The DEMPE framework provides a structured approach to identifying which entities within an MNE group contribute significantly to the creation, enhancement, maintenance, protection, and exploitation of intangibles. By delineating these functions and attributing them to specific entities, DEMPE facilitates a more accurate allocation of profits in accordance with the economic substance of each entity’s contributions. This framework not only helps in complying with international tax regulations but also enhances transparency and fairness in the distribution of income among related entities.

Here is a breakdown of each component of DEMPE:

• Development: Activities related to the creation and design of the intellectual property (IP). This includes research and development (R&D), innovation, and the initial creation of intellectual property assets.
• Enhancement: Activities that improve the value or functionality of the IP. This can involve further R&D, updates, upgrades, or improvements made to the existing IP.
• Maintenance: Activities required to keep the IP in good working condition or to prolong its lifecycle. This includes regular updates, bug fixes, and ensuring the IP remains relevant and operational.
• Protection: Activities to protect the IP from unauthorized use or infringement. This involves legal actions, obtaining patents, trademarks, or copyrights, and ensuring ongoing compliance with legal requirements.
• Exploitation: Activities that generate revenue from the IP. This includes licensing, selling, or otherwise commercializing the IP.

In the context of Transfer Pricing, the DEMPE analysis helps in allocating profits and costs associated with IP among different entities within a multinational group, ensuring that the entity that undertakes and controls the most significant DEMPE functions receives an appropriate share of the income derived from the IP. This helps prevent base erosion and profit shifting (BEPS) by ensuring that profits are taxed where economic activities occur and value is created.

According to paragraph 6.32 of the OECD Guidelines, in Transfer Pricing cases involving intangibles, it is essential to identify which entity or entities within a multinational enterprise (MNE) group are entitled to share in the returns from exploiting these intangibles. Equally important is determining which entity or entities should bear the costs, investments, and other burdens associated with the Development, Enhancement, Maintenance, Protection, and Exploitation (DEMPE) functions of these intangibles.

The OECD Guidelines also highlight that while the legal owner of an intangible might receive the income from its exploitation, other entities within the MNE group might have performed functions, utilized assets, or assumed risks that contribute to the intangible’s value. These contributing entities must be appropriately compensated for their contributions according to the arm’s-length principle, which ensures that transactions between related parties are priced as if they were between unrelated parties.

The purpose of the DEMPE framework is to assist both taxpayers and tax authorities in accurately evaluating transactions, identifying the entities involved in DEMPE functions, and ensuring they receive a fair, arm’s-length return. To achieve this, paragraph 6.34 of the OECD Guidelines outlines a detailed analytical framework for examining intangibles in controlled transactions:

1. Identify the Intangibles: Determine the specific intangible assets involved.
2. Identify the Full Contractual Arrangement: Review the entire contractual agreement related to the intangibles.
3. Identify the Parties Involved: Identify which entities are performing functions, using assets, and managing risks associated with the intangibles in relation to DEMPE.
4. Confirm Consistency: Verify that the actual conduct of the parties aligns with the contractual arrangements through a functional analysis.
5. Delineate the Transactions: Clearly define the actual controlled transactions related to the DEMPE of intangibles.
6. Determine Arm’s-Length Prices: Establish prices for the defined transactions that comply with the arm’s-length principle.

Before the introduction of the DEMPE concept, the entitlement to returns from exploiting intangibles was often determined solely by the legal ownership of those intangibles by an associated enterprise. For instance, a MNE could register its trademarks in a low-tax jurisdiction and claim that IP owner could charge royalties to related entities in other countries. This allowed the IP owner in the low-tax jurisdiction to receive income that was actually generated in other jurisdictions.

In addition to the DEMPE guidelines, the 2015 Final Report on Actions 8—10 provided updated instructions for analyzing risk in Transfer Pricing. Previously, contractual arrangements between related parties often determined which party bore relevant risks for Transfer Pricing. The updated guidance still considers these contractual allocations, but only if they align with the actual conduct of the enterprises. Paragraph 1.60 of the OECD Guidelines outlines the required steps for risk analysis:

1. Identify Significant Risks: Determine which risks are economically significant.
2. Review Contractual Allocation: See how the parties have contractually allocated these risks.
3. Conduct Functional Analysis: Identify which entities perform risk control and mitigation functions, which entities are exposed to the consequences of the risks, and which entities have the financial capacity to bear these risks.
4. Verify Consistency with Conduct: Ensure the contractual allocation of risk matches the parties’ actual behavior by analyzing:
   1. Whether the parties adhere to the contractual terms.
   2. Whether the party assuming the risk under the contract controls the risk and has the financial capacity to bear it.
5. Reallocate Risk if Necessary: If the party assuming the risk lacks the financial capacity or control, reallocate the risk to the entity that does control and can financially bear it, following the OECD Guidelines (paragraphs 1.98-1.99).
6. Price the Transaction: Set the price for the transaction, considering the appropriate risk allocation and compensating for risk management functions accordingly.

Following the BEPS initiative, the OECD rules clarify that merely having contractual arrangements or providing funding does not entitle an entity to returns from intangibles or risk assumption. To earn these returns, an entity must demonstrate “substance” by having decision-makers who control the risks or perform key DEMPE functions. Entities that fund intangible development or contractually assume risks without engaging in significant people functions will not be entitled to the returns from economically significant risks and intangibles.

While the OECD Guidelines explicitly state that legal ownership or contractual arrangements are insufficient on their own to justify entitlement to returns from risk assumption and intangible ownership, they do not provide precise criteria for what constitutes sufficient “substance” in practice. This lack of clarity allows tax authorities to interpret the guidelines differently, posing a challenge for taxpayers in determining how much substance is necessary to meet the functional requirements for earning rewards from assuming risks and owning intangibles.

The evolution in risk analysis, as outlined in the OECD guidelines, underscores the importance of aligning contractual allocations with the actual conduct and substance of business operations. It emphasizes that mere contractual assumptions of risk or legal ownership are insufficient to justify entitlement to returns from intangibles. Instead, entities must demonstrate substantial involvement through decision-making, control over risks, and performance of key functions related to the intangibles. This approach aims to prevent base erosion and profit shifting by ensuring that entities bearing significant risks are appropriately compensated.

While DEMPE and risk analysis frameworks provide essential tools for ensuring fair and transparent Transfer Pricing practices, ongoing adaptation and interpretation will be necessary to meet the evolving demands of a globalized economy and regulatory landscape. Collaborative efforts between stakeholders will be crucial in maintaining a balanced approach that supports both compliance and business growth in an increasingly interconnected world.

Sources:

https://www.thetaxadviser.com/issues/2022/jun/oecd-dempe-risk-guidance-us.html

https://kpmg.com/ch/en/insights/taxes/transfer-pricing-dempe-functions-impact.html

https://d-nb.info/1294961764/34#page=51