Rapid changes to the international tax system are underway, driven by growing public concern over aggressive tax strategies used by high-revenue multinational enterprises (MNEs). These strategies, broadly known as base erosion and profit shifting (BEPS), leverage discrepancies in national tax laws to artificially shift significant proportions of profits to lower tax jurisdictions.
On 5th October 2015, the Organization for Economic Co-Operation and Development (OECD) released a report detailing a new strategy to tackle BEPS. Since publication, more than 100 countries and jurisdictions have committed to implement the G20-endorsed measures. The strategy is comprised of 15 actions and new tools, both to standardise compliance and force transparency about where income is generated for large MNEs.
Broadly, these 15 actions address three principal objectives:
In combination, it is hoped that the comprehensive BEPS package will help realign taxable profits with true economic activities of MNEs, simplify tax compliance and encourage best practice. The reforms are set to place IP management integral to many larger-scale business objectives and are expected to transform the role of IP and IP professionals.
Over the recent years there has been an emergence of large companies that rely principally on innovation and branding to generate financial returns rather than physical assets or employee base. The increasing significance of intangible assets in many business models has rendered large proportions of many companies’ value physically mobile. MNEs are easily able to dissociate legal ownership or funding of intangibles from their creation or maintenance. For example, a company’s intellectual property is often centralised in a low tax, low substance holding company.
The prevalence and value of intangible assets creates new challenges for tax reporting, a system designed around assumptions of profit alignment with legal ownership and physical asset location. Therefore, identification, deployment and value of intellectual property, and other intangible assets throughout a MNE value chain is a dominant theme in the OECD’s BEPS reform.
One area highlighted by the OECD for IP-related reform are the transactions that occur between individual entities of a larger MNE. The rules and methods that are used to characterise these transactions within an MNE are referred to as transfer pricing (TP).
While these transactions are essential to all MNEs, to compensate MNE members for the use of different tangible or intangible assets, they can be manipulated to facilitate BEPS, and maximise profits, on a huge scale. In particular, the use of hard-to-value intangible assets can be used as a base, perhaps incorrectly, to rationalise the movement of large amounts of money between differentially taxed jurisdictions through aggressive intragroup TP.
Under best practice, there should be a limited and correct amount for any TP transaction. As described by the arm’s-length principle, each member of the multinational enterprise group should be compensated only for the specific functions it performs and at a rate as if each member were independent to each other and acting in their own self-interest. In practice, however, the appropriate TP is very hard to ascribe and indeed audit.
Actions 8-10 describe new rules to prevent BEPS focussed on the transfer of intangible assets, risk and excessive capital between different groups within a company to ensure that any attribution of value or remuneration represented by TP is consistent with true value creation. These three closely related action areas essentially reinforce guidance on the arm’s length principle.
In cases involving intangibles, Action 8 of the BEPS plan proposes taxpayer review of the key functions associated with hard-to-value intangible assets; their development, enhancement, maintenance, protection, and exploitation. Collectively, these are referred to as DEMPE functions.
The performance of DEMPE functions by individual members of an MNE essentially expand the definition of asset ownership to evaluate functional, rather than only legal, relationships to intangible assets. This description helps to more accurately guide the calculation of intangible-related returns for TP. If the legal owner does not control or perform any of the DEMPE functions related to the intangible, the legal owner should not fairly be entitled to any ongoing benefit attributed to the functions of a specific asset.
Concomitantly, the action also necessitates a broader and more complete description of intangible assets. Without allowing a broader definition, many of the factors that are used to define accurate and fair TP might go unnoticed and allow for inconsistent compliance. Broadly, the OECD describes intangible assets as “something which is not a physical or financial asset, capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties”. Examples of intangibles fall under three subcategories:
The broader definition of intangibles offered by the OECD relative to IP has two major implications. First, that the remit of the IP department is set to expand, from patents and trademarks to a diverse range of intangible assets. Second, those MNEs that maximise utilisation of their intangible assets will have a distinct advantage through effective exploitation of Action 8. As will be discussed further below, it is therefore expected that IP departments in MNEs will be required and are indeed incentivised to implement new company processes that ensure the vast majority of valuable intangibles are captured, tracked and appropriately used.
