The arm’s length principle and business restructuring 

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Intangibles with an uncertain value


Intangible assets47 bring a separate set of questions within a business restructuring. One question is how to identify the intangibles that were transferred in the business restructur-ing and another question is how to decide a value for the intangible.48 Therefore, this chap-ter will begin by discussing the challenges with identifying what is considered an intangible. Secondly the issues with valuation of intangibles will be discussed when the intangibles have an uncertain value at the time of the business restructuring. After answering these questions, this chapter will end with an analysis of the facts presented in the different parts.

Identification of intangibles

When trying to apply the arm’s length principle on a business restructuring of intangibles it is of great value to understand what constitutes as an intangible.49 As discussed earlier busi-ness restructuring lack a general definition50 and the same goes for what constitutes intan-gibles. To identify what may be considered as an intangible, it is important to first examine the standpoint of the OECD.51 The OECD TP guidelines do not in chapter IX discuss the meaning of intangibles. To identify what is to be regarded as an intangible, chapter VI of the OECD TP guidelines are of importance.52 This thesis will only use the general defini-tions of intangibles found in chapter VI.53
The definition given in chapter VI of the OECD TP guidelines is that “the term “intangible property” includes rights to use industrial assets such as patents, trademarks, trade names, designs or models. It also includes literary and artistic property rights, and intellectual property such as know-how and trade secrets.54
According to the OECD TP guidelines there are two different types of intangibles, market-ing intangibles and trade intangibles. Both of these types of intangibles are considered commercial intangibles and therefore fall within the general definition used for the purpose of this thesis.55 The term marketing intangibles are usually used when discussing trade-marks, trade names and other aids used to market a service or a product. For an example unusual name, symbols or pictures used to make the service or product stand out in a way that helps the marketing. Depending on the country in which the marketing intangible ex-ists, it may be protected by that country’s laws. This protection may imply that the owner needs to give its permission for the usage of the marketing intangible.56
Even if there are clearly two different types of commercial intangibles, only marketing in-tangibles are defined in the OECD TP guidelines. It is stated that all intangibles that does not fall within the definition of marketing intangibles are to be consider as trade intangi-bles. Trade intangibles are usually developed as the result of both costly and risky research done by the MNE. This costly development can be seen in the end price of the service or product since the developer needs to regain the money that went into developing the trade intangible. This development can occur in one entity of an MNE or in several entities. This can create some difficulties determining which entity of the MNE holds the legal and eco-nomic ownership of the trade intangible.57
There are several different approaches when defining what constitutes an intangible. One approach is that intangibles are the same as tangibles, an asset that can give rise to future benefits.58 The clearest differens between intangibles and tangibles are that intangibles lack physical shape.59 An approach that can be used to separate intangibles from tangibles is to examine the economic characteristics of the assets. This approach can be helpful for TP
purposes since knowing the economic characteristics is needed to determine the value of the intangibles.60
Another approach uses the following five features to explain what an intangible is:
1) non-physical in nature (no physical substance). However there should be tangible documenta-tion of the intangible existence (e.g. a contract or trademark registration);
future economic benefits are expected to flow to the owner;
 the value of the intangible arises from its intangible nature and not from its tangible nature. (for instance the literary or scientific works included in a book, and not the material carrier itself);
 subject to property rights, legal existence and protection, and private ownership; and
 separable and identifiable in order to determine value of specific intangible.61
Another point of view is that the definition of what is considered an intangible is unneces-sary for TP purposes. That this part has no impact on the application of the arm’s length principle since it is not the characteristics of the intangible but the value of the intangible that is of importance. The arm’s length principle seeks to find out what an independent en-terprise would have paid for the transfer of the intangible and the issue is therefore “what something is worth through the eyes of third parties.62
This point of view is of importance since there is no general definition what constitutes an intangible but it depends on interpretations and the area and the county where the intangi-ble is located. Since it is difficult to find a general definition, there is an increased risk that tax authorities and taxpayers will use different definitions that will lead to conflicts between the two parties.63

