The Russian company LLC OTIS LIFT carries out service and maintenance activities for lifts and escalators both under the registered trademarks and designations of Otis and lifts and escalators of other manufacturers. A License Agreement was in force between the Russian subsidiary and its US parent OTIS ELEVATOR COMPANY (NJ) (Licensor). In accordance with the License Agreement, LLC OTIS LIFT should pay to OTIS ELEVATOR COMPANY (NJ) an amount equal to three and a half percent (3.5%) of the net amount invoiced by Otis Lift for Goods and Services as payment for the right to manufacture, promote, sell, install, repair and maintain Goods under the registered trademarks and designations “Otis”. Hence, the License Agreement did not provide for charging royalties from the revenue for the services provided by LLC OTIS LIFT for the maintenance of lift equipment of third-party manufacturers. Following an audit it was established that in violation of the terms and conditions of the license agreement the royalties accrued LLC OTIS LIFT in favour of the Licensor – OTIS ELEVATOR COMPANY (NJ) were calculated and paid from the total amount of all invoices issued to customers for maintenance services and not only from invoices for maintenance of goods under the trademarks. Hence the company overstated its expenses. On that basis an assessment of additional taxable income was issued. This assessment of additional income was brought to court by LLC OTIS. Judgement of the Arbitration Court The court dismissed the complaint of LLC OTIS LIFT and decided in favor of the tax authorities. Excerpts “In support of its conclusion that the expenses for the payment of royalties for the use of the designation “Otis” in the provision of services for maintenance of lifts, escalators under other trademarks and designations are economically justified, the Company provides the following arguments: during the audited period the Company used the trademark “Otis” in its corporate name in all its activities, including the provision of services for maintenance of lift equipment of third party manufacturers; However, the Court considers it necessary to note the following. In view of the fact that royalties represent an equitable payment for the right to use intellectual property, it should be noted that the formula established by the license agreement for calculating the royalty as a percentage of revenue related only to sales and maintenance of Otis-branded goods is economically justified, since Otis Group has designed, developed, improved, maintained, promoted and protected intellectual property related directly to the goods produced. Accordingly, it is reasonable to assume that it is the Otis group that has the most knowledge, the most technology and the most competence to maintain its own equipment. At the same time, there is no reason to believe that the unique knowledge of the Company’s service personnel in the design and maintenance of Otis-branded lift equipment, including from foreign group companies, gives them an unconditional advantage in repairing and servicing equipment of other manufacturers. In the course of additional tax control measures the issue of using the business reputation of the Licensor in the course of rendering services on maintenance of the lift equipment of third-party manufacturers was investigated. In particular, whether potential contractors were guided by the company’s brand, trademark, reputation of the company in the world and other characteristics when choosing the Company as a supplier of maintenance services for lift equipment. The analysis of the documents submitted by the Company’s counterparties does not establish whether the potential counterparties were guided by the company’s brand, trademark and reputation in the world when selecting the Company as a supplier of services for maintenance of lift equipment. In accordance with paragraph 1 of Art. 252 of the Tax Code of the Russian Federation, the taxpayer reduces the income received by the amount of the costs incurred. Expenses are considered to be justified and documented expenses made (incurred) by the taxpayer. Reasonable expenses are economically justified costs, the assessment of which is expressed in monetary form. Therefore, the argument that the Company’s expenses on payment of the license fees for the use of the “Otis” trademark in the course of providing maintenance services for lift equipment of third parties does not comply with the provisions of Article 252 of the Tax Code of the Russian Federation on documentary confirmation and justification of the expenses charged by the taxpayer to expenses. Regarding the fact that the Company’s use of the Licensor’s intangible assets relating to the Otis trademark had a positive effect on the cost of maintenance services for third-party lift equipment, it should be noted that the Company has not provided any evidence of this and (or) calculations of this benefit effect.” “Thus, the Company’s argument that it used OTIS know-how when servicing lift equipment of third party manufacturers rather than the requirements stipulated by the Russian legislation is unfounded. Otis Lift LLC also failed to document that in providing maintenance services for third-party lift equipment, the use of the Licensor’s intangible assets relating to the Otis trademarks gave them a competitive advantage over other manufacturers and service companies engaged in the maintenance of such equipment or had any other positive effect on the cost of services for the maintenance of third-party lift equipment. Since the Company has not provided any evidence of this and (or) calculations of such benefit effect. Thus, there is no objective connection between the incurred expenses on payment of the license fee to OTIS ELEVATOR COMPANY (NJ) and the focus of the Company’s activities on obtaining profit when providing services for repair of lift equipment of third-party manufacturers. Furthermore, the Company’s argument that the tax authority suggests the Company’s gratuitous use of the Licensor’s tangible assets is unfounded and contrary to the facts of the case, as the Inspectorate has not made any claims against the Company in respect of license fees for maintenance of lift equipment (goods) under the registered trademark “OTIS”. On the basis of the above, the applicant’s claims are not subject to satisfaction.” Click here for English translation Click here ...

