In South Africa, section 31 of the Income Tax Act 58 of 1962 (“Income Tax Act”) applies the arm’s length principle to qualifying cross-border transactions, operations, schemes, agreements or understandings between relevant connected persons or associated enterprises. The South African Revenue Service describes section 31 as requiring specified international transactions between connected persons or associated enterprises to be priced on an arm’s length basis when determining taxable income. In the context of intellectual property (“IP”), this means that the contractual royalty or other IP return cannot be considered in isolation. The remuneration ultimately attributed to the relevant group entities must appropriately reflect the functions they perform, the assets they use and the risks they assume in relation to the intangible.

In transfer pricing, IP, or “intangibles” in the terminology used by the Organisation for Economic Co-operation and Development (“OECD”), can be one of the more difficult areas of the analysis. This is because the legal ownership of an intangible, the activities that create or increase its value, and the entities ultimately entitled to the returns from that intangible may be located in different jurisdictions. The OECD therefore requires the relevant intangibles to be identified specifically, together with the manner in which they contribute to value creation and the functions performed, assets used and risks assumed in relation to those intangibles.

The starting point is commonly referred to as the DEMPE analysis. DEMPE is shorthand for the Development, Enhancement, Maintenance, Protection and Exploitation of intangibles. The purpose of the analysis is to identify which entities within a multinational group perform and control the functions, use the assets and assume the risks that contribute to the value of the IP. The OECD explains that the ultimate allocation of returns from intangibles is achieved by appropriately compensating group members for those contributions in accordance with the arm’s length principle.

This is important because legal ownership of IP does not, by itself, entitle an entity to retain all of the returns generated by that IP. Legal ownership and the contractual arrangements between the parties are the starting point of the analysis, but the actual functions performed, assets used, and risks assumed must also be considered. Where the legal owner does not itself perform a relevant DEMPE function, it may outsource that function, including to another group company. However, the entity performing the function must receive arm’s length compensation, and the extent to which the legal owner is entitled to retain the remaining return will depend, amongst other things, on whether it actually controls the relevant functions and risks and contributes the necessary assets.

For example, assume that a foreign group company legally owns a brand used by a South African group company. The fact that the foreign company owns the trademark does not end the enquiry. If the South African company undertakes significant local marketing, develops local market knowledge, adapts products, bears substantial marketing expenditure or otherwise performs activities that materially enhance the value of the brand or other marketing intangibles, it is necessary to determine whether the remuneration received by the South African company appropriately reflects those contributions. This does not mean that ordinary local marketing automatically entitles the South African company to part of the residual IP return. The OECD requires consideration of the parties’ legal rights, the functions performed, assets used and risks assumed, the value expected to be created by the local activities and the remuneration already received.

The practical DEMPE enquiry is therefore broader than simply asking who owns the IP. One should ask:

1. Who developed (in part or whole) or acquired the IP, and what specific intangible is being analysed?
2. Who makes and controls the important decisions concerning its development and enhancement, including research, product development and marketing strategy?
3. Who maintains and protects the IP, including making important decisions concerning its legal and commercial protection?
4. Who decides how the IP will be exploited, including where and how it will be used, licensed or commercialised?
5. Who provides the funding and other assets required to develop and exploit the IP, and who controls the associated risks? Funding is relevant, but funding alone does not necessarily entitle an entity to the residual return. The OECD specifically notes that an entity which merely funds research and development would ordinarily expect a lower return than an entity that both funds and controls it.
6. Finally, do the written agreements reflect what the parties actually do? Where contractual arrangements are inconsistent with the parties’ conduct, the actual transaction must be determined having regard to the facts and conduct of the parties.

This analysis links directly to the arm’s length principle.

The appropriate transfer pricing method must then be selected. The OECD makes clear that any of the five recognised transfer pricing methods may, depending on the facts, be appropriate for a transaction involving intangibles. However, for transfers of intangibles, the OECD identifies the Comparable Uncontrolled Price (“CUP”) method and the transactional profit split method as the methods most likely to prove useful. A CUP may be appropriate where sufficiently reliable comparable third-party licence or royalty arrangements can be identified. Reliable comparables are, however, often difficult to find where the IP has unique characteristics. A transactional profit split may be appropriate where both parties make unique and valuable contributions or, in a licensing arrangement, where the respective contributions of the licensor and licensee need to be evaluated. The method must therefore follow the functional and comparability analysis rather than being selected simply because the transaction involves IP.

There is a separate South African withholding tax enquiry where payments are made for the use of IP. Importantly, the OECD expressly cautions that the concept of an “intangible” for transfer pricing purposes and the concept of a “royalty” for treaty and withholding-tax purposes are separate concepts. The transfer pricing characterisation of a payment does not itself determine whether that payment constitutes a royalty for withholding-tax purposes. In South Africa, a South African-source royalty paid to or for the benefit of a foreign person is generally subject to withholding tax on royalties at a final domestic rate of 15% of the gross royalty, subject to any applicable exemption or treaty relief.

The key point is therefore that an IP arrangement cannot be analysed only by looking at who owns the IP or what the licence agreement says. Legal ownership is the starting point, but the transfer pricing analysis must then determine who actually performs and controls the relevant DEMPE functions, what assets each entity contributes and which risks each entity actually assumes and controls. Each entity must receive arm’s-length compensation for those contributions, and the legal owner will only be entitled to retain the balance of the IP return to the extent justified by its own functions, assets and risks. Separately, where a royalty flows from South Africa to a non-resident, the withholding tax consequences must be determined under the South African royalty provisions and the applicable DTA, but that enquiry is distinct from the DEMPE analysis.