Do DEMPE rules reflect the reality of the market?

In October 2015, the action plan to combat tax evasion and profit shifting (the BEPS plan) was published by the Organization for Economic Co-operation and Development (OECD). The BEPS plan contained 15 actions aimed at “realigning taxation with economic substance and value creation, while preventing double taxation.” Action number 8 (intangibles) set out the following objectives:

“Develop rules to prevent the erosion of the tax base and the transfer of profits originating from the transfer of intangibles between companies belonging to business groups. This will involve: i) adopting a new definition of intangible assets that is broad and clearly delineated; ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from ) value creation; (iii) developing transfer pricing rules or special measures for transfers of hard to value intangibles; and iv) updating the guidance on cost contribution arrangements” (as they relate to the development and exploitation of intangible assets)- 

The new transfer pricing rules on intangibles have had a significant impact and have reoriented the transfer pricing policies of business groups around the world. And no wonder, the new standard imposed by the OECD to confirm the arm’s length condition of intercompany transactions establishes that it must: 1) identify the intangible that is the subject of the transaction (if different intangibles are transacted, it will be necessary to evaluate whether it is necessary to disaggregate them for their particular analysis), 2) identify to whom the legal ownership of the intangibles corresponds, 3) identify which entities of the multinational group have contributed to the development, improvement, maintenance and protection of the intellectual property, and 4) the nature of the linked transactions involving intangibles, including how such transactions contribute to the creation of value.

In this document, we will analyze the limits of the proposed OECD rules in their theoretical conception and economic foundation to have a perspective on their application.

Who owns the exploitation rights of intangible assets from a transfer pricing point of view?

As we have commented, Action 8 of the BEPS plan reorients the application of transfer pricing rules in terms of intangibles by providing a new concept: “the word intangible is intended to address something which is not a physical asset or a 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”.  That is to say, for the transfer pricing regime, not only the incorporeity of the asset, or the ability to control future economic benefits, is enough, but it must be evidenced that in transactions analogous to the one carried out, the asset would be subject to economic consideration (which is only possible taking into account the economic benefit that the transfer of the asset means for the parties). This clarification is relevant, because there may be intangibles that lack economic value in a specific context of exploitation and therefore do not qualify as assets for transfer pricing purposes.

Once the intangible asset status of the asset subject to the transaction has been confirmed, the OECD in its standard of analysis emphasizes the need to identify who is the person who legally owns it, having registered it as the owner in their respective patent and trademark office (for example, the US Patent and Trademark Office or the Mexican Institute for the Protection of Industrial Property –IMPI– in Mexico). However, proving legal ownership is not sufficient to claim the exploitation rights of an intangible asset.  The transfer pricing guidelines emphasize the need to identify through an analysis of functions, assets and risks who has or have contributed to the value creation of the intangible. For these purposes, it proposes to identify the development, enhancement, maintenance, protection or exploitation activities related to the intangible. (DEMPE functions, whose acronym stands for- development, enhancement, maintenance, protection, exploitation). 

The execution of DEMPE functions by related parties outside the legal owner of the intangible should be remunerated on the terms that would have been agreed with an independent third party. Otherwise, and for the purposes of the transfer pricing regime, it may constitute “economic property” and thus generate a series of tax consequences, for example, the loss of the royalty expense deduction (why pay a royalty on an intangible asset of which you are a co-owner), or even result in a redistribution of the income associated with the exploitation of intangible assets (if you have participated in the creation of value of the intangible asset, would you be entitled to claim part of the profits obtained from its exploitation?). Needless to say, the execution of DEMPE functions can be qualified as “a unique and valuable contribution” and then influence, even determine the selection of specific transfer pricing methods (v.gr. profit splitting methods).

How are independent third parties remunerated for the execution of DEMPE activities?

Accordingly, it is key to correctly identify who, when, and how has contributed to the development of intangible assets. Of course, there are practical considerations that are relevant. For example, patent development in the pharmaceutical industry can take lustrums and be carried out in various stages by different members of a business group through various research, development and clinical trial activities. On the other hand, intangible assets such as trademarks, managed by marketing departments, eventually reach their maximum value after spending years, if not decades, on mass media advertising campaigns. These clarifications are important because the analysis of functions, assets and risks associated with the transfer pricing analysis of intangibles would have to go back to the time of the intangible’s conception and evidence any contribution to the value of the intangible (identified through DEMPE functions), throughout the life of the asset.

Evidence of conduct among independent third parties in relation to DEMPE activities

Now, does the execution of DEMPE functions between independent third parties imply co-ownership or even an adjustment to the consideration agreed upon for the exploitation of the intangible asset? The question is relevant, since from the reading of the transfer pricing guidelines this conclusion seems to emerge and in fact, it seems that the tax authorities systematically condition the deduction of expenses related to DEMPE functions when the taxpayer also makes the payment of royalties. However, is this stance correct? Is there evidence of the conduct upheld by independent third parties?

In this regard, we conducted a quantitative economic analysis based on the information provided by the specialized database Data Insight (formerly Intangible Spring), obtaining 12,345 records of contracts between independent third parties. These contracts were classified by the industry to which they belonged, obtaining 51 industries of origin.

Given that the number of functions that correspond to the licensor and the licensee are counted in the contract records, it was decided to carry out the analysis based on the following type of variables,

F=F_licensor-F_licensee

Where:

F_licensor = Number of functions that correspond to the licensor.

