BEPS 2.0 and Intangible Property Planning
As of July 2023, 138 jurisdictions had signed on to the Organization for Economic Cooperation and Development (OECD) base erosion and profit shifting (BEPS) 2.0 framework aiming to ensure that multinational enterprises with group revenue of more than EUR 750 million pay a minimum corporate tax rate of 15.0%. While BEPS 1.0 led to many changes in rules in various jurisdictions to limit profit shifting, BEPS 2.0 is the largest coordinated effort to help address tax avoidance and bring international tax rules into alignment.
Historically, many multinationals placed their valuable intellectual property (IP) in tax-efficient jurisdictions to reduce their tax exposure. Jurisdictions such as the Cayman Islands, Bermuda, and the British Virgin Islands offered environments with either no direct taxation or a 0% corporate tax rate. Countries such as Ireland, Switzerland, and Singapore provided low corporate tax rates. The latter group of countries house regional headquarters for some of the largest U.S. companies and are regarded as attractive places to conduct business offshore.
Now that many zero-tax and low-tax jurisdictions have signed on to the OECD two-pillar global tax reform plan, which is intended to ensure that large multinationals pay a minimum 15.0% tax regardless of where they are headquartered or the jurisdictions in which they operate, does that mean IP planning is not as important, because there seems to be less opportunity for tax arbitrage?
DEMPE Still Triumphs
The short answer is no. Now more than ever, IP planning needs to be carefully evaluated to comply with the new global rules and minimize transfer pricing risk exposure. Specifically, multinationals should ensure that the entity legally holding the rights to IP has sufficient substance and control over the development of intangible assets.
Since introducing the concept in 2015, DEMPE — development, enhancement, maintenance, protection, and exploitation of intangibles — has become a new core framework that many tax authorities follow when analyzing the risks associated with intangible assets. Many tax authorities and multinational enterprises have applied DEMPE concepts to assess the control of risk, which is then used to determine what portion of profits from IP each entity should be entitled to.
With Pillar Two’s significant focus on preventing profit shifting associated with IP, multinationals should be able to demonstrate that any entities earning profits resulting from the ownership of intangible assets possess economic substance and control over the risks associated with the creation of intangible assets. Specifically, multinationals that have historically placed their IP in traditional tax haven jurisdictions may want to evaluate options and consider transferring the IP out of such jurisdictions to alleviate the potential impact of the Pillar Two rules, which are expected to apply from January 1, 2024, in some jurisdictions.
Multinationals may choose to keep their IP in their current locations as long as they can substantiate their position; however, it is often logistically challenging to build sufficient substance and control in certain historically low-tax jurisdictions, considering practical aspects including mobility of important decision makers, the attraction of skilled labor, and business infrastructure. Keeping IP in low-tax jurisdictions can also be an easy red flag for tax authorities to scrutinize the characterization of the IP holding entity as well as the transactions involved.
Looking Ahead
Given the new environment, what are some of the factors to evaluate when choosing a location for IP?
- A competitive tax rate
- Favorable tax credits and incentives
- A skilled labor force
- Established financial systems
- Location near key markets
As with any strategic tax planning, multinationals should carefully examine their overall cash tax liabilities and tax positions, as well as the pros and cons of a proposed structure, including where and how to move the IP. Companies should take a holistic approach that considers geographic location and substance requirements while ensuring they align their IP strategy with business strategies and priorities. Detailed modeling and a DEMPE functional analysis can together be useful in assessing the appropriateness of profit allocations related to IP and ensuring compliance with the new rules by demonstrating that the allocations are consistent with the arm’s length principle.
Grow Into a Proactive Approach to Transfer Pricing
Tax departments often start the new fiscal year with good intentions, which, in the practical world, get pushed from quarter to quarter until year-end has arrived again. Rather than be discouraged, companies can use the past to understand what is achievable and help prioritize the right-size improvement projects for the business.
Some common year-end transfer pricing challenges include:
Large transfer pricing adjustments. Many companies use transfer pricing adjustments as a mechanism to ensure they achieve the desired transfer pricing policy. However, if these adjustments are material, they can have both a tax and indirect tax impact, leading to further issues and risks.
Developing a multiperiod transfer pricing monitoring process that tracks profitability throughout the year to help reduce significant transfer pricing year-end adjustments. Such monitoring can also provide insight into whether underlying intercompany pricing changes are needed as a proactive approach to limit the number and magnitude of year-end adjustments.
Lack of transparency in calculations. Transfer pricing calculations are typically built in Excel by one person over many years. This leads to workbooks that lack a sufficient audit trail with hard-coded data that undermines the reviewer’s ability to validate the calculations. This leads to a lack of confidence in the calculations performed. Add to this key person dependency, and companies may be faced with not only year-end issues but also the risk that there could be a significant knowledge gap at any point throughout the year should the key person leave the company.
Identifying a material transaction or set of transactions and performing a detailed review of the calculation workbook can help a company pinpoint where existing workbooks are deficient. Examples could include a lack of version control, hard-coded amounts with no audit trail, limited or no key assumptions documented, and an overall incoherent calculation process. Companies can tackle one, some, or all of the issues identified based on timing and resources. The project doesn’t need to be large, but it can be impactful by making small changes.
Data constraints. The underlying mechanics of most transfer pricing calculations are not complex; however, difficulties arise when it comes to the variety of data needed (revenues, segmented legal entity P&Ls, headcount, R&D spend), and challenges associated with accessing that data can lead to short-cuts being taken and unvalidated assumptions being applied.
Defining a transfer pricing data-focused project allows companies to consider the data needed, investigate the form and availability of data, identify new data sources, and help providers of transfer pricing data understand their importance in the overall process. This can be done on a pilot basis with a material transaction or group of transactions to keep the project manageable. Companies often find new data sources through these projects, and the interaction with the data providers can form valuable connections when it comes to all parties understanding their role in the overall transfer pricing calculation process.
Learning is critical to adopting a proactive approach to transfer pricing — surviving a year-end process clarifies the areas that may need improvement. These observations should be captured and converted into small improvement projects as soon as possible after year-end. Companies can’t tackle everything at once, but by prioritizing key projects, developing a timeline with identified resources, and obtaining stakeholder buy-in quickly, companies can improve the next year-end experience.
Contact your GBQ team member to help you implement a transfer pricing project.