In considering any one of the methods described, the tax authorities need a substantial amount of reliable information about the activities of the MNE in different countries. Sometimes, fiscal authorities may lack certain information in examining transactions of intangible property within MNEs. Tax authorities in the country of the licensee may, for example, be unaware of the terms under which the licensor has concluded similar agreements with other associated or unrelated enterprises. Tax authorities in the developer’s country may, for example, need to know the volume of sales realised by the licensee using the property and the conditions of sub-licensing contracts, if any, and the general conditions in the licensee’s market ...

It may be useful to look at the costs incurred by the licensor in developing the property. However, the actual open market price of intangible property is not related in a consistent manner to the costs involved in developing it. This is because the price will exceed cost for successful research, but the price will be less than cost for less successful or unsuccessful research. Moreover, cost for successful research may often include the cost of unsuccessful research. The uncertainties attendant on the eventual return on expenditure on R & D and the length of time during which technology will prove to be commercially usable together with the monopoly element present in patent licensing make reference to cost hazardous. Moreover, it may not be easy to determine what the costs connected with the development of a particular item of intangible property were when research is performed in a group on a large scale and for various purposes. Despite these difficulties, there may be cases where the cost-oriented method gives some guidance, at least as regards the lower limit for the licensor’s profit in normal circumstances. Looking at the costs may also be appropriate to verify a provisionally acceptable price after other methods have been applied ...

It appears that one of the common approaches employed in practice is to make a pragmatic appraisal of the trend of an enterprise’s profits over a long period in comparison with those of other unrelated parties engaged in the same or similar activities and operating in the same area. There could, of course, be many reasons for an unusual profit situation and it may be possible for the tax payers to give satisfactory explanations for particular cases. The pro fit comparison approach thus remains more in the nature of an indication that the consideration charged for the use of intangible property may or may not be reasonable. Recourse to a comparison of the proportionate profits of the licensor and the licensee achieved thanks to the development and the use of the intangible property would not be a promising method. It would be very difficult to isolate the respective profits of the licensor and the licensee since a number of rights may be under licence at the same time for the manufacturing of different pro ducts and since the accounting methods in the countries concerned may differ fundamentally. In addition there is the difficulty of knowing how to apportion the overall profit between the licensor and the licensee ...

Where a sufficiently similar transaction involving an unrelated party cannot be found, or does not provide satisfactory evidence, other methods have to be used as a means of testing whether the price actually paid by the licensee is acceptable to the tax authorities. There will be many cases of this kind and this illustrates the difficulty of the subject. In general, reliance cannot be recommended on one particular method rather than another and usually it will be necessary to take account of more than one method in reaching a satisfactory approximation to an arm’s length price ...

In arm’s length situations cases arise where the payment made to the licensor varies according to the turnover of the licensee, being perhaps at a lower rate if sales exceed a certain figure. Variations in rates may be justified also according to the extent to which the intangible property concerned has already been used by the licensee in production ...

