Intellectual property (IP) is one of the important value drivers for sustained growth and in rendering competitive advantage for multinational enterprises (MNEs).
It is widely acknowledged that IP creation is correlated to Research & Development (R&D) spend. A typical business model observed in Vietnam is “in-licensing” whereby the IP is developed in countries that spend significantly on R&D and the IP holder licenses the commercialization rights to the licensee. Therefore, a typical manufacturing arrangement in Vietnam is that of toll manufacturer, contract manufacturer and licensed manufacturer whereby any IP-related returns are attributed to the IP owner.
IPs could be in the form of a trade secret, trademark, brand, copyrights, patents, technical know-how, etc. From a transfer pricing perspective, IP may not be limited to something which has been legally registered; rather, it may also include customer contracts, supply chain IP, human capital intangibles, process, procedures, etc. which can be commercially exploited. The open-ended definition of “intangible” has many meanings and interpretations.
Royalty is a usage-based payment for exploiting such IP without transfer of ownership. Royalty payments are tax deductible, leaving them open to manipulation. At the same time, developing economies rely greatly on tax revenue collected from MNEs, and thus, the fair collection of taxes from such MNEs is critical.
The revenue authority is often of the view that payments pertaining to royalties, management charges, interest, etc. are cash repatriation devices to siphon group profit to other favorable jurisdictions thereby eroding the tax base in the paying country.
The risk is even higher for Vietnam which primarily is the recipient of such services against which payments are made. However, these cases must be analyzed based on commercial reality.
IP Holding Company Structure
IP is mobile in nature and does not have a fixed geographical situs from a transfer pricing perspective. IP has often, therefore, been core to corporate tax planning structures.
Traditionally, the legal ownership of IP was used as a measure to determine the entity in an MNE entitled to IP-related returns. This facilitated mushrooming of the “IP holding” company structure at low-tax offshore locations with limited commercial substance allowed IP-related returns. Cynically planned structures can also benefit from a treaty advantage, minimizing withholding tax originating from such a structure, which will prove to be a “double whammy” for economies.
It used to be easy for an MNE to transfer the valuable IP, at the early stage of development, to a cash box company. Such cash box companies were generally resident of tax haven countries whose profitability was not subject to tax (or minimal tax) while corresponding expenses in countries like Vietnam were tax deductible.
This “IP holding” model led to tax base erosion and attracted serious political unrest and social upheaval worldwide. A collaborative approach by various economies to check on any base erosion and profit shifting (BEPS) was initiated. The current BEPS initiative addresses such issues and lays importance on commercial substance over a contractual form.
Doctrine of Substance Over Form
The doctrine of “substance over form” states that the “substance,” rather than the “form,” of a transaction governs the tax consequences. With the doctrine of substance over form, the IP holding company is not automatically entitled to all IP-related returns until it is commensurate with functions and the corresponding risk.
The transfer pricing statute (Decree No. 20/2017/ND-CP) mandates that the codes of business conduct between independent parties, the arm’s length and substance over form doctrine is used for re-determining related party transactions and business risks incurred by these parties.
In case the transactions are found to be a sham, the transfer price would be re-determined based on substance. Consequently, it is important to note that the actual conduct between parties will be given precedence over legal contracts.
Therefore, legal ownership of intangibles alone would not determine entitlement to returns from the exploitation of intangibles. Rather, entities will be compensated based on the value they create through functions performed, assets used and risk assumed in the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangibles. Therefore, when carrying out a transfer pricing study it is important to determine the entity to attribute the IP-related return.
The DEMPE framework ensures that the profit is attributed based on value creation and economic realities instead of legal ownership. This is in contrast to the past when the economic return was attributed to the legal owner irrespective of the commercial substance. This will prove to be the final nail in the coffin of IP holding structures lacking substance.
DEMPE helps in the distribution of IP returns among the entities based on their relative contribution. The legal owner, not participating in any DEMPE-related functions or who has assumed risks will be entitled to a reasonable financial return. Therefore, transactions should be aligned to contractual reality and so should the IP-related returns.
In summary, in the pre-DEMPE era the intangible-related returns belonged to the legal owner but in the post-DEMPE era this is more substance-based as to who performed critical functions, undertook critical risks and controls such risk and who funded.
When multiple entities perform DEMPE functions then all entities are entitled to the profits originating from an intangible asset based on a profit split on a relative contributory basis.
There are key issues that companies should bear in mind while conceptualizing and designing the pricing policy for royalty transactions.
A toll/contract manufacturer is generally instructed by the principal company on what to produce, in what quantity and of what quality and there is an assurance from the principal company to buy the entire proceeds.
Therefore, a toll/contract manufacturer whose sales are controlled by the principal company cannot be expected to pay a royalty on sales or any other output basis.
In other words, the manufacturer that produces on behalf of the principal company and pays royalty for usage of technical know-how, is like paying the royalty to itself.
