An Overview of the Rules Governing Intercompany Transactions Involving Intangibles for Multinational Corporations

Transfer pricing for intangibles between related entities requires arm’s-length rates or transfer prices for patents, trademarks, or software that independent parties would pay. Anytime a multinational corporation conducts the movement of intellectual property between two or more legally distinct companies, subsidiaries, or divisions that are under common ownership or control, such as a parent company and its subsidiaries, a “transfer price” must be computed under Section 482 of the Internal Revenue Code. The purpose of Section 482 is to ensure that U.S. taxpayers report and pay tax on their actual share of income arising from a controlled transaction. To this end, the regulations under Internal Revenue Code Section 482 adopt an arm’s-length standard for evaluating the appropriateness of a transfer price. Under this standard, a U.S. taxpayer should realize the same amount of income from a controlled transaction as an uncontrolled party would have realized from a similar transaction under similar circumstances. This article discusses how the regulations under Section 482 value an intercompany transfer of intellectual property.

An Overview of the Regulations Governing Transfer Pricing

The term “transfer pricing” is often used to refer to the setting of prices on all types of transactions between related parties. It applies to fixing the price on a sale of goods from one member to a corporate family to another, the royalty rate under a patent license, the fees under a services agreement, the interest rate on a loan, and the amount payable on any other intercompany transaction. To arrive at an arm’s-length amount, a multinational corporation must select and apply a method that provides the most reliable estimate of an arm’s-length price. The reliability of a pricing method should examine the comparability between controlled and uncontrolled transactions. The principal factors to consider in assessing the comparability of controlled and uncontrolled transactions include the following:

Functions. The economic functions carried out and resources employed by the parties involved in the controlled and uncontrolled transactions must be identified and compared.

Contractual terms. The contractual terms of the controlled and uncontrolled transactions must be analyzed. Significant contractual terms could affect the results of two transactions. For example, the rights to update or modifications, the duration of the contract, the extent of any collateral transactions between the parties and the extension of any credit or payment terms may have an economic effect on the transaction.

Risks. The comparability of risks involved in the controlled and uncontrolled transactions should be considered. These include risks associated with the success or failure of research and development activities, and financial risks.

The regulations promulgated under Section 482 of the Internal Revenue Code also discuss “special circumstances” that should be considered in assessing the comparability of controlled and uncontrolled transactions. They include:

Market share strategy. Price differentials attributable to attempts to enter a market or expand a market share should be considered in an analysis.

Differences in geographic markets. If it is necessary to compare transactions in another market, differences in the market that might affect the comparison should be taken into consideration.

Location savings. If different geographic locations account for cost differences, these cost differences should be taken into account in an analysis.

For transfer pricing purposes, an “intangible” includes any of the following:

1. patents, inventions, formulae, designs, patterns, or know-how;
2. copyrights and literary, musical, or artistic compositions;
3. trademarks, trade names, or brand names;
4. franchises, licenses, or contracts;
5. methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and
6. other similar items.

The owner of an intangible is ordinarily the company that owns the legally protected right to exploit the intangible. Conversely, if an intangible has no protection under law, in such a case, it may be uncertain who actually owns the intangible property. In these cases, the controlled party, the company that expended the largest amount to develop the intangible party is typically the owner of the intangible property. The regulations promulgated under Section 482 of the Internal Revenue Code discuss a number of different ways to estimate an arm-length charge for the transfer of intangibles. The entity involved in the transfer of intangible property must select the method that provides the most reliable estimate of an arm-length price. Below are three random methods of transfer pricing discussed in the regulations that historically have been used for transfer pricing.

Comparable Uncontrolled Transaction Method

Under the comparable uncontrolled transaction method, the arm-length charge for the transfer of an intangible is the amount charged the comparable intangibles in transactions between uncontrolled parties, adjusted for any material differences that exist between the controlled and uncontrolled transactions. In order for the intangibles involved in the uncontrolled transaction to be considered comparable to the intangibles involved in the controlled transaction, both intangibles must be used in connection with similar products or processes within the same general industry or market and must have similar profit potential. This article discussed the comparable profits method and the profit split method used to estimate an arm’s-length charge for transfers of intangibles.

