In this rapidly changing world, only one thing is constant which is the change itself.
In today`s era there is a visible difference between the type of technology that was used a decade ago and what we use now.
Moreover, in the context of business world there has been a considerable change in the procedures and methodologies that the businesses used to follow, due to the paradigm shift in technology and digitalization.
In our Transfer Pricing world, the OECD has duly acknowledged the fact that the business environment has evolved due to change in technology and digitalization. The efforts of OECD to walk hand in hand with the ongoing evolution of technology is visible from its work in Action 1 – Digitalisation, Business Models and Value Creation, where it is trying to justify its underlying principle “need to align transfer pricing outcome with value creation”.
Facebook, Amazon, Google are the perfect example of the emerging business models of the digitalized world.
From the table below it can be observed how the world has evolved. From the brick & mortar companies, we can see how technology has taken over and the biggest companies in today`s era are technology driven companies.
|Mid of 20th Century||Starting of 21st Century||As on date|
Armour & Co.
Coca Cola McDonald
Amazon Facebook Salesforce
In this context Tom Goodwin has rightly said: “The world’s largest taxi firm, Uber, owns no cars. The world’s most popular media company, Facebook, creates no content. The world’s most valuable retailer, Alibaba, carries no stock. And the world’s largest accommodation provider, Airbnb, owns no property. Something big is going on..”
Evolution of Intangibles
OECD in its recent Interim Report published in 2018 has discussed that intangibles like platform, networks, servers and algorithms have also acquired an important position as value drivers in today`s digitalized world.
However, the conventional IPs like trademarks, copyrights, patents, domain names, trade secrets, still continue to be important value creators.
By looking at the type of intangibles the companies have been using we can see how they have evolved:
Apart from the above-mentioned intangibles, one more intangible as an important value driver has been identified by OECD, which has never been given considerable importance in traditional business’s but however contributes to the success of digital business significantly. Therefore due importance is required to be given to it. Notably it is ‘user & data’.
Companies working in digitalized space extracts value from users & data in the following ways:-
Further, earlier the drivers of business were the final finished products. For example oil is a necessity product, so the ultimate consumer is indifferent who is selling it, as long as the quality and price marginally remains the same. Whereas in the case of facebook and related companies there is no product, it`s just a platform whose value increases if more and more users are participating. Hence here users have become more important than the product.
It is now very well established that the value drivers leading to the value creation in the digitalized business cycle vary significantly as compared to traditional business cycles i.e. brick and mortar based business cycles.
Compensation Model – New age Intangibles – In form of Royalty
Royalty payment is referred to as:
Payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work, including cinematographic films, patent, design, trade mark, model, plan, secret formula, process, or information concerning industrial, commercial, or scientific experience.
Business models under digitalization rely heavily on intangible assets that involves royalty payout. It is generally seen as the profit repatriation mechanism by MNEs.
Taxing Rights over royalty
|OECD Model Tax Convention||UN Model Tax Convention||US Model Tax Convention|
|Right of tax only lies with state of residence of recipient company||Right to tax only lies with state of residence of recipient company||Primary right of tax lies with state of residence of recipient company|
|Does not provide for source country taxation||Also provides for source country taxation for connected persons wherein recipient entity enjoys special tax regime in its residence state||Also provides for source country to charge withholding tax on recipient such rates depend upon the beneficial ownership threshold|
As per all the three model tax conventions, the recipient country has taxing right over royalties. However the new disruptive digitalized businesses have started a debate over the allocation of profits to jurisdictions for the purpose of taxation.
As per the new concepts in digitalization business profits are contributed by both demand and supply of the goods. Hence, a jurisdiction that contributes towards demand by facilitating the economy and the ability of their resident to pay or by maintenance of markets enabling sales as well as the jurisdiction that contributes to the production or supply of goods, contribute towards the business profits of an enterprise.
This gives rise to a valid justification of taxation by a market jurisdiction of the profits to which their economies have contributed.
Hence, alignment of transfer pricing outcome with the value creation by understanding the digital business models and the value creators becomes of paramount importance.
The Indian judicial and tax authorities have started to realize the need to tax the payments made for the use of the intangibles to the foreign enterprises which can be seen through one of the recent judgement as follows:
The Hon`ble Bangalore tribunal in the case of Google India Private Limited  93 taxmann.com 183 (Bangalore – Trib.) held that “Therefore, the consideration paid by the assessee is on account of usage of all these intangibles in order to provide better services to the GIL or to the advertisers and is certainly in the nature of payment of royalty, chargeable to tax under section 9(1)(vi)…..”
