Tax controversy update vol. 11 - Price adjustment measures for transactions involving hard-to-value intangibles

(Issue 11, September 26, 2022) Price adjustment measures for transactions involving hard-to-value intangibles

In the tax reforms of 2019, price adjustment measures for transactions involving hard-to-value intangibles were introduced which enable transfer pricing adjustments for intangible assets based on using ex-post outcomes as presumptive evidence.

1 Background

The aforementioned measures introduced the Hard-to-Value Intangible (HTVI) approach adopted in the OECD Transfer Pricing Guidelines. Japanese measures adopt the DCF method as the basis for adjustments. Therefore, Japanese measuresdo not generally allow to use the comparable profit method(CPM) to fix the profit level of related parties and to recover residual profit that results from a significant increase in value after the transfer of an intangible asset through super royalties like the commensurate with income standard introduced by the US Tax Reform Act of 1986.

2 Attribution of excess profits

So, which related party should excess profits be attributed to?

For example, if the royalty rate collected from a foreign related party is fixed under the CUT method, excess profit will be attributed to the foreign related party as residual profit. Conversely, if the profit level is fixed under CPM/TNMM for the foreign related party, the excess profit will be collected as an excess (super) royalty and attributed to the parent company.

In the recent US transfer pricing case against the Coca-Cola Company, the taxpayer fixed the royalty rate collected from its foreign related parties using the CUT method and attributed excess profits to the foreign subsidiary. The IRS, however, fixed the profit level by applying CPM to the foreign related parties, had the excess profits recovered as excess (super) royalties, and attributed the income to the parent company. The end result was a ruling against the Coca-Cola Company which resulted in additional taxes from the transfer pricing adjustments made by the IRS.

In applying the commensurate with income standard, the CUT method and CPM/TNMM attribute excess profits to one related party though the residual profit split method (RPSM) attribute excess profits to both related parties.

3 Attribution of excess profits in Japan

While we think that no tax assessments have been made so far based on using the DCF method within the application of the price adjustment measures pertaining to transactions involving hard-to-value intangibles, it is common for tax assessments to employ TNMM to fix the profit level of foreign related party and to collect excess profits as excess royalties for the parent company.

When the profit level of a foreign related party has increased significantly, all excess profits can be recovered through excess royalties if the profit level of the foreign related party is fixed under TNMM. However, we are not sure whether the enforcement of this recovered mechanism is based on the commensurate with income standard or traditional transaction method.

DCF differs from TNMM, which fixes the profit level of the foreign related party and indirectly calculates the excess royalties, and from RPSM, which divides the attribution of excess profits according to the contribution of R&D expenses, advertising expenses, and other expenses and indirectly calculates the excess royalties. Instead, DCF can be used as a method to attribute excess profits to related parties by estimating the value of the intangible itself and directly calculating the excess profits.

Paragraph 6.142 of the OECD Transfer Pricing Guidelines states that it is generally not recommended to use transfer pricing methods that estimate the value of intangibles based on their development costs. Given that there is rarely any correlation between the development costs of intangible assets and the post-development value or transfer price, it appears that companies are wary of attributing excess profits to subsidiaries due to the undervaluation of the intangible assets.

Accordingly, Paragraph 6.153 calls for the use of income based valuation techniques as a method of calculating excess profits on a profit basis rather than on a cost basis. In particular, it recommends valuation techniques premised on the calculation of the discounted value of projected future income streams or cash flows derived from the use of the intangible being valued.

Depending on the facts and circumstances, valuation techniques may be used as a part of one of the five OECD transfer pricing methods - CUP, RP, CP, TNMM, and PS - or as a tool that can be usefully applied in identifying an arm’s length price.

In the application of the DCF method, the calculation and attribution of excess profits to related parties depends on how the evaluation parameters are set. The OECD Guidelines recommends defining realistic and reliable financial projections, growth rate assumptions, discount rates, useful life and terminal value of intangibles, as well as tax assumptions and forms of payment. Section 4-13 of the Commissioner's Directive on the Operation of Transfer Pricing (Treatment of the DCF method) stipulates that intangible assets should be valued by verifying the projected profits, discount rate, and projection period, after which excess profits can be calculated and an optimal allocation amongst related parties can be conducted.

For example, with regard to projected profits, the guidance states to examine whether or not they were calculated based on information from reliable and verified sources such as business plans, to confirm the basis and purpose for the projections, and to consider the rationale for the length of the projection period and the actual results from prior periods which are used as the foundation for the projections. However, if we are to assume that taxpayers want to attribute excess profits to foreign related parties and are therefore likely to prefer undervaluing the projected profits as much as possible, it is also right to assume that tax authorities will prefer overvaluing the projected profits as much as possible in an effort to attribute excess profits to the parent company.

Similarly, in regard to growth rate assumptions, discount rates, useful life and terminal value of intangibles, tax assumptions and forms of payment, the same taxpayers who wish to attribute excess profits to foreign related parties may strive to underestimate the growth rate, set a high discount rate to account for the high risk rate, and undervalue the useful life and terminal value of the intangibles. In the same vein, the tax authorities would again prefer the opposite of all of these actions in order to attribute excess profits to the parent company as much as possible.

It is likely that taxpayers and the relevant tax authorities where the parent company is located will be at odds over the allocation of excess profits when applying the commensurate with income standard. It is also safe to say that it will be necessary to strategically consider the attribution of excess profits when applying the DCF method.

* Please note the opinions expressed in this article are solely those of the author and do not represent the opinions or views of EY Tax Co.