Valuation of intangibles
General approach

Valuation of intangibles is a complicated process with or without the involvement of a business restructuring. Business restructuring of intangibles may become even more prob-lematic when the intangibles at the time of restructuring have an uncertain value (pre-exploitation).64 According to the OECD TP guidelines this can become problematic since future expected profits are taken into account when determining the value of the intangi-bles that are transferred. The future expected profits may not conform to the actual future profit that comes from the transferee. A gap between the expected profit and the actual fu-ture profit may occur and this change in value affects the application of the arm’s length principle.65
An arm’s length price when the valuation of the transferred intangible is uncertain should be found with the help of both the taxpayers and the tax authorities. Both should seek guidance from what an independent enterprise would have done in a similar situation.66
The OECD TP guidelines give some examples in the annex to chapter VI of the OECD TP guidelines as to how the valuation could be done when a business restructuring of in-tangibles with an uncertain value has occurred.67
After examining the below mentioned examples, the OECD TP guidelines state that it is important to assess if the valuation was uncertain enough so that independent enterprises would not have accepted the valuation. The question then becomes if the independent en-terprise would have demanded a price adjustment mechanism, or would have demanded that the valuation should be renegotiated.68 An ex-post adjustment should not be done be-fore assessing what independent enterprises would have done in the same situation.69
Since the tax authorities have the possibility to make adjustments years after a business re-structuring of intangibles have occurred, it is important for taxpayers to be open and share the course of actions that were taken to find the arm’s length price. This could lead to great tax consequences for the taxpayers if the tax authorities do not agree that the price paid at the time of the business restructuring of the intangibles were at arm’s length.70

Example 1

The first example examines what may happen if the value of intangibles changes and if this change was not anticipated in the original contract between the associated enterprises. The example discusses manufacturing and distribution rights for a drug, where the licensing contract between the associated enterprises runs over a time period of three years. This three year contract regulates the rate of royalty that comes from the manufacturing and dis-tribution of the drug. The future benefits from the agreed upon rate are reasonable for both parties.
The terms of the contract at year one are in accordance with what independent enterprises would have agreed upon in a similar situation, even if the contract lacks an adjustment clause, and therefore follows the arm’s length principle. In the third year, a change of the value occurs when it found that the drug can be used for another purpose. If this new us-age of the drug had been known in the first year, then the rate of royalty would have been significantly higher.
If shown that the change of value could not have been anticipated at the first year then and the lack of any price adjustment clauses would be consistent with what independent enter-prises would have done. The change in value should therefore not be regarded as funda-mental enough to go against the arm’s length principle and demand a renegotiation of the price.71

Example 2

In the second example follows the same circumstances as the first example and begins at the end of the third year when the royalty value has increased. This time the contract is be-ing re-negotiated at the end of the three year period. Even though the royalty has a higher value now that at the beginning of the contract, it is still highly uncertain how this in-creased value will affect future benefits. This uncertainty creates an even more difficult re-evaluation process of the royalty.
In this example, the associated enterprise re-negotiates a new long term contract over ten years and this new contract adds on to the previous value for the royalty. The new value of the royalty is speculative and is in the form of a fixed royalty rate. When the value of royal-ty is expected to be high but has not been correctly established, then it is not customary to enter long term agreements like this one that extends over a period of ten year. An uncer-tain valuation like this would not be accepted by independent enterprises and a fixed royal-ty rate would not have been accepted. Independent enterprises would most likely demand some sort of an adjustment clause to protect them from future events that may affect the value of the royalty.
One example of where this adjustment clause could be used is if the sales of the drug ini-tially follow the ten year plan. At year four the royalty rate is in conformity with the arm’s length principle but the year after a new competitor enters the market. This new competi-tor has a drug that makes the first drugs sales to drastically go down and the royalty rate are no longer in conformity with the arm’s length principle after year five. By the sixth year, tax authorities can go in and demand TP adjustments of the royalty rate since independent enterprises would not have entered into a long term agreement without an adjustment clause based on yearly valuations of the royalty, as mentioned earlier.72

