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Anne Fairpo is a barrister at 13 Old Square Chambers in London, England, where she specializes in taxation of intellectual property and international tax. Ms. Fairpo can be reached at firstname.lastname@example.org. Jillian A. Centanni is an intellectual property associate at Gibbons P.C. in Newark, New Jersey. She recently graduated from Rutgers School of Law in Camden and additionally holds an M.B.A. from the Illinois Institute of Technology and a B.S.E. in chemical engineering from the University of Michigan. She can be reached at email@example.com. This article was the result of collaboration between members of the ABA’s Young Lawyer Division; Committee 465, Taxation, Bankruptcy and Security Interest; and Committee 112, Patent Litigation.
The world is no longer a place where corporations provide goods and services in one state or even one country. As a result of globalization or the relationships among people, culture, and economic activity around the globe, most corporations manage production and deliver services in multiple countries. For example, although it’s a rough measure, exports have increased from just over 12% of the global gross domestic product (GDP) to almost 28% of the GDP between 1960 and 2011.1
Such corporations, operating in multiple countries, have been termed multinational corporations (MNC) or multinational enterprises (MNE), comprising the parent company and multiple subsidiary companies. A subsidiary company is one in which another company, the parent, owns more than 50% of the subsidiary’s stock.
Given the close relationship between a parent and a subsidiary company, or other similarly affiliated companies with common ownership, that relationship could be used to create tax advantages for the MNE as a whole by manipulating the price at which transactions between the companies take place. For instance, a company in a low-tax jurisdiction (i.e., 10% tax rate) could license intellectual property to its parent company in a high-tax jurisdiction (i.e., 40% tax rate) at a high royalty. The company paying the royalty would deduct it as an expense in calculating its taxable profits, saving tax at 40%, and the licensor would only pay 10% tax on the royalty received. Without special rules in place, MNEs would have a substantial incentive to price transactions between the companies in the MNE at rates that minimize tax overall.
As a result, when transactions take place between affiliated businesses (often companies, but the rules apply to businesses in general, regardless of legal structure), the transfer price for such transactions needs to be determined for tax purposes.
This article provides an overview of what IP transfer pricing is and outlines the three main pricing methodologies associated with IP transactions—transaction-based, cost-based, and profit-based. Further, this article provides an overview of transfer pricing in Asia, the United States, and Europe.
Although this question may seem like it has a simple answer, there are multiple definitions.2 For our purposes, the most straightforward is: “Transfer pricing is the practice by which the price or fee for use of an asset is established for transfer from one affiliated company to another.”3 This definition is rather broad, and, for practical purposes, transfer pricing is generally understood as “the process encouraged by tax authorities of setting appropriate and market-based values and royalty rates for use and acquisition of intangible assets.”4 It should be noted that tax transfer pricing can apply to the prices or fees for all transactions, whether relating to the provision of assets (e.g., tangible or intangible) or the provision of services, between one affiliate to another. This article focuses on the intellectual property aspects of transfer pricing only.
Section 482 of the Internal Revenue Code (IRC) applies in both a domestic and international context. The arm’s length principle, as it relates to transfer pricing for tax purposes, is found in § 482 of the IRC, which requires, in particular, that “[i]n the case of any transfer (or license) of intangible property… the income [to be included for tax purposes] with respect to such transfer or license shall be commensurate with the income attributable to the intangible,” so that § 482 deals (inter alia) with prices charged by affiliated entities in a transaction between them involving intangibles.5 Simply put, the arm’s length principle requires that “transfer prices charged for such transactions are consistent with the results that would have been achieved if unrelated enterprises had engaged in the same transaction under the same circumstances.”6
The arm’s length standard has been used since 1934 to determine whether transfer pricing demonstrates a clear reflection of income for U.S. tax purposes.7 Nevertheless, due to the problems with establishing transfer pricing for intangibles outlined below, there is still considerable uncertainty with respect to IP transfer pricing.
To enable an appropriate transfer price to be determined for a transaction, the Treasury Regulations, at 26 C.F.R. § 1.482-4, set out a number of methods to determine intangible asset transfer prices. These methods fall into three categories: transaction-based, those relating to cost-sharing arrangements, and profit-based.
