Brand value: drawing the link between value creation and economic benefit

Amid the evolving transfer pricing landscape driven by ever-changing legislation, multinationals around the world are facing increased scrutiny from tax administrations on their intragroup, cross-border dealings.

Guidance released in 2017 (and updated in 2022) by the OECD in its publication OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines), which first incorporated the BEPS concepts, has driven the focus of global tax authorities on such issues, including how multinationals generate brand value and how financial benefits are attributed across these organisations accordingly.

Multinationals find themselves caught in such disputes as they grapple with the blurred lines between legal ownership and economic ownership of their intangible assets. This increased attention from tax administrations serves as a call to action for multinationals to proactively consider these complexities and clearly delineate the functions, assets, and risks associated with their intangible assets, to appropriately remunerate affiliates within their organisation.

There is not one universally agreed-upon definition of a brand. In fact, the term is often used interchangeably with “trademark” in cases where, for instance, a company develops an identifier for a product or service that is legally registered and becomes so closely associated with a brand identity that it becomes synonymous with the brand itself.

However, this blurred line between trademarks and brands is one of the reasons why multinationals are facing scrutiny from tax authorities. According to the OECD Guidelines, “a trademark is a unique name, symbol, logo or picture that the owner may use to distinguish its products and services from those of other entities” and that provides legal protection and visual representation. By contrast, “a brand is thought of as a trademark […] imbued with social and commercial significance”. It may “represent a combination of intangibles and/or other items, including among others, trademarks, trade names, customer relationships, reputational characteristics, and goodwill”.

With the definitions above, the OECD Guidelines emphasise the components of a brand that are beyond the trademark, which largely represent the true value of a brand. The OECD Guidelines also acknowledge the difficulty in segregating the various items that contribute to brand value. With that said, how would one interpret the value of a brand and ensure the fairness of profit allocation?

The concept of ‘economic ownership’, reflected in the OECD Guidelines as the performance of development, enhancement, maintenance, protection, and exploitation (DEMPE) functions, is not new but is one on which tax administrations have been hanging their hats.

Economic ownership differs from legal ownership in that the latter refers to the formal title or legal rights granted by law, while the former focuses on the practical control and the economic benefits derived from an asset. The OECD Guidelines emphasise the importance of aligning profit and taxation with the economic reality of an arrangement rather than focusing strictly on the legal terms of the transactions. A thorough DEMPE analysis is vital to determine whether affiliates are entitled to receive the economic benefits associated with a brand.

A DEMPE analysis assesses the development, enhancement, maintenance, protection, and exploitation of intangible assets, including brands, and provides a comprehensive assessment of the affiliates responsible for these activities and a determination of their contribution to the value of the intangible assets.

However, when applying the concept of DEMPE, it is crucial to first understand the key value drivers of a brand. This includes identifying the important factors that contribute to the overall value and success of a brand, such as brand reputation, brand awareness, customer loyalty, and perceived product quality and innovation. Identifying these value drivers allows one to set the parameters for the next step, which is to evaluate how much these DEMPE functions contribute to the true value of a brand, and whether there are any activities in other corners of the organisation from which value is derived.

It is essential to look beyond the key common functions involved in creating and supporting a brand, and to dissect the organisation’s value chain to identify the key activities that drive brand value. While legal activities are important to protect a brand through trademark registrations and infringement activities, and whereas marketing and advertising activities are necessary to enhance and maintain a brand, in reality, much of a brand’s value is likely generated through other activities. For example, if a brand’s value is synonymous with exceptional customer experience, the brand’s value may be derived more from a local affiliate that may not have legal ownership of the brand but, rather, employs individuals who are responsible for field activities that deliver exceptional customer service.

It is important to bear in mind that the above considerations may not apply equally across industries, where the key value drivers of a brand may vary. Consumers in certain industries may not place as much importance and preference on the brand to a point that it makes or breaks a brand’s value. For example, a consumer looking for a mortgage service provider is more likely to prefer one that offers a more favourable interest rate, while a consumer in the retail industry may be more likely to be highly driven by brand names. What drives incremental profits may not necessarily always be derived from the brand; it may be a well-known brand, but it may not be a value driver.

These intricacies are exactly what tax administrations have been focusing their attention on in recent years, shining a spotlight on the importance of proactively tailoring DEMPE analyses to each multinational’s unique circumstances, both externally and internally within their organisations, to understand the underlying economic activities that contribute to their brand values.

In the past, tax audits have focused mainly on aspects related to the market value of royalties paid in connection with licences for the use of brands. Now, although these valuation controversies continue to arise, tax administrations have gone a step further by questioning transfer pricing policies from a more holistic perspective, and challenging whether brand royalty charges are appropriate or sufficient.

In situations where the legal owner of a brand has not charged a royalty for the use of the brand by a local affiliate, tax administrations generally tend to argue that the brand has a value and confers to the local affiliate exploiting it a benefit or commercial advantage that it would not have obtained in the absence of the brand. On the contrary, in situations where the legal owner has charged a royalty to the local affiliate, tax administrations have argued that the trademark has no value in and of itself, and that the value of the brand is generated from the activities carried out by the local affiliate.

These arguments, as obvious and intuitive as they may seem a priori, require the consideration of several factors, which have not always been successfully addressed by tax administrations.

