Analyzing Intangibles.Cite Slc.May 7 2012

The Judge Building
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www.lhwplaw.com

Analyzing the Intercompany
Transfers of Intangible Property

Council for International Tax Education
May 7, 2012 Peyton H. Robinson
The Grand America Hotel (801) 746-6300
Salt Lake City, UT probinson@lhwplaw.com

Notice

► These slides are for educational and discussion purposes
only.

► 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.

Page 2 Analyzing the Intercompany Transfers of Intangible Property

Agenda

► What is “intangible property”?
► How does it interact with IRC § 197 and § 367(d)?
► What is the significance of the legal owner?
► What transfer pricing methods are available?
► Focus on the CUT, CPM, and profit split methods
► Analytical example involving intangible property


Potential Goals of Intangible Property
Management
► Place income related to the IP in low tax jurisdiction
► Reduce effective tax rate
► Increase earnings per share
► Integrate tax and business strategies
► Intellectual asset management
► Risk management
► Enhance ROI on process re-engineering


IP management – Methods and
Techniques
► Existing intangibles
► Sale or license = § 482
► Contribution = § 367(d)
► § 1031 exchange (see § 1.482-1(f)(1)(iii) and PLR 9222005)
► Developing intangibles
► Cost sharing (with/without contributions, options)
► Contract R&D, marketing services
► Acquired intangibles
► Initial ownership


What is
Intangible Property?


What is Intangible Property and Why Does
it Matter?
► Definitions matter – determines if the rules apply and how
► Core question: Is the intangible property subject to § 482?
► IRC § 482: In the case of any transfer (or license) of
intangible property (within the meaning of § 936(h)(3)(B)),
the income with respect to such transfer or license shall
be commensurate with the income attributable to the
intangible.
► CWI Standard
► Reference to IRC § 936


IRC § 936 – Puerto Rico and Possession
Tax Credit
► Definition of intangible property in § 936(h)(3)(B):
► The term "intangible property" means any--
(i) patent, invention, formula, process, design, pattern, or know-how;
(ii) copyright, literary, musical, or artistic composition;
(iii) trademark, trade name, or brand name;
(iv) franchise, license, or contract;
(v) method, program, system, procedure, campaign, survey, study,
forecast, estimate, customer list, or technical data; or
(vi) any similar item,
which has substantial value independent of the services of any individual.
► References to § 936 in §§ 482 and 367
► § 367(a) – transfer of property from the US
► § 367(d) – special rules for transfers of intangible property


Intangible Property Under IRC § 482
Regulations
► Treas. Reg. § 1.482-4(b):
(b) Definition of intangible. For purposes of § 482, an intangible is an asset that
comprises any of the following items and has substantial value independent of the
services of any individual –
(1) Patents, inventions, formulae, processes, designs, patterns, or know-how;
(2) Copyrights and literary, musical, or artistic compositions;
(3) Trademarks, trade names, or brand names;
(4) Franchises, licenses, or contracts;
(5) Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts,
estimates, customer lists, or technical data; and
(6) Other similar items. For purposes of § 482, an item is considered similar to those
listed in paragraph (b)(1) through (5) of this section if it derives its value not from its
physical attributes but from its intellectual content or other intangible properties.

► Nearly identical to § 936


Intangible Property Under IRC § 367
Regulations
► Treas. Reg. § 1.367(a)-1T(d)(5)(i):
► For purposes of § 367 and regulations thereunder, the term
"intangible property" means knowledge, rights, documents, and
any other intangible item within the meaning of § 936(h)(3)(B) that
constitutes property for purposes of §§ 332, 351, 354, 355, 356, or
361, as applicable.
► Treas. Reg. § 1.367(d)-1T(b):
► § 367(d) and the rules of this section shall apply to the transfer of
any intangible property, as defined in § 1.367(a)-1T(d)(5)(i).


