Trademark Transfers & Transfer Pricing: Recharacterization & Licensing

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For this latest edition?we analyze a Polish legal dispute over cross-border licensing and its transfer pricing implications amid evolving laws.

Poland vs. K.P., adjudicated on October 3, 2023, scrutinized the legitimacy of license fee expenses and the application of transfer pricing provisions. On December 2013, K.P., a Polish company (the Parent or Licensee or Taxpayer) engaged in retail sales of computers, peripheral equipment, and software, transferred valuable trademarks (the IP Asset) with its subsidiary (the Subsidiary or Licensor) in exchange for shares (i.e., contribution in kind). Subsequently, the Parent incurred license fees for using these trademarks. In the view of the tax authorities, the Parent reported a lower income than what would have been expected in the absence of such a relationship and therefore considered that the Parent had overstated its cost (i.e., by incurring excessive license fees). Consequently, they deemed this arrangement commercially irrational and recharacterized it. Dissatisfied with the assessment, the Parent filed an appeal.

Overview

The Polish tax authorities relied on the?2017 OECD Guidelines?(the latest version is the?2022 OECD Guidelines?where Chapter VI remains largely the same) and, more specifically, argued that the case at hand resembles example 1 of the Annex to Chapter VI,– Examples to Illustrate the Guidance on Intangibles, and characterised the Parent in line with point 4 of that example. In brief, example 1 provides that under the agreement, Premiere (parent entity and licensee) performs all functions related to the development, enhancement, maintenance, protection and exploitation of the intangibles except for patent administration services. Premiere contributes and uses all assets associated with the development and exploitation of the intangible and assumes all, or substantially all, of the risks associated with the intangibles. Premiere should be entitled to the bulk of the returns derived from exploitation of the intangibles. Company S’s (subsidiary, owner of the intangible and licensor) granting of full exploitation rights back to Premiere reflect, in substance, a patent administration service arrangement between Premiere and Company S. An arm’s length price would be determined for the patent administration services and Premiere would retain or be allocated the balance of the returns derived by the MNE group from the exploitation of the patents. With respect to the Polish case the license agreement was, in substance, a contract for the provision of trademark administration services and therefore priced the controlled transaction using a mark-up on the total operating costs of the Licensee (median value of 6.91%) and rejected the taxpayer approach from using the comparable uncontrolled price method in pricing the license agreement in calculating the arm’s length intra-group royalties. As a result, in the view of the Polish tax authorities, the Parent overstated its costs as the difference between the license fee paid to the Licensee and the remuneration for the provision of services.

It is worth mentioning that although the price when the IP Asset was transferred was not questioned, the Polish tax authorities argued that the facts of the case, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner in comparable circumstances. This is because, in December 2013, the Parent effectively sold its internally developed and most important business and valuable IP asset, and on the same day, it incurs significant license fees to continue using the IP asset for its business. Considering the DEMPE concept, the Parent, after transferring the function of administering the legal ownership of the IP Asset to its Subsidiary, continued to carry out marketing and advertising activities related to the promotion of the IP Asset. As a result, the business case lacks economic rationality as an independent entity would not enter into transactions leading to the disposal of valuable assets essential to its business, additionally financing its acquisition by another company, taking up shares in exchange with a nominal value significantly lower than the value of the lost assets (without subsequently receiving any compensation for this), and additionally having to incur additional costs due to the need to pay license fees for the use of the trademarks previously held. Further, the Parent did not achieve the expected economic effect as an entrepreneur, that is to strive not only to maximize revenue but also to minimize losses.

On the other hand, the Taxpayer successfully (the court decided in favor of the Taxpayer) argued, among other points, that the Polish tax authorities applied the mechanism of the so-called recharacterization, which was introduced into the legal system on January 1, 2019, yet the tax year under review began on April 1, 2016, and ended on March 31, 2017. Therefore, an anti-avoidance clause was not in force at that time. Further, the OECD Guidelines are not a binding law and should be treated as a “set of good practices” and an instrument supporting the interpretation of transfer pricing regulations. In this context, as of the date of the license agreement, the 2010 version of these OECD Guidelines was in force, and further, the DEMPE concept was introduced in the OECD Guidelines in July 2017, and therefore the Taxpayer was unable to take into account the substantially amended OECD Guidelines for the tax year from April 1, 2016, to March 31, 2017.

Conclusion and Planning Points

In conclusion, although the court ruled in favor of the Taxpayer and dismissed the Polish tax authority’s assessment, arguably if the transactions had taken place after the introduction of the anti-avoidance provision in 2019 and the significant amendments to the 2017 OECD Guidelines, the Taxpayer might have faced a different outcome, as the Polish tax authorities would have more grounds to challenge the economic substance and the valuation of the transaction. A further argument that the tax authorities could use to challenge the transaction is if the?legislative proposal for transfer pricing Council Directives announced by the European Commission on September 12, 2023, were in force. The TP proposal should be transposed into the national laws by December 31, 2025, at the latest, and the rules will come into effect as of January 1, 2026. The proposal stipulates that the arm’s length principle should be construed in accordance with the OECD Guidelines under article 14, paragraph 1. The aim is to: (1) incorporate the arm’s length principle into Union law; (2) harmonize the key transfer pricing rules; (3) clarify the role and status of the OECD Transfer Pricing Guidelines; and (4) create the possibility to establish, within the Union, common binding rules on specific transfer pricing subjects within the framework of the OECD Transfer Pricing Guidelines.

Consequently, taxpayers should ensure that their transfer pricing documentation is up to date and accurately reflects the economic reality of their transactions. This includes ensuring that the functional analysis accurately reflects the functions performed, assets used, and risks assumed by each party to the transaction. In a different case, tax authorities could, for example, contend that the license agreement did not reflect the actual contribution of each party to the development, enhancement, maintenance, protection, and exploitation of an intangible asset, and that the royalty paid by the licensee was not aligned witch reflects the economic reality and the value creation of the licensor. Further, taxpayers need to address the complexities of transfer pricing in cross-border transactions, emphasizing the need for careful planning and coordination to navigate differing tax laws, regulations, and interpretations across jurisdictions. Finally, taxpayers should also consider engaging with tax authorities in advance of undertaking significant transactions, in order to obtain certainty on the tax treatment of the transactions and to minimize the risk of disputes.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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The article was published in Bloomberg BNA at International Tax News

Best Regards

Christos Theophilou