DEMPE analysis as a practical conceptual tool to accept/reject comparables
Carlos Pérez Gómez and Karem Martínez Coeto of HLB MAAT Asesores explain why multinational enterprises would benefit from DEMPE analysis to reach a broad arm’s-length evaluation.
Since the release of Actions 8 to 10 of the OECD BEPS project, an issue that became essential in the analysis of the arm's-length principle is the value contributions made by entities of a multinational group, regarding the core business of the multinational group itself, as well as the assumptions and effective risk control, including the prioritisation of the economic substance as an issue that should not be overlooked in inter-company transactions, related to the amendments in Chapter 1 and 6 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TP Guidelines).
In this regard, as of 2017, some concepts were included into the OECD TP Guidelines to identify intangible-related activities or functions such as: development, enhancement, maintenance, protection and exploitation (DEMPE), which are aligned with the attribution of benefits and costs allocation between the entities that generate value within inter-company transactions. To perform a diagnosis that will allow to identify the value-creation functions in related party transactions, the OECD TP Guidelines suggest the following:
Full identification of the non-routine intangible(s) involved in the analyzed transaction, as well as the associated risks and the entity controlling these risks;
Detailed review of the contractual terms established between the parties, looking for consistency between the actual economic conduct of the involved entities and the enactment of such activities in the contracts, verifying that the entity bearing the risks related to the non-routine intangibles, has the financial capacity, control assumption, as well as the legal ownership (if applicable); and
That the price or amount of the compensation complies with the arm's-length principle in accordance with an appropriate functional analysis in which the contributions made by each of the entities involved in the transaction are considered.
Thus, the reason to include DEMPE into the OECD TP Guidelines is that taxpayers, tax authorities, and practitioners have a conceptual framework to better identify intangibles, through the activities or functions which may lead into their creation, despite the fact that accounting standards or legal property laws would not require their formal recognition as part of the taxpayer’s records.
It should be emphasised that certain DEMPE functions such as advertising, marketing and promotion (AMP) or research and developing (R&D) can be identified in the income statement operating expenses, and the following relevant points must be considered:
DEMPE expenses derive in intangibles when the entity has control over risk and financial capacity;
AMP and R&D expenses should be considered in correlation with the tested party’s intensity of said factors, as part of the acceptance/rejection comparability criteria;
Intangible creation activities may be implicit in generic concepts or registries, such as payroll expenses; and
Tax administrations are more focused in DEMPE expenses as part of the comparables selection process performed by companies.
Addressing the functions which lead to the creation of intangibles and the associated risk control, is crucial for the analysis of the arm's-length principle. Due to the increase of business restructurings, whether caused by economic crises (e.g. COVID-19) or tax planning, both companies and tax authorities are motivated, not only to identify the existence, type of intangible and economic substance, but also to assign a value to it.
Assigning a value to an intangible relates to the complexity of valuing elements (i) that are not visible; (ii) that can be unique; and (iii) that can be volatile when facing environment conditions.
In this regard, a desirable methodology is the comparable uncontrolled price method if comparable independent transactions can be identified (internal or external) and therefore, a reference framework can be formed. However, when this is not possible, that is, when intangible assets are hard to value or simply do not exist in the market, other valuation techniques should be used, such as the application of the profit split method (PSM), the residual profit split method (RPSM), or where appropriate, resort to financial valuation methodologies as alternative or complementary approaches.
Currently, methods that involve profit sharing (PSM and RPSM) can solve the problem when it comes to highly integrated operations or where complex value chains are identified. However, access to specific information on the entities that make up the entire group can cause a problem for both taxpayers and tax authorities. Nonetheless, to obtain greater transparency on both sides of the transaction, the master file may provide useful information.
Alternatively, regarding financial valuation methodologies, although they do not constitute a recognised TP methodology in some legislations, it is true that the application of existing financial valuation approaches (income, market and physical) can be the only and proven solution to find market values regarding the behaviour of independent economic agents in the free market.
The Mexican Tax Authorities (MTA), as many others around the world, have focused their TP audits on identifying the DEMPE functions, value creation and the proper compensations between the parties.
It is not enough to demonstrate that the inter-company transactions comply with the arm’s- length principle by proving that the amount of the compensation falls within a range, the complexity raises when the taxpayers have to explain the economic and value drivers of the entities, facing that the substance differs from the contractual and TP policies’ standpoint. The environment in TP compliance issues in Mexico tends to include part of this requirements as a formal obligation to taxpayers by requiring to address this information in the documentation report.
In conclusion, a thorough understanding of the nature of the transaction under analysis, its economic nature, the analysis of functions, assets and risks tend to be aligned, in a comprehensive manner, with the DEMPE analysis, is recommended to reach a broad arm’s-length evaluation.
In the current economic context and given the investment made by large multinational groups in technological innovation, taxpayers ought to focus on the identification of business drivers within a value chain analysis, exploring the economic logic of the transactions and the financial capacity and control decisions of the assumption of risks to carry out an appropriate assessment of the arm's-length principle.
Carlos Pérez Gómez
Partner, HLB MAAT Asesores
Karem Martínez Coeto
Manager, HLB MAAT Asesores