Tag: Contract R&D

Research and development activities performed based on an agreement/contract with another party – typically the owner of the intangibles.

German draft-legislation on application of the arm’s length principle to cross-border relocation of functions

On 5 July 2022, the Federal Ministry of Finance in Germany published draft legislation regarding application of the arm’s length principle to cross-border relocation of functions. According to the general provisions A function is a business activity that consists of a grouping of similar operational tasks performed by specific units or departments of an enterprise. It is an organic part of an enterprise, without the need for a sub-operation in the tax sense. A transfer of functions within the meaning of section 1(3b) of the Foreign Tax Act occurs if a function, including the associated opportunities and risks as well as any assets or other benefits that may have been transferred or left along with it, is transferred or left in whole or in part so that the acquiring company can perform this function or expand an existing function. The function transferred as a whole in accordance with sentence 1 constitutes the transfer package. Business transactions that are realised within five business years shall be combined as a single transfer of function at the time when the requirements of sentence 1 are economically fulfilled by their joint realisation. In cases of transfer of functions, intangible assets are essential within the meaning of section 1(3b) sentence 2 of the Foreign Tax Act if they are necessary for the transferred function and their arm’s length price amounts in total to more than 25 per cent of the sum of the individual prices of all assets and other benefits of the transfer package and this is credible, taking into account the effects of the transfer of function, which are evident from the records within the meaning of section 2 sentence 2. If an acquiring enterprise independently provides the services previously provided exclusively to the transferring enterprise, in whole or in part, to other enterprises at prices which are higher than the remuneration according to the cost-plus method or which are to be set higher in accordance with the arm’s length principle, a remuneration in accordance with 2 shall be charged to the other enterprises at the time of the first provision for assets and other advantages previously provided free of charge by the transferring enterprise for the provision of services; the assets or other benefits in question shall be deemed to be a transfer package, provided that the other requirements for this are met. A transfer of functions within the meaning of paragraph 2 shall not be deemed to have taken place if there is no restriction on the exercise of the function in question at the transferring company within five years of the assumption of the function by the acquiring company, although the other requirements of paragraph 2, sentence 1 are met (duplication of functions). If such a restriction occurs within this period, a transfer of functions shall be deemed to have taken place at the time when the restriction occurs, unless the taxpayer proves that this restriction is not directly related to the duplication of functions. The legislation will apply retrospectively to covered transactions after 31 December 2021. Click here for unofficial English translation Click here for other translation Germany - draft legislation on transfer of functions ...

TPG2022 Chapter VI Annex I example 28

101. Company A is the Parent company of an MNE group with operations in country S. Company B is a member of the MNE group with operations in country T, and Company C is also a member of the MNE group with operations in country U. For valid business reasons the MNE group decides to centralise all of its intangibles related to business conducted outside of country S in a single location. Accordingly, intangibles owned by Company B are sold to Company C for a lump sum, including patents, trademarks, know-how, and customer relationships. At the same time, Company C retains Company B to act as a contract manufacturer of products previously produced and sold by Company B on a full-risk basis. Company C has the personnel and resources required to manage the acquired lines of business, including the further development of intangibles necessary to the Company B business. 102. The MNE group is unable to identify comparable uncontrolled transactions that can be used in a transfer pricing analysis of the arm’s length price to be paid by Company C to Company B. Based on a detailed comparability and functional analysis, the MNE group concludes that the most appropriate transfer pricing method involves the application of valuation techniques to determine the value of the transferred intangibles. In conducting its valuation, the MNE group is unable to reliably segregate particular cash flows associated with all of the specific intangibles. 103. Under these circumstances, in determining the arm’s length compensation to be paid by Company C for the intangibles sold by Company B, it may be appropriate to value the transferred intangibles in the aggregate rather than to attempt a valuation on an asset by asset basis. This would particularly be the case if there is a significant difference between the sum of the best available estimates of the value of individually identified intangibles and other assets when valued separately and the value of the business as a whole ...

TPG2022 Chapter VI Annex I example 23

83. Birincil acquires 100% of the equity interests in an independent enterprise, Company T for 100. Company T is a company that engages in research and development and has partially developed several promising technologies but has only minimal sales. The purchase price is justified primarily by the value of the promising, but only partly developed, technologies and by the potential of Company T personnel to develop further new technologies in the future. Birincil’s purchase price allocation performed for accounting purposes with respect to the acquisition attributes 20 of the purchase price to tangible property and identified intangibles, including patents, and 80 to goodwill. 84. Immediately following the acquisition, Birincil causes Company T to transfer all of its rights in developed and partially developed technologies, including patents, trade secrets and technical know-how to Company S, a subsidiary of Birincil. Company S simultaneously enters into a contract research agreement with Company T, pursuant to which the Company T workforce will continue to work exclusively on the development of the transferred technologies and on the development of new technologies on behalf of Company S. The agreement provides that Company T will be compensated for its research services by payments equal to its cost plus a mark-up, and that all rights to intangibles developed or enhanced under the research agreement will belong to Company S. As a result, Company S will fund all future research and will assume the financial risk that some or all of the future research will not lead to the development of commercially viable products. Company S has a large research staff, including management personnel responsible for technologies of the type acquired from Company T. Following the transactions in question, the Company S research and management personnel assume full management responsibility for the direction and control of the work of the Company T research staff. Company S approves new projects, develops and plans budgets and in other respects controls the ongoing research work carried on at Company T. All company T research personnel will continue to be employees of Company T and will be devoted exclusively to providing services under the research agreement with Company S. 85. In conducting a transfer pricing analysis of the arm’s length price to be paid by Company S for intangibles transferred by Company T, and of the price to be paid for ongoing R&D services to be provided by Company T, it is important to identify the specific intangibles transferred to Company S and those retained by Company T. The definitions and valuations of intangibles contained in the purchase price allocation are not determinative for transfer pricing purposes. The 100 paid by Birincil for the shares of Company T represents an arm’s length price for shares of the company and provides useful information regarding the value of the business of Company T. The full value of that business should be reflected either in the value of the tangible and intangible assets transferred to Company S or in the value of the tangible and intangible assets and workforce retained by Company T. Depending on the facts, a substantial portion of the value described in the purchase price allocation as goodwill of Company T may have been transferred to Company S together with the other Company T intangibles. Depending on the facts, some portion of the value described in the purchase price allocation as goodwill may also have been retained by Company T. Under arm’s length transfer pricing principles, Company T should be entitled to compensation for such value, either as part of the price paid by Company S for the transferred rights to technology intangibles, or through the compensation Company T is paid in years following the transaction for the R&D services of its workforce. It should generally be assumed that value does not disappear, nor is it destroyed, as part of an internal business restructuring. If the transfer of intangibles to Company S had been separated in time from the acquisition, a separate inquiry would be required regarding any intervening appreciation or depreciation in the value of the transferred intangibles ...

