Anna Lucey of Ernst & Young Services Limited (UK) says that Her Majesty's Revenue and Customs (HMRC) audits heavily focus on source evidence and particularly functional interviews to support contractual arrangements. As an example, to test the characterization of an R&D entity, HMRC expects to understand the end-to-end R&D process, the progression of LS products through the R&D pipeline, the process and roles responsible for stage-gate decisions, and the interactions between UK and non-UK parties throughout the process — all of which are expected to be supported by internal documents, functional interviews or case studies. Another feature of HMRC audits is that the financial data requested are typically very granular and include transactional or segmented information to allow HMRC to understand the operational TP aspects (e.g., definition of pass-through costs, application of mark-ups to various cost components and treatment of share-based costs).
Authorities across the world apply OECD rules inconsistently
One of the stated goals of the BEPS Actions 8–10 report was to align tax authorities around the taxation of intercompany transactions. Specifically, Actions 8–10 report was intended to “provide[s] guidance to determine the transfer pricing outcomes in accordance with the actual conduct of related parties in the context of the contractual terms of the transaction.”1 Despite carefully drafted language regarding risk and control of risk, authorities around the globe continue to interpret the OECD rules as requiring profits to follow functions and not risks. Countries continue to assert that all IP-related profits should follow development, enhancement, maintenance, protection, and exploitation (DEMPE), when the rules clearly say otherwise.
In this regard, Mike McDonald of Ernst & Young LLP (US), who served as a US delegate to the OECD’s Working Party 6 during the BEPS project and the drafting of Actions 8–10, recently stated, “I would be distressed if [US] Treasury is significantly moving away from the foundational guidance in [US Treasury Regulations] §1.482-1(d)(3), which properly respects contractual allocations of risk that have substance and for which there is appropriate control over that risk. These foundational principles are also contained in the OECD TP guidelines, if only one would take the trouble to read what the guidance actually says.”2
Lucey notes that HMRC typically closely examines participation of UK employees in group governance bodies (e.g., R&D committees) and their roles in high-level regional or global positions within the organization. This often leads to HMRC arguing that such individuals are performing value-creating and risk-controlling activities warranting additional, and often profit-based, compensation.
Berger and Jan also point out that the FTA frequently scrutinizes the characterization and functional profile of French LS companies. This often results in a demand for greater remuneration, attributable to DEMPE functions and related value-creating and leadership activities, purportedly performed by local French companies. In support of its position, the FTA generally downplays the significance of the legal ownership of IP and instead focuses on, for example, the location of marketing operations and the personnel involved with marketing activities.
Finally, Jason Vella and Michael Jenkins of Ernst & Young (Australia) emphasize that the Australian Tax Authorities (ATO) also closely scrutinizes IP-related transactions, including any DEMPE contributions made by Australian entities in connection with what the ATO describes as the ‘‘economic substance’’ of an IP transfer, and the options realistically available to Australian entities in connection with outbound transfers of IP.