IntellectualProperty (7th Edition)

Tax Reference Library No 46

Published in association with:

GarriguesNERA Economic ConsultingErnst & Young Shinnihon Tax

Why transfer pricing matters inasset managementBy Emmanuel Llinares,Takefumi Suzuki andSylvain Gilibert of NERA

T he asset management industry has gone through rough times recently withthe turmoil in the financial markets. The press has reported a number offailures for hedge funds, with probably more than 10% already liquidated.

In fact, because the vast majority of the remunerations of asset managers are stip-ulated as a percentage of assets under management, to which a performance fee maybe added, a very large number of asset managers have seen their remuneration declinesignificantly over recent months. Indeed, 73% of the funds tracked by CSFB Tremontearned no performance fees last year.

BackgroundIndustry value chainIn a typical setup, the functions of an asset management multinational include corefunctions: that is, the day to day activities that characterise most asset managemententities and that are at the heart of the value creation process, and support functions,which tend to be common to many industries (even though the skill sets required maybe industry-specific).

Both sets of functions rely on some form of intellectual property (in a broadsense), which is typically an integral part (albeit often invisible) of the value creationprocess. In fact, in the asset management industry, just as in any other industry, intan-gible assets are at the origin of large profits when the asset management company out-performs, and they often tend to have a direct relationship with the cause of lossesincurred when the asset management company under-performs. The core functionsinclude the following.

Fund managementThe fund management function includes both portfolio management activities andsupporting activities such as investment research and is one of the key drivers in thevalue chain. Fund managers are required to follow the investment objectives outlinedin the investment prospectus for a particular fund. However, many funds do permitsome discretion without violating portfolio guidelines, in some cases up to a third oftotal asset value.

Fund design and marketingThis function is predominantly demand-driven and includes all activities relating tothe design of product offerings and the subsequent advertising and marketing offunds. Changing market conditions and increased competition have resulted in firmshaving to be more innovative and transparent with respect to product developmentand marketing.

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Fund distributionFund distribution relates to the structure that is being used tomarket the funds. Fund distribution may be direct (a businessto consumer channel) or indirect (a business to business chan-nel). In the direct channel, investors may contact invest in thefund by phone, internet or customer service centre. The indi-rect channel includes financial advisers (including advisers perse, banks, insurance providers and sales platforms), retire-ment plans (the distribution involves the employer of theinvestors) and institutions (non-personal accounts held bytrusts, corporations, financial institutions, endowments, non-profit organisations and other organisations).

Back and middle office functions These functions include all operations related to support,such as transaction processing, settlement, custody and stocklending, performance measurement, investment accounting,regulatory compliance and customer service. A substantialproportion of the back and middle office functions tend to beoutsourced, in particular with respect to custody, transactionprocessing and settlement, stock lending and investment

accounting. Support functions may include accounting and finance

(which may include tax and legal departments), humanresources and other types of similar transversal functions. Wenote in this respect that these functions typically require sig-nificant industry specific skill sets. As an example, it is notuncommon for a tax and legal department to extend wellbeyond the typical corporate function and cover operationalissues. For example, both departments will be highly involvedat a launch of a new fund to ensure that the fund is structuredproperly and efficiently.

Typical asset management firm set up in a cross-borderorganisationIn a typical cross-border set up, one or several funds are locat-ed in jurisdictions generally chosen for their regulatory andadministrative attractiveness, often offshore. In this context,there are then two fund management entities. One locatedoffshore that may be in direct relation with the investors (itmay collect the group’s revenues from the amount investedby the investors, for example) and one located onshore, gen-erally acting as a sub-manager and dealing with the offshorefund manager. The role of this entity may vary from beinglimited to the provision of research services to the actualmanagement of the funds themselves. Therefore, the follow-ing points should be observed.• The fund manager (the entity where the actual manager of

the fund who takes the investment decisions) can be locat-ed offshore or onshore. When located onshore it is often,but not systematically, in a large city in a mature market.

• The portfolio manager, which we define for the purposesof this article as the key person in respect of the invest-ment decisions or portfolio allocation decisions, may belocated offshore or onshore.

• The portfolio managers and staff involved in those invest-ment-related activities may be relying on know-how,processes and methods that can be described as intellectu-al property and are forming an intangible asset.

