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REPORT FROM THEFISCALIS SEMINAR 2006

TRANSFER PRICING AND INTANGIBLE PROPERTYPRAGUE (THE CZECH REPUBLIC)

29 31 MAY 2006

I.

Monday 29 May 2006

Opening and welcome

Mr. Radim Blha, director of Direct Taxes Administration Department, opened the seminar and welcomed allparticipants to Prague on behalf of Ministry of Finance of the Czech Republic. Then Mr. Blha forwarded the speech tothe Director General of Central Tax Directorate, Mr. Jan Knek, who also welcomed all delegates from European taxadministrations, representatives of private sector and delegates of the European Commission and pointed out theimportance of the Fiscalis seminar, which contributed to gaining better knowledge of transfer pricing and intangibleproperty issues and which allowed participants to exchange their valuable experiences.

Mr. Jean-Marc Van Leeuw and Mr. Edward Morris from the European Commission then welcomed all delegates on

behalf of the Commission and expressed the hope of the usefulness of the seminar performed on such current issue.They briefly described the current situation in the field of intangible property and mentioned the advantage of havingalso representatives of business participating, which should help to better understanding between tax administrationsand private sector.

Presentation Recent developments

Mr. Michal Rohek, representing the Ministry of Finance of the Czech Republic, demonstrated the structure of theCzech Tax Administration in relation to transfer pricing issues. He introduced to participants the main provisions relatedto transfer pricing and practice applied in accordance with these provisions. He also presented the APA system in theCzech Republic, which was newly established in 2006.

Since the year 1993 the Czech Republic has implemented into its tax law (Income Tax Act no. 586/1992 Coll. andAdministration of Taxes Act No. 337/1992 Coll.) necessary provisions arising from OECD Model Tax Convention onincome and capital, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations and

common practice applied within the EU (based on EU JTPF meetings conclusions). However the Czech taxadministration become properly involved in transfer pricing issues only 6 years ago. So far tax administration has dealtwith approximately 50 transfer pricing cases.

The main provision, Article 23, p. 7 of ITA, states, that if prices agreed between related persons differs from prices thatwould be agreed between independent persons under the same or similar circumstances and if this difference is notsufficiently proved the tax authority should particularly adjust taxable profit. Parties can be related trough:

a) capital

, . %if one person directly or indirectly shares in capital or voting rights of other person limit min 25

b) other relationships

one person participates in management or control of other person

the same persons or close persons participate in management or control of other persons

controlling and controlled companies

related natural persons

a relationship created for purpose to reduce taxable profit or to increase loss

The Czech Tax Administration has issued three main guidelines related to transfer pricing, which describes so calledbest practice - not legally binding but commonly used by both taxpayers and tax administration.

- ( ) D 258 January 2004 How to apply OECD Guidelines within the Czech Republic

- ( ) ,D 292 January 2006 Binding opinion for pricing of transactions between related parties based on the APAprincipals

- ( ) D 293 January 2006 Documentation based on Code of Conduct issued by EU JTPF

Presentation Defining of the types of IP Rights copyright, trademarks,patents, brands

Mr Mark Engelman, experienced lawyer engaged in intangible property cases, gave insightful definitions on IPR and

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divided IPR into several categories: patents, mini patents, copyrights, compilations (computer programs, etc.). Heintroduced system of registration of IP in UK and procedure of application for a patent. Subsequently Mr Engelmanpresented the fundamental issues concerning transfer of IPR and the legal implications of offshore transfers oftrademark rights. One theme became clear: that it was not always legally possible to separate IPR from the underlyingphysical assets that had helped to create the IPR in the first place.

Presentation OECD works and Intangible Property considerations

Mr Paul Mulvihill, who joined the OECD in 2005 as Adviser - Tax Dispute Resolution in the Tax Treaty, Transfer PricingDivision of the CTPA, explained the definition of Intangible Property. For defining the IP he used several sources (WIPO

