OECD DEMPE and risk guidance in the US

By Sean Foley, J.D., LL.M., Silicon Valley, Calif., and Cristian Faundez, LL.B., LL.M., Atlanta

Editor: Mary Van Leuven, J.D., LL.M.

Development, enhancement, maintenance, protection, and exploitation of intangibles (DEMPE) is a concept first introduced by the Organisation for Economic Co-operation and Development (OECD) in the 2015 Final Report on Actions 8-10, "Aligning Transfer Pricing Outcomes with Value Creation," part of its base-erosion and profit-shifting initiative.

The Actions 8-10 report provides guidance specifically tailored to determining arm's-length conditions for transactions that involve the use or transfer of intangibles between related parties under Article 9 of the OECD Model Tax Convention. This guidance, which has since been incorporated into the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD Guidelines), addresses the opportunities for base erosion and profit shifting resulting from the transfer of intangibles among members of a multinational enterprise (MNE) group. Under this guidance, members of the MNE group are to be compensated based on the value they create through functions performed, assets used, and risks assumed in the development, enhancement, maintenance, protection, and exploitation of intangibles.

The present discussion explores DEMPE and points out significant differences between the OECD Guidelines and the Treasury regulations under Sec. 482, concerning DEMPE and risk.

DEMPE and the analysis of risk

As stated by paragraph 6.32 of the OECD Guidelines, in transfer-pricing cases involving intangibles, it is crucial to determine the entity or entities within an MNE group that are ultimately entitled to share in the returns derived by the group from exploiting intangibles. So too is determining which entity or entities within the MNE group should ultimately bear the costs, investments, and other burdens associated with the DEMPE functions. The OECD Guidelines also recognize that, while the legal owner of an intangible may receive the proceeds from exploitation of the intangible, other members of the legal owner's MNE group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible. The members of the MNE group performing such functions, using such assets, and assuming such risks must be compensated for their contributions under the arm's-length principle.

The rationale behind DEMPE is to help both taxpayers and tax authorities achieve an accurate assessment of transactions, identify the entities performing DEMPE functions, and ensure an arm's-length return for them. To this end, paragraph 6.34 of the OECD Guidelines provides a precise analytical framework for analyzing intangibles in controlled transactions:

  • Step 1: Identify the intangibles;
  • Step 2: Identify the full contractual arrangement;
  • Step 3: Identify the parties performing functions, using assets, and managing risks related to intangibles in relation to DEMPE;
  • Step 4: Confirm the consistency between contractual arrangements and conduct of the parties through functional analysis;
  • Step 5: Delineate the actual controlled transactions related to the DEMPE of intangibles; and
  • Step 6: Determine arm's-length prices for the delineated transactions.

Before the DEMPE concept was introduced, the legal ownership of intangibles by an associated enterprise was often used to determine entitlement to returns from the exploitation of intangibles. Therefore, for example, an MNE could register its trademarks in a low-tax jurisdiction and take the position that the intellectual property (IP) owner could charge royalties to related entities in other jurisdictions, allowing the IP owner in the low-tax jurisdiction to be entitled to the income effectively generated in other jurisdictions.

In addition to the DEMPE rules, the 2015 Final Report on Actions 8—10 introduced updated guidance on the analysis of risk for transfer-pricing purposes. Historically, contractual arrangements between related parties were often used to determine which party bore relevant risks for transfer-pricing purposes. Under the updated guidance, the contractual allocation of risk remains relevant, but it will be respected only if it is consistent with the enterprises' conduct. Paragraph 1.60 of the OECD Guidelines provides an overview of the required risk analysis:

  • Step 1: Identify the economically significant risks;
  • Step 2: Determine how the risks are contractually allocated by the parties;
  • Step 3: Based on a functional analysis, determine which entities perform risk control and risk-mitigation functions; which entities are exposed to the upside and downside; the consequences of a risk; and which entities have the financial capacity to assume the risk;
  • Step 4: Determine whether the contractual allocation of risk is consistent with the parties' conduct by analyzing:
    • Whether the parties follow the contractual terms, and
    • Whether the party assuming the risk under the contractual terms exercises control over the risk and has the financial capacity to assume the risk;
  • Step 5: If, under Step 4, the party assuming the contractual risk lacks the requisite financial capacity or control, apply the OECD Guidelines' risk allocation guidance (paragraphs 1.98-1.99) and allocate the risk to the entity that controls the risk and has the financial capacity to assume it; and
  • Step 6: Price the transaction in question, taking into account the consequences of risk assumption as appropriately allocated and appropriately compensating risk management functions.

Now, after the base-erosion and profit-shifting initiative, it is clear under the OECD rules that contractual arrangements or funding alone does not entitle an entity to returns from intangibles or risk assumption. To earn returns from assuming risk or owning intangibles, an entity must have "substance," in the form of decision-makers' controlling the risks or performing important DEMPE functions. Entities funding intangible development or contractually assuming risks but with no significant people functions would not be entitled to the returns from economically significant risks and intangibles.

