TP aspects of intangibles: How deep should DEMPE be?

This first article in a three-part series offers practical guidance on conducting a development, enhancement, maintenance, protection and exploitation (DEMPE) analysis for organisations that tend to be increasingly complex in their allocation of functions and risk management.

The DEMPE concept is a proxy for a functional analysis in the sphere of intangibles with a focus on development, enhancement, maintenance, protection and exploitation functions. There are two dimensions to DEMPE analysis:

1. The entitlement to profits; and

2. The eligibility for cost allocation purposes (and risks).

As suggested by sub-section 6.32 of the 2017 OECD guidelines, in addition to the legal owner, "other members of the legal owner's MNE group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible".

The main issue is summarised in sub-section 6.33.v where the OECD notes that MNEs can perform DEMPE functions "often in a way and with a level of integration that is not observed between independent enterprises". The implicit proposition is that there could be a continuum within MNEs that would entitle a larger number of legal entities to intangible-derived income because they might contribute to one of the DEMPE functions.

Economic literature, whether based on either transactional costs, economics or internalisation economics, stipulates that the internalisation within MNEs can alleviate the existing market imperfections in third party relationships. There are four main reasons for this, as outlined by Narula, Asmussen, Chi & Kundu in the Journal of International Business Studies (2019) (The multinational enterprise in the twenty-first century):

1. Internalisation enables the corporate headquarters (HQ) to engage actively in the selection and training of managers so the goals of these managers align better with those of the business in its entirety with a level of control not existing between unrelated parties.

2. Internalisation facilitates monitoring because it can be imposed by the HQ without risking the appropriation of firm-specific knowledge by potential competitors (mitigation of the hazards of misappropriation that allows information continuum and quasi symmetry).

3. To make sure that sufficient effort is invested in specific asset recombination, the HQ can define proper incentives linked to job preservation, bonus or promotion decisions.

4. Internalisation enables the HQ to weaken potential perverse incentives by removing residual claims from the manager of each unit, and thereby also lowering the gains from free riding.

To achieve the benefits of internalisation, MNEs develop global organisations, generating hierarchical costs. The internalisation, therefore, unfolds as long as hierarchical costs are lower than those generated by market imperfections.

Equally important are the motives behind internalisation that lead to foreign direct investment (FDI). The identification of such motives are relevant because they are likely to indicate how the performance of internalisation should be assessed, and the action and control mechanisms that MNEs put in place to deliver above 'open-market' efficiencies.

The motives for FDI will vary across industries and can be of multiple nature. Nevertheless, a value chain analysis should seek to understand the motive and the process to secure the associated benefits that are attached to the most important specific asset, value driver or key success factor of the MNE. For instance, notwithstanding the weight of commercial operating expenses in the pharmaceutical industry, it is fair to assert that critical FDI (including quasi-internalisation such as strategic alliances) is mainly aimed at the acquisition of strategic IP assets and scale related efficiency sources.

The last layer of the framework is based on the distinction operated in economic literature between architectural design and engineering (ADE) and component competencies, in the context of a firm's productive knowledge:

• Component competencies are abilities and skills that are essential for day-to-day problem solving at a local or component (regional or business unit) level. These tend to have a large geographical footprint.

• Architectural design and engineering (ADE) competencies are capabilities for integrating different areas of abilities and skills to develop new product or process configurations, containing higher order knowledge connecting component competencies into a coherent whole. These tend to be centralised around a narrow number of jurisdictions.

One of the most significant challenges on the development of a DEMPE analysis is determining the level of granularity of doing a DEMPE analysis.

Within a MNE, this difficulty resides in the decision making process that spreads across all the hierarchical layers of a given organisation or unit. As previously illustrated, MNEs can rely on a more symmetrical information architecture to enhance the decision-making process all along its streamlined structure.

There could, therefore, be a temptation (for tax administrations) or the risk (for taxpayers) to determine that the DEMPE analysis has to be carried at the lowest possible level of granularity of the MNE to unveil all the decisions, delegations and bodies for a given process. This could easily lead to additional claims on returns generated by intangibles.

In line with the described framework, and in order to be relevant from both economic and transfer pricing standpoints, the focus of the DEMPE analysis should be on:

• Activities that are related to the firm-specific assets (FSAs) that can deeply affect the mid- to long-term performance of the company. The list of such FSAs should be aligned with the key value drivers in the master file of the company; and

• Architecture, design and engineering levels – and not at operational levels – to capture the contribution of key entrepreneurial and risk-taking functions to the DEMPE activities on intangibles.

Due to the sensitivity of the DEMPE file, and the deep ramifications of a misguided or disputed approach, it is best to elaborate a thorough rationale on the pertinence of the level of granularity that was defined as adequate for the exercise. One approach would consist of slicing the contributions of the different stakeholders between operational, tactical and strategic components.

While this might appear to be a complex exercise, companies have largely harmonised the grading of positions and performed extensive job levelling campaigns. Usually, such grading initiatives adhere to the strategic/tactical/operational framework and those concepts tend to be described in the grading matrix. The suggestion here would be to concentrate the efforts on the upper tactical levels and on the strategic levels and to determine where the decision-making nexus is within the organisation.

While this information can be difficult to obtain, for confidentiality reasons, it remains critical to the delineation of highly impactful positions in the organisation. As a complement, such information can be cross-referenced with the level of bonuses (in percentage of fixed salary) that these positions are entitled to, it reflects their stake and their reach in the hierarchical architecture in charge of developing and maintaining the firm's specific assets.