Comparable Profits Method

Under the “comparable profits method,” the method that determines an arm’s length result is based on profit level indicators derived from similarly situated uncontrolled companies. See Treas. Reg. Section 1.482-5(a). Under this method, the profitability of comparable companies is used as a benchmark for determining an arm’s-length net profit for one of the controlled parties and then a transfer price is established that leaves the tested party with that amount of net profit.

The methodology for determining an arm’s-length profit involves the following steps:

1. A controlled party is selected. The controlled party is selected that has the least complex, readily available and accurate financial data from which to draw a comparison will be the party to whom a test is applied and is called the “tested party.”
2. A search is made for comparable companies. Adjustments are then made for all material differences between the tested party and the comparable companies which serves as a basis for comparison.
3. Then, a profit level indicator is selected. Examples of profit level indicators that can be used include the ratio of operating profit to operating assets, the ratio of operating profit to sales, and the ratio of gross profit to operating expenses.

Below, please find Illustration 1, Illustration 2., and Illustration 3. which discusses how transfer pricing operates under the comparable profits method.

Illustration 1.

USAco, a domestic corporation, developed AI software that drafts the perfect legal brief for lawyers. USAco licenses technology to an unrelated company in New York for a royalty of 10% of sales. USAco also licenses the technology to its Canadian subsidiary headquartered in Vancouver (“CANco”). If all the company factors between the two licenses are identical, CANco should pay USAco a royalty of 10% of sales. However, if the two licenses are not comparable in a manner for which the parties cannot make adjustments, the 10% return on sales royalty is not a comparable uncontrolled transaction.

Illustration 2.

SwissMiss, a Swiss pharmaceutical company, owns 100% of Big Pharma, a domestic corporation. SwissMiss develops a pharmaceutical Stay Healthy, a powerful vitamin. SwissMiss licenses the formula to Stay Healthy with the rights to use the Stay Healthy trade name in the United States to Big Pharma. Big Pharma is selected as the tested party as a result of engaging in similar activities as SwissMiss. Big Pharma is also selected as the tested party because it engages in less complicated activities than SwissMiss. Next, an analysis is made of several comparable uncontrolled U.S. companies that distribute pharmaceuticals to determine which operating profits to sales is the most appropriate profit level indicator. After adjustments have been made to account for material differences between Big Pharma and a sample of similar companies, an arm’s-length range price is developed to determine the transfer price.

Illustration 3.

USAco is a U.S. pharmaceutical company that develops a drug to soothe bee stings. USAco owns a subsidiary in the British Virgin Islands (“BVI”) and also sells the chemicals used in the formula. The BVI subsidiary consists of three locals that make the drug in their home and sell it to USAco. Under these circumstances, as opposed to testing each of a number of intercompany transactions of large corporations, the parties merely may select a couple of comparable profits method analysis for the transaction.

Profit Split Method

Under the “profit split method,” the operating profit or loss is determined from the most narrowly identified business activity of the controlled party which includes the controlled transaction. Such profit or loss is then divided between the controlled parties based upon “the relative value of each controlled party’s contributions” to the success of the activity. The value of each party’s contributions is to be based upon “the functions performed, risks assumed, and resources employed.” See Treas. Reg. Section 1.482-6(b).

The division can be accomplished through the comparable profit split method or the residual split method. Under the comparable profit split method, the allocation of the combined operating profit between the two controlled parties is based on how uncontrolled the parties engaged in similar activities under similar circumstances allocate their profits. The residual profit split method calls for the application of a two-step process. First, the operating income is allocated to each party by reference to the market rate of return for its routine contributions to the activities. Routine contributions are those made by uncontrolled parties involved in similar business activities for which market returns can be identified. They include contributions of tangible property, services and intangibles which similarly situated uncontrolled parties generally own. The market rate of return is determined by reference to uncontrolled parties engaged in similar activities.

