Conventional transfer pricing (TP) practices focus on a number of important factors, including the availability of documentary evidence (such as intercompany agreements), an applicable withholding tax deduction, workings related to royalty computation, and the availability of prevailing comparable market rates to ensure the arm’s-length nature of royalty payments between related parties.
In response to tax avoidance concerns arising from intragroup royalty payments, the OECD’s BEPS projects aims to adjust the TP outcomes with the creation of ‘value’. With the introduction of the subject to tax rule (STTR) under pillar two of the OECD’s BEPS 2.0 projects, various countries are enforcing stricter measures to prevent tax base erosion and profit shifting through cross-border royalty payments. The aim is to ensure that multinational enterprises (MNEs) pay a fair share of tax in the jurisdictions where value is created, addressing long-standing concerns about tax avoidance strategies involving intellectual property (IP).
How the OECD’s BEPS projects view intragroup royalty payments
One of the key challenges in taxing IP is determining its economic substance and ensuring that its allocation aligns with actual business activities. Historically, MNEs have used IP-holding companies in low-tax jurisdictions to channel royalties, minimising their global tax burden.
The OECD’s BEPS Action 8 provides that the creation of value is measurable based on the DEMPE (development, enhancement, maintenance, protection, and exploitation) analysis of IP. This analysis outlines guidelines to ascertain the ‘economic ownership’ of IP and positioning of the entities in an MNE group involved right from the development of IP to its exploitation.
IP – including trademarks, patents, copyrights, know-how, and trade secrets – is fundamental to the OECD’s BEPS 2.0 as it often drives profit allocation strategies among MNEs. The guidelines emphasise that profits should be attributed to jurisdictions where value is created, rather than where legal ownership resides. In other words, IP-related profits must reflect substantive economic functions such as the development, enhancement, maintenance, protection, and exploitation of IP. As a result of this, the tax administrations of many countries are placing greater emphasis on DEMPE analysis to assess whether royalty payment transactions comply with TP rules.
This has significant implications for MNEs relying on IP to structure their tax arrangements. For instance, Brazil historically applied a fixed-limit approach to the deductibility of royalty payments, which often restricted the amount companies could deduct for TP purposes, regardless of the actual economic substance or value created. To modernise its tax system, Brazil recently adopted new TP legislation, eliminating the old deductibility caps, and now requires royalty transactions to be supported by economic substance and functional contributions. This alignment with OECD standards allows MNEs to deduct royalties based on actual value creation, provided they maintain proper documentation and justify pricing through robust TP analysis.
Meanwhile, the South African Revenue Service (SARS) recently challenged the TP arrangement between a South African entity and its Mauritian affiliate. While the Mauritian entity was formally assigned responsibility for managing trademarks, know-how, and related intangibles under franchise agreements, SARS found that the South African entity played the dominant role in developing and implementing the group’s market expansion strategy across Africa. Evidence showed that employees of the South African entity drafted and vetted franchise agreements, which the Mauritian entity merely executed, and that the South African entity spearheaded the creation of marketing intangibles.
SARS concluded that the South African entity’s remuneration did not reflect the arm’s-length value of its contributions and used the comparable uncontrolled price method to adjust taxable income upward. The case highlighted the need for TP outcomes to reflect where DEMPE functions have been actually performed, rather than relying solely on formal IP ownership.
Minimum tax requirements for royalty payments
The STTR, in the OECD’s pillar two guidelines, recommends a minimum tax rate on various cross-border payments, including royalties, to deter profit shifting to low-tax jurisdictions. If a jurisdiction taxes royalty income below 9%, the payer jurisdiction may impose a top-up tax to bring the effective tax rate in line with the required threshold of 9% as mentioned above. This rule is designed to curb tax avoidance through the artificial allocation of profits to entities in low-tax jurisdictions with little or no economic substance.
Governments worldwide are adopting policies to ensure compliance with these rules. Many countries, including Thailand, have already introduced domestic top-up taxes to align with the global minimum tax standards. Others are amending tax treaties and TP regulations to ensure that royalty payments accurately reflect the economic contributions of the entities involved.
Thai TP audits: what is happening at ground level?
Thailand has taken significant steps to align its TP rules for royalty transactions with global tax standards. As part of this effort, the Thai Revenue Department (TRD) now requires detailed disclosures regarding royalty transactions through a TP disclosure form. However, evaluating an arm’s-length royalty rate remains a challenge for the TRD. During a typical TP audit, the tax officers would generally be looking into not only the benchmarking studies maintained by the taxpayers using industry-specific agreements to establish fair and reasonable royalty rates but also make reference to economic and other relevant factors (such as geographical regions and class of industry) that may impact – directly or indirectly – the royalty rates under scrutiny. Thus, accurate valuation of IP is critical to justify royalty charges, and businesses must maintain extensive documentation to support their TP policies.
Unlike some jurisdictions that are planning to adopt threshold limits on royalty percentages in their safe harbour rules or limit the deductibility of intragroup royalty payments, Thailand has not taken any such measures in its TP regulations so far. Instead, each transaction is evaluated by the TRD on a case-by-case basis.
Given the above evolving standards, MNE groups must ensure that their IP-holding entities maintain adequate manpower, engage in meaningful decision-making, and have verifiable operational functions in relation to IP. The OECD, in its BEPS projects, has recommended stricter documentation requirements and revised safe harbour provisions, making it more difficult for MNEs to justify royalty payments without substantive economic activity. Failure to comply with these requirements could result in costly tax adjustments, double taxation, and legal disputes.
