Tax Treaties, Transfer Pricing and Financial Transactions Division
Centre for Tax Policy and Administration
Organisation for Economic Co-operation and Development
Comments on the Public Discussion Draft on BEPS Action 8
Implementation Guidance on Hard-to-Value Intangibles
The OECD is currently working on a number of matters related to its recommendations on base erosion and profit shifting (BEPS) under the Inclusive Framework. These include implementing peer review of the minimum standards, addressing remaining issues such as those pertaining to transfer pricing taxation and the digital economy, and tackling the issue of tax certainty. Keidanren continues to support these initiatives and remains committed to constructively engaging in associated tasks.
The BEPS Project has resulted in the inclusion of the approach to hard-to-value intangibles (hereinafter, "the HTVI approach") in the revised Chapter VI (Special Considerations for Intangible Property) of the OECD Transfer Pricing Guidelines.
In previous discussions, there was a phase during which the HTVI approach was proposed as a potential special measure with the satisfaction of the arm's length principle not being a critical issue. However, the HTVI approach has been ultimately defined as a measure within the arm's length principle. For this, we appreciate the efforts of the relevant parties.
On the other hand, as the HTVI approach grants tax administrations the powerful authority to make adjustments based on ex-post outcomes, we cannot dismiss concerns that the HTVI approach may give rise to taxes imposed in hindsight. The inappropriate application of the HTVI approach may in some cases give rise to unresolvable double taxation and impose on taxpayers an undue administrative burden, including documentation creation and maintenance and a requirement to provide detailed explanation during audit.
Each country should recognize that ensuring tax certainty has become an increasingly important issue for the OECD and the G20 in recent years, and acknowledge that the HTVI approach is applicable only to a limited number of unique tax-avoidance schemes. In this regard, the OECD is expected to issue detailed and rigorous guidance regarding the definition of hard-to-value intangibles, how exemptions to the application of the HTVI approach should be interpreted, and how double taxation should be prevented and resolved.
Although we welcome the Implementation Guidance as a useful resource for providing an explanation of the application of the HTVI approach per se, our view is that it lacks adequate explanation of the exemptions. Further explanation is also required with regard to the statute of limitations rules, and the elimination of double taxation.
In light of the above, we provide our comments below.
1. General Comments
(1) Enhancement of guidance on exemptions
(i) Appropriateness of taxpayers' ex-ante projections
Paragraphs 19 and 24 of the Implementation Guidance generally illustrates the application of the HTVI approach to a situation where taxpayers are unable to explain the appropriateness of their ex-ante projections. However, in practice, the first question asked would be in what circumstances a tax administration would be convinced by a taxpayer's explanation.
When transferring an intangible, an enterprise usually determines the price by taking into account a variety of factors, such as future earnings projections, similar prior transactions, the buyer and seller's positions, and the negotiation process. As such, the transaction price, as determined at the time of entering into the agreement, should be presumed to have sufficient economic rationality. Accordingly, supporting documentation and explanation provided by the taxpayer should be respected.
For situations that still require consideration of the application of the HTVI approach, easy-to-understand guidance, coupled with illustrative examples, should be provided to assist taxpayers in the preparation of information indicating that their position is valid. Furthermore, the guidance should also include the criteria by which a tax administration should assesses a taxpayer's evidence.
Specifically, further guidance should be provided on the meaning of such terms as "details of . . . the probability of occurrence" of events referred to in item (i)1 of paragraph 6.193 of the OECD Transfer Pricing Guidelines, and "reliable evidence" in item (i)2 of the same paragraph. For example, in cases where a transaction has been conducted between associated enterprises and an independent third-party valuation of the intangible has been obtained, it is not clear whether the reliability of the valuation will be considered. The Implementation Guidance should also provide an example of inappropriate cases in which, despite a taxpayer having provided sufficient documents and explanations, the tax administration applies the HTVI approach in hindsight.
(ii) Additional exemptions
Cases to which the HTVI approach applies should be substantially restricted in order to minimize the risk of double taxation. Given the HTVI approach has been proposed in the context of the BEPS Project, a possible way of achieving this is to restrict its application to transfers of hard-to-value intangibles to low-tax jurisdictions.
In addition, consideration should be given to certain industries, such as manufacturers of electronics, machinery, and transportation equipment. In such industries, the creation of a single product requires the use of several to tens of thousands of patents and other intangibles. It follows that what contributes to a product's earnings is not a single intangible but an intricate combination of countless intangibles, which makes accurately valuing each intangible extremely difficult. Accordingly, it is conceivable that the application of the HTVI approach is limited to cases where there is a clear correlation between the transferred intangible and the transferee's sales, or where the transferred intangible has significant monetary value.
We submit that a statement should be added to the Implementation Guidance clarifying that jurisdictions are allowed to create these additional exemptions at their discretion.
(2) Handling of statutes of limitations
We are concerned that going forward, an increasing number of jurisdictions may consider extending the statute of limitations on transfer pricing assessments, for the following reasons.
First, an exemption to the HTVI approach applies where "a commercialisation period of five years has passed", as provided in item (iv) of paragraph 6.193 of the OECD Transfer Pricing Guidelines. Second, there may be cases where the transferred intangibles require a certain "incubation" period as mentioned in paragraph 8 of the Implementation Guidance. An extension of the statute of limitations would undermine predictability for taxpayers and increase tax uncertainty.
