The “unique and valuable” nature of intangibles makes it challenging to conduct a valuation due to the absence of comparables. This alert examines the transfer pricing treatment of unique and valuable intangibles.
The term “intangible” is intended to address something that is not a physical asset which is capable of being owned or controlled for commercial use and the use would be compensated for. Further, there are various categories of intangibles. This alert examines the treatment of “unique and valuable” intangibles – essentially by examining the method of valuation for such intangibles especially in a related party transaction.
Paragraph 6.17 of the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines 2022 (the OECD Transfer Pricing Guidelines) has defined “unique and valuable” intangibles to be intangibles that:
i. Are not comparable to intangibles used or available to parties to comparable transactions.
ii. The use in business operations is expected to yield greater future economic benefits than expected in the absence of the intangible.
Method Of Valuating: OECD Transfer Pricing Guidelines
The appropriate method of valuation largely depends on the specific characteristics of the intangibles. It is often the case in transactions involving intangibles that the comparability analysis would divulge the fact that there are no reliable comparable to determine the arm’s length pricing, especially where the intangibles have unique characteristics.
Where the comparable cannot be identified, the arm’s length principle requires the use of another method to determine the price that uncontrolled parties would have agreed under comparable circumstances. In making such determination, consideration is given to:
i. The function, assets and risks of the respective parties of the transaction.
ii. The business reason for engaging in the transaction.
iii. The perspectives and options realistically available to parties of the transaction.
iv. The competitive advantages conferred by the intangibles especially in relation to profitability of products and services related to the intangibles.
v. The expected future economic benefits from the transaction.
vi. Other comparability factors such as features of local markets, location savings, assembled workforce and Multinational Enterprises (MNE) group synergies.
It is crucial to note that to date there are no reported Malaysian cases on the method for choosing the most appropriate method for the valuation of intangibles. However, there is an Indian transfer pricing case that examines this pint. The case of Orange Business Services India v DCIT (I.T.A No. -1201/Del/2015 & SA-169/Del/2015) is discussed below to illustrate the application of the OECD Transfer Pricing Guidelines in relation to the valuation of intangibles.
Brief Facts
The taxpayer’s principal business was in the field of data transfer and communications. The taxpayer had taken over the business operations of Global One India Private Ltd (GOIPL) after it had ceased its operations. It was submitted by the taxpayer that the business follows the same business model, undertake the same operations, service the same group of clients and employ the same management personnel and employees as GOIPL.
The taxpayer had applied the profit split method (PSM) which was also applied by GOIPL, on the basis that it was the most appropriate method as it satisfies the conditions for PSM. The taxpayer contended that PSM was the most appropriate method of valuation as it satisfied the following conditions:
i. That the international transactions should involve the transfer of unique intangibles.
ii. There are multiple international transactions which are so integrated that they cannot be evaluated separately.
However, the PSM was rejected by the Indian Transfer Pricing Officer (TPO) in both the valuations prepared by the taxpayer and GOIPL. The Dispute Resolution Panel (DRP) rejected the taxpayer’s objections to the TPO order and held that the transactional net margin method (TNMM) was the most appropriate method as opposed to PSM applied by the taxpayer.
The Court’s Findings
The Income Tax Appellate Tribunal found merits in the taxpayer’s appeal and allowed the appeal. The tribunal found that the TPO had erred in facts as the revenue was generated in a transaction where there was contribution from multiple entities. Where a transaction was integral and interrelated, and when costs were incurred by multiple entities, the factual conclusions of the TPO need to be vacated. In determining the most appropriate method, the TPO was required to examine the functional profile of the taxpayer and the nature of the international transaction. The court held as follows:
a) That the TPO had erred in the facts when he had compared the operations to a simple e-mail and as a plug in operator as the taxpayer possess unique intangibles in the field of data transfer and communications.
b) The fact that the taxpayer had suffered a loss was not a ground to reject PSM as the most appropriate method. The conclusion of the TPO that the PSM was adopted to camouflage the loss at the net level was merely an allegation and was not substantiated. Hence, it was devoid of merit.
c) TNMM cannot be used for benchmarking returns earned by a number of complex entities where each make valuable contributions. The tribunal cited the OECD Transfer Pricing Guidelines where it stated that a transactional net margin method was unlikely to be reliable if each party to a transaction makes valuable, unique contributions. In such cases, the transactional profit split method will generally be the most appropriate method.
d) Intangible assets pose a difficult issue in relation to both their identification and to their valuation. Identification of intangibles can be difficult because not all invaluable intangible asset is legally protected and registered and not all valuable tangible assets are recorded in the accounts. An essential part of a PSM analysis was to identify what intangible assets were contributed by each associated enterprise to the controlled transaction and their relative value.
Commentary
Malaysia’s perspective for the valuation of intangibles is similar to India. The Income Tax (Transfer Pricing) Rules 2012 (P.U. (A) 132/2012) provide that where a property is highly valuable or unique, the residual PSM shall be applied especially in cases where difficulties arise in identifying reliable comparables due to the uniqueness of the intangibles as laid down in IRBM Transfer Pricing Guidelines 2012.
PSM is the most appropriate method for the valuation of intangibles as it seeks to eliminate the effect on profits of special conditions made or imposed in a controlled transaction. Firstly, it identifies the profits to be split between the associated enterprises. Then, it splits the combined profits between the associated enterprises on an economically valid basis that approximates the division of profits that would have been anticipated and reflected in an agreement made at arm’s length. Unlike The TNMM, The PSM does not require the valuation to be based on comparables. This is crucial for unique and valuable intangibles as it can be difficult to find a comparable due to the unique characteristic of the intangible.
Further, the PSM also eradicates the issue of identification of intangibles. An essential element of PSM analysis is to identify the intangible that has been contributed by the corporation to the transaction and the value of the said contributions.
20 February 2023
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