Intangibles gaining prominence – a tax and transfer pricing perspective
Amid the rapidly evolving world of intangibles, Uday Ved, Amitabh Khemka and Hetav Vasani of KNAV in India highlight the tax implications and how to steer clear of controversy.
In ancient times, trade began as a barter system before being gradually replaced by currency. As time passed, the markets dominated by the manufacturing industry shifted towards the service sector. In a similar vein and for a few decades now, the internet of things, automation, robotics, machine learning and other new technologies have taken humans’ work, especially after COVID. This was due to business being conducted, services being rendered, and online content being streamed, all via innovative routes resulting from technology and other know-how. These technologies can broadly be described as “intangibles”. Anything you want will reach you in minutes, and it is the result of these intangibles. The dependency on intangibles will increase manifold in future generations.
According to the Cambridge Dictionary, an “intangible” is something which is “impossible to touch, to describe exactly, or to give an exact value”. Due to its inherent complexity, an intangible is generally understood as something which is “difficult to describe, understand or measure”.
The concept of transfer pricing (TP) applies to intangible assets when enterprises develop, acquire, transfer, or use them. Most commonly, intangibles are owned by a group company based in one jurisdiction. This group company grants licences, such as rights to use technology or know-how, to another company in another jurisdiction for royalty payments. In many cases, overpaid royalties are challenged in the licensee’s country. There have been cases where royalty rates were undercharged in the licensor country, leading to a deadlock. As a solution, illustrating the development, enhancement, maintenance, protection and exploitation (DEMPE) functions being carried out by the licensor may be sufficient to justify these royalty rates when compared to a similar third-party scenario.
The concept of legal ownership versus economic ownership emanated from BEPS action plans (APs) 8 to 10 wherein the concept of DEMPE was considered. It is essential to evaluate the legal and economic ownership of intangibles to determine how income generated from them can be divided among related parties. For both legally protected and unprotected intangibles (including trade secrets and unpatented know-how), OECD Guidelines hold that the company that bears the greatest costs in developing the intangibles is the economic owner. The return ultimately retained by the legal owner depends upon the functions, assets and risk (FAR) analysis. An entity that undertakes significant functions relating to intangible spending must bear the risk – and reap the rewards.
Intangibles restructuring – the fundamentals
Before delving into business restructuring, there are a few critical aspects in the recognition of intangibles, and their transfer to preferred IP jurisdictions. The OECD has introduced BEPS AP 5, which has caused many countries to amend their IP regimes. Due to these amendments, there is an increased requirement of the IP holding company to demonstrate substance and exhibit that actual research and development expenditure is being incurred in the country in which IP is held (known as the “nexus” approach).
Some jurisdictions with stable political environments, availability of infrastructure, migration of tax costs, better access to talent pools and a robust economy help in better development, enhancement, and maintenance of intangibles. In certain countries, exchange control regulations are either limited or absent. This facilitates the transfer of the intangible – in other words, the smooth and fast registration of IP without any hassles and minimal regulatory approval.
Developing countries often lack the domain knowledge, infrastructure or skilled labour to build intangibles. Even with those capabilities, the laws and regulations governing intangibles may not be robust, leading to ideas getting stolen, which may further discourage the inventor. Consequently, developing countries often lose an opportunity to earn revenue because of the exploitation of the intangible, leading to further loss of tax revenue to the exchequer.
One of the crucial reasons for transferring intangibles to a robust IP jurisdiction is that some countries provide legal protection against the infringement of IP and have data privacy regulations. Consequently, many investors prefer owning intangibles in such jurisdictions. Moreover, stakeholders may want to own IP in a jurisdiction where value can be created in the future. This includes future public listing of the company or generating a regular royalty income stream.
Several jurisdictions provide various tax incentives if IPs are owned in their jurisdictions. Tax incentives include tax holidays, lower royalty tax rates and lower corporate tax rates. One such jurisdiction is Ireland, which introduced the Knowledge Development Box in January 2016, a corporation tax (CT) relief with benefits like a 12.5% corporate tax rate, a 6.25% corporate tax rate for certain patent and copyright income and relief from foreign withholding taxes on royalty income. Some of the other preferred IP jurisdictions are the US, Switzerland, Singapore, Hong Kong, the United Kingdom, Sweden, and the Netherlands.
