Intellectual property (IP) rights may pose different challenges to professionals, including but not limited to, specialist valuers, tax advisors, accountants and auditors and also other subject persons. The intricacies involved in ascertaining the value of IP, coupled with the possibility for companies to manipulate transfer prices, have raised concerns regarding tax evasion.
Transfer pricing entails the establishment of prices for intangible assets, among others, exchanged between related entities. The transfer price ideally should mirror the arm’s length price, representing what unrelated parties would agree upon under comparable conditions. When associated enterprises transact with each other, subject persons should not automatically assume that associated enterprises have sought to manipulate their profits. A genuine difficulty in determining a market price may exist. The OECD Transfer Pricing Guidelines (‘OECD TPG’) states that “The consideration of transfer pricing should not be confused with the consideration of problems of tax fraud or tax avoidance, even though transfer pricing policies may be used for such purposes.” As such, upon investigating the facts and circumstances of the case at hand, it may be quite normal for a transaction between associated enterprises to deviate from market conditions. The arm’s length principle takes each associated enterprise under a separate entity approach principle, and it is a fair assessment that even member companies within the same group may have an element of autonomy on any of the in-scope transactions.
The Arm’s Length principle is the generally accepted approach on transfer pricing matters, and has time and time again been proved to work effectively in many cases. Nevertheless, the arm’s length principle may be seen as “inherently flawed” due to the separate entity approach. As a result of difficulties in procuring comparable data, associated enterprises may engage in transactions that independent parties would not conduct and data available may be incomplete and difficult to interpret. This is specifically highlighted even further when an entity would need to determine an appropriate price for hard-to-value intangibles. The OECD TPG introduce the concept of DEMPE (development, enhancement, maintenance, protection and exploitation) in order to appropriately allocate IP and IP rights to each associated enterprise however there is a general acceptance that additional layers of complexity are created in order to arrive at a fair market price. Paragraph 1.9 of the OECD Transfer Pricing Guidelines in fact states that: “Nevertheless, there are some significant cases in which the arm’s length principle is difficult and complicated to apply, for example, in MNE groups dealing in the integrated production of highly specialized goods, in unique intangibles, and/or in the provision of specialized services.”
Anti-Money Laundering Considerations
Due to this layer of complexity and subjectivity, companies may exploit transfer pricing, through the application of the DEMPE concept, to relocate profits to jurisdictions with lower tax rates. This practice, commonly known as base erosion and profit shifting (BEPS), can be regarded as a form of corporate crime. This may lead to other corporate crimes, such as money laundering and fraud – companies may often create complex structures involving multiple jurisdictions, making it difficult for authorities to trace the movement of funds and identify potential criminal activities.
Unfortunately, there are several challenges when it comes to intellectual property rights which may include the complexities underpinning the valuation of the intangible assets per se, the uniqueness of certain intellectual property rights (e.g. certain brands), the scarcity of comparable data, the value attributable to cross border royalty fees charged and the prospect of tax manipulation.
So, what are the red flags, a subject person should be alerted to when it comes to potential cross-border tax fraud in the context of intellectual property rights?
Lack of substance
The factsheet issued by the FIAU ‘’Typologies and Red Flags: Indicators of Tax Related ML’’, 2021, highlights that ‘’the establishment of a company in a jurisdiction where the company does not actually have any presence or conduct any activities is also a further red flag to consider and is a known typology used to allow the movement of funds between different jurisdictions. The end purpose may be to disguise as much as possible fund movements and render their tracing as difficult as possible. While it is acknowledged that there are activities that do not require any particular level of activity or presence, the commercial purpose behind the incorporation of such legal entities should be questioned and understood, especially if it does not seem that the said entity have the ability to conduct any income generating activity. This to avoid situations where these entities are merely used as conduits to channel funds from one jurisdiction to another, possibly inflating costs in the process. This is especially relevant in the context of non-residents establishing entities in Malta’’.
A company holding intellectual property rights situated in a low tax jurisdiction with no or minimal employees, no local base, no research activities, no or minimal development costs and/or no maintenance activities carried out to preserve the asset, are all indicative of lack of substance in that jurisdiction.
In cases where the customer indicates that the intellectual property company is structured in this way for tax optimization reasons, individuals responsible should ask for a copy of the tax advice to confirm if this was indeed the rationale behind the structure.
Complex structures
According to the FIAU Fact sheet ‘’a common ML/FT typology and red flag which also features in tax-related ML as well is the use of inexplicably intricate structures. This means that the complex structure has no clear and reasonable commercial purpose nor some rational explanation for being so. In other words, there is no justification for this structure to be so complicated, when a simple structure would have been enough for the purpose’’.
This may be the case for large groups of companies having intellectual property companies situated in various jurisdictions especially unreputable non-cooperative tax jurisdictions within a complex structure including multi-layered structures, the use of trusts, foundations or charitable organizations which makes the flow of funds more difficult to follow.
Lack of documentation
Inadequate or inconsistent documentation for transactions, including incomplete or falsified records, may indicate attempts to conceal illicit activity or evade tax obligations. In the case of intellectual property rights, the company must be able to support its valuations both of the intangible assets and any royalties charged through adequate support, workings and other comparable data.
Subject persons need to establish strong reporting protocols, both internal and external, for suspected or known instances of Money Laundering and Terrorism Financing (ML/FT), including tax-related crimes. Subject persons must heed the typologies and red flags highlighted by the FIAU fact sheet and prioritize complex cases, regardless of transaction value, focusing resources where they can make the most impact.
Professionals must be aware of these red flags and ask the right questions when one or more of the abovementioned red flags are identified. The complexities of the subject matter often require the input of transfer pricing specialists, anti-money launder specialists and specialist valuers. Our team of specialists look forward to assisting you with any advice you may require.
Disclaimer
While every effort was made to ensure that the contents of this article are accurate and reflect the current position at law and in practice, we do not accept any responsibility for any damage which may result from a change in the law or from a different interpretation or application of the local law by the authorities or the local courts.
The information contained in the article is intended to serve solely as a guidance and expresses the personal views of the authors; hence any contents therein do not constitute or are to be interpreted as advice.
John Debattista
Partner
