(Published in IDC, Asesor Fiscal, Jur\u00eddico y Laboral magazine on September 15, 2023)<\/p>\n\n\n\n
Jes\u00fas Aldrin Rojas M.<\/p>\n\n\n\n
Jos\u00e9 Augusto Chamorro G\u00f3mez<\/p>\n\n\n\n
Introduction<\/p>\n\n\n\n
In October 2015, the Organization for Economic Cooperation and Development (OECD) published an action plan to combat tax avoidance and profit shifting (the BEPS plan). The BEPS plan contained 15 actions aimed at “realigning taxation with economic substance and value creation while preventing double taxation.” Action No. 8 (intangibles) set out the following objectives:<\/p>\n\n\n\n
“Develop rules to prevent base erosion and profit shifting arising from the transfer of intangibles between enterprises belonging to business groups. This will involve: (i) adopting a broad and clearly delineated definition of intangible assets, (ii) ensuring that profits related to the transfer and use of intangibles correspond (rather than being detached) to their value creation, (iii) developing transfer pricing rules or special rules for cases where hard-to-value intangible assets are transferred, and (iv) updating the guidelines on cost contribution arrangements (regarding the development and exploitation of intangible assets).”<\/p>\n\n\n\n
The new transfer pricing rules on intangibles have had a significant impact, reshaping the transfer pricing policies of business groups worldwide. And rightly so\u2014the new OECD standard for confirming the arm\u2019s length condition of intercompany transactions requires the identification of:<\/p>\n\n\n\n
In this document, we analyze the limitations of the OECD’s proposed rules in their theoretical conception and economic foundation to gain perspective on their application.<\/p>\n\n\n\n
As previously discussed, Action 8 of the BEPS plan redefines the application of transfer pricing rules on intangibles by introducing a new concept: \u201cThe term intangible is intended to refer to something that is not a physical or financial asset, that can be owned or controlled for commercial use, and whose use or transfer would be compensated if it were conducted in a transaction between independent parties under comparable circumstances.\u201d<\/p>\n\n\n\n
In other words, under the transfer pricing regime, it is not enough for an asset to be intangible or to have the ability to control future economic benefits. Instead, it must be demonstrated that, in analogous transactions, the asset would be subject to economic compensation (which is only possible given the economic benefit that the transfer of the asset represents for the parties). This clarification is important because certain intangibles may lack economic value in a specific context of exploitation and, therefore, may not qualify as assets for transfer pricing purposes.<\/p>\n\n\n\n
Once the condition of the asset as an intangible is confirmed, the OECD\u2019s analytical framework emphasizes the need to identify the legal owner, as recorded in its respective patent and trademark office (e.g., the United States Patent and Trademark Office or the Mexican Institute for the Protection of Industrial Property – IMPI). However, mere legal ownership is not sufficient to claim exploitation rights over an intangible asset.<\/p>\n\n\n\n
Transfer pricing guidelines stress the necessity of identifying, through a functional, asset, and risk analysis, who has contributed to the intangible’s value creation. This entails identifying the development, enhancement, maintenance, protection, or exploitation activities related to the intangible (the DEMPE functions).<\/p>\n\n\n\n
The execution of DEMPE functions by related parties other than the legal owner should be compensated as would have been agreed with an independent third party. Otherwise, for transfer pricing purposes, “economic ownership” may be established, leading to various tax implications, such as the loss of royalty expense deductions (why pay a royalty for an intangible asset of which one is a co-owner?) or even the redistribution of income derived from the exploitation of intangible assets (if an entity has contributed to the creation of an intangible asset\u2019s value, should it be entitled to claim a share of the resulting benefits?).<\/p>\n\n\n\n
Needless to say, the execution of DEMPE functions may be classified as a “unique and valuable contribution,” which can even influence the selection of specific transfer pricing methods (e.g., profit split methods).<\/p>\n\n\n\n
For the above reasons, it is crucial to correctly identify who, when, and how contributions to the development of intangible assets have been made. Practical considerations are also relevant. For example, the development of patents in the pharmaceutical industry may take decades and be executed in various stages by different members of a business group through diverse research, development, and clinical trial activities. Similarly, trademarks managed by marketing departments often reach peak value after years or even decades of advertising campaigns in mass media. These distinctions are important because the functional, asset, and risk analysis associated with transfer pricing for intangibles should trace back to the inception of the intangible and document any value contributions (identified through DEMPE functions) throughout the asset\u2019s lifecycle.<\/p>\n\n\n\n
