Taxing the returns to intangible assets – will tax authorities know ‘value creation’ when they see it?

Volume No. 15-03

One hallmark of good guidance is clarity of terms and their meaning.  The OECD BEPS Project has adopted the term ‘value creation’ to represent, insofar as we can determine, the outcome of functions, risks, assets, funding and the development, enhancement, maintenance, protection and exploitation of valuable intangible assets.  The aim of several of the BEPS Actions is to create tax policy guidance that will enable multinational companies and tax authorities to better connect the tax jurisdiction in which ‘value creation’ occurs and the taxable income attributed to that jurisdiction.  Despite hundreds of pages of published draft guidance, which frequently employ the term ‘value creation’, the term remains undefined.  Troublingly, commentators in the tax community and tax authorities are beginning to use the term in a manner that implies its meaning is understood.

A clear definition is urgently needed, given double taxation often results from fundamental differences in opinion between companies and tax authorities.  If, as many expect, one of the outcomes of the BEPS Action Plan will be more litigation and double taxation cases, and a greater case burden for the already-strained Mutual Agreement Procedure and Advance Pricing Agreement personnel at many of the world’s tax authorities, an undefined or ill-defined term central to the workings of the international tax system will be sure to make difficult conditions worse.

The various BEPS Project drafts suggest that value creation is alternatively something like consumer surplus, the outcome of ‘key value drivers’, an anticipated outcome as opposed to an actual one, and the result of the performance of functions.

In business strategy and economic terms, value creation (or value added) is assessed only by an end customer or consumer.  Value is thought of as the difference between the cost of production and the benefit to a consumer derived from the product, service or right.  Value in this context is not profit.  Companies use labour, capital and intangible assets in production processes to produce or create value for customers, but if customers do not buy or do not exhaust all consumer surplus, all value is not captured by the firm in the form of profit.  More value can be captured than is created – just think of non-competitive pricing.  It is therefore one thing to correlate value creation with firm profit, and entirely another to correlate value capture (producer surplus) and firm profit. 

The OECD’s intangible assets draft also suggests that the factors contributing to value creation are easily separated and their marginal contributions or average contribution shares are measurable.  While this allows a new justification for the use of profit split methods found in other BEPS Project drafts (and a drift away from the arm’s length principle), the reality is that factors affecting value creation are most usually enumerated, and not individually measured or measurable in a robust way.  As value creation is measureable at one point – at the end of the value chain – the mystery of the quantification of marginal additions to value along the chain, always central to the transfer pricing question, remains unsolved.

Terms like ‘value creation’ are common parlance in the business world, but less so in the tax world.  It is not a foregone conclusion that all businesses think of value creation or value added in the same way.  It’s also not clear that tax authorities will not rush to substitute ‘profit’ for ‘value creation’ and demand income tax on an unanticipated share of global profit, somehow measured.  With the current policy focus on taxation at source, often the jurisdiction of the end consumer, ‘value creation’ seems to be a telling choice of term. 

As long as the definition used by businesses and tax authorities is the same, then we can be assured a comprehensible series of policy changes.  Without clear meaning, companies can’t be so sure.


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