REPORT FROM THE FISCALIS SEMINAR 2006 TRANSFER PRICING AND INTANGIBLE PROPERTY PRAGUE (THE CZECH REPUBLIC)

29 31 MAY 2006
I.
Monday 29 May 2006
Opening and welcome
Mr. Radim Blha, director of Direct Taxes Administration Department, opened the seminar and welcomed all participants to Prague on behalf of Ministry of Finance of the Czech Republic. Then Mr. Blha forwarded the speech to the Director General of Central Tax Directorate, Mr. Jan Knek, who also welcomed all delegates from European tax administrations, representatives of private sector and delegates of the European Commission and pointed out the importance of the Fiscalis seminar, which contributed to gaining better knowledge of transfer pricing and intangible property issues and which allowed participants to exchange their valuable experiences. Mr. Jean-Marc Van Leeuw and Mr. Edward Morris from the European Commission then welcomed all delegates on behalf of the Commission and expressed the hope of the usefulness of the seminar performed on such current issue. They briefly described the current situation in the field of intangible property and mentioned the advantage of having also representatives of business participating, which should help to better understanding between tax administrations and private sector.

Presentation Recent developments

Mr. Michal Rohek, representing the Ministry of Finance of the Czech Republic, demonstrated the structure of the Czech Tax Administration in relation to transfer pricing issues. He introduced to participants the main provisions related to transfer pricing and practice applied in accordance with these provisions. He also presented the APA system in the Czech Republic, which was newly established in 2006. Since the year 1993 the Czech Republic has implemented into its tax law (Income Tax Act no. 586/1992 Coll. and Administration of Taxes Act No. 337/1992 Coll.) necessary provisions arising from OECD Model Tax Convention on income and capital, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and common practice applied within the EU (based on EU JTPF meetings conclusions). However the Czech tax administration become properly involved in transfer pricing issues only 6 years ago. So far tax administration has dealt with approximately 50 transfer pricing cases. The main provision, Article 23, p. 7 of ITA, states, that if prices agreed between related persons differs from prices that would be agreed between independent persons under the same or similar circumstances and if this difference is not sufficiently proved the tax authority should particularly adjust taxable profit. Parties can be related trough:

a) capital
if one person directly or indirectly shares in capital or voting rights of other person, limit min. 25%

b) other relationships
one person participates in management or control of other person the same persons or close persons participate in management or control of other persons controlling and controlled companies related natural persons a relationship created for purpose to reduce taxable profit or to increase loss The Czech Tax Administration has issued three main guidelines related to transfer pricing, which describes so called best practice - not legally binding but commonly used by both taxpayers and tax administration. D-258 (January 2004) How to apply OECD Guidelines within the Czech Republic D-292 (January 2006) Binding opinion for pricing of transactions between related parties, based on the APA principals D-293 (January 2006) Documentation based on Code of Conduct issued by EU JTPF

Presentation Defining of the types of IP Rights copyright, trademarks, patents, brands

Mr Mark Engelman, experienced lawyer engaged in intangible property cases, gave insightful definitions on IPR and

divided IPR into several categories: patents, mini patents, copyrights, compilations (computer programs, etc.). He introduced system of registration of IP in UK and procedure of application for a patent. Subsequently Mr Engelman presented the fundamental issues concerning transfer of IPR and the legal implications of offshore transfers of trademark rights. One theme became clear: that it was not always legally possible to separate IPR from the underlying physical assets that had helped to create the IPR in the first place.

