Transfer Pricing and Trade Secrets

By Oliver Treidler and Donal O’Connell 

Transfer pricing is probably the most important issue in international corporate taxation. In taxation and accounting, transfer pricing refers to the rules and methods for pricing transactions between enterprises under common ownership or control.

A transfer price is the price at which members of a group transact with each other, such as the trade of goods and services between group members. Transfer prices are used when individual group members of a larger multi-entity firm are treated and measured as separately run entities.

Transfer pricing also comes into play when the transaction between group members involves intangible assets. In other words, transfer pricing is not limited to just tangible assets.

With the growing importance of intangibles as the core value drivers within highly integrated value chains, understanding how to properly cope with intangibles in transfer pricing is one of the key challenges faced by tax practitioners.

Arm’s length principle:

Transfer pricing rules are based on the arm’s-length principle.

The arm’s length principle is the condition or the fact that the parties to a transaction are independent and on an equal footing. Such a transaction is known as an “arm’s-length transaction”.

The OECD and World Bank recommend intra-group pricing rules based on the arm’s-length principle, and almost all of the G20 countries have adopted similar measures through bilateral treaties and domestic legislation, regulations, or administrative practice.

Countries with transfer pricing legislation generally follow the OECD ‘Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations’ in most respects.

So, transfer prices between group members of a multinational enterprises should be established on a market value basis, i.e. reflect prices that independent parties would agree under similar conditions.

Transfer pricing is not a tax avoidance practice:

Although transfer pricing is sometimes inaccurately presented as a tax avoidance practice or technique, the term ‘transfer pricing’ refers to a set of substantive and administrative regulatory requirements imposed by governments on certain corporate taxpayers.

Identifying market prices:

For the majority of transactions, it is often difficult or impossible to identify market prices that can be directly utilized as transfer prices, simply because the economic conditions of the controlled transaction do not exactly match the conditions that can be observed on the market (i.e. for which sufficient data is available).

By conducting appropriate adjustment calculations, it will, however, in most case be feasible to find a price (or a range of prices) that are reasonably close (approximate) market prices and thus ensure an arm’s length allocation of profits.

As acknowledged by the OECD, however, transfer pricing is not an ‘exact science’ and transfer prices are routinely challenged by tax authorities in cases that have absolutely nothing to do with tax avoidance or aggressive tax planning.

The tax risks:

The tax risks resulting from these challenges are immediately proportionate with the degree of uncertainty (subjectivity) involved in determining transfer prices. Considering that intangibles are by definition highly idiosyncratic (i.e. comparables are scarce and adjustment calculations highly subjective), it is notoriously challenging to determine arm’s length prices for transactions featuring intangibles.

In order for taxpayers to stand a chance to minimize the related tax risks, it is a pre-condition to have a detailed internal data of the intangibles. In addition to the fundamental information on ownership and costs, the data should also include information on the functions performed by the related parties for the Development, Enhancement, Maintenance, Protection and Exploitation of the intangibles (so-called “DEMPE”-functions).

In view of the increasing importance of intangibles, it is no coincidence, that one of the main features of the 2017 revisions of the OECD ‘Transfer Pricing Guidelines resulting from the BEPS project was the introduction of the DEMPE concept as a measuring-rod for an arm’s length allocation resulting from the exploitation of intangibles.

Hence, aligning the applied transfer pricing with the intangibles utilized by a MNE, including trade secrets, should feature prominently on the to-do-lists of transfer pricing professionals post BEPS.

Transfer pricing and trade secrets:

Yes, transfer pricing also comes into play when the transaction between group members involves intangible assets such as trade secrets.

This should not be a surprise, as trade secrets may be among some of the most valuable assets within an organisation. Transfer pricing professionals may, however, be prone to underestimate the impact of trade secrets, due to the fact that they do not have a clear understanding of what qualifies as a trade secret.

The EU Directive on Trade Secrets defines a trade secret as information that:

• is secret
• has commercial value because it is secret
• has been subject to reasonable steps to keep it secret

Trade secrets are a very important part of any intangible asset portfolio. It is no exaggeration to say that virtually every business possesses trade secrets, regardless of whether the business is small, medium or large.

A trade secret is a formula, practice, process, design, instrument, pattern, commercial method, or compilation of information which is not generally known or reasonably ascertainable by others, and by which a business can obtain an economic advantage over competitors or customers. The scope of trade secrets is virtually unlimited.

Examples of transfer pricing involving trade secrets:

There are many times when trade secrets have to be considered:

• One group member may transfer its assets including its trade secrets to another group member (for example as part of the re-organisation of the business, in preparation for a spin-out, in preparation for a divestment, to support some JV activity by that other group member)
• One group member may license its assets including its trade secrets to another group member (for example when those assets are needed by the other group member to support its activities, such as R&D or Operations)

The challenge for transfer pricing with trade secrets:

Unfortunately, most companies are unorganized when it comes to their trade secrets and their management of such assets.

• Trade secrets are poorly managed
• There is a lack of ownership
• Documentation is poor.
• Protection mechanisms are poor or non-existent.
• There is a lack of any classification of such assets.
• Details on whether trade secrets have been shared is often missing
• Trade secrets not properly addressed in agreements & contracts
• There is no audit trail.

Neglecting to implement processes for managing and accounting for trade secrets can be extremely costly for companies. Many organizations are failing to properly protect these valuable assets, and this failure is not unique to any one specific stage in the business life cycle.

This list below captures some of the typical trade secret incidents we see befall businesses:

• A founding member leaves the company and takes some trade secrets with him and then establishes another competing start-up.
• The company fails to understand that certain things should be kept secret and shares too much information with an external party.
• A potential investor walks away after asking the company about their trade secret policy, processes and systems to properly protect such valuable assets.
• A disgruntled employee leaves the company and takes some trade secrets with him, put onto a memory stick on his last day of employment.
• A new starter joins the company but has stolen trade secrets from his previous employer, and shares that trade secret with his new colleagues
• A supplier entrusted with one of the trade secrets of the company shares it with a competitor.
• Cyber criminals hack the network of the company and steal some trade secrets. Cyber criminals are after the trade secrets of the company, the confidential business information which provides an enterprise with a competitive edge.
• The company divests one part of the business but mistakenly gives away some trade secrets as well.
• A collaboration partner accuses the company of stealing one its trade secrets, breaking the terms and conditions of the collaboration agreement.

In addition to these traditional trade secret incidents, tax risks are of increasing importance in a post-BEPS world. Lack of communications between the personnel designated to managing intangible, including trade secrets, and  the transfer pricing department further exacerbates these risk, as aligning transfer pricing with intangibles without the required internal data will prove to be a tricky exercise indeed.

Proper and professional management of trade secrets is required:

Trade secrets are an important, but an invisible component of a company’s intellectual property portfolio of assets. They can add tremendous business value, so they need to be properly and professionally managed, and looked after.

Trade secrets should already be on the agenda of any in-house Legal/IP function as well as on the agenda of any Legal/IP Firm advising organizations.

However as these are important assets with associated costs and value, they are more and more on the agenda of the in-house finance and tax function as well as on the agenda of any Accountancy and Tax Firm advising clients.

Good practice:

As stated earlier, many companies are poor when it comes to trade secret asset management. However, those exceptional companies who have this mastered tend to have the following 5 things in place:

• A Trade Secret Policy
• Education of Employees about Trade Secrets
• Robust Fit for Purpose Trade Secret Process & Procedures
• A System to Underpin that Process
• Trade Secret Governance

Having these five things in place will simultaneously and without any additional effort help those involved with transfer pricing with addressing the challenges identified above.

[This post originally appeared at ipeg.com.]