1. In transfer pricing cases involving intangibles, the determination of who are ultimately entitled to share in the returns derived by the MNE group from exploiting the intangibles is crucial. This includes issues regarding who should ultimately bear the costs, investments and other burdens associated with the DEMPE of the intangibles. Although a legal owner of an intangible may receive proceeds from exploitation of the intangibles, other members of the group may have performed functions, used assets, or assumed risks that contribute to the value of the intangible. Members of the MNE Group performing such functions, using such assets, and assuming such risks must be compensated for their contributions under the arm's length principle.

  2. The legal owner will be considered to be the owner of the intangible for transfer pricing purposes. If no legal owner of the intangible is identified under applicable law or governing contracts, then the member of the MNE Group that controls decisions concerning the exploitation of the intangibles and has the practical capacity to restrict others from using the intangibles will be considered to be the 'legal' owner for transfer pricing purpose.

  3. In identifying the owner of intangibles, the intangible and any license relating to that intangible are considered to be two separate and distinct intangibles, each having a different owner. Intangible registration and licensing agreements can help identify the legal owner of the intangible and the owner of the license.

    Example 1

    Company A, the legal owner of a trademark, may provide an exclusive license to Company B to market and distribute goods using the trademark. The first intangible is the trademark, which is legally owned by Company A. The second intangible is the license to use the trademark in connection with marketing and distribution of trademarked products, which is legally owned by Company B. Depending on the facts and circumstances, marketing activities undertaken by Company B pursuant to its license agreement may potentially affect the value of the underlying intangible legally owned by Company A, the value of Company B's license or both.

  4. If the legal owner neither performs the functions, nor control the functions or risks related to the development, enhancement, maintenance, protection or exploitation (DEMPE) of the intangible, the legal owner would not be entitled to that portion of return associated with the performance of the functions or the control of the functions and risks relating to the DEMPE of the intangibles. The final return to the legal owner will depend on its contributions and the contributions of the other members of the MNE Group to the value of the intangible. This value is attributable to its functions, assets and risks related to the DEMPE of the intangibles

For transfer pricing purpose, in analyzing transactions involving the use or transfer of intangibles between associated persons, the following factors should be taken into consideration :-

  1. Identifying the intangibles
    1. Specifically identify the intangibles used or transferred in the controlled transaction together with the economically significant risks associated with the DEMPE of the intangibles.

    2. When a taxpayer pays royalty for the use or transfer of intangibles, the taxpayer needs to provide evidence for:
       
      • the intangibles that are involved;

      • the processes where the intangibles are utilized

      • the benefit obtained from the intangibles;

      • the specific, economically significant risks associated with the transactions involving the intangibles; and

      • withholding tax payments that are made with regards to the royalty payment.

  2. Analyzing the contractual terms
    1. Identify the full contractual arrangements with special emphasis on determining legal ownership of intangibles based on the terms and conditions of legal arrangements, including relevant registration, license agreements, other relevant contracts, the contractual rights and obligations and the contractual assumption of risks in the relations between the associated persons.

    2. In identifying the contractual arrangements, the following information is necessary and may be obtained from legal documents including public registration such as patent or trademark registration and written contracts such as licensing agreements:
      • legal ownership;

      • role, responsibilities, obligations and rights of the relevant parties including those who undertake the functions and controls the risks with respect to the DEMPE functions;

      • identity the funder and level of risks assumed by the funder;

      • quantum of payment and mode of payment; and

      • how expenses and receipts related to intangibles are allocated.

    3. Correspondence and communications between the parties involved are also important in identifying and analyzing the controlled transactions involving intangibles and evaluating the terms of the transactions (including risks assumption involving the transfer or use of the intangibles).

    4. The determination of legal ownership is distinct from the question of remuneration. Legal ownership of intangibles, by itself, does not confer any right ultimately to retain returns derived by the MNE Group from exploiting the intangible. Even though such returns may initially accrue to the legal owner as a result of its legal or contractual right to exploit the intangible, this would depend upon the functions the legal owner performs, the assets it uses, and the risks it assumes, and upon the contributions made by other MNE group members through their functions performed, assets used, and risks assumed (refer to paragraph 8.2.3).

  3. Functional Analysis
    1. Functional analysis needs to be done to identify the parties performing economically significant functions, using assets, and managing risks related to DEMPE of the intangibles.

    2. Taxpayer needs to identify:
      • the economically significant functions that contribute to the value of the intangibles and instrumental to the success of the DEMPE of the intangibles

      • ascertain the relative importance of each DEMPE functions; and

      • group members who:-
        • perform and exercise control over the functions associated with the DEMPE of the intangibles;

        • provide the assets and funding, and have financial capacity necessary to bear the cost in relation to the funding; and

        • assume and exercise control over the various specific, economically significant risks associated with the intangible and have the financial capacity to bear the risks associated with DEMPE of the intangibles.