Presentation OECD works and Intangible Property considerations

Mr Paul Mulvihill, who joined the OECD in 2005 as Adviser - Tax Dispute Resolution in the Tax Treaty, Transfer Pricing Division of the CTPA, explained the definition of Intangible Property. For defining the IP he used several sources (WIPO web site, www.investorwords.com, etc). The basic definition of IPR was that IPR are the rights of creative workers in literature, artistic, industrial and scientific fields, which can be protected either by copyright or trademarks and patents. Later on Mr Paul Mulvihill mentioned par. 3, Art 12 of OECD Model Tax Convention: This par. provides that in the State of source royalties are taxable as part of the profits of the permanent establishment there owned by the beneficiary which is a resident of the other state and the par. 17.4 of above mentioned Tax Convention: In the case of IPR, the rules concerning the relations between enterprises of the same group (e.g. payment of royalties or cost sharing arrangements) cannot be applied in respect of the relations between parts of the same enterprise. He also explained division of intangibles on trade and marketing intangibles. He showed several examples of arrangements which could be assessed as transfer of IPR - (outright sale of the IPR, licensing arrangement (royalty); royalty would be based on output, sales, profit, rate may vary according to the turnover; the transfer price may be a package price for the goods and IPR, important is then to watch for double payment; IPR bundled in a package contract patents, trademarks, trade secrets, know how). Mr Mulvihill then noticed the important aspect of choosing the applicable transfer pricing methodology. Finally he concentrated on uncertain valuation at outset and on relationship between IP and marketing activities when a company is not an owner of a trademark. There was an interesting debate between the speakers and some of the audience about the possibility of revisiting the price of a contract in the light of later events. Most commentators were firmly of the opinion that this happened only very rarely between independents the price is the price when the deal is struck. Only in very peculiar circumstances would the price be changed later and then only perhaps in the light of adjusting an on-going business relationship. The Chair, Mr. E. Morris from the Commission, summed up the day. It had been most useful to hear the view of Mr Engelman about what IPR actually was and what could be done with it from a purely commercial point of view. This, of course, was very different from what tax advisors wanted to do to shift profits between tax jurisdictions. Morris also cautioned against moving to a US style commensurate with income standard where this would allow tax administrations to have two bites of the cherry, effectively re-writing history using hindsight where they did not like the outcome. Doing this might create a hostile investment environment.

Tuesday 30th May: Taxpayers perspectives tax planning opportunities

How IPR is exploited at arms length; Options open to a MNE concerning IPR: how IPR can be organised, created and financed
Monique van Herksen who heads the European Transfer Pricing Team of Baker & Mackenzie aimed her presentation on problems how IPR is exploited at arms length. In the beginning she divided IPR into routine and non-routine intangibles; routine intangibles represents the common skills such as basic know-how to perform a specific job whereas non-routine intangibles are special values that can be evaluated these can be further divided into protected and non-protected IP. She specified some valuation issues and appropriate transfer pricing methods (CUT/TNMM/Profit Split). Consequently Mrs Herksen outlined how to structure IP and talked about planning the acquisition, about migration of IP and also about IP rights protection.

Tax planning opportunities at different stages: creation, purchase, sale,and destruction

Victoria Horrocks from PWC presented the possible tax planning opportunities at various stages of business operating models and demonstrated them trough a case study.

Tax advantages & the commercial imperative

At the beginning another case-study was introduced by Mrs Horrocks. Participants were divided into four groups. They were asked to find possible solutions to three cases concerning transfer of IP. 1) Moving a business 2) Moving a licensed business 3) Business with R&D activities Consequently, the common solutions were consulted in plenary. Mrs Horrock then presented conclusions arising from the best practice and highlighted the challenges of a tax audits.

Wednesday 31: Tax Administrations' defences against pricing manipulation of IPR.

Valuation of IPR: how different circumstances can affect value
Antonio Russo, member of Baker & McKenzie Amsterdams Transfer Pricing Team, focused his presentation mainly on valuation of intangibles. In the beginning he pointed out that intangibles can be identified for financial statement purposes according to local generally accepted accounting principles (GAAP), International Financial Reporting Standards (IFRS) and Financial Accounting Standards Board (FASB). IFRS 3 and International Accounting Standard (IAS) 38 determines Intangible Assets as identifiable non-monetary assets without physical substance which are separable and transferable or which arise from contractual or other legal rights, which are controlled by the enterprise, which are likely to bring future economic benefits and whose costs can be measured reliably. Fair Value is defined as the amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in an arms length transaction. Firstly, Mr. Russo distinguished intangible property from goodwill. Under SFAS 141 Guidelines intangibles are divided as Marketing related (trademarks, trade names etc.), Customer related (customer list, backlog, contracts and customer relationships etc.), Artistic related (plays, books, music works, video, audiovisual etc.), Contract based (Licensing/Royalty agreements, use rights, operating rights etc.) and Technology based (patents, computer software, databases, trade secrets, recipes etc.). There are other values, which from the accounting point of view cant be evaluated and brought into accounts of a company separately. The total amount of such acquired assets is recognized as goodwill and represents the remaining or residual value (if any) after identifying and valuing all intangible assets. SFAS 141 defines goodwill as the excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed. Goodwill may be even negative. Common reasons to value intangibles are allocation of and overall business purchase price for financial accounting or income tax purposes, establishment of intercompany transfer price, pre-acquisition assessment of business value, reorganization and bankruptcy analysis, business formations or litigation support and dispute resolution. Mr. Russo acquainted participants with three primary valuation approaches. The income approach is the most common approach, which relies upon an estimate of income for the IP and assumes that the income derived from an asset will drive its value. There are many methods for making income projections like extrapolation, tabula rasa, life cycle analyses, sensitivity/scenario analyses etc., which are mainly dependent on estimation of discount rates and capitalization rates for IP and estimation of its remaining useful life. The market approach is based on the current market-value data and is rarely used because of lack of public information that regards comparable intangible assets. The cost approach estimates value based on the cost to recreate the asset in its current condition and functionality but thus doesnt capture the economic contribution to the enterprise. Therefore it is used only exceptionally. By the end of his presentation Mr. Russo demonstrated two examples - first the valuation of trade name based on Relief from Royalty Method and finally customer relationship valuation using Excess Earnings Method.