• Then, marketing and distribution-related activities (whichmay be located anywhere the funds are sold, or which maybe centralised) are key in a number of setups. These activ-ities themselves rely at times on a number of marketingintangibles developed by the group. We will describe thosemarketing intangibles and the intellectual property theyrelate to later in this article.

• Finally, the trade execution and other back and middleoffice functions that directly support the core portfoliomanagement activities may be located in various jurisdic-tions or be centralised. The location of these functions mayhave important implications from an operational risk man-agement perspective. When located in different jurisdictions, each of the activi-

ties involved in the asset management value chain within a

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Emmanuel Llinares

NERA Economic Consulting28 av Victor Hugo75783 Paris Cedex 16 FranceTel: +33 1 70 75 01 93Fax: +33 1 45 03 30 01Email: emmanuel.llinares@nera.com

Emmanuel Llinares is an economist specialising in transfer pricing andintellectual property. For a number of years, he has advised multinationalcompanies in terms of defining and implementing their transfer pricingpolicies and assisting them with documentation. Emmanuel also assistsgroups in the context of intellectual property-related litigation.

In addition, Emmanuel has managed several advance pricing agreementsfor multinationals in the automotive, financial services, consumerelectronics and consumer products industries. He has also managed thetransfer pricing aspects of a large number of tax audits in France and in theUK. Before joining NERA, Emmanuel was an economist with ArthurAndersen’s transfer pricing practice in London and Paris and the KPMG taxnetwork in Paris.

Emmanuel is a former lecturer at the economics department of the Universityof Delaware and at the Ecole Supérieure de Gestion, a business school inParis. Emmanuel has a PhD in economics from the University of Lyon.

Biography

group gives rise to intra-group transactions and hence transferprices: the remuneration of the group as a whole (which com-prises the asset management fees, the performance fee whenapplicable and the potential other fees charged by the fundsto the investors) is used to remunerate the various partici-pants in the value chain. This remuneration should take intoconsideration their functions, assets and risks and mostimportantly their contribution to the overall value creationprocess.

As with other industries, the transfer pricing issues have anumber of tax and non-tax implications. On the tax side, theissue is the recognition of income and tax base in differentcountries. Non-tax consequences include the impact of trans-fer prices on the compensation of employees of the variousentities (from the obvious and sometimes mandatory employ-ee profit sharing schemes to the more subtle impact on thecompensation structure of the group and its key persons).

Nature and role of intellectual property Overview of intangible assets in the asset managementindustryAlthough interrelated, for purposes of this article we will dis-tinguish between three categories of intellectual property: • investment processes and related know-how;• proprietary IT systems; and• marketing intangibles.

For each of these assets, we will provide an overview ofwhat it may include and the key transfer pricing issues associ-ated with it.

Investment philosophy, investment processes and relatedknow-howA key asset that drives the success of the firm is the invest-ment selection and review process in place and related know-how. In most asset management organisations, the investmentselection and review process is formalised and drives the dayto day activities of both analysts and portfolio managers. Thiscan include internal procedures with a description of thedeliverables for each phase of the investment selection: forexample, related software, the organisation of the approvalsand reviews and the risk management systems in place, amongother things.

Typically, these processes have been developed over timeby the various asset managers and the management. It is gen-erally materialised by some written procedures, IT systemsand various levels of controls that are part of the risk man-agement system. However, the visible part of this know-howis only the tip of the iceberg. An important part of this (tech-nical) know-how may well be the corporate culture of theasset management group itself. This corporate culture isembedded not only in the various processes discussed abovebut also in the group’s candidate selection process, the train-ing systems, the career review and promotion processes and

the variables that affect the compensation scheme, amongother things.

Finally, the investment process and related know-how alsoinclude the investment philosophy of the group. The invest-ment philosophy may or may not be formalised. It corre-sponds to the underlying investment principles that guide thedecisions of the personnel involved in the investment selec-tion process.

The categories of intellectual property we have describedabove are almost never recognised explicitly in the group’sfinancial communication: it is rare that the pieces of intellec-tual property as defined above give rise to an intangible assetbeing recognised in the balance sheet and valued. Yet, theseintangibles are at the heart of the value creation process. Thevalue creation associated with the functions of the portfoliomanagers can be neither understood nor valued unless thegroup’s know-how in terms of investments is identified.

From a transfer pricing perspective, the first issue is toidentify and recognise those intangibles. This may be particu-larly difficult to do in practice.