    3. Carefully evaluate the relative value of contributions by various entities to the DEMPE to ensure all affected entities in the group are appropriately compensated on an arm's length basis.

    4. The performance of activities by a Malaysian taxpayer which are economically significant and important include:
       
      • research and development activities which leads to customization / enhancement of existing products or new products;

      • activities which leads to improvement in manufacturing processes;

      • the performance of advertising, marketing and promotional activities by the Malaysian taxpayer which leads to creation / enhancement of marketing intangibles such as customer lists, marketing / distribution channel, or favorable contracts; and

      • managing customers' relationship, localization of products / advertisements or marketing survey including collection of local data.

    5. All these local functions performed by the Malaysian entities which improved the value of intangibles should be appropriately compensated and the costs incurred for such expenses should not be merely reimbursed to the local entity without any profit element, especially when they are performed in conjunction with the manufacturing or distribution functions.

    6. A local entity who is not the legal owner of the intangible may nevertheless be entitled to a share of returns from its exploitation if the local entity has contributed to the enhancement of the intangibles. Thus, the local entity is considered as having 'economic ownership' of the associated intangibles created.

  4. Control of the performance of significant functions.
    1. In carrying out the functional analysis, a taxpayer needs to assess the capacity of a particular entity to exert control and the actual performance of such control functions. It is not essential that the legal owner physically performs and controls all the functions related to DEMPE of an intangible. Where associated persons other than the legal owner perform and control relevant functions that are anticipated to contribute to the value of the intangibles, they should be compensated on an arm's length basis.

    2. Similarly, where the performance of the DEMPE functions by a local entity is said to be controlled by another entity, documentary evidence has to be provided, to show that the said entity has the capability to control and perform its control functions.

    3. A local entity carrying out core functions as mentioned in paragraph 8.2.2 (iii)(e) above would control the strategic operations decisions regarding its activities and should be entitled to more than a routine low cost plus remuneration for its performance and control of the core functions. It is highly unlikely to separate the performance and control of a function.

  5. Funding 
    1. Group members involved in the creation of intangibles may contribute physical assets, intangibles or funding for the project. The nature and amount of compensation attributable to any of the group members should be appropriately determined based on the arm's length principle.

    2. Funding and risks taking are closely integrated as funding is often linked with certain risks such as bad debts risks or the risks of losing all the funds. Compensation to the funder will depend on the level and extent of the risks it bears.

    3. To show control over a specific financial risk, a taxpayer must provide evidence that the funder is capable of making relevant decisions related to the risk bearing opportunities together with the actual performance of these decisions (including risk mitigation activities).

    4. Generally, a funder who only exercise control over financial risks associated with the provision of funding, without the assumption of further risks in relation to the investments, and without any control over the use of the contributed funds or the conduct of the funded activity, would only entitle the funder to a risk-adjusted rate of anticipated return on its capital.

  6. Risks associated with DEMPE of the intangibles
     
    1. Many local entities are treated as contract risk free service providers, by contending that higher return to foreign entity is justified because the foreign entity:

      • provides funding for the project, hence bearing the risks of failure of the R&D functions; and

      • establishes and controls strategy / direction and priorities of research program or creative undertakings while the local entity is merely implementing such strategy / direction.

    2. Although the strategic decisions and overall directions from parent / foreign entities are cascaded down to the local entity, this does not imply that the foreign entity has control over the R&D functions of the local entity or would bear the related risks.

    3. If the local entity performs important R&D functions and even customizes the know-how provided which leads to enhancement of intangibles or creation of new intangibles, and the management and personnel of the local entity are responsible for operational decisions and monitoring of its R&D activities, the local entity is in a better position to control over the operation and its related risks than an entity who is controlling the functions / risks from afar.

    4. As mentioned in paragraph 8.2.2 (v) above, provisions of funding will not entitle the funder to a premium return, if it did not perform control functions and bear risks with regards to the R&D activities. Besides that, other important assets possess by the local entity such as skilled workforce must be considered when determining the return to the local entities. The parent / foreign entity will be entitled to a return for the provision of funding and overall direction and strategy, while the local entity should also be entitled to a return on their core R&D functions and control of risks related to the operation of R&D activities. Hence, the local entity should not merely be reimbursed on a cost plus margin as a risk free service provider since the performance, control functions and its associated risks are closely linked and should not be separated and assigned to different parties.

    5. When analyzing the economic substance of a transaction in relation to risks, it is necessary to examine whether the conduct of the associated persons over a period of time has been consistent with the allocation of risks and not merely at the time when risks are realized and whether changes in the pattern of behavior of the parties have been matched by changes in the contractual arrangements.

