Annex II to Chapter VI: Guidance for tax administrations on the application of the approach to hard-to-value intangibles

Action 8 of the BEPS Action Plan mandated the development of transfer pricing rules or special measures for transfers of hard-to-value intangibles aimed at preventing base erosion and profit shifting by moving intangibles among group members.

The outcome of this work is found in Section D.4 of the Revised Chapter VI of the Transfer Pricing Guidelines, contained in the 2015 Final Report for Actions 8-10, “Aligning Transfer Pricing Outcomes with Value Creation” (BEPS TP Report) and now formally adopted as part of the Guidelines. Section D.4 addresses the treatment of hard-to-value intangibles (HTVI) for transfer pricing purposes. That Section contains an “approach consistent with the arm’s length principle that tax administrations can adopt to ensure that tax administrations can determine in which situations the pricing arrangements as set by the taxpayers are at arm’s length and are based on an appropriate weighting of the foreseeable developments or events that are relevant for the valuation of certain hard-to-value intangibles, and in which situations this is not the case” (paragraph 6.188). The HTVI approach protects tax administrations from the negative effects of information asymmetry by ensuring that tax administrations can consider ex post outcomes as presumptive evidence about the appropriateness of the ex-ante pricing arrangements. Under the approach, the taxpayer has the possibility to rebut such presumptive evidence by demonstrating the reliability of the information supporting the pricing methodology adopted at the time the controlled transaction took place. There are a number of additional exemptions that, where the conditions governing those exemptions are met, render the approach inapplicable. Importantly, where the approach applies, a tax administration is entitled to use, in evaluating the ex ante pricing arrangements, the ex post evidence about financial outcomes to inform the determination of the arm’s length pricing arrangements that would have been made between independent enterprises at the time of the transaction (see paragraph 6.192). However, the ex post evidence should not be used without considering whether the information on which the ex post results are based could or should reasonably have been considered by the associated enterprises at the time the transaction was entered into (see paragraph 6.188).

The BEPS TP Report mandates the development of guidance for tax administrations on the implementation of the approach to HTVI. This guidance is aimed at reaching a common understanding and practice among tax administrations on how to apply adjustments resulting from the application of the approach to HTVI. This guidance should improve consistency and reduce the risk of economic double taxation.

The BEPS TP Report also states that the practical application of the exemptions listed in paragraph 6.193 of the BEPS TP Report, including the measurement of materiality and time periods contained in the current exemptions, will be reviewed by 2020 in the light of further experience.

Tackling information asymmetry between the extensive information available to the taxpayer and the absence of information available to the tax administration, other than what the taxpayer may present, is at the heart of the reason for HTVI guidance in Section D.4 of Chapter VI of the Guidelines. When a HTVI is transferred, each of the parties involved in the transaction are likely to prepare a valuation at the time of the transaction using assumptions based on its specialised knowledge, expertise and insight into the business environment in which the intangible is developed or exploited. The problem for the tax administration is that the valuation is extremely difficult to objectively evaluate since such evaluation may be wholly based on the information provided by the taxpayer. Such information asymmetry restricts the ability of tax administrations to establish or verify, at an early stage, the developments or events that might be considered relevant for the pricing of a transaction involving the transfer of intangibles or rights in intangibles, as well as the extent to which the occurrence of such developments or events, or the direction they take, might have been foreseen or reasonably foreseeable at the time the transaction was entered into.

The HTVI guidance aims at providing a tool for tax administrations to address this problem. In the case of intangibles which fall within the definition of HTVI found in paragraph 6.189, and under certain conditions, tax administrations are entitled to consider ex post outcomes as presumptive evidence about the appropriateness of the ex ante pricing arrangements. Where, the actual income or cash flows are significantly higher or lower than the anticipated income or cash flows on which the pricing was based, then there is presumptive evidence (from the perspective of the tax administration) that the projected income or cash flows used in the original valuation should have been higher or lower, and that the probability-weighting of such an outcome requires scrutiny, taking into account what was known and could have been anticipated at the time of entering into the transaction involving the HTVI. However, it would be incorrect to base the revised valuation on the actual income or cash flows without also taking into account the probability, at the time of the transaction, of the income or cash flows being achieved.

