Transfer pricing: intercompany alignment of intangible property

22nd Annual Health Sciences Tax Conference Transfer pricing in life sciences update: intercompany alignment of intangible property and pricing issues December 3, 2012

Transfer pricing in life sciences update: intercompany alignment of intangible property and pricing issues

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Disclaimer

► Any US tax advice contained herein was not intended or written to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.


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Disclaimer Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young LLP is a client-serving member firm of Ernst & Young Global Limited operating in the US. For more information about our organization, please visit www.ey.com. This presentation is © 2012 Ernst & Young LLP. All rights reserved. No part of this document may be reproduced, transmitted or otherwise distributed in any form or by any means, electronic or mechanical, including by photocopying, facsimile transmission, recording, rekeying, or using any information storage and retrieval system, without written permission from Ernst & Young LLP. Any reproduction, transmission or distribution of this form or any of the material herein is prohibited and is in violation of US and international law. Ernst & Young LLP expressly disclaims any liability in connection with use of this presentation or its contents by any third party. Views expressed in this presentation are not necessarily those of Ernst & Young LLP.


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Presenters

► Jon Haug Director and Tax Counsel Eli Lilly and Company

► John Hickey Senior Manager, Global Transfer Pricing Johnson & Johnson

► Lynne Sullivan

Vice President of Tax Biogen IDEC

► Cedric Bernardeau Ernst & Young LLP New York, NY +1 212 773 2165 [email protected]

► Siv Schultz Ernst & Young LLP New York, NY +1 212 773 3818 [email protected]


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Agenda

► Intangible property (IP) alignment and transfer ► Tax authority IP transfer pricing focus

► Internal Revenue Service (IRS) — income method ► Organization for Economic Co-operation and Development

(OECD) intangibles draft

► Alternative IP transfer pricing methods ► Comparable uncontrolled transaction (CUT) method ► Profit split methods ► Other IP transfer pricing methods


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Need for IP alignment

► Multinational companies have global operations that need access to IP in order to serve customers.

► These companies have options with respect to how IP rights are aligned with foreign operations: ► Options include sale, licensing, contribution or cost sharing ► Different approaches may be taken based on type of IP and geographic

market ► The need to align IP with operations and other business

considerations (e.g., supply chain and legal protection) arises in a number of contexts: ► Mergers and acquisitions activity ► Organic expansion into new markets ► Research and development (R&D) breakthroughs, new product launches ► Changes in business model and supply chain management

IP alignment and transfer


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Identify IP and other value drivers — overview ► Understand current nature and ownership of IP:

► Legal owner vs beneficial owner ► Purchase price analysis, license, service contract, other agreements ► Funding and strategic management of activities generating or protecting IP

► Understand current tax situation: ► R&D incentives ► Transfer pricing ► Tax treaty considerations (e.g., permanent establishment, qualification for benefits) ► Withholding tax planning ► Existing tax authority controversies

► Evaluate ongoing IP-related projects (e.g., IT transformation, substantial contribution, assistance analysis)


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Identify IP and other value drivers — ownership and nature of IP

► Understand relationship between or among transacting parties ► Identify role of value drivers and related intangibles ► Goodwill, going concern, workforce-in-place

► Value-adding synergies related to business activity that do not attach to any particular asset

► Common legal characteristics of an intangible asset: ► Specific identification and recognizable description ► Subject to legal existence and protection ► Subject to right of private ownership and private ownership legally transferable ► Tangible evidence of existence (e.g., contract, license) ► Created or came into existence at an identifiable time or as result of identifiable event ► Subject to being destroyed, termination of existence at an identifiable time or as

result of identifiable event


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Identify IP and other value drivers — ownership and nature of IP (cont.)

► Common tax categories of intangible assets (see Internal Revenue Code (IRC) Section 936(h)(3)(B)(i)-(v))*: ► Marketing: trade name, trademark, brand name ► Technology: patent, invention, formula, process, design, pattern, know-

how, technical data ► Art: copyright, literary, musical, artistic composition ► Systems/processes: method, program, campaign, survey, system, study,

procedure, forecast, estimate ► Engineering applications: patent, invention, formula, process, design,

pattern, know-how, technical data ► Customer relationships: customer list ► Contracts: franchise, license, contract

*IRC Section 936(h)(3)(B)(i)-(v) includes any similar item that has substantial value independent of the services of an individual.


