10 minute read 26 Jun 2019
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Why businesses must keep an eye on invisible assets

By EY Global

Multidisciplinary professional services organization

10 minute read 26 Jun 2019

Mismatches exist between geographic recognition of returns for taxation and locations of contributions to intangibles in operating models.

Among the many miles of media headlines that propelled tax along its decade-long journey from the business pages to the front page, one message in particular has been conspicuous by its absence: that what constitutes a “fair share” of taxes is, at heart, a story of how the very concept of value has changed in nature.

This concept of changing value fuels many of today’s most vigorous discussions. How do “digital” companies create value, for example? Is it their technology, or is it their brand? Is it the intangible contribution of their users, effectively replacing many of the tasks that a business may previously have performed? (“If you can’t tell what the product is, it’s you.”) 

It’s no secret that companies driving business models that are lean on people and tangible assets but heavy on intangible assets or data are quickly becoming some of the world’s biggest. Traditional brick-and-mortar companies, meanwhile, are scrambling to adapt and find their new role. Sometimes what is less visible can add the most value.

Not only rewards, but also risks

Trademarks, patents, copyrights and brand recognition are all examples of intangible assets. Over the last two decades their contribution to the balance sheet has greatly expanded. At the same time, intangible assets can bring not only huge value, but significant challenges to governments that wish to secure tax revenue, and to taxpayers who must pay it.

The many challenges of identifying, properly valuing and then attributing profit to intangible assets in fact sits at the very heart of the base erosion and profit shifting (BEPS) project that is now updating more than 100 years of internationally accepted tax norms. Likewise, it sits as a cornerstone in US tax reform and, as we move forward, it will continue to drive discussions on digital taxation and the longer-term division of taxing rights between countries.

In this changing world, sustaining competitive advantage while also mitigating risk is key. In this case, it requires a solid understanding of what the intangible value drivers are for your company, clear insights into the processes that drive and develop intangibles, and a conscious choice on how intangibles are managed and controlled. 

The potential consequences of getting this model wrong can include unplanned and chaotic ownership of key assets for tax purposes, substantial complexity in determining an acceptable allocation of taxable profits between competing tax authorities, an increasing incidence of tax disputes as a result and significant reputational risks.

More importantly, it could be argued that any lack of clarity on intangibles management may suggest that a corporation may not be applying the right level of focus on one of its most fundamental value drivers — and thus its core business.

Ever-changing drivers of business success

Although patented products continue to play an important role in the world of intangibles, there has been a shift in emphasis in recent years for businesses to use (and for customers to reward and tax authorities to tax) intangibles that are more difficult to define and protect, and that tend to be constantly evolving. 

It could be argued that any lack of clarity on intangibles management may suggest that a corporation may not be applying the right level of focus on one of its most fundamental value drivers — and thus its core business.

The most recent guidance on transfer pricing (TP) from the Organisation for Economic Co-operation and Development (OECD)1 describes intangibles as: “Something which is not a physical or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.”

What this means in practical terms is that intangibles are taking entirely new and different forms. These include:

  • Marketing intangibles, which are constantly evolving as businesses adapt to changing market requirements and opportunities. For example, in China the tax authorities place special focus on the marketing activities undertaken by companies, adding “promotion” to the typical functions related to intellectual property (IP) such as development, enhancement, maintenance, protection and exploitation (the “DEMPE” functions).
  • “Know-how,” including negative know-how (i.e., lessons from failed initiatives). 
  • Data — and in particular the insights provided through applying analytics and artificial intelligence (AI) to data — is recognized as a critically valuable input to all areas of business. As a further example, the contribution of user data to a business’s success — coupled with the use of other intangible assets and the ability to sell without being physically present —is driving a significant part of Europe’s desire to tax the turnover of many intangible-rich companies.
  • Composite intangibles (i.e., combinations of different intangibles forming, for example, a business model, have greatly increased in importance).
  • Customer interfaces that use digital enablers, predictive analytical tools and AI to transform existing businesses, improve business value and further facilitate innovations should themselves be seen as intangibles.

A key result of these shifts is that the traditional value chain has evolved into an interactive value circle, at the center of which sit data and insights. Companies are in effect now acting as part of an ecosystem or value web, where improved awareness drives different levels and types of collaboration, all fueled through greater insight and the ability to rapidly adapt to business opportunities, heading off competitive threats. 

But while this allows new competitive advantages to be secured, these new types of IP, as well as changes in the processes and contributors to their development, are putting significant pressure on more “traditional” tax administration models that must try to capture IP’s value.

More than just R&D

When the development and maintenance of intangibles was the sole preserve of easily identifiable “people in white coats” working, for example, in a single global R&D center, it was relatively easy to determine where intangibles were developed. And, until relatively recently, tax authorities accepted that legal ownership and the financing of the development of intangibles conferred a right to the profits arising from their exploitation, after “routine” returns had been allocated to easily identifiable development, production and sale entities.

This model, though, has been turned on its head. 

Post-BEPS, considerable emphasis is now placed on the governance of DEMPE functions (to which China has added promotion, resulting in “DEMPEP”) in determining the allocation of the profits derived from intangibles.