The nature of a patent can also be important: it is likely that an entirely new and distinctive ” breakthrough ” patent will command a higher price than one either designed to improve a process already governed by an existing patent or one for which substitutes are readily available (but a breakthrough patent may also, because of its novelty, be hard to evaluate). The length of the period during which patents and know-how etc. are likely to maintain their value will also affect the amount of the payments which would be asked for the right to use them, and this period may vary widely since in some branches of industry techniques are superseded more quickly than in others. The degree and duration of protection afforded under the patent laws of the relevant countries is variable but this factor must be evaluated, bearing in mind that new patents may speedily be developed on the basis of old ones, so that the effective protection of the intangible property is prolonged correspondingly. The process of production for which the property is used and the value it contributes to the final product have to be taken into account and it would not be appropriate, for example, if the royalty for a patented invention which only covered one component of a device was calculated by reference to the selling price of the complete product. In a case where an invention covers only one part of a complicated machine, a royalty of a small proportion of the selling price of that machine may seem reasonable at first sight but may well be exorbitant if this component is measured by reference to the value of other components and if its impact on the final product is compared to the impact of other parts. If the licensee has the right to participate in further developments by the licensor or if, on the contrary, the licensee is under the obligation to impart further improvements of an invention, or other intangible, to the licensor, these circumstances will influence the level of the payment made for the original patent or know-how ...

In using evidence provided by comparable transactions in seeking to arrive at an acceptable price for tax purposes in relation to an intra-group licence contract, it is necessary to take all the circumstances into account. This is as much the case where the evidence is provided by transactions between completely unrelated parties as in other circumstances. It is necessary for example to take account of the following factors. The expected profits and conditions in the relevant market can affect the amount, and account needs to be taken for example of the possibility that the fee paid in one market may not reflect the arm’s length price in another. The terms on which the transfer of the intangible property is mad need to be considered; limitations on the geographic area in which rights may be exercised, export restrictions on goods produced by virtue of any rights transferred, and the exclusive or non-exclusive character of any rights granted may affect the amounts payable (the amount of the consideration to be paid by the licensee may be expected to be higher, for example, if an exclusive right is conferred than if there are restrictions or limitations on its use). The value of services such as technical assistance, training o{ employees and so on, rendered by the developer in connection with the transfer have to be allowed for, as may the capital investment (to construct new plants or to buy special machines), the starting-up expenses and the development work required of the transferee, if any ...

In determining the amount of an arm’s length consideration, the standard to be applied is the amount that would have been paid by an unrelated party for the same intangible property under the same circumstances. An arm’s length consideration may sometimes be determined by looking to licence contracts that the same developer has concluded with unrelated parties involving the same or similar intangible property under the same or similar market conditions. Likewise, the offers to unrelated parties or the genuine bids of competing licensees, could be considered when the data exist. Where the user sub licenses the property to third parties, the price paid by the latter may be relevant. The amount of the consideration for similar transactions between unrelated enterprises in the same industry may also be a guide to the arm’s length rate, but appears to be infrequently used. In many cases, it will be difficult to find satisfactory comparable open market transactions since the owner of intangible property (and particularly the owner of a patent) is essentially the owner of a monopoly right which he may not make available to unrelated enterprises. It is considered that it is unlikely to be possible to construct any standard rates, such as a certain percentage of sales, as even within a given sector of industry it is extremely difficult to discern any typical rate or range of rates ...

The compensation for the use of intangible property may be included in the price charged for the sale of goods when, for example, one enterprise sells unfinished products to another and, at the same time, makes available its experience for further processing of these products. Whether it could be assumed that the transfer price for the goods includes a licence charge and that, consequently, any additional payment for royalties would ordinarily have to be disallowed by the country of the buyer, would depend very much upon the circumstances of each deal and there would appear to be no general principle which can be applied except that there should be no double deduction or double charge for the provision of the technology ...

