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 or tangible 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.
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. Treasury Regulation Section 1.482-1(d)(3)(ii)(B) addresses the importance of written agreements in the context of supporting and documenting transfer pricing matters in connection with a showing of “economic substance,” as follows” “The contractual terms, including the consequent allocation of risks, that are agreed to in writing before the transactions are entered into will be respected if such terms are consistent with the economic substance of the underlying transactions.”
The salient terms of an intercompany agreement must be drafted and executed and thus put in place before the transactions are undertaken and those terms must be consistent with economic reality in order for the Internal Revenue Service (“IRS”) to respect the transactions. As a corollary, the actual conduct of the parties must be consistent with the intercompany agreements because “if the contractual terms are inconsistent with the economic substance of the underlying transaction, the district director may disregard such terms and impute terms that are consistent with the economic substance of the transaction. Treas. Reg. Section 1.482-1(d).
The following should be included in a written transfer pricing agreement:
1 The agreement should identify all the parties to the agreement and should include an identification of all parties to the agreement.
2. The agreement should describe in detail the relevant transactions covered by the agreement, with specific commentary on the characteristics of each transaction including what is considered within the scope of the transfer pricing agreement and what is not considered within the scope. Because such types of transactions may vary from year to year, including this “scope description” may be better presented in an exhibit to the agreement that could be modified from time to time.
3. The agreement must have an effective date, expiration date, renewal provisions and similar timing details should be included in the agreement as would be the case between any non-related party agreement.
- The agreement should include the grounds for termination including specification for events of default as well as grounds for automatic termination such as engaging in illegal conduct. These provisions should also include appropriate “cure” provisions.5. The agreement should contain a detailed description of the specified transactions whether dealing with the sale of goods or provision of services, and how title will pass, where services are to be performed, what markets will be covered, and whether any specified intellectual property will be involved in those transactions and if so what terms and conditions.6. The agreement should always include appropriate payment terms for each specified transaction, including a designation of the currency in which the payment will be made, and whether any discounts will be triggered based on volume of activities, and a detailed summary of the basis for the prescribed payment assuming the transaction does not involve a fixed-fee arrangement. The payment provision, if based on a percentage of gross sales or other types of revenues, should contain a detailed description of the particular market, customers, and other relevant jurisdictional considerations.
7. The agreement should address applicable product warranties or guarantees, as if the related parties were dealing with unrelated parties, including detailed provisions regarding minimum standards, quantities, service quality and how these benchmarks will be measured.
8. The agreement should contain a detailed description of preexisting intellectual property including the ownership of such intellectual property and a detailed summary of how that intellectual property interfaces with the covered transactions under the agreement. This provision should also address the terms and conditions of any new intellectual property that might be developed during the pendency of the intercompany agreement and how the intellectual property is licensed, a description and breakdown of the intellectual property.
9. The agreement should include customary provisions of what happens in case either party undergoes a change-of-control and whether or not this would cause a termination of the intercompany pricing agreement.
10. The agreement should take into account any relevant liability limitation and related insurance provisions.
11. The agreement should contain a provision on how the parties would react to force majeure events.
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 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.
As with the transfer of intangible property, a transfer price must be determined for the intercompany transfer of tangible property. Similar to the transfer of intellectual property, there are a number of arm’s length methods available. The taxpayer must select and apply the most reliable estimate of an arm’s length price.
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. It is not only important for parties entering into an intercompany agreement to consider the tax consequences of such a transaction, it is also important for the parties to an intercompany agreement to plan around the non-tax impacts of an intercompany agreement. Assuming an intercompany agreement is based on an arm’s length standard, insurance risks should also be considered. The following example will illustrate insurance risks that are typically not considered in intercompany agreements.
For example, assume a foreign-based part corporation manufactures and distributes a variety of high tech products for the global market place. The parent corporation enters into a contract with related party foreign subsidiary (“FSI”) to perform certain contract manufacturing services as a part of the finishing process for many of these high tech products in return for a very limited margin or mark-up. In addition, the parent corporation requires FS1 to offer similar contract manufacturing services to other related party manufacturers (such as FS2). Following is an illustration of this example:
Under various intercompany agreements between FS1 and other foreign-based manufacturing related parties (FS2), the agreement states that FS1 is liable for any and all defective products as well as business interruption losses that occur from such defective products, even though another related party (FS2) provides all designs specifications and related guidance. As it turns out, many of these products for which FS1 provides finishing contract manufacturing services are defective, and FS1 files a claim for insurance coverage.
Under these circumstances, it is possible that once the claim is filed, the insurance company may question, limit or even deny coverage by virtue of FS1 accepting an unreasonable level of risk through its unlimited risk relationship with its various parties including FS2 and FS1’s parent corporation. Consequently, manufacturers such as FS1 should not accept un;limited liability for enumerated risks. In drafting an intercompany agreement, transfer pricing issues should be considered, tax consequences of the intercompany agreement should be considered, and insurable risks should be carefully considered. See A. Hughes, Multinationals Should Pay More Attention To Their Intercompany Agreements, Tax Notes International, May 25, 2020, pg. 883.
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).
Written By Anthony Diosdi
Anthony Diosdi focuses his practice on international inbound and outbound tax planning for high net worth individuals, multinational companies, and a number of Fortune 500 companies.
