Services provided using intangibles. – (i) P’s worldwide group produces and markets Product X and subsequent generations of products, which result from research and development performed by P’s R&D Team. Through this collaboration with respect to P’s proprietary products, the members of the R&D Team have individually and as a group acquired specialized knowledge and expertise subject to non-disclosure agreements (collectively, “knowhow”). (ii) P arranges for the R&D Team to provide research and development services to create a new line of products, building on the Product X platform, to be owned and exploited by S1 in the overseas market. P asserts that the arm’s length charge for the services is only reimbursement to P of its associated R&D Team compensation costs. (iii) Even though P did not transfer the platform or the R&D Team to S1, P is providing value associated with the use of the platform, along with the value associated with the use of the knowhow, to S1 by way of the services performed by the R&D Team for S1 using the platform and the knowhow. The R&D Team’s use of intangible property, and any other valuable resources, in P’s provision of services (regardless of whether the service effects a transfer of intangible property or valuable resources and regardless of whether the property is relatively high or low value) must be evaluated under the section 482 regulations, including the regulations specifically applicable to controlled services transactions in § 1.482-9, to ensure that P receives arm’s length compensation for any value (attributable to such property or services) provided to S1 in a controlled transaction. See §§ 1.482-4 and 1.482-9(m). Under paragraph (f)(2)(i)(A) of this section, the arm’s length compensation for the services performed by the R&D Team for S1 must be consistent with the value provided to S1, including the value of the knowhow and any synergies with the platform. Under paragraphs (f)(2)(i)(B) and (C) of this section, the best method analysis may determine that the compensation is most reliably determined on an aggregate basis reflecting the interrelated value of the services and embedded value of the platform and knowhow. (iv) In the alternative, the facts are the same as above, except that P assigns to S1 all or a pertinent portion of the R&D Team and the relevant rights in the platform. P takes the position that, although the transferred platform rights must be compensated, the knowhow does not have substantial value independent of the services of any individual on the R&D Team and therefore is not an intangible within the meaning of § 1.482-4(b). In P’s view, S1 owes no compensation to P on account of the R&D Team, as S1 will directly bear the cost of the relevant R&D Team compensation. However, in assembling and arranging to assign the relevant R&D Team, and thereby making available the value of the knowhow to S1, rather than other employees without the knowhow, P is performing services for S1 under imputed contractual terms based on the parties’ course of conduct. Therefore, even if P’s position were correct that the knowhow is not an intangible under § 1.482-4(b), a position that the Commissioner may challenge, arm’s length compensation is required for all of the value that P provides to S1 through the interrelated provision of platform rights, knowhow, and services under paragraphs (f)(2)(i)(A), (B), and (C) of this section ...

Arm’s length compensation for equivalent provisions of intangibles under sections 351 and 482. P owns the worldwide rights to manufacturing and marketing intangibles that it uses to manufacture and market a product in the United States (“US intangibles”) and the rest of the world (“ROW intangibles”). P transfers all the ROW intangibles to S1 in an exchange described in section 351 and retains the US intangibles. Immediately after the exchange, P and S1 entered into a CSA described in § 1.482-7(b) that covers all research and development of intangibles conducted by the parties. A realistic alternative that was available to P and that would have involved the controlled parties performing similar functions, employing similar resources, and assuming similar risks as in the controlled transaction, was to transfer all ROW intangibles to S1 upon entering into the CSA in a platform contribution transaction described in § 1.482-7(c), rather than in an exchange described in section 351 immediately before entering into the CSA. Under paragraph (f)(2)(i)(A) of this section, the arm’s length compensation for the ROW intangibles must correspond to the value provided between the parties, regardless of the form of the transaction. Accordingly, the arm’s length compensation for the ROW intangibles is the same in both scenarios, and the analysis of the amount to be taken into account under section 367(d) pursuant to §§ 1.367(d)-1T(c) and 1.482-4 should include consideration of the amount that P would have charged for the realistic alternative determined under § 1.482-7(g) (and § 1.482-4, to the extent of any make-or-sell rights transferred). See §§ 1.482-1(b)(2)(iii) and 1.482-4(g) ...

