Big pharma takes apart the OECD on marketing intangibles

Since the OECD released its policy note on digital tax in January, business leaders have had time to chew over the details and they fear that the move away from the arm’s-length principle (ALP) will hit them hard. This might even scathe companies outside the high-tech sector.

The OECD’s discussion draft suggested that the existing transfer pricing (TP) rules have resulted in corporate income being under-allocated in certain jurisdictions. This is due to the ability of companies to participate in a jurisdiction without having any physical presence there.

“This simply does not apply to more traditional businesses,” said Catherine Harlow, head of TP at AstraZeneca. “The pharmaceutical industry, for example, requires significant physical presence to perform value generating activities and current transfer pricing rules under the arm’s-length principle are capable of allocating profit to those activities.”

“Any potential marketing [intellectual property] generated locally is simply a by-product of the performance of routine functions that are rewarded in accordance with the arm’s-length principle,” she explained.

Yet the focus is very much on IP assets and particularly marketing intangibles. The OECD has to find the key to overhaul global tax rules, and intangibles are high up on the list of options.

The OECD breaks down its focus into two pillars. The first seeks to address the digital economy and focuses on taxing rights, profit allocation, nexus issues and value creation. Whereas the second pillar is focused on shoring up the BEPS project and strengthen the taxing rights of those jurisdictions facing base erosion.

How to approach the first pillar is highly contested. The US favours the creation of a robust regime on marketing intangibles such as user data, whereas the UK favours apportioning residual profits according to number of users.

AstraZeneca has “significant concerns” about how the marketing intangibles proposal would apply to its business operations. These concerns have, no doubt, worsened because the digital tax debate spells fundamental change.

“We do not agree with the OECD’s premise that low risk distributors are established to facilitate the ability of a multinational to ‘reach into’ a jurisdiction,” AstraZeneca’s Harlow said. “Nor do we agree with the assumption that marketing intangibles are created locally by the existence of favourable attitudes from customers.”

Harlow said the marketing intangibles proposal would “undermine the arm’s-length principle by moving taxing rights from the innovator to the end market for countries resulting in more profit being allocated to those countries with the largest populations”.

This would run the risk of misallocating profits out of line with value creation. It would not only take companies beyond the ALP, but it would make the profit split method the main approach to allocating residual profit.

AstraZeneca is far from alone in its concerns about marketing intangibles. Pharmaceutical company GlaxoSmithKline (GSK) has made it clear that it shares these concerns.

“Certain sectors, such as pharmaceuticals, are highly regulated in how they engage and interact with customers and are, in most countries, subject to regulated pricing which means they do not interact with their customer base in the same way as in other sectors,” GSK said in a statement.

“Seeking to allocate a marketing intangible return in such scenarios would be an inappropriate deviation from the [ALP] which would not reflect the nature of the engagement with the market jurisdiction,” the company said.

The pharmaceutical industry derives much of its value through research and development (R&D), not from marketing intangibles – although the sector is rich in IP given the nature of its products. Nevertheless, TP directors stress that the value of the intangibles still comes down to the outcome of clinical trials.

This may be why Timothy McDonald, vice president of finance at Procter & Gamble (P&G), stressed the problems of reducing value to marketing intangibles.

He said: “The most difficult part of this process is not defining what a marketing intangible is, it is in developing what is the relative share of residual income attributable to that defined marketing intangible as compared to all other intangibles deployed within the enterprise.”.

“Over the last few years, we have divested over 150 small or local brands and now focus on 65 brands globally and regionally,” he continued. “Across all P&G brands, it would be nearly impossible to separate the relative value contribution either by market , or between marketing versus trade intangibles, because of the integrated nature of the two types of assets.”

In other words, the same arguments over the role of data in value creation extend to marketing intangibles as a whole. “It is not about the data,” McDonald said, adding, “it is about what companies do with the data that creates value”.

There are alternative proposals on the table. A third group of countries in the developing world prefer the idea of a digital significant economic presence to build a nexus-based approach to the online economy.

However, many observers are concerned that this would open the door to formulary apportionment (FA). This would threaten the basis of traditional TP arrangements. Not only could it expand the remit of taxing rights in the developing world, it could see a new wave of legal challenges around the world.

“Any of the Inclusive Framework’s recommendations within the consultation document will lead to increased tax controversy,” McDonald said.

It’s no surprise that the business community remains firmly wedded to the ALP. Yet the direction of travel appears to be away from this standard. The consequences of abandoning the principle could be immensely expensive.

“The [ALP] is sufficient to ensure that the vast majority of multinationals pay the appropriate amount of tax in each territory in which they operate in line with the functional and risk profile of their activities in that territory,” Harlow said.

“A fractional apportionment method represents a departure from economic reality,” GSK said. “This could drive unwanted behaviours , encouraging businesses to withdraw from certain jurisdictions and use third-party distributors if the outcome were not aligned to economic and commercial [operations].”

It’s obvious why countries vulnerable to capital flight would want to expand their taxing rights, but there is no consensus on how exactly FA should work in practice.

If the world does move away from the ALP, the OECD will need to look at ways to limit the potentially destructive fallout. This might mean a second multilateral instrument or even a global tax court. In any case, the work that began with BEPS is far from finished.