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Transfer of IP — risks and functions

► Identify transferable IP ► Break identified value drivers into smallest component parts ► Determine which value drivers require consideration

► Evaluate from tax perspective for all interested jurisdictions (typically the transferor, transferee and transferor shareholder(s))

► Approach to IP development: ► Licensing (single owner) ► Cost sharing (multiple owners) ► Cost contribution arrangements ► Asset contribution ► Use of partnerships ► Contingent arrangements/options ► Combination


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Transfer of IP — risks and functions (cont.)

► Methods of transfer: ► Asset sale, stock sale or license (Section 482) ► Contribution to corporation or partnership (Sections 367/721) ► Assumption of key functions and risks without asset transfer

► Deemed goodwill transfer or other conversion costs

► Compensable IP transfers ► Methods:

► CUT — viable in a number of industries (see the Veritas case) ► Profit split — consider whenever IP ownership or unique skill set resides

offshore ► Income — generally required as a primary or confirming approach; can be best

method if reasonably applied ► Acquisition price

► Payments: lump sum, installments or contingent royalties


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Transfer of IP — risks and functions — methods of transfer

Method of IP transfer

Description of transaction

Form/timing of payment

Tax ownership (amortization)

Source of income (to transferor)

Sale for fixed consideration

“All substantial rights” in IP (or an undivided interest therein) for a defined geographic area (country or countries) are transferred for a non-contingent amount.

Lump sum or installments paid over useful life

Transferee Residence of transferor — Section 865(a)

Sale for contingent consideration

“All substantial rights” in IP (or an undivided interest therein) for a defined geographic area are transferred for an amount contingent on use or productivity.

Royalty (flat or declining rate) and/or milestones paid over useful life

Transferee Place of use subject to US amortization recapture — Section 865(d)

License (fixed or contingent consideration)

Less than “all substantial rights” in IP (or an undivided interest therein) are transferred for fixed or contingent amount.

Fixed = lump sum or installments; contingent = declining or fixed royalty and/or milestones; non-lump sums paid over useful life

Transferor Place of use — Sections 861/862(a)(4)


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Transfer of IP — risks and functions — methods of transfer (cont.)

Method of IP transfer

Description of transaction

Form/timing of payment

Tax ownership (amortization)

Source of income (to transferor)

Contribution to controlled corporation in exchange for shares

IP rights are contributed to controlled corporation in exchange for (actual or deemed) shares — Section 351.

Deemed license payments made to transferor for up to 20 years — Section 367(d)

Transferee (assuming no rights are retained)

Place of use — Sections 861/862(a)(4)

Contribution to partnership in exchange for partnership interest

IP rights are contributed to partnership in exchange for common interest or for common and preferred interests — Section 721.

Depends on terms of partnership interests and partnership profits; no time limits but Section 482 principles likely apply to total consideration

Transferee (assuming no rights are retained)

Look to distributable share of partnership income (foreign IP rights typically generate foreign-source income)

Contingent services arrangement; option pricing

IP is developed under contract, and consideration depends on future contingency.

Small up-front fee (premium) + larger success-based fee if future contingency met/option exercised (strike price)

Transferor initially; transferee if exercise/ future contingency met

Place of performance — likely location of R&D services

Tax authority IP transfer pricing focus


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IRS focus on IP transfers

► Controversy ► Medtronic, Docket No. 6944-11, Filed 3/23/2011

► Guidant, Docket No. 5989-11, Filed 3/11/2011

► Western Union settlement (December 2011), network intangible

► IRS to pursue litigation to limit impact of the Veritas case

► Final cost-sharing regulations ► No major changes to new methods introduced in the temporary regulations

► Limited revisions/additional guidance:

► Use of weighted-average cost of capital (WACC)

► Adjustments for tax rate differentials

► Coordinated issue paper, cost sharing, withdrawn (6/26/2012) ► Section 367(d) regulations on current IRS business plan:

► Intended to harmonize with updated Section 482 regulations

► Proposed rules to replace IP with platform contribution transaction concept

► IRS reorganization ► Establishment of LB&I Transfer Pricing Practice under Sam Maruca, adding transfer pricing

specialists as resources to IRS local audits that will focus on transfers of intangibles and high-value services


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IRS focus on IP transfers (cont.)