Distinguishing provision of value from characterization – (i) P developed a collection of resources, capabilities, and rights (“Collection”) that it uses on an interrelated basis in ongoing research and development of computer code that is used to create a successful line of software products. P can continue to use the Collection on such interrelated basis in the future to further develop computer code and, thus, further build on its successful line of software products. Under § 1.482-7(g)(2)(ix), P determines that the interquartile range of the net present value of its own use of the Collection in future research and development and software product marketing is between $1000x and $1100x, and this range provides the most reliable measure of the value to P of continuing to use the Collection on an interrelated basis in future research, development, and exploitation. Instead, P enters into an exchange described in section 351 in which it transfers certain intangible property related to the Collection to S1 for use in future research, development, and exploitation but continues to perform the same development functions that it did prior to the exchange, now on behalf of S1, under express or implied commitments in connection with S1’s use of the intangible property. P takes the position that a portion of the Collection, consisting of computer code and related instruction manuals and similar intangible property (Portion 1), was transferrable intangible property and was the subject of the section 351 exchange and compensable under section 367(d). P claims that another portion of the Collection consists of items that either do not constitute property for purposes of section 367 or are not transferrable (Portion 2). P then takes the position that the value of Portion 2 does not give rise to income under section 367(d) or gain under section 367(a). (ii) Under paragraphs (f)(2)(i)(A) and (C) of this section, any part of the value in Portion 2 that is not taken into account in an exchange under section 367 must nonetheless be evaluated under section 482 and the regulations thereunder to determine arm’s length compensation for any value provided to S1. Accordingly, even if P’s assertion that certain items were either not property or not capable of being transferred were correct, arm’s length compensation is nonetheless required for all of the value associated with P’s contributions under the section 482 regulations. Alternatively, the Commissioner may determine under all the facts and circumstances that P’s assertion is incorrect and that the transaction in fact constitutes an exchange of property subject to, and therefore to be taken into account under, section 367. Thus, whether any item that P identifies as being within Portion 2 is properly characterized as property under section 367 (transferable or otherwise) is irrelevant because any value in Portion 2 that is provided to S1 must be compensated by S1 in a manner consistent with the $1000x to $1100x interquartile range of the overall value ...

Contractual terms imputed from economic substance. (i) Company X is a member of a controlled group that has been in operation in the pharmaceutical sector for many years. In years 1 through 4, Company X undertakes research and development activities. As a result of those activities, Company X developed a compound that may be more effective than existing medications in the treatment of certain conditions. (ii) Company Y is acquired in year 4 by the controlled group that includes Company X. Once Company Y is acquired, Company X makes available to Company Y a large amount of technical data concerning the new compound, which Company Y uses to register patent rights with respect to the compound in several jurisdictions, making Company Y the legal owner of such patents. Company Y then enters into licensing agreements with group members that afford Company Y 100% of the premium return attributable to use of the intangible property by its subsidiaries. (iii) In determining whether an allocation is appropriate in year 4, the Commissioner may consider the economic substance of the arrangements between Company X and Company Y, and the parties’ course of conduct throughout their relationship. Based on this analysis, the Commissioner determines that it is unlikely that an uncontrolled taxpayer operating at arm’s length would make available the results of its research and development or perform services that resulted in transfer of valuable know how to another party unless it received contemporaneous compensation or otherwise had a reasonable anticipation of receiving a future benefit from those activities. In this case, Company X’s undertaking the research and development activities and then providing technical data and know-how to Company Y in year 4 is inconsistent with the registration and subsequent exploitation of the patent by Company Y. Therefore, the Commissioner may impute one or more agreements between Company X and Company Y consistent with the economic substance of their course of conduct, which would afford Company X an appropriate portion of the premium return from the patent rights. For example, the Commissioner may impute a separate services agreement that affords Company X contingent-payment compensation for its services in year 4 for the benefit of Company Y, consisting of making available to Company Y technical data, know-how, and other fruits of research and development conducted in previous years. These services benefited Company Y by giving rise to and contributing to the value of the patent rights that were ultimately registered by Company Y. In the alternative, the Commissioner may impute a transfer of patentable intangible property rights from Company X to Company Y immediately preceding the registration of patent rights by Company Y. The taxpayer may present additional facts that could indicate which of these or other alternative agreements best reflects the economic substance of the underlying transactions, consistent with the parties’ course of conduct in the particular case ...

