Transfer pricing: intercompany alignment of intangible property

22nd Annual Health Sciences
Tax Conference
Transfer pricing in life sciences update:
intercompany alignment of intangible property
and pricing issues

December 3, 2012

Disclaimer

► Any US tax advice contained herein was not intended or
written to be used, and cannot be used, for the purpose of
avoiding penalties that may be imposed under the Internal
Revenue Code or applicable state or local tax law
provisions.

Page 2 Transfer pricing in life sciences update: intercompany
alignment of intangible property and pricing issues

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Presenters

► Jon Haug ► Cedric Bernardeau
Director and Tax Counsel Ernst & Young LLP
Eli Lilly and Company New York, NY
+1 212 773 2165
► John Hickey cedric.bernardeau@ey.com
Senior Manager,
Global Transfer Pricing ► Siv Schultz
Johnson & Johnson Ernst & Young LLP
New York, NY
► Lynne Sullivan +1 212 773 3818
Vice President of Tax siv.schultz@ey.com
Biogen IDEC


Agenda

► Intangible property (IP) alignment and transfer
► Tax authority IP transfer pricing focus
► Internal Revenue Service (IRS) — income method
► Organization for Economic Co-operation and Development
(OECD) intangibles draft
► Alternative IP transfer pricing methods
► Comparable uncontrolled transaction (CUT) method
► Profit split methods
► Other IP transfer pricing methods


Need for IP alignment

► Multinational companies have global operations that need access to
IP in order to serve customers.
► These companies have options with respect to how IP rights are
aligned with foreign operations:
► Options include sale, licensing, contribution or cost sharing
► Different approaches may be taken based on type of IP and geographic
market
► The need to align IP with operations and other business
considerations (e.g., supply chain and legal protection) arises in a
number of contexts:
► Mergers and acquisitions activity
► Organic expansion into new markets
► Research and development (R&D) breakthroughs, new product launches
► Changes in business model and supply chain management


IP alignment and transfer


Identify IP and other value drivers —
overview
► Understand current nature and ownership of IP:
► Legal owner vs beneficial owner
► Purchase price analysis, license, service contract, other agreements
► Funding and strategic management of activities generating or protecting IP
► Understand current tax situation:
► R&D incentives
► Transfer pricing
► Tax treaty considerations (e.g., permanent establishment, qualification for benefits)
► Withholding tax planning
► Existing tax authority controversies
► Evaluate ongoing IP-related projects (e.g., IT transformation,
substantial contribution, assistance analysis)


ownership and nature of IP
► Understand relationship between or among transacting parties
► Identify role of value drivers and related intangibles
► Goodwill, going concern, workforce-in-place
► Value-adding synergies related to business activity that do not attach to any
particular asset
► Common legal characteristics of an intangible asset:
► Specific identification and recognizable description
► Subject to legal existence and protection
► Subject to right of private ownership and private ownership legally transferable
► Tangible evidence of existence (e.g., contract, license)
► Created or came into existence at an identifiable time or as result of identifiable event
► Subject to being destroyed, termination of existence at an identifiable time or as
result of identifiable event


ownership and nature of IP (cont.)
► Common tax categories of intangible assets (see Internal Revenue
Code (IRC) Section 936(h)(3)(B)(i)-(v))*:
► Marketing: trade name, trademark, brand name
► Technology: patent, invention, formula, process, design, pattern, know-
how, technical data
► Art: copyright, literary, musical, artistic composition
► Systems/processes: method, program, campaign, survey, system, study,
procedure, forecast, estimate
► Engineering applications: patent, invention, formula, process, design,
pattern, know-how, technical data
► Customer relationships: customer list
► Contracts: franchise, license, contract
*IRC Section 936(h)(3)(B)(i)-(v) includes any similar item that has substantial value independent of the
services of an individual.


