Valuation and Management of Intellectual property within the Value Chain

Intellectual property (IP), also referred to as intangible property, constitutes a significant portion of companies’ profitability throughout the value chain. It is often the subject of scrutiny and high-profile, lengthy transfer pricing disputes. In this article, we will describe the key methods to value IP for transfer pricing purposes and how to ensure that IP tax structures align with your transfer pricing policies and are sustainable in the face of transfer pricing audits.

TP Methods for Valuation of IP:

Both the OECD guidelines and the US 1.482-4 regulation specify four methods that are appropriate for IP valuation.

• The Comparable Uncontrolled Transaction (CUT): This method compares the transfer of IP in controlled transactions to similar transfers in uncontrolled transactions to determine an arm’s-length price. However, the application of the CUT method is challenging due to the uniqueness and specialization of IP assets, making truly comparable transactions rare. Additionally, many IP licensing agreements are confidential, and IP is often bundled with other assets, making it difficult to isolate its specific value. Market conditions and industry factors also change over time, further reducing the relevance of past transactions.

• The Comparable Profits Method (CPM) / Transactional Net Margin Method (TNMM): Both methods are widely accepted by the IRS and OECD. In a CPM/TNMM analysis, the tested party (often a distributor or contract manufacturer) is compared to uncontrolled taxpayers. Residual profits are then allocated to the other party (typically the entity responsible for strategic decisions and owning the IP). CPM is commonly used for tax-related transfer pricing of IP but is less favored for standalone IP valuation in transactions where direct IP value measurement is required.

• The Profit Split Method (PSM): The PSM ensures that transactions between related companies are conducted at an arm’s-length price, reflecting fair market value. Unlike other methods that may emphasize individual contributions, the PSM focuses on the value jointly created by the related entities. This method is particularly useful in complex industries with high profits, such as technology and pharmaceuticals, where the contributions of each party are intertwined and difficult to separate.

• Unspecified/Other Methods: When other methods are deemed not reliable to provide an arm’s length result, taxpayers may select another method. Mainly, other methods are based on either income or cost-based approaches. Common income-based approaches include discounted cash flow (DCF), which requires determining the projected free cash flows over the life of the IP and then discounting them with an appropriate discount factor to arrive at a present fair market value. Additionally, relief from royalty is another common method that examines the hypothetical royalty rate that a taxpayer would have to pay a third party to license such IP, instead of owning it. Cost-based approaches identify the IP development costs and apply a reasonable markup or multiple to determine the IP’s value. Lastly, hybrid methodologies may combine any of the above methods to determine the fair market/arm’s length value.

Commensurate with Income and Hard-to-Value Intangibles

The Commensurate with Income (CWI) approach by the IRS and the Hard-to-Value Intangibles (HTVI) framework by the OECD both aim to prevent tax avoidance by allowing tax authorities to reassess the pricing of transferred IP based on actual income earned after the transaction. CWI, under U.S. tax law (IRC Section 482), applies for up to 20 years and requires periodic adjustments if the transferred intangible generates significantly higher income than initially projected. The OECD’s HTVI approach, included in the “Aligning Transfer Pricing Outcomes with Value Creation Action 8-10” final report in 2015, allows for ex post adjustments but provides exceptions if taxpayers can justify their initial valuation with reasonable assumptions and documentation. Both methods primarily target highly uncertain and unique intangibles, such as patents and proprietary technology, where future earnings are unpredictable. While CWI is stricter, with fewer exceptions, HTVI offers more flexibility, depending on the specific country’s tax regulations.

As the above section describes common methodologies to value IP, the following section describes best practices to align and maintain IP structures.

Aligning IP Ownership with DEMPE

In the same OECD report mentioned above, the OECD issued a revised Chapter VI to the Transfer Pricing Guidelines regarding Intangibles. The section on the ownership of intangibles and transactions involving their development, enhancement, maintenance, protection, and exploitation (DEMPE) discusses the allocation of returns and costs within a multinational enterprise (MNE) group. It emphasizes that while the legal owner of an intangible may initially receive proceeds from its exploitation, other group members who perform functions, use assets, or assume risks contributing to the intangible’s value must be compensated according to the arm’s length principle.

