Our Oak tool explained
Donal O'Connell
Managing Director of Chawton Innovation Services Ltd; 13PM Committee Chair on Trade Secrets & Know-How; Cerebral House
Introduction:
This short paper explains my company's Oak tool, an 'OECD BEPS compliance from an IP Management perspective - readiness assessment tool'.
I should stress that Oak is very much an IP Management tool, NOT a tax tool.
In order to fully understand and truly appreciate Oak, one must first understand OECD BEPS.
OECD:
The Organization for Economic Co-Operation and Development (OECD) is at the forefront of efforts to?improve international tax co-operation between governments to counter international tax avoidance and?evasion.
OECD BEPS:
The OECD / G20 Base Erosion and Profit Shifting (BEPS) package of measures has been agreed upon with?over 100 countries and jurisdictions confirming their commitment to consistently implement this comprehensive package. The package provides 15 Actions ranging from new minimum standards to?revision of existing standards; common approaches which will facilitate the convergence of national practices and guidance drawing on best practices.
Described by the OECD as “the most significant re-write of international tax rules in a century,” the BEPS?package provides countries with the powerful tools to standardize compliance requirements and force firms to be transparent about where they generate income.
Simply put, more and more tax authorities now view OECD BEPS as their 'bible' when it comes to?intergroup licenses and transfer pricing of intangibles between group members.
Terminology:
Although I use the term 'OECD BEPS Compliance' throughout this short paper, please be aware that?others may use alternatives terms such as ‘Transfer Pricing Compliance’ or ‘Double Taxation Risks’.
Background:
To better understand OECD BEPS, it is worthwhile noting that the chief goal of OECD BEPS is to stop tax?avoidance by MNEs, and in particular tax avoidance using intangible assets like IP.
MNEs were using a variety of different approaches to do tax avoidance. Below I have identified some of? these approaches ...
a) The IP value approach
b) The IP risk approach
c) The IP financing approach
d) The low-balling R&D approach
The IP value approach:
This approach leverages intergroup licenses and transfer pricing. Firstly, a company establishes an IP?Holding Company in a low-tax regime and moves all its IP into that entity, with legal ownership of the IP now resting with this IP Holding Company. However, the other parts of the company still need to use this IP in various ways so needs permission from the legal owner of this IP. So, the company has this IP Holding Company license its IP to its operating companies (usually located in high-tax regimes) charging a high?royalty rate, so much so that its operating companies make little if any profit. As the IP Holding Company?is located in a low-tax jurisdiction, it therefore pays little tax.
The IP risk approach:
One may think of this approach as being like the IP insurance model, namely you pay someone else to?take the IP risk, except here it is about self or captive IP insurance.
Firstly, the company sets up a legal entity in a low-tax regime to manage its IP. The company then identifies?various IP related risks facing its group members located in high tax regime locations. The legal entity in the low-tax regime in essence finances the IP risk management activities of these group members (e.g.?insuring these IP related risks. It will for example charge a sizeable premium for this insurance coverage, thus reducing the profit of the group members located in high-tax locations
The IP financing approach:
This basically involves the use of financial loans between group members. The company sets up a legal?entity in a low-tax regime to manage its IP. This entity then provides financial loans to the other group?members to cover all the costs of all their IP activities – IP creation, IP portfolio management, IP?enforcement, IP exploitation, etc.
These loans from the entity in the low-tax regime to the other group members comes with an associated?very high interest rate, thus helping to reduce the profitability of these group members and reducing their?tax bills.
The low-balling R&D approach:
This approach tends to be used by MNEs with R&D activities located in high-tax jurisdictions. The company deliberately compensates the R&D unit on a cost-plus basis rather than compensating the R&D unit based on the true value of their output.
Given that the output of most R&D units tends to be IP in one form or another, I would argue that this is yet another example of IP being leveraged (or deliberating not considered from a finance perspective in this case) to reduce profit and thus reduce tax.?
The main objective with each of the IP related tax avoidance approaches outlined above is to reduce or?eliminate the profit in any group members operating in high-tax jurisdictions and increase the profitability of group members in low-tax jurisdictions.