    6. Hence, a routine service provider who earns a very low margin should not suffer the loss when certain risks are realized, as it had consistently earned a minimal margin when the risks did not materialized. In a genuine case, a local entity who bears the risks would earn a reasonable margin and have taken mitigating actions to protect itself against any risks should it materialized.

  1. If the legal owner of an intangible in substance:
    1. performs and controls all the economically significant functions related to the DEMPE of the intangible;

    2. provides all assets, including funding, necessary to the DEMPE of intangibles; and

    3. assumes all the risks related the DEMPE of the intangible.

      then it will be entitled to all the anticipated, ex ante returns derived from the MNE Group's exploitation of the intangible.

  2. The extent to which one or more members of the MNE Group other than the legal owner perform functions, uses assets or assumes risks related to the DEMPE of the intangible, will determine its arm's length compensation for their contributions. This compensation may, depending on the facts and circumstances, constitute all or part of the return anticipated to be derived from the exploitation of the intangible.

  3. In evaluating whether associated persons that perform functions or bear risks related to the DEMPE of intangibles have been compensated on an arm's length basis, it is necessary to consider:

    1. the level and nature of the activity undertaken;

    2. the expected contribution of the functions performed and risks assumed to the creation of intangible value and the generation of income; and:

    3. the amount and form of compensation paid. 

  4. Determining Arm's Length Compensation
    1. In determining the arm's length compensation for the functional contributions, assets used and risks assumed, the principles in accurately delineating the actual transaction, analysis and allocation of risks and the recommended process for conducting a comparability analysis apply equally to transactions involving intangibles.

        • comparability factors that may contribute to the creation of value or generation of returns derived by the MNE Group from exploitation of the intangibles;

        • the availability of comparable uncontrolled transactions;

        • the importance and the relative contribution of the functions performed to the creation of intangible value; and

        • the realistically available options of the parties.
          It is necessary to consider the following in determining the arm's length price for controlled transactions involving intangibles:

    3.  When it is difficult to find comparable transactions involving intangibles, it may be necessary to utilize transfer pricing methods not directly based on comparable including profit split method and ex ante valuation techniques to appropriately reward performance of those important functions.

  1. An ex ante (anticipated) remuneration refers to the future income expected to be derived by a member of the MNE Group at the time of a transaction while ex post (actual) remuneration refers to the income actually earned by a member of the group through the exploitation of the intangible

  2. The terms of the compensation that must be paid to members of the MNE Group that contribute to the DEMPE of intangibles is determined generally at the time transactions are entered into and before risks associated with the intangible play out (ex-ante). The form of such compensation may be fixed or contingent. The actual (ex post) profit or loss of the business after compensating other members of the MNE Group may differ from these anticipated profits depending on how the risks associated with the intangible or the other relevant risks related to the transaction or arrangement actually play out.

  3. The difference between ex ante (anticipated) and ex post (actual) return arises largely from risks associated with the uncertainty of future business outcome. The risks may materialize in a different way to what was anticipated through the occurrence of unforeseeable developments. The ex-ante contractual assumptions of risks provide clear evidence of a commitment to assume risks prior to the materialization of the risk.

  4. The party which is entitled to the unanticipated profit (or required to bear the unanticipated loss), will be the party which is found to assume the risks when accurately delineating the actual transaction or which contribute to the control of the economically significant risks or which performed the important functions with respect to the DEMPE activities and for which it is determined that an arm's length remuneration of these functions would include a profit sharing element.

  5. In addition, consideration must be given to whether the ex-ante remuneration paid to members of the MNE Group for their functions performed, assets used, and risks assumed is, in fact, consistent with the arm's length principle. Care should be taken to ascertain, for example, whether the group in fact underestimated or overestimated anticipated profits, thereby giving rise to underpayments or overpayments (determined on an ex ante basis) to some group members for their contributions. Transactions for which valuation is highly uncertain at the time of the transaction are particularly susceptible to such under or overestimations of value.

  1. One common situation to consider is when an entity associated with the legal owner performs advertising, marketing and promotional (AMP) functions, which would benefit the legal owner of an intangible. In this case, considerations to determine how the distributor / marketer should be compensated for its AMP activities would include whether to compensate the distributor / marketer as a service provider for providing AMP functions or whether the distributor / marketer should also be compensated for enhancing the value of the trademarks and other intangibles by sharing in the potential benefits by virtue of its functions performed, assets used, and risks assumed.

  2. Malaysian subsidiaries of MNEs usually incur and bear very large amounts of AMP for the benefit of the legal owner of the intangible and simultaneously developed local marketing intangibles such as distribution network, customers' relationship etc. These entities are usually characterized as buy/sell or limited risk or routine distributor and only generate a nominal profit or even incurred losses at times.

