OECD BEPS Action #8 - Thoughts on the Guidance on Transfer Pricing Aspect of Intangibles (4)

As a tax or operational manager of your organization, managing the risk potentially arising from the new OECD definition of intangibles ("New Definition") may require a three-step process:

1.Identifying the items within your organization or corporate group that are best represented by the New Definition; 

2.Determining how the transfers/utilization of those items are made between related parties; and

3.Deciding whether any of such transfers/utilization can be recognized as a transfer pricing transaction.  

The first step above is the most crucial element, which is the central theme of this post. It is all about applying the test based on the New Definition (diagram below - please see my previous post for further detail), and, if needed, (or if the items happened to be abstract, as will be explained in a moment)  performing additional analyses to identify specific items of "intangibles" for which specific actions may be devised and executed to minimize any transfer pricing risk.

As regards the test mentioned (to save you some time), the practical starting point, in my view, is to look at OECD's analysis on this. OECD has provided (non-exhaustive) illustrations of how the New Definition may be applied and, in so doing, has verified for us which ones are "intangibles" and which ones are not (please refer to para. 6.18 through 6.31, Guidance on Transfer Pricing Aspects of Intangibles ("GTPAI")) :

Category	Intangible?
1.Patents	Y
2.Know-how and trade secrets	Y
3. Trademarks, trade names and brands	Y
4. Rights under contracts and government licenses	Y
5. Licenses and similar limited rights in intangibles	Y
6. Goodwill and ongoing concern value	Undefined
7. Group synergies	N (not capable of being owned or controlled)
8. Market specific characteristics

As you can see, most of the conventional intangibles (#1 through #5) are still identified as such under the New Definition. You could choose to bypass them if your organization undertakes economically and legally recognized inter-company transactions involving them and has specific transfer pricing policies or otherwise tax risk mitigation mechanisms in place.

What you have to worry about, though, is category #6. The OECD left goodwill and ongoing concern value undefined, creating rooms for future debates and controversies between tax administrations and taxpayers around the world.  It is left to the whims of the two parties to decide whether the items identified under that category should be labeled as intangibles. GTPAI (para. 6.29) says:
"The absence of a single precise definition of goodwill makes it essential for taxpayers and tax administrations to describe specifically relevant intangibles in connection with a transfer pricing analysis and to consider whether independent enterprises would provide compensation for such intangibles in comparable circumstances" 

"Goodwill" has been used frequently in the realms of financial statement analyses or due diligence for M&As, serving as the basis for buy-side and sell-side pricing of a target company. So it is used mainly to indicate a specific monetary value rather than the actual source of such value, for use either before or after the merger. To be more specific, from an accounting perspective, the term is defined as the excess value over and above the net asset of an enterprise or the amount paid above the enterprise's book value which comprises part of the price (or consideration) paid.

For verification of intangibles under the New Definition, however, it is necessary that you direct your attention to pure operational and/or economic aspects of goodwill. In other words, goodwill should be thought of as something a fictional buyer of your organization or business would be willing to pay for, for instance, in M&A situations. In that sense, goodwill may be thought of as 'value drivers' of your organization that your third-party customer or buyer would recognize as an element of differentiation, even competitiveness, which may be defined as follows:

"An activity or organizational focus which enhances the perceived value of a product or service in the perception of the consumer and which therefore creates value for the producer" (p.129,  Miller, Warren D., Value Maps)

So when identifying value drivers or the components of goodwill, you should look at (i) how your organization's value chain is currently structured and (ii) which activities/features within each link affect those of other link(s) in ways that create/improve perceived value in the eyes of the third-party customers.  The notions of value perception is well illustrated by the concept of "signaling criteria" introduced by Dr. Michael E. Porter, the author of Competitive Advantage:

"Signaling criteria reflect the signals of value that influence the buyer's perception of the firm's ability to meet its use criteria. Activities a firm performs, as well as other attributes, can be signaling criteria. Signaling criteria may help a particular supplier to be considered and/ or may play an important role in the buyer’s final purchase decision."

