Our chief economist, Mimi Song, is joined by Dr. Ednaldo Silva from RoyaltyStat to discuss the evolution, challenges and outlook for transfer pricing rules as it relates to hard to value intangibles (HTVI).

Mimi Song: How have transfer pricing methods related to intangibles evolved?

Dr. Ednaldo Silva: As a consultant many years ago, I was engaged to look at a portfolio of inbound distributors that all had sustained losses. Under 1968 regulations, there were three transfer pricing methods to derive arm’s length price: Comparable Uncontrolled Price (CUP) and two methods based on gross profit.

Through my research I discovered that transfer pricing existed not only through purchases recorded as cost of goods sold (COGS), but also in operating expenses—management fees, outbound royalty payments and also the deduction of advertising expenses. As a solution to this problem, I proposed a method based on operating profits because then you can solve transfer pricing violations whether they belong in COGS or in operating expenses.

This discovery led to the opportunity to contribute to new IRS legislation related to transfer pricing that culminated in the development of the Comparable Profits Method (CPM).

Mimi Song: This method is currently applied about 80% of the time as the best method for almost all different types of arm’s length transactions.

Mimi Song: What are HTVIs and why are they different from intangibles?

Dr. Ednaldo Silva: To reframe the question, what sets intangible assets apart from other assets that make it so difficult for us to establish value? While the OECD has provided guidance on the characteristics of HTVI, I challenge the very notion that this concept should exist— it’s not an empirical concept because there is not a definable time or location. It could be for the next 10, 20 years, and it doesn’t distinguish the space—it doesn’t matter if you’re in Germany, the U.S., China or Brazil.

Nevertheless, according to the OECD, especially as it relates to chapter six that was revised in 2017, hard to value intangibles are distinguished by two characteristics:

• Comparables cannot be found.
• You can’t predict the future stream of net revenue or benefits with certainty.

Currently there are three methods used to value intangibles, which in my opinion, are not sufficient in isolation. While one approach would be to combine methods #1 and #3—predicting the future profitability of an intangible by relying on historical and empirical evidence—in reality, these are complex situations that don’t have a ‘one size fits all’ solution. My concern is that multinational corporations (MNCs) are defining intangibles value in a way to correspond to the reality that they want to measure.

To that end, what ends up happening by default is that the implied method to value intangibles is through discounted cash flow – this income approach is favored by the OECD and the U.S. However, it can lead to many controversies as assumptions must be made and applied about the company’s present value based on projected income.  Recent court cases involving Medtronic, Veritas and Amazon highlight this issue, although the taxpayers in these cases ultimately prevailed.

Mimi Song: What is a better way to do measure HTVIs? 

Dr. Ednaldo Silva: I’m not advocating any particular methods, not even for the CPM, which was my brainchild. What I want is flexibility and the understanding that there are many ways of valuing these intangibles. It’s the recognition that it’s a dynamic issue and we need the flexibility to come up with new approaches. It’s about developing a hypothesis, and testing it on a case-by-case basis.

Currently, the approach is imbued with an intention—that it is “hard to value” because intangibles produce excess profits for the MNC. What is really crucial however is that intangibles are “commensurate with income” (CWI) –the recognition that intention as an asset is dynamic over time—there are assets that under certain conditions produce high profits, and under other conditions, do not, e.g. if the MNC has market concentration, it’s more likely to produce the former.

What’s interesting in the aforementioned court cases is that no one makes reference in substance to CWI. So you see, for example, people referencing CUPS or comparable uncontrolled transactions (CUT) without demonstrating profit potential or making reference to CWI.

Mimi Song: How do you think transfer pricing methods for intangibles evolve over the next few years?

Dr. Ednaldo Silva: There has been a longstanding approach by tax authorities to target intangibles for assessing larger adjustments on MNCs. The aforementioned high profile cases all deal with the value of intangibles.

To make the method for valuing intangibles more straight forward, I believe we’re going to move more and more into safe harbors, limits and deductions. That’s because I think that it is time that tax authorities recognize that we there are so many potential comparables for manufacturing activities, so many comparables for distribution activities, all within a predictable profit range.

We have already seen this based on OECD guidance with respect to capitalization rules. It’s moving from the concept of comparability to the concept of limits in our laws where you cannot deduct interest expense that exceeds 30% of EBITDA.

I am optimistic that more practical solutions regarding valuing intangibles will be forthcoming with respect to limits of deduction and safe harbors, but also that intangibles will reach a level of discourse that is a more well-defined without as much subjectivity.

Mimi Song: What advice do you have to multinationals who have received an IDR for their intangibles?

Dr. Ednaldo Silva: Based on my experience working on both sides, it’s critical for MNCs to provide a full and salient picture to the tax authorities when they get an IDR so the transaction is based on trust from the outset.

For example, if you track the expense attributed to the intangible, you disclose it to the tax authority. One of the things that really frustrated me when I was at the IRS was that taxpayers sometimes use the shotgun approach. They don’t know what you have so when an IDR is requested they share a truckload of information, which the IRS doesn’t have the ability to analyze.

To hear more of Mimi’s and Dr. Silva’s conversation about hard to value intangibles, listen to this episode of The Fiona Show.