As part of Base Erosion and Profit Shifting Project (BEPS), OECD has recently issued a publication on transfer pricing aspects of intangibles. The topic of the publication is important, as during the past decades many countries have witnessed a shift from the capital intensive economy to the economy driven primarily by knowledge. This shift has been particularly evident in Finland where manufacturing industry, and paper industry especially, has been reducing capacity while knowledge driven industry sectors, such as the game industry, that did not virtually exist a couple of years ago have been flourishing. This has greatly contributed to development of ever-increasing role of intangible rights in the global business arena.
The increasing role of intangible rights has put pressure on countries' tax collection capabilities. As part of the development it has become rather common for multinational enterprises to transfer all intangible rights to one location, which in turn has led to a competition whereby countries amend their tax regimes in an effort to position themselves as an attractive location for companies' intangible rights. From a country's taxation point of view, in a case where intangible rights are transferred from the country in question, it is crucial that valuation of intangible rights used for taxation purposes in connection with the transfer reflects fair market value of future cash flows generated by the intangible rights, as otherwise the transfer results in a loss of taxable income for the country from which the intangible rights are transferred.
However, determination of fair market value of intangible rights for taxation purposes is challenging. In addition to the conventional valuation issues – such as the question of applicable valuation method – which arise in all valuation exercises, the nature of intangible rights gives rise to additional questions which seldom surface when conducting, for example, a company valuation. Such a question is the identification of intangible rights that are de facto being transferred in connection with a transfer. This question arises due to the fact that it is commonly the case that intangible rights to be transferred (for example, patents) are not necessarily valuable as separate assets, but it is the combination of the patent and certain other intangible rights of the company in question that makes the patent valuable. In particular, the question is relevant in acquisition cases where purchase price significantly exceeds net asset value of the acquisition target and – following the acquisition – certain intangible rights are transferred cross border from the acquisition target. In these cases transfer of intangible rights gives rise to the question whether valuation to be used for the transfer should be equal to the purchase price paid in excess of net asset value. In other words, the question is whether there will be any significant intangible value remaining in the acquisition target after transferring central intangible rights such as patents.
It is apparent that it is difficult to find a definitive answer to the above issue, and thus it is understandable that varying approaches to address the issue have been adopted by different countries. In part for this reason, also this issue is discussed in the aforementioned publication by OECD, which focuses on providing guidance on identifying transactions involving intangibles as well as on determining arm's length conditions for transactions involving intangibles. In order to facilitate the identification of intangible rights in valuation context, the publication discusses at length the definition of an intangible right and potential categories of intangible rights there may exist. As regards the identification of an intangible right, it is noted in the publication that determination whether an item is regarded as an intangible right for transfer pricing purposes is not limited to accounting or general tax characterization. Further, it is noted that neither availability of legal or other protection nor separate transferability is a necessary condition for an item to be characterized as an intangible right for transfer pricing purposes. The reasoning for separate transferability not being the necessary condition is, according to the publication, that some intangibles may be transferred only in combination with other business assets. As mentioned, these are typical topics that arise in transactions involving intangible rights, and thus it is obvious that the publication is beneficial for companies contemplating a transfer of intangible rights, as it harmonizes approaches and brings more clarity to these issues.
In addition to the benefits, however, there is almost always a downside in harmonizing regulations in numerous countries. Due to complexities involved in these questions, laws and regulations in this area vary between countries and, thus, harmonization potentially creates tension between national laws and guidance. In Finland, for example, there are no specific laws or guidelines on the issues outlined above, and the case law around this area is rather limited as well. However, the Finnish Supreme Administrative Court has given a ruling on a related matter – namely on tax treatment of intangibles in connection with liquidation of a company. According to the ruling, fair market value of an intangible asset which is not separately transferable should not be recognized for Finnish tax purposes in a liquidation. As a result, in cases where purchase price paid for a Finnish acquisition target substantially exceeds net asset value of the target, and the intention is to transfer its intangible rights post-transaction, liquidation may often be a favourable option for the transfer from Finnish corporate income tax point of view.
Due to the fact that the above interpretation by the Supreme Administrative Court can be seen as being somewhat in conflict with the guidance given in the OECD publication, it is a good example of the tension between established national practices and guidance given by an international organization. Therefore, it is likely that instead of clarifying the issue the guidance will create more uncertainty about tax implications in liquidation cases where substantial amount of intangible assets are involved. Whether the benefits arising from more harmonized practices outweigh the harm created by increased uncertainty is a question with no definitive answer. What is certain, however, is that in an era of uncertainty an increase of uncertainty is always an unwelcome development.