DEMPE: Six steps for analyzing transactions involving intangibles

Section 6.34 of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (published by the Organisation for Economic Co-operation and Development (OECD) outlines six steps for multinational enterprises (MNEs) to follow when analyzing transactions involving intangibles. They help to determine appropriate arm’s length prices for transactions made between associated enterprises, as per the base erosion and profit shifting (BEPS) initiative.

Conducting this analysis is important for accurately determining whether any entities within an MNE are entitled to a portion of the returns gained from the exploitation of a particular intangible. They may have performed functions, used assets or assumed risks in relation to the development, enhancement, maintenance, protection and exploitation (DEMPE) of the intangibles (6.32). If the DEMPE functions contributed value to the intangible, then the MNE entities will need to be compensated accordingly before a transfer price is delineated.

Analyzing transactions involving intangibles

The OECD’s six steps for analyzing transactions involving intangibles are as follows:

1. Identify the intangibles and risks within a particular transaction
2. Identify the contractual agreements relating to the transaction in question
3. Identify which parties performed DEMPE functions, by means of a functional analysis
4. Determine whether the conduct of the parties was consistent with the contractual assumption of risk
5. Delineate the actual controlled transactions relating to DEMPE
6. Determine arm’s length prices for the transactions

The steps should be carried out in line with Section D.1. (‘Identifying the commercial or financial relations’) of Chapter 1 of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017 (2017 Transfer Pricing Guidelines or Guidelines). Chapter 1 outlines how MNEs can identify the information needed for a comparability analysis between the conditions of a controlled transaction and those of a comparable transaction between independent parties. It provides guidance on determining the commercial or financial relations of associated enterprises and accurately delineating the controlled transaction so that arm’s length transfer pricing can be set. The economically relevant characteristics or comparability factors that need to be identified in the commercial relations between the associated enterprises in order to accurately delineate the actual transaction can be broadly categorized as follows:

1. The contractual terms
2. The functions performed
3. The characteristics of property transferred or services provided
4. The economic circumstances of the parties and of the market
5. The business strategies

Below, we take a closer look at each of the six steps to make sure you are able to determine fair and accurate arm’s length transfer pricing for your company’s controlled transactions.

1. Identify the intangibles and risks

The OECD states that MNEs should start their analysis by identifying the intangibles used or transferred in the transaction. This should be done “with specificity”, as applying too broad or narrow a definition of ‘intangible’ could result in an inaccurate compensation delineation.

Paragraph 6.6 states that, for the purposes of the Guidelines, ‘intangible’ refers to something that is “not a physical asset or 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.”

Section A provides guidance on identifying intangibles for the purposes of transfer pricing.

This step involves identifying the “specific, economically significant risks” associated with DEMPE in the transaction. Guidance on this can be found in Section D.1.2.1.1. of the Guidelines, which defines ‘risk’ as “the effect of uncertainty on the objectives of the business” (1.71).

2. Identify the contractual agreements

The second step of the OECD’s analysis framework is to identify the contractual agreements relating to the transaction. As Paragraph 1.42 states, written contracts for controlled transactions “reflect the intention of the parties at the time of the contract, including […] the division of responsibilities, obligations and rights, assumption of identified risks, and pricing arrangements.” At this stage, MNEs should place “special emphasis on determining legal ownership of intangibles based on the terms and conditions of legal arrangements” (6.34). This includes registrations, license agreements and other contracts that indicate the legal ownership of intangibles, and rights and obligations in a transaction. Details about identifying intangible ownership can be found in Section B.1. of the Chapter VI on Intangibles.

It is important to note that the determination of legal ownership, by itself, does not influence remuneration under the arm’s length principle. Compensation is dependent on the DEMPE functions performed, assets used and risks assumed by MNE entities in relation to a transaction involving intangibles (6.42).

3. Identify which parties performed DEMPE functions

By means of a functional analysis, MNEs must identify which parties performed functions, used assets and managed risks relating to DEMPE within the transaction. In particular, MNEs should determine which parties control any outsourced functions, and control specific, economically significant risks. As Paragraph 6.56 of the Guidelines explains, some functions have a significant impact on the value of an intangible. If the legal owner outsources these functions to associated enterprises, then those entities should be compensated with a fair share of the returns gained from the exploitation of the intangible.