Once the accurate level of contributors is defined, with the functions they perform within the company, it is necessary to tackle the risk and assets part of the equation to provide a sound picture on the control over risk landscape of the company on firm specific assets.

This exercise has been made more complex by MNEs adopting Matrix or Helix organisation structures for generating intangibles and management activities. In such organisations, the nexus of decision making is more evasive.

Should the pillar one journey reach its goal, the importance of this topic might even attract more attention and resources

For instance, most large pharmaceutical companies have migrated to agile organisation models in their R&D activities to foster the level of productivity through cross-functional processes usually combined with patient centric functions such as medical and market access.

The aim of such cross-functional organisations is to achieve a higher portfolio and resource optimisation and to decrease the risks related to the historically linear and resource consuming development process. Such goals can be achieved by deprioritising projects that are likely to fail and reallocate resources to projects with a higher potential. Identifying the managers of those risks is therefore crucial.

Agility of the organisations and adequate digital abilities are likely to serve that purpose and to complicate the DEMPE exercise. The digitalisation of the R&D function has certainly eased the emergence of virtual organisations, with certain contributors sitting in a different location to their team. This has triggered a certain level of concern for tax and transfer pricing professionals because either the tracking exercise is far too complex or the invoicing mechanism of such individuals can be highly manual. The two situations must be differentiated based on a critical mass factor: an isolated contributor or an entire team. The main differences between these situations can be summarised as follows:

• It could be sustained that an isolated contributor should be assimilated to a third-party consultant, even if highly integrated in the risk management and decision-making mechanism. On a third-party agreement with an individual, it is highly unlikely that such party would be entitled to profits on the asset it supervises.

• An entire team might trigger more acute questions as the critical mass of the team could allow a higher reach in the value generation that could open an entitlement to profits in addition to their expenses. Moreover, one could also argue that a team would have a higher capacity to attract the necessary capital to increase its stake on a product development.

Capital remains the elephant in the room when it comes to DEMPE analysis.

While some consideration is given to capital allocation in the OECD guidelines, capital should not be neglected in a DEMPE analysis, even if it's not contemplated in the DEMPE framework. While one can adhere to the principle that funding an empty shell might not be able to capture all intangibles related income, a lean and optimised organisation without capital will not operate as an IP owner neither. This is particularly the case in the pharmaceutical industry where investments are colossal, and failures are statistically the norm (hence the premium return to capital).

It is in this sense that the capacity to recombine firm specific assets should be the driver in defining the capacity of the firm to manage and control its core and defining risks and rewards activities through the recombination of its specific assets.

To determine the effective involvement of the key contributors, it might be necessary to reach beyond the transfer pricing framework and embrace the enterprise risk management or the governance compliance and risk frameworks. Valid, but incomplete, reference could be made to SOX controls. Corporate social responsibility reports can serve as an introduction to the matter.

While all the above-mentioned frameworks can provide useful guidance on the risks to document and identify the persons managing such risks, the enterprise risk management is the framework that is more likely to deliver answers regarding the management of the risks related to FSAs and intangibles. the risk management and internal control environments can still provide elements regarding risk escalation and arbitration procedures that can sustain a DEMPE analysis.

Enterprise risk management frameworks tend to be more suitable because they are implemented as operational corporate governance tools to ensure among many things:

• Accountability and competency for managing significant risks of the company;

• Alignment of decision-making processes with risk acceptance; and

• Oversight on inter-connected risks (to avoid silo management).

As such, it tends to offer a higher level of alignment with the transfer pricing framework of DEMPE analysis, and the adequate level of granularity of the risks (magnitude and importance) on par with the selection of strategic and top tactical job levels.

Nevertheless, it is still possible that such documents do not provide the required level of information. In this case, two additional options can be activated:

1. The interviews with unit heads with the support of organisational presentations; and

2. The review of the many alliances and collaboration agreements that MNEs are increasingly entering into, especially in the industries such as pharmaceuticals.

Collaborations have progressively migrated from license agreements to global alliances mainly focused in the co-generation of intangibles. Unlike internal documents, alliances tend to provide extensive descriptions on risks and the mechanism to manage those risks, generally through joint management committees. The agreements tend to provide deep insight on the identification of critical economic risks and allow the key contributing functions in an organisation to be clearly identified.

Finally, public sources should be checked, and among these, presentations to investors or institutional communication, as well as 20-F or 10Ks because MNEs often explain a certain level of detail on the organisation of their units – especially R&D – and the main strategic and operational risks. Nevertheless, this might represent a minimalistic approach in the context of increasing transparency and enhanced communication requirements MNEs are facing.

Whether initiatives such as pillar one are successful or not, it will not deeply affect the more important and geographically concentrated issues on the entitlement to intangible profits, and more precisely to IP profits.

Notwithstanding the importance profit allocation to markets, one could assess that in some industries the main problems in base shifting are related to IP income entitlement. Should the pillar one journey reach its goal, the importance of this topic might even attract more attention and resources.

The BEPS derived 2017 OECD guidelines have put a significant pressure on taxpayers with the DEMPE analysis. While feedback from tax administrations might still be limited, taxpayers should undertake a risk assessment exercise to identify potential areas of exposure and undertake the necessary corrective actions. Both the analysis and the corrective actions can be fed with outcomes based on enterprise risk management, but they might only be relevant if the level of granularity of the analysis is aligned with the critical value drivers of the company, determined through the prism of control over risk, and backed with evidence.