Capital gains taxes are calculated by valuing the IP being transferred. The OECD prescribes income-based valuation methods based on the discounted projected future cash flows arising from the transfer of intangibles. It also highlights the various indicative factors to be considered when conducting the analysis. These include the accuracy of financial projections, discount rates, assumptions on growth rates, tax rates and the useful life of the intangibles.
Relief from royalty is another income-based approach commonly used to value marketing-related intangible assets. It is also possible to derive valuations by using a market-based approach, where the valuation of the intangible is compared to similar intangibles and the cost approach reflects the amount necessary to replace the service capacity of an asset. The transferor sometimes must contend with accumulating large cash traps from the sale of intangibles, which needs to be utilised.
India Domestic Company (IDC), having an online business, decides to transfer its proprietary technology platform to a suitable IP tax jurisdiction. The initial customer presence was restricted to the domestic market in India. IDC has set a strategy to expand its footprint globally. The intangible’s proprietary technology belongs to IDC. Since it has already established its business in India, it will be considered the economic owner of all the market-related intangibles.
It is relevant for IDC to identify suitable jurisdictions considering the above criteria for transferring its proprietary technology platform. Based on the criteria, it can be assumed that IDC chooses to transfer its proprietary technology platform to its foreign parent company (FPC) based in Singapore. Based on an expert’s valuation report, fair value for the proprietary technology platform is determined. Using the royalty rates derived from the TP benchmarking analysis, the valuation expert can compare the rates with rights for similar IP and intangibles. After the transfer, the FPC will become the legal owner of the proprietary technology platform. It may grant rights to India and other jurisdictions for the use of such technology in return for royalty payments.
In addition to the IP transfer, senior personnel who conduct DEMPE activities for technology intangibles at the FPC will be required to demonstrate the substance in Singapore. The support activities related to the proprietary technology platform could be performed by IDC under the instructions of the FPC. Consequently, IDC could be remunerated at cost plus an arm’s length markup for rendering support services. The marketing intangibles for the Indian market may remain with IDC whereas the advertisement, marketing and promotion expenses for Singapore and the rest of the world will be owned by the FPC, which would therefore be considered the economic owner.
Building up substance by the IP holder
Since 1998, the OECD Forum on Harmful Tax Practices (FHTP) has been reviewing preferential IP jurisdictions to determine if they could adversely affect the tax bases of other jurisdictions. There are certain areas that the FHTP is currently focused on, one of which is substantial activities requirements. In terms of the activities that jurisdictions must undertake, the FHTP agreed that jurisdictions must require companies to have an adequate number of full-time employees with necessary qualifications, and to incur enough operating expenditure to undertake the core income-generating activities associated with the income that may benefit from a jurisdiction.
Once the IP is transferred, the new owner must carry out significant functions to demonstrate that all the critical decisions related to the said IP are undertaken by the new owner. It is vital to align risk management with IP transfer and global expansion. As part of DEMPE, the new owner will undertake risk management related to the IP and decisions for global operations through its employees. The new owner will have control over risk to perform decision-making functions related to accepting or declining risk-bearing opportunities and responding to threats. The following are a few risk management activities:
The ability to decide whether to accept, lay off, or decline risk-bearing opportunities;
The ability to decide whether and how to respond to risks associated with opportunities; and
The capability to manage day-to-day risk mitigation.
Hence, senior managerial personnel contributing by taking strategic management and commercial decisions is an important factor that showcases substance at the new owner level.
WIPO filings reached an all-time high in 2021, showing the essence of the global innovation ecosystem. Taxation of digital activities lies at the foundation of an increasingly digitalised economy, where profits are attributed and taxed accordingly. This has caught the attention of various tax administrations resulting in controversies and difficulties when attempting to identify where the income is generated.
There was a time when countries created suitable and favourable IP regimes to attract investments and boost their economy. Ireland was one such country, which gave some foreign corporates effective tax rates of 0% to 2.5% on global profits re-routed to Ireland via their tax treaty network. But Ireland soon realised that the forgone tax costs had severe repercussions.