This evaluation of the ex ante pricing arrangements based on the ex post outcomes will necessarily consider the guidance contained in Chapters I-III and, in particular, the guidance in Chapters VI and VIII of these Guidelines.

In performing such evaluation, tax administrations may consider not only the ex post outcomes taken as presumptive evidence (within the limits of Section D.4 of Chapter VI of these Guidelines) about the appropriateness of the ex ante pricing arrangement, but also any other relevant information related to the HTVI transaction that becomes available to the tax administrations and that could or should reasonably have been known and considered by the associated enterprises at the time the transaction was entered into (see Section B.5 of Chapter III).

Importantly even if the HTVI approach is not applicable to a particular transaction, an adjustment may still be appropriate under other parts of these Guidelines, including other sections of Chapter VI.

Any application of the HTVI approach should be done in a manner that promotes tax certainty for taxpayers, and reduces the risk of double taxation resulting from a primary adjustment, considering the jurisdiction’s domestic law (for example, the applicable statute of limitations) and treaty framework. Tax administrations should identify and act upon HTVI transactions as early as possible.

The nature of the approach to HTVI inevitably requires some consideration of timing issues. In some cases, the elapsed time between the transfer of the HTVI and the emergence of ex post outcomes may not correspond with audit cycles or with administrative and statutory time periods. This problem may be more acute where an adjustment is appropriate under the HTVI approach in transactions involving intangibles qualifying as HTVI under paragraph 6.189 that have a long incubation period – that is, the period after the transfer and before the intangible can be exploited commercially and income can be derived (see paragraph 6.190).

The impact of timing issues should not be overstated since there is already a time lag in typical audit cycles. For example, assume an audit of Years 1-3 is carried out in Year 5; during the course of the audit, the tax administration may identify not only a transfer of a hard-to-value intangible in Year 1 but also ex post outcomes of that transfer that may be evaluated during the audit process. Tax administrations are encouraged to identify transfers of potential HTVI, to evaluate the assumptions made by the taxpayer in valuing the intangible, and to seek information about developments that lead to ex post outcomes which may call into question those assumptions, even when those outcomes arise in years subsequent to those under audit, in order to be in a position to consider the appropriateness of the ex ante pricing.

Tax administrations should apply audit practices to ensure that HTVI transactions are identified and acted upon as early as possible. However, it should be kept in mind that in some cases it may be difficult for tax administrations to perform a risk assessment at the time of the transaction, or even shortly thereafter, to evaluate the reliability of the information on which pricing has been based, or to consider whether the transfer is priced at arm’s length. Such analysis may only be possible some years after the transaction. Under the HTVI approach, the tax administration may, in particular circumstances, use ex post outcomes to consider the reasonableness of the projections and probability weightings taken into account in the valuation at the time of the transaction.

This guidance for tax administrations on the application of the HTVI approach should not be used to delay or bypass normal audit procedures. In fact, it remains important to identify transfers of HTVI as early as possible and to act on presumptive evidence promptly as a matter of good administrative practice, and in order to avoid running into difficulties with administrative or statutory time limits for audits and reassessment. Nothing in this guidance changes those time limits, which are a matter of sovereignty of jurisdictions.

To enhance tax certainty for taxpayers and reduce the risk of double taxation, it is desirable that the HTVI approach be applied consistently. However, some jurisdictions may encounter difficulties in applying the HTVI approach due, for example, to short audit cycles or a short statute of limitations. This guidance does not require jurisdictions to adopt legislation aimed at overcoming such difficulties, but it does not prevent jurisdictions from considering targeted changes to procedures or legislation (such as the introduction of a requirement to notify promptly the transfer or licence of an intangible falling within the HTVI definition, or amendment of the normal statute of limitations).

