In transfer pricing analysis, the determination of the entity or entities within a multinational enterprise that are entitled to share in the returns derived by the group from exploiting intangibles is crucial. A related issue is which entity or entities within the group should bear the costs, investments and other burdens associated with the development, enhancement, maintenance, protection and exploitation of intangibles. The Organization for Economic Cooperation and Development has addressed this topic as part of its 2017 Transfer Pricing Guidelines, and that guidance is the subject of this post. Although the legal owner of an intangible may initially receive the proceeds from exploitation of the intangible, other members of the legal owner’s group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible. Members of the group performing such functions, using such assets and assuming such risks must be compensated for their contributions under the arm’s length principle.
Legal rights and contractual arrangements form the starting point for any transfer pricing analysis of transactions involving intangibles. The terms of a transaction may be found in written contracts, public records such as patent or trademark registrations, or in other communications between the parties. In identifying the legal owner of intangibles, an intangible and any license relating to that intangible are considered to be different intangibles for transfer pricing purposes, each having a different owner. While determining legal ownership and contractual arrangements is an important first step in the analysis, these determinations are separate from the question of remuneration under the arm’s length principle. For transfer pricing purposes, legal ownership of intangibles, by itself, does not necessarily confer any right ultimately to retain returns derived by the group from exploiting the intangible. Identification of legal ownership, combined with the identification and compensation of relevant functions performed, assets used, and risks assumed by all contributing members, provides the analytical framework for identifying arm’s length prices and other conditions for transactions involving intangibles.
The arm’s length principle requires that all members of the group receive appropriate compensation for any functions they perform, assets they use, and risks they assume in connection with the development, enhancement, maintenance, protection and exploitation of intangibles. An important question is how to determine the appropriate arm’s length remuneration to members of a group for their functions, assets and risks within the framework established by the taxpayer’s contractual arrangements, the legal ownership of intangibles, and the conduct of the parties. The determination of arm’s length compensation for functional contributions should consider the availability of comparable uncontrolled transactions, the importance of the functions performed to the creation of the intangible value, and the realistically available options of the parties. In assessing whether the compensation provided in the controlled transaction is consistent with the arm’s length principle, reference should be made to the level and nature of activity of comparable uncontrolled entities performing similar functions, the compensation received by comparable uncontrolled entities and the anticipated creation of intangible value by comparable uncontrolled entities.