Dr. Porter provided examples of typical signaling criteria as below. Your marketing/sales folks may have more specific and detailed signaling criteria for your organization:

• reputation or image
• cumulative advertising
• weight or outward appearance of the product
• packaging and labels
• appearance and size of facilities
• time in business
• installed base
• customer list
• market share
• price (where price connotes quality)
• parent company identity (size, financial stability, etc.)
• visibility to top management of the buying firm

So what you can do to 'ferret out'  those value drivers or components of your organization's goodwill'  is as follows:

1. Identify your organization's value chain. You should first understand specifically how your organization functions in transactions with its third-party customers or related parties overseas. Don't get bogged down or frustrated with the term "value chain." What it simply means is this:

• the whole process of how your organization performs R&D and product development, purchase of raw materials, operation of production lines, quality control, inventory control, marketing and sales, after-sales activities and so forth; and 
• the way of how those functional elements interacts with each other to generate/transfer value.  We, transfer pricing specialists call it, a "functional analysis" (I have another post explaining what it is). 

You could perform the above analysis yourself internally or seek help from external transfer pricing expert, if such is more practical. Here's how a theoretical value chain looks like (please click on the diagram below for further explanations on value chain):



At the end of step 1,  you might want end up with something like this with detailed description of what each item entails (link to the source) :


2. Identify value drivers. From the value chain identified, you should detect and analyze the activities or features from each link that improves those of other link(s) or of the value chain as a whole. You might want to relate these activities/features to each of the signaling criteria of your organization and try to deduce exactly how each criterion is satisfied or improved by one or more of those activities/features identified. Those that prove to satisfy or improve the signaling criteria in a single or multiple ways may be considered "value drivers", the aggregate of which may be considered "goodwill."

3. Determine whether the value drivers are compensable. Once the value drivers are determined, you need to select the ones that 'improve' the signaling criteria  - that is, the elements of differentiation - that would justify the level of margin on the price of your organization's output i.e., product or service. Remember. the most common definition of "goodwill" is the excess value over and above the net asset of an enterprise. Hence, a value driver that enhances one or more of the signaling criteria  should be able to command part of that excess value, which, in turn, contributes to the overall "attractiveness" of your organization or business in the eyes of its potential buyers. You could consider such value drivers as "intangibles" under the New Definition.

4. Determine overall capital employed and functionality associated with the selected value drivers.   Finally, you have to identify the capitals employed in operating those selected value drivers and the functions performed by the key people or assembled workforce assigned to them. They are the true "generators" of "excess value" and understanding how they are mobilized, utilized and transferred from one unit to another becomes a basic building block for the transfer pricing risk management in terms of intangibles. In other words, the transfer between the affiliates or mere use by your organization's related party, of those capital or the people behind the value drivers selected in 3 may trigger recognition of a related party transaction for transfer pricing purposes.

This four-step analysis will lay an ideal groundwork for establishing a risk management framework within your organization regarding transfer pricing aspects of intangibles. Remember. If your organization is global and has business presence in key tax jurisdictions, you'll quickly have to adept to the new way of thinking: that is, "Intangibles"  should now be perceived throughout your organization as anything through which compensable value is created. As one of the commentators on the discussion draft of GTPAI once mentioned, "Intangibles" must now be considered, from an entity standpoint, that is, from the perspective of value creation rather than from an asset standpoint (please see p. 596 of this link).

Basically, what this entails is this: as an operational or tax manager for your organization, you must now have a fairly clear and comprehensive mental picture of the entire value chain of your organization, and by diligently tracking how capitals move throughout the value chain, you need to be attentive on how the value drivers of your organizations are affected by such movements.

All this for tax? Yes, sadly and unfortunately.

Real Price = Toil + Trouble

• "The real price of everything, what every thing really costs to the man who wants to acquire it, is the toil and trouble of acquiring it...."  
• "What is bought with money or with goods is purchased by labour as much as what we acquire by the toil of our own body.."
• "Labor was the first price, the original purchase-money that was paid for all things. It was not by gold or by silver, but by labour, that all the wealth of the world was originally purchased...."