In applying the HTVI approach contained in Section D.4 of Chapter VI, tax administrations may make appropriate adjustments, including adjustments that reflect an alternative pricing structure that differs from that adopted by the taxpayer but reflects one which would have been made by independent enterprises in comparable circumstances to take account of the valuation uncertainty in the pricing of the transaction (for example, milestone payments, running royalties with or without adjustable elements, price adjustment clauses, or a combination of these characteristics). See paragraph 6.185 and 6.192. Since hard to value intangibles are intangibles for which no reliable comparables exist, tax administrations cannot be expected to substantiate adjustments to the pricing structure by referring to uncontrolled transactions involving comparable intangibles.

Some of the practical ways in which the approach to HTVI can be applied are illustrated in the examples in the following section. The application of the approach to HTVI should be underpinned by the following principles:

• •Where the HTVI approach applies, tax administrations can consider ex post outcomes as presumptive evidence about the reasonableness of the assumptions of the ex ante pricing arrangements.
• •The ex post outcomes inform the determination of the valuation that would have been made at the time of the transaction; however, it would be incorrect to base the valuation on the actual income or cash flows without taking into account whether the associated enterprises could or should reasonably have known and considered, at the time of the transfer of the HTVI, the information related to the probability of achieving such income or cash flows.
• •Where a revised valuation shows that the intangible was transferred at an undervalue or overvalue compared to the arm’s length price, the revised price of the transferred intangible may be assessed to tax taking into account price adjustment clauses and/or contingent payments, irrespective of the payment profiles asserted by the taxpayer, consistently with paragraph 16.
• •Tax administrations should apply audit practices to ensure that presumptive evidence based on ex post outcomes is identified and acted upon as early as possible.

Company A, a resident of Country A, has patented a pharmaceutical compound. Company A has concluded pre-clinical tests for the compound and has successfully taken the compound through Phases I and II of the clinical trials. Company A transfers in Year 0 the patent rights to an affiliate, Company S, a resident of Country S. Company S will be responsible for the Phase III trials following the transfer. In order to determine the price for the patent on the partially developed drug, the parties made an estimation of expected income or cash flows that will be obtained upon exploitation of the drug once finalised over the remaining life of the patent. Assume the price so derived at the time of the transfer was 700 and that this was paid as a lump sum in Year 0.

In particular, the taxpayer assumed sales would not exceed 1 000 a year and that commercialisation would not commence until Year 6. The discount rate was determined by referring to external data analysing the risk of failure for drugs in a similar therapeutic category at the same stage of development. Even if the tax administration of Country A had been aware of these facts relating to the transfer of the patent rights in Year 0, it would have had little means of verifying the reasonableness of the taxpayer’s assumptions relating to sales.

In Year 4, the tax administration of Country A audits Company A for Years 0-2 and obtains information that commercialisation in fact started during Year 3 since the Phase III trials were completed earlier than projected. Sales in Years 3 and 4 correspond to sales that were projected, at the time of the transfer, to be achieved in Years 6 and 7. The taxpayer cannot demonstrate that its original valuation took into account the possibility that sales would arise in earlier periods, and cannot demonstrate that such a development was unforeseeable.

The tax administration uses the presumptive evidence provided by the ex post outcome to determine that the valuation made at the time the transaction took place did not consider the possibility of sales occurring in earlier years. The taxpayer’s original valuation is revised to include the appropriately risk-adjusted possibility of earlier sales resulting in a revised net present value of the drug in Year 0 of 1 000 instead of 700. The revised net present value also takes into account the functions performed, assets used and risks assumed in relation to the HTVI by each of the parties before the transaction and reasonably anticipated, at the time of the transaction, to be performed, used or assumed by each of the parties after the transaction. Therefore, assume for the purposes of the example that the arm’s length price anticipated in Year 0 should have been 1 000. Note that the value of 1 000 is not necessarily the net present value of the transferred rights based solely on the actual outcome (see paragraph 6 of this guidance).

In accordance with the approach to HTVI, the tax administration is entitled to make an adjustment to assess the additional profits of 300 in Year 0.