TPG2022 Chapter VI Annex I example 17

59. Company A is a fully integrated pharmaceutical company engaged in the discovery, development, production and sale of pharmaceutical preparations. Company A conducts its operations in country X. In conducting its research activities, Company A regularly retains independent Contract Research Organisations (CROs) to perform various R&D activities, including designing and conducting clinical trials with regard to products under development by Company A. However, such CROs do not engage in the blue sky research required to identify new pharmaceutical compounds. Where Company A does retain a CRO to engage in clinical research activities, research personnel at Company A actively participate in designing the CRO’s research studies, provide to the CRO results and information derived from earlier research, establish budgets and timelines for CRO projects, and conduct ongoing quality control with respect to the CRO’s activities. In such arrangements, CROs are paid a negotiated fee for services and do not have an ongoing interest in the profits derived from sales of products developed through their research. 60. Company A transfers patents and related intangibles related to Product M, an early stage pharmaceutical preparation believed to have potential as a treatment for Alzheimer’s disease to Company S, a subsidiary of Company A operating in country Y (the transaction relates strictly to the existing intangibles and does not include compensation for future R&D services of Company A). It is assumed for purposes of this example that the payment of Company S for the transfer of intangibles related to Product M is based on a valuation of anticipated future cash flows. Company S has no technical personnel capable of designing, conducting or supervising required ongoing research activities related to Product M. Company S therefore contracts with Company A to carry on the research programme related to Product M in the same manner as before the transfer of intangibles to Company S. Company S agrees to fund all of the ongoing Product M research, assume the financial risk of potential failure of such research, and to pay for Company A’s services based on the cost plus margins earned by CROs like those with which Company A regularly transacts. 61. The transfer pricing analysis of these facts begins by recognising that, following the transfer, Company S is the legal owner of the Product M intangibles under relevant contracts and registrations. However, Company A continues to perform and control functions and to manage risks related to the intangibles owned by Company S, including the important functions described in paragraph 6.56, and is entitled to compensation for those contributions. Under these circumstances, Company A’s transactions with CRO’s are not comparable to the arrangements between Company S and Company A related to Product M and may not be used as a benchmark for the arm’s length compensation required to be provided to Company A for its ongoing R&D activity with respect to the Product M intangibles. Company S does not perform or control the same functions or control the same risks in its transactions with Company A, as does Company A in its transactions with the CROs. 62. While Company S is the legal owner of the intangibles, it should not be entitled to all of the returns derived from the exploitation of the intangibles. Because Company S lacks the capability to control research related risks, Company A should be treated as bearing a substantial portion of the relevant risk and Company A should also be compensated for its functions, including the important functions described in paragraph 6.56. Company A should be entitled to larger returns than the CROs under these circumstances. 63. A thorough examination of the transaction in this example may show that it should accurately be delineated as the provision of financing by Company S equating to the costs of the acquired intangibles and the ongoing development. As a result, Company S is entitled to only a financing return. The level of the financing return depends on the exercising of control over the financing risk in accordance with the guidance in Section D. 1 of Chapter I and the principles outlined in paragraphs 6.63 and 6.64. Company A would be entitled to retain the remaining income or losses ...