Why the focus on IP with these various tax avoidance schemes. Well firstly because this is where the real?value lies for many companies. Secondly, because we are dealing with intangibles, they are easily moved?around and difficult for others to identify, track and trace. Last but last, little if any IP assets are recorded?in the financial systems of companies so they are somewhat hidden away.
The OECD BEPS 15 actions:
As stated earlier, OECD BEPS consists of 15 Actions developed to address tax avoidance.
These 15 Actions are publicly available. I suggest an extra large and very strong coffee if you decide to allocate some time to read through these 15 Actions as they are somewhat detailed..
However, looking at these 15 Actions, it is clear that the OECD BEPS guidelines are not just about tax, they can be seen?as an IP management handbook, dictating how companies should behave when managing their intangible assets.
I suggest that OECD BEPS Actions #4, #8, #9, #10 and #13 are especially relevant from an IP Management?perspective.
Emphasis on intangible assets:
An essential feature of the new regulations is an emphasis on intangible assets.?
It is increasingly recognized that intangible assets create a substantial part of the business value. However,?until now there has been no single definition of Intangible Assets in use by tax authorities or the OECD,?and no proper guidance on how such assets should be reported.
The accurate and complete identification, taxation and valuation of intellectual property and other?intangible assets is now recognized as one of the most important areas of the international tax reform and transfer pricing legislation.
Assessing compliance:
Compliance means conforming to a rule, and the OECD guidelines clearly define new rules as far as an MNE’s IP management is concerned.?
Assessing compliance is an activity to determine, directly or indirectly, that a process meets relevant?standards and fulfils relevant requirements.
I suggest that such a conformity assessment may be broken down into at least 9 parts …
Qualification:
The OECD guidelines apply to all multinational enterprises. An MNE is defined as an organization that?owns or controls production of goods or services in one or more countries other than their home country.
Several of the OECD measures have been crafted in such a way as to minimize the impact on SMEs with?negligible BEPS risks.
This part of the conformity assessment simply sanity checks if the company is a MNE as defined by the?OECD and as far as OECD BEPS guidelines are concerned.
Certain tax jurisdictions may apply OECD BEPS guidelines to smaller enterprises, and there is evidence?that this is certainly happening in many jurisdictions.
Definition of intangible assets:
In the OECD guidelines, it defines intangible assets as including the following categories
It is worthwhile noting the OECD BEPS defines intangible assets in broad terms and does not limit it to?registered forms of intellectual property like patents and trademarks.
The OECD guidelines also specifically exclude certain items from being considered as intangible assets as?far as OECD BEPS compliance is concerned.
This part of the conformity assessment compares and contrasts the OECD’s definition of intangible assets?to that definition in active use within the company and identifies any differences which require further?examination.
IP data management:
Within Action Plan #8, the OECD describes several IP data management related tasks required of the MNE.
This part of the conformity assessment checks if the MNE has the skills and competencies, knowledge and experience, process and systems in place to enable the MNE to complete these IP data management related tasks, and if not, what actions need to be taken to remedy the situation.
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Maturity of IP processes and systems to support OECD BEPS compliance:
Although perhaps not directly linked to OECD BEPS compliance as such, I suggest that an MNE will need?to be at a certain level of IP maturity and sophistication in order to be able to properly and professionally?help and support the finance and tax function with OECD BEPS.
This touches on such IP matters as ...
Therefore, this part of the conformity assessment reviews the maturity and sophistication of the IP?processes and systems in use for each category of intangible asset within the MNE and identifies any gaps?that may cause issues when it comes to OECD BEPS compliance.
Transfer pricing:
Transfer pricing is the setting of the price for goods and services sold between controlled (or related) legal?entities within an enterprise. As far as OECD BEPS is concerned, it is the setting of the price for intangible?assets being licensed by one member of the group to other member(s) of the group.
The guidance on transfer pricing documentation requires MNEs to provide tax administrations high-level?global information regarding their global business operations and transfer pricing policies in a “master?file” that would be available to all relevant country tax administrations.
It also requires that more transactional transfer pricing documentation be provided in a "local file" in each?country, identifying relevant related party transactions, the amounts involved in those transactions, and?the company’s analysis of the transfer pricing determinations they have made with regard to those?transactions.