In the context of its work on permanent establishment, theOrganisation for Economic Co-operation and Development(OECD) has introduced the concept of the Key

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Takefumi Suzuki

NERA Economic ConsultingThe Imperial Hotel Tower 13F1-1-1 Uchisaiwai-choChiyoda-ku, Tokyo 100-0011JapanTel: +81 3 3500 3307Fax: +81 3 3500 3291 Email: takefumi.suzuki@nera.com

Takefumi Suzuki provides economic consulting services to clients in Japan,with specialisations in transfer pricing and intellectual property in the healthcare and pharmaceutical industries. He has more than 10 years ofmanagement consulting experience, including operation and supply chainmanagement, business strategy, business process reengineering andtransfer pricing. Before joining NERA, he worked as a principal with ATKearny in Tokyo, where he was a core member of the global operationpractice group and actively developed and managed consulting projects forboth Japanese and western clients, including transfer pricing projects forJapanese multinational companies, global logistics strategy developmentand implementation for a big US food company and a corporation-widebusiness process re-engineering (BPR) project for a Japanese oil andchemical company. Takefumi has also worked for a big medical equipmentcompany, where he was responsible for purchasing, logistics operation andinventory management for Japanese operations.

Biography

Entrepreneurial Risk Taking (KERT) function, which mayprove useful in this context. However, one should not forget,regarding such intangibles, that often their origins are at theroots of the organisation. Though the roles and responsibilitiesof the personnel in charge of KERT functions are important,intangibles often predate the current organisation and maynot be completely apprehended by simply reviewing the loca-tion of current key personnel.

Proprietary IT systemsLike many financial services companies, the asset manage-ment industry has invested heavily in software. Typically,asset management companies acquire a number of off-the-shelf packages and tailor them to their own needs. In general,software that is closely related to the investment selectionprocess, reviews and risk management is highly tailored.

From a transfer pricing perspective, the main issues inrespect of IT-related intangibles relate to their funding.Typically, there are large investments associated with thedevelopment of such assets. As a result, it is tempting for anasset management group operating in several countries tohave these developments funded by a number of entities. Theresult is joint economic ownership of the assets. That beingsaid, however important they may be, IT investments are pri-marily designed to support decision makers and other invest-

ment-related functions.

Marketing intangiblesAs mentioned above, asset management companies can oper-ate in a business to consumer (B to C) context, in which casethe asset management company is directly in contact withinvestors, or in a business to business (B to B) context, wherethe asset management company is in contact with agents (tobe taken in a broad sense) that are responsible for promotingthe product to investors.

Unlike the know-how and processes described above,brands and trade marks are relatively easy to identify. Valuingthem is another matter. We note, however, that their attrib-utes are closely related to the investment philosophy, reputa-tion and history of the asset management group.

Marketing intangibles can be of a high value in both B to Cand B to B contexts. Though the development and mainte-nance of marketing intangibles in a B to C context is likely torequire significant and recurrent media and communicationinvestments, developing and maintaining marketing intangi-bles in a B to B context will require or rely on a network ofdistributors that may be costly to build up and preserve.

As described above, these intangible properties could belocated in different countries, following the structures ofasset management multinationals. Hence, defining the remu-neration attributable to each of them might be problematic.

OECD methods and applicability to the asset manage-ment industryThe OECD, in assessing whether a transaction between relat-ed parties conforms to the arm’s-length principle, prefersthree methods. These are:• the comparable uncontrolled price method (CUP); • the cost plus method; and • the resale price method (RPM).

Additionally, where it is not possible to apply any of therecommended transactional methods listed above, because ofconcerns about the accuracy of results, the OECD makes ref-erence to other methods that can be used, namely profit splitmethods and the transactional net margin method (TNMM).A description of these five OECD methods and their applica-bility to the asset management industry is given below.

Comparable uncontrolled price methodThe CUP method compares prices charged on the transfer ofgoods (or provision of services) in group transactions withprices charged in uncontrolled transactions either betweenthe controlled party and an independent third party (internalCUP) or between two independent third parties (externalCUP). This method uses the most direct level of comparisonand, if practicable, is regarded by the OECD as preferable tothe other methods. The uncontrolled transactions should bein services of a similar type, quality and quantity to those

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Sylvain Gilibert

NERA Economic ConsultingEmail: sylvain.gilibert@nera.com

Sylvain Gilibert is a consultant at NERA, specialising in economic analysisapplied to transfer pricing. Sylvain has supervised several transfer pricingplanning and documentation projects in a range of industries includingenergy, transportation and pharmaceutical products. In particular, heassisted a leading European industrial group in determining its worldwidetransfer pricing policy and conducted several large French and pan-European transfer pricing documentation projects in the transport andgeophysics industries.