TPG2022 Chapter VI Annex I example 16

54. Shuyona is the parent company of an MNE group. Shuyona is organised in and operates exclusively in Country X. The Shuyona group is involved in the production and sale of consumer goods. In order to maintain and, if possible, improve its market position, ongoing research is carried out by the Shuyona group to improve existing products and develop new products. The Shuyona group maintains two R&D centres, one operated by Shuyona in country X, and the other operated by Company S, a subsidiary of Shuyona, operating in country Y. The relationships between the Shuyona R&D centre and the Company S R&D centre are as described in Example 14. 55. In Year 1, Shuyona sells all rights to patents and other technology related intangibles, including rights to use those intangibles in ongoing research, to a new subsidiary, Company T, organised in country Z. Company T establishes a manufacturing facility in country Z and begins to supply products to members of the Shuyona group around the world. For purposes of this example, it is assumed that the compensation paid by Company T in exchange for the transferred patents and related intangibles is based on a valuation of anticipated future cash flows generated by the transferred intangibles at the time of the transfer. 56. At the same time as the transfer of patents and other technology related intangibles, Company T enters into a contract research agreement with Shuyona and a separate contract research agreement with Company S. Pursuant to these agreements, Company T contractually agrees to bear the financial risk associated with possible failure of future R&D projects, agrees to assume the cost of all future R&D activity, and agrees to pay Shuyona and Company S a service fee based on the cost of the R&D activities undertaken plus a mark-up equivalent to the profit mark-up over cost earned by certain identified independent companies engaged in providing research services. 57. Company T has no technical personnel capable of conducting or supervising the research activities. Shuyona continues to develop and design the R&D programme related to further development of the transferred intangibles, to establish its own R&D budgets, to determine its own levels of R&D staffing, and to make decisions regarding whether to pursue or terminate particular R&D projects. Moreover, Shuyona continues to supervise and control the R&D activities in Company S in the manner described in Example 14. 58. The transfer pricing analysis begins by identifying the commercial or financial relations between the parties and the conditions and economically relevant circumstances attaching to those relations in order that the controlled transaction is accurately delineated under the principles of Chapter I, Section D. 1. Key assumptions in this example are that Company T functions as a manufacturer and performs no activities in relation to the acquisition, development or exploitation of the intangibles and does not control risks in relation to the acquisition of the intangibles or to their further development. Instead, all development activities and risk management functions relating to the intangibles are performed by Shuyona and Company S, with Shuyona controlling the risk. A thorough examination of the transaction indicates that it should accurately be delineated as the provision of financing by Company T equating to the costs of the acquired intangibles and the ongoing development. A key assumption in this example is that, although Company T contractually assumes the financial risk and has the financial capacity to assume that risk, it does not exercise control over that risk in accordance with the principles outlined in paragraphs 6.63 and 6.64. As a result, in addition to its manufacturing reward, Company T is entitled to no more than a risk-free return for its funding activities. (For further guidance see Section D. 1 of Chapter I, and in particular paragraph 1.103.) ...

TPG2022 Chapter VI Annex I example 15

49. Shuyona is the parent company of an MNE group. Shuyona is organised in and operates exclusively in country X. The Shuyona group is involved in the production and sale of consumer goods. In order to maintain and, if possible, improve its market position, ongoing research is carried out by the Shuyona group to improve existing products and develop new products. The Shuyona group maintains two R&D centres, one operated by Shuyona in country X, and the other operated by Company S, a subsidiary of Shuyona, operating in country Y. 50. The Shuyona group sells two lines of products. All R&D with respect to product line A is conducted by Shuyona. All R&D with respect to product line B is conducted by the R&D centre operated by Company S. Company S also functions as the regional headquarters of the Shuyona group in North America and has global responsibility for the operation of the business relating to product line B. However, all patents developed through Company S research efforts are registered by Shuyona. Shuyona makes no or only a nominal payment to Company S in relation to the patentable inventions developed by the Company S R&D centre. 51. The Shuyona and Company S R&D centres operate autonomously. Each bears its own operating costs. Under the general policy direction of Shuyona senior management, the Company S R&D centre develops its own research programmes, establishes its own budgets, makes determinations as to when R&D projects should be terminated or modified, and hires its own R&D staff. The Company S R&D centre reports to the product line B management team in Company S, and does not report to the Shuyona R&D centre. Joint meetings between the Shuyona and Company S R&D teams are sometimes held to discuss research methods and common issues. 52. The transfer pricing analysis of this fact pattern would begin by recognising that Shuyona is the legal owner/registrant of intangibles developed by Company S. Unlike the situation in Example 14, however, Shuyona neither performs nor exercises control over the research functions carried out by Company S, including the important functions related to management, design, budgeting and funding that research. Accordingly, Shuyona’s legal ownership of the intangibles does not entitle it to retain or be attributed any income related to the product line B intangibles. Tax administrations could arrive at an appropriate transfer pricing outcome by recognising Shuyona’s legal ownership of the intangibles but by noting that, because of the contributions of Company S in the form of functions, assets, and risks, appropriate compensation to Company S for its contributions could be ensured by confirming that Company S should make no royalty or other payment to Shuyona for the right to use any successfully developed Company S intangibles, so that the future income derived from the exploitation of those intangibles by Company S would be allocated to Company S and not to Shuyona. 53. If Shuyona exploits the product line B intangibles by itself, Shuyona should provide appropriate compensation to Company S for its functions performed, assets used and risks assumed related to intangible development. In determining the appropriate level of compensation for Company S, the fact that Company S performs all of the important functions related to intangible development would likely make it inappropriate to treat Company S as the tested party in an R&D service arrangement ...

TPG2022 Chapter VI Annex I example 14

46. Shuyona is the parent company of an MNE group. Shuyona is organised in and operates in country X. The Shuyona group is involved in the production and sale of consumer goods. In order to maintain and, if possible, improve its market position, ongoing research is carried out by the Shuyona group to improve existing products and develop new products. The Shuyona group maintains two R&D centres, one operated by Shuyona in country X and the other operated by Company S, a subsidiary of Shuyona operating in country Y. The Shuyona R&D centre is responsible for the overall research programme of Shuyona group. The Shuyona R&D centre designs research programmes, develops and controls budgets, makes decisions as to where R&D activities will be conducted, monitors the progress on all R&D projects and, in general, controls the R&D function for the MNE group, operating under strategic direction of Shuyona group senior management. 47. The Company S R&D centre operates on a separate project by project basis to carry out specific projects assigned by the Shuyona R&D centre. Suggestions of Company S R&D personnel for modifications to the research programme are required to be formally approved by the Shuyona R&D centre. The Company S R&D centre reports on its progress on at least a monthly basis to supervisory personnel at the Shuyona R&D centre. If Company S exceeds budgets established by Shuyona for its work, approval of Shuyona R&D management must be sought for further expenditures. Contracts between the Shuyona R&D centre and the Company S R&D centre specify that Shuyona will bear all risks and costs related to R&D undertaken by Company S. All patents, designs and other intangibles developed by Company S research personnel are registered by Shuyona, pursuant to contracts between the two companies. Shuyona pays Company S a service fee for its research and development activities. 48. The transfer pricing analysis of these facts would begin by recognising that Shuyona is the legal owner of the intangibles. Shuyona controls and manages both its own R&D work and that of Company S. It performs the important functions related to that work such as budgeting, establishing research programmes, designing projects and funding and controlling expenditures. Under these circumstances, Shuyona is entitled to returns derived from the exploitation of the intangibles developed through the R&D efforts of Company S. Company S is entitled to compensation for its functions performed, assets used, and risks assumed. In determining the amount of compensation due Company S, the relative skill and efficiency of the Company S R&D personnel, the nature of the research being undertaken, and other factors contributing to value should be considered as comparability factors. To the extent transfer pricing adjustments are required to reflect the amount a comparable R&D service provider would be paid for its services, such adjustments would generally relate to the year the service is provided and would not affect the entitlement of Shuyona to future returns derived from exploiting intangibles derived from the Company S R&D activities ...