Transfer of IP — risks and functions

► Identify transferable IP
► Break identified value drivers into smallest component parts
► Determine which value drivers require consideration
► Evaluate from tax perspective for all interested jurisdictions (typically
the transferor, transferee and transferor shareholder(s))
► Approach to IP development:
► Licensing (single owner)
► Cost sharing (multiple owners)
► Cost contribution arrangements
► Asset contribution
► Use of partnerships
► Contingent arrangements/options
► Combination


Transfer of IP — risks and functions (cont.)

► Methods of transfer:
► Asset sale, stock sale or license (Section 482)
► Contribution to corporation or partnership (Sections 367/721)
► Assumption of key functions and risks without asset transfer
► Deemed goodwill transfer or other conversion costs
► Compensable IP transfers
► Methods:
► CUT — viable in a number of industries (see the Veritas case)
► Profit split — consider whenever IP ownership or unique skill set resides
offshore
► Income — generally required as a primary or confirming approach; can be best
method if reasonably applied
► Acquisition price
► Payments: lump sum, installments or contingent royalties


Transfer of IP — risks and functions —
methods of transfer

Method of IP Description of Form/timing of Tax ownership Source of income (to
transfer transaction payment (amortization) transferor)
Sale for fixed “All substantial rights” in IP Lump sum or installments Transferee Residence of transferor —
consideration (or an undivided interest paid over useful life Section 865(a)
therein) for a defined
geographic area (country or
countries) are transferred for
a non-contingent amount.
Sale for contingent “All substantial rights” in IP Royalty (flat or declining Transferee Place of use subject to US
consideration (or an undivided interest rate) and/or milestones amortization recapture —
therein) for a defined paid over useful life Section 865(d)
geographic area are
transferred for an amount
contingent on use or
productivity.
License (fixed or Less than “all substantial Fixed = lump sum or Transferor Place of use —
contingent rights” in IP (or an undivided installments; contingent = Sections 861/862(a)(4)
consideration) interest therein) are declining or fixed royalty
transferred for fixed or and/or milestones; non-
contingent amount. lump sums paid over
useful life


Transfer of IP — risks and functions —
methods of transfer (cont.)
Method of IP Description of Form/timing of Tax ownership Source of income (to
transfer transaction payment (amortization) transferor)
Contribution to IP rights are contributed to Deemed license Transferee (assuming no Place of use —
controlled controlled corporation in payments made to rights are retained) Sections 861/862(a)(4)
corporation in exchange for (actual or transferor for up to 20
exchange for shares deemed) shares — years — Section 367(d)
Section 351.
Contribution to IP rights are contributed to Depends on terms of Transferee (assuming no Look to distributable
partnership in partnership in exchange for partnership interests and rights are retained) share of partnership
exchange for common interest or for partnership profits; no income (foreign IP rights
partnership interest common and preferred time limits but Section typically generate foreign-
interests — Section 721. 482 principles likely apply source income)
to total consideration
Contingent services IP is developed under Small up-front fee Transferor initially; Place of performance —
arrangement; option contract, and consideration (premium) + larger transferee if exercise/ likely location of R&D
pricing depends on future success-based fee if future contingency met services
contingency. future contingency
met/option exercised
(strike price)


Tax authority IP transfer pricing focus


IRS focus on IP transfers

► Controversy
► Medtronic, Docket No. 6944-11, Filed 3/23/2011
► Guidant, Docket No. 5989-11, Filed 3/11/2011
► Western Union settlement (December 2011), network intangible
► IRS to pursue litigation to limit impact of the Veritas case
► Final cost-sharing regulations
► No major changes to new methods introduced in the temporary regulations
► Limited revisions/additional guidance:
► Use of weighted-average cost of capital (WACC)
► Adjustments for tax rate differentials
► Coordinated issue paper, cost sharing, withdrawn (6/26/2012)
► Section 367(d) regulations on current IRS business plan:
► Intended to harmonize with updated Section 482 regulations
► Proposed rules to replace IP with platform contribution transaction concept
► IRS reorganization
► Establishment of LB&I Transfer Pricing Practice under Sam Maruca, adding transfer pricing
specialists as resources to IRS local audits that will focus on transfers of intangibles and high-
value services

IRS focus on IP transfers (cont.)

