Assessing intangibles for compliance and R&D grant eligibility

With this rapid change, invisible assets, or intangible assets (“intangibles”) are progressively more important value drivers for many Multinational Enterprises (MNEs). These intangibles have become the focus of tax controversy worldwide.

Tax authorities have been examining the business models and contractual arrangements of intangibles by multinationals, in a bid to enforce and enhance the latter’s tax obligations in their respective jurisdictions.

Intangibles generate significant economic value and need to be considered for transfer pricing purposes. While intangibles in their traditional meaning continue to be significant, their constant evolution and expanded scope has accentuated the challenges in terms of an accurate identification, definition, determination and evaluation of intangibles. 

What is an intangible?

The Organisation for Economic Co-operation and Development (“OECD”) defines an intangible as: “something which is not a physical or financial asset, is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated if it occurred in a transaction between independent parties in comparable circumstances.” This definition is intentionally broad, and goes beyond patents, copyrights, trademarks, etc. 

Due to the ever changing business and economic environment coupled with constant regulatory amendments, economic ownership of intangibles within a MNE is an increasingly contentious issue because of the “significant mismatch” between creation of intangibles value and the recognition of operating returns in different jurisdictions for tax purposes.

To DEMPE or not to DEMPE?

With the introduction and adoption of Base Erosion and Profit Shifting (BEPS) Action Plans, the OECD has identified five functions that are critical in the accurate delineation of intangible transactions: Development, Enhancement, Maintenance, Protection, Exploitation (DEMPE), and subsequent, allocation of corresponding returns to all entities in the value chain.

This DEMPE framework means that any value or income from the use of the intangibles is attributable not only to the legal owner of such intangible but also to all entities in the MNE responsible for performing functions, using assets and assuming risks in relation to the DEMPE activities.

Arm’s length or not?

An added difficulty is associated with the peculiar nature of intangibles as being unique and valuable assets. This uniqueness leads to an onerous exercise that usually relies on limited or weak comparability to establish benchmark returns. The application of traditional and commonly applied transactional methods that utilise external comparable uncontrolled prices are no longer considered accurate or reliable. With the adoption of the DEMPE approach there is a shift towards undertaking value-based analysis that considers the value created by all participants in the supply chain. The DEMPE approach is considered more reflective of the unique contributions made by all entities in the value chain. 

A uniquely Australian approach to intangibles

Transfer pricing authorities worldwide have actively adapted legal mechanisms in the form of new or revised guidance and laws to address the transfer pricing issues relating to intangibles.

In Australia, the Australian Taxation Office (ATO) has released the draft Practical Compliance Guideline (PCG) 2021/D4¹. The draft PCG outlines the ATO’s compliance approach to international arrangements connected with the use, DEMPE functions and transfer/migration of intangibles. 

The draft PCG provides a self-assessment framework based on risk factors and the extent of supporting documentation for their intangible arrangements (including examples of arrangements that are used to assess the level of risk posed by a taxpayer’s intangible arrangements). These factors include:

• Understanding and evidencing the commercial considerations and decision-making,
• Understanding the legal form of the intangible arrangements,
• Identifying and evidencing the intangibles and connected DEMPE activities, and
• Analysing the tax and profit outcomes of the intangible arrangements.
  
  

The draft PCG does not include any threshold and thus, implies that all taxpayers should review all intangible arrangements. The latest informative guideline focuses on the ATO’s high expectations in terms of the documentation and emphasises the ATO’s continued focus on the review of taxpayers’ intangible arrangements as a key tax/transfer pricing risk area.

The Australian R&D Tax Incentive – a key consideration for MNEs?

The Australian Government in recent years has made a conscientious effort to encourage and support businesses to undertake R&D activities in Australia that they may not otherwise be willing to attempt. As a result MNE’s have been attracted to setting-up or expanding their local R&D activities in Australia to access the support offered by the Australian Research and Development Tax Incentive (R&D Tax Incentive).