Commensurate with Income Requirement

In addition to determining a transfer price, the parties must adjust the original sales price or royalty rate annually to reflect any unanticipated changes in the income actually generated by the transferred intangible. See Treas. Reg. Section 1.482-4(f)(2)(i).  For example, if the intangible property at issue turns out to be far more successful than was expected at the time it was licensed, the transferring party must increase the intercompany royalty payments to reflect that unanticipated profitability. A determination in an earlier year that the royalty was arm’s length does not preclude the IRS from making an adjustment in a subsequent year.

For example, let’s assume that USAco, a pharmaceutical company, licenses the rights to a lotion that soothes sunburns to its Cayman Islands subsidiary for what is considered an arm’s-length royalty rate of 15% of sales. Four years later, it is determined that an ingredient in the lotion causes skin to age backwards. As a result, the Cayman Islands company earns a highly profitable return on sales of 960%. Even though the Cayman Islands subsidiary paid an arm’s-length royalty to USAco for the lotion, the Internal Revenue Service (“IRS”) can make an adjustment to reflect the unanticipated profitability.

Congress has enacted a requirement that transfer prices for sales or licenses of intangibles must “commensurate with income attributable to the intangible.” In other words, transfer prices must reflect the actual profit experience realized subsequent to the transfer. To meet this requirement, the original sales price or royalty rate must be adjusted annually to reflect any unanticipated changes in the income actually generated by the intangibles. This means that the parties to an intercompany transfer of intellectual property will need to make periodic adjustments to the transferred intangible to reflect any unanticipated profitability. This burden is mitigated somewhat by the following exceptions:

De minimis exception- Period adjustments are not required if the total profits actually realized by the controlled transferred from the use of the intangible are between 80% and 120% of the profits that were foreseeable when the agreement was entered into and there have been no substantial changes in the functions performed by the transferred since the agreement was executed, except for changes required by unforeseeable events. Other requirements include the existence of a written royalty agreement, and the preparation of contemporaneous supporting documentation. ^[1]

Extraordinary event exception- Even if the total profits actually  realized by the controlled transferee from the use of the intangible are less than 80% or more than 120% of the profits that were foreseeable when the agreement was entered into, the parties need not make periodic adjustments if the unexpected variation in profits is due to extraordinary events that could not have been reasonably anticipated and are beyond the parties’ control.

Transactional and Net Adjustment Penalties

In an attempt to promote more voluntary compliance with the arm-length standard, Congress has enacted two special pricing penalties: the transactional penalty and the net adjustment penalty. Both penalties equal 20% of the tax payment related to a transfer pricing adjustment made by the IRS to an intercompany transfer The transactional penalty applies if the transfer price used by the parties is 200% or more (or 50% or less) of the amount determined under Section 482 of the Internal Revenue Code to be the correct amount. The net adjustment penalty applies if the net increase in taxable income for a taxable year as a result of Section 482 adjustments exceeds the lesser of $5 million or 10% of the parties gross income. Both penalties increase to 40% of the related tax underpayment if the transfer price used by the parties is 400% or more (or 25% of less) of the amount determined under Section 482 to be the correct amount or if the net adjustment to taxable income exceeds the lesser of $20 million or 20% of the U.S. corporation’s gross receipts.

Conclusion

This article is intended to acquaint readers with an overview of the transfer pricing rules that apply to intercompany transfers of intellectual property. This area is relatively complex and is constantly evolving with Congress entertaining new tax laws, the IRS issuing new regulations and interpretations and courts rendering new rulings in this area. As a result, it is crucial that any U.S. company or foreign company with U.S. shareholders considering making an intercompany transfer of intellectual property consult with a qualified international tax attorney.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.

^[1] Treas. Reg. Section 1.482-4(f)(2)(ii)(C).