Joint Committee on Taxation Report from
July 2010
► JCT report on “Present Law and Background Related to
Possible Income Shifting and Transfer Pricing” states:
► Both §§ 367(d) and 482 incorporate by reference the definition of
intangible property in § 936(h)(3)(B). Because they are not
specifically mentioned in § 936(h), whether goodwill, going
concern value and workforce in place are intangible property for
which compensation must be provided is unsettled. The IRS has
taken the position that any workforce in place, goodwill and going
concern value are within the scope of intangible property under
§ 936(h)(3)(B), because they constitute "similar items" under
§ 936(h)(3)(B)(vi).


Amortizable § 197 Intangibles

► § 197 provides for amortization of goodwill and certain
other intangibles.....“any amortizable section 197
intangible”
► Much broader definition than § 936, including
(i) goodwill and going concern value,
(ii) workforce in place,
(iii) business books and records, operating systems, or any other
information base,
(iv) any license, permit, or other right granted by a governmental unit ,
(v) any covenant not to compete (with some limitations),
(vi) “customer-based intangibles” and “supplier-based intangibles” which
are generally those acquired through relationships, but can include
“market share” as well as value from goods or services to be provided.


IRC § 197 Intangibles (continued)

► § 197 provides for amortization of goodwill, going concern
value, and workforce in place
► Defined in Treas. Reg. § 1.197-2(b)(1) – (3);
(1) Goodwill is the value of a trade or business attributable to the
expectancy of continued customer patronage. This expectancy may be
due to the name or reputation of a trade or business or any other factor.
(2) Going concern value is the additional value that attaches to property by
reason of its existence as an integral part of an ongoing business activity.
(3) Workforce in place includes the composition of a workforce (for
example, the experience, education, or training of a workforce), the terms
and conditions of employment whether contractual or otherwise, and any
other value placed on employees or any of their attributes.


IRS Viewpoint of the Definition of
Intangibles
► The IRS cost sharing regulations (§ 1.482-7) issued in
final form December 2011, and effective in temporary
form from January 2009, make it clear that workforce in
place, goodwill, and going concern value may be
compensable intangibles depending on the facts.
► See Veritas Software Corp. v. Comm’r, 133 T.C. 297 (2009),
nonacq., AOD 2010-49 (Dec. 6, 2010), in which the IRS
pursued adjustments related to a “buy-in” payment for
contributed intangibles, including workforce in place,
goodwill, and going concern value.
► IRS not acquiesce – clarification of law and not new position
► Same broad view of intangibles generally under § 1.482-4


Interaction with
IRC §367(d)


Interaction with IRC § 367(d)

► Where a taxpayer transfers an intangible to a foreign
related party, § 482 generally applies instead of § 367(d)
► Treas. Reg. § 1.367(d)-1T(g)(4)(i) –
► § 367(d) shall not apply in the case of an actual sale or license of
intangible property by a US person to a foreign corporation.
► If an adjustment is made, it must be analyzed under § 482.
► However, if a US person transfers intangible property to a related
foreign corporation without consideration, or in exchange for stock or
securities of the transferee in a §§ 351 or 361 transaction, then no sale
or license subject to adjustment under § 482 is deemed to have
occurred. Instead, the US person is treated as having made a transfer
of the intangible property that is subject to § 367(d).
► IRS can disregard the sale or license and treat the transaction as a
sham if the economic substance does not fit the terms – in which
case § 367(d) applies

Practical Effect if § 367(d) Applies

► The transfer of an intangible is treated as a sale for
payments contingent on the productivity or use over the
useful life of the intangible (regardless of whether in fact
such payments are made).
► In general, deemed annual license payments will continue
if a transfer is made to a related person, while gain must
be recognized immediately if the transfer is to an
unrelated person.
► The terms of the purported sale of license will be
determined by the actual practice of the parties and the
surrounding facts and circumstances.
► § 482 principles may still be used (e.g., valuation).

Practical Effect if § 367(d) Applies
(continued)
► FSA 200023014 (Feb. 29, 2000), fn. 26:
► Additionally, we note that § 367(d) would not generally apply in the case
of an express sale or license of intangible property by a US person to a
foreign corporation.….[see the] White Paper, A Study of Intercompany
Pricing under § 482 of the Code, 1988-2 C.B. 458, 473, stating “The
commensurate with income standard treats related party transfers of
intangibles as if an intangible had been transferred for a license payment
that reflects the intangible's value throughout its useful life, a result similar
to section 367(d) . . . . [A] license payment that is less than some specific
percentage of the appropriate arm's length amount could be considered
so devoid of economic substance that the arm's length charge should be
subject to section 367(d). Thus, those related party transfers which
deviate substantially from the proper commensurate with income payment
would be subject to 367(d), even if cast in the form of a sale or license.”