The R&D Tax Incentive comprises several levels of support including a refundable offset of up to 43.5 per cent for taxpayers where their annual aggregated turnover is less than AUD$20 million. The refundable tax offset is independent of the income tax liability of a company, i.e. in the event of no tax liability, the tax offset is refundable in cash. Taxpayers with turnover greater than AUD $20m can access non-refundable support from 8.5 per cent up to 16.5 per cent plus their respective corporate tax rate. The higher rate is available to companies that achieve an R&D intensity of greater than 2 per cent of their total expenses. 

Such incentive is eligible for re-investing into an entity’s operations, for example, towards funding further research in Australia to enhance the scope and robustness of trials in comparison to other jurisdictions.

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Eligibility for R&D Tax Incentive claims is subject to the following prescribed criteria:

• the applicant must generally be an Australian tax resident company,
• the R&D activities must be conducted in Australia², and
• the company must incur at least AUD $20,000 of eligible R&D expenditures during the income year – including both core³ and supporting⁴ R&D activities.

Several MNEs structure their global R&D to take advantage of the R&D Tax Incentive by establishing Australian subsidiaries that subcontract the R&D activities to another third party entity. Before an entity can claim any R&D it needs to consider who:

• has ownership or rights to exploit any intellectual property generated from the R&D activities,
• bears the financial risk of conducting the R&D activities, and controls how the R&D activities are performed. 

Where MNEs have established local subsidiaries that subcontract R&D activities to another third-party entity, we recommend a thorough analysis of the MNEs plans (including the proposed operational and structural aspects) is undertaken ahead of time to ensure eligibility and compliance with the R&D Tax Incentive nuances in combination with applicable transfer pricing considerations.

In particular, where vital control functions in relation to the DEMPE of the IP are performed and the corresponding risks are assumed by MNE personnel located overseas, such a potential mismatch poses a two-fold risk: 

• Not fulfilling the prescribed criteria for a successful R&D Tax Incentive claim, and
• Significant transfer pricing mismatch between actual conduct of parties vis-à-vis agreed upon contractual obligations and the potential for the overseas entity of the MNE to be considered the economic owner of the underlying IP.

Accordingly, MNEs undertaking R&D activities in Australia are strongly encouraged to proactively undertake a comprehensive review of their plans, policies and operations to ensure congruency between their R&D activities and their transfer pricing policies for intangibles. This will concurrently boost their bid for successful R&D Tax Incentive claims in Australia and manage their tax and transfer pricing risks. 

Suggested guidance for the journey ahead

In this fast-paced and ever-evolving transfer pricing landscape, intangibles continue to be a focus area for regulators and tax authorities alike. In this context, for taxpayers, it would be in their own interest to undertake a cogent and prompt evaluation in terms of:

• Development and maintenance of a business model/ecosystem wherein all activities and processes across all MNE group entities are consistent from a business and tax perspective,
• Identification of intangibles and a robust functional analysis in the light of DEMPE activities,
• Documentation of inter-company arrangements including description of intangibles, rights and obligations of the parties, and a “substance over form” inter-company pricing policy, i.e. contractual arrangements consistent with the actual conduct of the parties, and
• Initiatives and measures to assess eligibility and to avail the applicable benefits of the R&D Tax Incentive scheme.

_{¹ Source: https://www.ato.gov.au/law/view/document?docid=DPC/PCG2021D4/NAT/ATO/00001 
² Overseas R&D activities may also be eligible for RTDI under specific circumstances basis an advanced ruling :(i) Successful demonstration of the necessity of such activities outside of Australia for reasons other than cheaper cost, and (ii) The quantum of overseas R&D expenditure is less than the R&D expenditure conducted in Australia. 
³ Experimental activities based on principles of established science which are carried out with the purpose of generating new knowledge, the outcome of which is not known.
⁴ Preliminary research, project management, data collection and related processes.}