Businesses increasingly recognize the value of blockchain technology. Software applications based on blockchain are being offered to serve industries spanning from supply chain management, logistics, and manufacturing to insurance, financial services, and health care. As blockchain technology companies grow and expand globally, their intercompany (i.e., related-party) group dealings will increase and they will need to carefully consider transfer-pricing issues.
Blockchain, an open-source technology, was introduced by Satoshi Nakamoto in the 2008 bitcoin white paper.1 A blockchain is a distributed ledger system that allows for the creation of an unalterable record of information from transactions, which provides greater transparency, traceability, and security in executing transactions. A blockchain is managed by a peer-to-peer network of computers that simultaneously verify and record transactions and maintain a copy of the distributed ledger. Since its introduction as bitcoin's underlying platform, blockchain has proved to have applications for the maintenance of digital records well beyond the cryptocurrency space for the broader financial services industry, for technology companies, and for companies seeking to increase competitiveness through implementing more efficient supply chains.
Given the widespread applicability of blockchain technologies for improving business operations and supply chain management, there has been a growth in blockchain development companies, and the number of patents related to new blockchain technologies has risen dramatically since 2016. Software applications may include blockchain developer tools, enterprise solutions, custom blockchain development services, token development, and blockchain ecosystems, to name a few. The demand for blockchain platform solutions is anticipated to increase as the applicability of the blockchain platform for businesses becomes more widely known and accepted.
The valuation, for income tax purposes, of cross-border transactions between associated enterprises is based on the "arm's-length principle" under both the Sec. 482 regulations (commonly referred to as the transfer-pricing rules) and the Organisation for Economic Co-operation and Development's 2017 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines).2 A controlled (i.e., related-party) transaction meets the arm's-length principle if the transaction's results are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.3 (The arm's-length principle has been the subject of much discussion in recent years, and the OECD is leading a global tax reform effort hoping to transform the applicable international taxation framework.)
Key to the application of the arm's-length principle in determining the valuation of transfers of physical and intangible goods and the provision of services between related parties is the determination of the transfer prices of the transactions. Transfer prices are significant because they determine the taxable income of related parties in different tax jurisdictions.
To determine transfer prices for a transaction, a transfer-pricing method appropriate to the transaction is used. To decide which method is appropriate, a functional analysis should be performed that includes studies of the functions performed, assets used, and risks borne by each party in the related-party transaction.
Transfer-pricing methods fall into two broad categories:traditional transaction methods and transactional-profit methods. Traditional transaction methods seek to determine an arm's-length price by evaluating terms and conditions of specific uncontrolled transactions that are determined to be comparable to the controlled one under review. They include the comparable uncontrolled transaction (CUT) method4 from the Sec. 482 regulations, the comparable uncontrolled price (CUP) method5 from the OECD Guidelines, the cost-plus method, and the resale-price method.
Transactional-profit methods seek to determine an arm's-length price by evaluating the net operating profits that uncontrolled parties have obtained from entering into comparable transactions. These include the comparable-profits method (CPM)6 from the Sec. 482 regulations, the transactional net margin method (TNMM)7 from the OECD Guidelines, and the profit-split method.
The United States and more than 135 countries have transfer-pricing compliance regulations and requirements, which must be addressed by multinational entities (MNEs) engaged in intercompany transactions. Emerging global blockchain companies need to evaluate and structure their intercompany dealings to be consistent with the Sec. 482 regulations and the OECD Guidelines. The following subsections present commonly seen related-party transactions observed for software companies, which also may be relevant for blockchain multinational entities.
Transfers of intangible property
Global blockchain companies, like other software development companies, are predominantly structured on an intellectual property (IP) holding model or on a central entrepreneur/principal business model. In such business models, the IP is centralized and, in cases of transfers of intangibles to related-party entities, the principal entity (e.g., the parent) would need to charge an arm's-length royalty/licensing fee to its related party for the use of the intangible property (i.e., software).