Significance of
the Legal Owner


Significance of the Legal Owner of the
Intangible
► Situation: If foreign parent develops a valuable product
and licenses its US distributor to sell and market it, under
what circumstances would US distributor be entitled to
profits from the sale of the product beyond what a
“routine” distributor would make?
► What if US distributor develops the customer lists,
establishes a monopoly in a niche market, or contributes
to the further development of the next generation product?
► Who is the economic owner of the intangible as compared
to the legal owner?
► Is there really more than one intangible?


Historical View of Legal v. Economic
Ownership
► 1968 regulations (“developer-assister” rules)
► The determination as to which member of a group of related
entities is the developer and which members of the group are
rendering assistance to the developer in connection with its
development activities shall be based on all the facts and
circumstances of the individual case.
► Ignoring legal ownership in favor of an economic approach
► 1994 regulations and “cheese examples”
► Legal owner ordinarily considered the owner for § 482 purposes
► However, examples suggested long term distribution contract with
exclusive rights could lead to economic ownership of intangibles


Present US Regulations – § 1.482-4

► Treas. Reg. § 1.482-4(f)(3)(i)(A):
► The legal owner of intangible property pursuant to the intellectual
property law of the relevant jurisdiction, or the holder of rights
constituting an intangible property pursuant to contractual terms
(such as the terms of a license) or other legal provision, will be
considered the sole owner of the respective intangible property for
purposes of this section unless such ownership is inconsistent with
the economic substance of the underlying transactions….[If no
legal owner is identified] then the controlled taxpayer who has
control of the intangible property, based on all the facts and
circumstances, will be considered the sole owner of the intangible
property for purposes of this section.
► Treas. Reg. § 1.482-1(d)(3)(ii)(B)(1) – written terms
respected if consistent with the economic substance


Present US Regulations – § 1.482-4
(continued)
► Examples:
► If FP licenses its US registered trademark to US Sub with
exclusive rights to manufacture and market products in the US
under the trademark, then FP is the owner of the trademark
pursuant to IP law, and US Sub is the owner of the license.
► Factor: a license is considered a separate intangible under § 482
► If FP provides US Sub rights to distribute a product in the US, and
US Sub develops a valuable customer list, unless the customer list
ownership is specified in the distribution agreement, US Sub may
be considered the owner of the list.
► Factor: US Sub has practical control over the customer list use and
dissemination
► GlaxoSmithKline & marketing intangibles (settled 2006)


Transfer Pricing
Methods


Transfer Pricing Methods Under § 482

► Treas. Reg. § 1.482-4 specifies four methods to
determine the arm’s length transfer price in connection
with the transfer of the right to use (but not outright
ownership) of intangibles:
► The comparable uncontrolled transaction method (CUT)
► Used in cases where comparable data (comparable intangible, comparable
circumstances) is available
► The comparable profits method (CPM)
► Typically used to test the less complex entity for determination of a royalty rate by
applying a routine return to the licensee (where one party owns IP)
► The profit split method (PSM)
► Used in cases where both parties own nonroutine intangibles
► Unspecified methods


CUT Method – Treas. Reg. § 1.482-4(c)

► General approach:
► The owner of intangible property – e.g., trademark, trade name,
patent, manufacturing know-how, customer list, etc. – licenses it to
a related party. How does the owner decide what the appropriate
license rate should be, as well as how to apply it?
► Comparable license agreements = > CUTs
► The comparable uncontrolled transaction method evaluates
whether the amount charged for a controlled transfer of intangible
property was arm's length by reference to the amount charged in a
comparable uncontrolled transaction.


