Startups and entrepreneurship have recently become increasingly important concepts globally. Simply put, startups are entrepreneurial companies typically established to offer solutions to current problems and have rapid growth potential. In many countries, the importance of technology-oriented startup business models is gradually increasing.
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Startups exist in all sectors, with a large number in technological areas such as payment solutions, ed-tech, big data, data analytics, e-commerce, etc. Typical characteristics of startups include:
- Significant emphasis on intellectual property with operations spanning multiple jurisdictions,
- Significant losses in the early years,
- Exponential revenue growth in subsequent years
- Dependence on external financing.
These characteristics can create transfer pricing implications in all jurisdictions. Therefore, it becomes imperative for businesses to ensure they design their operational model and plan transfer pricing policies at an early stage to optimize shareholder value.
Failure to define correct transfer pricing policies could lead to a reduction in shareholder value.
The OECD does not explicitly discuss the exemption of transfer pricing for startup companies; however, it emphasizes that comparability factors, particularly strategies and functions, are influenced by the initial operating conditions, making the identification of comparables extremely complex. Therefore, restructuring initiatives, especially when the company starts generating profits, could lead to disputes with tax authorities, resulting in multiple taxation on the same income (double taxation) and potential penalties. The resulting litigation is usually burdensome and costly.
Furthermore, a startup may also face exit charge/exit tax issues, which could result in significant tax costs. Organizations must develop an appropriate operational model to ensure that the revenues and profits/losses from their operations are fairly allocated to various entities within the group.
According to the OECD Transfer Pricing Guidelines (“OECD”), intangible assets are defined as commercially valuable assets that can be transferred between independent parties and have a comparable price, although they are not physical or financial assets. According to the OECD Guidelines, for an asset to be considered an intangible right, it does not need to be registered or included in the companies’ financial statements. The intangible rights explained in the OECD TP Guidelines are as follows:
- Patents,
- Know-how and trade secrets,
- Trade names and trademarks,
- Concessions and contractual licenses,
- Goodwill and going concern value.
According to the OECD TP Guidelines, the legal ownership of intangible rights by companies alone will not be sufficient to receive a share of the profit related to the intangible activity. Therefore, the functions performed by the related parties, the risks assumed, and the activities employed are crucial in determining the arm’s length value to be applied in the transfer of intangible rights and related benefits among related parties. Five key concepts (DEMPE functions) regarding intangible rights are established in transfer pricing literature:
- Development,
- Enhancement,
- Maintenance,
- Protection,
- Exploitation.
Determining the arm’s length value for intangible assets can be complex and subject to increasing scrutiny in transactions involving the use or transfer of intellectual property (“IP”) among related parties. Tax authorities may consider the DEMPE concept as fully determinative, not only for attributing income to intellectual property but also for assessing the economic and ownership aspects of the IP itself.
A common feature of startups is that they seek to establish their brand for rapid growth, particularly utilizing technological infrastructure. As the country where intangible rights such as a brand, patent, or know-how are developed and the ownership of such rights are essential, it is necessary to analyze both the location where DEMPE functions are performed and the country holding the intangible rights. It is crucial that the allocation of rewards reflects the economic and commercial substance of what is actually happening. Since there is often a significant element of judgment in determining these allocations, startups should be aware that intercompany transactions related to intangible assets may be challenged.
Unfortunately, there is no exemption from transfer pricing laws. As cross-border activities are subject to scrutiny by tax authorities, startups can inadvertently expose themselves to costly consequences.
In conclusion, while startups focus on growing their business, they should not neglect the tax and transfer pricing aspects of their operations. Business and tax planning must go hand in hand to ensure maximum value from their operations.