Understanding the value creation process
Currently, taxation rules are developed in a way that they mainly focus on brick and mortar based industries. They fail to fully capture or focus on the digitalized business models.
In traditional methods the creation of value could be easily determined by establishing normal value chain. But in digitalised world the businesses does not run on a sequential or in a mechanical manner where upfront it can be found out that where the value is being created.
Therefore, OECD in its Interim report published in March 2018, in order to cover the digitalized models has tried to provide a structure of business cycles to understand where value could be created in a digitalized world.
Rules of Attribution of Profit to Transactions
The OECD has done considerable work and is now coming up with the identification and methodologies to tax the value created from these new type of intangibles. In its recent public consultation document released in March 2019, for the starters it has focused on users and marketing intangibles –
Let us discuss the said two principles in details:
1. User participation principle:
This proposal considers the active participation of users as a critical component of value creation for certain highly digitalised businesses.
As per this proposal, the users are responsible for
This proposal suggests that this source of value is more significant in digitalized business than traditional business`s, for the following business models:
The value generated by user participation is not captured in user jurisdictions under the existing international tax framework, which focuses on the physical activities of a business itself in determining where profits should be allocated and the extent of the taxing rights of user jurisdictions. This results in businesses being able to generate significant value from a jurisdiction with a significant and engaged user base (user jurisdiction) without the profits they derive from that value being subject to local tax.
Mechanics proposed to capture value created by users:
The proposal suggests allocating an amount of profit to jurisdictions in which the businesses have active and participatory user base.
However, OECD has recognized the following issue in implementing the said mechanics to capture value created by users:
“23. The proposal acknowledges the difficulties in using traditional transfer pricing methods for determining the amount of profit that should be allocated to a user jurisdiction. For example, it dismisses the idea that the value created by user activities can somehow be determined through the application of the arm’s length principle, e.g. through hypothesising the user base as a separate enterprise and asking what return it would receive at arm’s length in its dealings with other group entities.”
2. Marketing Intangible principle:
This proposal addresses a situation where an MNE group can essentially “reach into” a jurisdiction, either remotely or through a limited local presence (such as an LRD), to develop a user/customer base and other marketing intangibles.
OCED has very well explained the said proposal with the help of the following example.
Online retailers with no or only a small physical presence in one country may develop a large user and customer base in that country and know more about these users’ and customers’ shopping preference than a local book shop around the corner. The same is increasingly true for many branded consumer goods companies either because they are directly and digitally engaged with their customers or because they do so via the intermediation of highly digitalised businesses, or both.
The more data on consumers that can be collected, analysed and exploited remotely through the use of digital technology, the easier it is to avoid exercising any of the DEMPE and related risk management functions in the market jurisdiction that under today’s rules govern the allocation of income from marketing intangibles.
Mechanics proposed to capture value created by marketing intangibles:
Therefore, the proposal considers that the market jurisdiction would be entitled to tax some or all of the non-routine income properly associated with such intangibles and their attendant risks, while all other income would be allocated among members of the group based on existing transfer pricing principles.
Traditional methods – still holds good – to value new age intangibles.
Essentially, we are moving forward from traditional intangibles to the new age intangibles.
Now with this change, the question that come up is whether the Traditional Transfer pricing method still hold good.
The traditional methods namely Comparable Uncontrolled Price and resale price were used in a very limited manner; while Transactional Net Margin Method was used extensively. However, these were one-sided methods
These methods did not consider some of the developments that has happened in digital world, that require two sided approach:
All these changes have made these traditional methods somewhat outdated in the new digital economy.
Therefore, OECD is recommending two sided methods; as one sided methods may not be able to reflect the appropriate values.
In both cases, Revised profit allocation method maybe applied which has two step approach i.e.
a. Attribute routine returns to routine activities based on traditional methods
b. Residual profits to be allocated based on appropriate allocation keys
First, in the case of User participation, user base shall be used as the appropriate allocation key whereas:
In the second case of marketing intangibles; sales, AMP expenses may be considered as allocation key.
Challenges in application of PSM
Profit split method is widely promoted to be used in profit allocations. However, the application of this method still faces many challenges such
At this stage, the said proposals are under discussion stage. Hence, we have to wait until OECD issues its final report in 2020.
Written by: Anurag Agrawal & Manasi Raval
 Organization for Economic Cooperation & Development
Written by: Anurag Agrawal & Manasi Raval