CUT Method (continued)

► As with the CUP Method used in tangible property
transactions, comparability is a major factor in the ability
to use the CUT Method.
► If an uncontrolled transaction involves the transfer of the
same intangible under the same, or substantially the
same, circumstances as the controlled transaction, the
results derived from applying the CUT Method will
generally be the most direct and reliable measure of the
arm's length result for the controlled transfer of an
intangible.
► Preference for CUT over CPM or PSM


CUT Method (continued)

► Ideal CUT would be where the owner of the IP licenses
the same intangible to both related and unrelated parties
on the same terms, during the same time period, and has
written agreements and other supporting data showing the
agreement terms have been followed in both cases.
► This is an internal CUT
► The method can also be applied using external CUTs –
where comparable license agreements are used to
develop a range of license rates and other terms.
► Interquartile range frequently used with external CUTs


CUT Method – Comparability

► Comparability factors of Treas. Reg. § 1.482-4(c)(2)(iii)
► Involve similar products or processes within the same general
industry or market
► Have similar profit potential (often very difficult to know)
► Involve comparable circumstances – considerations…
► Rights granted (e.g., exclusive or non-exclusive)
► Geographic area involved
► Stage of development of the intangibles
► Rights to receive updates
► Uniqueness of the IP, including degree of legal protections
► Duration of the license and any termination rights
► Risks to be assumed by the transferee
► Any collateral relationships or transactions between the parties
► Any functions to be performed by the parties (e.g., services)


CUT Method – Interquartile Range

► Treas. Reg. § 1.482-4(c)(3) specifically acknowledges the
use of an interquartile range in the CUT Method
► Example: P licenses to Sub rights to use IP, but does not
license the same IP to unrelated parties
► A search may be performed to Observation Royalty rates

1 2.0%
identify third party licensing
2 3.5%
agreements, with consideration of
3 4.0%
the comparability factors
4 7.0%
► If 10 comparable licenses were
5 8.0%
identified, then an IQR could be
6 8.0%
constructed that would include the
7 10.0%
3rd and 8th observations
8 12.0%
► Arm’s length royalty rate would
9 12.5%
be between 4.0% and 12.0%
10 15.0%


Comparable Profits Method (CPM)

► CPM may be used to evaluate the licensing of intangible
property (Treas. Reg. § 1.482-4(a)(2) refers to –5 reg.)
► Review core concepts of CPM
► Tested party
► Profit level indicators
► Comparable public companies
► Comparability adjustments
► Arm’s length range – IQR
► Use of multi-year data
► Adjustments to the median when out of the range


CPM (continued)

► No specific profit level indicator applies
► Operating margin, return on assets, or other appropriate PLI
► CPM typically used as an “excess profits method” for IP license
► Example: Parent licenses manufacturing know-how and related
processes to its foreign subsidiary, ManuCo, which pays a royalty
to P for the intangibles.
► If ManuCo is the least complex of the entities and has none of its own
nonroutine IP, it may be the tested party for the CPM (e.g., a contract
manufacturer).
► ManuCo could be tested using a return on assets.
► ManuCo could pay a royalty to Parent of X% of sales to the extent
ManuCo was within the IQR of the ROA – assume the bottom of the
range was a 4% ROA, then the royalty could not be such to put
ManuCo below the range, or an adjustment may be required.
► See Treas. Reg. § 1.482-5(e), Example 4

Profit Split Method (PSM)

► Treas. Reg. § 1.482-4(a)(3) refers to –6 reg.
► The PSM evaluates whether the allocation of the
combined operating profit or loss attributable to one or
more controlled transactions is arm's length by reference
to the relative value of each controlled taxpayer's
contribution to that combined operating profit or loss.
► Two types of PSMs
► Comparable PSM
► Residual PSM


PSM (continued)

► Comparable PSM is rarely used because data on how
unrelated parties split profits or losses is generally not
publicly available.
► Primary problem with the types of intangibles involved and
comparability to the transactions being evaluated
► Identification of how relative shares were decided not disclosed
► Residual PSM the primary method when PSM used
► Provides for a “routine” return for functions performed, with the
residual profit or loss being split according to the parties’ relative
value of their nonroutine contributions to the combined profit (or
loss)
► Nonroutine contributions may be valued using external
benchmarks (e.g., relative sales) or internal benchmarks (e.g.,
relative capitalized cost of intangible development)

Residual PSM Example

► US Co and UK Co were both independent companies in
the same industry for many years and developed their
own products using their own unique intangibles.
► Both companies have ongoing R&D for their products.
► US Co acquires UK Co, and they begin sharing R&D
knowledge and resources.
► They combine their sales and manufacturing activities.
► They become a global company under the US Co brand.
► Transactions between the US and UK may be evaluated
using the residual PSM.
► Transactions include shared R&D, manufacturing, shared
services, and each company sells the other’s products.