► IRS default valuation technique — income method ► Used to maximize intangible value ► Aggregation of intangible assets ► Expansion of definition of IP

► Chief Counsel advice on cost sharing from the IRS: (CCA201111013, dated 6/25/10, released 3/18/11) ► Rejection of the US Tax Court opinion in the Veritas case

► Previous comments from IRS National Office: ► Good comparables don’t exist for intangible transactions that shift a significant

amount of income offshore; need another way to determine arm’s length, such as the income method (summarized comments by Christopher Bello, Branch 6 Chief, IRS Office of Associate Chief Counsel (International), April 15, 2010)

► New methods introduced in temporary cost-sharing regulations could be applied to non-cost-sharing intangibles (summarized comments by Steven Musher, IRS Associate Chief Counsel (International), Dec. 11, 2009)


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Income method — Treas. Reg. §1.482-7(g)(4)

► Overview of income method ► Value of IP equal to net present value (NPV) of future flow of residual value after

routine returns are subtracted

► Considerations: ► Quality of data

► Central importance of projections ► Consistent with assumptions of method (return on future R&D)?

► Reliability of assumptions ► Discount rate (e.g., hurdle rate, WACC) ► Sensitivity to deficiencies in data ► Probability of success ► Assumptions about participant tax rates ► Note: cross-reference in Treas. Reg. §1.482-4 allows income method to be applied

to intangible transfers outside of cost sharing


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Income method — considerations

► The income method values all intangibles that drive profit in aggregate.

► What if the transaction is related to specific intangibles? ► Need to allocate projected profit to various intangibles ► May require more assumptions, which could lessen reliability ► Examples:

► Technology ► Marketing ► Customer relationships ► User relationships ► Trademarks/trade names ► Pre-existing vs future IP

► The method does not account for how parties allocate risk. ► All residual profit is assumed related to intangibles, accruing to intangible owner.


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Income method — sensitivities

► Discount rate ► Before or after tax ► Probability of success

► Growth rate for revenue and costs ► Useful life of intangible ► Routine returns ► Measurement of up-front investment


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OECD intangible draft — impact on IP transfer pricing methods

► Draft issued June 2012 ► Endorses use of financial valuation techniques based on

“discounted value of projected future cash flows” (e.g., income method)

► Endorses methods based on looking at commercial alternatives available to both parties (in other words, endorses “the realistic alternatives” principle of U.S. regulations)

► Legal and accounting definitions of intangibles are rejected in favor of emphasis on what unrelated parties, acting at arm’s length, would pay for: ► In other words, intangible is “something of value” that is not a

tangible asset or a financial asset. ► The implication is that goodwill, going-concern value and

workforce-in-place are all potentially intangibles.


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OECD intangible draft — impact on IP transfer pricing methods (cont.)

► The party that has claim to a significant return with respect to an intangible asset will typically perform significant functions with respect to the intangible asset through its own employees. ► Implication: the “cash box” is not expected to receive a premium

return. ► Effectively, the revised Chapter 6 represents an endorsement of

the IRS approach to valuation of intangibles in the new cost-sharing regulations.

► Since OECD countries are endorsing the IRS approach, it is likely the conflicts we have seen in the US over the arm’s-length value of intangibles will also be repeated.

► Commentary on the OECD draft was released on October 29, and a public hearing was held in mid-November.


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Income method — example

Source: Ernst & Young LLP


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Income method — example (cont.)

Routine return assumptions: ► Distribution, 6.50%

► Marketing, 11%

► Manufacturing, 20%

► Contract R&D, 10%



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Income method — example (cont.)

