Intangible asset : A Transfer Pricing Appraisal !

THE layman description of intangible asset is understood as distinct from a physical and visible asset. The investors and the stakeholders add on the attribute of future benefits that will be valued for the stake repatriation. Corporate national and international are demanding a common language for identifying and valuing intangible assets.

With Indian Inc in the global ground for takeovers and mergers, intangible assets valuation is becoming captive with the Indian corporate.

Indian economy had the real flavour of intangible assets when India turned out to be an outsourcing hub of the world.

Transactions with respect to transfer of technical know-how and payment of royalty and license fee are universal in the international transactions between the foreign holding companies and its Indian subsidiaries.

The importance of intangible assets for the corporate is apparent by the fact of rising number of intellectual property registrations for legal protection. Further the research and development expenditure of the product industries has been on the rise which has a direct impact on the creation of intangible assets.

A functional classification is framed by the OECD to deduce the meaning of intangible assets. Manufacturing related intangibles are created through research and development and the marketing related intangibles are created through the brand promotion and projection.

An economic classification of intangible assets would be more on the legal perspective namely; protected intangible assets and unprotected intangible assets. Trade contracts, franchises and intellectual property are normally legally protected, documented and defined. Market relationships and goodwill would form the latter category and are not defined or in general protection by the legal strap.

The functional classification explains how intangibles are created in an organization. The economic classification talks about the sharing or usage facet of the intangible assets. The transfer of intangible assets occurs between the MNCs' and among their affiliates as well as externally to the third parties.

Intra-firm transfer and external transfer of manufacturing intangible assets depend upon the stage of development of the intangible asset and the protection level it carries along with it. The externally transferred intangible assets are characterized by mature stage of development and would be unprotected. The intangible assets which are in the early stages of development and with high profit potential are less likely to be transferred externally and thus would be transferred only among the affiliates.

Valuation of intangible assets: Considering the OECD Guidelines

The OECD guidelines do not specify any method for the valuation of intangible assets. The general guidelines applicable for the tangible assets are implied to be applicable to the transfer of intangible assets. The methods used to analyze the transfer of tangible assets are Comparable Uncontrolled Price (CUP) Method, Transactional Net Margin Method (TNMM) and the Profit Split Method (PSM), Cost Plus Method and the Resale Price Method.

The Cost Plus and Resale Price methods are primarily used in the valuation of tangible transfers. The applicability of first three methods in the valuation of intangible transfers is analyzed below:

CUP

The CUP method compares the prices of

• Controlled transactions (i.e.) transactions between the affiliates

and

• Comparable uncontrolled transactions (i.e.) between unrelated parties under comparable circumstances

CUP is the most direct method in the sense the prices at which transactions should be effected is obtained and just a one to one comparison is performed.

CUP method is warranted when the degree of reliability and accuracy is high in the selected comparable transactions. Transfers of intangible assets are usually unique transactions and rarely exact comparables are found. The degree of reliability of transactions in respect of intangibles is doubtful as the transfers contain highly confidential and secret information which are not supposed to be disclosed.

Hence, the applicability of external CUP for analyzing the intangible transfers is mired due to the non-availability of the reliable comparable data. But internal CUP data may be available for companies which has research and development function as the main process for their deliverables to customers; both affiliates and unrelated parties.

TNMM

TNMM compares the net margin relative to an appropriate base (Cost, sales etc.) between the tested party which is involved in the transfer of the intangible asset and the average net margin of the comparable companies in the same trade.

The usage of net margin for comparison enables to eliminate the functional differences between the companies that are compared. The applicability of TNMM for intangible transfers has to be made on transactional basis rather than on a company wide basis. The intention is that the profit margin compared has to be restricted to what is attributable to the intangible transfer.

PSM

OECD Guidelines provides a last option to value intangibles through PSM. Profit Split Method is also transaction based and is applied in case of interrelated transactions which can not be evaluated separately. The different approaches to Profit Split Method are summarized in the table given below:

Basis of Splitting Profits	Application
Contribution	Combined operating profit of the related entities is split based on the relative contributions. The percentage for the split up is supplemented by external comparable data
Balance Profits	Initially normal profit that would be earned by using market return in an uncontrolled transaction is allocated to the related entities. The balance profits or loss is allocated among the related entities based on the contributions
Actual Profits	Profit is split based on the ratio of actual profit division among unrelated parties under comparable situations
Return on Capital Employed	This approach assumes functional similarity between the controlled parties and hence requires the profits to be earned at the same rate of return on capital employed
Discounted Cash Flow	This approach considers the cash flow discounted at the market rate of return to arrive at the profits of the controlled entities

Profit Split Method is considered as the last alternative because of the difficulty of obtaining data for comparable transaction between uncontrolled parties.

Arm's Length Price for valuation of intangible assets

The arm's length price for the valuation of intangible assets is examined with respect to the functional classification (i.e.) manufacturing related intangibles and marketing related intangibles.

Manufacturing related intangibles is created through extensive research and development which may be short-term or long-term. Product patent, software license, technical know how for manufacture are examples of manufacturing related intangibles. Marketing related intangibles also may span into different periods for its development starting from marketing research of the product to sales support and quality service. Trade marks and trade names are the products of marketing related intangibles.

The period of development of the business asset created by research and development will have an impact on the cost recovery when the intangible asset is transferred Intangible assets that has been developed in a very short period (i.e.) within one year would have its cost written off in that year itself. This treatment of such cost of developing the intangible asset would determine the methods used to recover that cost from the associated enterprises.