Where payments are made in respect of the use of intangible property in intra-group situations, they should be in a form which is compatible with the form which would be adopted in transactions bet ween unrelated parties under the same circumstances, though it has to be taken into account that there are a number of forms which might be adopted in an arm’s length situation. Usually, a royalty or a know­how fee would be paid, that is, a recurrent payment based on the user’s output, sales or, in some circumstances, profits. When such royalty-payments are based on the licensee’s output or sales a degressive payment would be acceptable to tax authorities if this would be usual between independent parties. The consideration may also take the form of a lump-sum payment, sometimes combined with a recur rent ·payment. Enterprises may also agree on reciprocal licensing rights ...

The general principle to be taken as the basis for the evaluation for tax purposes of transfer prices between associated enterprises under contracts for licensing patents or know-how is that the prices should be those which would be paid between independent enterprises acting at arm’s length. It follows from this that such transactions should not be treated differently for tax purposes from similar transactions between independent parties solely by virtue of the fact that the enterprises are associated. Thus, if payments for the use of intangible property are deductible for tax purposes when made between unrelated parties, similar payments made in similar circumstances bet ween associated enterprises ought to be treated similarly. Also, in conformity with Article 24 of the OECD Model Double Taxation Convention a deduction should not be refused on the grounds that the payment is made to a non-resident. On the other hand, it seems hardly likely in an arm’s length situation that a licensor would waive or defer payment of royalties due to financial difficulties of the licensee. The licensor would usually be entitled to withdraw the right to use the relevant property ...

Whilst it has to be demonstrated that the patent, or know how, in question is in fact useful for the particular needs of the enterprise paying for them and that a real benefit is thereby conferred, this point should not be confused with the separate matter of the calculation of what is the appropriate rate of the payment to be made for that benefit ...

Payments under licensing agreements would be allowed as a deduction for tax purposes only if a real benefit had been conferred, or could be reasonably expected at the time of the conclusion of the contract to be conferred, on the licensee. It would normally be expected that a licensing agreement should be concluded in writing defining as closely as possible the nature of the intangible property which is involved, and hence providing a basis for assessing the benefit conferred. In addition, the taxpayer would have to produce all the evidence needed by the tax authorities to check if a benefit had in fact been conferred on him as licensee in the particular case. Itis clearly important to determine what is the underlying reality behind an arrangement irrespective of the latter’s formal aspect ...

Intra-group contracts licensing patents or know-how are frequently concluded between a parent company, as the developer who has borne the entire costs of the development, and one or several of its subsidiaries. Where MNEs have formed research units in different countries, members may also license the intangible property they have developed to the parent or to other members, although R & D would normally be undertaken on behalf of the parent company. Reciprocal licensing (cross-licensing) is not uncommon, and there may be other, more complicated arrangements as well. For tax purposes, the arrangements made between members of MNEs should correspond to those that would be made between parties unrelated to each other ...

As already noted, there are numerous ways of making intangible property available, but three main methods may be distinguished for tax purposes. A developer may recoup costs for R & D activities by requiring payments from another party for the latter’s use of patents and know-how once they are developed. This is discussed in Sub section A. Another entirely different concept consists of contributing to the cost of R & D. Various forms of cost contribution arrangements are dealt with in Sub-section B. If research is performed by an enterprise at the specific request of another enterprise to which that property then developed is assigned, this may often be regarded simply as a service rendered by that developing enterprise and, if so, the payments made for the research may be more appropriately treated as fees for services (see Chapter IV) ...