Even though the OECD Guidelines are clear that legal ownership or contractual terms alone do not entitle an entity to returns, the guidelines are less clear on the degree of substance required for an entity to earn the returns from risk assumption and intangible ownership. The OECD Guidelines are open to differing interpretation by tax authorities, leaving taxpayers with the challenge of determining the appropriate level of substance to satisfy the functional requirements for earning the rewards of risk assumption and intangible ownership.

DEMPE and the US

Several countries around the world have expressly incorporated the DEMPE concept and its analytical framework into their own domestic law, but that is not the case for the United States. In public pronouncements, U.S. government officials have said that the Sec. 482 regulations are consistent with the OECD Guidelines. However, the ambiguous language in the OECD Guidelines can trigger differences in interpretation between the United States and other tax authorities.

Although the OECD Guidelines and the DEMPE rules are occasionally referred to by the IRS in bilateral advance pricing agreements and competent authority cases as a common reference point for negotiation and resolution, they do not constitute binding authority for interpreting Sec. 482. However, as a member of the OECD, the United States seeks to follow OECD recommendations in interpreting its treaties with other member countries. In 2019, the IRS issued a memorandum titled "Interim Guidance on Mandatory Issue Team Consultations With APMA for Examination of Transfer Pricing Issues Involving Treaty Countries," which requires Large Business and International (LB&I) exam teams to consult with the IRS Advance Pricing and Mutual Agreement program (APMA) when auditing transfer-pricing transactions that involve counterparties in jurisdictions that are U.S. treaty partners.

This consultation requirement allows APMA to provide early input into transfer-pricing audits that could become competent authority cases, including advising exam teams on whether a contemplated adjustment would likely be sustained in the competent authority process. Even though this guidance does not expressly refer to DEMPE, as a practical matter, APMA would take into account any DEMPE-based arguments that it anticipates the counterparty competent authority would make.

However, there remain significant differences between the Treasury regulations under Sec. 482 and the OECD Guidelines on DEMPE and risk. For example, regarding contractual arrangements, the U.S. transfer-pricing regulations respect allocations of risk pursuant to a written contract as long as they are consistent with the "economic substance" of the transaction (Regs. Sec. 1.482-1(d)(3)(ii)(B)). In considering the economic substance of the transaction, the following facts are relevant (Regs. Sec. 1.482-1(d)(3)(iii)(B)):

  • Whether the taxpayer's conduct over time is consistent with the purported allocation of risk or, where the pattern is changed, whether the relevant contractual arrangements have been modified accordingly;
  • Whether a controlled taxpayer has the financial capacity to fund losses that might be expected to occur as the result of the assumption of a risk, or whether, at arm's length, another party to the controlled transaction would ultimately suffer the consequences of such losses; and
  • The extent to which each controlled taxpayer exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized. In arm's-length dealings, parties ordinarily bear a greater share of those risks over which they have relatively more control.

Broadly speaking, the U.S. rules on risk allocation are conceptually similar to the OECD Guidelines, although the Sec. 482 regulations are less precise. In practice, the "economic substance" test under Sec. 482 may pose a higher bar for risk reallocation than the OECD Guidelines, and the IRS and U.S. Tax Court have generally respected contractual allocations of risk by taxpayers. In other ways, however, the U.S. regulations may prove harsher: The OECD Guidelines contemplate that contractual terms "may also be found in communications between the parties other than a written contract" (paragraph 1.42), while Regs. Sec. 1.482-1(d)(3)(ii)(B)(2), in the absence of a written contract, allows the IRS to impute contractual terms consistent with the economic substance of the transaction.

With respect to transactions involving intangibles, the apparent gap between the Sec. 482 regulations and the OECD Guidelines is broader. Regs. Sec. 1.482-4(f)(3) provides that for U.S. transfer-pricing purposes, the legal owner of an intangible will be considered its sole owner unless the ownership is inconsistent with economic substance. While a DEMPE analysis could be used to determine whether legal ownership is consistent with economic substance, the economic substance test remains a relatively high bar.

In Coca-Cola Co., 155 T.C. 145 (2020), the Tax Court placed significant weight on the importance of contractual arrangements regarding intangible ownership and held that the taxpayer could not invoke the economic substance exception to prove that an entity other than the contractual owner possessed intangibles. In a clear divergence from the OECD Guidelines, the Sec. 482 regulations regarding cost-sharing arrangements allow cost-sharing participants to receive intangible-related returns without regard to operational control over DEMPE functions.

To conclude, even though U.S. government officials have maintained that the Sec. 482 regulations are consistent with the OECD Guidelines, actually, there are clear differences in application, and these differences are underscored when it comes to DEMPE and risk allocation. Therefore, MNEs and tax practitioners need to keep following and complying with the U.S. regulations but always keep an eye on DEMPE rules to be prepared when these two similar, but in practice not identical, approaches interact.


Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Contributors are members of or associated with KPMG LLP.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.

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