Adam Smith from the Wealth of Nations

I've always believed that the key part of my job as a tax professional is to organize a good story-line for clients, persuasive and illustrative, all based on given facts, in such a manner that no unnecessary challenges from the tax authority can arise. For transfer pricing (TP) matters however, it shouldn't be just a good story-line.  In TP, "capturing" the dynamics between the industry and the company functions (e.g., how profit drivers affects the client's business and functionality) and "translating" that into a common language (so tax authorities and possibly judges can understand) are the most critical process. I would like to call this latter part 'functional analysis.' 

In TP studies, I'd say the key to any functional analyses is to understand the nature of "toil and trouble" the parties have gone through in a related-party transaction. And it is all in the art of how the tax adviser go about interacting with his/her client's key employees along the client company's value chain - for instance, all the way from R&D and product development to logistics and sales - primarily through interviews and/or open discussions. That is perhaps the only way he/she can also breathe life into his story-line, making it less arbitrary and more taxpayer- and reviewer-friendly. 

Unfortunately, for some reasons, that crucial art has been de-emphasized by both TP practitioners and their clients. Somehow, both parties seems to have found comfort in the fact that TP studies are nowadays usually prepared in a very mechanical fashion. The typical ritual is that, with just a basic set of facts provided by the client, the TP practitioner prepares a functional profile write-up, looks for comparables from a commercial/pubic database, selects and applies a transfer pricing method ("TPM") and derive an arm's length result.  

Mannerism is often a vice that obliterates the sense of purpose and value. Sadly, what is often missing from the above ritual is the serious conviction to develop rationales or defense strategies for the client's specific TP position. That part is usually reserved for in times of tax audits or appeals when time is a crucial resource.    

The arm's length principle emphasizes the importance of creating a fiction simulating what would have happened if the transacting parties had been unrelated. The proper starting point, therefore, for creating that fiction is not just to gather as many facts and information as possible from their clients, but also to understand the people behind all those facts and what they actually do and "feel" about the tasks or the risks they are assuming, within the offices, or from the production lines. And such understanding is usually gained from personal interactions with them, that is, through personal interviews and discussions with the company staff.  

As Adam Smith said, labor - toil and trouble - was the first price. If TP is to remain as an art and not a science, I guess one must take certain amount of courage to repent and to do what is right; that is, in terms of TP, to return to the basics of verifying where value truly originates. Value is generated by people's toil and trouble, meaning that true valuation, i.e., TP must always start from understanding the people behind the scene and the nature of their labor.        

  

OECD BEPS Action #8 - Thoughts on the Guidance on TransferPricingAspectof Intangibles (3)

So from now on, the overall trend will dictate that we accept this new OECD definition as the new "ordinary meaning" in every transfer pricing disputes involving intangibles.

And in doing so, we should also remind ourselves that this definition is an offspring of the OECD's notorious BEPS action plan, implying that in "inventing" this definition, the emphasis was on protecting (and perhaps expanding) the member states' tax base and relatively little attention has been paid to preventing double taxation, which is the traditional conviction of the OECD when it comes to the matters of international taxation.

Hence, with the advent of this new definition, I fear that the incidence of double taxation may rise. As I indicated in my previous post, what seems really controversial is the arm's length compensibility feature within the definition. One must now rely on a "mere fiction" to decide whether something should be considered an "intangible." Not only is this radical deviation from the traditional meaning given to intangibles with which everyone has felt comfortable, such undue reliance on fictions create rooms for conflicts/disputes, not only between tax authorities and taxpayers, but also between different tax jurisdictions.

The scenario below is a rough demonstration of what would most likely happen within the next four to five years if the new definition becomes an international convention:

• Companies A and B are controlled parties. During the tax audit, Company A is found to have let Company B use a non-physical or non-financial "things" which could be both owned/controlled and, most importantly, compensable (1). The tax authority identifies them as intangibles for transfer pricing purposes and recognizes several inter-company transactions where compensation-free use of the identified intangibles allegedly occurred (2) and then applies the arm's length principle to determine the compensations that should have been charged to Company B(3), resulting in significant tax assessment to Company A.

