Bifurcation of local vs offshore intangibles: a legal perspective on commercial rationale

Although you could say that the international world doesn’t need yet more unilateral tax measures or country-specific TP compliance rules, I would give the ATO the benefit of the doubt. I applaud the ATO’s attempts to articulate clearly the standards of governance and documentation which MNEs are expected to achieve.

The ATO’s recently updated draft guidance on TP aspects of intangibles (PCG 2023/D2) is a great example of this.

Example 2 in the PCG describes a relatively common structure: the splitting of local intangibles from offshore intangibles.

In essence, the arrangements are as follows:

• AusCo owns patents, know-how, trade marks and other intangibles as part of a multinational manufacturing group
• AusCo carries on DEMPE functions and assumes / controls risk
• AusCo sells the offshore rights in the intangibles to NewCo
• As part of that sale, the benefit of IP licences granted by AusCo is novated, so that henceforth NewCo receives the royalties
• Some AusCo staff relocate to NewCo, but AusCo continues to perform most DEMPE functions regarding the offshore intangibles
• AusCo charges NewCo an ongoing cost plus fee for R&D services.

One of the issues raised in the PCG is commercial rationale. The stated rationale for the change is “a desire to facilitate expansion into emerging markets and establish a global centre of expertise for new product development.”

In the ATO’s view this explanation is insufficient to evidence the commercial rationale for transferring the offshore intangibles to NewCo.

I’d like to add a legal perspective on this. Which is that within the legal / commercial dimension, there are two levels for any commercial rationale:

1. The group rationale – i.e. why it makes sense to do this from a group-wide perspective.

2. The legal entity rationale – i.e. why it makes sense for each individual entity to do this, from a narrow corporate benefit perspective.

Some TP commentators describe rationale 2 as a ‘legal fiction’, but actually it’s not. It’s legal reality. Systems of company law generally allow directors of individual entities to take into account rationale 1, but only if rationale 2 is first satisfied – taking into account the interests / requirements of creditors, employees, regulators, shareholders etc.

And of course, rationale 2 needs to be satisfied for every participating entity. Not just the TP ‘tested party’.

This is the ‘golden rule’, the legal filter through which any TP policies or global value chain reorganisation need to be viewed.

Applying this to Example 2 above, clearly the commercial rationale will take into account wider circumstances than those set out in the PCG. This may include how NewCo is capitalised, and what AusCo will do with the proceeds of selling the intangibles.