TPG2022 Chapter VII paragraph 7.41

Research is similarly an example of an activity that may involve intra-group services. The terms of the activity can be set out in a detailed contract with the party commissioning the service, commonly known as contract research. The activity can involve highly skilled personnel and vary considerably both in its nature and in its importance to the success of the group. The actual arrangements can take a variety of forms from the undertaking of detailed programmes laid down by the principal party, extending to agreements where the research company has discretion to work within broadly defined categories. In the latter instance, the additional functions of identifying commercially valuable areas and assessing the risk of unsuccessful research can be a critical factor in the performance of the group as a whole. It is therefore crucial to undertake a detailed functional analysis and to obtain a clear understanding of the precise nature of the research, and of how the activities are being carried out by the company, prior to consideration of the appropriate transfer pricing methodology. The consideration of options realistically available to the party commissioning the research may also prove useful in selecting the most appropriate transfer pricing method. See Section B .2 of Chapter VI ...

TPG2022 Chapter VI paragraph 6.79

The principles set out in the foregoing paragraphs also apply in situations involving the performance of research and development functions by a member of an MNE group under a contractual arrangement with an associated enterprise that is the legal owner of any resulting intangibles. Appropriate compensation for research services will depend on all the facts and circumstances, such as whether the research team possesses unique skills and experience relevant to the research, assumes risks (e.g. where “blue sky†research is undertaken), uses its own intangibles, or is controlled and managed by another party. Compensation based on a reimbursement of costs plus a modest mark-up will not reflect the anticipated value of, or the arm’s length price for, the contributions of the research team in all cases ...

TPG2022 Chapter II paragraph 2.61

Company A of an MNE group agrees with company B of the same MNE group to carry out contract research for company B. All risks related to the research are assumed by company B. This company also owns all the intangibles developed through the research and therefore has also the profit chances resulting from the research. This is a typical setup for applying a cost plus method. All costs for the research, which the associated parties have agreed upon, have to be compensated. The additional cost plus may reflect how innovative and complex the research carried out is ...

TPG2022 Chapter I paragraph 1.101

In the circumstances of Example 1 in paragraph 1.83, Company A assumes and controls the development risk and should bear the financial consequences of failure and enjoy the financial consequences of success. Company B should be appropriately rewarded for the carrying out of its development services, incorporating the risk that it fails to do so competently ...

THE APPLICATION OF THE PROFIT SPLIT METHOD WITHIN THE EU (2019)

The profit split method (PSM) is one of the five transfer pricing methods in Chapter II of the OECD Transfer Pricing Guidelines. These methods can be used to establish whether the conditions imposed on the commercial or financial relations between associated enterprises are consistent with the arm’s length principle. The OECD guidelines of 1995 referred to the PSM as a method of “last resortâ€, to be used when other methods could not be reliably applied (para. 3.50). Yet, since the revision of the OECD Guidelines in 2010, the PSM is considered a pricing method to be applied in an equally reliable manner as the other methods in accordance with the “most appropriate method†criterion. Due to the increased integration of multinational enterprises and the globalization of national economies and markets, the clarification of the PSM was one of the priorities identified in the action plan against Base Erosion and Profit Shifting (BEPS). Indeed, in order to develop rules that can prevent BEPS resulting from engaging in transactions which would not, or would only very rarely, occur between third parties, Action 10 called for clarification of the application of transfer pricing methods, in particular of the transactional profit split method, in the context of global value chains. In June 2018 the OECD published a Report containing Revised Guidelines on the application of PSM that clarifies and significantly expands the Guidelines on when a profit split may be the most appropriate method. The Guidelines also note that the basic premise that the transactional profit split method is applicable where it is found to be the most appropriate method is unchanged. In addition, the programme of work 2015-2019 of the Joint Transfer Pricing Forum (JTPF) referred to the PSM as one of the topics on which the JTPF should provide output in order to address the problems in the practical application of the PSM. A particular reference is made to the high degree of subjectivity encountered when stakeholders determine how to share the profit. As pointed out in the OECD Guidelines, the main advantage of the PSM is that it can offer solutions in cases where all relevant parties make unique and valuable contributions and/or there is a high degree of integration. In such cases, it is frequent that the reliable information on comparables is insufficient for applying another transfer pricing method although as pointed out by the OECD, lack of external comparable per se should not lead to default use of PSM (para 2.128 and 2.143 of the OECD Guidelines). Secondly, when parties share the assumption of economically significant risks or assume closely related risks, its flexibility allows the determination of an arm’s length profit for the parties according to the actual assumption of the risks. The analysis of the economically relevant characteristics of the transaction and in particular, the functional analysis, supported by the information in the MNE group’s transfer pricing documentation, should reveal: (i) how value is generated by the group as a whole; (ii) the interdependencies between the functions performed by the associated enterprises; and (iii) the contribution that each of the associated enterprises makes to that value creation. In particular, the analysis of risks and the determination of which group entities take the key decisions related to control over risk as well as which of these entities have the financial capacity to assume the risk should help identify the most appropriate way of splitting the relevant profit from the transaction under review. report_on_the_application_of_the_profit_split_method_within_the_eu_en ...