In considering the appropriateness of charges to local affiliates for the use of a brand, some tax administrations have relied on public brand valuations issued by consultancies as evidence of the value of a brand, even though the consultancies themselves acknowledge that their reports are not intended for financial or tax purposes. Another indicator of brand value relied upon by tax administrations is the marketing and advertising expenses assumed by the legal owner of the brand, which are usually higher than those assumed by local affiliates.

Amid such uncertainties, some multinationals without a royalty arrangement are generally faced with challenges from tax authorities in the jurisdiction of the trademark’s legal owner. In these circumstances, the tax authorities typically do not consider the value drivers of the organisation, which may not be the trademark itself but, rather, other elements of the brand.

Tax authorities may also argue that the marketing and advertising expenses assumed by local affiliates are connected to routine marketing activities typically performed by full-fledged distributors and take the position that the local affiliates are therefore not entitled to earn non-routine returns related to the brand. On the other hand, tax authorities in the local affiliates’ jurisdiction tend to agree that a royalty arrangement should not be in place as the local affiliates that use the brand perform important functions that contribute to the recognition of the brand in their markets, therefore contributing to the value of the brand.

By the same token, taxpayers that do have royalty arrangements in place find themselves being challenged by tax authorities in the local affiliates’ jurisdictions, which assert that the local affiliates are being overcharged by the legal owner, arguing that the important DEMPE functions performed by the local affiliates result in the creation of value for the brand. Accordingly, they may seek to impose adjustments to increase the income retained in the local jurisdictions as remuneration for the performance of DEMPE functions.

In the face of the above challenges, taxpayers are further confronted with challenges when trying to furnish sufficient evidence to tax authorities of the activities carried out by the relevant entities. For instance, when analysing the contributions to the value of the brand, tax authorities in the jurisdiction of the legal owner of the brand may claim that there is insufficient evidence to sustain that the local affiliates perform DEMPE functions that would imply that they are economic owners.

However, if evidence is provided, tax administrations may minimise the importance of the contributions made by local affiliates using the brand and disregard their degree of autonomy with respect to such activities. Consequently, they could consider the coordination and control exercised by the legal owner and the existence of a broader branding plan to homogenise content and marketing actions as more compelling evidence of control of the relevant DEMPE function.

Analysing the financial benefit that the local affiliates (that is, licensees) are receiving for the use of the brand is a very relevant aspect. Contrary to other provisions, the OECD Guidelines are very clear in stating that the financial benefit received by licensees when using a brand should be quantified. In this respect, some tax administrations assume that, as the brand has a value, it provides an advantage to its local affiliates, without carrying out a quantitative analysis to substantiate this position.

However, although it is true that some courts have accepted this reasoning, others have ruled that the tax administrations have failed to prove the economic value connected to the use of the brands, or that the correct view is to balance the benefits obtained by the licensor (due to the efforts made by the licensee) and by the licensee (use of a brand).

The previous adjustments, where a tax authority asserts a royalty charge is justified, are typically made in cases where the local affiliate using the brand has a full risk profile and can therefore capture the residual profit associated with its exploitation. However, if the local affiliate using the brand is a limited risk distributor, some tax administrations systematically deny the deductibility of trademark royalty charges. In essence, they argue that given the limited risk nature of the local affiliate, for which it is entitled to a stable but capped remuneration, it cannot exploit the brand.

While such a position may make sense from a transfer pricing perspective in certain situations (for example, if the royalty prevents distributors from achieving market profitability, as recognised by the OECD Guidelines), aspects such as the tax neutrality of the royalty charges due to the transfer pricing policy (usually a guaranteed margin on sales), the need to monetise the investment made by the brand’s economic owner, or the fact that the limited risk distributor is remunerated according to the arm’s-length principle (after royalty charges) should also be taken into consideration.

Lastly, another key aspect not always addressed by tax administrations is the provisions set forth in the brand licence agreement and the actual conduct of the parties, which should be assessed to understand the degree of autonomy and the limitations imposed on the licensee in exploiting the brand.

The post-BEPS transfer pricing environment, the high degree of subjectivity associated with the valuation of brands from a transfer pricing perspective, and the room left for interpretation in the OECD Guidelines have led to a significant increase in transfer pricing controversy in relation to intangible assets.

Performing in-depth DEMPE analyses and assessing whether intercompany arrangements and transfer pricing policies are aligned with the DEMPE analyses is an imperative first line of defence to avoid the potential push and pull between opposing tax authorities. This is especially relevant for arrangements in force, given the many years that the changes in national and international provisions have been in effect.

Although prior arrangements may have been accepted by tax authorities in tax audits or in (expired) advance pricing agreements (APAs), this will not prevent tax authorities from proposing adjustments in later years, as the new guidance on intangibles incorporated since the 2017 OECD Guidelines provides tax authorities with tools that were not available before.

To mitigate this risk, it is advisable to strengthen existing transfer pricing documentation by clearly defining and delineating the key DEMPE functions within a multinational group, in relation to all intangible assets. This also involves gathering contemporaneous evidence in respect of the contributions made by affiliates within the group.

Additionally, taxpayers should have a clear defence strategy during tax audits by being more proactive and considering the use of different avenues available to increase tax certainty, such as bilateral or unilateral APAs, or dispute resolution options, including mutual agreement procedures.

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