► IRS default valuation technique — income method
► Used to maximize intangible value
► Aggregation of intangible assets
► Expansion of definition of IP
► Chief Counsel advice on cost sharing from the IRS: (CCA201111013,
dated 6/25/10, released 3/18/11)
► Rejection of the US Tax Court opinion in the Veritas case
► Previous comments from IRS National Office:
► Good comparables don’t exist for intangible transactions that shift a significant
amount of income offshore; need another way to determine arm’s length, such as
the income method (summarized comments by Christopher Bello, Branch 6 Chief,
IRS Office of Associate Chief Counsel (International), April 15, 2010)
► New methods introduced in temporary cost-sharing regulations could be applied to
non-cost-sharing intangibles (summarized comments by Steven Musher, IRS
Associate Chief Counsel (International), Dec. 11, 2009)


Income method — Treas. Reg. §1.482-7(g)(4)

► Overview of income method
► Value of IP equal to net present value (NPV) of future flow of residual value after
routine returns are subtracted
► Considerations:
► Quality of data
► Central importance of projections
► Consistent with assumptions of method (return on future R&D)?
► Reliability of assumptions
► Discount rate (e.g., hurdle rate, WACC)
► Sensitivity to deficiencies in data
► Probability of success
► Assumptions about participant tax rates
► Note: cross-reference in Treas. Reg. §1.482-4 allows income method to be applied
to intangible transfers outside of cost sharing


Income method — considerations

► The income method values all intangibles that drive profit in
aggregate.
► What if the transaction is related to specific intangibles?
► Need to allocate projected profit to various intangibles
► May require more assumptions, which could lessen reliability
► Examples:
► Technology
► Marketing
► Customer relationships
► User relationships
► Trademarks/trade names
► Pre-existing vs future IP
► The method does not account for how parties allocate risk.
► All residual profit is assumed related to intangibles, accruing to intangible owner.


Income method — sensitivities

► Discount rate
► Before or after tax
► Probability of success
► Growth rate for revenue and costs
► Useful life of intangible
► Routine returns
► Measurement of up-front investment


OECD intangible draft — impact on IP
transfer pricing methods
► Draft issued June 2012
► Endorses use of financial valuation techniques based on
“discounted value of projected future cash flows” (e.g., income
method)
► Endorses methods based on looking at commercial alternatives
available to both parties (in other words, endorses “the realistic
alternatives” principle of U.S. regulations)
► Legal and accounting definitions of intangibles are rejected in favor
of emphasis on what unrelated parties, acting at arm’s length,
would pay for:
► In other words, intangible is “something of value” that is not a
tangible asset or a financial asset.
► The implication is that goodwill, going-concern value and
workforce-in-place are all potentially intangibles.

OECD intangible draft — impact on IP
transfer pricing methods (cont.)
► The party that has claim to a significant return with respect to an
intangible asset will typically perform significant functions with
respect to the intangible asset through its own employees.
► Implication: the “cash box” is not expected to receive a premium
return.
► Effectively, the revised Chapter 6 represents an endorsement of
the IRS approach to valuation of intangibles in the new cost-
sharing regulations.
► Since OECD countries are endorsing the IRS approach, it is likely
the conflicts we have seen in the US over the arm’s-length value
of intangibles will also be repeated.
► Commentary on the OECD draft was released on October 29, and
a public hearing was held in mid-November.


Income method — example

Source: Ernst & Young LLP


Income method — example (cont.)

Routine return assumptions:
► Distribution, 6.50%
► Marketing, 11%
► Manufacturing, 20%
► Contract R&D, 10%



Income method — example (cont.)

