The Base Erosion and Profit Shifting (BEPS) Action Plan of OECD attempts to tackle the issue of tax avoidance among multinational enterprises. The components of the OECD Transfer Pricing Guidelines, such as the DEMPE (development, enhancement, maintenance, protection, and exploitation) analysis, are linked to the functional structure of businesses. At the same time, the COVID-19 pandemic has accelerated restructuring and digitalisation. Emerging technologies and, more generally, intangible assets often play a central role in start-ups. However, new firms may be paying little attention to transfer pricing in the first years due to the expected losses. It can be valuable to explore how DEMPE would impact the decision-making of start-ups worldwide.
Allocation of profits under DEMPE
Traditionally, the returns generated by an intangible are allocated to the legal owner of the intangible. DEMPE establishes that the income generated by an intangible is owned by the parties that perform the DEMPE functions:
- Development – actions related to the creation of intangibles;
- Enhancement – improvement and promotion of intangibles;
- Maintenance – ensuring that intangibles continue to generate revenue;
- Protection – securing legal rights and license agreements;
- Exploitation – how intangibles generate revenue.
Determining which entities perform a particular function is based on three factors: control, funding, and risk. The relative importance of contributions determines the proportional share of income allocated to each entity.
When should start-ups worry about DEMPE?
Start-up businesses are firms in the early development stage of products and services. They are seeking to scale their operations to realise the growth potential and gain market share. As such, it is expected that start-ups will not be profitable in the first years of operation. Since there are no taxable profits, entrepreneurs may ignore tax considerations, including transfer pricing and intangible rights. Indeed, it is unlikely that tax authorities would be interested in auditing a fresh business that is still reporting losses. However, the tax position of the start-up during the first years may impact its tax affairs in the future, once it engages in transactions involving intangibles. Tax authorities may use the decisions of start-up entrepreneurs made in the early stage of the businesses as a basis for taxing rights. The decisions may include the choice of the location for developing the product, stock-based remuneration of employees, and local marketing in other countries.
Thus, the choices made by start-ups in the first few years may become relevant when determining one or several DEMPE functions of an entity in the future. This becomes especially important during the ongoing COVID-19 pandemic, as it influences business decisions of new firms. For example, remote working has become more widespread, which could affect the allocation of taxation rights and profits once the business scales and the DEMPE analysis becomes applicable. Therefore, entrepreneurs should consider how their decisions may influence taxation rights in the future, even when they are still reporting no taxable profits. Otherwise, the DEMPE analysis may become complicated, as some decisions could be shifting value between locations or distort the alignment between resource location and profit allocation.
What issues may start-ups face when applying DEMPE?
The key problem with DEMPE is that there is still no universal agreed definition of its functional components. Different tax administrations may have different views and interpretations of these components. It can be challenging for new businesses to navigate these differences, which will likely result in conflicts and additional regulatory costs. As the start-up grows and scales internationally, applying the DEMPE framework can be expected to become more and more difficult. In particular, it might not be clear for entrepreneurs whether it is needed to perform the DEMPE analysis starting from the lowest organisational levels, since this may inflate the returns claimed from intangibles.
Moreover, start-ups often employ flexible cross-functional organisational structure, as agility allows for using available resources more efficiently. Coupled with increasing digitalisation, this further and further complicates the DEMPE analysis, as it may be challenging to identify and disentangle the role of intangibles dispersed across individual entities. Start-ups also use assets that are unique, volatile, and not visible. This makes it difficult to value intangibles and highlights how DEMPE is dependent on the underlying methodology of asset valuation. Notably, this includes the comparable uncontrolled price method and the residual profit split method, which may yield different results depending on whether there is a reference framework for the transactions. Another potential issue is the subjectivity of transfer pricing advisors. Start-ups may employ a variety of methods for estimating the role of their processes, including value chain analysis and process contribution analysis. However, these methods rely on interviews and perceived importance of individual processes and departments, which could lead to misallocation of value when performing the DEMPE analysis.
How does the COVID-19 pandemic influence the application of DEMPE for start-ups?
The pandemic has accelerated the digitalisation trend, which has resulted in companies re-evaluating their operating and business models. Start-ups make similar decisions when determining value drivers and the ways of introducing new technologies in supply chains. However, outsourcing and acquisition complicate the identification of DEMPE functions for intangibles. For example, it might be more appropriate to integrate new development functions with initially outsourced activities when considering the value of an intangible. The COVID-19 pandemic highlighted the role of emerging technologies that disrupt existing markets. Start-ups with innovative propositions are heavily investing in intangible assets, which will only increase the role of the DEMPE analysis in the future. The economic crisis forces entrepreneurs to restructure their businesses and re-evaluate the contributions to the value of intangibles.
How does DEMPE benefit start-ups?
DEMPE is a part of the BEPS action plan to combat tax avoidance. A major implication of this for start-ups is a more even playing field in terms of tax regulations across different tax administrations. This may encourage governments to provide local support to new businesses. Notably, in 2021 the Greek Ministry of Finance issued a new guidance on taxes for start-ups. Under the new provisions, angel investors can deduct €300,000 from taxable income annually per start-up. Another benefit for start-ups is that DEMPE encourages developing a clear understanding of the linkages between profits and resources. This may help improve strategic decision-making in the long run.
While DEMPE may benefit new businesses in some ways, it is unclear whether this will outweigh the increasing compliance and regulatory costs. Furthermore, some of the new initiatives, such as the digital levy proposed by the European Commission, may create a disconnect between the EU framework and the OECD reforms, such as the DEMPE analysis. As such, regulatory authorities should ensure that the DEMPE framework evolves with the environment and needs of both large multinationals and start-ups.
