On June 4, 2015 the Organisation for Economic Co-operation and Development (OECD) released a discussion draft concerning work in relation to Action 8 of the base erosion and profit shifting (BEPS) project, which deals with hard-to-value intangibles. The discussion draft explains the difficulties faced by tax authorities in verifying the arm’s length basis on which pricing is determined by taxpayers for transactions involving a specific category of intangibles. When valuation of an intangible or the rights to an intangible at the time of the transaction is uncertain, the question arises as to how arm’s length pricing should be determined.
The draft refers to hard-to-value intangibles or HTVI. Intangibles falling under the HTVI category may exhibit one or more of the following features:
- they are only partially developed at the time of the transfer;
- they are not expected to be commercially exploited until several years following the transaction;
- are separately not HTVI but are connected to the development or enhancement of other intangibles which fall under the category of HTVI;
- they are expected to be exploited in a manner that is novel at the time of the transfer.
For such HTVI, information asymmetry between the taxpayer and the tax authorities may be acute and may exacerbate the difficulty encountered by tax authorities in verifying the arm’s length basis on which pricing was determined. As a result, it will be difficult for tax authorities to perform a risk assessment for transfer pricing purposes and to evaluate the reliability of the information on which the taxpayer has based its pricing. It will also be difficult to determine whether the intangible or the rights to the intangible were undervalued or overvalued upon transfer compared to the arm’s length price. The risk assessment may only be possible until ex post outcomes are known in the years following the transfer.
OECD Proposed Approach
The discussion draft proposes an approach based on the determination of the arm’s length pricing arrangements, including any contingent pricing arrangements that would have been made between independent entities at the time of the transaction.
Although the ex post evidence about financial outcomes provides relevant information for tax authorities to consider the appropriateness of the ex ante pricing arrangements, in circumstances concerning HTVI:
- where the taxpayer can satisfactorily demonstrate what was foreseeable at the time of the transaction and reflected in the pricing, and that
- the developments leading to the difference between projections and outcomes arose from unforeseeable events,
no adjustment to the ex ante pricing arrangements based on these special considerations would be justified.
Implications of the OECD proposed approach
Under the proposed approach by the OECD, taxpayers will have to provide full details on their HTVI:
- its ex ante projections, and
- provide satisfactory evidence that any significant difference between the financial projections and actual outcomes is due to, for example, unforeseeable or extraordinary developments.
This approach is applied after specific conditions are met and it is intended to protect tax authorities against the negative effects of information asymmetry.
Comments on the OECD discussion draft are welcomed by the OECD and must be submitted by June 18, 2015. An OECD public consultation is scheduled for July 6-7, 2015.