• Having learned a painful lesson from country A, Companies A and B immediately enter into a new arrangement whereby the intangibles so identified are subject to the arm's length compensation in the event of transfer or use. Hence, Company B starts paying royalty-like payments to Company A for the use of the intangibles identified by the tax authority in Country A.  

• After some time, seeing the size of inter-company charges made and the nature of the intangibles used, the tax authority in country B challenges the arrangement and denies deductibility of the royalty-like payments (5) on the grounds that, according to their own viewpoint, the intangible identified as compensable in country A are found to be non-compensable (4) if the same transactions were undertaken between highly comparable independent third parties. This denial of deductibility also results in a sizable tax assessment to Company B(6),  not to mention the company may also be subject to a secondary adjustment by virtue of re-characterization of the adjusted income as dividend.

Hence, double taxation seems inevitable because the states will have hard time agreeing on the extent of the arm's length fiction suggested by one state to the other in regards to a related party transaction involving intangibles. 

So MNEs must make due preparations for this potential conflicts of different "fictions" conjured up by different taxing jurisdictions. What would be the "things" that could be captured along the MNEs' value chains as constituting "intangibles" under the new OECD definition? How do we go about measuring the transfer pricing risk accordingly? My next post will be discussing specifically the nature of the arm's length compensability requirement within the new definition and the "things" that could most likely be considered as "intangibles" by virtue of the OECD definition. 

OECD BEPS Action #8 - Thoughts on the Guidance on Transfer Pricing Aspect of Intangibles (2)

In my latest post on BEPS Action #8, I mentioned that the OECD Guidance on Transfer Pricing Aspect of Intangibles ("GTPAI") is an interesting development because:

• it is a jail-breaking attempt to free "intangibles" from the traditional boundaries of legal and/or accounting convention; and 
• it is also a bond-severing attempt to change the context in which traditional "intangibles" were recognized and dealt with under the implicit legal/accounting notions and to enable introducing an entirely new cadre of "somethings" into the conception of "intangibles"

So what would be the implications of this new definition of "intangibles"?

Figure 1.

Figure 1. shows a series of tests that were typically applied for determining whether a non-physical or non-financial  asset or property constitutes an intangible asset/property as per the previous, ordinary meaning of intangibles. All that was required was a sequence of two simple tests:

1. Is there a legal protection?: if the non-physical or non-financial asset was patented,  registered or otherwise protected by the applicable laws, then it was automatically presumed to constitute an "intangible". 
2. Is it recognizable as an asset from an accounting standpoint? : even if the assets above fails the first test, most of the intangible assets/properties fell to be recognized as intangible assets as long as the accounting principle required their recognition.

As such, the taxpayers had some clarity in terms of how to establish and defend their position with respect to their intangible asset transactions with related parties. The uncertainty therefore relating to the tax implications of such transactions was more or less manageable. 

Now, however, severing all the accounting and legal "lineages" from the notion of intangibles, the GTPAI seems to shift the focus of a transfer pricing analysis from mere recognition of intangibles to characterization of abstract "somethings" as intangibles that would not have been recognized as intangibles before. 

                                

Figure 2.

The new definition requires the following four tests: 

1. Is it a physical or financial asset?: this serves as a safeguard that none of the financial instruments falls to be "intangibles."
2. Is it capable of being owned?: the question is directed not at verifying whether the legal ownership may be exercised, but rather at determining whether "something" can be merely owned. This opens up a possibility that even if there is no legal ownership present, a mere discovery that certain "something" is an object of an effective or economic ownership by virtue of its use or exercise of certain interests can still trigger an intangible characterization. 
3. Is it capable of being controlled?:  This is actually an extension of the second question above. In contesting whether "something" could be an object of effective or economic ownership, a mere hint of control (whatever the definition may be) by virtue of certain activities or functions (e.g., exploitation, development, derivative works, etc.) performed by some of the transacting parties concerned may also trigger an intangible characterization. 
4. Is the use or transfer of "something" compensable?: what baffles me most about this new definition is that the badge of "intangible" now presupposes, ultimately, the compensability of "something" had it been used or transferred under the arm's length conditions. Why should this abstract and fictitious "compensability" be a necessary component? 