Establishing a nexus
Developing countries are facing several challenges when it comes to taxing rights related to intangibles. The lack of physical presence of multinational enterprises (MNEs) results in complexities in identifying the jurisdictions in which such income is generated. Companies are not able to properly attribute or quantify income (profits) generated in these jurisdictions even though sales are being made there. There are instances when it gets challenging to establish a nexus between the income-generating source (the jurisdiction from where products or services are sold online), and the destination (end customers in a particular jurisdiction that buy online products or services).
Even if tax administrations can somehow quantify the income on which tax needs to be levied, establishing the entity on which such taxes are to be imposed may become tricky due to a lack of physical presence. Further, challenges may be faced by them due to tax treaties adopted by such jurisdictions in which the MNEs are tax residents, as, in the absence of any permanent establishment in the source jurisdictions, profit attribution may not apply.
After IP transfers, tax authorities generally challenge the valuations as they are highly subjective. This is because they are based on the assessment of various criteria and tax authorities try to enhance value as much as possible. This leads to additional tax demands to protect the tax base, which a transferor must defend and justify.
Approach followed by the OECD
To ensure better alignment between transfer pricing outcomes and the value creation of MNE groups, BEPS APs 8 to 10 address transfer pricing guidance. Additional guidelines addressed to tax administrations on applying the hard-to-value intangibles (HTVI) approach were finalised in June 2018 and incorporated in the OECD transfer pricing guidelines (TPG), 2022.
It is defined in paragraph 6.189 that HTVI encompasses intangibles or rights in intangibles for which (i) no reliable comparable exists at the time of the transfer, and (ii) at the time of the transfer, the projections of future cash flows or income, as well as the assumptions used in valuing it, are highly uncertain. Accordingly, as these guidelines provide tax administrations guidance on valuing the intangibles, they can use after the outcomes to determine whether or not a transfer of an intangible in the past was at arm’s length.
Paragraph 6.58 of the OECD TPG, 2022 states that one-sided methods, including the transactional net margin method, are unreliable when multiple parties have made valuable contributions to the intangibles and share significant risks. Such one-sided methods may lead to inappropriate allocation of residual profits not factored in the two-sided functional analysis. Therefore, in paragraph 6.145, the OECD states that the comparable uncontrolled price method and profit split method would be more useful in matters involving the transfer of one or more intangibles.
Occasionally, the arrangements stated in writing do not provide sufficient information or the details may be inconsistent with the parties’ actual conduct. Therefore, it is necessary to consider both the contractual form and actual conduct. With the introduction of three-tier documentation by BEPS AP 13, there is a separate clause in the master file on the development and maintenance of IP, the entity legally owning the IP, a list of agreements relating to IP, TP policies relating to research and development of IP and more. Tax administrations could identify such information, so MNEs need to align their legal agreements with actual conduct. The voluntary exercise may help MNEs defend themselves during TP litigation.
It was acknowledged by the OECD in BEPS AP 1 that three significant phenomena facilitated by digitalisation, namely scale without mass, reliance on intangible assets and data centrality, pose severe challenges to the global tax system. It was also acknowledged that the emergence of new technologies has facilitated tax avoidance through the shifting of profits by MNEs to low-tax or no-tax jurisdictions. Two fundamental issues arising from the digitalisation of the economy present a challenge to the well-established base elements of the global tax system that determines where taxes should be paid (nexus rules based on physical presence) and how much profit should be taxed (profit allocation rules based on the arm’s length principle).
The OECD BEPS 2.0 Inclusive Framework introduced a two-pillar solution to address the digital economy’s tax challenges, comprising pillar one and pillar two. In a nutshell, pillar one proposes to grant new taxing rights to the market jurisdictions over the MNE’s profits, whether or not there is a physical presence. However, it only applies to huge MNE groups with a group turnover of more than €20 billion (approximately $21.5 billion) and more than 10% profitability. Pillar two proposes to provide a minimum effective group tax rate of 15% on corporate profit, with some specific carve-outs. Pillar two applies to MNEs with €750 million or more in consolidated revenues. For example, pillar two provides taxing rights to the parent jurisdiction through the income inclusion rule if the subsidiary (which holds IP) is in a low-tax jurisdiction with an effective tax rate of 15%. This will discourage the transfer of IP to a low-tax jurisdiction after the implementation of pillar two, expected to be after financial year 2024 or 2025.
