Tax authorities in many countries are heavily investing in their field tax audit teams and systems. For example, Germany has hired more than 300 additional auditors for the Federal Tax Office, resulting in a total of more than 460 tax auditors – on the federal level alone. They are also increasingly investing in new IT systems that allow the identification of transfer pricing risks in the audit of supply networks and other audits fields.
The German federal audit team has also developed electronic tools to analyse the data of the accounting system, which they are successfully using to detect and analyse the value drivers for the profits of cross border transactions. This increased focus and the OECD concept of "Hard-to-Value Intangibles" leads to unexpected and extremely high tax adjustments.
The German field tax audit also prepares the IT-architecture to analyse the future DAC6-returns and estimates to receive 20 to 70 thousand of these returns per year. The data analytics may provide a bit of certainty in some cases, but in general highly increased risk for MNCs.
There are also positive developments for tax payers: The Federal Tax Office is actively developing ICAP procedures, which should provide an excellent alternative to APAs. Furthermore, Germany has increased its staff for competent authorities procedures to more than 60.
TP audits of intangibles
In practice, on the biggest trends in TP audits around the world has been that tax authorities are using the "DEMPE" concept that was established by the OECD: Field tax audits stipulate that local entities in their geographies have conducted development, enhancement, maintenance, protection or exploitation functions for intangibles that they license from group companies. Therefore, tax authorities argue, the royalties should be lowered – or disregarded entirely. In addition, tax authorities in high-tax countries, such as Germany, focus on the remuneration of manufacturing technologies.
This development requires a new approach by tax payers, both for setting their IP remuneration and for TP documentation and tax audit situations. One challenge is that, while DEMPE is becoming ubiquitous, the definition offered by the OECD is very open.
NERA has established a procedure to address the open points of the DEMPE analysis. Our method follows a combination of qualitative economic reporting that shows who has developed these intangibles, and quantitative analysis of the value and the relative importance of these contributions. Over the past year, NERA has performed a series of DEMPE studies in tax audits and for TP documentation and planning, and applied the results to calculate profit splits or defend benchmarking studies of comparable licence agreements. In all cases, it was key to analyse the economic underpinning of the concrete DEMPE functions in order to see the overall value creation contribution.
TP audits on trademarks (US-Mexico)
In the first audit case, we were asked to defend a CUP analysis for a trademark licence agreement between a licensor in the US and a licensee in Mexico. For the audit period, which predated the new OECD guidelines, the Mexican tax authorities challenged the CUP studies and demanded a DEMPE analysis.
NERA analysed the facts and could show that the US company developed the brand originally and performed strategic management to enhance the brand (e.g., periodical rebranding activities and concepts for new online distribution channels). It also provided guidance for local marketing activities (e.g., branding material) and centrally registered the trademarks. On the other hand, the local licensor performed local marketing activities and exploited the brand value to generate sales.
In the next step, the insights of the DEMPE analysis were used to test if this contribution split is similar to contracts between unrelated third parties (i.e., we reviewed the functions and responsibilities assigned in third-party contracts). Many brand licensing contracts demand the licensee to perform certain marketing activities under the strategic guidance of the licensor. NERA demonstrated that the selected CUP benchmarks were comparable in the functional split between licensor and licensee.
TP audits on the use of Global trademarks (Switzerland – Germany)
In a second project, NERA performed a DEMPE study to support a profit split analysis and measure contributions of two entities to the joint creation of valuable technologies.
A multinational group had acquired a German company, and soon started to use both the umbrella brand of the group and the company's previous name. The TP audit started to question the brand royalty, stipulating that the value was primarily due to the local brand and that the international umbrella brand was essentially worthless.
NERA proceeded to undertake an interview-based survey of internal experts. Qualitatively, it was possible to establish the various forms of contributions to the respective brands, such as platform intangibles, trade fair exhibitions, and rebranding initiatives. More importantly, following a rigorous selection of interviewees, we collected a substantial number of responses. The analysis showed that the value was indeed derived from the combination of umbrella and local brands; the market-facing experts could identify the contribution of the umbrella brand in detail.
This allowed the establishment of a profit split methodology based on the relative contribution to the intangibles, and ultimately showed that the trademark royalty for the umbrella brand was arm's length.
Hard to value intangibles
An increasing focus of audits has been the OECD definition of HTVI's as intangibles that fulfil two criteria: (1) There is no reliable comparable; and (2) At the time of the transaction, the projected future income associated with the intangible is uncertain.
Unfortunately, this is true for nearly all intangibles, since intangibles are by definition unique. After-all, they are what sets a successful company apart from its competition, so one can rarely identify a transaction between independent parties where almost an identical intangible is transferred.
The OECD guidelines tackle this in two ways:
1) They reject cost-based valuations in favour of the discounted cash flow method, despite uncertainties prevailing at this stage of transfer; and
2) More critically, they prescribe to validate forecasts through ex-post actuals. If there is a significant difference, tax authorities are entitled to impose adjustments based on the actuals, even if the transacting parties have not agreed on price adjustments clauses.
Based on these rules, recent German tax audits start to challenge existing license agreements. Multinationals that do not want the valuation of their transactions to be open for ex-post adjustments must therefore provide evidence that they have properly considered ex-ante uncertainties. When these uncertainties are reflected in the original valuation, ex-post adjustment should simply not be justified, since deviations were then already accounted for.
TP audits on Digital Technology (Germany – Ireland)
As an example, we valued a software program in a continuing development stage that was transferred between German and Irish entities based on five different scenarios. These scenarios were based on the actual business development plan regarding potential future software features and associated business strategies.
Today, several years later, it looks like the software will be successful. However, under a normal cash-flow valuation, the original buy-out would need to have been adjusted significantly. However, since very positive development was explicitly accounted for and incorporated into the valuation, there is no need for further adjustments, even in the new HTVI framework.
Methods that NERA used for this case consider the specific risks related to the development of HTVI and include real option pricing, which is supported by Monte Carlo simulations, and the binomial tree analysis. These methods are based on not just assuming a single prediction of a future income, but explicitly looking at different scenarios, which range from failure to better-than-expected.
Digitals in the Chemical Industry
Along with the mega trends in the digital industry, we conducted a central planning case of the digitalisation effects in the chemical industry. A producer of chemicals expanded its relatively traditional business into new digital offerings. The group already had well-known patents and brands, production technology, and customer relationships with clients around the globe. However, the group is now starting to offer field management software that allows clients to estimate yields to plan and target the use of the chemicals more efficiently.
All these activities are driven by different entities within the group and are highly intertwined. The software is developed by a new start-up within the group, which relies on the R&D experience by the group's laboratories and is advertised to the clients by the sales entities using local client relationships and the global brand.
On the other hand, the software sends back information to the groups data centres where it is then processed and structured by some of the group's data scientists and then used by both the R&D centres to improve the core products as well as by the sales entities to better target their campaigns. The software start-up development entity in the group also uses customer feedback to improve the software. While there are some direct revenues created from the licensing of the software to clients, much of the value creation happens in this network of effects.
As can be seen from this example, it is not only that new intangibles are created, but that intangibles are increasingly interlinked and influencing each other. For transfer pricing, this is a challenge, as it becomes more difficult to pinpoint the exact impact of one company within this value network and its appropriate remuneration. While many companies contribute to the business success, it is obvious that these contributions are very different, both in nature and likely in value.
Therefore, we had to interrelate these intangibles and DEMPE contributions and their economic impacts in detail by mapping and explaining their relations.
Finally – and remarkably – we could show that the results were identical to the old Non-Routine Principal / Routine sales company structure; we are curious what the field tax auditors will say.