Assumption: discount rate applied, 10%



Alternative IP transfer pricing methods


CUT method — Treas. Reg. §1.482-4(c)

► The CUT method evaluates whether the amount charged for an
intangible transfer was arm’s length, relative to a comparable
uncontrolled transaction.
► Generally, the CUT method compares the compensation
earned by a licensor in a third-party agreement to an
intercompany transaction.
► Transactions entered into by a company with third parties are
key sources of data.
► If complete and accurate data exists to measure and establish
the comparability of the controlled and uncontrolled
transactions, the CUT method will provide the best method for
determining the arm’s-length price for the IP.


CUT method — Treas. Reg. §1.482-4(c)
(cont.)
► Comparability factors:
► Comparable intangible
► Similar product or process within the same general industry
► Similar profit potential
► Most reliably measured by the NPV of the benefits to be realized as a result of the
transfer of a property
► Comparable circumstances:
► Terms of transfer (i.e., exclusivity, geography, etc.)
► Stage of development of IP
► Rights to receive updates, revisions or modifications of the IP
► Uniqueness of IP and IP protection
► Duration
► Product liability risk
► Collateral transactions
► Functions to be performed
► Data and assumptions


CUT/comparable uncontrolled price method
(CUP) litigation

► Compaq
► Compaq Computer Corporation and Subsidiaries v. Commissioner
of Internal Revenue, T.C. Memo No. 1999-220

► Veritas
► Veritas Software Corporation and Subsidiaries v. Commissioner of
Internal Revenue, 133 T.C. 297 (2009)

► Xilinx
► Xilinx Inc. and Subsidiaries v. Commissioner of Internal Revenue,
125 T.C. 37 (2005), aff’d 598 F. 3d 1191 (9th Cir. 2010)


CUT method — example



CUT method — considerations

► Considerations:
► Milestone payments
► Can be significant ($10 million–$100 million)
► Geographic markets
► Stage of development
► Collateral transactions
► Examples: co-promotion, cross-license and development


Profit split methods — Treas. Reg. §1.482-6

► Under these methods, an arm’s-length result is determined by
comparing the relative contributions made by each of the controlled
participants to the overall operating income of a transaction or
business activity and allocating returns based on the relative value of
these contributions.
► The relative value assigned to such contributions considers:
► Functions performed
► Risks assumed
► Resources employed


Profit split methods — Treas. Reg. §1.482-6
(cont.)
► Residual profit split method (RPSM)
► The combined operating profit or loss from the relevant business activity is
allocated between the entities by:
► Allocating income to routine contributions
► Allocating residual profit
► Least reliable method as no arm’s-length data is used
► IRS uses RPSM to increase IP
► Comparable profit split method (CPSM)
► Applied when reliable revenue and cost data exist for uncontrolled
taxpayers engaging in similar transactions and activities
► Factors that affect comparability:
► Functions performed
► Risks assumed
► Economic conditions (profit potential)
► Property/services transferred


Other IP transfer pricing methods

► Comparable profits method (CPM) — Treas. Reg. §1.482-5
► Evaluates whether the amount charged is arm’s length based on profit level
indicators derived from uncontrolled taxpayers that engage in similar business
activities under similar circumstances
► In practice, identifies firms considered comparable (similar facts, circumstances,
functions and risks) and compares profit levels of the firms to profit level of the
tested party
► Reliability of the CPM based on the degree of comparability between the tested
party and the uncontrolled firms identified
► Acquisition price method — Treas. Reg. §1.482-7(g)(5)
► Applies the CUT/CPSM to evaluate whether the amount charged for the stock or
asset purchase of an entire organization, or portion, in an uncontrolled transaction
is arm’s length
► Market capitalization method — Treas. Reg. §1.482-7(g)(6)
► Applies the CUT/CPSM to evaluate whether the amount charged is arm’s length in
reference to the average market capitalization of a controlled participant whose
stock is regularly traded on an established securities market


What next?

► Further controversy
► IRS’s new transfer pricing practice
► Further guidance from IRS through revised regulations
► Finalization of OECD guidance


Questions?


Transfer pricing: intercompany alignment of intangible property

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