Owning the IP Is Not the Same as Earning From It

The structure is familiar. One group company holds the patents, the brand or the software, and the operating companies pay it a royalty. The arrangement is documented, the registrations are in the right name, and the accounting follows the contract. The FTA transfer pricing guide accepts none of that as the answer, because it asks a question the paperwork does not address: which company actually did the work that made the intangible worth paying for.

The guide's own warning about this subject

The guide opens section 7.3 by saying that questions regarding intangibles are perhaps the most complex in transfer pricing, and gives its reasons: the unique characteristics of intangibles, the ease of transfer via a contractual arrangement, the difficulty of finding comparable arrangements, and the importance of intangibles in generating revenue.

The second of those is the one to sit with. An intangible can be moved between group companies with a signature, in a way a factory cannot. That is precisely why the analysis does not stop at who signed what.

What counts as an intangible, and three things that do not

The guide defines an intangible as something that is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances.

Its illustrative list of intangibles for transfer pricing purposes covers patents, know-how and trade secrets, trademarks, trade names and brands, rights under contracts and government licences, and licences and similar limited rights in intangibles.

A further class sits above the rest. Unique and valuable intangibles are defined by two limbs together: they are not comparable to intangibles used by or available to parties in potentially comparable transactions, and their use in business operations is expected to yield greater future economic benefits than would be expected in the absence of the intangible. Both limbs, not either.

DEMPE, and the sentence that decides most structures

The allocation of intangible returns is accomplished by compensating group members for functions performed, assets used, and risks assumed in the development, enhancement, maintenance, protection and exploitation of the intangibles — DEMPE. The guide sets out a six-step framework: identify the intangible; identify the full contractual arrangements and legal ownership; identify the parties performing DEMPE functions, using assets and managing risks through a functional analysis; confirm consistency between contract and conduct; characterise the actual controlled transactions; and price them.

Step two carries the sentence that determines the outcome in most owner-managed and holding structures. Legal ownership of intangibles, by itself, does not confer any right ultimately to retain returns derived by the group from exploiting the intangible. What the legal owner retains depends on the functions it performs, the assets it uses, the risks it assumes, and the contributions made by other group members.

That is worth reading against the common UAE arrangement in which a newly formed entity is assigned the group's trademarks and immediately begins invoicing royalties. If the entity has no people, makes no decisions and carries no risk, the royalty it charges has no support in this framework however carefully the licence is drafted.

Outsourcing DEMPE is allowed. Losing control of it is not

The guide does not require the legal owner to do everything itself. It says the legal owner need not physically perform all the DEMPE functions, and that some functions could be outsourced — but overall control of these functions should remain with the legal owner.

Two consequences follow. Where the outsourcing is to a related party, the legal owner must compensate that entity on an arm's length basis for the functions it performs. And group members with more significant contributions should receive proportionate remuneration, including compensation for using their assets.

On risk, the guide is equally direct: the level of risk assumed determines the reward a group member is entitled to receive, and the member asserting entitlement to returns from assuming risk must actually bear responsibility for the actions required and the costs incurred if the risk materialises. It names four that are commonly significant for intangibles — development risk, infringement risk, product liability risk, and exploitation risk.

Where the contract and the conduct disagree, the conduct wins

Step four asks whether the contractual arrangements and the actual conduct of the parties are consistent. If they are, the contracts can serve as the basis for determining the controlled transactions. If they are not, the guide says the conduct of the parties should be considered as the basis for determining the actual transactions and their nature.

This is the practical reason an intangibles file cannot be assembled from agreements alone. The evidence that matters is who chairs the development meetings, who signs off the roadmap, who instructs counsel on an infringement, and who absorbs the cost when a launch fails.

The guide's worked example, and what the funder gets

Example 22 in the guide takes a group of two companies. Company X provides all the funding for developing an IP asset and becomes its legal owner. Company Y performs and controls all DEMPE activities. The contractual terms are adhered to throughout the five-year development period, and no inconsistency is observed between conduct and contract.

The functional analysis finds that although Company X is the legal owner and entitled to book the revenue, its contribution does not go beyond providing funding. It contractually assumes the financial risk and has the capacity to assume it. Company Y, however, exercises control over the risk, manages it, provides the expertise, and through its track record significantly de-risks the project for Company X.

Pricing, when there is nothing to compare

In selecting a method, the guide asks for attention to the nature of the intangibles, the difficulty of identifying comparable uncontrolled transactions and intangibles in most cases, and the difficulty of applying certain methods to intangibles at all. Where a transferred intangible provides a unique competitive advantage, purportedly comparable intangibles should be carefully scrutinised, and it is critical to assess whether the potential comparables in fact exhibit similar profit potential.

Any of the five prescribed methods may be the most appropriate depending on the facts. Where none can be reliably applied, the guide points to Article 34(4) of the Corporate Tax Law, under which other alternative methods may be considered — it gives market appraisal or valuation as the example, particularly for a unique intangible or a one-off transfer.

Free zone entities holding IP face a second and separate test. Qualifying Income from intellectual property is restricted by a nexus fraction that asks what proportion of the qualifying expenditure was incurred by the entity itself — a different question from DEMPE, applied to the same facts.

What to check

1. Identify the specific intangible, without relying on the accounting or legal definition alone.
2. Check that what you are charging for is an intangible at all — group synergies, market characteristics and assembled workforce are expressly excluded.
3. Map DEMPE functions to entities, and be honest about which entity controls each one.
4. Where the legal owner outsources DEMPE to a related party, price that service at arm's length as a separate transaction.
5. Test whether the risk-assuming entity can actually bear the cost if the risk materialises, rather than merely signing that it does.
6. Compare the contracts against the conduct, because where they diverge the conduct is what is priced.
7. Where the legal owner is only a funder, expect a funding return and not the residual.
8. Where no method applies reliably, consider a valuation under Article 34(4) rather than forcing a weak comparable.

The FTA Transfer Pricing Guide (CTGTP1) is guidance rather than legislation; the underlying obligation is in Articles 34 and 55 of the Corporate Tax Law. Confirm the position for your own facts before relying on it.