Switzerland vs R&D Pharma, December 2018, Tribunal fédéral suisse, 2C_11/2018

The Swiss company X SA (hereinafter: the Company or the Appellant), is part of the multinational pharmaceutical group X, whose parent holding is X BV (hereinafter referred to as the parent company) in Netherlands, which company owns ten subsidiaries, including the Company and company X France SAS (hereinafter: the French company). According to the appendices to the accounts, the parent company did not employ any employees in 2006 or in 2007, on the basis of a full-time employment contract. In 2010 and 2011, an average of three employees worked for this company. By agreement of July 5, 2006, the French company undertook to carry out all the works and studies requested by the parent company for a fee calculated on the basis of their cost, plus a margin of 15%. The French company had to communicate to the parent company any discoveries or results relating to the work entrusted to it. It should also keep the parent company informed of the progress of the transactions, directly or through the Company. The results of all studies became the property of the parent company. By an agreement of February 19, 2008, the parent company granted the Swiss Company access to the research and development activities carried out by the French company, in exchange for paying the parent company a royalty of 2.5% of all revenues generated on the products or registered by the parent company through the French company. In 2013, the Swiss Tax Administration informed the Company of the initiation of a tax assessment for the years 2008 to 2010, as well as a tax evasion attempt procedure for the year 2011. These proceedings resulted from a communication from the Federal Tax Administration that mentioned the existence of charges not justified by commercial use during the years in question. Later the same year the Tax Administration informed the Company that the proceedings were extended to the years 2003 to 2007. In 2014 a tax assessment was issued for the tax years 2003 and 2005 to 2010. The Tax Administration estimated that the Company had paid royalties to the parent company for the use of research and development of certain molecules. However, the latter company had no substance or technical expertise to carry out this activity. In practice, the research and development of the X group was led by the Swiss Company, which subcontracted some of the tasks to the French company. The amount of royalties paid by the Swiss Company to the parent company, after deduction of the costs actually borne by the company for subcontracting, constituted unjustified expenses on a commercial basis. The Swiss company stated that the parent company assumes important financial, regulatory and operational risks, for which it should be compensated. The Supreme Court concluded that the parent company was a mere shell company, and as a result, disregarded the transaction. The court found that the parent did not hold the required substance to be entitle to any royalty payments. The parent was not involved in the group’s R&D activity and had no/very few employees. It was not even the legal owner because the patents were registered in the Swiss company’s name. The Swiss company had 60 employees and made all the strategic decisions over the R&D functions. The Federal Tribunal ruled in favor of the Swiss Tax Administration. The Court found the transactions and payments to be a hidden distribution of profit leading to tax evasion. Click here for translation Swiss vs Pharma Corp2 ...

Chile vs Monsanto Chile S.A, December 2018, Tax Court, Case N° RUC N° 14-9-0000002-3

Monsanto Chile – since 2018 a subsidiary of Bayer – is engaged in production of vegetable seeds and Row Crop seeds. The company uses its own local farmers and contractors, employs some 250 people and hires a maximum of 2,000 temporary workers in the summer months. It receives parental seed from global planners in the US and other countries and then multiplies these seeds in Chile on its own or third-party farms. The seeds are then harvested, processed and shipped to locations specified by global planners. Following an audit of FY 2009-2010 an adjustment was issued related to the profitability obtained in the operations of the “Production” segment (sale of semi-finished products to related parties) and “Research and Development” carried out on behalf of related parties abroad. The adjustment was determined by the tax authorities using the a Net Margin method. The tax authorities found that the income obtained under the production segment and in the research and development business line, did not provide a reasonable return to the local company, since in the production segment the operating margin over costs and expenses (ROTC) obtained by Monsanto Chile amounting to -5.87% was lower than the ROTC obtained by comparable companies which were in a range between 4.573% and 12.648%, with a median of 11.216%; and in the research and development segment the ROTC obtained by Monsanto Chile was -6.54%, whereas the arm’s length ROTC determined by the tax authorities was in a range between 7.93% and 12.48%, with a median of 10.21%. An assessment was issued in 2013 where an adjustment of $2,422,378,384 had been determined in regards to the production segment, and an adjustment of $38,637,909 had been determined in regards to the Research and Development segment, in total resulting in additional taxes of $862,958,963. Monsanto was of the opinion that the assessment was bared due to statues of limitations, and that the transfer pricing analysis conducted by the tax authorities in regards to both the production segment and the research and development segment was erroneous. Monsanto also held that the added fine was unfounded. Decision of the Tax court The decision of the Tax Court was largely in favour of the tax authorities. “That the claim filed in the main part of page 1 by Mr. Manuel Jiménez Pfingsthorn, RUT N°7.021.291-9, on behalf of MONSANTO CHILE S.A., is partially accepted, RUT N°83.693.800-3, against the Assessment N° 38, carried out on 28 August 2013, by the Large Taxpayers Directorate of the Internal Revenue Service, only insofar as the fine established in article 97 N°11 of the Tax Code is left without effect, as stated in recital 35°), being rejected for the rest. III. That the Director of the Large Taxpayers’ Directorate of the Internal Revenue Service shall arrange for administrative compliance with the above decision, for which purpose he must carry out a tax re-calculation.“ Following the decision of the tax court, an appeal has been filed by Monsanto Chile to the Court of Appeal where the appeal is still pending. Click here for English translation CH vs M14-9-0000002-3 ...

