The division and distinction of value creation will likely be affected, altering expectations on profit for each affiliate. United efforts around taxation of the digital economy continue to play out, and where it ends remains to be seen. COVID-19 disruptions present both transfer pricing complications and opportunities in the technology and intellectual property (“IP”) space. We present 6 key action steps for tech companies to take today that address transfer pricing challenges and capitalizes on current unique opportunities:
Increasingly, technology and software developed by multinational enterprises (“MNEs”) is becoming widespread on a global basis, in developed and developing economies alike. As technology expands into the future, some business functions that are traditionally performed by humans may soon be replaced with artificial intelligence (“AI”), software or machines. This substitution of human functions with technological functions creates new and complex challenges pertaining to transfer pricing and the value creation of those functions.
The significant profit potential of successful technology companies foster a need for MNEs to establish efficient transfer pricing policies. As relatively larger operating profits will ultimately be earned within the one country hosting the MNE affiliate that owns and develops the IP, tax authorities in the other countries want to ensure they are getting their fair share of the global profit pie. This is especially the case in countries where an affiliate provides research and development (“R&D”) services to the IP owner. To avoid such an issue, MNEs should have clearly defined transfer pricing studies reflecting arm’s length pricing between those affiliates. The service provider must always be paid by the IP owner for R&D services. This compensation must include a profit element, typically calculated as a markup on costs for providing those services. There is no such thing as a cost center in the world of transfer pricing, where tax authorities expect MNEs to operate as total strangers rather than related parties.
A transfer pricing analysis ensures that each affiliate of a global organization would be compensated at market rate for its relative contribution. “Economic substance” is essential to justify allocation of income across various entities contributing to the global organization. Historically, there would need to be actual people there performing a critical function. This is changing with the increasing use of AI and the digitalization of the economy. What if the company now only needs cloud-based software instead of an actual person for specific activities? Could AI or automated software be valid support for this critical “economic substance” and thus justify allocation of income into that location where it exists? There is much controversy over how to assess functions and risks, and thus value the contributions and allocate income when the intercompany activity is tech or data-driven, coming from metal rather than human form.
Under the old paradigm of “no people, no substance,” businesses would not earn a return, but that is certainly no longer the case, especially for tech-driven companies. Through increased reliance on AI, value-added services may now be performed by machines that are replacing the value-added services that were performed by humans. The entity legally owning the technology should thus be earning an arm’s length profit. The replacement of people with AI would not necessarily redefine economic substance, however it would reframe how economic substance is viewed. AI can produce significant value via analytical intuition and should be compensated for their contributions and value accordingly.
Seemingly overnight, the COVID-19 pandemic turned the global economy on its head. During times of severe economic stress, MNEs are getting a chance to test their operational efficiencies. Many tech companies operating around the world discovered flaws in their cashflow management, realizing too late that their cash was trapped in affiliates in locations such as India and China, where it takes many months to transfer out. We tend to think of transfer pricing as a minimization tool, but it is also a very effective in developing a global cashflow management strategy where cash is diverted to key geographic markets via realigning the functions and risks of the entities, and supporting the flow of funds via economic substance.
Tech companies are struggling when their R&D or customer support service centers were solely located in one geographic location, creating complete shut-down of operations. Since the pandemic hit in waves, a more geographically diversified approach to these critical services would have mitigated the damages.
Along with the structure and function changes related to cashflow and service centers, there are issues and opportunities with respect to the transfer and ownership of IP. Technology companies can reap the benefits of potentially lower valuations of IP due to lower interest rates and cashflow projections and possibly reduced exit taxes on IP relocation if they choose to transfer these assets sooner rather than later.
Recently completed valuation analyses and IP transfers to related parties may now need to be reexamined. The IRS expects a “true-up” for each of the first five years that IP is transferred to an affiliate, and the actual revenue must fall within 80% to 120% of the projections used for the valuation at the time of transfer.
Tech companies should always have a pulse on where they stand in relation to these transfer pricing considerations, as they are of particular interest to tax authorities. This is especially important during times of economic turmoil that could shed light on potential weaknesses that could pivot into strategic opportunities.