Sharing intellectual property with affiliates in China: status of Chinese cost-sharing rules and other observations.

• Author: Chandler, Clark J.

Cost-sharing arrangements represent a good approach to the inherent tension of the low marginal cost of sharing innovation and the need for arm s-length transfer pricing. Cost-sharing arrangements may reduce withholding taxes and business taxes. As multinational corporations (MNCs) move more high-value activities to China, many MNCs may consider implementing cost-sharing arrangements in China. Unfortunately, China has yet to draft formal guidance on cost sharing, and Chinese tax authorities have evinced reluctance to accept cost-sharing proposals from MNCs before the planned release of cost-sharing rules in the not too distant future.

This article provides background on cost-sharing arrangements with regard to the Organisation for Economic Co-operation and Development (OECD) guidelines (the Guidelines) and China, touches on key issues China's tax authorities should consider when implementing cost-sharing rules, and describes possible options MNCs operating in China may follow when sharing technology, until China's tax authorities establish cost-sharing rules.

The Challenge

MNCs with operations in different parts of the world typically own various types of intellectual property (IP) that are used by their affiliates in different tax jurisdictions. In some cases, the IP may represent the "crown jewels" of the company--valuable pharmaceutical patents, proprietary semiconductor chip technology, or brands for a consumer products company. The value of IP can vary by market; for example, a brand that is well known in some countries may not gain the same acceptance in another. Difficulties in IP protection and piracy can make IP less valuable in certain markets. IP also can be less valuable simply because the IP that is being shared may be more mundane--for example, internal software that produces incremental improvement in rolling mill operations or proprietary knowledge that leads to modest reductions in the energy consumption of a chemical process.

Typically, MNCs are very interested in making sure that IP developed by one member of the corporate group be shared with other members of the corporate group that can benefit from the use of that innovation. If, for example, the U.S. affiliate of a chemical manufacturer develops an enhanced set of controls that reduce energy consumption by 10 percent, a rational corporate policy would encourage its China affiliate to adopt that innovation and realize similar savings. This is particularly true given that, once developed, the cost of sharing the innovation may be very minor.

The transfer pricing regulations in effect in most countries require an arm's-length payment for any transfer of IP. In the simple example given above, the U.S. Internal Revenue Service (IRS) would expect the China affiliate to pay an arm's-length price for access to the energy saving innovation developed by the U.S. affiliate. China's tax authorities, however, may take a very different position as their current tendency is to limit their view of IP to those items legally protected by trademarks and patents.

This is a much more limited definition than is used in the United States, for example, and may suggest systematically lower IP values. As China works through its views on IP, the expectation is that its view on IP will become similar to that of the rest of the world. Before that occurs, allowing several affiliates to share in the use of IP that is owned by one affiliate presents serious challenges since there is a fundamental disconnect between the optimal price to generate the efficient use of IP and the arm's-length price required under transfer pricing rules. The optimal price from a business standpoint is the marginal cost incurred in transferring the IP to the China affiliate. This incremental cost is often very low and may even be close to zero. (For example, once developed, the cost of copying software to a new disc is trivial. The same principle applies to a wide variety of IP transfers.) Transfer pricing rules, however, require that prices be set at arm's-length levels.

Such a payment may make the transfer of IP very costly. If the payment is based on the total cost of developing the innovation, it may exceed the benefits realized by the China affiliate, for example, if the China affiliate is much smaller than the affiliate that developed the transferred IP. If the payment is set to equal the benefits realized by the China affiliate, then there is little incentive for the affiliate to adopt the new process. Even if the business decision-making is completely separate from the transfer pricing used for tax compliance, it may be difficult and costly to develop an accurate measure of the arm's-length price of the innovation.

The effect of this underlying economic issue is aggravated by the difficulty of determining the magnitude of payments for intangibles, often one of the most difficult problems confronting MNCs. The very nature of the IP often makes it unique and "one of kind." Under such circumstances, there are no reliable market benchmarks that can be used to set prices.

This problem is compounded by the economic attributes of IP, for while it may be very expensive to develop initially, the success or lack of success of the IP may not be known until after the investment needed to develop the IP has been completed. Moreover, the incremental cost of having two affiliates use the IP rather than just one may be essentially zero. In short, the close relationship between cost and price that underlie the most widely used transfer pricing methods (resale price method, cost plus method, transactional net margin methods) often does not exist in the case of intangible transactions.

Finally, especially in the case of high-value IP that supports high residual profits, tax authorities and taxpayers may have very different views about what is the most appropriate price, and tax authorities may suggest very high transfer pricing adjustments upon audit. (1)

The transfer of IP from one affiliate to another gives rise to other tax issues as well. In particular, royalty payments are subject to withholding taxes under many tax treaties. Such withholding taxes add yet another layer of cost, and therefore present another barrier to the sharing of IP across affiliates operating in different tax jurisdictions. This is particularly true when different tax jurisdictions have a different view of IP attributes. Major differences between the United States and China include the following:

* China's definition of IP is limited to legally protected IP whereas the U.S. view is broader;

* China's tax authorities are likely to take a more narrow view of the value of global trademarks; and

* China's tax authorities tend to focus on local...