Transfer Pricing Of Intangibles

Article by Andreas Köster-Böckenförde and Alexa Clauss

1. Introduction

   The development, transfer, and licensing of intangibles are part and parcel of cross-border transactions among related parties. The allocation of costs and revenues, risks and chances, has a fundamental impact on the tax liability of multinational companies. Therefore, enterprises should pay special attention to transfer-pricing strategies, particularly with regard to intangible assets. But determining adequate transfer prices is extremely difficult. And the national fiscal authorities closely examine how companies deal with this matter, paying particular attention to whether they comply with the documentation rules.

2. The Definition of "Intangible Property"

   When determining transfer prices, the first step is to identify the intangibles. Since there is no universal, abstract definition of "intangible assets" in German legislation or administration, the identification of intangibles often presents serious difficulties. The applicable rules and guidelines comprise only enumerations of intangibles.1

   Under Section 266.II.A of the German Commercial Code (Handelsgesetzbuch), "intangibles" are identified as concessions, industrial property and similar rights, the licenses referring to such rights, goodwill, and advance payments. Section 5 of the 1983 Administrative Guidelines lists industrial property and similar rights, design protection rights, copyrights, business secrets, and other rights and benefits not legally protected.2 The 2005 Administrative Guidelines discuss the transfer of intangibles without defining the term at all.3

   In several judgments, the Federal Tax Court defined "intangibles" as "incorporeal objects."4 Nevertheless, in most cases the Court merely gives examples (the right to supply, options, concessions,5 software6) without providing a more general or abstract definition.

   The literature tries to bridge this gap, holding that the lack of physical substance distinguishes intangible from tangible assets. Commentators further define "intangible assets" by explaining what they are not: neither material fixed assets nor financial assets.7 While financial assets obviously have no physical substance, they do have a monetary value and serve the enterprise in a financial respect, whereas intangibles are used in the operative group of goods and services.8 The criterion of physicality is not always determinative. Many assets, such as software or copies, have both corporeal and incorporeal features and are distinguished according to their ratio of tangible to intangible components.

   The definition of "intangible asset" provided by Chapter 38 of the International Accounting Standards ("IAS") may be also indicative. According to IAS 38.8, an "asset" is a resource that is controlled by the enterprise as a result of past events (e.g., a purchase or self-creation) and from which future economic benefits (inflows of cash or other assets) are expected, while an "intangible asset" is an identifiable nonmonetary asset without physical substance. Thus, the three critical criteria of an intangible asset as listed by IAS 38.10 are control, identifiability, and future economic benefits. Pursuant to IAS 38.12, an intangible asset is identifiable when it is separable (i.e., capable of being separated and sold, transferred, licensed, rented, or exchanged, either individually or as part of a package) or arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. Additionally, IAS 38.21 requires an enterprise to recognize a resource as an intangible asset if it is probable that the future economic benefits that are attributable to the asset will flow to the enterprise and that the cost of the asset can be measured reliably.

   In summary, "intangible assets" may be understood as identifiable matters of potential benefit without physical substance which may be either legally protected or unprotected and which are used in the operation of a business.

3. German Generally Accepted Accounting Principles ("GAAP")

   Long-term intangible assets that are acquired for a consideration have always been capitalized on the asset side of the German GAAP balance sheet. In contrast, companies were not allowed to account for self-made intangible assets. Now, however, the GAAP in Germany stipulate that self-developed long-term intangibles created after December 31, 2009, may be capitalized if the owner elects to do so. The only exceptions are self-made brands, publishing rights, customer lists, and similar assets.9 With respect to R&D expenses, only expenses arising from the development or advancement of products or procedures within the scope of applied research may be capitalized. Expenses for evident research—the independent and methodical search for new scientific or technical expertise for general purposes, regardless of technical applicability or economic success—cannot be capitalized. Nor can the costs of projects in which development cannot be distinguished from pure research.10 Business expenses that cannot be capitalized are immediately deductible. The capitalized expenses have to be depreciated over the useful economic life of the asset.

4. The Development of Intangibles

   In order to increase economic efficiency, multinational groups often assign their research and development projects to separate specialized companies within the international group. A company may fund and conduct R&D activity in three different ways: own development, contract research, and the R&D pool.11 In terms of location, forms of global development have been relevant for the past couple of years.

   1. Own Development

      In the case of "own development," the company conducts all research and development activities on its own. The development, ownership, and associated risks are concentrated within that company, which bears all the research and development expenses and reaps all the benefits that result.12 This form of R&D is rarely used by multinational groups, since ownership of the intangibles would then be located in various companies in several jurisdictions, making the protection and administration of these assets difficult and inefficient. In multinational groups, the development of intangibles is usually centralized, with local development restricted to minor adjustments required by local markets.

   2. Contract R&D

      A company engaging in "contract research" retains another company to conduct defined R&D activities on behalf of the principal. Contract research is used for basic and applied research, new inventions, and product development.13 The principal, rather than the research company, bears all the risks and reaps all the benefits of the activity.14 Because contract research is a service, the performing company receives remuneration, but it does not receive a license.15 Contract research may be ordered by any company, a group of companies, or an R&D pool.

      Engaging in contract research is the most efficient way to exploit both local expertise and centralized ownership. It enables companies to make use of the specific knowledge of employees or research facilities existing in certain jurisdictions. At the same time, it makes it possible to place ownership of the intangible within the jurisdiction that best fits the business strategy, provides the best legal protection, and/or optimizes the multinational group's tax position.

   3. R&D Pools

      "R&D pools" are commitments in which the participants jointly undertake research and development activities. Each participant may have a different obligation: some may make personnel available while others provide funding, with the rest supporting the project by other means. In return, each participant benefits from the results of the research in its own or some other territory at no additional cost. The participants share the costs and risks according to a defined percentage of payment, e.g., cost allocation, and obtain co-ownership of the research results.16 R&D pools may also be implemented by unrelated parties.

   4. Global Development

      The term "global development" refers to any R&D activity that is conducted at multiple locations around the world by multiple R&D teams. The R&D teams work on the same project and share their results frequently, if not daily. Global development projects are often seen in the software industry. Since global development projects can be spread over multiple locations, they can be conducted in all three R&D forms: as own development, in the rare instances when a company has multiple R&D offices around the world; as contract research, in which a company engages multiple contractors that share results; or as R&D pools, when the participants are in multiple locations.

5. The Use of Intangibles

   There are different ways to make use of an intangible asset: a company may either temporarily license the right to use it, sell it outright, or transfer it by other means.

   1. Licensing or Transfer

      The intellectual property rights owner (licensor) may enter into a licensing agreement with another party (licensee) authorizing the licensee to use such rights in return for an agreed payment (fee or royalty). Normally, the right to use the intangible is granted for a limited time and/or for a defined territory only, so the licensor remains the owner of the intangible. Restricting the license to a certain period, territory, application, etc., provides the licensor with a great deal of flexibility with respect to the exploitation of the intangible.

      The intangible may also be sold and transferred. In such cases, no restrictions as to time, territory, or application apply. The legal character of the transaction is determined by the interpretation of the...