While the Implementation Guidance states at paragraph 10 that "nothing in this guidance changes those time limits, which are a matter of sovereignty of countries", it also states at paragraph 11 that "it does not prevent countries from considering targeted changes to procedures or legislation."
The issue is that the level of BEPS risks varies from country to country. To preclude a country with negligible BEPS risks from unnecessarily extending the statute of limitations on the pretext of introducing the HTVI approach, the Implementation Guidance should emphasize that each jurisdiction is required to carefully consider the existence and extent of tax avoidance obtained by taking advantage of hard-to-value intangibles.
We begin with three overall comments. First, paragraph 15 of the Implementation Guidance, which explains the assumptions that inform the examples, should explicitly state that there exists an information asymmetry between taxpayers and tax administrations.
Second, whereas all the examples are premised on the use of the discounted cash flow (DCF) method, the DCF method is not the only available valuation methodology. Therefore, we agree with what is stated in paragraph 16.
Third, we consider it useful, from a comparative perspective, to add examples that illustrate cases in which the actual income or cash flows are lower than the anticipated income or cash flows.
(1) Example 1
(i) Scenario A
The key to this scenario is to what extent Company A, at the time of transferring the intangible property, appropriately accounted for the possibility that Company S's Phase III trials might be completed, and commercialization would commence earlier than projected. Despite this, the example does not adequately explain pertinent points, such as how Company A evaluated the management efforts made by Company S (to which the intangible was transferred), and what efforts were made by Company S. Information with regard to these points should be included.
Furthermore, in this example pertaining to pharmaceuticals, the reasonableness of the compensation for the transfer, determined at the time of the transaction, should have been verified considering the product's life cycle. However, the example appears to focus solely on the profits generated in periods when sales were strong. For example, where, in subsequent years, the taxpayer suffers declining sales and losses resulting from the emergence of competing products or side effects, would the taxpayer be allowed to request a readjustment? In this regard, we would expect the Implementation Guidance to provide clearer guidance.
(ii) Scenario B
In this example, one of the exemptions to the HTVI approach is applied because the adjustment to the compensation for the transfer is within 20% of the compensation determined at the time of the transaction. However, even if the adjustment were to exceed the 20% range, it might make more sense to reassess the portion exceeding 20% only, and not the entire adjustment.
At present, when exceeding the transfer pricing range set by the bilateral advance pricing arrangement, an adjustment is usually made to the median of the range; and there may also be cases where an advance agreement is reached with the counterpart country on the point that an adjustment will be made to the closest edge of the range. Ex-ante projections related to transfers of hard-to-value intangibles are difficult to make and inevitably involve uncertainty. We are therefore of the view that, even in cases to which the HTVI approach applies, the method proposed above is worth considering from the perspective of minimizing double taxation.
Paragraph 23 provides that, "Notwithstanding that the HTVI approach does not apply, an adjustment under other sections of these Guidelines may be appropriate." This statement is confusing in that it may render the creation of the exemptions meaningless. At the very least, an explanation should be provided as to what adjustment is being referred to.
(2) Example 2
Based on the premise that it is common in the pharmaceutical sector to transfer patent rights to independent parties through a combination of initial lump sum payments and additional contingent payment arrangements, this example concludes that the tax administration is entitled to make adjustments, assuming an additional contingent payment was made in a subsequent year. However, paragraph 28 states that "this paragraph is not intended to, and does not, imply that modification of the payment form can only occur when there is a common practice in the relevant business sector regarding the form of payment."
We are concerned that this statement may make the example's conclusion broadly applicable to any industry. Assume that a tax administration adjusts the compensation for the transfer determined at the time of the transaction with respect to a tax year on which the statute of limitations has not expired and, in the case of such adjustment being impossible due to the statute of limitations, adjusts additional income in subsequent years. Such extreme enforcement in an unrestricted manner could effectively undermine the statute of limitations rules. We consider that the application of this conclusion should be limited to cases where the agreement concluded between associated enterprises has clauses stipulating additional payments or contractual renegotiation.
(3) Example 3
As mentioned earlier, in industries such as electronics, machinery, and transportation equipment, a single product is manufactured using a combination of countless intangibles. In light of that, the method illustrated in this example (using the net present value of sales over the period of the agreement to arrive at the value of the intangible and determine the royalty rate) is not practical. We expect examples dealing with non-pharmaceutical industries to also be provided.
In addition, attention should be paid to the fact that, even if a tax administration applies the HTVI approach and assesses additional royalty income, remittance regulations imposed by some countries may make the situation difficult to resolve.
3. Relationships with Mutual Agreement Procedures
As long as the HTVI approach is a measure within the arm's length principle, any double taxation arising from the application of the approach must be resolved. In this regard, the word "permit" used in paragraph 31 of the Implementation Guidance is too vague. To start with, jurisdictions introducing the HTVI approach should fully commit themselves to implementing mutual agreement procedures. Similarly, the implementation of mutual agreement procedures should be a prerequisite for the application of the HTVI approach.
Furthermore, to ensure disputes are resolved, individual countries should continue working to include arbitration provisions in their tax treaties.
Subcommittee on Taxation