  3. Some local distributors have a well-trained and organized marketing team, which performs functions which help create marketing intangibles such as:
     
      1. enhancing the value of the foreign trademark or brand name or logo;

      2. enhancing brand or product loyalty in the minds of consumers;

      3. establishing networking / distribution channels;

      4. performing customers research or survey or investing in information systems leading to creation of customers list/database or customers' preference information;

      5. establishing an efficient after-sales services and support network locally; or

      6. creating a reputational goodwill.

  4. These intangibles should attract much more than a routine reward that a "limited/routine distributor" would earn. The marketing team should be sufficiently rewarded, i.e. the marketing organization should be rewarded for its effort with or without the creation of local marketing intangibles depending on the facts and circumstances of the case.

  5. Where the marketer / distributor actually bears the costs and associated risks of its marketing activities, the marketer / distributor will have a share in the potential benefits from those activities. The margin earned by the local entity, must be comparable to those earned by independent marketers bearing similar risks and costs. In these cases, the marketer / distributor is expected to generate higher margin which may be in the form of:
      1. a reduction in purchase price e.g. via additional discount on the purchase price to allow additional profits to reflect the functions, risks and cost incurred in promoting the products;

      2. a reduction in royalty rate as compared to previous year (if it's a licensed distributor); or

      3. a share of profits associated with the enhanced value of the trademark or other marketing intangibles.

  6. The method of compensation for the AMP functions must be identifiable, quantifiable and easily verifiable. A statement which merely mentions that the extra return was embedded in the purchase price is not acceptable evidence that the AMP functions are appropriately compensated.

  7. If the local entity only performs buy sell function (e.g. limited risks distributors) and undertakes marketing activities on behalf of its principal which did not result in the development of marketing intangibles, the local entity has to be compensated by the principal for the marketing functions, where it should earn;
      1. an arm's length margin from selling the products for the distribution functions it performs, the assets it uses and the risks it assumes; and

      2. a service fee for the marketing function it performs on behalf of the principal.

  8. The service fee paid to the local entity for its marketing activities should be based on compensation paid to independent parties performing similar functions. Even if there is no written agreement covering this service, this does not prevent the application of the arm's length principle to that transaction.

  1. Generally, the arm's length compensation for research services will depend on a number of factors such as the unique skill and experience of the research team, the risks assumes (e.g. where blue sky research is undertaken), the assets and intangibles used and who performs the control functions (whether the research team is controlled and managed by another party) etc. Generally, a compensation based on reimbursement of costs plus will not reflect the anticipated value of the intangibles created or the contribution of the research team.

  2. Research and Development (R&D) activities.
    1. Some local entities are established to carry out research and development work under a contract for its associated foreign entity where the local entities will have no ownership of the intangibles, and the results of the research and development activities will belong to the associated foreign entity. Generally, these local entities are treated as contract research and development companies with limited risks and the service fee paid to the local entity is the cost of the research and development activities undertaken plus a mark-up. However, a compensation based on reimbursement of costs plus will not reflect the anticipated value of the intangibles created or the contribution of the research team. Therefore, the local entity should be rewarded based on the functions performed, assets used and risks assumed that contribute to the value of the intangible. A proper analysis of the value provided by the contract research and development entity to the overall group operations should be provided.

    2. In determining the amount due to the local entity, the relative skill and efficiency of the research personnel, the nature of the research being conducted and other factors contributing to the value should be considered.

    3. If the local entities perform the core R&D activities, make day-to-day operational decisions and exercise substantial control over the operational risks in the R&D projects, possess sizeable assets and skilled workforce, in such case, the allocation of routine and low cost plus return will not reflect a true arm's length price of the transaction.

    4. Where in particular the research team has unique skills or experience, or where blue sky research is undertaken, compensation should be based, at least in part, on a share of profits from the future exploitation of successfully developed intangibles. This would be more in keeping with the arm's length principle and the provisions of the Transfer Pricing Rules.

    5. Similarly where the local entities create unique intangibles as a result of the R&D activities, and legal ownership are transferred to the foreign entity, such transfer normally takes place without any appropriate compensation. In these cases, compensation of such transfer should be based on a share of profit from its future exploitation, in addition to its arm's length compensation for its R&D activities.

  3. Enhancement of product or process while performing manufacturing functions.
    1. Another situation to consider is where a manufacturer in its provision of manufacturing services to another member of the group (e.g. contract manufacturer), leads to enhancement of processes and legal ownership is assumed by another group member. The local entity should be entitled to a return on the enhancement of these processes, products or intangibles if they are transferred to or shared with the other related entities. If the enhanced intangibles is self-exploited by the local entity, an increased in margin should be reflect.