Embedded vs Fragmented Intangible Property A Case Study applying International TP in the Ethical Pharmaceutical Industry
Mr. Wndisch, specialist from the core of pharmaceutical industry, introduced the particular transfer pricing challenges and the special risks of the pharmaceutical and biotech industry as a sector with intangible assets of a great value. He resumed why CUP or COST+ methods are practically not applicable to Pharma/Biotech industry (COST+ can be used in contractual manufacturing) and that RPM is likely to be the only applicable method to negotiate transfer prices for Pharma/Biotech products. In the second half of his presentation, Mr. Wndisch presented a case study concerning the typical Pharma/Biotech industry MNEs business model. He explained to representatives of European tax administrations the basics of the business model of pharmaceutical companies using contract manufacturing with consignment stocks. He drew their attention to the problem of a time gap between the moment when tax for IP is due and the moment of real profit realising if the owner of IP has to sell active ingredient to the manufacturer within intragroup transactions. He proposed a conclusion, which would bring transparent and defendable TP system with no sale of active ingredients, using COST+ method for manufacturing and RPM for finished products including intangibles. For Pharma/Biotech enterprises the protection of intellectual property rights is their lifeline. Private financing of high risk R&D can only then be expected.

An audit into intangibles: a UK Case Study

Mr. Jon Clarck from HM Revenue & Customs presented a case study concerning a typical MNE with a very valuable IP. The value chain for such businesses usually consist of: 1. Research Continuing development Maintenance of IP 2. First tier manufacture 3. Second tier manufacture 4. Marketing & distribution Such structure could give tax-planning opportunities, when second tier manufacturer would be established in law tax regime and intangibles would be transferred to such country. In such case, it is important for tax administration to identify the real characteristic of that transaction, consider, whether it is commercially driven and consequently set the

appropriate TP methodology reflecting the real allocation of assets, risks and functions. Mr Clarck mentioned that very often a suitable CUP cant be identified, particularly where rare intangibles are involved. If there is a question of attributing profit to valuable intangibles, profit split method is usually suitable.

Practical experience in Member States

At the end of the Seminar representatives of Belgian, French and German tax administrations introduced the practical experience with transfer pricing issues concerning intangible property. They pointed out the main obstacles they have come across and delineated the possible solutions.

Final summaries and future developments

During the final resume of the Seminar Mr. Edward Morris emphasized the most crucial moments of the last tree days presentations. He highlighted the need of European tax administrations to be aware of transfer pricing issues regarding intellectual property. Some developments were more welcome than others but transfer pricing of IPR would be of increasing importance. At the end the Commission stated that the feed-back sheets already submitted showed that the Fiscalis seminar could be considered as a great success and also very useful for the future work of all participants. In the main this success could be attributed to the presence of the private sector speakers who had given their time freely in a splendid manner of co-operation. Public sector speakers who had made very welcome contributions were also thanked. A common theme had become clear early on: tax administrations were worried by IPR manipulation and wanted to develop new ways of combating it. The Chair was confident that the seminar had provided better ways of looking at the problem. Participants were asked to spread the new gained knowledge among their colleagues in member states.