On 4 June, the Organisation for Economic Co-operation and Development ("OECD") published a discussion draft on "hard-to-value-intangibles" in terms of which the OECD proposes revising its Transfer Pricing Guidelines. In particular, it is proposed that tax authorities will be allowed to use ex post "evidence", (i.e. hindsight), to assess the arm's length nature of transfer pricing arrangements in respect of "hard-to-value-intangibles".
What are hard-to-value-intangibles?
The OECD defines hard-to-value-intangibles as meaning intangibles or rights in intangibles "for which, at the time of their transfer in a transaction between associated enterprises:
- no sufficiently reliable comparables exist; and
- there is a lack of reliable projections of future cashflows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertain.
Hard-to-value intangibles therefore include, inter alia, intangibles that are only partially developed at the time of transfer or are not anticipated to be exploited commercially until several years following the transaction, as well as intangibles that are anticipated to be exploited in a manner that is novel at the time of the transfer.
The problem faced by tax authorities
Due to the specialised and complex nature of many industries, tax administrations depend to a large extent on the disclosures and explanations provided by the taxpayer. Inevitably, this situation has been abused in the past, which has led to systemic mispricing. The OECD's concern is that "information asymmetry between taxpayer and tax administrations may be acute and may exacerbate the difficulty encountered by tax administrations in verifying the arm's length basis on which pricing was determined."
As the OECD explains, "an enterprise may transfer intangibles at an early stage of development to an associated enterprise, set a royalty rate that does not reflect the value of the intangible at the time of the transfer, and later take the position that it was not possible at the time of the transfer, to predict the subsequent success of the product with full certainty. The difference between the ex ante and ex post value of the intangible would therefore be claimed by the taxpayer to be attributable to more favourable developments than anticipated."
While in South Africa the scope for such mispricing is limited due to the exchange control restrictions applicable to the transfer of intangibles developed in South Africa to related parties outside of the country, the OECD's proposed reforms to protect tax administrations from the negative effects of the above described information asymmetry.
Proposed changes to the OECD Guidelines
The OECD proposes revising the guidance in Section D.3 of the Transfer Pricing Guidelines so that tax administrations may consider ex post (i.e. hindsight) evidence about the actual financial outcomes of the transfer of hard-to-value intangibles. Ex post evidence may be used where:
- "the difference between ex post outcomes and ex ante projections is significant; and
- where such a difference is due to developments or events that were or should have been foreseeable at the time of the transaction."
How taxpayers should prepare for this proposed change
In order to avoid the application of hindsight to transfer pricing decisions made by the taxpayer in the context of the transfer or licensing of intangibles, it is necessary for the taxpayer to satisfy the tax administration that the decision taken at the time was based on reliable information. This can be achieved by:
- providing full details of the ex ante projections used at the time when the decision on the pricing arrangements was made; and
- providing satisfactory evidence that any significant difference between the financial projections and the actual outcomes is due to unforeseeable or extraordinary developments or events occurring after the determination of the price that could not have been anticipated by the associated enterprises at the time of the transaction.
Therefore, the importance of the taxpayer preparing a detailed analysis of all potential commercial outcomes when it agrees upon a price or sets a royalty rate involving hard-to-value-intangibles cannot be over-emphasized.
However, while it might be possible to limit the risk of the tax administration being able to use hindsight in its assessment of the arm's length nature of the transfer and/or licensing of hard-to-value intangibles through the preparation of detailed documentation at the time the decision on the pricing arrangements is made, it is concerning that the judgment of whether or not the ex ante projections used by the taxpayer were reasonable will rest with the tax authority.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.