The OECD first introduced the term “hard to value intangibles” (HTVI) in 2013 as part of its ongoing efforts to revise transfer pricing guidance related to intangibles with a definition provided in paragraph 6.189 of the OECD Guidelines. Action 8 of the OECD’s BEPS action plan mandated the development of transfer pricing rules for transfers of HTVI. In June 2018, the OECD released the OECD Guidance for Tax Administrations on the Application of the Approach for HTVI Intangibles (the “HTVI Approach”).
HARD TO VALUE INTANGIBLES AND PERCEIVED INFORMATION ASYMMETRY
The HTVI Approach codifies a perception that various tax authorities have regarding the information available to taxpayers at the time of entering into transactions involving intangibles with values that are highly uncertain.
By definition, an HTVI is an intangible for which a comparable uncontrolled transaction (CUT) does not exist and for which projections will be necessary. When transferring HTVI, the parties involved generally prepare a valuation that relies on assumptions based on knowledge, expertise, or insights into the business environment in which the intangible is developed or exploited that by their nature are somewhat subjective and speculative. The use of projections to value HTVI necessarily yields values that are heavily dependent on those assumptions, and tax authorities are concerned that taxpayers could potentially make assumptions that yield favorable values for the intangibles being transferred based on inappropriate assumptions. The use of inappropriate assumptions would necessarily be hard for tax authorities to detect, given the information asymmetries that exist between tax authorities and taxpayers. The OECD introduced the HTVI Approach as a way to bridge that perceived asymmetry.
As a solution, the HTVI Approach suggests the consideration of ex-post outcomes as presumptive evidence regarding the appropriateness of the ex-ante information used by the taxpayer in an HTVI transaction. Under the HTVI Approach, tax administrations may use ex-post outcomes to consider the reasonableness of any income or cash flow forecasts, probability weightings, and other assumptions used in the valuation at the time of the transaction.
Taxpayers are rightfully concerned about the potential for abusive uses of ex-post information by tax authorities seeking to re-price intangibles using information that was unknowable at the time of the transaction. The OECD Guidance states that the ex-post information is allowed to be used as presumptive evidence, but also states that presumption is rebuttable if the taxpayer is able to demonstrate that the projections appropriately reflected what was reasonably known or knowable at the time the transaction was entered into. Any ex-post outcomes that could not have been reasonably foreseen at the time the transaction was entered into by the taxpayer cannot be considered. There is an inherently subjective nature to this guidance, thus creating the potential for disputes between taxpayers and tax authorities when determining whether ex-post information could have been known or reasonably foreseen by the taxpayer at the time of the HTVI transaction.
SELECT JURISDICTIONS’ APPROACH TO THE USE OF EX-POST INFORMATION
Canada’s Framework on HTVI and the Use of the Ex-Post Outcomes (Hindsight)
Canadian tax and valuation governing bodies are both in agreement that the use of hindsight to determine fair market value of intangibles is not appropriate. However, the use of hindsight or ex-post outcomes can be used to assess the reasonableness of ex-ante assumptions that went into the valuation of an intangible.
The Canadian tax authority, Canada Revenue Agency (CRA), issues publications called information circulars (IC). These ICs are not legally binding laws or regulations, but do summarize the CRA’s views on various tax subject matters. IC 87-2R was published on Sept. 27, 1999 (and was canceled as of Dec. 30, 2019) and addressed the topic of international transfer pricing. Part 5 of IC 87-2R addressed intangible property, with paragraph 149 stating:
“Despite the difficulty in determining a transfer price for intangibles, using hindsight to determine their value is not appropriate. Under the arm’s length principle, an agreement that is, in substance, the same as one into which arm’s length parties would have entered, would not usually be subject to adjustment by a tax administration as a result of subsequent events. Therefore, it would be inconsistent with the arm’s length principle for a tax administration to require, or accept, an adjustment solely on the basis that income streams or cost savings differ from those initially estimated by the parties. However, the Department may consider factors that a reasonable person with some knowledge of the industry would have taken into account at the time the valuation was projected.”
In addition, in the Introduction to Business Valuation Level I Fall 2018 Edition, the Canadian Institute of Chartered Business Valuators (“CBV Institute”) state:
The courts have consistently held that hindsight should not be used in determining fair market value. However, the courts have held that hindsight can be used to: (1) test the validity of assumptions made at the valuation date with respect to future events and (2) obtain a better understanding of facts or conditions which already existed at the valuation date.
The viewpoints expressed by the CRA and the CBV Institute expressed above are generally consistent with the HTVI Approach put forth by the OECD.