France vs Philips, September 2018, Conseil d’État, Case No 405779

Philips France SAS provides contract R&D to it’s Dutch parent. Compensation for the service was calculated as cost plus 10%. In the years 2003 to 2007 Philips France received government subsidies for performing R&D. These subsidies had been deducted by the company from the cost base before calculating of the cost plus remuneration. The French tax authorities issued a tax assessment where the deduction was denied and the remuneration calculated on the full cost base. The Supreme Administrative Court ruled that a deduction of subsidies from the cost base does not constitute a “transfer of profits abroad” and allowed the reduced cost base for calculation of the arm’s length remuneration. Click here for English translation Click here for other translation CÉt_8ème_-_3ème_chambres_réunies_19_09_2018_405779 ...

TPG2017 Chapter VI Annex example 28

101. Company A is the Parent company of an MNE group with operations in country S. Company B is a member of the MNE group with operations in country T, and Company C is also a member of the MNE group with operations in country U. For valid business reasons the MNE group decides to centralise all of its intangibles related to business conducted outside of country S in a single location. Accordingly, intangibles owned by Company B are sold to Company C for a lump sum, including patents, trademarks, know-how, and customer relationships. At the same time, Company C retains Company B to act as a contract manufacturer of products previously produced and sold by Company B on a full-risk basis. Company C has the personnel and resources required to manage the acquired lines of business, including the further development of intangibles necessary to the Company B business. 102. The MNE group is unable to identify comparable uncontrolled transactions that can be used in a transfer pricing analysis of the arm’s length price to be paid by Company C to Company B. Based on a detailed comparability and functional analysis, the MNE group concludes that the most appropriate transfer pricing method involves the application of valuation techniques to determine the value of the transferred intangibles. In conducting its valuation, the MNE group is unable to reliably segregate particular cash flows associated with all of the specific intangibles. 103. Under these circumstances, in determining the arm’s length compensation to be paid by Company C for the intangibles sold by Company B, it may be appropriate to value the transferred intangibles in the aggregate rather than to attempt a valuation on an asset by asset basis. This would particularly be the case if there is a significant difference between the sum of the best available estimates of the value of individually identified intangibles and other assets when valued separately and the value of the business as a whole ...

TPG2017 Chapter VI Annex example 23

83. Birincil acquires 100% of the equity interests in an independent enterprise, Company T for 100. Company T is a company that engages in research and development and has partially developed several promising technologies but has only minimal sales. The purchase price is justified primarily by the value of the promising, but only partly developed, technologies and by the potential of Company T personnel to develop further new technologies in the future. Birincil’s purchase price allocation performed for accounting purposes with respect to the acquisition attributes 20 of the purchase price to tangible property and identified intangibles, including patents, and 80 to goodwill. 84. Immediately following the acquisition, Birincil causes Company T to transfer all of its rights in developed and partially developed technologies, including patents, trade secrets and technical know-how to Company S, a subsidiary of Birincil. Company S simultaneously enters into a contract research agreement with Company T, pursuant to which the Company T workforce will continue to work exclusively on the development of the transferred technologies and on the development of new technologies on behalf of Company S. The agreement provides that Company T will be compensated for its research services by payments equal to its cost plus a mark-up, and that all rights to intangibles developed or enhanced under the research agreement will belong to Company S. As a result, Company S will fund all future research and will assume the financial risk that some or all of the future research will not lead to the development of commercially viable products. Company S has a large research staff, including management personnel responsible for technologies of the type acquired from Company T. Following the transactions in question, the Company S research and management personnel assume full management responsibility for the direction and control of the work of the Company T research staff. Company S approves new projects, develops and plans budgets and in other respects controls the ongoing research work carried on at Company T. All company T research personnel will continue to be employees of Company T and will be devoted exclusively to providing services under the research agreement with Company S. 85. In conducting a transfer pricing analysis of the arm’s length price to be paid by Company S for intangibles transferred by Company T, and of the price to be paid for ongoing R&D services to be provided by Company T, it is important to identify the specific intangibles transferred to Company S and those retained by Company T. The definitions and valuations of intangibles contained in the purchase price allocation are not determinative for transfer pricing purposes. The 100 paid by Birincil for the shares of Company T represents an arm’s length price for shares of the company and provides useful information regarding the value of the business of Company T. The full value of that business should be reflected either in the value of the tangible and intangible assets transferred to Company S or in the value of the tangible and intangible assets and workforce retained by Company T. Depending on the facts, a substantial portion of the value described in the purchase price allocation as goodwill of Company T may have been transferred to Company S together with the other Company T intangibles. Depending on the facts, some portion of the value described in the purchase price allocation as goodwill may also have been retained by Company T. Under arm’s length transfer pricing principles, Company T should be entitled to compensation for such value, either as part of the price paid by Company S for the transferred rights to technology intangibles, or through the compensation Company T is paid in years following the transaction for the R&D services of its workforce. It should generally be assumed that value does not disappear, nor is it destroyed, as part of an internal business restructuring. If the transfer of intangibles to Company S had been separated in time from the acquisition, a separate inquiry would be required regarding any intervening appreciation or depreciation in the value of the transferred intangibles ...