The tax administration uses the presumptive evidence provided by the ex post outcomes to determine that the valuation made at the time the transaction took place, did not consider the possibility of sales occurring in earlier years. The taxpayer’s original valuation is revised to include the appropriately risk-adjusted possibility of sales occurring in earlier years resulting in a revised net present value of the drug in Year 0 of 800 instead of 700. Therefore, assume for the purposes of the example that the arm’s length price anticipated in Year 0 should have been 800. Note that the value of 800 is not necessarily the net present value of the transferred rights based solely on the actual outcome (see paragraph 6 of this guidance).

In accordance with the approach to HTVI, the tax administration is entitled to make an adjustment to assess the additional profits of 100 in Year 0. However, in this example, the exemption provided by item (iii) in paragraph 6.193 applies since the adjustment to the compensation for the transfer is within 20% of the compensation determined at the time of the transaction.

The facts are the same as in paragraphs 21-22. Based on those facts, assume that in Year 7, the tax administration of Country A audits Company A for Years 3-5 and obtains information that sales in Years 5 and 6 of the product to which the patent relates were significantly higher than those projected. In the original valuation, the taxpayer had not projected sales any higher than 1 000 in any year, but outcomes in each of Years 5 and 6 show sales of 1 500. The taxpayer cannot demonstrate that its original valuation took into account the possibility that sales would reach these levels, and cannot demonstrate that reaching that level of sales was due to an unforeseeable development.

The tax administration uses the presumptive evidence provided by the ex post outcomes to determine that the possibility of higher sales should have been taken into account in the valuation. The taxpayer’s original valuation is revised to include the appropriately risk-adjusted possibility of sales occurring in earlier years, resulting in a revised net present value of the drug in Year 0 of 1 300 instead of 700. The revised net present value also takes into account the functions performed, assets used and risks assumed in relation to the HTVI by each of the parties before the transaction and reasonably anticipated, at the time of the transaction, to be performed, used or assumed by each of the parties after the transaction. Therefore, assume for the purposes of the example that the arm’s length price anticipated in Year 0 should have been 1 300. Note that the value of 1 300 is not necessarily the net present value of the transferred rights based solely on the actual outcome (see paragraph 6 of this guidance).

In accordance with the approach to HTVI, the tax administration is entitled to make an adjustment to assess the additional profits of 600. Assume for the purposes of this example that none of the exemptions listed in paragraph 6.193 of Chapter VI of the Guidelines applies.

One way to implement the adjustment is to re-assess the price paid in Year 0. However, the significant revision of the lump-sum payment highlights the risks posed by the high uncertainty in valuing the intangible and gives rise to consideration, in light of this significant uncertainty, of whether adjustments consistent with an alternative payment structure might be more consistent with what unrelated parties would have done (see paragraph 16 of this guidance and paragraph 6.183 of Chapter VI of the Guidelines).

Evidence of pricing arrangements for the transfer of intangibles in comparable circumstances to address high valuation uncertainty may point to appropriate alternatives to making the adjustment in Year 0. For example, assume that in the pharmaceutical sector it is common to transfer patent rights to independent parties through a combination of an initial lump sum payment and additional contingent payment arrangements based on the successful completion of development phases or regulatory approvals in a particular market. In this case, assume that the first market approvals were obtained in Year 3. The tax administration may, therefore, determine that it is consistent with arm’s length practices in comparable circumstances to recover the underpayment through a further payment in Year 3. Note that this paragraph is not intended to, and does not, imply that modification of the payment form can only occur when there is a common practice in the relevant business sector regarding the form of payment for the transfer of a particular type of intangible.

The principles illustrated by this example apply irrespective of whether the tax administration in fact carries out an audit for Years 0-2 and then a second audit for Years 3-5, or whether it audits only for Years 3-5. In both scenarios, a revision to the original valuation is justified based on ex post evidence emerging in Year 7, and, subject to any treaty or domestic law limitations, the undervaluation may be recovered based on the HTVI approach contained in Section D.4 of Chapter VI (see paragraph 6.192).