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The Rules Governing Cross-Border Intercompany Transfer Pricing of Intangible Property for Multinational Corporations

The Rules Governing Cross-Border Intercompany Transfer Pricing of Intangible Property for Multinational Corporations

By Anthony Diosdi

Multinational corporations usually engage in a variety of cross-border intercompany transactions. A common arrangement is for a U.S. parent corporation to license its intangibles to a foreign subsidiary for exploitation abroad. When such a transfer takes place, a “transfer price” must be computed in order to satisfy various financial reporting, tax, and other regulatory requirements. Internal Revenue Code Section 482 governs the transfer pricing rules and provides that multinational corporations must allocate their worldwide profits among the various countries in which they operate. To this end, Section 482 and its regulations adopt an arm’s-length standard for evaluating the appropriateness of a transfer price. To arrive at an arm’s-length result, a multinational corporation must select and apply the method that provides the most reliable estimate of an arm’s-length price.

Under Section 482 of the Internal Revenue Code, the Internal Revenue Service (“IRS”) is empowered to reallocate income, deductions, credits and allowances among business enterprises controlled directly or indirectly by the same interests as may be necessary clearly to reflect the income of each such enterprise. In effect, the IRS is empowered to shift income, deductions and credits in order to produce the tax results that would have been obtained if the related parties had been dealing as independent parties at arm’s length. The Section 482 arm’s length standard applies to all transfers of intangible property. For transfer pricing purposes, an “intangible” includes any of the following items:

1) patents, inventions, formulae, processes, 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) Workforce, goodwill, and customer relations;

6) methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data, and;

7) other similar items.

Transfers of Intangible Property

The starting point under the regulations of Section 482 is to identify the owner of the intangible property. The owner of intangible property is typically the entity that owns a legally protected right to exploit the intangible. The owner of intangible property that is not legally protected will generally be the entity that bore the greatest part of the development costs. Because in theory the owner and a related party may enjoy the rights of intangibles through consolidated groups (e.g., one by the other or both by a common owner), the regulations to Section 482 refer to the owner as the controlled owner and the party using rights to the intangible as the controlled person.

The general rule is that when a controlled corporation pays inadequate consideration for the right to exploit an intangible, and the transfer retains a substantial interest in the intangible, the arm’s length consideration should be in the form of a taxable royalty. That is, unless under the circumstances a different classification of the payment is more appropriate. There are three primary methods for estimating an arm’s length charge for transfers of intangibles:

1) The comparable uncontrolled transaction method or “CUT;”

2) The comparable profits method or CPM; and

3) The profit split method or PSM.

The parties involved in the transfer of intangible property must select and apply the method which provides the most reliable estimate of an arm’s length price.

Comparable Uncontrolled Transaction Method

The CUT method generally provides the most direct and reliable measure of an arm’s length royalty. It may be used if the same intangible is transferred in both the controlled and uncontrolled transactions and only minor differences exist between the uncontrolled and the controlled transactions, provided that these differences have a definite and reasonably ascertainable effect on pricing and that appropriate adjustments are made for them.

Although all the general factors for determining comparability of the controlled and uncontrolled transactions described in the regulations must be considered. To be considered comparable 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. Basically, controlled and uncontrolled transfers of intangibles used for the same product type in the same industry will be comparable if they are anticipated to generate substantially the same tax benefits for the transferees. The profit potential of an intangible involves calculating the net present value of the benefits to be derived from the use of the intangibles by the transferee. Profit potential is most reliably measured by direct calculations, based on reliable projections of the net present value of the benefits to be realized through use of the intangible.

The Comparable Profits Method

The CPM may be used to determine the arm’s length consideration for intangible property where the CUT method cannot be employed because a comparable uncontrolled transaction has not been identified. The CPM relies on the general principles that similarly situated taxpayers will tend to earn similar returns over a reasonable period of time. In essence, it involves imputing to the related transferee a level of operating profit that would be earned by an unrelated similarly situated transferee.

The CPM determines the arm’s length consideration for a controlled transaction by referring to objective measures of operating profit or profit level indicators derived from uncontrolled persons that engage in similar activities with other uncontrolled persons under similar circumstances. The profit level indicators that are used to evaluate operating profit include two types of measure: the rate of return and financial ratios. In the alternative, any measure of profit based on objective measures of profitability derived from uncontrolled parties that engage in similar business activities under similar circumstances may be utilized.

In determining an arm’s length royalty under the CPM, a company’s average reported operating profit for the year under review and the preceding two tax years ordinarily will be compared to the average profit of the uncontrolled comparable persons for the same period. However, a multiple year profit average tends to provide a more accurate reflection for purposes of a transfer pricing analysis. Adjustments must also be made for all material differences to the extent that such adjustments improve the reliability of the analysis. The CPM looks to the operating profit of the entire enterprise, rather than operating profit attributable to a particular intangible. It also focuses on the total operating profit based on all functions performed, capital invested and risks assumed. Finally, the CPM takes into account the profitability of uncontrolled parties that engage in similar business activities under similar circumstances.