TPG2017 Chapter VI Annex example 17

59. Company A is a fully integrated pharmaceutical company engaged in the discovery, development, production and sale of pharmaceutical preparations. Company A conducts its operations in country X. In conducting its research activities, Company A regularly retains independent Contract Research Organisations (CROs) to perform various R&D activities, including designing and conducting clinical trials with regard to products under development by Company A. However, such CROs do not engage in the blue sky research required to identify new pharmaceutical compounds. Where Company A does retain a CRO to engage in clinical research activities, research personnel at Company A actively participate in designing the CRO’s research studies, provide to the CRO results and information derived from earlier research, establish budgets and timelines for CRO projects, and conduct ongoing quality control with respect to the CRO’s activities. In such arrangements, CROs are paid a negotiated fee for services and do not have an ongoing interest in the profits derived from sales of products developed through their research. 60. Company A transfers patents and related intangibles related to Product M, an early stage pharmaceutical preparation believed to have potential as a treatment for Alzheimer’s disease to Company S, a subsidiary of Company A operating in country Y (the transaction relates strictly to the existing intangibles and does not include compensation for future R&D services of Company A). It is assumed for purposes of this example that the payment of Company S for the transfer of intangibles related to Product M is based on a valuation of anticipated future cash flows. Company S has no technical personnel capable of designing, conducting or supervising required ongoing research activities related to Product M. Company S therefore contracts with Company A to carry on the research programme related to Product M in the same manner as before the transfer of intangibles to Company S. Company S agrees to fund all of the ongoing Product M research, assume the financial risk of potential failure of such research, and to pay for Company A’s services based on the cost plus margins earned by CROs like those with which Company A regularly transacts. 61. The transfer pricing analysis of these facts begins by recognising that, following the transfer, Company S is the legal owner of the Product M intangibles under relevant contracts and registrations. However, Company A continues to perform and control functions and to manage risks related to the intangibles owned by Company S, including the important functions described in paragraph 6.56, and is entitled to compensation for those contributions. Under these circumstances, Company A’s transactions with CRO’s are not comparable to the arrangements between Company S and Company A related to Product M and may not be used as a benchmark for the arm’s length compensation required to be provided to Company A for its ongoing R&D activity with respect to the Product M intangibles. Company S does not perform or control the same functions or control the same risks in its transactions with Company A, as does Company A in its transactions with the CROs. 62. While Company S is the legal owner of the intangibles, it should not be entitled to all of the returns derived from the exploitation of the intangibles. Because Company S lacks the capability to control research related risks, Company A should be treated as bearing a substantial portion of the relevant risk and Company A should also be compensated for its functions, including the important functions described in paragraph 6.56. Company A should be entitled to larger returns than the CROs under these circumstances. 63. A thorough examination of the transaction in this example may show that it should accurately be delineated as the provision of financing by Company S equating to the costs of the acquired intangibles and the ongoing development. As a result, Company S is entitled to only a financing return. The level of the financing return depends on the exercising of control over the financing risk in accordance with the guidance in Section D. 1 of Chapter I and the principles outlined in paragraphs 6.63 and 6.64. Company A would be entitled to retain the remaining income or losses ...

TPG2017 Chapter VI Annex example 15

49. Shuyona is the parent company of an MNE group. Shuyona is organised in and operates exclusively in country X. The Shuyona group is involved in the production and sale of consumer goods. In order to maintain and, if possible, improve its market position, ongoing research is carried out by the Shuyona group to improve existing products and develop new products. The Shuyona group maintains two R&D centres, one operated by Shuyona in country X, and the other operated by Company S, a subsidiary of Shuyona, operating in country Y. 50. The Shuyona group sells two lines of products. All R&D with respect to product line A is conducted by Shuyona. All R&D with respect to product line B is conducted by the R&D centre operated by Company S. Company S also functions as the regional headquarters of the Shuyona group in North America and has global responsibility for the operation of the business relating to product line B. However, all patents developed through Company S research efforts are registered by Shuyona. Shuyona makes no or only a nominal payment to Company S in relation to the patentable inventions developed by the Company S R&D centre. 51. The Shuyona and Company S R&D centres operate autonomously. Each bears its own operating costs. Under the general policy direction of Shuyona senior management, the Company S R&D centre develops its own research programmes, establishes its own budgets, makes determinations as to when R&D projects should be terminated or modified, and hires its own R&D staff. The Company S R&D centre reports to the product line B management team in Company S, and does not report to the Shuyona R&D centre. Joint meetings between the Shuyona and Company S R&D teams are sometimes held to discuss research methods and common issues. 52. The transfer pricing analysis of this fact pattern would begin by recognising that Shuyona is the legal owner/registrant of intangibles developed by Company S. Unlike the situation in Example 14, however, Shuyona neither performs nor exercises control over the research functions carried out by Company S, including the important functions related to management, design, budgeting and funding that research. Accordingly, Shuyona’s legal ownership of the intangibles does not entitle it to retain or be attributed any income related to the product line B intangibles. Tax administrations could arrive at an appropriate transfer pricing outcome by recognising Shuyona’s legal ownership of the intangibles but by noting that, because of the contributions of Company S in the form of functions, assets, and risks, appropriate compensation to Company S for its contributions could be ensured by confirming that Company S should make no royalty or other payment to Shuyona for the right to use any successfully developed Company S intangibles, so that the future income derived from the exploitation of those intangibles by Company S would be allocated to Company S and not to Shuyona. 53. If Shuyona exploits the product line B intangibles by itself, Shuyona should provide appropriate compensation to Company S for its functions performed, assets used and risks assumed related to intangible development. In determining the appropriate level of compensation for Company S, the fact that Company S performs all of the important functions related to intangible development would likely make it inappropriate to treat Company S as the tested party in an R&D service arrangement ...