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 ...

Care should be taken in determining whether or when an intangible exists and whether an intangible has been used or transferred. For example, not all research and development expenditures produce or enhance an intangible, and not all marketing activities result in the creation or enhancement of an intangible ...

A Swiss company manufactured and distributed pharmaceutical and chemical products. The Swiss company was held by a Dutch parent that held another company in France. R&D activities were delegated by the Dutch parent to its French subsidiary and compensated with cost plus 15%. On that basis the Swiss company had to pay a royalty to its Dutch parent of 2.5% of its turnover for using the IP developed. Following an audit the Swiss tax authorities concluded that the Dutch parent did not contribute to the development of IP. In 2006 and 2007, no employees were employed, and in 2010 and 2011 there were only three employees. Hence the royalty agreement was disregarded and an assessment issued where the royalty payments were denied. Instead the R&D agreement between the Dutch parent and the French subsidiary was regarded as having been concluded between the Swiss and French companies Judgement of the Supreme Court The Court agreed with the decision of the tax authorities. The Dutch parent was a mere shell company with no substance. Hence, the royalty agreement was disregarded and replaced with the cost plus agreement with the French subsidiary. The Court found that it must have been known to the taxpayer that a company without substance could not be entitled to profits of the R&D activities. On that basis an amount equal to 75% of the evaded tax had therefore rightly been imposed as a penalty. Click here for English translation Click here for other translation ...