With the introduction of BEPS 2.0, there has been a sea change in the expansion of taxing rights to market jurisdictions. This expansion is also known as FARM (functions, assets, risks and markets) analysis and not just FAR analysis. For profit allocation, the traditional approach uses DEMPE functions, as discussed above, which only consider supply side factors. With the pillar one approach, Amount A is computed giving due weightage to market jurisdictions where there is a significant user base.
The approach followed by tax administrations
Many countries have customised taxation rules for intangibles to dissuade the transfer of IP to low-tax or no-tax jurisdictions like the Global Intangible Low Taxed Income (GILTI) initiative in the US. The tax on GILTI is intended to prevent erosion of the US’s tax base by discouraging MNEs from shifting their profits on intangibles from the US to such jurisdictions.
In India, the general anti-avoidance rules (GAAR) is an anti-tax avoidance law aimed at businesses. Further, as per draft Central Board of Direct Taxes (CBDT) guidelines, the committee recommended that arm’s- length principles under transfer pricing cannot be applied for the attribution of profits to permanent establishments under Indian tax treaties. They also declared that a formulary approach for such attribution needs to be derived based on factors like sales, employees, assets, and users. Therefore, the draft guidelines also advocated for a shift from the FAR approach to the FARM approach.
BEPS AP 6 introduced the principal purpose test to prevent treaty abuse. The benefits of a treaty may be denied if one of the purposes of an arrangement is to benefit from the treaty.
Indirect tax perspective
The transfer of intangibles or the right to use IP attracts VAT and goods and services tax (GST). Where intangibles or IP are transferred by an entity to another entity in a different jurisdiction, generally, the recipient is required to pay VAT or GST in its own jurisdiction. This manner of payment by the recipient is termed as a ‘reverse charge mechanism’.
Where such intangibles or IP are embedded into certain physical goods, and such goods are transferred from one jurisdiction to another, then the value of intangible or IP per item of such goods needs to be ascertained.
The arm’s length principle for determining the value equally applies for these indirect taxes, which include VAT, GST and customs duty.
As noted earlier, in the digital economy, businesses do not require a physical presence in countries where they have sales or provide services and can instead reach end customers through remote platforms. Globally, consumption tax policies are changing to tax sales and services where they are consumed, even when provided by businesses lacking a presence within the country of consumption. To tax digital consumption based on where the consumption occurs is merely expanding the tax base on such principle.
Digital business models including social media companies, e-commerce marketplaces, cloud services, and web-based services have influenced such changes in consumption tax policies. This change now requires businesses to evaluate consumption tax-related implications in the country of consumption. Now countries require digital supply by non-residents to persons not registered under the local VAT or GST laws to make payment of VAT or GST, even if there is no local presence of the non-resident in that country. The threshold amount for registration in many of these countries is very low or zero.
It was the term ‘Google tax’ that caught everyone’s attention, and it became a frequently used tool for diverting profits, primarily for technology giants to reduce taxable profits. A zero-employee company registered in low-tax jurisdictions can derive huge profits from its user base in other jurisdictions through online ads and in-app purchases. Gone are the days when companies diverted profits to low-tax jurisdictions, and such freedom may no longer be enjoyed at the will of the MNEs. Indirect taxes apply in the country of consumption, whether that is paid as customs duty, under the reverse charge mechanism, or by the non-resident supplier.
The OECD BEPS pillar one and pillar two initiatives are essential steps that various countries have realised. As long as complexity and ambiguity over the intangibles' taxability exists, it is imperative to identify the revenue source and tax accordingly. The preparedness and willingness of all members of the Inclusive Framework, as well as the MNEs, is equally vital in supporting MNE initiatives to align their IP structures with the OECD principles and keep transfer pricing controversies at bay.