Example: USP, the IP owner, is also the central entrepreneur/principal company/parent, based in the United States. USP is a blockchain platform company that has developed unique platform developer tools or a software-as-a-service (SaaS), known also as a blockchain-as-a-service (BaaS) platform, allowing companies to create their own projects using the software platform. USP seeks to expand into Canada and decides to set up a subsidiary (fSub), which will be an exclusive distributor of USP's software products in the local/regional market.
In this case, USP is characterized as both the entrepreneurial entity and the IP owner bearing the development and financial risks associated with the software product.
As discussed above, conducting a functional analysis to understand the life cycle of the software product from development to end-consumer sale and the relative roles and responsibilities of the related parties informs the choice of the transfer-pricing method. In transfers of intangible property from one related party to another, the intercompany transaction commonly calls for a licensing arrangement between the two related entities. Consistent with the Sec. 482 regulations and the OECD Guidelines, the IP owner must be compensated based on the arm's-length principle, that is, it must be remunerated in line with the licensing fee it would have charged an unrelated licensee.
This suggests that a transaction-based methodology, such as the CUT method or the CUP method, be used. Under these methods, a transfer-pricing benchmarking analysis is performed to determine the arm's-length licensing fee or range of licensing fees that may be charged by USP to fSub. The chart "Transaction Flow Between Related Entities" (below) illustrates this setup between USP andfSub.
Cross-border R&D/software engineering activities
Blockchain development companies require significant human capital to develop software products and provide engineering consulting and technical customer support services. Building on the base case presented above, recall that USP bears the financial and development risks associated with developing the software. Based on proximity to the local market, availability of human capital, and efficient labor costs, fSub is optimally situated to be a limited-risk/routine provider of research-and-development (R&D)/engineering services to USP. Routine functions do not generate economic profits through value creation. Consistent with the functions it performs, assets it uses, and risks it bears, fSub will be remunerated for its direct and indirect costs associated with the provision of R&D/engineering services, plus an arm's-length return. As such, the transfer price between USP and fSub for the provision of services has two components: (1) the service-specific cost base and (2) the arm's-length profit element.
From a transfer-pricing perspective, it is important to evaluate the cost base associated with fSub's provision of R&D/engineering services. A common misconception is that an evaluation of the markup is the more significant component to get right from a transfer-pricing perspective. This is not the case. Tax authorities pay particular attention to how the cost base is calculated, as the markup will be determined as a percentage of the cost base. A transfer-pricing analysis of the cost base ensures that the correct direct and indirect expense items are included/allocated (aka fully loaded costs).
In determining an arm's-length, or appropriate, markup, transfer-pricing specialists commonly apply the comparable-profits method (CPM) and the transactional net margin method (TNMM). Under these methods, net cost plus (NCP)8 profit-level indicators (PLIs)9 are used to perform a benchmarking analysis and derive an arm's-length range of markups over costs achieved by comparable service providers. See the chart "Intercompany Transaction Flow" (below) for an illustration of the process.
Centralized corporate management services
Global companies often find that by centralizing certain management and administrative functions, the group can benefit from synergies and implement a cost-effective management services model. Nonstrategic/leadership management, back-office, and administrative activities are typically considered routine activities. Similar to the routine intercompany R&D/engineering services described above, the group entity providing management or back-office support service must be compensated based on the functions it performs, the assets it uses, and the risks it bears.
Routine management/back-office service providers typically use minimal assets, such as computer and office equipment, do not engage in generating or using intangible assets, assume almost no entrepreneurial risks, and perform activities that allow for efficient day-to-day operations of the global group. As such, a cost-based approach is adopted, and the transfer price is typically set by applying an arm's-length markup to the fully loaded costs incurred by the group management/back-office services provider.
Similar to the case of the intercompany R&D service provider, a transfer-pricing analysis should be performed to ensure the direct and indirect costs incurred by the intercompany management service provider in its provision of intercompany services are identified, the cost base is determined, and a transfer-pricing benchmarking analysis is performed using the CPM/TNMM with the NCP as the PLI, to derive an arm's-length range of markups achieved by comparable service providers.