[See Chapter II, Part III, Section C of these Guidelines for general guidance on the application of the profit split method. The adjustments and assumptions about arm’s length arrangements in the examples that follow are intended for illustrative purposes only and should not be taken as prescribing adjustments and arm’s length arrangements in actual cases or particular industries. While they seek to demonstrate the principles of the Sections of the Guidelines to which they refer, those principles must be applied in each case according to the specific facts and circumstances of that case.] 1. The success of an electronics product is linked to the innovative technological design both of its electronic processes and of its major component. That component is designed and manufactured by associated company A, is transferred to associated company B which designs and manufactures the rest of the product, and is distributed by associated company C. Information exists to verify by means of a resale price method that the distribution functions and risks of Company C are being appropriately rewarded by the transfer price of the finished product from B to C. 2. The most appropriate method to price the component transferred from A to B may be a CUP, if a sufficiently similar comparable could be found. See paragraph 2.15 of the Guidelines. However, since the component transferred from A to B reflects the innovative technological advance enjoyed by company A in this market, in this example it proves impossible (after the appropriate functional and comparability analyses have been carried out) to find a reliable CUP to estimate the correct price that A could command at arm’s length for its product. Calculating a return on A’s manufacturing costs could however provide an estimate of the profit element which would reward A’s manufacturing functions, ignoring the profit element attributable to the intangible used therein. A similar calculation could be performed on company B’s manufacturing costs, to give an estimate of B’s profit derived from its manufacturing functions, ignoring the profit element attributable to its intangible. Since B’s selling price to C is known and is accepted as an arm’s length price, the amount of the residual profit accrued by A and B together from the exploitation of their respective intangible property can be determined. See paragraphs 2.114 and 2.127 of the Guidelines. At this stage the proportion of this residual profit properly attributable to each enterprise remains undetermined. 3. The residual profit may be split based on an analysis of the facts and circumstances that might indicate how the additional reward would have been allocated at arm’s length. Paragraph 2.127 of the The R&D activity of each company is directed towards technological design relating to the same class of item, and it is established for the purposes of this example that the relative amounts of R&D expenditure reliably measure the relative value of the companies’ contributions. See paragraph 2.126 of the Guidelines. This means that each company’s contribution to the product’s technological innovation may reliably be measured by their relative expenditure on research and development, so that, if A’s R&D expenditure is 15 and B’s 10, the residual could be split 3/5 for A and 2/5 for B. 4. Some figures may assist in following the example: a) Profit & Loss of A and B   A B Sales 50 100 Less: Purchases (10) (50) Manufacturing costs (15) (20) Gross profits 25 30 Less: R&D 15 10 Operating expenses 10 (25) 10 (20) Net profit 0 10 b) Determine routine profit on manufacturing by A and B, and calculate total residual profit 5. It is established, for both jurisdictions, that third-party comparable manufacturers without innovative intangible property earn a return on manufacturing costs (excluding purchases) of 10% (ratio of net profit to the direct and indirect costs of manufacturing).1 See paragraph 2.127 of the A’s manufacturing costs are 15, and so the return on costs would attribute to A a manufacturing profit of 1.5. B’s equivalent costs are 20, and so the return on costs would attribute to B a manufacturing profit of 2.0. The residual profit is therefore 6.5, arrived at by deducting from the combined net profit of 10 the combined manufacturing profit of 3.5. c)  Allocate residual profit 6. The initial allocation of profit (1.5 to A and 2.0 to B) rewards the manufacturing functions of A and B, but does not recognise the value of their respective R&D that has resulted in a technologically advanced product. That residual can, therefore, be split between A and B based on their share of total R&D costs, since, for the purposes of this example2, it can reliably be assumed that the companies’ relative expenditure on R&D accurately reflects their relative contributions to the value of the product’s technological innovation. A’s R&D expenditure is 15 and B’s 10, giving combined R&D expenditure of 25. The residual is 6.5 which may be allocated 15/25 to A and 10/25 to B, resulting in a share of 3.9 and 2.6 respectively, as below: A’s share 6.5 x 15/25= 3.9 B’s share 6.5 x 10/25= 2.6. d)  Recalculate Profits 7. A’s net profits would thus become 5 + 3.9 = 5.4. B’s net profits would thus become 2.0 + 2.6 = 4.6. The revised P & L for tax purposes would appear as: A B Sales 55.4 100 Less: Purchases (10) (55.4) Manufacturing costs (15) (20) Gross profit 30.4 24.6 Less: R& D 15 10 Operating expenses 10 (25) 10 (20) Net profit 5.4 4.6 Note 8. The example is intended to exemplify in a simple manner the mechanisms of a residual profit split and should not be interpreted as providing general guidance as to how the arm’s length principle should apply in identifying arm’s length comparables and determining an appropriate split. It is important that the principles that it seeks to illustrate are applied in each case taking into account the specific facts and circumstances of the case. In particular, it should be noted that the allocation of the residual split ...

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 ...

This case is about business restructuring and transfer of intangibles – customer list, technology, trademarks and goodwill. Cytec Norge was originally a full-fledged manufacturer that was changed into a toll manufacturer. The customer portfolio, technology, trademarks and goodwill were transferred to the related entity, Cytec Netherlands, free of charge. The court found that Cytec Norge AS had held intangibles of considerable value prior to the business restructuring in 1999, and that the Norwegian entity should have received an arm’s-length remuneration for the transfer of these rights to the related Dutch entity. The court ruled that the Norwegian tax authorities’ calculation of such remuneration and the increased income was correct. An appeal to the Supreme Court was dismissed in 2008. Click here for translation ...

In this case a pharmaceutical company in the US, Eli Lilly & Co, transferred valuable pharmaceutical patents and manufacturing know-how to its subsidiary in Puerto Rico. The IRS argued that the transaction should be disregarded (substance over form) and claimed that all of the income from the transferred intangibles should be allocated to the U.S. parent. The Judgment from the Tax Court: “Respondent’s argument, that petitioner, having originally developed the patents and know-how, is forever required to report the income from those intangibles, is without merit. Respondent ignores the fact that petitioner, as developer and owner of the intangible property, was free to and did transfer the property to the Puerto Ricanaffiliate in 1966.” The Court of Appeals altered the judgement from the Tax Court. According to the Court of Appeals, the parent company had received an arm’s length consideration for the transfer of intangibles in the form of stock in the subsidiary. Hence, the Court disallowed the allocation of the intangibles’ income to the U.S. parent ...