INTM464070 - Transfer pricing: types of transactions: Intangibles: what are intangibles?

It is more straightforward to grasp the concept of transactions involving physical, or tangible, goods. If a house constructed by a property development company would be sold by estate agents to the public at £500,000 then it is easy to spot that this is the arm’s length price. It is easy to spot the provision and the underlying transaction - the sale of the house.

Business is not just concerned with the sale of tangible goods, however. The sale or exploitation of intangible property is equally important.

Questions of intangible property are perhaps the most complex in transfer pricing. The OECD Transfer Pricing Guidelines recognise this complexity by having a whole chapter on intangible property - 'Special Considerations for Intangible Property' (Guidelines Chapter VI). This section in this guidance is a discussion of some of the factors arising from intangible property that affect transfer pricing.

What is intangible property? This question raises many issues. From a transfer pricing point of view, intangible property is any property that is not tangible but is none the less still clearly property that could be exploited. This exploitation would have a value between independents.

For example a biotech company may discover a chemical compound that potentially could cure the common cold. The biotech company does not have the infrastructure or the finance to properly develop the compound and market any resulting drug. Instead it grants a licence to a large pharmaceutical multinational enterprise to develop and market the compound in exchange for a lump sum and royalties on the eventual sale of the drug. This is something that could happen between independent parties.

By contrast, a company owns know-how relating to the manufacture of personal home computers. The know-how is relatively old, and associated patents have been superseded by newer technology. In fact the technology to manufacture the PCs is now well known and easy to get hold of. The company grants an affiliate a licence to manufacture the PCs, which are then sold by other associated companies under a brand name. The manufacturer, if independent, would not be prepared to pay anything under the licence in respect of the know-how, as it could obtain it for free elsewhere.

Arguments as to whether certain provisions would have been put in place between independent persons are considered in more detail in INTM464130.

The OECD Transfer Pricing Guidelines say that intangible property includes rights to use industrial assets such as patents, trademarks, trade names, designs or models. Intangible property can also include literary and artistic property rights and intellectual property such as know-how and trade secrets.

OECD defines all such intangibles as 'business rights' - intangible property associated with commercial activities. Within this broad definition, intangibles are further divided into two areas:

Marketing intangibles, including trademarks and trade names that are connected with the exploitation of a product, customer lists, distribution channels, unique names, symbols or pictures that have some sort of promotional connection with the product. (These types of intangible are more frequently created through marketing endeavour.)
Trade intangibles, including patents, know how, designs, models for production and assets that are used in operations such as computer software. (This type of intangible is more often created through research and development endeavour.)

There are (at least) four vital, somewhat interrelated questions to ask when considering transactions involving intangible property in the context of transfer pricing.

Is there actually any intangible property needing to be considered?
If there is, who owns it?
If there is, would it be worth anything at arm’s length?
If so, what would an independent pay to use it? (Or what would an independent charge for somebody else to use it?)

All answers to these questions will always be a matter of fact and degree.

Is there actually any intangible property that needs to be considered?

Intangible property protected by some sort of legal framework demonstrably exists. Consider critically claims that other intangible property exists merely because some activity has been going on. For instance, the mere fact that a distribution company has been selling a range of goods does not mean that a marketing intangible automatically exists. The existence of a brand name will be clearer cut (the value of the brand may not be so clear) but the existence of the more opaque types of marketing intangible over and above property directly associated with a brand is always open to question. Carefully consider assertions that operations in a particular market create an intangible merely because of factors peculiar to that market. For example, the intrinsic, potential size of a market does not mean that a company operating in that market owns a valuable marketing intangible (see INTM467160 for further discussion).

Who owns the intangible property?

In some cases ownership issues can be very complicated. There are two classes of ownership. A person may have more than one type of interest in a particular asset.

Legal ownership - some intangible property such as copyrights, patents, etc. can be protected from infringement. The degree of protection will depend on the country where protection is sought. Title to the intellectual property will be registered in the name of the legal owner.
Economic ownership (sometimes referred to beneficial ownership) - intangible property is created, and in most cases the creation is an expensive process. The rewards for exploiting the intangible property should accrue to the economic owner. A person who has rights over intellectual property, such that he can exploit and develop and use it in a way that a legal owner may, but who does not have legal title, enjoys economic ownership. For example, a multinational enterprise may set up a cost contribution scheme for research and development. A central company is formed to hold the legal ownership of the fruits of R & D of three different group companies around the world. Each company incurs the same levels of expenditure and each has an equal right to exploit the fruits of the R & D carried out from the date the agreement is put in place. If a licence agreement was granted to a third party to use some of the developed know-how in return for recurrent royalties, then the royalties should be split between the three R & D companies. The central company does not have any rights to share in the royalties.

Would the property have any value at arm’s length?

Always consider the facts carefully to decide whether a third party would pay or charge for the intangible property. Valuing intangible property can be difficult, and is complicated by issues such as exploitation over a period rather than outright sale, relative values of different types of intangible property, and who created and owns the intangible property.

Even if it could be shown that intangible property does exist at arm’s length, be aware of the zero option - it may not be worth anything.

Establishing the arm’s length price for transactions involving intangible property is considered in more detail at INTM467160.

Review the facts to ascertain whether an intangible is actually being used. A company may be paying to use one brand but actually using something different. It is possible that prices for goods being sold already include a charge for intangibles. This is particularly relevant for technology-related intangibles.

What would be paid at arm’s length for the intangible property?

The price struck for intangible property between independent enterprises will reflect the dynamic between them when they negotiate.

Each party is at the opposite end of the dynamic but each will be governed by similar principles of maximising their own profit. Consider what would have happened between independents when examining a payment for intangibles between affiliates.