Introduction
Hard to Value Intangibles (HTVI) can have significant impacts on transfer pricing for multinational enterprises (MNEs) operating across various tax jurisdictions. Tax professionals in MNEs, have the difficult task of understanding the challenges and risks they pose.
Here we provide a quick overview on what HTVIs are, their impact on transfer pricing and what those impacts mean in real-world terms for tax professionals. We also look at a case study where intangibles were a focus, to bring the information in this article, to life.
Valuations are a complex topic. This article provides a simple overview and includes a case law example for context.
What are HTVIs?
HTVIs are intangible assets—such as patents, trademarks, copyrights, or technology—that are difficult to accurately value at the time of a transaction due to:
- Uncertainty about future profits or revenues they may generate.
- Long development periods before commercialization.
- Market volatility, especially in tech or pharmaceutical sectors.
The Challenges of HTVI’s within Transfer Pricing
For tax professionals working on transfer pricing for MNEs, uncertain future value causes challenges with HTVIs. With an uncertain future value, it’s incredibly difficult to set a fair price at the time of transfer. This is why the following challenges come up:
1. Risk of Tax Adjustments: Tax authorities may scrutinize HTVI transactions more closely because of the potential for significant divergence between projected and actual future profits. . If the actual profits from the HTVI are much higher than expected, authorities may question the transfer pricing arrangement. This could lead to substantial retroactive adjustments, penalties, and increased tax liabilities.
2. Compliance Burden and Transfer Pricing Documentation: HTVIs significantly increase the compliance burden for MNEs. To mitigate the risk of transfer pricing disputes, tax teams are forced to:
- Develop robust transfer pricing policies that account for the uncertain value of intangibles.
- Ensure comprehensive documentation that includes detailed projections, valuation methodologies, and assumptions.
- Regularly review and potentially revise transfer pricing strategies in response to changes in the value of the intangible assets.
- Do their best to identify comparable transactions. This is very difficult with HTVIs because they can be very specialized or unique.
3. Impact on Tax Planning and Strategy: HTVIs can affect an MNE's broader tax planning strategy. As tax authorities pay more attention to valuing intangibles, there is a higher risk. Pricing strategies aimed at optimizing global tax rates may face challenges. There's an onus on tax teams to regularly assess where intangibles are held, how they are developed, and, ultimately, how they are transferred between entities.
What do these challenges around intangibles mean for a Tax Professional in an MNE?
The challenges outlined above mean that tax teams handling HTVI’s must be readily prepared for:
- Audit Risks: As mentioned earlier, HTVIs are likely to face more scrutiny from tax authorities. This increases the risk of audits and disputes. Therefore, it is important to have strong defense files and documentation that is ready for audits.
- Financial Exposure: Retroactive tax adjustments for HTVIs could have big financial effects, especially if adjustments are made years after the transaction. This raises the importance of regular monitoring and adjusting transfer pricing strategies. This ensures they reflect evolving market conditions or new information about the intangible's value.
- Cross-border Disputes: Different jurisdictions may take varying approaches to HTVI valuation. This can lead to double taxation risks. These risks make it harder to manage transfer pricing compliance across countries. As a result, there is a greater need for advance pricing agreements.
Real-world challenges of HTVIs
Case: Sweden vs Twilio Sweden AB (Feb 2024 >review the full case here)
Overview: Swedish company Twilio had entered into an agreement with its new US parent company regarding a license for intangible assets. According to the tax authorities, this was a taxable transfer of those assets. Because of this, they issued an assessment for additional taxes.
Challenges:
1: Determining the Actual Transaction
Formal agreements vs. economic reality: One main challenge for transfer pricing professionals is understanding the actual transaction between related parties. While a formal agreement, such as a license agreement, may exist, the real economic situation might be different.In the Twilio case, a license agreement was in place. However, the Swedish Tax Agency argued that the deal involved intangible assets. These assets included customer relationships, know-how, and the ability to generate returns. This difference in interpretation has significant implications for the valuation of the intangibles involved.
2: Identifying and Valuing All Intangibles
Explicitly listed vs. implicitly transferred: Transfer pricing teams must find and value all intangibles in a transaction. This can be hard when some intangibles are not clearly stated in an agreement.
In this case, the Swedish Tax Agency argued that the Twilio case involved more than just software. It also included other intangible assets, such as customer and supplier relationships, know-how, and trade secrets. These intangibles were part of the company's valuation of Beepsend IP but not explicitly included in the license agreement.
3: Assessing Control
Legal ownership vs. economic ownership: Determining which party has control over the intangible asset is crucial for valuation. This can be complicated by the distinction between legal ownership and economic ownership.
In this case, the Swedish Tax Agency said that Twilio Sweden AB kept legal ownership of ‘Beepsend IP’. However, Twilio Inc took control of developing, improving, maintaining, protecting, and using the asset.
4: Determining Arm's Length Compensation
Finding similar transactions in the open market for unique intangibles can be hard. This makes it tough to set a fair arm's length price.
In this case, both parties in the Twilio case agreed to use the external price of the company's shares. However, they disagreed on the adjustments needed to find a fair price. This disagreement came from different opinions on the transaction's scope. It also involved factors like control premiums and liquidity discounts.
The Twilio case exemplifies the complexities surrounding the valuation of hard-to-value intangibles in transfer pricing. Identifying the real transaction is a key challenge for transfer pricing teams. They must consider all relevant intangibles, assess control and find an arm's length price.
Conclusion
Hard-to-value intangibles (HTVI) present one of the most complex challenges in transfer pricing due to the difficulty in accurately predicting future returns. This complexity underscores the need for robust, data-driven approaches to pricing these assets.
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