TPG2017 Chapter VI Annex example 14

46. Shuyona is the parent company of an MNE group. Shuyona is organised in and operates in country X. The Shuyona group is involved in the production and sale of consumer goods. In order to maintain and, if possible, improve its market position, ongoing research is carried out by the Shuyona group to improve existing products and develop new products. The Shuyona group maintains two R&D centres, one operated by Shuyona in country X and the other operated by Company S, a subsidiary of Shuyona operating in country Y. The Shuyona R&D centre is responsible for the overall research programme of Shuyona group. The Shuyona R&D centre designs research programmes, develops and controls budgets, makes decisions as to where R&D activities will be conducted, monitors the progress on all R&D projects and, in general, controls the R&D function for the MNE group, operating under strategic direction of Shuyona group senior management. 47. The Company S R&D centre operates on a separate project by project basis to carry out specific projects assigned by the Shuyona R&D centre. Suggestions of Company S R&D personnel for modifications to the research programme are required to be formally approved by the Shuyona R&D centre. The Company S R&D centre reports on its progress on at least a monthly basis to supervisory personnel at the Shuyona R&D centre. If Company S exceeds budgets established by Shuyona for its work, approval of Shuyona R&D management must be sought for further expenditures. Contracts between the Shuyona R&D centre and the Company S R&D centre specify that Shuyona will bear all risks and costs related to R&D undertaken by Company S. All patents, designs and other intangibles developed by Company S research personnel are registered by Shuyona, pursuant to contracts between the two companies. Shuyona pays Company S a service fee for its research and development activities. 48. The transfer pricing analysis of these facts would begin by recognising that Shuyona is the legal owner of the intangibles. Shuyona controls and manages both its own R&D work and that of Company S. It performs the important functions related to that work such as budgeting, establishing research programmes, designing projects and funding and controlling expenditures. Under these circumstances, Shuyona is entitled to returns derived from the exploitation of the intangibles developed through the R&D efforts of Company S. Company S is entitled to compensation for its functions performed, assets used, and risks assumed. In determining the amount of compensation due Company S, the relative skill and efficiency of the Company S R&D personnel, the nature of the research being undertaken, and other factors contributing to value should be considered as comparability factors. To the extent transfer pricing adjustments are required to reflect the amount a comparable R&D service provider would be paid for its services, such adjustments would generally relate to the year the service is provided and would not affect the entitlement of Shuyona to future returns derived from exploiting intangibles derived from the Company S R&D activities ...

TPG2017 Chapter VII paragraph 7.41

Research is similarly an example of an activity that may involve intra-group services. The terms of the activity can be set out in a detailed contract with the party commissioning the service, commonly known as contract research. The activity can involve highly skilled personnel and vary considerably both in its nature and in its importance to the success of the group. The actual arrangements can take a variety of forms from the undertaking of detailed programmes laid down by the principal party, extending to agreements where the research company has discretion to work within broadly defined categories. In the latter instance, the additional functions of identifying commercially valuable areas and assessing the risk of unsuccessful research can be a critical factor in the performance of the group as a whole. It is therefore crucial to undertake a detailed functional analysis and to obtain a clear understanding of the precise nature of the research, and of how the activities are being carried out by the company, prior to consideration of the appropriate transfer pricing methodology. The consideration of options realistically available to the party commissioning the research may also prove useful in selecting the most appropriate transfer pricing method. See Section B .2 of Chapter VI ...

TPG2017 Chapter VI paragraph 6.79

The principles set out in the foregoing paragraphs also apply in situations involving the performance of research and development functions by a member of an MNE group under a contractual arrangement with an associated enterprise that is the legal owner of any resulting intangibles. Appropriate compensation for research services will depend on all the facts and circumstances, such as whether the research team possesses unique skills and experience relevant to the research, assumes risks (e.g. where “blue sky†research is undertaken), uses its own intangibles, or is controlled and managed by another party. Compensation based on a reimbursement of costs plus a modest mark-up will not reflect the anticipated value of, or the arm’s length price for, the contributions of the research team in all cases ...

TPG2017 Chapter II paragraph 2.61

Company A of an MNE group agrees with company B of the same MNE group to carry out contract research for company B. All risks related to the research are assumed by company B. This company also owns all the intangibles developed through the research and therefore has also the profit chances resulting from the research. This is a typical setup for applying a cost plus method. All costs for the research, which the associated parties have agreed upon, have to be compensated. The additional cost plus may reflect how innovative and complex the research carried out is ...

TPG2017 Chapter I paragraph 1.101

In the circumstances of Example 1 in paragraph 1.83, Company A assumes and controls the development risk and should bear the financial consequences of failure and enjoy the financial consequences of success. Company B should be appropriately rewarded for the carrying out of its development services, incorporating the risk that it fails to do so competently ...

Sweden vs AB Tetra Pak, April 2015, Administrative Court of Appeal, Case No 1168-14

An agreement had been entered between AB Tetra Pak and Tetra Pak International, according to which AB Tetra Pak conducted research and development on behalf of Tetra Pak International and was compensated on a cost plus 3 percent basis. The Swedish Tax Agency, after examining four comparable businesses and their profit levels, concluded that the remuneration of AB Tetra Pak should have been cost plus 7 percent. The Administrative Court of Appeal ruled in favor of AB Tetra Pak. The burden of proof for transfer pricing not being at arm’s length was on the tax authorities. The Court refereed to the OECD’s TPG art. 3.38. – decisive for the selection of comparables is whether their activities are sufficiently comparable to the R&D activities conducted by AB Tetra Pak. The Court also referred to TPG art. 2.55 where it is stated that the profit margin in contract research arrangements should reflect the complexity of the activities” Click here for translation 1168-14 ...