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Derivative Nature of Certain Delineated Controlled Transactions

Sept. 28, 2022, 8:45 AM

A meaningful intercompany agreement unambiguously allocates rights and obligations to each party. Its arm’s-length value is zero at inception, a necessity to satisfy the realistic alternative of the status quo. Some agreements require an upfront payment. Moreover, many agreements provide for a year-end transfer pricing adjustment.

Distribution agreements often involve a transfer price set at the beginning of the year but recalculated at year end to ensure that the distributor’s operating income falls within a specified range. A transfer pricing adjustment is booked when necessary. Year-end transfer pricing payments are derivative.

License agreements often express royalty payments as a function of sales. A plain-vanilla license provides for a payment as a linear function of sales; a complex license is nonlinear because of a floor and/or ceiling on sales, plus the possibility of multiple non-zero royalty rates. All such license payments are derivative. Contingent contractual provisions are also often of a derivative nature.

Definition of a Derivative Payment

A payment is derivative if its value is a function of the uncertain future value of an underlying. The underlying may be a stochastic cash flow, the random value of an asset, or any other random variable.

In the case of a distribution agreement with year-end adjustments, the underlying is typically the value of a random profit level indicator. In the case of a license, the underlying is typically the licensee’s sales.

Accurate Delineation

Accurately delineating a controlled transaction means unpacking the various components of value being exchanged and identifying the uncontrolled markets where such exchanges take place.

In the uncontrolled markets, derivative exchanges of value take place in the financial markets. They include the options markets, the forwards and futures markets, and the swap markets.

A distribution agreement with year-end adjustments is economically equivalent to a distribution agreement without year-end adjustments alongside a financial derivative controlling year-end payments. Similarly, any license, whether plain vanilla or complex, is economically equivalent to a royalty-free license alongside a financial derivative controlling royalty payments.

Valuation and the Realistic Alternatives Principle

If the relationship between a derivative payment and its underlying is not linear, then the discount rate at which to discount the derivative payment is unknown. A derivative pricing technique must therefore be used.

All derivative pricing techniques start by requiring the price of the instrument to be fair. Fair pricing means pricing such that neither party can enter a self-financed trade and make a profit with positive probability and zero probability of a loss. This trade is called an arbitrage and encapsulates the realistic alternatives principle that buying or selling the instrument must be of zero value to the parties. It is a stronger condition; although unspecified in transfer pricing regulation, derivative pricing techniques satisfy the realistic alternatives principle, as all unspecified methods must do.

Valuation of a Derivative-Controlled Transaction

Under the realistic alternatives principle, taxpayers can structure a controlled transaction that includes a derivative payment as option one, controlled by one agreement, or option two, controlled by two agreements. Option two bifurcates the leg of the transaction that concerns the exchange of real property rights absent any derivative provision from the leg that concerns the derivative provision.

What was a year-end transfer pricing adjustment controlled by a distribution agreement under option one becomes a derivative payment made under a financial derivative agreement under option two. What was a payment of royalty controlled by a license agreement under option one becomes a derivative payment made under a financial derivative agreement under option two.

It doesn’t matter whether a transaction is structured as option one or option two; the realistic alternatives principle is a valuation principle. The fact that a taxpayer chooses to structure a transaction following option one does not negate the fact that option two is a realistic alternative.

The IRS cannot recharacterize option one into option two if option one has economic substance. Similarly, the IRS cannot recharacterize option two into option one if option two has economic substance, despite option one being the option most often adopted by taxpayers. However, the IRS certainly can use option two to price a transaction structured as option one.

Conclusion

The unprecedented scrutiny of transactions shifting risk and return from one affiliate to another puts pressure on their accurate delineation. Taxpayers accurately delineating their transactions will often find payment obligations or options that are derivative. Any controlled transaction subject to a year-end transfer pricing adjustment is likely to fall into that category. Accurately delineating a transaction is essential in informing the most reliable method to price it.

To be clear, we are not suggesting that taxpayers should structure a license as royalty-free alongside a synthetic financial instrument, although it is a realistic alternative.

What we are asserting, however, is that the fair price of the license can be obtained by reference to the fair price of a synthetic of European call and put options, each priced by Black and Scholes (1973). Similarly, the fair price of a business restructuring transaction can be obtained by reference to the value of a swap agreement fairly priced by a series of forward contracts.

The same holds true with pricing contingent contractual provisions, including those allowing for any year-end transfer pricing adjustment, early termination, renegotiation or non-exclusivity. The realistic alternatives principle offers an essential tool to reliably price, at arm’s length, an accurately delineated controlled transaction under the terms of its written agreement.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Philippe Penelle is a managing director in the Transfer Pricing practice at Kroll, an independent provider of global risk and financial advisory solutions. He leverages more than 25 years of extensive experience in designing, valuing, and defending controlled transactions involving the transfer of intellectual property rights on behalf of multinational clients and their counsel.

Stefanie Perrella is a managing director and the Global Head of Transfer Pricing and leader of the New York Office at Kroll. She specializes in financial transactions transfer pricing and has more than a decade of experience establishing best practices for assessing intercompany debt and other financing arrangements for the firm’s top clients across a wide spectrum of industries.

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