In this article, we discuss the critical transfer pricing issues relevant to startups, from the establishment and investment stages through to the later stages of the enterprise.
Startups and entrepreneurship are concepts that have recently grown more important globally. To put it simply, startups are entrepreneurial companies that are generally established to offer solutions to any problem and exhibit rapid growth potential. In many countries, the importance of technology-oriented startup business models is gradually increasing, and a rising number of unicorns are emerging. Companies such as Facebook, Twitter, Snapchat, Xiaomi, Airbnb, and SpaceX, each a multinational giant now, were initially startups.
Transfer pricing is tax legislation setting out methods for the pricing of transactions between group companies according to their contributions to the group and relies upon the OECD’s “arm’s length principle”. The sensitivity of tax authorities to the intentional manipulation of pricing among Multinational Enterprises (MNEs) by group companies and the erosion of countries’ tax base is gradually increasing.
The rapid and aggressive growth momentum of startups, particularly due to increased investment, means their financial and tax systems can quickly become overwhelmed. At these stages, startups need consultancy on tax and financial matters. This should be a top priority for enterprises looking to gain an international dimension.
Seed investment phase
This is the initial phase when start-ups are showcased for corporate investors. It is considered to be decisive for the future of an enterprise. However, start-ups must meet multiple criteria to attract investment from corporate or other investors. An essential standard is a successful completion by such companies of a special analysis called “due diligence”. To successfully complete financial and tax due diligence processes, start-ups are expected to minimise their tax risks before and during the seed phase.
Start-ups should consider the factors described below when developing transfer pricing policies that cater to the company’s current and potential growth, thus helping to manage and minimise tax risks.
Value chain analysis and value creation concept
In essence, the concept of “added value” can be defined as the difference between the value of inputs and the value of outputs. Although the concept seems simple and easy to apply, it is often difficult to determine the value applicable to each element of the chain, particularly where there are high value-added components in the chain.
Today, companies operating in multiple countries, undertake high risks, set and implement strategic goals, form highly specialised teams worldwide, and develop market and bargaining power in excess of that possible by a disparate group of individuals. Without a specific definition and transfer pricing analyses applying OECD principles, the value creation process may conclude that most of the added value is produced in R&D and marketing departments, and minimal value is attributed to corporate functions managed centrally that can make a significant contribution to R&D and marketing activities.
Therefore, it is important to determine precisely which activity contributes most to value-added functions in order to correctly apply transfer pricing principles to transactions between group companies. Group companies that undertake significant business risks and own significant tangible and intangible assets can be expected to earn higher returns than other companies.
Another issue that entrepreneurs should consider is that “post box companies/shell companies” are now becoming history, thanks to the BEPS (Base Erosion and Profit Shifting) action plans implemented under the leadership of the OECD and G20 countries. Previously, companies were able to establish post-box companies in so called “tax havens” and engage in related transactions with such companies. However, in the post-BEPS world, the commercial and economic substance of these artificial structures are now in question. Therefore, we think it would be right for start-ups to consider substance and form when deciding on the related party transactions with these companies.
Creation and ownership of intangible rights
According to the OECD Transfer Pricing Guidelines (“OECD TP Guidelines”), intangible rights are defined as assets that are owned and used commercially, that can be transferred by an independent person, and are priced similarly, although they are not physical or financial assets. According to the TP Guidelines, for an asset to be considered an intangible right, it does not need to be registered or included in the balance sheet of companies. The intangible rights explained in the OECD TP Guidelines are listed below:
- Know-how and trade secrets
- Trade names and trademarks
- Concessions and contractual licenses
- Goodwill and ongoing concern value
According to the OECD TP Guidelines, the legal ownership of intangible rights by businesses will not be sufficient on its own for them to receive a profit share in respect of the intangible asset. Accordingly, the functions assumed between the related parties, the risks assumed, and the assets used are key in determining the arm’s length value to be applied in the transfer of intangible rights and related rewards among the related parties. Five major concepts (DEMPE functions) regarding intangible rights are established in the transfer pricing literature:
A common feature of start-ups is that they try to establish their brand for rapid growth, particularly by using the technological infrastructure. Since the country in which intangible rights such as a trademark, patent, or know-how is developed, and the ownership of such rights are essential, both the location where the DEMPE functions are performed and the country holding intangible rights should be analysed. It is key that the allocation of reward should reflect the economic and commercial substance of what is actually going on. As there is often a large element of judgment in determining these allocations, start-ups should be aware that intragroup transactions relating to intangibles are likely to be challenged.
Significant people function
While analysing transactions between group companies in terms of transfer pricing, another major point to consider is the group company in which key executives work. These individuals can add significant value to the organisation and their activity is termed as “significant people functions (SPFs)”. Key executives refer to the employees who have the capacity to directly affect the profits of the company, for example, the founder, CEO (mostly, the founder may be the CEO), CTO, and Marketing Directors.
Start-ups are usually established with a very small number of key individuals such as the idea owner and a technical manager. The number of employees increases in direct proportion to the transaction volume. Although the number of employees rises with the company’s growth, the number of key executives generally remains limited. Therefore, the group company in which these people work deserves attention. It should be considered that the international relocation of a person such as the CEO or CTO would bring about significant changes in the structure of the TP policy of the group. If these people serve multiple group companies and an integrated business model exists, profit sharing methods can be developed that reflect the structure and location of related party transactions via a scoring system.
Although start-ups are commonplace in today’s commercial environment, they struggle with many challenges including the capital, investor, and cost pressure. On the other hand, they can grow rapidly through incoming investments and quickly launching operations in multiple countries. Such businesses need to create robust transfer pricing models, with the help of seasoned consultants, to minimise tax risks that may limit incoming investments or result in a confrontation with tax administrations in the countries in which they operate.