Sylvain has also managed intangible property and company valuationprojects and has been involved in complex tax audits. He notably assisteda leading pharmaceutical group in the defence of its transfer pricing policyin France. In the course of his career, he has developed knowledge oftransfer pricing and valuation techniques. Before joining NERA, Sylvain wasa transfer pricing specialist within the KPMG tax network in Paris.

Sylvain has a master’s degree in market finance from the CERAM Sophia-Antipolis business school and is a Level II applicant for the CharteredFinancial Analyst (CFA) programme.

Biography

being tested. Other factors should also be comparable, forexample the time at which the transactions took place (recentmarket conditions have made this obvious). In practice, it isoften difficult to find exact comparables. However, if thereare differences such that an adjustment to the CUP can bemade with reasonable accuracy, it may still be possible to usethis method. Where there are differences (such as in thenature of the services, the geographic markets, the level of themarket or in the amount or type of intangible property) forwhich it is not possible to quantify adjustments, it will gener-ally not be appropriate to use the CUP method.

Typically, there are two categories of transactions or com-parables that can be used to complete a CUP analysis. Thefirst category, often referred to as internal CUP, relies on theanalysis of transactions entered into by a group entity and athird party. The other category of transactions or comparablesthat can be used in the context of the application of the CUPmethod is referred to as external CUP, which typically relieson the use of publicly available data on third party to thirdparty transactions.

Though the internal CUP analysis can only be completedin some case, we note that, because the asset managementindustry is relatively fragmented, it facilitates the identifica-tion of relationship with third parties, which may mimic someof the intra-group transactions. This can be the case for distri-bution activities: for example, for some trade execution andother back office services and, in some circumstances, withthe portfolio management activities themselves. In the appli-cation of the CUP analysis, it is essential to bear in mind thecharacteristics derived in the functional analysis: the analysiscannot ignore the comparability criteria (geography or regula-tion may be essential in some cases), as well as the answer tothe key question of why is it that this transaction is exter-nalised rather than performed in house.

The asset management industry has also attracted a consid-erable number of studies, and there are a number of externaldata providers that can be a useful source of data. For thesereasons, there are a number of transactions in the industrywhere we believe there to be scope for applying the externalCUP method. In particular, there are external data on trans-actions for the provision of investment advisory services orportfolio management services. Those external sources ofdata may be an excellent starting point for a robust CUPanalysis. Asset management is one of the few industries wherethe CUP method applies well. Furthermore, the methodapplies well to situations where there are intangibles, provid-ed the strict comparability criteria are satisfied. In thisrespect, one should not underestimate the impact of a chang-ing market environment on such data. For example, it is notunreasonable to expect both the levels of remunerations andthe structure of the remunerations of independent sub-advis-ers or of sales agents to vary significantly following the recentsharp decline in financial markets.

Cost plus and resale price methodsThese methods are gross margin-based. Given the difficultiesassociated with dealing with gross margins, these methods,though applicable in principle, are rarely applied in practice.However, we describe below their net margin equivalent, thetransactional net margin method.

Transactional net margin methodThis method compares the controlled company’s net prof-itability on a transaction to the net profit obtained by broad-ly similar companies on similar transactions. The OECDGuidelines state that the TNMM may afford a practical solu-tion to otherwise insoluble transfer pricing problems whenused sensibly with appropriate adjustments to account for anymaterial differences.

Similar to the cost plus and resale price methods, theTNMM assesses the arm’s-length nature of the transfer price ina controlled transaction by testing the profit results of one of theparties in the transaction. The OECD Guidelines state: “Thetransactional net margin method examines the net profit marginrelative to an appropriate base (for example, costs, sales andassets) that a taxpayer realises from a controlled transaction.”