Assumption: discount rate applied, 10%


Alternative IP transfer pricing methods


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CUT method — Treas. Reg. §1.482-4(c)

► The CUT method evaluates whether the amount charged for an intangible transfer was arm’s length, relative to a comparable uncontrolled transaction.

► Generally, the CUT method compares the compensation earned by a licensor in a third-party agreement to an intercompany transaction.

► Transactions entered into by a company with third parties are key sources of data.

► If complete and accurate data exists to measure and establish the comparability of the controlled and uncontrolled transactions, the CUT method will provide the best method for determining the arm’s-length price for the IP.


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CUT method — Treas. Reg. §1.482-4(c) (cont.)

► Comparability factors: ► Comparable intangible

► Similar product or process within the same general industry ► Similar profit potential

► Most reliably measured by the NPV of the benefits to be realized as a result of the transfer of a property

► Comparable circumstances: ► Terms of transfer (i.e., exclusivity, geography, etc.) ► Stage of development of IP ► Rights to receive updates, revisions or modifications of the IP ► Uniqueness of IP and IP protection ► Duration ► Product liability risk ► Collateral transactions ► Functions to be performed

► Data and assumptions


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CUT/comparable uncontrolled price method (CUP) litigation

► Compaq ► Compaq Computer Corporation and Subsidiaries v. Commissioner

of Internal Revenue, T.C. Memo No. 1999-220

► Veritas ► Veritas Software Corporation and Subsidiaries v. Commissioner of

Internal Revenue, 133 T.C. 297 (2009)

► Xilinx ► Xilinx Inc. and Subsidiaries v. Commissioner of Internal Revenue,

125 T.C. 37 (2005), aff’d 598 F. 3d 1191 (9th Cir. 2010)


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CUT method — example



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CUT method — considerations

► Considerations: ► Milestone payments

► Can be significant ($10 million–$100 million) ► Geographic markets ► Stage of development ► Collateral transactions

► Examples: co-promotion, cross-license and development


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Profit split methods — Treas. Reg. §1.482-6

► Under these methods, an arm’s-length result is determined by comparing the relative contributions made by each of the controlled participants to the overall operating income of a transaction or business activity and allocating returns based on the relative value of these contributions. ► The relative value assigned to such contributions considers:

► Functions performed ► Risks assumed ► Resources employed


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Profit split methods — Treas. Reg. §1.482-6 (cont.)

► Residual profit split method (RPSM) ► The combined operating profit or loss from the relevant business activity is

allocated between the entities by: ► Allocating income to routine contributions ► Allocating residual profit

► Least reliable method as no arm’s-length data is used ► IRS uses RPSM to increase IP

► Comparable profit split method (CPSM) ► Applied when reliable revenue and cost data exist for uncontrolled

taxpayers engaging in similar transactions and activities ► Factors that affect comparability:

► Functions performed ► Risks assumed ► Economic conditions (profit potential) ► Property/services transferred


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Other IP transfer pricing methods

► Comparable profits method (CPM) — Treas. Reg. §1.482-5 ► Evaluates whether the amount charged is arm’s length based on profit level

indicators derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances

► In practice, identifies firms considered comparable (similar facts, circumstances, functions and risks) and compares profit levels of the firms to profit level of the tested party

► Reliability of the CPM based on the degree of comparability between the tested party and the uncontrolled firms identified

► Acquisition price method — Treas. Reg. §1.482-7(g)(5) ► Applies the CUT/CPSM to evaluate whether the amount charged for the stock or

asset purchase of an entire organization, or portion, in an uncontrolled transaction is arm’s length

► Market capitalization method — Treas. Reg. §1.482-7(g)(6) ► Applies the CUT/CPSM to evaluate whether the amount charged is arm’s length in

reference to the average market capitalization of a controlled participant whose stock is regularly traded on an established securities market


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What next?

► Further controversy ► IRS’s new transfer pricing practice ► Further guidance from IRS through revised regulations ► Finalization of OECD guidance


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Questions?

Economy & Finance

Transfer pricing: intercompany alignment of intangible property