Some common methods espoused to recover the expenditure relating to the intangible assets are:

• Technical know how fees charged in lump sum or deferred as annual payment
• Royalty charged over the period of usage of the asset
• Charging associated enterprises with a percentage of sales of products using the patent, know how, trade mark or trade name

The determination of arm's length price for the intangible property needs to examined both from the transferor's and the transferee's perspective.

Arm's Length Price: Transferor's view

• Examine the price at which a comparable third party would transfer the property
• Cost benefit analysis of using the trade mark in its own business Vs. Receipt from transferring the trade mark
• Consider the highest expected benefits that will flow to the transferee from the intangible property transferred
• Quantify the market lost for the related products with the transfer of the property
• Consider the restrictions imposed in the production or marketing of products benefited by the property
• Tax benefits obtained by amortising or writing off the expenditure related to the development of the intangible property
• Tax impact on the transfer of property
• If the transfer price recovery is deferred over a period of time, the risks arising due to change in the circumstances like new models or sudden change in the market related to the trade mark

Arm's Length Price: Transferee's view

• Analyse the value addition that the purchase of the property would make in its business
• Project the expected cash flow through increase in sales with the use of the intangible property
• Consider the least expected benefits that will occur due to the usage of the property
• Consider the additional investments and the expenditures with the usage of the new property
• Consider the legal validity period of the property transferred

• If the transfer price payment is in lump sum, discounting the risks arising due to change in the circumstances like new models or sudden change in the market related to the trade mark
• Tax impact on the different methods of payment for purchasing the property

Usage of the Transfer Pricing Methods

• In using CUP method for arriving at the arm's length price, a similar transfer by the same transferor of similar license, trademark or patent to an independent enterprise can be considered as the base. The internal comparable will be more reliable to justify the price of the property transferred
• The transfers in the same industry of similar property can be considered to obtain a range of prices within which the valuation can be made
• The price charged in competing bids in the transfer of know how or expertise can be considered to arrive at the best comparable price of the property
• In case of property that can be sub-licensed, the price that would be charged by the sub-licensee can be evaluated
• Finding of exact comparable for transfer of intangible property is very difficult, if not impossible. Hence the comparable price in such cases can be arrived by considering the price of property transferred relating to a different product discounted appropriately with functional differences of the products
• Profit-split method can be used in case of unique intangible properties where it is not possible to find comparables
• Risks imposed by geographical differences needs to be considered while arriving at the transfer price
• Revision in the royalty rates because of foreseen changes in the sales or market needs to be documented
• A modified TNMM may be used where the net margin for the tested party is calculated by taking into consideration only the additional income generated and the additional cost incurred in relation to the introduction or the usage of the new intangible property

Transfer Pricing Assessment of intangible assets

Transfer Pricing assessment in the case of international transactions involving transfer of intangible property is not a smooth task due to difficulty in obtaining comparable data. The success of the assessment for the assessee would depend on providing all the background of the development and transfer of the property. Further the assessee would need to justify all the assumptions and the adjustments made to arrive at the transfer price.

The Transfer Pricing Officer in the absence correct data to support the transfer price would be forced to compare the price with any predecessor transfer which will be of entirely different type of intangible property. Hence a lot depends on the assessee's capacity in establishing the uniqueness of the intangible property transferred and the

reliability of discounting factors when compared to another independent transfer among third parties of similar intangible property.

Establishing the arm's length price for the transfer of intangible property would also depend on proving the basis on which the different methods of payment of transfer price was arrived at. For example, if the transfer price is repatriated by royalty paid annually, an agreement executed between the associated enterprises with supporting clause to revise the rates according to the changing circumstances can give more flexibility to the assessee and the Transfer Pricing Officer to resolve the issues in the assessment.

In case of technical know how transfer between the holding company and its subsidiaries in different countries, maintaining a consistent transfer policy for majority of the subsidiaries supported by appropriate agreements can be helpful to establish the basis of the transfer price.

The Transfer Pricing Officers should be equipped with data relating to similar transfers in the international playground for a fair assessment. It assumes importance in the cases when a foreign transferor is the tested party for the purpose of establishing the arm's length price.

Transfer Pricing assessment as such has been recognized as a specialized assessment in India, for the reason was created a Transfer Pricing Directorate inside the Income Tax Department. It is high time to realize that Transfer Pricing is related to international transactions and not transactions within the Indian high seas. The Transfer Pricing Officers in India should be given opportunities of studying the Transfer Pricing assessment functioning in the foreign countries.

A practical exposure by technical interactions among the Transfer Pricing authorities of major trading countries can be a long term solution to the Transfer Pricing issues, more important in the case of transfer of intangible property.

Presently we have seen Double Taxation Avoidance Agreements been amended to suit the taxability of various Income Streams. But the Agreements only have provisions structured for Withholding taxes. Hence a new Transfer Pricing regime can be formulated by which India can form a consortium with its major and common trading countries to give birth to common Transfer Pricing Rules customized for geographical and functional differences. The Transfer Pricing Rules so made can provide a range of options for the assessee to justify the transfer price.

Transfer Pricing assessments should be framed to narrow down the difference in the methods to arrive at and justify the arm's length price and hence the assessee has to be given the fair opportunity to support transfer price with different options rather than by any specific transfer pricing method.