Derivative nature of certain delimited controlled transactions

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A meaningful B2B agreement unambiguously assigns rights and obligations to each party. Its arm’s length value is zero initially, a necessity to satisfy the realistic alternative to the status quo. Some agreements require an upfront payment. In addition, many agreements provide for an adjustment of transfer prices at the end of the year.

Distribution agreements often involve a transfer price set at the beginning of the year but recalculated at the end of the year to ensure that the distributor’s operating profit is within a specified range. A transfer pricing adjustment is recognized if necessary. Year-end transfer pricing payments are derived.

Licensing agreements often express royalty payments based on sales. A plain-vanilla license provides payment based on linear sales; a complex license is non-linear due to a floor and/or cap on sales, plus the possibility of multiple non-zero royalty rates. All of these license payments are derived. Conditional contractual terms are also often derivative in nature.

Defining a derivative payment

A payment is derivative if its value depends on the uncertain future value of an underlying. The underlying can be a stochastic cash flow, the random value of an asset or any other random variable.

In the case of a distribution agreement with year-end adjustments, the underlying is usually the value of a random profit level indicator. In the case of a license, the underlying is generally the licensee’s sales.

Precise delimitation

Delineating a controlled transaction with precision means dissecting the different components of the value exchanged and identifying the uncontrolled markets where these exchanges take place.

In uncontrolled markets, trading in derivative values ​​takes place in financial markets. They include options markets, futures and futures markets, and swap markets.

A distribution agreement with year-end adjustments is economically equivalent to a distribution agreement without year-end adjustments alongside a financial derivative controlling the year-end payments. Likewise, any license, whether simple or complex, is economically equivalent to a royalty-free license alongside a financial derivative controlling royalty payments.

Assessment and principle of realistic alternatives

If the relationship between a derivative payment and its underlying is not linear, the discount rate at which to discount the derivative payment is unknown. A derived pricing technique must therefore be used.

All derivative pricing techniques begin by requiring that the price of the instrument be fair. Fair pricing means pricing such that neither party can enter into a self-funding transaction and make a profit with positive probability and zero probability of loss. This trade is called arbitrage and encapsulates the principle of realistic alternatives that the purchase or sale of the instrument must be of zero value to the parties. It is a stronger condition; although not specified in transfer pricing regulations, derived pricing techniques satisfy the principle of realistic alternatives, as all unspecified methods must.

Valuation of a transaction controlled by a derivative

According to the principle of realistic alternatives, taxpayers can structure a controlled transaction that includes a derivative payment as option one, controlled by agreement, or option two, governed by two agreements. The second option bifurcates the leg of the transaction which relates to the exchange of immovable rights in the absence of any derivative provision from the leg which relates to the derivative provision.

What was a year-end transfer pricing adjustment controlled by a distribution agreement under option one becomes a derivative payment made under a financial derivative agreement under option of them. What was a royalty payment controlled by a license agreement under option one becomes a derivative payment made under a derivative financial agreement under option two.

It does not matter whether a trade is structured as option one or option two; the principle of realistic alternatives is a principle of evaluation. The fact that a taxpayer chooses to structure a transaction following the first option does not negate the fact that the second option is a realistic alternative.

The IRS cannot reclassify Option 1 as Option 2 if Option 1 has economic substance. Similarly, the IRS cannot reclassify option two as option one if option two has economic substance, although option one is the option most often adopted by taxpayers. However, the IRS can certainly use option two to price a transaction structured like option one.

Conclusion

The unprecedented scrutiny of transactions transferring risk and return from one subsidiary to another is putting pressure on their precise delineation. Taxpayers who precisely delineate their transactions will often find payment obligations or derivative options. Any controlled transaction subject to a year-end transfer pricing adjustment is likely to fall into this category. Accurate scoping of a transaction is essential in determining the most reliable method of pricing it.

To be clear, we are not suggesting that taxpayers should structure a license as royalty-free alongside a synthetic financial instrument, although that is a realistic alternative.

What we claim, however, is that the fair price of the license can be obtained by reference to the fair price of a synthetic set of European call and put options, each valued by Black and Scholes (1973) . Similarly, the fair price of a corporate restructuring transaction can be obtained by referring to the value of a swap agreement whose fair price is fixed by a series of forward contracts.

The same applies to contingent contractual pricing clauses, including those that allow for any year-end transfer pricing adjustment, early termination, renegotiation or non-exclusivity. The principle of realistic alternatives provides an essential tool for reliably valuing, at arm’s length, a precisely defined controlled transaction under the terms of its written agreement.

This article does not necessarily reflect the views of the Bureau of National Affairs, Inc., publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Philippe Penelle is managing director of the transfer pricing practice at Kroll, an independent provider of global risk management and financial advisory solutions. He draws on more than 25 years of experience in designing, evaluating and defending controlled transactions involving the transfer of intellectual property rights on behalf of multinational clients and their advisers.

Stefanie Perrella is Managing Director, Global Head of Transfer Pricing and Head of Kroll’s New York office. She specializes in financial transaction transfer pricing and has over a decade of experience in establishing best practices for valuing intercompany debt and other financing arrangements for the firm’s major clients. in a wide range of sectors.

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