transfer pricing planning and compliance and, therefore, must be carefully analysed. It may be appealing to look to third-party arrangements as benchmarks when crafting intercompany arrangements; however, attention must be paid to the specifics and details of each arrangement to confirm they reflect the true economics of the arrangement appropriately. In many instances, it may not be possible to replicate the essential relationships on an intercompany basis to a sufficient degree as to make a third-party arrangement a useful comparable for planning and/or compliance purposes. The forces that bring independent parties together in collaboration often have more to do with the specialised resources, knowledge, and capabilities of each of the parties, and less to do with the shifting of risk and functionality between them. Further, even if such arrangements might be replicated successfully, changes in those third-party arrangements frequently arise due to factors unrelated to the original economic considerations, such as subsequent acquisition/disposition activity or competing technological developments. Those changes make it increasingly challenging for multinational corporations to convince tax authorities that third-party arrangements should continue to be respected as comparable.
While many of the issues highlighted here are not specific to the life sciences industry, the stakes tend to be much higher for pharma and biopharma companies because of the often large and highly risky investments and long lead times involved in product development and commercialisation. Planning, under sometimes extreme uncertainty, can be challenging, and because hindsight is always 20/20, contention over who knew what when can often plague taxpayers that may be embroiled in difficult audits and even litigation with tax authorities. As with everything in international tax and transfer pricing, careful and broad-based documentation of all relevant facts and circumstances contemporaneous with – or at least as close as possible to the actual timing of transactions – can be critical to not only structuring arm's-length arrangements but, more importantly, to sustaining such arrangements for the long term.
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Aydin Hayri is a principal in the Washington, DC office of Deloitte Tax. He is the life sciences industry leader for the transfer pricing practice, and manages the Philadelphia transfer pricing practice group. He has been with Deloitte since 1998.
Aydin assists clients with transfer pricing planning involving global and domestic intellectual property development and licensing strategies; and planning and implementation of supply chain and business model restructurings. He has provided thought leadership by developing and applying China and the Far East sourcing strategies, such as adjustments for manufacturing and distribution risk differences, and adjustments for recession, market share, and book-to-market value differences. In addition to the pharmaceutical industry, his experience covers the medical device, defense/aerospace, manufacturing, and retail sectors.
Before joining Deloitte, Aydin was an assistant professor of economics at Charles University, Prague; the University of Warwick, England; and a research fellow at Princeton University. His primary specialization was industrial organization, with emphasis on the economics of risk, uncertainty, and valuation. He taught courses on this subject, published articles in international journals, and obtained grants from the European Commission, the Economic and Social Research Council, and the World Bank. Aydin still teaches occasional courses for MBA students.
PhD, Economics, Princeton University
MA, Economics, Princeton University
BA, Economics, Bogazici University, Istanbul
Selected transfer pricing publications
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Keith Reams is the US and global leader for clients and markets for Deloitte's Global Transfer Pricing Services practice. He has advised clients around the globe on intercompany pricing transactions with respect to income tax regulations in Argentina, Australia, Belgium, Brazil, Canada, Chile, China, Colombia, Czech Republic, Denmark, France, Germany, India, Ireland, Israel, Italy, Japan, Korea, Luxembourg, Malaysia, Mexico, the Netherlands, Norway, Peru, Poland, Singapore, South Africa, Spain, Switzerland, Taiwan, Thailand, the UK, and the US. He has assisted numerous multinational companies with international valuation and economic consulting services involving merger and acquisition activity, international tax planning, and restructuring and reorganisation of international operations. Reams is on the global tax management team for Deloitte's Technology, Media, and Telecommunications practice and is a leader in the area of transfer pricing for newly emerging industries, such as electronic commerce and cloud computing, where he has extensive experience around the world in helping clients extend their business models into new territories.
Keith has testified as a qualified expert in numerous valuation and transfer pricing disputes, including the cases of Nestle Holdings Inc. v. Commissioner, DHL Corp. v. Commissioner, and United Parcel Service of America, Inc. v. Commissioner. In addition, he is one of only three economists in the US approved by the New York State Department of Taxation and Finance to provide transfer pricing expertise and testimony in cases involving cross-border transactions within commonly controlled affiliated groups. He has also helped many clients to successfully resolve valuation and transfer pricing disputes before they reach trial.
Keith completed course requirements for a Ph.D. in international finance from New York University. He holds a Master of Arts in economics from California State University Sacramento and a Bachelor of Science in chemical engineering from Stanford University.
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Susan Eisenhauer is a director with Deloitte Tax LLP's Global and US Transfer Pricing practice and a senior member of the East Region Transfer Pricing team. Susan has over 30 years of tax experience, focusing exclusively on transfer pricing planning, documentation and audit defence for 20 plus years, with hands-on experience in developing and implementing transfer pricing policies.
Since joining Deloitte in 1997, Susan has worked on a wide variety of inbound and outbound transfer pricing projects, including numerous advance pricing agreements, cost sharing arrangements and intangible migrations. Susan also spends significant time on tax controversy matters, including mutual agreement process requests and tax provision work relating to transfer pricing. She has successfully defended her own transfer pricing studies upon audit by the IRS, as well as helping companies without existing documentation develop audit strategies and responses to IRS information document requests. Susan has handled transfer pricing matters for nearly 100 different clients across a broad spectrum of industries. Susan's current clients operate mainly in the consumer products, office products, chemical, and pharmaceutical/biotech industries.
Before joining Deloitte, Susan worked for several large US-based multinationals. Within the corporate environment, Susan began her career in international tax planning and was involved in most aspects of corporate international tax and foreign income tax matters including transfer pricing, as well as being heavily involved in monitoring and managing IRS audits.
Susan speaks on various transfer pricing topics at conferences and meetings sponsored by The Tax Executives' Institute, Insight Information Co., and CITE, Inc., as well as facilitating numerous in-house and client trainings at Deloitte. She has co-authored several articles.
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