In practice, properly using ex post evidence may be more challenging than the current guidance implies. Given the complexity of the valuation issues
- two years of ex-post evidence are insufficient to reliably revise the overall valuation
- and to arrive at a profit adjustment.
The use of presumptive ex-post evidence should take into account the allocation of functions and risk between the entities involved. Such situation arises if the purchasing company creates additional value through process improvements achieved after acquisition of the intangible. Under arm’s length conditions, the buyer may not automatically share the benefits through an adjusted purchase price.
The examples should be supplemented to clarify that presumptive ex-post evidence may also reveal that the initial valuation overstated the value of the underlying intangible.
If tax authorities employ the presumptive ex-post evidence as illustrated, transferring such intangibles for a single lump-sum payment leads to regular purchase price reviews and adjustments. In order to limit the risk of assessments and the associated administrative burden of mutual agreement procedures other pricing approaches should be considered. Ultimately transactional profit split procedures supplemented by means of advanced pricing agreements may be appropriate to master the pricing challenges associated with hard-to-value intangibles.
Ex post evidence is used to cope with HTVI related valuation risk / information asymmetry
A transaction between controlled parties involves hard-to-value intangibles if the following conditions are met at the time of the transfer:
- reliable comparables do not exist;
- the future cash flows / economic benefit derived from the respective intangible and/or the underlying valuation assumptions are highly uncertain.1
As the future is unknown to the parties involved and the tax authorities the arm’s length basis of the resulting value is not readily verifiable through a tax audit. Any attempt to verify the result requires an in-depth understanding of the valuation method chosen and the underlying assumptions. In particular, reviewing assumptions heavily relies on specialised knowledge and insights into the respective business segment2.
In practice, taxpayers attributed any differences between the ex-ante and ex-post valuation to events / conditions unforeseeable at the time of the transaction. Under the new approach, tax administrations infer from such discrepancies that the taxpayers valuation model did not properly reflect the uncertainties associated with the future exploitation of the respective intangible (“presumptive evidence”)3. The rule – deemed in line with the arm’s length principle – should enable tax administrations to determine whether or not a particular pricing arrangement chosen by the taxpayer is at arm’s length and properly takes into account the foreseeable circumstances affecting the value of the respective intangible.4
In practice, properly using ex post evidence may be more challenging than the current guidance implies. The revised examples given below illustrate the challenges associated with the often indeterminate useful life of certain hard-to-value intangibles.
Review of Examples
Lump-sum payments for hard-to-value intangibles are not a preferred option
Given our limited ability to forecast the future, it is hardly possibly to develop a valuation procedure that is consistent with any actual outcome. In particular, if only two years of presumptive ex-post evidence are deemed sufficient to make assessments / adjustments different, more flexible pricing procedures should be used.
Eventually combinations of lump-sum payments, contingent payments and royalties may be more appropriate to cope with the valuation uncertainty. Combining lump-sum payments with contingent payments and/or royalties may be more appropriate to cope with the uncertainty inherent to the valuation of hard-to-value intangibles5.
In particular, such combinations are more suitable to properly reflect the allocation of functions and risk between the entities involved. Eventually, some sort of transactional profit split may be useful to make sure that each entity receives remuneration commensurate with the functions performed and the risk assumed. Instead of an ex-post mutual agreement procedure advanced pricing procedures may be more appropriate to resolve such challenges with reasonable efforts.
Company A, the developer and resident of country A, owns a patented pharmaceutical compound for which it completed phases I and II of the clinical trials. The patent is then sold to a foreign affiliate S, a resident of country S. Company S will conduct the phase III clinical trials, acquire approval and exploit the drug. The agreed lump sum price of 700,– is the net present value of the expected cash flows. The valuation is based on the following assumptions:
- expected annual sales will not exceed 1.000;
- the discount rate is determined taking into account external data analysing the risk of failure for drugs in a similar category and stage of development;
- drug sales will start beginning year 6.6
Generally, patent protection expires after 20 years7. Since the patent is acquired earlier (e.g. 4 years before the right was transferred to company S), patent protection covers 10 years of sales. Please note that a drug’s useful life does not necessarily expire with the patent protection. The product might still be sold but at a lower price and lower profits.