Profit Split Methods

If members of a controlled group are engaged in a functionally integrated business and each member uses valuable intangibles, it will normally be difficult to identify comparable uncontrolled transactions and comparable uncontrolled transferees of comparable intangibles that can be used to determine arm’s length pricing for particular intangible transfers. Without comparable transactions or comparable uncontrolled holders of similar intangible rights, neither the CUT method nor the CPM can be used. In such a situation, a profit split method could be utilized for transfer pricing purposes.

The basic approach of the profit split method is to estimate an arm’s length return by 1) comparing the relative economic contributions that the parties make to the success of a business venture and 2) dividing the returns from that venture between them on the basis of the relative value of such contributions. The relative value of each controlled party’s contribution to the success of the relevant business activity must be determined in a manner that reflects the functions performed, risks assumed and resources employed by each participant in the relevant business activity. Such an allocation is intended to correspond to the division of profit or loss that would result from an arrangement between uncontrolled parties, each performing functions similar to those of the various controlled parties engaged in the relevant business activity.

Two profit split methods are provided: the comparable profit split and the residual profit split. A comparable profit split is derived from the combined operating profit of uncontrolled parties, the transactions and activities of which are similar to those of the controlled parties in the relevant business activity. Each uncontrolled party’s percentage of the combined operating profit or loss to allocate the combined operating profit or loss of each controlled party involved in the relevant business activity.

The residual profit split method determines an arm’s length consideration in a two-step process. First, using other methods such as the CPM, market returns for routine functions are estimated and allocated to the parties that performed them. The remaining, residual amount is then allocated between the parties on the assumption that this residual is attributable to intangible property contributed to the activity by the controlled parties. Using this assumption, the residual is divided based on the estimate of the relative value of the parties’ contributions of such property. Since the fair market value of the intangible property usually will not be readily ascertainable, other measures of the relative values of intangible property may be used, including capitalized intangible development expenses.

Special Rules for Periodic Adjustments

The consideration for a transfer of the use of the intangible for more than one year is generally subject to an annual adjustment to ensure that it is commensurate with the income attributable to the intangible in the hands of the controlled transfer. No periodic adjustment will need to be made if the consideration paid for the intangible is determined to be an arm’s length amount under the CUT method for the first year based on a transfer of the same intangible to an uncontrolled party under substantially the same circumstances. Thus, for example, the consideration for the transfer of an intangible to a controlled party in one country could be determined to be arm’s length based on the transfer of the same intangible under similar circumstances to an uncontrolled party in another country in which the relevant economic conditions are substantially similar to those in the first country.

If the arm’s length result is derived from the application of the CUT method based on the transfer of a comparable intangible under comparable circumstances to those of the controlled transaction, no adjustment for a subsequent year will be made if each of the following facts is established:

1) The controlled parties entered into a written agreement that provided for an amount of consideration with respect to each tax year subject to such agreement, such consideration was an arm’s length amount for the first tax year in which substantial periodic consideration was required to be paid under the agreement and such agreement remained in effect for the tax year under review.

2) There is a written agreement setting forth the terms of the comparable uncontrolled transactions relied upon to establish the arm’s length consideration, which contains no provisions that would permit any change to the amount of consideration, a renegotiation or a termination of the agreement, in circumstances comparable to those of the controlled transaction in the tax year under review.

3) The controlled agreement is substantially similar to the uncontrolled agreement.

4) The controlled agreement limits use of the intangible to a specified field or purpose in a manner that is consistent with industry practice and any such limitation in the uncontrolled agreement.

5) There were no substantial changes in the functions performed by the controlled transferee after the controlled agreement was executed, except changes required by events that were not foreseeable.

6) The total profits actually earned or the total cost savings actually realized by the controlled party from the exploitation of the intangible in the year under examination by the IRS and all past years, are not less than 80 percent nor more than 120 percent of the prospective profits or cost savings that were foreseeable when the comparability of the uncontrolled agreement was established.

Under methods other than the CUT method, no subsequent adjustment will be made if each of the following is established:

1) The controlled parties entered into a written agreement that provided for an amount of consideration with respect to each tax year subject to suchy agreement, and such agreement remained in effect for the tax year under review.

2) The consideration called for in the controlled agreement was an arm’s length amount for the first tax year in which substantial periodic consideration was required to be paid, and relevant supporting documentation was prepared contemporaneously with the execution of the controlled agreement;

3) There have been no substantial changes in the functions performed by the transferee since4 the controlled agreement was executed, except changes required by events that were not foreseeable; and

4) The total profits actually earned or the total cost savings realized by the controlled transferee from the exploitation of the intangible in the year under IRS audit, and all past years, are not less than 80 percent nor more than 120 percent of the prospective profits or cost savings that were foreseeable when the controlled agreement was entered into.

Finally, no periodic adjustments need to be made if the aggregate actual profits fall outside the permissible 80 to 120 percent band of projected profits or cost savings and if this variation from the projected result was due to extraordinary events. These are events that could not reasonably have been anticipated.

