Tax law and regulations often treat different types of transactions differently. For example, income from intangibles is often subject to a withholding tax at source and, in the US, is also subject to adjustment under a "commensurate-with-income" analysis when received from a related party. Services, in contrast, generally are not subject to either of these specialized provisions.
However, the economic differences between two different types of transactions are often not as clear as implied by tax definitions. This has recently become apparent in the case of services and intangibles, where it is easy for a contract right to a service to give rise to an intangible over time, often with no change in the underlying economics of the transaction.
As a simple example, take the case of a long-term contract for oil refinery services. Under the terms of the contract, Company A, the service provider, agrees to provide refinery services for Company B in return for a fixed price per barrel of oil. The service provider insists on a 10-year "take-or-pay" contract at a fixed price schedule to protect its upfront investment.
During the course of the 10-year contract period, changes are likely to occur in the market. As a result of these changes, the contract can become either less valuable than expected (for example, there is a glut of refinery capacity and, absent the take-or-pay contract, Company B could save money by buying refinery capacity at a lower spot rate) or it can become more valuable than expected (for example, there is a shortage of refinery capacity and, absent its contract with A, Company B would incur higher costs in purchasing refinery services). In either case, the contract that began as a simple services arrangement might now include a "favourable contract" intangible - in the case of falling spot prices, in favour of Company A, and in the case of rising spot prices, in favour of Company B. Focusing on the latter case, Company B could sell the contract for a positive price and/or could earn higher profits than it could absent its rights under the contract.
This case of rising spot prices is particularly interesting because Company A could be seen to own an intangible associated with the shortage of refinery capacity. In the absence of the contract, Company A would earn above-normal profits and its refinery assets therefore result in an intangible that exists over and above any contractual rights. The question that arises is whether the contractual rights shift the beneficial ownership of that intangible. Company A owns the refinery capacity that gives rise to the intangible, and so the intangible's existence is dependent upon Company A's assets. However, Company B has provided specific contractual commitments under the take-or-pay provisions that might have been a critical part of Company A's decision to build the refinery and its ability to obtain financing. Should tax authorities attribute the profits of the intangible to the entity with the resources that are needed to generate the intangible, or to the entity that has the contractual rights to the intangible?
The second question that arises is how to price the intangible. The measurement of the spot value of an intangible is often easy to measure. In the refinery example set out above, if the contractual price for the refining services is $1 per barrel while the price of buying similar refinery services is $1.75, the spot value of the intangible at that particular point in time is $0.75. This tends to be the value that tax authorities focus on in determining transfer prices.
However, the spot value as measured above is generally not the correct value, in that it does not take into account the fundamental difference between long-term pricing and short-term pricing, and fails to properly adjust for risk. When they entered into the 10-year contract, both Company A and Company B might have expected the spot pricing to be:
the same as the long-term contractual price a third of the time;
lower than the long-term contractual price a third of the time; and
higher than the long-term contractual price a third of the time.
The only time that an intangible exists is in the last case, or when the spot price is higher than the long-term contractual price. However, while intangible value "appears" to exist in those years, this occasional advantage is needed to offset the period in which the long-term contractual price is higher than the spot price.
Lastly, we come to the question of when the nature of the services becomes so similar to an intangible that it is subjected to any special transfer-pricing rules governing intangibles. Using the US commensurate-with-income requirement as an example, does the commensurate with income requirement come into play:
whenever the spot price is higher than the long-term contractual price, thereby generating intangible value in that year;
only if the contract is sold in an intercompany transaction when the spot price is higher than the long-term contractual price, thereby generating intangible value in that year; or
any time after the contract is sold in an intercompany transaction, but not otherwise?
And does the answer to this question change if there is an intangible component to the pricing when the original contract was negotiated?
In many cases, there are clear "economic" answers to these questions. For example, the benefits associated with the assumption of risk should clearly accrue to the legal entity that bears the risk. So in the example given above, Company B should realize the benefits of the favourable contract intangible that results from a change in market conditions for refinery services during the 10-year period of the contract. Company A, however, is entitled to the benefits in years 11 and onward of its intangible associated with ownership of scarce capacity, as Company B does not guarantee that Company A will have a customer and also lacks the rights needed to prevent Company A from selling its services to the highest bidder. The economic answer to this question should not vary with the classification of the transaction as a services or an intangible transaction.
Similarly, it is clear that the pricing of any intangible created during the course of the 10-year contractual period should reflect the down years when the contract generated negative value for Company B, as well as the upside when the contract had a positive value. Pricing based on a single year's results taken in isolation from other years could give biased results in many cases, overstating or understating the true value of the contract. This is particularly true in the case of service contracts in which the risk-bearing entity incurs losses in the early years of the contract that are recovered by higher than usual profits in the latter years of the contract. This situation is common in the case of pharmaceutical marketing/co-promotion agreements, in that there might be losses during product launch followed by several years of sales with high operating margins.
The legal/regulatory environment in which these transactions are evaluated is one in which tax authorities might be reluctant to accept a complete economic analysis. For example, taxpayers are audited for specific years, and tax authorities often give little if any credit for future or past events. In the simple example given above, the tax authorities auditing Company A might be tempted to make an adjustment that brings income into Company A when the spot price of refinery services is higher than the long-term contractual prices. Conversely, the tax authorities auditing Company B might be tempted to make an adjustment that brings income into Company B when the spot price is lower than the long-term contractual price.
The key to addressing these issues is the development of clear intercompany agreements supported by economic analysis. In essence, a long-term services contract that might give rise to intangibles has to be documented at the beginning of the deal, with documentation:
clearly specifying which entity bears which risks; and
including an economic analysis that shows that the long-term pricing is appropriate, given the range of market developments that can be expected to occur over the period of the contract.
By having these agreements in place upfront, taxpayers can potentially avoid or minimize the risk of double taxation arising out of the actions of duelling tax authorities.
Biography |
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Clark Chandler is a principal with KPMG LLP's Washington national tax practice. He focuses primarily on the areas of transfer pricing and the valuation of intangibles for large firms. Chandler has testified extensively, and has worked both for tax authorities and for multinationals in a wide range of different industries. In his more than 15 years in transfer-pricing controversy work, Chandler has served as an economic adviser for taxpayers, the Internal Revenue Service, and other tax authorities on transfer-pricing issues, including the preparation of studies for advance pricing agreements and the documentation required under Internal Revenue Code section 6662. Chandler has extensive experience with international transfer-pricing issues involving tangible and intangible property, as well as services and cost-sharing arrangements. Chandler received his BA from Dickinson College in 1974 and his MA and PhD in economics from the University of Michigan in 1978. Chandler is a member of the American Economic Association. |