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Alternative approaches

There are alternative approaches developed when trying to find ways as to how to deal with the issue of an uncertain value at the time of the restructuring. One approach in determin-ing how to value intangibles with an uncertain value at the time of the business restructur-ing is to include the added risk in the transaction terms. This means that the structure of the business restructuring should include upside- and downside risks that the parties should share. The seller (A) takes the upside risk73 and the buyer (B) takes on the downside risk74 and to adjust for the uncertain value of the intangibles in the business restructuring an ad-justment mechanism could also be added in the structuring of the business restructuring. Both the risk distribution and the adjustment mechanism will offer the two parties some protection when dealing with intangibles with an uncertain value at the time of the business restructuring.75
This means that the business restructuring of the intangible will be done in two steps. The first step being the one-time-sum paid when the business restructuring is done and the se-cond step being the adjustment mechanism. By structuring the business restructuring of in-tangibles this way, the first one-time-sum will be lower since the seller may receive a posi-tive adjustment in the future and the downside risk that the buyer has overpaid for the in-tangible will be softened.76
As mentioned above chapter VI in the OECD TP guidelines gives some guidance as to how to define what constitutes intangibles. There are some questions as to how this guid-ance can be helpful when trying to assess the value of intangibles. Instead of seeking guid-ance in chapter VI for a valuation method for intangibles some taxpayers have sought
guidance from the valuation ways used for tangibles.77 The OECD acknowledges that there are some difficulties determining the value for intangibles since intangibles within an MNE may have characteristics that are hard to find between independent enterprises.78
The comparability analysis that the OECD uses to find an arm’s length price is a very diffi-cult analysis to use when dealing with intangibles. This since it puts a huge burden on both the taxpayers and the tax administration in finding “sufficiently similar open-market references”. The term “open-market” reference in itself contains difficulties since this rarely can be up filled by the MNE on the market even if they compete on the same market.79
Another problem that may occur when trying to value intangibles is the fact that intangi-bles and tangibles often are bundled together. An example is the business restructuring of a new machine. The machine would not be transferred by itself but the technological process that belongs to the development and usage of the matching would be transferred together with the machine. In a case like this it is not uncommon that the tangible and the intangi-bles value are tied together in a way that makes it hard to determine the value of intangible in itself. To determine the value of only the intangibles, tax authorities are forced with the demanding task of separate the tangibles from the intangibles.80
The fact remains that the only guidance given by the OECD is that in order to finding an arm’s length price is to ask “would independent parties at arm’s length remunerate the element and, if so, how?”. Once again the question does not seem to be the identification of what consti-tutes an intangible but if an independent enterprise would have paid for the transfer. Mean-ing, would an independent enterprise have seen the transfer as something valuable for them. If an independent enterprise sees the transfer as something valuable and would pay for it then that may indicate that an intangible exist.81


As shown above, there are a several factors to consider when talking about intangibles with an uncertain value at the time of the restructuring. All these factors need to be examined to know how a transaction should be regarded when determining an arm’s length price. The OECD TP guidelines do not give an extensive amount of guidance in this matter, which may affect the legal certainty for business restructuring of intangibles.
Before discussing the valuation issues that may occur with a business restructuring of in-tangibles, the definition of what constitutes an intangible had to be examined. Intangibles lack in a similar way as business restructuring a general definition which in itself can create problems when trying to find an arm’s length price. To begin with, the OECD has not giv-en a separate definition of intangibles in the new chapter IX regarding business restructur-ing. Guidance therefore has to be taken from the separate chapter VI of the OECD TP guidelines. In this chapter the OECDs general standpoint is that there are two different types of intangibles, marketing intangibles and trade intangibles. For the application of the arm’s length principle on business restructurings of intangibles with an uncertain value at the time of the restructuring, there is no need to separate intangibles into these two types. In this thesis only a general definition of intangibles has been used. The reasons this thesis still mentions these two different types of intangibles is because trade intangibles often are a result of costly and risky research. This will create a more expensive intangible and this increased price will be seen in the service or product that is tied together with the intangi-ble. This change in price will affect the taxation when the intangible is part of a business re-structuring and therefore also the application of the arm’s length principle. When dealing with intangibles with an uncertain value, all factors that can be helpful in determining a fair value is useful. Knowing the type of intangible and the fact that it may have a higher value from the start is something that therefore should be considered when finding an arm’s length price.
There are other approaches that may be used when trying to define what constitutes an in-tangible. One approach is that intangibles can be defined in the same way as tangibles, namely that intangibles are assets that creates future benefits. The only difference between tangibles and intangibles in this case would be that intangibles lack physical form. To seek to differentiate between tangibles and intangibles, the economic characteristics of the assets could be examined. This is one of the more useful approaches for TP purposes since the economic characteristics will be used later on when trying to determine a value for the intangibles that has been part of a business restructuring and thereafter finding an arm’s length price that should be used for the taxation issues. Other approaches use several fea-tures that need to be present for an asset to be regarded as an intangible.

Table of Contents
1 Introduction
1.1 Background
1.2 Purpose and delimitations
1.3 Method and materials
1.4 Disposition
2 The arm’s length principle and business restructuring 
2.1 Introduction
2.2 The legal value of the OECD
2.3 The arm’s length principle in Article 9
2.4 Definition of a business restructuring
2.5 Business restructuring models
2.6 Analysis .
3 Intangibles with an uncertain value
3.1 Introduction
3.2 Identification of intangibles
3.3 Valuation of intangibles
3.4 Analysis
4 The applicability of the arm’s length principle
4.1 Introduction
4.2 Ownership of intangibles
4.3 Comparability analysis
4.4 The comparable uncontrolled transaction
4.5 Analysis
5 Conclusion 
List of references
Business Restructuring The applicability of the arm’s length principle for intangibles with an uncertain value at the time of the restructuring

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