On June 21, the OECD released its report entitled “Guidance for Tax Administrations on the Application of the Approach to Hard-to-Value Intangibles” (hereafter, “The HTV Report”). This report was a follow-up effort from the recommendation under BEPS Action 8 in the 2015 Final Report: Aligning Transfer Pricing Outcomes with Value Creation (“2015 Final Report”). Enclosed is a summary of the report’s findings.
Hard-to-value (“HTV”) intangibles are defined in the 2015 Final Report as follows:
6.189 The term hard-to-value intangibles (HTVI) covers intangibles or rights in intangibles for which, at the time of their transfer between associated enterprises, (i) no reliable comparables exist, and (ii) at the time the transactions was entered into, the projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain, making it difficult to predict the level of ultimate success of the intangible at the time of the transfer.
There are a number of ways to value intangibles, but often it involves the use of royalties/licenses, a lump-sum amount, or some combination of the two. Obviously, with newer technologies, there often might be a lack of commerciality which renders the finding of comparables extremely difficult. In addition, while a company may attempt a discounted cash flow model of the likely benefits of exploiting an intangible, from a practical perspective, economic models of newer technologies will be rife with uncertainty and based on assumptions that may be difficult to make and thus will be subject to change.
The primary issue is that actual ex-post results may differ from the original projected ex-ante figures, sometimes to a significant degree. The question for taxation authorities is to what degree they can propose audit adjustments under such circumstances.
We could summarize the possibilities as follows:
- any difference between ex-ante and ex-post results should be eligible for an adjustment;
- differences between ex-ante and ex-post can be adjusted on a probabilistic, risk adjusted manner;
- only previously-defined large differences between ex-ante and ex-post are adjusted; or
- differences between ex-post and ex-ante do not bring rise to an adjustment, so long as ex-ante projections were reasonable at the time.
In a pre-BEPS world, option d) was often employed by tax authorities (with the primary exception being the United States who still continues to use a commensurate-with-income rule when examining intellectual property). Option a) seems unfair and inconsistent with the arm’s length standard since third parties in the real world cannot often change terms of the agreements simply because actual results differ from expectations.
The recommendations in the HTV Report are a blending of options b) and c). In other words, first the tax authorities must assess the reasonability of whether actual results could have been forecasted at the time the agreement was made. In most cases, the answer to this will be yes, although I can see some outlier cases where results (either good or bad) could not have been reliably foreseen by either party at the time a contract was struck. Assuming the answer to above question is yes, then the actual results should have been reflected as a possible scenario when the forecasts were made. When forecasting, it is common to run both optimistic and pessimistic scenarios (and some in between). The final forecast may blend these scenarios together using a probabilistic approach (e.g., a company may forecast there is a 20% chance of a pessimistic scenario occurring). In addition, the forecasts should be adjusted for risk. This is often achieved through adjusting the discount rate upwards to reflect higher risk (or conversely lower to reflect lower risk). Thus, the fact that actual results differed from forecast results should at worst, only result in a partial adjustment (since the other scenarios forecasted originally should still be given some degree of weight).
Paragraph 6.193 (iv) of the 2015 Final report deals with materiality measurements, limiting adjustments to those that have the effect of “…reducing or increasing the compensation for the HTVI by more than 20% of the compensation.” The other exemptions noted Paragraph 6.193 must also be considered:
- Ex-ante projections were reasonably considered, probabilistically-weighted and risk adjusted, and the difference between ex-ante and ex-post results was due to developments that could not have been foreseen by either party at the time the projections were made (or alternatively, the developments were considered but ranked as a low-probability event, which at the time the forecast was made would have been a reasonable assumption by either party);
- The transfers were covered under a bilateral or multilateral Advance Pricing Agreement;
- A commercialization period of greater than five years has past since the intangible was first transferred and where the differences between actual and forecast results (as noted above in point (i)) was not greater than 20% of the projections for that period.
The HPV Report provides additional guidance not found in the 2015 Final Report:
- Ex-post results can be used by tax authorities to assess the reasonableness of the original assumptions used when the forecast was made;
- Price adjustment clauses or contingent payments should be considered when proposing adjustments;
- Tax authorities should apply audit practices that are timely with respect to assessing evidence regarding ex-post results.
The guidance provided in the HTV report is meant to provide uniformity on how HTV intangibles are assessed and audited such that the interests of taxation authorities and fairness to the corporate taxpayer are equally considered and applied.