Transaction-based methods allow for the fees between the affiliates to be calculated by reference to the terms of a comparable transaction agreed between independent third entities. The key to transaction-based methods is determining what constitutes a “comparable” transaction. These methods include the comparable uncontrolled price (CUP) method, the resale and cost plus methods, and the comparable uncontrolled transaction (CUT) method. Due to their “historic record of acceptability,” these methods are considered the “most reliable way of discerning an arm’s length price” and were historically favored in the United States. Due to the complicated nature of IP transactions, the CUT and CUP methods are becoming less preferred. Although there is no hierarchy of methods, the Regulations require a “best method rule” approach and “no method will invariably be considered to be more reliable than others.”8 Under Treasury Regulation § 1.482-1(c), factors regarding a particular method include: (1) the use of comparable uncontrolled transactions, and their degree of comparability with the taxpayer’s transactions under review; (2) the quality, i.e., the completeness and accuracy of the underlying data; and (3) the reliability of the assumptions used in the analysis.9 With respect to choosing the best method, one U.S. practitioner has compared it to trying to determine the best method of parenting.10
The Organisation for Economic Co-operation and Development (OECD) has recently restructured its Transfer Pricing Guidelines to similarly require businesses to use the “most appropriate” transfer pricing method.11
The Treasury Regulations state that the CUT method “evaluates whether the amount charged for a controlled transfer of intangible property was arm’s length by reference to the amount charged in a comparable uncontrolled transaction.”12 The method depends on finding an uncontrolled transaction involving the transfer of the same intangible under the same or substantially the same circumstances. Although other comparable intangibles transferred under comparable circumstances may be used when uncontrolled transactions cannot be identified, the Treasury Regulations caution that this will reduce the reliability of the analysis.13 Factors influencing comparability include intangibles involved in the controlled and uncontrolled transactions being used in connection with similar products or processes within the same general industry or market, and having similar “profit potential.”14 Profit potential is determined by “calculating the net present value of the expected future benefit stream related to the intangible transfer, considering the required capital investment and start-up expenses, as well as risks assumed and other relevant considerations.”15
In practice, the IRS has only been successful in finding a comparable uncontrolled transaction in a small number of cases.16 As practitioners have commented, this is most likely because “high-value intangibles are not ordinarily licensed or transferred between unrelated parties.”17
The CUP method is the OECD counterpart to the CUT method in the United States. In the United States, the CUP method is only used for tangible goods. The CUP method is “closest to market conditions” and “provides a direct estimate of the price the parties would have agreed to had they resorted directly to a market alternative to the controlled transaction.”18 Given the unique nature of intangible assets, the OECD Guidelines note that it is difficult to determine transfer pricing on comparable uncontrolled transactions, particularly because “differences between intangibles can have significant economic consequences that may be difficult to adjust for in a reliable manner.”19 The most important factor when using the CUP method is product similarity, and therefore unique intangibles cannot be considered.20
The OECD is currently undertaking a review of transfer pricing aspects of intangible assets, given the complexity of this area. A discussion draft of a proposed revision to chapter VI of the Transfer Pricing Guidelines, covering intangibles, was published on June 6, 2012, setting out a proposed approach to transfer pricing of intangibles, focusing on the economic consequences of a transaction. The general approach of “most appropriate” method is followed through, although (as noted above) the draft acknowledges that the differences between intangibles may require the use of methods that are less dependant on the identification of comparable intangibles or comparable transactions.21
Cost-sharing may be defined as “an agreement to share the costs of development of one or more intangibles in proportion to the share of anticipated benefits from the parties’ use.”22 The Treasury Regulations set out various methods where the “transaction [is] reasonably anticipated to contribute to developing intangibles pursuant to a cost sharing arrangement.”23 An advantage of cost-sharing according to the OECD Guidelines is that each participant is able exploit its interest separately as an effective owner and not as a licensee without paying a royalty or any other consideration.24 Likewise, § 482 of the IRC states that each participant in a cost-sharing arrangement is an owner and does not need to pay an arm’s length consideration to the participant holding legal title to the intangible.25