COVID-19 pandemic and the era of losses
In light of the unprecedented COVID-19 pandemic that has swept the globe this year and the shutting down of large segments of the global economy, it is necessary to at least briefly mention the impact of this significant event on blockchain technology companies' intragroup entities and associated transfer-pricing policies. For blockchain technology companies, the pandemic may bring about significant short-term losses due to a sudden drop in demand, with many businesses coming to a standstill and priorities shifting to maintaining existing cash flows. The allocation of losses incurred by limited-risk and entrepreneurial entities will need to first and foremost consider the functional and risk profiles of the loss-making entities.
The basic economic principle that with the assumption of greater risk comes potentially greater reward is not lost even in the context of a pandemic. MNEs may be inclined to allocate group losses across group entities; however, the authors would caution against this approach, as tax authorities of jurisdictions in which limited-risk entities operate may question the appropriateness of the loss allocation given that limited-risk entities do not enjoy the economic upside during profitable years.
This is not to say that some costs may not be allocated or markups reduced; however, some factors will play significant roles in assessing intragroup loss allocations, such as the terms of the intercompany agreements, reevaluation of functional and risk profiles of the loss-making entities, the market behavior of unrelated parties, and the understanding of how intragroup members took advantage of stimulus programs in the jurisdictions in which they operate. In the context of global blockchain companies that are experiencing intragroup losses, it is imperative to take a proactive approach in managing intragroup losses and developing supportable transfer-pricing positions. Transfer-pricing-related documentation is crucial because these positions may be questioned by applicable tax authorities in the next few years.
As the benefits of blockchain business applications become more widely known, accepted, and implemented, blockchain companies will become prevalent, vertically integrated, and increasingly engaged in intragroup arrangements and transactions. The resulting cross-border transactions may require weighing allocation and apportionment of income/loss as well as documentation of the effective transfer-pricing policy where intragroup entities operate.
From an international tax perspective, multinational blockchain technology companies headquartered in the United States or subsidiaries operating in the United States will want to ensure their related-party transactions are consistent with current Sec. 482 transfer-pricing regulations, the OECD Guidelines, and the arm's-length principle. Additionally, each jurisdiction may have its own methodological, benchmarking, and reporting requirements that may have to be addressed depending on whether the MNE or intercompany transaction(s) meets certain threshold requirements.
Finally, during times of economic shocks caused by external factors, such as the COVID-19 pandemic, global blockchain and technology companies may experience losses and supply chain disruptions and will want to take a proactive approach in managing intragroup losses. MNEs will want to observe and review market behavior of unrelated market participants, evaluate the terms of intercompany agreements, reevaluate the functional and risk profiles of the related-party entities, and investigate potentially applicable stimulus provisions in the jurisdictions in which they operate in an effort to manage groupwide losses. In the final analysis, the transfer-pricing approach taken by MNEs should be carefully thought through and supportable from the tax perspective of applicable jurisdictions.
1Nakamoto, "Bitcoin: A Peer-to-Peer Electronic Cash System" (2008), available at bitcoin.org/bitcoin.pdf.
2OECD, OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (July 10, 2017).
3Regs. Sec. 1.482-1 and OECD Guidelines, Chapter I.
4Regs. Sec. 1.482-4(c).
5OECD Guidelines, Chapter II, Part II, Section B.
6Regs. Sec. 1.482-5.
7OECD Guidelines, Chapter II, Part III, Section B.
8NCP = Operating profit ÷ Total costs (Cost of goods sold + Operating expenses).
9Regs. Sec. 1.482-5(b)(4) and OECD Guidelines, Chapter II, Part III, Section B.3.2.
|Farnaz Amini, Ph.D., is an economist and transfer-pricing specialist with Friedman LLP, based in Los Angeles, and Adnan Islam, Esq., CPA, LL.M., MBA, is a tax partner with the same firm, based in New York. For more information about this article, contact email@example.com.