web site, www.investorwords.com, etc). The basic definition of IPR was that IPR are the rights of creative workers inliterature, artistic, industrial and scientific fields, which can be protected either by copyright or trademarks and patents.Later on Mr Paul Mulvihill mentioned par. 3, Art 12 of OECD Model Tax Convention: This par. provides that in the Stateof source royalties are taxable as part of the profits of the permanent establishment there owned by the beneficiarywhich is a resident of the other state and the par. 17.4 of above mentioned Tax Convention: In the case of IPR, therules concerning the relations between enterprises of the same group (e.g. payment of royalties or cost sharingarrangements) cannot be applied in respect of the relations between parts of the same enterprise. He also explaineddivision of intangibles on trade and marketing intangibles. He showed several examples of arrangements which couldbe assessed as transfer of IPR - (outright sale of the IPR, licensing arrangement (royalty); royalty would be based onoutput, sales, profit, rate may vary according to the turnover; the transfer price may be a package price for the goodsand IPR, important is then to watch for double payment; IPR bundled in a package contract patents, trademarks, tradesecrets, know how). Mr Mulvihill then noticed the important aspect of choosing the applicable transfer pricingmethodology. Finally he concentrated on uncertain valuation at outset and on relationship between IP and marketingactivities when a company is not an owner of a trademark.

There was an interesting debate between the speakers and some of the audience about the possibility of revisiting theprice of a contract in the light of later events. Most commentators were firmly of the opinion that this happened only veryrarely between independents the price is the price when the deal is struck. Only in very peculiar circumstances wouldthe price be changed later and then only perhaps in the light of adjusting an on-going business relationship.

The Chair, Mr. E. Morris from the Commission, summed up the day. It had been most useful to hear the view of MrEngelman about what IPR actually was and what could be done with it from a purely commercial point of view. This, ofcourse, was very different from what tax advisors wanted to do to shift profits between tax jurisdictions. Morris alsocautioned against moving to a US style commensurate with income standard where this would allow taxadministrations to have two bites of the cherry, effectively re-writing history using hindsight where they did not like theoutcome. Doing this might create a hostile investment environment.

Tuesday 30th May: Taxpayers perspectives tax planning opportunities

How IPR is exploited at arms length; Options open to a MNE concerningIPR: how IPR can be organised, created and financed

Monique van Herksen who heads the European Transfer Pricing Team of Baker & Mackenzie aimed her presentation onproblems how IPR is exploited at arms length. In the beginning she divided IPR into routine and non-routine intangibles;routine intangibles represents the common skills such as basic know-how to perform a specific job whereas non-routineintangibles are special values that can be evaluated these can be further divided into protected and non-protected IP.She specified some valuation issues and appropriate transfer pricing methods (CUT/TNMM/Profit Split). ConsequentlyMrs Herksen outlined how to structure IP and talked about planning the acquisition, about migration of IP and also aboutIP rights protection.

Tax planning opportunities at different stages: creation, purchase, sale,anddestruction

Victoria Horrocks from PWC presented the possible tax planning opportunities at various stages of business operatingmodels and demonstrated them trough a case study.

Tax advantages & the commercial imperative

At the beginning another case-study was introduced by Mrs Horrocks. Participants were divided into four groups. Theywere asked to find possible solutions to three cases concerning transfer of IP.

1) Moving a business

2) Moving a licensed business

3) Business with R&D activities

Consequently, the common solutions were consulted in plenary. Mrs Horrock then presented conclusions arising fromthe best practice and highlighted the challenges of a tax audits.

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Wednesday 31: Tax Administrations' defences against pricingmanipulation of IPR.

Valuation of IPR: how different circumstances can affect value

Antonio Russo, member of Baker & McKenzie Amsterdams Transfer Pricing Team, focused his presentation mainly onvaluation of intangibles. In the beginning he pointed out that intangibles can be identified for financial statementpurposes according to local generally accepted accounting principles (GAAP), International Financial ReportingStandards (IFRS) and Financial Accounting Standards Board (FASB). IFRS 3 and International Accounting Standard(IAS) 38 determines Intangible Assets as identifiable non-monetary assets without physical substance which areseparable and transferable or which arise from contractual or other legal rights, which are controlled by the enterprise,which are likely to bring future economic benefits and whose costs can be measured reliably. Fair Value is defined asthe amount for which an asset could be exchanged or a liability settled between knowledgeable, willing parties in anarms length transaction.

Firstly, Mr. Russo distinguished intangible property from goodwill. Under SFAS 141 Guidelines intangibles are dividedas Marketing related (trademarks, trade names etc.), Customer related (customer list, backlog, contracts and customerrelationships etc.), Artistic related (plays, books, music works, video, audiovisual etc.), Contract based(Licensing/Royalty agreements, use rights, operating rights etc.) and Technology based (patents, computer software,databases, trade secrets, recipes etc.). There are other values, which from the accounting point of view cant beevaluated and brought into accounts of a company separately. The total amount of such acquired assets is recognizedas goodwill and represents the remaining or residual value (if any) after identifying and valuing all intangible assets.SFAS 141 defines goodwill as the excess of the cost of an acquired entity over the net of the amounts assigned toassets acquired and liabilities assumed. Goodwill may be even negative.

