While the arm’s length principle is the fundamental concept governing the valuation of intellectual property (IP) for Transfer Pricing purposes, a number of additional aspects need to be considered in order to limit the potential risk of challenges by tax authorities and double taxation.
As oil and gas companies dominated the list of the world’s most valuable companies only a decade ago, technological innovations in recent years led to IP-heavy companies with predominantly digital business models leading the valuation tables. In light of this, questions around the valuation of IP become more frequent and more important.
IP is defined as intangible assets that are non-physical in nature, the value of which can be derived from their potential to generate revenue and, due to their nature, can be legally protected. The most common types of IP are patents, trademarks, copyrights and trade secrets. Each of them qualifies for legal protection, which means that these assets can only be exploited through parties who own the respective IP rights or have these rights assigned to them (e.g. through franchising or licensing agreements).
Rationales for evaluating IP
The valuation of IP is necessary when transferring IP or rights thereto, for determining the terms and conditions of licensing arrangements, for evaluating IP heavy businesses or for litigating infringement cases.
OECD guidance on IP valuation
Even though the valuation of IP is an important and frequent topic in practice, the 2017 OECD Transfer Pricing Guidelines offer rather limited guidance on IP valuation and remain somewhat vague on the topic. The general guidance provided in the Guideline is summarized below:
Challenges in practice
In practice, challenges in evaluating IP mainly arise from two sources.
Firstly, in many cases the planning of IP-related income and cost streams is rather difficult. Depending on the development stage and nature of the IP, significant uncertainty with regards to the remaining useful life of the IP, to-be-expected income streams as well as the risk posed by competing companies or technologies may make business planning particularly tough. This group of intangibles is referred to as “hard-to-value intangibles” (HTVI) by the OECD, which acknowledges the issues with regards to the creation of accurate financial projections in these cases that may lead to different ex-ante and ex-post valuation outcomes. In order to mitigate the risks arising from such uncertainties, the OECD suggests that the taxpayer either:
In addition, price adjustment clauses may be introduced as a way to ensure that the compensation determined ex ante is in alignment with the ex-post materialization of results.
Secondly, in many countries, local laws and regulations, or even worse, common practice of tax authorities may include specific requirements with regards to the valuation of IP, which may not only challenge the arm’s length nature of a valuation but may also lead to situations of valuation mismatches between two countries, and, thus lead to double taxation. Such requirements or practices may be tied to the following valuation aspects:
The fair valuation of IP requires a broad skillset, ranging from the technology and market know-how needed for business planning, the technical performance of the valuation as well as the tax law and common practices in the countries involved. The early involvement of tax and valuation experts ensures the avoidance of any blind spots and limits the risk of tax assessments and potential double taxation down the road. In addition, significant transactions can be secured in a bilateral or multilateral APA, which provides additional certainty on the tax treatment of a transfer of IP.