A know-how contract and a service contract may be dealt with differently in a particular country according to its internal tax legislation or to the tax treaties it has concluded with other countries. Thus, in the United States the regulations for the allocation of income differ fundamentally in the two cases. A charge reflecting fair market value would be required for transfers of intangible property (unless a cost sharing arrangement was concluded), whereas only cost has to be charged for the rendering of services (except if the services are an integral part of the business activity of one of the contracting parties or if they are rendered in connection with the transfer of property other than under a cost sharing agreement). In several countries, whether or not a withholding tax is levied on payments made to non-residents depends on the way an agreement is viewed. If the payment is seen as service fees, it is usually not taxed in the country of origin unless the receiving enterprise carries on business in that country through a permanent establishment situated therein. On the other hand, royalties paid for the use of intangible property are subject to a withholding tax in some countries ...

It may be important for tax purposes to distinguish clearly a transfer making available the use of know-how to another party, from technical assistance or similar activities which constitute personal ser vices. Again, the Commentary on Article 12 gives some indications that may be helpful in this respect : ” In the know-how contract, one of the parties agrees to impart to the other, so that he can use them for his own account, his special knowledge and experience which remain unrevealed to the public. It is recognised that the granter is not required to play any part himself in the application of the formulae granted to the licensee and that he does not guarantee the result thereof. This type of contract thus differs from contracts for the provision of services, in which one of the parties undertakes to use the customary skills of his calling to execute work himself for the other party “. Examples of personal services would be pure technical assistance, an opinion given by an engineer, a lawyer or an accountant and services in connection with the sale of goods, such as after-sales services or services rendered by a seller to the purchaser under a guarantee. However, in practice, it is often very difficult t9 determine where the exact border line lies as most know-how contracts include a service element ...

A patent gives a legally protected monopoly right to an invention. The term know-how is perhaps a less precise concept. The Commentary on Article 12 of the OECD Model Double Taxation Convention – paragraph 12 – gives the following definition : ” Know-how is all the undivulged technical information, whether capable of being patented or not, that is necessary for the industrial reproduction of a product or process, directly and under the same conditions; in as much as it is derived from experience, know-how represents what a manufacturer cannot know from mere examination of the product and mere knowledge of the progress of technique “.-Know-how thus may include secret processes or formulae or other secret information concerning industrial, commercial or scientific experience which is not covered by patent ...

MNEs therefore recoup their costs of R & D and allocate their profits in various ways for various reasons. In doing so, they may create problems for national tax authorities. The transfer pricing system or the cost allocation method agreed upon within an MNE need not necessarily provide an acceptable basis for the determination of profits for tax purposes in each of the countries concerned. The respective tax authorities have to consider if, and to what extent, such payments need to be adjusted for tax purposes ...

The pricing policies adopted by MNEs in relation to intra group transfers of intangible property present a number of difficulties for national tax authorities since the terms and conditions of such transfers may not correspond to the economic realities but may be used – partly because of the differences of national tax systems – as a means of shifting profits between members in order to alleviate the overall tax burden of the MNE. Tax considerations may themselves determine the way in which R & D expenditures are recovered as well as the form and amount of a transfer price or of a cost allocation – particularly, for example, where the tax laws of a particular country treat one kind of payment differently from another by allowing or refusing a deduction or by requiring, or not requiring, certain kinds of payment to be made under deduction of withholding tax and also where one of the associated enterprises operates in a country with a lower tax rate than that in which the other operates or in a country with no tax at all. On the other hand, as pointed out in paragraph 2, tax considerations may be outweighed by other factors ...

The manner in which expenditures on R & D (including the cost of unsuccessful projects) are recovered varies according to the circumstances. Part will be obtained from the sales of the goods which benefit from the results of successful R & D expenditure; part will come from sale and licensing of successful items of intangible property to related, or unrelated, parties. In both cases, taxable profits accrue to the entities using the results of their R & D against which the costs involved can be offset. R & D activities within multinational enterprises are organised and financed in various ways. In some multinational enterprises R & D is undertaken by one or more members, the results being made available to the other members mainly by way of licensing contracts; in such a case, R & D expenditures will not be recouped until such time as any intangible property is developed. Other MNEs find it convenient to adopt varying forms of cost contribution arrangements (such as those considered in Subsection B below) for allocating R & D expenses (and sometimes other expenses like services and overheads)l among the different members participating in the agreement; in such a way, R & D expenditures can be recouped before any item of intangible property is developed. It may occur also that R & D is undertaken at the specific request of one member ...