Common reasons to value intangibles are allocation of and overall business purchase price for financial accounting orincome tax purposes, establishment of intercompany transfer price, pre-acquisition assessment of business value,reorganization and bankruptcy analysis, business formations or litigation support and dispute resolution. Mr. Russoacquainted participants with three primary valuation approaches. The income approach is the most common approach,which relies upon an estimate of income for the IP and assumes that the income derived from an asset will drive itsvalue. There are many methods for making income projections like extrapolation, tabula rasa, life cycle analyses,sensitivity/scenario analyses etc., which are mainly dependent on estimation of discount rates and capitalization ratesfor IP and estimation of its remaining useful life. The market approach is based on the current market-value data and israrely used because of lack of public information that regards comparable intangible assets. The cost approachestimates value based on the cost to recreate the asset in its current condition and functionality but thus doesnt capturethe economic contribution to the enterprise. Therefore it is used only exceptionally.

By the end of his presentation Mr. Russo demonstrated two examples - first the valuation of trade name based on Relieffrom Royalty Method and finally customer relationship valuation using Excess Earnings Method.

Embedded vs Fragmented Intangible Property A Case Study applyingInternational TP in the Ethical Pharmaceutical Industry

Mr. Wndisch, specialist from the core of pharmaceutical industry, introduced the particular transfer pricing challengesand the special risks of the pharmaceutical and biotech industry as a sector with intangible assets of a great value. Heresumed why CUP or COST+ methods are practically not applicable to Pharma/Biotech industry (COST+ can be used incontractual manufacturing) and that RPM is likely to be the only applicable method to negotiate transfer prices forPharma/Biotech products.

In the second half of his presentation, Mr. Wndisch presented a case study concerning the typical Pharma/Biotechindustry MNEs business model. He explained to representatives of European tax administrations the basics of thebusiness model of pharmaceutical companies using contract manufacturing with consignment stocks. He drew theirattention to the problem of a time gap between the moment when tax for IP is due and the moment of real profit realisingif the owner of IP has to sell active ingredient to the manufacturer within intragroup transactions. He proposed a

conclusion, which would bring transparent and defendable TP system with no sale of active ingredients, using COST+method for manufacturing and RPM for finished products including intangibles. For Pharma/Biotech enterprises theprotection of intellectual property rights is their lifeline. Private financing of high risk R&D can only then be expected.

An audit into intangibles: a UK Case Study

Mr. Jon Clarck from HM Revenue & Customs presented a case study concerning a typical MNE with a very valuable IP.The value chain for such businesses usually consist of:

1. Research

Continuing development

Maintenance of IP

2. First tier manufacture

3. Second tier manufacture4. Marketing & distribution

Such structure could give tax-planning opportunities, when second tier manufacturer would be established in law taxregime and intangibles would be transferred to such country. In such case, it is important for tax administration toidentify the real characteristic of that transaction, consider, whether it is commercially driven and consequently set the

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appropriate TP methodology reflecting the real allocation of assets, risks and functions. Mr Clarck mentioned that veryoften a suitable CUP cant be identified, particularly where rare intangibles are involved. If there is a question ofattributing profit to valuable intangibles, profit split method is usually suitable.

Practical experience in Member States

At the end of the Seminar representatives of Belgian, French and German tax administrations introduced the practicalexperience with transfer pricing issues concerning intangible property. They pointed out the main obstacles they havecome across and delineated the possible solutions.

Final summaries and future developments

During the final resume of the Seminar Mr. Edward Morris emphasized the most crucial moments of the last tree dayspresentations. He highlighted the need of European tax administrations to be aware of transfer pricing issues regardingintellectual property. Some developments were more welcome than others but transfer pricing of IPR would be ofincreasing importance. At the end the Commission stated that the feed-back sheets already submitted showed that theFiscalis seminar could be considered as a great success and also very useful for the future work of all participants. Inthe main this success could be attributed to the presence of the private sector speakers who had given their time freelyin a splendid manner of co-operation. Public sector speakers who had made very welcome contributions were alsothanked. A common theme had become clear early on: tax administrations were worried by IPR manipulation andwanted to develop new ways of combating it. The Chair was confident that the seminar had provided better ways oflooking at the problem. Participants were asked to spread the new gained knowledge among their colleagues inmember states.