Transfer pricing of intangibles in the age of BEPS

SUITS THE C-SUITE By Joyce A. Francisco

Business World (12/14/2015 – p.S1/3)

In our previous columns, we tackled some of the recommendations from the Organisation for Economic Co-operation and Development (OECD) on how to address the issue of Base Erosion and Profit Shifting (BEPS) in international tax systems. We will now focus on the topic of transfer pricing (TP) of intangibles as covered in Aligning Transfer Pricing Outcome with Value Creation, Actions 8-10 — 2015 Final Reports issued on 5 October 2015.


Intangibles often have unique characteristics and, as a result, have the potential for generating returns and creating future benefits that could differ widely. Usually, the intangible is transferred between related parties at a point in time before it has been fully developed. An example given is where chemical compounds may be patented by a pharmaceutical company and the patents are transferred to its related party. This is done well in advance of the time when further research, development and testing demonstrate that the compounds constitute a safe and effective treatment for a particular medical condition. In this instance, the value of the intangible is highly uncertain at the time of the transaction, making it difficult for a tax administration to evaluate the reliability of the information upon which the taxpayer priced the transaction.

To address these challenges, an approach to pricing hard-to-value intangibles has been developed. This approach allows the taxpayer to demonstrate that its pricing is based on a thorough transfer pricing analysis and leads to an arm’s length outcome, while, at the same time, protects the tax administrations from the negative effects of information asymmetry.

The term hard-to-value intangibles (HTVI) covers intangibles or rights in intangibles for which, at the time of their transfer between associated enterprises:

· No reliable comparables exist, and

· At the time the transactions were entered into, the projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of the transfer.

Transactions involving the transfer or the use of HTVI may exhibit one or more of the following features:

· The intangible is only partially developed at the time of the transfer.

· The intangible is not expected to be exploited commercially until several years following the transaction.

· The intangible itself does not fall within the definition of HTVI as mentioned, but is integral to the development or enhancement of other intangibles which fall within the definition of HTVI.

· The intangible is expected to be exploited in a manner that is novel at the time of the transfer and the absence of a track record of development or exploitation of similar intangibles makes projections highly uncertain.

· The intangible, meeting the definition of HTVI, has been transferred to an associated enterprise for a lump sum payment.

· The intangible is either used in connection with or developed under a Cost Contribution Arrangement or similar arrangements.

When there is a transfer of HTVI, the tax authorities may consider ex post evidence (refers to the income actually earned through the exploitation of the intangible) about the actual financial outcomes of the transfer to be necessary in determining the appropriateness of the ex ante (refers to the future income expected to be derived at the time of the transaction) pricing arrangements. These may include any contingent pricing arrangements that would have been made between independent enterprises at the time of the transaction.

The approach intends to ensure that tax administrations can determine in which situations the pricing arrangements, with respect to a HTVI as set by the taxpayers, are at arm’s length and are based on an appropriate weighting of the foreseeable developments or events that are relevant for the valuation of certain HTVI and in which situations this is not the case.

The taxpayer, on the other hand, can prove the original pricing was based on reasonable forecasts taking into account all reasonably foreseeable eventualities. Thus, a rigorous transfer pricing analysis by taxpayers is required to ensure that transfers of HTVI are priced at arm’s length.


The above approach will not apply when at least one of the following exemptions applies:

· The taxpayer provides:

o Details of the ex ante projections used at the time of the transfer to determine the pricing arrangements, including how risks were accounted for in calculations to determine the price and the appropriateness of its consideration of reasonably foreseeable events and other risks, and the probability of occurrence; and

o Reliable evidence that any significant difference between the financial projections and actual outcomes is due to:

o Unforeseeable developments or events occurring after determining the price that could not have been anticipated by the associated enterprises at the time of the transaction; or

o The playing out of probability of occurrence of foreseeable outcomes, and that these probabilities were not significantly overestimated or underestimated at the time of the transaction;

o The transfer of the HTVI is covered by a bilateral or multilateral advance pricing arrangement in effect for the period in question between the countries of the transferee and the transferor.

o Any significant difference between the financial projection and actual outcomes mentioned in 1) b above does not have the effect of reducing or increasing the compensation for the HTVI by more than 20% of the compensation determined at the time of the transaction.

o A commercialization period of five years has passed following the year in which the HTVI first generated unrelated party revenues for the transferee and in which commercialization period any significant difference between the financial projections for that period.


An example given in the report is when the evidence of financial outcomes shows that sales of products exploiting the transferred intangible reached 1,000 a year, but the ex ante pricing arrangements were based on projections that considered sales reaching a maximum of only 100 a year. In such a case, the tax administration should consider the reasons for sales reaching such higher volumes. If the higher volumes were due to unforeseen events, for example, when an exponentially higher demand for the products incorporating the intangible was caused by a natural disaster or the unexpected bankruptcy of a competitor, then the ex ante pricing should be recognized as being at arm’s length, unless there is evidence other than the ex post financial outcomes indicating that price setting did not take place on an arm’s length basis.

The OECD is set to release in 2016 the guidance on the implementation of this approach and the practical application of the exemptions, including the measurement of materiality and time periods contained in the current exemptions, will be reviewed by 2020 in the light of further experience.

Joyce A. Francisco is a Tax Senior Director of SGV & Co.