U.S.’s Framework on HTVI and the Use of Ex-Post Outcomes (Hindsight)
When the BEPS project was first being promulgated and discussed, many wondered if there would be any consideration of a principle similar to the commensurate with income (CWI) standard in the U.S. Transfer Pricing Section 482 Regulations (“Section 482 Regulations” or “Treas. Reg.”). Contextually, when discussing transfers of intangible property, Treas. Reg. 1.482-4(f)(2)(i) states:
“If an intangible is transferred under an arrangement that covers more than one year, the consideration charged in each taxable year may be adjusted to ensure that it is commensurate with the income attributable to the intangibles…The determination in an earlier year that the amount charged for an intangible was an arm’s length amount will not preclude the district director in a subsequent taxable year from making an adjustment to the amount charged for the intangible in the subsequent year. A periodic adjustment under the commensurate with income requirement of section 482 may be made in a subsequent taxable year without regard to whether the taxable year of the original transfer remains open for statute of limitation purposes.”
Historically, the periodic adjustment provisions have allowed the IRS to apply hindsight toward intellectual property (IP) valuations. It should be noted that in the view of the IRS, CWI is a one-way street to be applied by the IRS (and not unilaterally by taxpayers). This means that, effectively, the enforcement of the CWI provisions allow only for an increase to the U.S. tax basis. This again reflects the view that the periodic adjustment provisions are resolving information asymmetry (which works to the disadvantage of the IRS). It should be noted that taxpayers can protect their ability to adjust compensation downward based on actuals if their agreements reflect a symmetrical sharing of upside and downside risk. That is, if a taxpayer has an agreement that subjects intangible compensation to differences between projected and actual results, this kind of risk allocation may be respected. However, committing to this requires taxpayers to make adjustments that may be unfavorable if actuals are better than expected.
In both the Section 482 Regulations and the OECD Guidelines, there are exceptions or conditions that protect taxpayers from the application of adjustments based on ex-post information. With respect to transfers of IP under Treas. Reg. 1.482-4(f)(2)(ii)(A)-(B), the application of the CUT method, whether using the same intangible or comparable intangibles, may result in no adjustment being implemented. Further, if the controlled taxpayers could demonstrate the following:
- written agreement was entered into which was effective for the taxable year in question;
- the consideration was deemed arm’s-length;
- relevant supporting documentation was prepared contemporaneously with the execution of the agreement;
- there were no substantial changes in functions performed by the transferee after the execution of the agreement, and
- the total profits actually earned or the total cost savings realized by the controlled transferee from the exploitation of the intangible in the year under review was not less than 80% nor more than 120% of the prospective profits or cost savings that were foreseeable (or +/- 20% threshold);
then an adjustment would not be applied (see Treas. Reg. 1.482-4(f)(2)(ii)(C)). Further, Treas. Reg. 1.482-4(f)(2)(ii)(D) notes that extraordinary events that could not be reasonably anticipated may also result in no adjustment, if all other requirements are met by the taxpayer. Finally, Treas. Reg. 1.482-4(f)(2)(ii)(E) states if the outlined requirements are met for each year of a five-year period beginning with the first year in which substantial period consideration was required to be paid, then no periodic adjustment is made in any subsequent year.
Paragraph 6.189 of the OECD’s HTVI Guidance adopts a very similar set of conditions that yield exemption from adjustments based on ex-post information, including boundaries on the level of the size of difference between projections and actuals, as well as on length of the commercialization period for the HTVI, among others.
It is important for taxpayers to understand these exemptions, because with the implementation of certain steps, taxpayers may be able to alleviate risk of future pricing adjustments surrounding intangible and HTVI transfers.
Other Jurisdictions’ HTVI Framework and Use of Ex-Post Outcomes (Hindsight)
Action 8 of the OECD’s BEPS action plan has been far-reaching and has impacted the way in which countries worldwide treat HTVI transactions. For example, in countries such as Greece and the U.K., while local legislation does not provide for special transfer pricing measures on HTVI, these countries effectively incorporate any guidance within the OECD Guidelines, and therefore the OECD’s HTVI approach is indirectly incorporated into legislation. In other instances, local legislation has been directly impacted based on the OECD’s guidance on HTVI. In March of 2019, Japan’s National Diet passed a tax reform bill, which amended Japan’s transfer pricing rules to comply with BEPS Action 8 treatment of HTVI. Per the amendment, in situations when ex-post outcomes give a result different from the ex-ante pricing arrangement for the arm’s-length pricing of HTVI transactions, the Japanese tax authority would be able to make a tax assessment based on the arm’s-length price measured by the most appropriate method to reach an arm’s-length price of HTVI transactions, taking into consideration ex-post outcomes and the probability of events to bring such discrepancy (unless exemptions are applied).