Personally, I think that any definition of intangible should only serve as a minimum standard for 'recognition' of an intangible actually traded or otherwise utilized in a related party transaction, and not for 'identification' of some abstract "intangibles" for transfer pricing purposes.  At least in accordance with the present version of the OECD Transfer Pricing Guidelines ("OECD TPG"), the arm's length testing of intercompany compensation for an intangible or even its compensability should be the one and the only concern for a transfer pricing review after it has been established that there was a related party transaction involving the intangible. The identification of intangibles was not part of a transfer pricing review; it was a task always delegated to the applicable laws, accounting practices or even court decisions. 

 

Food for thoughts - my experience with a gaming company

I had a meeting a couple of month ago with the CEO of a mobile game company. He was in his early thirties, and the cadre of his staffs  mostly in their late 20s and early 30s joined him in the meeting. 

The company develops gaming apps sold from both Apple App Store and Google Play and had two blockbusters that led the company to accomplish a revenue size exceeding KRW 14 billion within the two-year time frame. 

Encouraged by this huge feat of success, the company decided to test its luck from an offshore location with a slightly different business model: the game publishing business. The CEO wanted to help third-party game developers with marketing their games from the offshore market where legal restrictions are much less stringent than in Korea.  

The meeting was held to probe for any key tax issues that may arise both when they set up a business (a branch or a subsidiary) in the target country and when they try to reap the fruits of their investment by means of dividends, royalties or interests. 

During the first thirty minutes of the meeting, the discussions were going nowhere; a lot of redundant, disorganized questions were strewn away, and nobody seemed to understand the answers that my colleagues and I were providing them.  The biggest problem was that there was no consensus among the CEO and his staff on what the short- and long-term objectives should be and how the company should go about accomplishing them.   

They all had ambition, reasonable expertise and experience in their own field and passion for their business, but one thing was critically lacking: a well-structured business plan. 

The gaming industry has been burgeoning during the last decade or so in South Korea, fueled mostly by the nation's globally competitive smart phone industry and the government's consistently generous investments in IT infrastructure (e.g., introduction of 5G) and other related service industries. There have been twice or thrice as many cases of failures as the cases of success, and the successful companies usually tend to speculate over the dreams of selling their apps overseas. And when they do, the smart ones think about tax.

So they come to people like us, tax advisers, line up their questions and expect us to provide simple answers thinking that tax is no more than a black-and-white matter.  What they usually don't realize are the followings:

• that the tax law is usually very complex and therefore contains lots of grey areas that are the source of uncertainties; there is no one-size-fits-all type of solution;
• that an exercise of tax planning requires, just like any plans in life, some sort of algorithm by itself; in other words, it needs a carefully thought-out strategy which would go hand-in-hand with a specific business model; and 
• that most tax authorities around the world are focusing on, and taking concerted actions nowadays in developing/amending international standards of taxation so as to effectively assess taxes on the incomes generated by e-commerce/online businesses (e.g., OECD BEPS action plan #1).   

So if you are either one of the gaming business CEOs or a staff working for a gaming company and have tax-related questions or assistance concerning your company's investment or business model,  I would like to suggest that you first prepare a draft business/investment plan with all the basic elements (e.g., short- and long-term objectives, company status, investment structure, financing options, etc.) laid out before you seek any assistance from your tax advisers.  That way, you are more likely to get the kind of answers and attention you would require from your advisers and to be able to protect yourself from any malpractices.