Residual PSM Example (continued)

► In the first step of the RPSM, each party is given a return
for its routine functions.
► Sales functions earn a “distribution” return using the CPM and an
operating margin PLI.
► Services that each party performs for the other party are given a
routine return using the cost of services plus method under Treas.
Reg. § 1.482-9.
► Manufacturing functions performed by each side earn a return
based on the CPM and a return on assets PLI.
► In the second step, after each narrowly identified routine
function is remunerated, the residual is shared according
to each parties’ relative R&D spend over the past 5 years
(based on the life of developed intangibles).


Analytical Example


Analytical Example – Background

► US Distributor sells products in the US that were
developed by its Japan Parent Company, and
manufactured by Parent’s Hong Kong contract
manufacturer.
► Year One: US Distributor buys products from Parent
► Parent takes flash title from Hong Kong and on-sells to US
► US Distributor gets a routine distribution return – CPM, OM PLI
► Year Two: For business efficiency reasons, Japan Parent
directs Hong Kong to sell directly to US Distributor.
► Cost of product to US Distributor drops significantly
► US Distributor pays a royalty to Japan Parent
► Question: How to evaluate royalty to Parent in Year Two?

US Company Distributes for Japan Parent –
Tangible Property Transaction (Year One)
Transaction Flow in Year One

US Distribution Company

Payment for tangible property and all
Tangible property from Japan Parent along with
intangible property rights from Parent
all intangible property rights from Parent

Tangible property
Japan Parent Company Hong Kong Contract
(and owner of all IP) Manufacturer
Rights and
Japan Parent grants Hong Kong rights payment for
Hong Kong earns modest return on
to manufacture product according to tangible property
contract manufacturing function
Parent specifications, and rights to sell
tangible products to Parent only.
Parent provides Hong Kong
manufacturing know-how and
processes.


US Company Distributes for Japan Parent –
Intangible Property Transaction (Year Two)
Transaction Change in Year Two

Payment for intangible property rights
from Parent separate from those
granted to Hong Kong – including (1) US Distribution Company
rights to distribute products that embody
Parents ’s patented technologies, (2)
rights to physically modify the products,
(3) rights to modify the integral
Tangible property with
software, (4) rights to access trade
embedded IP related to
names, trademarks, designs, patterns,
manufacturing know-how
methods, systems, technical data, and
and processes.
other materials, and (5) rights to provide Payment Payment
aftermarket services on Parent’s
products to end customers.

Payment
Japan Parent Company Hong Kong Contract
(and owner of all IP) Manufacturer
Rights
Japan Parent grants Hong Kong rights to Hong Kong to have a full cost
manufacture products according to Parent markup of 3.0% to 5.0% for
specifications, and rights to sell tangible contract manufacturing.
product to affiliates anywhere in the world.
Parent provides Hong Kong with
manufacturing know-how and processes.


Analytical Example – Conclusion

► Problem: Tangible property transactions generally have embedded
intangibles in the price of the product, but where contract
manufacturer is selling Parent’s products to US, has a separation of
tangible and intangible property occurred?
► US Distributor’s functions in Year Two have not changed
► Still selling Japan Parent’s products in the US
► Solution is to separately identify what intangible transactions are
actually occurring – what valuable IP from Japan Parent is US
Distributor using in Year Two?
► CPM may be used for both tangible and intangible property
transactions
► Payment to Japan Parent by US Distributor recharacterized as royalty
rather than payment for tangible property
► US Distributor as tested party still given routine return – CPM, OM PLI


Questions? Comments?


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