No independent party would enter into the contract when it pays royalty to an entity on whose behalf it is producing. Further, the price of the IP may already be included in the price of the goods which are procured by the manufacturer from the principal company.
In a triangular arrangement, a manufacturer selling its entire proceeds to the principal company while paying royalty to another IP holding company still lacks substance.
Considering the doctrine of substance over form such transactions may be rejected. In substance, two different principal companies and IP holding company may be considered as a same entity from the arm’s length standard perspective. Therefore, the principal company should charge royalty on third party sales only and not on related party sales.
A toll/contract manufacturer is typically compensated on a cost-plus basis. However, if the royalty is paid to the principal company then such a royalty would form part of the cost base on which mark-up has to be charged to the principal company. This would lead to round tripping of royalty charge wherein the principal company charges royalty to the toll/contract manufacturer and pays back to the toll/contract manufacturer on a cost-plus basis which includes mark-up on royalty.
Furthermore, a toll/contract manufacturer whose only client is the principal company and restricted by agreement from selling proceeds to third parties should not pay for the trademark. Such a manufacturer is not expected to undertake any marketing or promotion activity when the only client is an in-house group company which is fixed.
Typically, such a manufacturer would not pay a royalty under an arm’s length scenario. Instead, it should be paid by the entity which exploits the IP and retains the residual profits arising from such exploitation and manufacturing (i.e., a licensed manufacturer). In case of a licensed manufacturer, the sales are driven by open market conditions and there is no assurance to buy the entire production of the taxpayer by the principal company.
Careful characterization of the entity is vital, to show that the licensed manufacturer IP payout is justified as it retains the residual profit in contrast to the toll/contract manufacturer. Characterization plays a crucial role in determining the royalty pay-out.
Relevance of IP
IP has a definite useful life which is beneficial for exploitation. Therefore, it is important to analyze the present and future benefits for the taxpayer. A company should analyze whether the value of IP has deteriorated from when the royalty was originally determined.
The royalty rate may be adjusted downwards for the benefit which has been absorbed from the useful life. The royalty adjustment should be documented in the legal contract and TP documentation. An old IP that has been absorbed may have a deteriorating royalty rate, while a new company investing in Vietnam may have an increasing staggered royalty rate.
The licensee should demonstrate that the actual services have enhanced the commercial position of the taxpayer. The tax authority may disallow the full amount if the taxpayer fails to demonstrate the commercial and business benefit derived from such a payout.
At the very outset, the company should maintain documentary proof listing the intangibles. Any document which validates the legitimacy of the royalty pay-out could be evidence of such services. Evidence could be in the form of a communiqué, email correspondence, blue print of technical know-how, training materials, presentations, research materials, case studies, workshops, etc.
Need Benefit Test
The licensee may be required to justify the actual nature of services, benefits and how it enhanced the commercial position. Was the licensee in a position to run the operation normally in absence of such services? The reasonableness of the expenditure should be judged from the perspective of a businessman. The tax authority can test the transactions under an arm’s length standard but should not challenge commercial judgment. The authority should be flexible towards such transactions as it would be impossible to measure the benefits with great precision.
In contrast, the licensee should keep a record of ongoing benefits derived from the use of such services. How critical is such technical know-how, brand for normal business operation? The increase in sales, profit, market share, future benefits, competitive advantage could be some of the benefits.
Determination of Arm’s Length
Once it has been established that certain services have been availed and benefit derived, it is vital to determine the arm’s length price of such transactions.
Generally, it has been observed that taxpayers adopt entity as a whole approach wherein all international transactions are clubbed and benchmarked together.
The comparable profit method (CPM) is not generally a sufficient approach in royalty benchmarking and the tax authority may be interested in benchmarking it separately by applying CUP. Appropriate comparability analysis is necessary with proper due diligence for covering the nature of service for which royalty is being paid, geography, terms of contract, etc.
Also, the Law on the Technology Transfer of Vietnam mandates that inbound technology transfer requires substance and is subject to registration with the competent state agencies. Companies are expected to perform a separate benchmarking analysis for the royalty payment to the related party by the CUP method.
However, the tax authority should be aware that companies may choose to enter into a packaged deal for several transactions and not necessarily a separate royalty dealing. For instance, the raw materials supplied by the principal company may also have the royalty priced in or embedded in an overall packaged deal.
Due to BEPS, value creation and commercial substance is significantly important. Companies are required to define their global operation and articulate how the entity performs DEMPE functions.
Companies should carry out a diagnostic review of the existing royalty transactions to ascertain that they meet the arm’s length standard.
The evidence and need benefit tests are essential to safeguard at the time of a TP audit. If companies adopt an aggregated approach to establish the arm’s length, then it is advisable to maintain separate royalty benchmarking as a corroborative approach.
Vishwa Sharan is Associate Director and Nguyen Dinh Du is a Partner of Transfer Pricing Services at Grant Thornton, Vietnam
This article is of general nature only and readers should obtain advice specific to their circumstances from professional advisers.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.