OECD BEPS Action #8 - Thoughts on the Guidance on Transfer Pricing Aspect of Intangibles

When it comes to an interpretation of a certain treaty provision, Article 31 of the Vienna Convention on the Interpretation of Treaty dictates that such interpretation should give the provision its ordinary meaning. 'Ordinary meaning' could be understood as commonly accepted meaning by the general public. What has always been puzzling to me is how one should resolve a situation where two parties debate on the exact meaning of a treaty provision or terminology, and those parties are coming from completely different cultural backgrounds and where that which is plain and ordinary to one party could be completely absurd to the other. 

Before OECD announced and thereby finalized its  4-year long project on the Guidance on Transfer Pricing Aspect of Intangibles (the "OECD Guidance"), people had a fairly clear sense of the term 'intangible', or more precisely, 'intangible asset,' since nearly every OECD member state had its own legal or accounting definition of whatever constitutes "intangible." Not all such definition were perfect, but at least both taxpayers and tax authorities knew exactly what was being said and meant. So at least in everyone's mind, there was a sense of what was an ordinary meaning for 'intangible.'

Now, let's look at OECD's new 'ordinary meaning' of (para. 6.6, OECD Report) (or, at least what OECD wants everyone to accept as given):

“The word 'intangible' is intended to address something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances. Rather than focusing on accounting or legal definitions, the thrust of a transfer pricing analysis in a case involving intangibles should be the determination of the conditions that would be agreed upon between independent parties for a comparable transaction.“

Two interesting observations can be made about the definition:

• Jail-breaking: as mentioned in the above definition, the focus has been deliberately shifted from the accounting and legal hemisphere - which constituted the ordinary meaning (or convention) all this time -  to the arm's length hemisphere where all kinds of fictitious claims may be attempted.
• Bond-severing: Breaking away from the legal or accounting context would sever bonds that existed between intangibles and the context/manners in which those intangibles were traditionally exploited. For instance, it was impossible to separate the notion of control from that of ownership, especially when the latter is protected by the law. Most countries with civil law systems have specific laws and regulations in place both establishing and protecting basic property ownership, and the notion of control is usually inseparable from property ownership. The new definition, however, implies that such laws/regulations may be overridden when applying the arm's length principle, which is another way of saying that a mere fiction may override a fully binding and effective legal structure under certain circumstances  

Even if we can forgive these two points, what does this definition point to in the end? What is the point of referring to 'something' when intangibles could be easily identified had it not for this arbitrary definition?

Is this an enlightenment to the true semantics of "intangibles"? Perhaps. Is the meaning ordinary?  Well, nobody can say for sure. But one thing has become quite obvious: the multinationals will now have tons of work to do, especially when they have IP (intangible property) holding structures with the ownership of IP and the value-creation functions separated. They may also have to look out for any human activities with profit potential which might be targeted as a constructive source of income by the non-reluctant tax authorities.
    

Article published in 2013

Attached below is my article contributed to the BNA Tax Planning International Review of International Taxation in 2013. This article deals with February 2013 amendment to Korean corporate income tax rule (the Corporate Tax Act and its Enforcement Rules Article 130 Article 64, paragraph 1), applicable from January 2014, whereby the domestic source income generated from intra-group transactions between the head office and its branch of a foreign corporation would now be subject to the arm's length principle ("ALP").

It's been a while that the application of ALP became administrative convention for the Korean tax authorities for reviewing the taxpayers' branch-to-headquarters or inter-branch transactions, but there was no express statutory authority for such convention, which was always a source of great uncertainty for taxpayers in the financial services industry.

It is worthy to note that some of the financial services intragroup transactions i.e., intragroup fundings and/or credit guarantees, are excluded from the arm's length testing and denied deductibility.

Should you need a full copy of the article, please leave a comment with your email address.

Korean Transfer Pricing Rules and Regulations (2014)

I'd like to share my article contributed to 'Getting the Deal Through' this year. This article provides the summary of the Korean transfer pricing rules and trends for 2015. Should you need a full *.pdf copy of the article, please send me an email to txk175@gmail.com.