At each stage in the R & D process, the final commercial bene fits to be derived remain uncertain, though no doubt more so at the research than at the development level, and the degree of risk involved makes it difficult to estimate benefits from the outlays made which, in the event that some R & D projects prove successful commercially, will only materialise in the future. Moreover, MNEs will understandably seek to recoup the cost of financing unsuccessful research from the results of successful research ...

In most sectors of industry, it appears that it is the larger enterprises, though not necessarily the largest, that spend proportionately more money on R & D activities and, in particular, R & D is a sine qua non for the MNE for which the penetration of new markets and competition in already-established markets depend very much on success in product renewal and innovation. It does not appear that there are any considerations of general validity which explain the level or the growth of R & D expenditure in an industrial group. This reflects the diversity of products which MNEs manufacture and sell and of the industries they are engaged in, some being technology intensive (for example, computers and aerospace) some not (for example, distribution of food and clothing ; also the degree and pattern of integration and the autonomy allowed to the various members of the group may vary. But in all cases, a successful R & D activity is a prerequisite for the growth and profitability, and even for the continued existence, of the industrial group. The actual size of R & D budgets depends on a variety of factors, including the policy of competitors or potential competitors, the expected profitability of the research activity, and the trend of profits (the research activity possibly rising if profits shrink); or considerations based on some relation to turnover, or an assessment of the yield from R & D activity in the past as a basis for fixing future expenditure levels ...

Transfers of technology raise problems of particular importance as the relative items of intangible property, such as patents and know-how, may be the result of long-lasting and expensive R & D undertaken by the parent company alone or by some, or all, of the associated enterprises in an MNE. To remain competitive, industrial groups have to devote considerable resources to research – whether fundamental or applied – and development. Basic research is of great importance. There have been many instances where private groups have helped to advance the limits of scientific knowledge as a result of basic research sometimes undertaken with only the broadest commercial objective in view. As to applied research, such activities will be oriented to the solution of fairly immediate, and well-defined, problems whose commercial potential is perceived by the enterprise which undertakes it. In the development phase of research, specific commercial objectives are clearly uppermost and will concern such activities as the building of prototypes and pilot plants or the design of new equipment, or the redesigning of already existing models ...

In considering payments for research and development (R & D) in this Chapter, a distinction is made between individual transfers of particular patents and know-how and more general arrangements for making the benefits of R & D available to members of an MNE, and this Chapter considers how far different methods of payment for these benefits are appropriate. The question of whether a payment can be allowed as a deduction in arriving at profits for tax purposes is related to the reality of the benefit which the payer has received or may be expected to receive from the rights, know-how, research activity, etc. for which the payment was stated to be made. It is explained that the amount of any payment has to be calculated for tax purposes on the arm’s length basis and a number of ways in which this may be attempted are reviewed, setting out what seem to be the main factors to be taken into account in the process and attempting to provide some guidance as to the effect which these factors may be expected to have in the calculation ...

The term “intangible property ” covers industrial property rights (such as patents, know-how, trademarks, trade names, designs or models) as well as literary and artistic property rights (copyrights). This Chapter concentrates on problems involving patents and know­how and trademarks as these are of most concern to tax authorities in connection with the taxation of MNEs. A transfer of intangible property can be made in various ways. Only the use, and not the sale, of rights is discussed, though there may be cases where it is difficult to determine whether a right is sold outright or merely made available to another person for a limited period of time. Section I deals with transfers of technology. Payments for rights to use patents and know-how developed by one member of an MNE for other members are discussed in Sub-section A. Cost contribution arrangements among associated enterprises for research and development expenditure are treated in Sub-section B. The transfer of the right to use trademarks and trade names is dealt with in Section II ...