Taxpayers in the United States that seek to participate in cost-sharing arrangements must overcome complex and restrictive rules. Particularly, the arrangement must meet the definition of a “cost-sharing arrangement” and the taxpayer must be a “controlled participant.” Specific requirements include having “a methodology to calculate each controlled participant’s share of intangible development costs, based on factors that can reasonably be expected to reflect the participant’s share of anticipated benefits,” and this methodology must be recorded in the transfer pricing documentation maintained by the taxpayer.26
Profit-based methods rely on gross margins of comparable companies and not actual transactions.27 Profit-based methods are considered to be relatively new, nontraditional, and include the comparable profits method (CPM), profit split method (PSM), transactional net margin method (TNMM), relative profit method (RPM), and resale method (RSM). In general, profitability is calculated by looking at a taxpayer’s relative contribution of profit to its intangibles to the combined entity and allocating intercompany fees or royalty rates.28
Under Treasury Regulation § 1.482-5(a), the CPM determines an arm’s length nature of a controlled transaction by using objective measures of profitability derived from uncontrolled taxpayers engaging in similar business activities under similar circumstances.29 This method uses profit level indicators (PLIs) to compare operating profits.30 PLIs are simply “ratios that measure relationships between profits and costs incurred or resources employed.”31 PLIs are calculated by using the “financial information of comparable uncontrolled transactions and applied to one of the parties involved in the controlled transaction, in order to determine the arm’s length operating profit of such party” and the arm’s length royalty rate.32 Practitioners have stated that the CPM is reliable when the “financial data of the uncontrolled comparables are not sufficiently detailed to make reliable judgments about differences in accounting classifications between the uncontrolled comparables and the tested party.”33 Conversely, this method had been criticized as being inconsistent with the arm’s length approach and additionally because “operating profit can be influenced by factors totally unrelated to prices or margins involved in intercompany transactions.”34
The TNMM is an OECD method, substantially similar to the CPM under § 482 regulations. This method compares net profit margins from controlled and uncontrolled transactions relative to an appropriate base—for example, sales, costs, or assets.35 An advantage of this method is that net margins are less sensitive than price to transactional differences and less affected by functional differences as reflected in variations in operating expenses.36 Additionally, only one of the associated enterprises needs to be examined and a more sophisticated enterprise does not need to be examined.37 Determining a reliable arm’s length net margin becomes difficult when the net margin of a taxpayer can be influenced by factors that do not have an effect or have less than a direct effect on price or gross margins.38
When it pertains to transfer pricing related to intangible assets, the United States has a substantial influence both because of the size and sophistication of its economy and (although this may be a slightly cynical view) because the largest transfer pricing adjustment to date was made in the United States.39 Compliance with the United States’ rules regarding transfer pricing has become more “sophisticated, comprehensive and Draconian”40 and has become a burden to MNEs. As noted by a former international tax counsel for the United States Department of Treasury:
[D]etermining an appropriate transfer price for intangibles has been particularly problematic because of the difficulty in identifying comparable uncontrolled transactions that provide a reasonable benchmark of an arm’s-length price. The problem of identifying comparables is increased when intangibles are transferred simultaneously with, or used in connection with, the transfer of tangible property or the provision of services.41
As a result, advanced pricing agreements (APAs), agreements between the taxpayer and one or more tax authorities as to the method of transfer pricing to be used, have become more important to ensure that transfer pricing policies meet the arm’s length standard.42
Some flexibility is, however, built into the regulations in the United States through the use of the “arm’s length range.” This means that an adjustment will not be made if the results are within an arm’s length range derived from two or more comparable uncontrolled transactions.43 The acceptability of a range of outcomes versus a single arm’s length answer gives a distinct advantage over other jurisdictions that are less flexible.44
The current transfer pricing rules in the United Kingdom are located in the Taxation (International and Other Provisions) Act 2010, Part 4, having been rewritten as part of the Tax Law Rewrite Program. In substance, the rules were unchanged by the rewrite (there have been transfer pricing rules in U.K. tax law since 1915, albeit changing substantially over the years since then).