MNEs will be required from an IP perspective to:
If there are significant numbers of such arrangements in place within the group, the conformity?assessment will also review and check that the MNE has the following in place:
IP risks:
OECD BEPS Action Plan #9 focuses on the issue of risk within an organization and given that such risks may?include IP related risks, in this section, we focus on understanding IP Management within the company?when it comes to IP related risks.
The focus is really only on economically significant IP related risks where various aspects (such as who?controls the IP risk; who is managing the IP risk; who is mitigating of the IP risk; who is bearing the associated costs; who is financing the associated activity) of related risk may link to different group members.
The financing of IP activities:
OECD BEPS Action #4 aims to limit tax avoidance through the use of financial loan arrangements to achieve?excessive interest deductions or to finance the production of exempt or deferred income.
MNEs may achieve favourable tax results by adjusting the amount of debt in a group entity. This may be?achieved as follows
The use of third party and/or related party interest is perhaps one of the most simple tax avoidance?techniques available in international tax planning. The fluidity and fungibility of money makes it a relatively simple exercise to adjust the mix of debt and equity in a controlled entity.
This part of the conformity assessment reviews whether the company have any significant financial loan?arrangements in place either between group members or with an independent external entity to finance any of its IP activities.
Reporting:
The OECD specifically asks for the following information to be reported within a Master file:
This part of the conformity assessment checks if the MNE is capable of producing such reports in a proper?and professional manner and identifies any gaps which need addressing. It should also assess what evidence logs that company maintains to back up the data in any such reports.
Exceptions:
There are a number of exceptions which need to be considered when conducting a conformity?assessment.
From legal to economic:
The essence of OECD BEPS is the switch away from a focus on the legal ownership of the intangible assets?(like patents, trademarks, trade secrets, etc.) within a corporate group to a focus on the economic?ownership of these intangible assets by the group members.
This is OECD BEPS's so-called DEMPE concept (where DEMPE stands for the Development, Enhancement,?Maintenance, Protection and Exploitation of intangible assets).
This switch I suggest will have a major impact on IP management and the associated IP policies, IP?processes, IP systems, IP data, IP governance, etc. within organizations.
So what is Oak:
I would like to repeat that Oak is not a tax tool but rather an IP management tool.
The purpose of Oak is to help the in-house IP manager better prepare for the new tax environment when it comes to intangibles and intergroup licenses and transfer pricing.
I suggest that it is much better to sanity check if your company is OECD BEPS 'ready' from an IP Management perspective when times are calm and relaxed as opposed to when times are crazy and turbulent.
An example of a crazy or turbulent time would be when your company is the middle of a tax audit by the tax authorities.
This is not a good time I suggest for IP Management to start reading through the OECD BEPS 15 Actions to try to understand what they mean from an IP Management perspective, and why more and more tax authorities are using OECD BEPS as their 'bible' when it comes to tax and intangibles.
One tax expert described Oak as like a bridge across the interface between the IP and Tax functions within a company. Another described it as like a translation of OECD BEPS from a tax document into an IP Management handbook.
In essence, Oak has codified everything discussed in this short paper plus much more.
The Oak tool itself runs on a secure online platform. The platform underpinning the Oak tool is ISO27001 and Cyber Essentials Plus certified and compliant with GDPR and the Data Protection Act.
One interesting technical feature to highlight is that the system date and time stamps all of the information gathered during such an assessment.
The output of any Oak assessment would be a report which I believe should feed into a meeting between the in-house IP Manager, the in-house Tax Director and the company’s Tax Advisory Firm to determine what steps to take to address any issues or concerns.
To help with such a report, a rich suite of different files are available from the Oak tool.
Another interesting technical feature to highlight is that the system can generate trend type file, useful for those companies wanting to conduct say regular annual Oak assessment exercises to sanity check the state of IP management from a BEPS perspective from one year to the next, and the progress being made.
Although Oak has been designed and developed by my company Chawton Innovation Services, I need to say a big thank you to half a dozen or more different transfer pricing experts who have kindly provided help and support.
Final thoughts:
I trust that the above information is of interest and of value, especially since this is “the most significant?re-write of international tax rules in a century”.
These OECD BEPS guidelines are not just about tax, they can be seen as an IP management handbook,?dictating how companies should behave when managing their intangible assets.
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Donal O'Connell is the Managing Director of Chawton Innovation Services Ltd.