Further, Action 8 implies that in addition to the broadening description of intangible assets, IP professionals may be required to liaise with tax advisors and business leaders to offer value to higher level TP and strategic decisions. In essence, the recognition of intangible assets to quantitatively guide previously more subjective, strategic decisions is likely to broaden the responsibilities and influence of an MNE’s IP department.
The OECD also aims to reduce the burden of tax compliance and audit. New BEPS measures require MNEs to provide transparent disclosures to enable tax authorities to audit and assess compliance to TP without any additional significant operational cost.
Specifically, this objective is addressed in relation to IP under BEPS Action 13. This action details the requirement for each MNE to provide a three-tier master file, which must present, amongst other things:
The most significant implications of Action 13 come with an appreciation of the difficulty of its practical implementation. New, tailored database structures and asset capture work-flows must be designed and implemented that facilitate the regular harvesting and documenting of new or modified intangible assets in an organised and maintainable format. Further, this system must produce an appropriate ‘master file’ for distribution to tax authorities and offer complete compliance with BEPS. Ideally, this process will eventually become contemporaneous with innovation, yet the resource investment upfront to document asset backlogs and establish a reliable capture process will be significant.
Moreover, there is still a practical line to be negotiated which defines the level of intangible disclosure in a master file to provide BEPS compliance. Whilst all relevant assets must be disclosed for TP purposes, an early stage, developing intangible asset, not yet of any TP influence but strong strategic value, may be better to remain undisclosed, if only for reasons of confidentiality. The greatest IP risk of Action 13 is unnecessary disclosure of highly competitive assets. Whilst appreciating compliance with BEPS, the level of required disclosure must be considered in the near future and an appropriate balance struck.
Further to the practical implementation of Action 13, it is essential that IP professionals lead the education of MNE business leaders. In a post-BEPS landscape, MNEs will be at an advantage if future strategies are informed by an appreciation of the functional and economic advantages of IP.
Whilst it is expected that the vast majority of database and work-flow tools might be built by experienced 3rd party IP consultants or SAAS tool providers, these will need to be tailored to each MNE. Four-way engagement between IP and tax teams from both MNEs and experienced 3rd party consultancies is suggested to be the most effective way to cover ground towards corporate education and practical BEPS implementation.
Considering the scope of BEPS to affect the responsibilities of IP departments, personal education and full appreciation of the BEPS IP-related guidelines will be valuable. This should certainly include exploration of new IP responsibilities given the expanded intangibles definition and the assignment of DEMPE functions. Further, this might also include a preliminary analysis of intangible value throughout the MNE value chain and the identification of significant risk areas and remediation as required. Education around BEPS and exploration of one’s own company will allow effective engagement with strategic IP and tax consultation. This will guide entry to BEPS compliance and the beginnings of identification of significant risk areas and remediation as required.
BEPS offers an opportunity for IP and its management to become a board level agenda item, both in the recognition of the commercial value of intangibles and in the strategic value that BEPS places on IP management. Further, it is hoped that the implementation of the IP-related BEPS actions and the necessary accompanying processes discussed above, if properly managed, might increase MNE value in a number of ways. For example, new commercialisation avenues may be explored through identifying lesser known intangible assets of value. Perhaps more importantly, it is expected that the organisation of IP and commercial information necessitated by the BEPS framework will help business leaders articulate and demonstrate the value of intangible assets to their business and shareholders.
For a smooth transition to, and full exploitation of, an inevitable post-BEPS world, the expertise of educated IP professionals is required to fully understand the creation of intangible company value. With forward looking MNE organisations already taking steps towards BEPS implementation, and wider compliance expected in 2020, now is the time engage in intra-departmental education and collaborate with tax and IP advisors to really get ahead.