There are two important requirements that must be metfor using the TNMM. First, comparability standards gobeyond product and functional similarity. In fact, the OECDGuidelines consider the threat of new entrants to the indus-try, competitive position, management efficiency and individ-ual strategies, threat of substitute products, varying coststructures, differences in the cost of capital and the degree ofbusiness experience.

Second, analysis under the TNMM should consider onlythe profits of the related enterprise that are attributable toparticular controlled transactions. It would be inappropriateto apply the TNMM on a company-wide basis if the companyengages in a variety of different controlled transactions thatcannot be appropriately compared on an aggregate basis withthose of the independent party.

In the asset management industry, the TNMM may applyto various activities, from the traditional support functions(accounting and human resources) to some of the simplerback and middle office functions. It may also apply to someinvestment research services, provided that it is possible toidentify functionally comparable companies that have similarrisk profiles. Like the cost plus and the resale price methods,the TNMM cannot be reliably applied in order to determinethe remuneration of entities that own or are involved in thedevelopment of intangibles.

Profit split methodsThe OECD Guidelines describe the profit split as a methodthat “seeks to eliminate the effect on profits of special condi-tions made or imposed in a controlled transaction by deter-mining the division of profits that independent enterprises

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would have expected to realise from engaging in the transac-tion or transactions”.

This method is particularly adapted where transactions areinterrelated and/or where two or more entities provide signif-icant contribution to the group operations and that it is notpossible to reliably evaluate the transactions on a separatebasis.

Under the profit split method, three types of analyses canbe conducted, as follows.

Overall profit split method – contribution analysis The combined profits (generally, the combined operatingprofits) are split among the participants in the value chainbased on the relative value of the functions performed. Inorder to justify this split, the OECD Guidelines recommendthe use of external market data. In practice, the determina-tion may be based on an analysis of the relative value of eachparticipant’s contribution. This analysis can either be based onexternal data (such as data from joint ventures, for example)or internal data (including financial data).

Comparable profit split method (CPSM) The combined operating profits of participants are dividedamong the participants in the value chain based on data fromobserved comparable transactions between third parties.Comparable transactions should refer to a division of profitsand should satisfy comparability criteria (similar activities andcircumstances).

Residual profit split method (RPSM)This method relies on a characterisation of functions, risksand assets according to which simple functions are rewardedwith a routine remuneration and are distinguished fromentrepreneurial functions, which are rewarded with a non-routine remuneration. In general, the routine remuneration isdetermined based on the application of the TNMM. On theother hand, entrepreneurial functions and/or risks involvefinancing the development of valuable intangibles and/orassuming substantial risks. Once arm’s-length returns havebeen attributed to routine functions, residual profits (theprofits left over once routine remuneration has been deter-mined) are split between affiliates based on one or more splitfactors.

As indicated in the OECD Transfer Pricing Guidelines, theprofit split methods are used especially where transactions arehighly interrelated and may not be evaluated on a separatebasis and when both parties contribute significantly to thedevelopment of intangibles. The method can be applied to anumber of transactions in the asset management industry.This method is particularly suitable, in the absence of CUPsor to back up a CUP analysis, to remunerate entities in differ-ent jurisdictions performing high value added activities suchas portfolio management and significant sales and marketing

efforts. It is clear that this method is likely to apply often inthe presence of intangibles being developed in two (or more)jurisdictions. The application of this method will be affectedby the market environment. For example, in a situation wherea fund is managed by portfolio managers in different locationsspecialising in different asset classes, the relevance of the splitfactors in the profit split analyses may need to be assessed inlight of the impact of market conditions.

Intangibles play a key role in the asset management indus-try. Asset management firms’ know-how and processes arelikely to make a big difference in the current dismal marketenvironment and distinguish the successful firms (that sur-vive) from those that fail. As with many other industries, themere identification of the nature of the intellectual propertyis not a simple task. Many informal processes, know-how, sys-tems and tools constitute the intellectual property of thegroup. Their contribution to value added is essential: intellec-tual property (and intangible assets) may go a long waytowards enabling asset management firms, even small ones, tosurvive the departure of a key person.

In terms of transfer pricing, once the relevant intellectualproperty has been recognised and located, we expect twomethods to apply regularly: the CUP method can apply inmany situations because there are multiple sources of dataavailable to perform those analyses (the increased transparen-cy in the industry should lead to further improvements indata availability) and the profit split methods, because theseare commonly used when determining the remuneration ofentities that own or develop intellectual property.

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