• Mischa Sollberger, Partner |

Recent controversy cases showed tax authorities arguing IP values to be low or even zero when they considered the purchasing group entity to be already performing DEMPE functions. Is there a correlation between performing of DEMPE functions and the intrinsic value of IP? 

Impact of the DEMPE concept in intangible valuation

The determination of an arm’s length value for intangible assets can be complex and is facing increasing scrutiny in transactions involving the use or transfer of intellectual property (“IP”) between related parties. Some tax authorities may take a view that the development, enhancement, maintenance, protection and exploitation (“DEMPE”) concept is fully determinative, not just for the allocation of income due to IP ownership, but also for the valuation and the economic ownership of the IP itself. 

In recent tax controversy cases involving the transfer of IP, the tax authorities of the jurisdiction purchasing the IP claimed that the IP was already owned economically by the purchasing entity, and therefore suggested a low or zero IP value based on their own DEMPE assessment.

Intangible value and ownership

The valuation of IP and the resulting arm’s length royalty or transfer price requires a correct delineation of the arm’s length principle outlined in the OECD Transfer Pricing Guidelines for Multinationals and Tax Administrations (“OECD Guidelines”). These have been revised several times, with the introduction of the DEMPE concept in 2017. However, many tax administrations have also taken the view that the guidance was simply the clarification of existing positions on the allocation of revenue and should not in practice change the way that income is allocated. In addition, the OECD Guidelines did not refer to DEMPE having an impact on the methodology or valuation of IP owned by a group entity.

In the OECD Guidelines, the allocation of profit or loss (income-related returns) from exploitation of the IP is based on the location of functions and control over risk. This is distinct from determining the arm’s length value of the IP itself. Furthermore, the OECD Guidelines do not mention that the performance of DEMPE functions entitles an entity to the ownership of the IP. 

In relation to the allocation on income from exploitation of the IP, the OECD Guidelines recognize that, while the legal owner of an IP may receive the proceeds from exploitation of the IP, other members of the legal owner’s group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the IP. The members of the group performing such functions, using such assets, and assuming such risks must be compensated for their contributions under the arm’s length principle.  

The DEMPE guidance lays out a six-step framework to establish the IP-related returns from the IP:

  • Step 1: identify the intangibles used and the economically significant risks associated with DEMPE;
  • Step 2: identify the full contractual arrangements, with an emphasis on legal ownership, rights and obligations, including assumption of risks;
  • Step 3: identify the parties performing functions, using assets and managing risks related to DEMPE;
  • Step 4: confirm consistency between the contractual terms and the parties’ conduct and determine whether the party assuming economically significant risks controls and has the financial capacity to assume those risks, applying the risk guidance;
  • Step 5: delineate the actual controlled transactions related to the DEMPE of IP; and
  • Step 6: price the delineated transactions.

As mentioned above, while tax authorities can use this to challenge the allocation of historical returns, this allocation should not have any bearing on the valuation or ownership of the IP itself.

Practical challenges of DEMPE risk control functions

It is rare to see in practice that taxpayers have all risk-controlling functions for economically significant risks relating to the DEMPE of IP employed by a single entity and based in one jurisdiction. Many large multinational groups find themselves in a situation where DEMPE risk control functions are split between several entities in different jurisdictions due to a range of factors, including:

  • impact of historical mergers and acquisitions (“M&A”) activities; 
  • multi-layered governance and internal processes around research and development (“R&D”) vs. commercial exploitation; and 
  • increasing trends to hire best talent irrespective of location.

In cases where the IP development activity was outsourced under a contract R&D arrangement, the question is on the arm’s length compensation paid for such contract R&D services. The OECD Guidelines highlight that the functions performed by contract R&D providers, including any risk mitigation or DEMPE functions, should be appropriately compensated via a service payment and should not impact the valuation of the IP. 

While it may be not necessary for the IP owner to perform all DEMPE risk control activities itself for it to be recognized as the economic owner of the IP, it is essential that the IP owner undertakes meaningful risk control functions for the specific economically significant risks relating to the IP it owns, as well as having the financial capacity to bear financially significant risks.

Having a detailed understanding of which decisions and activities are likely to be of greatest significance in your IP portfolio when applying the risk control framework and DEMPE concept is crucial. Since these value-contributing decisions and activities are often split between governance boards and key management in various business units, it is important that the governance is set up clearly to support the ownership and the risk control functions accordingly. Using a value chain analysis to get clarity where in your organization value-contributing DEMPE functions are performed is a first step in tax-efficient and sustainable IP management.  

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