Your Taxes: From Carrots to Carats the OECD Way

Once upon a time in Never Land, a high tax country, Old Macdonald Inc. (OMI) hit upon a way of converting carrots into 24 carat pure gold at minimal cost. Unable to believe its good fortune, OMI licenses this knowhow to its subsidiary company OMI Offshore Ltd in Utopia, an offshore jurisdiction, for an annual royalty of $1,000, based on a professional valuation.

However, in each of the next 5 years OMI Offshore Ltd managed to generate revenues of a billion dollars, 99% of which was profit. The tax rate in Utopia is zero, compared with 40% in Never Land.

In year 6, the Never Land Tax Authority conducts a tax audit. Can it use hindsight to challenge the $1,000 royalty valuation? Was it an arm’s length value at the time or not?

While the above story is fictional, it is based on many real cases which drove the OECD to issue guidance on “hard-to-value-intangibles” (HTVI) in Actions 8-10 of the OECD’s action plan for addressing base erosion and profit shifting (BEPS) published in October 2015.

And on May 23, 2017, the OECD published draft Implementation Guidance on Hard-To Value Intangibles which reiterates the October 2015 guidance and provides a few examples. Comments are invited on the May 23 draft by June 30, 2017. A version of this article will be submitted to the OECD. Readers are invited to write in to us or the OECD with their comments.

What about Hard-To-Value Intangibles?  

According to the October 2015 guidance, the term hard-to-value intangibles covers intangible assets or rights in intangibles for which, at the time of their transfer between associated companies, (i) no reliable comparable exist, and (ii) the projections of future cash flows or income expected to be derived from the transferred intangible, or the assumptions used in valuing the intangible are highly uncertainFor example, the intangible may be only partially developed at the time of the transfer.

In such circumstances, the OECD says a tax administration can consider ex post outcomes as presumptive evidence about the appropriateness of the ex ante pricing arrangements, i.e. use hindsight.

However, the OECD disallows hindsight taxation where an exception applies, such as where the taxpayer uses detailed risk-based ex ante projections which prove to be at least 80% accurate (20% variance) by reference to subsequent actual revenues or compensation (e.g. the above $1000 royalties); or a tax ruling is obtained.

What does the OECD May 2017 draft say?

The new draft emphasize that the “probability-weighting” (by the taxpayer) of such an outcome requires scrutiny, taking into account what was known and could have been anticipated at the time of entering into the HTVI transaction.

In other words, before shifting intangibles offshore, apply prophecy and record the probability of it happening.


The OECD May 2017 draft gives some simplistic examples of prophecy with probability. In one example, a pharmaceutical company transfers patent rights to an overseas subsidiary with responsibility for conducting Phase III trials. The transfer price is a lump sum of 700 based on discounted projected cash flows. The taxpayer assumes sales of 1,000 per year starting in year 6.

In practice the Phase III trials are completed earlier than expected and sales begin in year 3. The taxpayer cannot demonstrate that this was unforeseeable, therefore the tax administration may use hindsight to adjust the transfer price from 700 to 1,000 for tax purposes, according to the OECD draft.

But if the tax administration thinks the taxpayer should have foreseen earlier sales and arrive at a price of NIS 800, the variance is within the 20% exception and the transfer price may only be adjusted from 700 to 800.

The OECD says similar principles apply if actual sales are higher than 1,000 per year or if a lump sum transfer price is charged. All this is unless an exception in the October 2015 guidance applies.


It can be seen that prophecy with probability is subjective and heavily tilted in the tax authorities’ favor. Greater clarity and tolerance levels are needed. Alternatively, we believe a good faith requirement would be sufficient.

The May 2017 draft does contain a solution of sorts – apply the mutual agreement procedure in an applicable tax treaty. But there this is a bureaucratic procedure, which can take years and still not yield a certain outcome, assuming a tax treaty exists in a particular case.

Technology is often the result of a collaborative deal involving parties in many countries, including Israel sometimes. In such cases, an offshore joint venture entity may be used to own the technology to help avoid multiple taxation in the participants’ home countries. This is done for similar reasons in other sectors too from low tech to real estate. Unfortunately, the OECD May 2017 draft does not make an exception for collaborative deals.

As always, consult experienced tax advisors in each country at an early stage in specific cases.

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