A key result of these shifts is that the traditional value chain has evolved into an interactive value circle, at the center of which sit data and insights. Companies are in effect now acting as part of an ecosystem or value web.

After rewarding functional contributions (which can continue to be priced using conventional TP methods), the new OECD guidance implies that residual returns (or, equally importantly, losses) should be captured by the entity or entities controlling the important risks associated with DEMPE functions.

This is known as the “control test.” To meet it, an entity must have the capacity and capability to make the relevant decisions — and must actually do so. Neither setting a policy environment for the relevant decisions nor formalizing decisions made in other locations is sufficient to meet it.

Isn’t that easy to address?

That might seem at first glance like a relatively easy task for business to address. But today’s reality is quite different. 

As a result of numerous and complex regulatory and business changes, many companies may now have a significant mismatch between the geographic recognition of returns for tax purposes and the locations of contributions to intangibles (as defined by the OECD’s new guidance) in their operating models.

Further adding to this is that business strategies and business models may be subject to (or may need to) change. It has always been the case that the design of an operating model, and more particularly the locations in which key managers are located, drives where profits should be recognized for tax purposes. This also makes sense from the perspective that, while companies work across borders, the corporate tax sovereignty of a country, in principle, stops at the border.

The DEMPE-focused BEPS changes (as well as related nexus changes) mean that all multinationals should now expect far greater scrutiny from tax authorities of the locus of control of the business processes and assets that drive their profits. Moreover, given the pace of business evolution, the value attributed to new kinds of intangibles will become an increasing focus for tax authorities. It should be fully expected that tax authorities will further refine their frameworks for addressing the role of key intangibles within the future value chain and the changing role of existing functions.

In particular, the role of business concepts or ideas and access to capital is expected to intensify as they become key determinants of success. But, while issues related to the DEMPE functions are indeed important, the assumption, management, and control of risk and funding must also be considered when addressing the overall intangibles strategy. Indeed, some jurisdictions, including the US, may argue that these issues are actually more important than DEMPE. 

Furthermore, as illustrated in the current debate on how to tax digitalized business activity, access to customer data and the ability to use it efficiently to better serve other customers will become a major driver for operating models, with related permanent establishment, withholding and indirect tax effects all being experienced as a result.

While we would not advocate having “tax drive the business,” having an integrated design that considers all the different layers of the operating model is key to create a robust, sustainable model from the business and tax perspectives.

Understanding whether there is a “mismatch,” as we defined, is essential in deciding whether action is needed and in determining its urgency and direction of change. This requires an understanding of the nature, ownership and importance of intangibles and an analysis of contributions to these intangibles, ultimately mapped to entities or countries.

Once this is achieved, there are essentially three approaches available to address a mismatch, each of which has differing outcomes, goals, challenges and results: 

  • Transforming the operating model requires a high level of ambition, fundamentally transforming the company operating model from a business and tax perspective. This can include moving from a vertically integrated to a horizontal organization.
  • Enhancing the operating model may require less ambition, but still requires substantial change. It may include reallocating IP ownership, amending processes and pricing models, or moving from “brick to click,” with related changes in structure, processes and value drivers.
  • Protecting the operating model can be done by protecting existing tax and business framework by improving on substance (i.e., better alignment of intangibles in context of DEMPE), governance or pricing.

Future-proofing for success 

Innovation, disruption and differentiation among products and services are essential ingredients to  win in today’s challenging business environment. 

The intangibles created by these three ingredients are potentially the most valuable assets a business will own, regardless of whether a traditional company is re-inventing itself or is already a digital “native.” 

Tax and TP guidelines have been updated and are continuing to evolve to better recognize and capture value, but also to better reflect various business functions that contribute to the value equation. 

No longer can we identify a single function as being the owner of and responsible for advanced intangibles; rather, value is created by different participants along a company’s value chain, if not in a different ecosystem altogether. 

Successful companies therefore need to design their operating models around three key themes: 

  • First, they must develop an effective set of specific processes, roles, metrics and governance to invent, fund, own, enhance and exploit intangibles. 

  • Second, they must establish, measure and manage an ecosystem of employees, suppliers, contractors and alliance partners to work on this — including a specific view on the concept of “location” (i.e., where the actual value is created). 

  • Third, they must embed the updated OECD guidelines for intangibles, including the clarified DEMPE process definition, into their activities, and align the business and after-tax outcomes as necessary. Moreover, they must closely monitor national level laws, regulations and stances to help confirm that any deviations from the OECD approach are constantly identified and addressed.

The first two steps will provide companies with an improved focus on these essential value drivers, if not their core business. The third step will be mission-critical if companies wish to head off future risk. 

As with our earlier definition of “composite intangibles,” however, it is the simultaneous optimization of these three steps that will truly allow companies to design a winning operating model. While this is not an easy task, it appears that the incredibly high pace of innovation and disruption, combined with the new guidelines, has moved the debate on intangibles to a higher level of sophistication and importance. Are your invisible assets in sight and under control? 

This article was originally published in Tax Insights on 9 Aug 2018.


Some of the world's fastest-growing companies are those with limited work forces and tangible assets -- but with significant intangible assets or data. Traditional brick-and-mortar businesses sometimes struggle to adapt and reinvent themselves in new roles.

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By EY Global

Multidisciplinary professional services organization