Does the execution of DEMPE functions between independent third parties imply co-ownership or even an adjustment to the compensation agreed for the exploitation of the intangible? This question is critical because reading the transfer pricing guidelines might suggest this conclusion, and, in fact, tax authorities often systematically challenge the deduction of expenses related to DEMPE functions when the taxpayer also pays royalties. However, is this stance correct? Is there evidence of independent third-party behavior supporting this approach?<\/p>\n\n\n\n
To address this question, we conducted a quantitative economic analysis using data from the specialized database Data Insight (formerly Intangible Spring), yielding 12,345 records of contracts between independent third parties across 51 industries.<\/p>\n\n\n\n
Since contract records account for the number of functions assigned to the licensor and the licensee, the analysis was conducted based on the following type of variables:<\/p>\n\n\n\n
F= F licensor<\/sub>-F licensee<\/sub><\/p>\n\n\n\n Where:<\/p>\n\n\n\n The variable Fi<\/strong> would capture the impact of the distribution of functions between the two contracting parties to analyze its effect on the pricing of compensation.<\/p>\n\n\n\n The regression model would be as follows:<\/p>\n\n\n\n Ti<\/sub>=\u03b1+\u03b2(Fi<\/sub>)<\/p>\n\n\n\n Where:<\/p>\n\n\n\n The variable Fi<\/strong> would capture the impact of the distribution of functions between the two contracting parties to analyze its effect on the pricing of compensation.<\/p>\n\n\n\n The regression model would be as follows:<\/p>\n\n\n\n Ti<\/sub>=\u03b1+BMKi<\/sub>(FMKi<\/sub>)+BPTi<\/sub>(FPTi<\/sub>)+BQCi<\/sub>(FQCi<\/sub>)+BRDi<\/sub>(FRDi<\/sub>)<\/p>\n\n\n\n Where:<\/p>\n\n\n\n FRDi<\/strong> = Difference between the research and development functions performed by the licensor and the licensee in the i-th<\/em> industry.<\/p>\n\n\n\n FMKi<\/strong> = Difference between the marketing functions performed by the licensor and the licensee in the i-th<\/em> industry.<\/p>\n\n\n\n FPTi<\/strong> = Difference between the protection functions performed by the licensor and the licensee in the i-th<\/em> industry.<\/p>\n\n\n\n FQCi<\/strong> = Difference between the quality control functions performed by the licensor and the licensee in the i-th<\/em> industry.<\/p>\n\n\n\n Analysis Criteria<\/strong><\/p>\n\n\n\n Without differentiating by function type, we found a significant impact of DEMPE functions<\/strong> in only 4 industries out of the 40<\/strong> that met the minimum requirement of 100 observations. (For confidentiality reasons, industry names are withheld to prevent misuse of the results.)<\/em><\/p>\n\n\n\n In the extended version of the model, specific DEMPE-related functions<\/strong> were identified as relevant, particularly Research & Development, Marketing, Quality Control, and Protection.<\/strong><\/p>\n\n\n\n Based on this information, we can preliminarily conclude<\/strong> (subject to case-by-case review of specific taxpayer situations) that, in general, there is no sufficient evidence<\/strong> to prove that performing DEMPE functions inherently leads to an adjustment<\/strong> in the agreed-upon compensation between independent parties.<\/p>\n\n\n\n This finding is relevant because if tax authorities attempt to disallow royalty deductions<\/strong> based on DEMPE functions, or conversely, reject the deduction of expenses<\/strong> related to DEMPE functions by arguing economic ownership, the situation should be re-evaluated based on the actual conduct of independent third parties, as required by the arm\u2019s length principle.<\/strong><\/p>\n\n\n\n 1 OECD (2014), Guidance on Transfer Pricing Aspects of Intangibles, <\/em>OECD\/G20 Base Erosion and Profit Shifting Project, OECD Publishing. Develop rules to prevent BEPS by moving intangibles among group members. This will involve (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the<\/em> transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; (iii)<\/em> developing transfer pricing rules or special measures for transfers of hard to value intangibles; and (iv) updating the guidance on cost contribution arrangements.<\/em><\/sub><\/sup><\/p>\n\n\n\n\n
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Results<\/strong><\/h3>\n\n\n\n
Industria<\/td> No. Obs.<\/td> Coeficientes<\/td> Estad\u00edstico t<\/td> Prob. Rechazo<\/td><\/tr> a<\/td> B<\/td> a<\/td> B<\/td> a<\/td> B<\/td><\/tr> Industria 1<\/td> 1,023<\/td> 11.67<\/td> 2.20<\/td> 28.06<\/td> 3.52<\/td> 6.72E-129<\/td> 4.46E-04<\/td><\/tr> Industria 2<\/td> 316<\/td> 6.66<\/td> -1.60<\/td> 12.98<\/td> -2.10<\/td> 3.91E-31<\/td> 3.67E-02<\/td><\/tr> Industria 3<\/td> 578<\/td> 20.11<\/td> -2.47<\/td> 25.73<\/td> -2.24<\/td> 8.60E-98<\/td> 2.55E-02<\/td><\/tr> Industria 4<\/td> 112<\/td> 15.12<\/td> 3.98<\/td> 9.68<\/td> 2.18<\/td> 2.08E-16<\/td> 3.15E-02<\/td><\/tr><\/tbody><\/table><\/figure>\n\n\n\n \n
Conclusions<\/strong><\/h3>\n\n\n\n