Cost Sharing Arrangements

The Section 482 regulations contain an important exception to the general rule that an arm’s length royalty or other consideration must be paid by a related enterprise when intangibles are transferred to it by an enterprise controlled by the same interest. Intangles may be shared between two or more related enterprises under an arrangement that provides for the sharing of the costs and risks of developing intangible property in return for an interest in the intangible property that may be produced. Under a qualified cost sharing arrangement, the related person receiving an interest in intangible property is not required to pay an arm’s length royalty for its use; it need only bear or pay an appropriate share of the cost of the research and development concerned.

For example, a U.S. parent parent corporation and a foreign subsidiary may agree to equally share the costs of developing a new software program. Under such an agreement, the parent might own the rights to engineer and market an English language program in the United States, while the subsidiary may own the rights to develop and market the English language program abroad. The advantage of a cost-sharing arrangement is that the foreign subsidiary’s ownership of the foreign rights to the software program negates the need to have that subsidiary pay a royalty to the U.S. parent corporation.

Tres. Reg. Section 1.482-7(a)(1) defines a cost sharing arrangement as an agreement for sharing costs of development of one or more intangibles in proportion to the participants’ shares of reasonably anticipated benefits from their exploitation of interests in any intangibles that are developed. If a “qualified cost sharing arrangement” exists, no Section 482 allocation of arm’s length royalties or equivalent payments can be made by the IRS. The IRS can only adjust the cost sharing payments to make each controlled participant’s share of the relevant intangibles development costs equal to its share of reasonably anticipated benefits from use of the intangibles developed. To be treated as a qualified cost sharing arrangement and thus insulated from risk of royalty allocations, the arrangement must satisfy the following four requirements:

1) Include two or more participants;

2) Provide a method to calculate each controlled participant’s share of intangible development costs, based on factors that can reasonably be expected to reflect the participant’s share of anticipated benefits;

3) Provide for adjustment to the controlled participant’s shares of intangible development costs to account for changes in economic conditions, the business operations and practices of the participants and the ongoing development of intangibles under the arrangements; and

4) Be recorded in a document that is contemporaneous that includes:

i) A list of the arrangement’s participants, and any other member of the controlled group that will benefit from the use of intangibles developed under the cost sharing arrangement;

ii) The information described in paragraphs (2) and (3) above;

iii) A description of the scope of the research and development to be undertaken, including the intangible or class of intangibles intended to be developed;

iv) A description of each participant’s interest in any covered intangibles;

v) The duration of the arrangement; and

vi) The conditions under which the arrangement may be modified or terminated and the consequences of such modification or termination, such as the interest that such participants will receive in any covered intangibles.

Development Costs and Reasonably Anticipated Benefits

The costs that may be shared to develop intangible property include all costs of any research actually undertaken under the cost sharing arrangement. These costs include cost sharing payments a participant makes to the other participant or participants less such payments it receives from other participants. Over the years, issues have surfaced concerning whether operating expenses include stock-based compensation provided by a controlled participant, often in the form of stock options. Treasury Regulation Section 1.482-7(d)(2) was issued by the Department of Treasury which takes the position that operating expenses include any stock-based compensation provided to an employee or independent contractor, including for example, restricted stock, stock options, and stock appreciation rights. Under Treasury Regulation Section 1.482-7(d)(2)(ii), the determination of whether stock-based compensation is related to the development of an intangible is to be made as of the date the stock-based compensation is granted. The regulation deals in detail with permissible methods for measuring the cost associated with stock-based compensation. A word of warning to any multinational corporation having cost-sharing arrangements with foreign affiliates which involves stock-based compensation arrangements to develop intangible assets, this area is full of minefields. This is particularly the case after the United States Supreme Court announced that it was denying the petition for certiorari for Altera Corporation & Subsidiaries v. Commissioner, 926 F.3d. 1061 (2019). By way of background, in Altera Corp. v. Commissioner, Altera prevailed in a suit before the United States Tax Court. The Tax Court invalidated a requirement that related parties allocate stock-based compensation costs when entering into cost-sharing arrangements to develop intangible assets. On appeal, the Ninth Circuit Court of Appeals reversed the Tax Court and upheld the regulation. The Supreme Court’s denial of Altera’s petition for certiorari basically affirmed the Ninth Circuit Court of Appeal’s decision.

Foreign Transfer Pricing Considerations

Many foreign countries have developed their own transfer pricing rules. The methodology and transfer price that the IRS may accept, may or may not be acceptable to a foreign country’s taxing agencies. Any multinational corporation that is involved in the cross-border transfer of intangible property should develop a plan that takes into consideration the regulations of Section 482 and the substantive internal law of the applicable foreign jurisdiction or jurisdictions. In some cases, a multinational corporation may mitigate potential double taxation and needless administrative burdens under treaty-based mutual agreement procedures of “MAPs.” If possible, the use of a MAP relevant to a bilateral tax treaty should be closely reviewed for potential application.


In the current environment, multinational transfers of intellectual property is transfer pricing strategy driven to a great extent. Consequently, it is extremely important to develop an effective transfer strategy well in advance to avoid costly adjustments by the IRS or a foreign taxing agency.

We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in foreign tax planning and compliance. We have also  provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & 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.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. 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.