Understanding the Contrast: IRS Rules on Allocation of Intangible Property Income vs. OECD DEMPE Rules

At a glance

• The main takeaway: The IRS and OECD offer contrasting perspectives and guidance on allocating profits for income generated from intangible property.
• The implications for your business: The differing frameworks and resulting opinions of the tax authorities involved can lead to disputes between tax authorities and multinational corporations, which could ultimately lead to double taxation. Navigating these complex laws and striking a supportable, balanced approach is critical.
• Next steps: Aprio’s Transfer Pricing specialists can help your company manage transfer pricing rules and prepare for potential risks by improving documentation around your company’s transfer pricing policies, processes, and procedures to reduce the risk of double taxation.

The full Story

With the rise of digitalization in the global economy, the complexities of cross-border transactions and multinational corporations have prompted governments to rethink the allocation of income generated from intangible property.

These intangibles, such as patents, copyrights, trademarks, and intellectual property, often transcend physical borders, posing significant challenges in terms of taxation and profit allocation. Two prominent frameworks guiding this allocation are the Internal Revenue Service (IRS) rules in the United States; and the Organization for Economic Cooperation and Development’s (OECD) Development, Enhancement, Maintenance, Protection, and Exploitation (DEMPE) guidelines. Understanding the distinctions between these frameworks is crucial for a comprehensive grasp of international taxation.

IRS Rules on Allocation of Intangible Property Income

The Internal Revenue Service (IRS) operates under a set of guidelines that emphasize substance over form that historically were susceptible to tax avoidance and profit shifting. To counteract this issue, the IRS introduced the “arm’s length standard,” a rule that insists transactions between related entities should be priced as if they were conducted between unrelated entities. The IRS primarily relies on the core transfer pricing methods for intangible transactions[1] (comparable uncontrolled price, comparable profits method, and profit split method) to evaluate the arm’s length nature of these transactions. However, these methods often lack the specificity needed when dealing with intangibles, prompting the need for more comprehensive guidelines.

OECD DEMPE Rules

The OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), which is followed by the majority of the rest of world’s tax authorities, has also issued a framework as part of its Base Erosion and Profit Shifting (BEPS) project. In response to the rise of the “digital economy” The OECD developed core functions that should be present to guide the analysis of intangible transactions: Development, Enhancement, Maintenance, Protection, and Exploitation (DEMPE).  The intention of the DEMPE guidelines is to reduce the exploitation of different countries’ tax systems and improve the coherence of international tax laws regarding intangible property transactions. This approach aligns with the notion that value is created not only during initial development but also throughout the intangible’s lifespan.

Before the DEMPE framework was introduced, the property owner was entitled to all the returns generated by that asset. In practice, the owner of a brand could set up their company in one country but register their trademark in a low-tax environment, which allowed them to charge royalties to the brand for any income related to the asset registered in the low-tax environment. A system similar to the IRS rules.

The DEMPE guidelines emphasize economic substance, giving more weight to the functions performed, risks assumed, and assets employed by each related entity. This stands in contrast to the IRS rules, which may focus more on contractual arrangements. By emphasizing substance, the DEMPE framework aims to ensure that each entity involved in the value chain is adequately compensated for their contributions to the intangible’s success.

With the DEMPE framework, any income generated as a result of the intangible asset is divided amongst each party involved in its lifecycle. Now, rather than the owner receiving the total returns, the income is instead allocated between the relevant parties based on their contribution to the asset’s value. By emphasizing each phase of an intangible asset’s lifecycle, the OECD aims to ensure each entity involved in the value chain is proportionately compensated.

Differences and Implications

While the IRS and the OECD share a common goal in reducing tax avoidance and profit sharing amongst multinational corporations and their intercompany intangible property transactions, these agencies diverge on approach. The arm’s length standard and transfer pricing methods are the focus of the IRS, relying heavily on contractual terms, which increases flexibility for taxpayers but also lacks consistency with the OECD view of the rest of the world’s tax authorities, which can lead to disputes between tax authorities and multinational corporations. Contrarily, the DEMPE framework places a greater emphasis on economic substance, aligned with the functions and risks each entity undertakes, and requires a more detailed analysis of assets; however, this framework achieves a more comprehensive approach to transfer pricing and intangible asset evaluation, thereby diminishing disproportionate concentration of profits.

This distinction can lead to varying outcomes in profit allocation. The DEMPE approach is particularly advantageous in cases where the development, enhancement, or exploitation of intangibles involves substantial contributions from multiple entities across borders. It prevents undue concentration of profits in the jurisdiction of the legal owner and ensures that entities adding value throughout the intangible’s lifecycle receive their fair share of compensation.

In contrast, the IRS rules may at times rely heavily on contractual terms, which could be manipulated to artificially allocate income in a way that minimizes tax liabilities. This can lead to disputes between tax authorities and multinational corporations, ultimately affecting cross-border business operations.

Conclusion

In the complex realm of international taxation, the allocation of income generated from intangible property demands careful consideration. The divergence of these rules worldwide demonstrates the evolving challenges of digitalization in a globalized economy The IRS prioritizes the arm’s length standard and transfer pricing methods, while the DEMPE framework underscores the significance of economic substance and value creation throughout an intangible’s lifecycle. Understanding these differences is essential for governments, businesses, and tax professionals navigating the intricate landscape of international taxation and ensuring a fair distribution of profits.

Schedule time with the Aprio Transfer Pricing team to take advantage of our expertise and dedication to helping clients with their tax planning, while minimizing risk.

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[1] Treas. Reg. § 1.482-4