Key points include:

• Legal Ownership and Contractual Arrangements: Legal rights and contracts are the starting point for analyzing transactions involving intangibles. These documents outline roles, responsibilities, and rights concerning intangibles, including funding, research, maintenance, and exploitation. Therefore, having up-to-date IC agreements is a crucial first step to align the profit split within a value chain as per the IP ownership structure.

• Compensation Based on Contributions: The ultimate allocation of returns and costs is based on compensating group members for their contributions in terms of functions performed, assets used, and risks assumed. Legal ownership does not automatically entitle the owner to all returns.

• Functional Analysis: A detailed functional analysis is required to determine which group members perform and control functions related to intangibles, provide funding, and assume risks. This analysis helps in identifying arm’s length prices for transactions.

• Challenges in Implementation: The section acknowledges challenges such as lack of comparability with independent enterprises, difficulty in isolating the impact of intangibles on income, and the complex integration of functions within MNEs.

• Steps for Analysis: The framework for analyzing intangible-related transactions includes identifying intangibles and associated risks, contractual arrangements, parties performing functions, consistency between contracts and conduct, and determining arm’s length prices based on contributions.

Overall, the section underscores the importance of compensating all relevant contributions within an MNE group to ensure compliance with the arm’s length principle in transactions involving intangibles.

Identifying and Monitoring DEMPE Functions

The bigger and more complex MNEs are, the more challenging it is to identify, map, and monitor DEMPE functions. As there is constant change within MNEs, DEMPE functions naturally shift over time. Even if you have successfully identified key DEMPE functions and documented them, they are not static and may change over time, so refreshing the DEMPE landscape and ensuring that it is aligned with the current IP transfer pricing policies is crucial.

Here are key steps to identify and monitor DEMPE functions:

• Map the Organizational Structure: Identify key business units and legal entities involved in DEMPE of intangibles. Determine which entities own, manage, or contribute to IP-related activities.

• Conduct Functional Interviews and Data Collection: Engage with key personnel across R&D, marketing, finance, legal, and operations to understand where DEMPE functions are performed and where associated costs arise. Gather documentation on decision-making processes, funding arrangements, and risk management related to intangibles.

• Analyze Cost and Profit Allocation: Assess whether costs incurred and profits earned are aligned with the functions performed by each entity. Ensure that IP-owning entities can substantiate their involvement in DEMPE functions with financial and operational data.

• Establish and Maintain Legal Entity Governance: Define clear roles and responsibilities within IP owner entities to ensure compliance with transfer pricing policies. Implement governance structures to track and monitor where DEMPE functions are conducted.

• Continuously Monitor and Update DEMPE Mapping: Recognize that DEMPE functions shift over time due to organizational changes, restructuring, or strategic decisions. Regularly review and refresh the DEMPE landscape to maintain compliance with evolving tax and transfer pricing regulations.

• Document and Substantiate DEMPE Functions: Maintain detailed records of DEMPE-related activities, including agreements, financial statements, and operational workflows. Ensure that the functions, risks, and asset sections in your transfer pricing documentation support the economic substance of IP ownership and function allocation.

By following these steps, MNEs can effectively identify, manage, and defend DEMPE functions, ensuring compliance with transfer pricing regulations and reducing risks related to IP ownership and profit allocation.

Conclusion:

Effectively managing DEMPE functions requires ongoing monitoring, structured governance, and alignment with profit allocation across the value chain. Given the fluid nature of MNE operations, companies should implement regular reviews and robust documentation practices to ensure compliance with transfer pricing regulations. By doing so, MNEs can substantiate their IP ownership claims and avoid potential tax disputes related to intangible asset allocation.