Intragroup IP transfer was undervalued for tax purposes, Norway appeals court rules

By Pilar Barriguete & Edland Graci, Duff & Phelps, Spain

On 19 March, Norway’s Borgarting Court of Appeal validated the Norwegian tax office’s adjustment of the income of Dynamic Rock Support AS (now Normet Norway AS) from a merger and acquisition transaction, agreeing with the tax office that the company’s use of the “relief from royalty” method to value intangibles was inappropriate.

Dynamic Rock Support AS was engaged in the sale of a self-developed rock securing bolt for use in deep-lying mines and had patents and trademark rights related to the bolt. The company also owned two foreign subsidiaries: Dynamic Rock Support Australia and Dynamic Rock Support Canada. Dynamic Rock Support ran sales and distribution activities of self-developed rock and the Australian and Canadian subsidiaries carried out sales activities related to the bolt.

On 30 January 2013, Dynamic Rock Support was acquired by the Swiss company Normet International Ltd for NOK 78,290,186 (approx. EUR 10.5 million). Two days after the deal, Dynamic Rock Support transferred intellectual property rights to Normet valuated for NOK 3,666,140 (approx. EUR 494 thousand) and, later that year, on October 2013, transferred the shares of its two subsidiaries to Normet for a purchase price of NOK 82,053,000 (approx. EUR 10,125 million).

Hence, it is clear that the transfer in both cases included patents and trademarks. The reason for the transfer was that the Normet Group wanted to collect all IPs in the Swiss company (efficient management of the IPs).

To estimate the value of the intangibles transferred, the “relief from royalty” method was used by the group as a well-recognized valuation method that determines the present value of the future cash flows that can be generated through licensing exploitation of intangibles to third parties.

Norwegian tax office position

The Norwegian tax office contested this valuation. In the tax office´s point of view, the remuneration of the intragroup transfers of intellectual property rights and shares was incorrectly distributed. While the intellectual property rights transfer was priced too low, the subsidiaries transfer was priced too high, the tax office said.

In Norway, gains from the sale of intellectual property rights are considered taxable income; however, gains on the sale of shares are not taxable. As such, the incorrect distribution resulted in a reduction of the taxable income attributed to the sale of the IP, the tax office argued.

The tax office noted that since the transactions were carried out between related parties, the taxation of the income of each party had to fulfill the arm’s length principle, as detailed on the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017.

Seeing the transfer of intangibles and shares as a single transaction, the tax office’s view was that the distribution of the revenues between the sale of shares and intangibles was incorrect.

On the one hand, the subsidiaries were considered limited risk distributors with limited assets and strained finances and only two employees each (and sales activity that had been initiated without specific sales agreements). Therefore, from the tax office’s perspective, the value of NOK 80 million was too high.

On the other hand, after the transfer of intangibles, no intangibles were left in Dynamic Rock Support (the transfer pricing documentation gives no indication), nor was there any evidence that goodwill remained in Dynamic Rock Support after the transfer. Furthermore, the tax officers believed that all the economic significance of the technology was transferred as well.

Therefore, the “relief from royalty” method used by Dynamic Rock Support to value the intangibles transferred was not capable of capturing the entire value of the intangible assets transferred from Dynamic Rock Support to Normet, the tax office said.

Comparable uncontrolled price method

The valuation approach proposed and applied by the Norwegian tax officers was the comparable uncontrolled price (CUP) method and to follow the OECD transfer pricing guidelines for the split of the remuneration received from the value of Dynamic Rock Support’s intangibles as well as that of its subsidiaries’ shares.

Following paragraph 6.147 of the OECD transfer pricing guidelines, in cases when intangibles acquired by an MNE group from independent enterprises are transferred to a member of the MNE group in a controlled transaction immediately following an acquisition, the price paid for the acquired intangibles will often (after any appropriate adjustments) represent a useful comparable for determining the arm’s length price for the controlled transaction under a CUP method.

The tax office proceeded to identify the value of intangibles. First, the value of Dynamic Rock Support’s shares was distinguished and then the value of the subsidiaries, as well as other assets in Dynamic Rock Support, was subtracted. The “residual” value left was regarded as the market value of intangibles at the time of transfer.

The following table shows the steps followed and exhibits the intangible value considered by the Norwegian tax office.

Transaction	Value (in million NOK)
Acquisition of Dynamic Rock Support	78.3
Dynamic Rock Support book value	16.2
Difference, i.e. intangibles and subsidiaries value	62.1
Subsidiaries market value	3.9
IPs value	58.2

The Norwegian tax authorities concluded that the value of IP was approximately NOK 58 million.

Although the group defended that there were no CUPs and claimed having used a relief from royalty method, the tax authorities affirmed that this method was not capable of capturing the entire value of the intangible assets transferred from Dynamic Rock Support to Normet.

Therefore, the Norwegian tax authorities concluded, on 22 December 2015, that the valuation did not correspond to the arm´s length price.

Court of Appeal decision

The court agreed with the tax office’s judgment as having been based on the correct facts when using the CUP method to analyze the transfer of shares and intangibles jointly.

As the OECD transfer pricing guidelines recognize, there are situations where separate transactions are closely linked and cannot be adequately evaluated on a separate basis.

Regarding the “relief from royalty” method used by Dynamic Rock Support, the Court of Appeal considered this method not to be suitable in identifying the market price, since it does not evaluate the entire transfer of commercial value that Dynamic Rock Support technology contributes to its patents.

And, albeit the method would have been accepted as suitable in other situations, the value of the intangible assets transferred was considered to be set beyond an acceptable range due to the assumptions used in its application.

In this sense, the royalty rate of 2% appeared in the lower part of the acceptable interval, the assumed lifetime of 5 years was too short, the use of a 15% discount rate after tax appeared to be too high, and the fee of approx. NOK 3.7 million corresponded to less than 6% of the “residual” value of Dynamic Rock Support, i.e., value beyond book values.

The Court of Appeal’s majority thus rejected the appeal to drop out the tax office’s adjustments.

Conclusion

While it is true that both the OECD transfer pricing guidelines and most the local transfer pricing rules allow the application of other valuation methods and techniques for the determination of arm’s length value, it should not be forgotten that the application thereof must be in line with the OECD transfer pricing guidelines.

The Court of Appeal’s Decision regarding the valuation of intangible property transferred within a group emphasizes the importance of manifesting cohesion between general valuation and transfer pricing principles, as well as showcasing the consequences that can result by the misinterpretation and misunderstanding of these.