For self-developed intangibles, or intangibles that may be used for development in the future, these functions may include:

• Design and control of research and marketing
• Direction and management of creative tasks
• Strategic decision-making for the intangible’s development
• Budget management and control

Important functions that relate to all intangibles (either self-developed or acquired) include:

• Decision-making regarding the intangible’s protection
• Quality control over functions performed by independent or associated enterprises that may affect the intangible’s value

The functional analysis will clarify which parties contributed to the value of the profit-generating intangibles within a transaction, and help MNEs determine fair compensation.

4. Compare contractual terms with party conduct

MNEs need to assess whether the terms of the contractual arrangements (outlined in Step 2 of this article) are consistent with the conduct of the relevant parties.

As stated in Step 4 (i) of Paragraph 1.60, this involves analyzing whether associated enterprises have followed the contractual terms as per the principles outlined in Section D.1.1: how the responsibilities, risks and anticipated outcomes arising from their interaction were intended to be divided at the time of entering into the contract (1.42).

This step is designed to determine whether the party that contractually assumed economically significant risks actually controls the risk and is financially able to assume the risks relating to DEMPE.

If all parties have fulfilled their contractual obligations and this conduct is consistent with the contractual arrangements, then the delineated transaction can be priced, also taking into account appropriate compensation for risk management functions (step 6, 1.60). If a party that is contractually obliged to assume risk does not control the risk or have financial capacity to control the risk, then the risk must be allocated to the enterprise that does (1.98, D.1.2.1.5).

5. Delineate the actual controlled transactions

MNEs should now be able to precisely outline the actual controlled transactions related to DEMPE. As per Section 6.34, this process should take into account the legal ownership of the intangibles, relevant contractual relations, and the conduct of the parties, including their relevant contributions of functions, assets and risks.

The delineation of the actual controlled transactions should be carried out in line with the framework provided in Section D.1.2.1 of Chapter I for analyzing and allocating risk. A summary of this framework is as follows:

1. Identify economically significant risks with specificity
2. Determine how these risks are contractually assumed by the associated enterprises
3. Conduct a functional analysis to determine how the associated enterprises operate in relation to the risks
4. Determine whether the contractual assumption of risk is consistent with the conduct of the associated enterprises
5. If the contractual assumption of risk and conduct of the associated enterprises are not consistent, then risk will need to be allocated
6. Price the accurately delineated transaction, taking into account appropriate compensation for the risk management functions performed

At this stage, organizations will have a clear understanding of the transaction in question and which parties performed functions, used assets or assumed risks in relation to DEMPE.

6. Determine arm’s length prices for the transactions

The final step of the OECD’s framework for analyzing transactions involving intangibles is to determine, where possible, arm’s length prices for the transactions in question. Guidance on identifying suitable arm’s length conditions is outlined throughout the Guidelines. Prices should be “consistent with each party’s contributions of functions performed, assets used, and risks assumed, unless the guidance in Section D.2 of Chapter 1 applies” (6.34). Section D.2 discusses situations in which transactions may be disregarded, and perhaps replaced, for transfer pricing purposes. It states: “The key question in the analysis is whether the actual transaction possesses the commercial rationality of arrangements that would be agreed between unrelated parties under comparable economic circumstances, not whether the same transaction can be observed between independent parties […] the mere fact that the transaction may not be seen between independent parties does not mean that it does not have characteristics of an arm’s length arrangement” (1.123). Organizations can find in-depth examples of criterion for non-recognition in Paragraphs 1.126–1.128 of the Guidelines.

Accessing data for your analysis

In order to help with the analysis of transactions involving intangibles, MNEs can access high-quality comparables data through a royalty rates database such as RoyaltyRange. By using publicly available, third-party data for their analysis, MNEs can ensure that they are complying with the OECD’s 2017 Transfer Pricing Guidelines and identifying suitable arm’s length conditions for their transactions.

RoyaltyRange provides MNEs around the world with reliable, OECD-compliant royalty rates data that can be used for a wide range of purposes. RoyaltyRange data reports include a detailed third party license agreement functional, risk and asset analysis. This information on DEMPE related functions is a great tool and could be instrumental to your DEMPE analysis. You can start using this information by selecting one of the RoyaltyRange royalty rates database subscription options.

Kestutis Rudzika, Director

You can use this text with reference to RoyaltyRange website.