With respect to compliance, large U.K. companies are required to use the arm’s length principle in determining the income and expenses relating to transactions with affiliates,45 whether these are in the United Kingdom or overseas. Small and medium-sized companies (the sizes are determined by European Union legislation) are not required to use the arm’s length principle when dealing with U.K. affiliates, or affiliates in relevant treaty countries. A medium-sized company may be compelled to use the arm’s length principle if the U.K. tax authority requires it to do so.
The U.K. tax authority largely follows the OECD Transfer Pricing Guidelines in interpreting the arm’s length requirements.
Recent case law suggests the U.K. tax authorities will generally prefer the PSM of transfer pricing for intangibles.46
Statutory rules in Germany are not found within a specific section of the legislation, but instead are found in several provisions of different statutes.47 German regulations emphasize using three primary transfer pricing methods, which include comparability, hypothetical arm’s length test, and retroactive price adjustments.48 Under the comparability standard, if comparable data does not exist, then the transfer pricing ranges should be narrowed. Further, under the hypothetical arm’s length test, a taxpayer unable to find a comparable uses the range of the minimum price for one party and the maximum price for another party in the transaction.49 Moreover, with respect to intangibles and the application of the arm’s length principle, it is assumed that third parties would have agreed on an adjustment. If an adjustment has not been made, the authorities can assume one adjustment within a 10-year period.50
With regard to intangibles, the German tax authorities tend to favor the hypothetical arm’s length test.51
In France, the rules for transfer pricing adopt the arm’s length principle for cross-border related party transactions.52 When questioning a transfer pricing policy, the tax authorities may use section 57 of the French tax code or the concept of acte anormal de gestion.53 Section 57 relates to the indirect transfer of pricing in cross-border transactions and states that any profits transferred to enterprises indirectly “shall be added back into the taxable income.”54 The concept of acte anormal de gestion states that expenses are tax deductible “only to the extent that they are incurred for the benefit of the business or within the framework of normal commercial management.”55 To invoke this concept, one must prove that a transfer of profits has taken place and there was a deliberate intention to move profits or losses from one taxpayer to another.56
There is no specific requirement to use a particular transfer pricing methodology for intangibles, but the CUP method is generally not likely to be appropriate for transactions involving significant intangibles, although it is often used to assess royalty flows; the France tax authority tends to favor the TNMM in tax audits.57
China is not a member of the OECD, although transfer pricing rules in China have previously been consistent with the OECD Guidelines. China’s regulations are specifically contained in its corporate income tax law (CIT) and detailed implementation regulations (DIR).58 With regard to intangibles, China has tended to prefer the PSM of transfer pricing.59
Japan has well-developed transfer pricing rules, having enacted transfer pricing legislation in 1986.60 Japan is an OECD country and its transfer pricing legislation is consistent with OECD Guidelines and is based on the arm’s length principle.61
Japanese transfer pricing legislation does not apply to partnerships, individuals, and unincorporated entities,62 and the focus has, historically, been on inbound transactions (i.e., sales to Japan, looking at deductions for Japanese tax purposes). There is some indication that outbound transactions (with a focus on income in Japan from overseas sales) are now beginning to attract more attention. The PSM of transfer pricing has usually been favored for intangibles, although the TNMM is becoming more used. Japan recently abolished the hierarchy of transfer pricing methodologies to harmonize with the OECD changes, so that the “most appropriate method” in the circumstances must be used, rather than a preferred method in law.63
Transfer pricing is covered in sections 92–92F of the Indian Income Tax Act, 1961, and has been enacted in India since April 1, 2001.64 The regulations are based on the OECD Guidelines and require the arm’s length principle to be applied to cross-border transactions only.65
The transfer pricing of intangibles is a complicated task and requires sophisticated oversight by an increasing number of businesses as cross-border transactions become ever more commonplace and tax authorities seek to maximize their receipts without significantly raising tax rates. The ongoing OECD project on the transfer pricing aspects of intangibles may assist with providing a common approach to the difficulties, particularly with consideration of the appropriate transfer pricing methodologies. Not all countries follow the OECD Guidelines, but they are often persuasive.