CASE STUDY EXAMPLE
Given the relatively new nature of the HTVI guidance, substantiated evidence around how taxing authorities will ultimately audit and analyze HTVI transactions is not yet available. However, there have been U.S. Tax Court opinions related to the CWI principle, which can provide potential insight into a taxing authority’s approach to HTVI. An illustrative example regarding the practical application of CWI guidance is listed below. The facts and recommendations are for expository purposes only and should not be taken as prescribing arm’s-length arrangements in actual cases or industries.
Duff-Beverage Inc. (DBI) is a U.S.-based multinational beverage manufacturing and distribution company. Based on business needs and considerations, DBI decided to transfer certain intellectual property from the U.S. to its entity, Duff-Beverage Netherlands B.V. (DBN), located in the Netherlands. Given this decision, DBI needed to establish the price at which the IP should be transferred from U.S. to Netherlands to ensure the intercompany transaction was conducted at arm’s-length. As such, DBI underwent a thorough and detailed process to prepare financial projections attributable to the transferred IP over its estimated remaining useful life (which in this case was perpetual) to then determine the present value of the projected income using an appropriate discount rate for intangibles. As part of this process, DBI documented the considerations around each assumption, and performed a sensitivity analysis using a range of discount rates under varying risk scenarios to understand the resulting impact on the IP value. Based on this analysis, DBI and DBN mutually agreed upon an appropriate value for the IP being transferred.
Further to this detailed analysis, DBI decided to test the projections used in the valuation analysis against the actual income earned every year to determine if the difference was within a +/-20% threshold, which are consistent with those applied for examination of adjustments as part of Treas. Reg. 1.482-4(f)(2)(ii)(B)(6). The results of this annual process were documented to test the reasonableness of the projections and the assumptions made in the valuation analysis.
Three years after the IP transfer, the IRS audited DBI, and had particular focus on the transfer of IP from the U.S. to Netherlands. As part of the audit, the IRS requested, and DBI provided, the detailed documentation of the valuation analysis as described above, including any decision-making on the assumptions used at the time of the transfer. Further, DBI provided the results of the annual testing process of the projections to actual income earned and demonstrated the differences to be within a +/-20% variation. Upon review, the IRS found there was sufficient evidence of the reasonableness of the assumptions and projections used in the analysis and determined that no adjustment was needed.
HOW TO COMBAT HTVI CONCERNS
Due to the expected increase in the number of tax disputes regarding IP value and scrutiny on the classification and valuation of IP, taxpayers should consider taking proactive steps to mitigate against potential effects of the proposed HTVI guidance. One approach is to carefully document forecast assumptions and inputs (i.e. useful life assumptions, macroeconomic trends, market growth, industry growth, etc.) made at the time the transaction was entered into so that such assumptions are readily available upon request from tax authorities. It is best, wherever possible, to rely on projections that the business is using for other (i.e. non-tax) purposes, as such projections will have a higher perceived credibility as a starting point than projections that are made exclusively for the purpose of an intercompany intangible transfer. Business projections also will have the benefit of reflecting the knowledge of people closest to the business operations (and should reflect their understanding of business and market conditions). It is important to explain how any reasonably foreseeable risk was considered and incorporated into these forecasts at the time of the transaction. In addition, where possible, taxpayers should corroborate the results using a secondary method or approach to solidify the assumptions made and resulting conclusions of the valuation analysis.
It is also recommended that taxpayers document the differences between actual and forecasted outcomes on a regular basis. This will help justify that the differences were primarily due to unforeseeable events at the time of the valuation. Taxpayers may also consider incorporating a CWI or HTVI clause into intercompany agreements related to IP transfers, which would allow for adjustments to be made by the taxpayer under the CWI and HTVI regulations based on actual outcomes and improve transparency between the relevant parties and tax authorities.
Monitoring the differences between forecasts and actuals periodically after the valuation date will allow taxpayers to assess the likelihood of potential audit issues related to the IP transaction. In the case of a divergence, understanding the source of that divergence relative to what was expected could help the taxpayer make the case that such changes were not reasonably foreseeable. If complete documentation on the reasoning behind the initial assumptions is maintained, it will allow the taxpayer to be in a better position to discuss why there is a discrepancy between forecasts and actuals during an audit.
In conclusion, the interpretations of HTVI and the use of hindsight by tax authorities have not yet fully come to light. Tax authorities will be tempted to use hindsight in more than just exceptional cases. There are not yet large bodies of evidence on how HTVI will be implemented by tax authorities or interpreted by courts or other judicial authorities. However, it is clear that there will only be increased scrutiny on the classification and valuation of intangibles going forward, so the more the taxpayer can document their decision-making regarding the valuation analysis on an ex-ante basis, the better.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Susan Fickling-Munge is a managing director and Sarah Stauner is a vice president in the transfer pricing practice at Duff & Phelps in Chicago.