F_licensee = Number of functions that correspond to the licensee.

F= Difference between the functions performed by the licensor and the licensee.

The variable F_i would end up capturing the impact of the distribution of functions between the two parties to the contract in order to analyze the impact that this would have on the price of the considerations. 

The regression model would be the following:

T_i=α+β(F_i)

Where:

T_i = Contract consideration rate in the i-th industry. 

F_i= Difference between the functions performed by the licensor and the licensee in the i-th industry.

On the other hand, the functions were also grouped into four types to consider the particular impact they may have by type of function: Marketing, protection, quality control, and research and development. 

In the extended version of the model we take the impact by the type of functions:

T_i=α+β_MKi(F_MKi)+β_PTi(F_PTi)+β_QCi(F_QCi)+β_RDi(F_RDi)

Where:

F_MKi = Difference between the marketing functions performed by the licensor and the licensee in the i-th industry.

F_PTi = Difference between the protection functions performed by the licensor and the licensee in the i-th industry.

F_QCi = Difference between the quality control functions performed by the licensor and the licensee in the i-th industry.

F_RDi = Difference between the research and development functions performed by the licensor and the licensee in the i-th industry.

The following criteria were established for the analysis:

• In the perspective by industry, it was required to have a minimum of 100 observations in order to be considered.
• On the other hand, the criterion was established to consider the impact of the variables as significant if they reach a confidence level of 95%. 

Results:

Without separating by type of functions, we found that only in 4 industries out of the 40 with a minimum of 100 observations did we find a significant impact of DEMPE functions:

Industry	No. Obs.	Coefficients		T Statistic		Prob. Rejection
		α	β	α	β	α	β
Industry 1	1,023	11.67	2.20	28.06	3.52	6.72E-129	4.46E-04
Industry 2	316	6.66	-1.60	12.98	-2.10	3.91E-31	3.67E-02
Industry 3	578	20.11	-2.47	25.73	-2.24	8.60E-98	2.55E-02
Industry 4	112	15.12	3.98	9.68	2.18	2.08E-16	3.15E-02

In the extended version, relevant functions associated with the execution of DEMPE functions were identified, specifically “research and development,” “marketing,” “quality control,” and protection. Significant impact was found on the consideration in 9 industries regarding research and development activities, in 6 industries regarding marketing activities, in 4 industries regarding quality control activities, and in 5 industries regarding protection activities out of the total of 40 industries analyzed.

Conclusions

Based on the information above, we could preliminarily conclude (subject to a case-by-case review of specific taxpayer situations) that, in principle and there doesn’t appear to be sufficient evidence to establish that the execution of DEMPE functions results in a de facto adjustment to the consideration agreed upon between independent third parties. This is relevant because in cases where the tax authority intends to disallow the deduction of royalty payments based on the execution of DEMPE functions, or conversely, reject the deduction of expenses related to DEMPE functions by arguing economic ownership, the situation would need to be reassessed based on the behavior observed between independent third parties, as required by the arm’s length principle

_{^{1 OECD (2014), Guidance on Transfer Pricing Aspects of Intangibles, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing. Develop rules to prevent BEPS by moving intangibles among group members. This will involve (i) adopting a broad and clearly delineated definition of intangibles; (ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation; (iii) developing transfer pricing rules or special measures for transfers of hard to value intangibles; and (iv) updating the guidance on cost contribution arrangements.}}

_{^{2 OECD Transfer Pricing Guidelines, 2017, 6.6}}

_{^{3  The non-binding criterion 39/ISR/NV provides the following definition of unique and valuable contributions: “those conditions or attributes of the business that generate value in a significant way and that imply the expectation of generating greater future economic benefits than would be expected in their absence, such as intangibles created or used, or comparability factors that define some competitive advantage of the business, including the activities of development, improvement, maintenance, projection and/or exploitation of intangibles”.}} 

_{^{4 It is even necessary to consider the juicio de atracción 15378/16-17-09-2/1484/18-S2-08-04 [a petition filed before the Supreme Court of Justice of the Nation (SCJN) because it considers that its intervention is necessary for the resolution of a matter due to its special characteristics of interest or transcendence for the Mexican State] where the tax authorities deny the deduction of propaganda and advertising expenses to a taxpayer that simultaneously made the payment of royalties (prior corporate restructuring) in an apparent interpretation of action 8 of the BEPS plan.}}

_{^{5 Data utilized in this research was sourced from the comprehensive Royalty Rates database provided by Data Insight AI (www.datainsightai.com) in July 2023. As an information services firm specializing in transfer pricing analysis, Data Insight AI offers a suite of databases and an extensive Contracts Search Engine. The firm’s unique approach employs a combination of internal large language models, Natural Language Processing (NLP), and manual processing. This results in enriched, contextual data, such as detailed Development, Enhancement, Maintenance, Protection, and Exploitation (DEMPE) information for each transaction, and developmental stage information for pharmaceuticals and medical devices. Data Insight AI’s enriched data aids professionals in identifying potential comparables with greater precision and ensuring a full understanding of the licensed intangible assets. This combination of depth and breadth in data contextualization not only improves accuracy but also reduces the risk of false negatives and positives, significantly enhancing the transfer pricing analysis process.}}