1. See World Bank, http://data. worldbank.org/ (last visited July 22, 2012).
2. See, e.g., Michelle Markham, The Transfer Pricing of Intangibles 9–10 (2005).
3. Weston Anson & Chaitali Ahya, Tax Issues: Transfer Pricing, Royalty Rates, and Intellectual Property Holding Companies, in Fundamentals of Intellectual Property Valuation: A Primer for Identifying and Determining Value 180 (2005).
6. Markham, supra note 2, at 20.
7. Id. at 792.
8. 26 C.F.R. § 1.482-1(c) (2009).
9. Markham, supra note 2, at 91.
10. Id. at 92.
12. 26 C.F.R. § 1.482-4(c).
13. Id. § 1.482-4(c)(2)(ii).
14. Id. § 1.482-4(c)(2)(iii)(B)(1).
15. Markham, supra note 2, at 95.
16. Id. at 96. Further, the position has not improved in the seven years since this text was published.
17. Id. at 97.
18. Id.; OECD, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations ¶ 1.35 (2010) [hereinafter OECD Guidelines].
19. OECD Guidelines, supra note 18, ¶ 1.9; OECD, Discussion Draft: Revision of the Special Considerations for Intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions ¶ 103 (2012) [hereinafter OECD Discussion Draft].
20. Markham, supra note 2, at 98.
21. OECD Discussion Draft, supra note 19, ¶ 103.
22. Anson & Ahya, supra note 3, at ch. 18.
23. 26 C.F.R. §§ 1.482-7, -7T.
24. OECD Guidelines, supra note 18, ¶ 8.3.
25. 26 C.F.R. § 1.482-7T(b) (2009).
26. Id.; Markham, supra note 2, at 54.
27. Markham, supra note 2, at 95.
28. Anson & Ahya, supra note 3, at ch. 18.
29. 26 C.F.R. § 1.482-5(a).
30. Id. § 1.482-5(b)(3).
31. Id. § 1.482-5(b)(4).
32. Markham, supra note 2, at 107.
34. Id. at 109.
35. OECD Guidelines, supra note 18, ¶ 2.58.
36. Id. ¶ 2.62.
37. Id. ¶ 2.63.
38. Id. ¶ 2.64.
39. Press Release IR-2006-142, Internal Revenue Serv., IRS Accepts Settlement Offer in Largest Transfer Pricing Dispute (Sept. 11, 2006), available at http://www.irs.gov/newsroom/article/0,,id=162359,00.html. This settlement required a payment by GlaxoSmithKline to the IRS of $3.4 billion dollars. Id.
40. Markham, supra note 2, at 4.
41. Id. at 5.
42. PricewaterhouseCoopers LLC, International Transfer Pricing 791 (13th ed. 2012).
43. Id. at 795.
45. Taxation (International and Other Provisions) Act 2010 (TIOPA) § 147 (U.K.).
46. See DSG Retail Ltd. v. Comm’rs for Her Majesty’s Revenue & Customs,  UKFTT 31 (TC).
47. PricewaterhouseCoopers LLC, supra note 42, at 713.
48. Id. at 414.
51. Oliver Wehnert & Jakob Frotscher, Germany: Transfer Pricing and Intangible Transactions, Int’l Tax Rev. (Jan. 3, 2012), http//www.internationaltaxreview.com/Article/2955306/Germany-Transfer-pricing-and-intangible-transactions.html.
52. PricewaterhouseCoopers LLC, supra note 42, at 386.
55. Id. at 387.
57. BNA International Transfer Pricing Forum: France (Feb. 2011).
58. PricewaterhouseCoopers LLC, supra note 42, at 307.
59. Guo Shui Fa  No. 2 (Circular 2).
60. PricewaterhouseCoopers LLC, supra note 42, at 516.
63. In effect for fiscal years starting on or after October 1, 2011. See Atsuko Kamen, FY 2011 Amendment of the Japanese Transfer Pricing Legislation, KPMG, http://www.kpmg.com/us/en/whatwedo/industries/japanese-practice/pages/2012-issue1-article3.aspx.
64. PricewaterhouseCoopers LLC, supra note 42, at 545.