Scenario A: limited ex-post evidence might be insufficient to justify an adjustment
Five years after the transfer the tax administration audits company A for the years 0 – 2. As part of the audit, the tax administration obtained the following ex-post evidence associated with the above transfer of the intangible in year 0:
Company S completed the phase III trials earlier than initially expected and started selling the drug 3 years earlier extending the patent protected sales period to 13 years. The sales in years 3 and 4 are in line with the initial projections.
The taxpayer could not demonstrate that the initial valuation considered the opportunity of shorter phase III trials. The tax administration determined that the possibility of earlier sales should have been considered. Based on the adjusted valuation model, the net present value is 1.000 instead of 700. This leads to a profit adjustment of 300 for tax purposes.
Given the patent protected sales period of 10 – 13 years 2 years of ex-post evidence should be deemed insufficient to justify such an adjustment. After two years of business there is no evidence ruling out the risk that future sales are significantly lower than expected.
Scenario A: earlier sales might be attributable to Company S process improvements
The ex-post analysis should take into account the root cause of the earlier sales. Company S purchased the compound and conducted the phase III clinical trials. It specialises in these trials and continuously improves its processes in order to obtain approval as early as possible.
From the integrated group’s point of view, such progress improves the integrated / consolidated net present value of a compound. This however, does not necessarily imply, that company S needs to share benefits stemming from own efforts with Company A through a higher purchase price in case of a first time innovation. In such situation it might be consistent with the arm’s length principle to go without an adjustment to the initial sales prices.
Two years of deviating evidence may be insufficient to justify an adjustment
Example 2 is similar to example 1 except that the tax administration reviews periods 3 – 5 in year 7. the audit does not constitute a follow-up audit. Although this would have been a more realistic scenario. The early sales findings discussed above are ignored. The audit reveals that sales in years 5 and 6 were significantly higher (1.500 instead of 1.000) than those projected.
Since the probability of higher sales was not considered initially and the higher sales are not attributable to unforeseeable events, the tax administration uses the presumptive evidence to adjust the initial valuation model. The resulting net present value is 1.600 and leads to an adjustment of 600 for tax purposes.8
Again, the crucial question whether two years of deviating ex-post evidence are sufficient to adjust the initial projection / forecast is implicitly answered in the affirmative. As already pointed out, this issue requires further clarification. Taxpayers may well be able to argue that since sales in the earlier years were in line with the projection the remaining future sales will be lower than initially expected.
Company S may have implemented marketing and sales improvements
Furthermore, Company S may have undertaken specific marketing efforts and/or may have established additional sales channels which have not been available when the purchase price was determined. In such situation – considering the arm’s length principle – the extent to which Company S has to share such additional benefits with Company A is at least doubtful. Obviously, the entities functional and risk profile needs to be considered.
Presumptive ex-post evidence leads to a reduction of the price
The example is similar to example 2. However, the tax audit conducted in year 7 reveals that sales in years 5 and 6 were significantly lower than expected (500 instead of 1.000). Since the initial valuation did not provide for such low sales the intangible is re-valued on the basis of the presumptive ex-post evidence. The revised net present value is 500 – compared to the initially derived 700. As the adjustment of 200 is outside the 20% the threshold the purchase price has to be reduced for tax purposes.
- OECD, BEPS Action 8, Implementation Guidance on Hard-to-Value Intangibles, 23. May – 30. June 2017
- OECD / G20 Base Erosion and Profit Shifting Project, Aligning Transfer Pricing Outcomes with value creation, Actions 8-10: 2015 Final Reports
1See , page 110, #6.189
2See , page 109, #6.186
3See , pages 109/110, #6.188
4See , page 2, #2
5See , page 6, #28
6See , page 5, #17 ff
7European law provides a 5 year extension for particular drugs (supplementary protection certificates).
8See , page 6, #24 ff