Meaning
Intellectual property valuation relies on identifying which entities perform development, enhancement, maintenance, protection, and exploitation of intangible assets. The concept of DEMPE functions was introduced into international tax standards and adopted by the State Taxation Administration to prevent the artificial shifting of profits to low tax jurisdictions. It moves away from the simple legal ownership of a patent or trademark as the basis for profit allocation.
Instead, it looks at the actual activities performed by employees and the control over risks related to the intangible asset. The boundary of the concept is the distinction between the entity that holds the paper title and the entity that creates the commercial value. If a Chinese subsidiary performs the research that leads to a new patent, it should receive a share of the royalty income regardless of whether the patent is registered in another country.
This framework applies to trademarks, trade secrets, software, and industrial designs. It ensures that tax is paid in the location where the substantive economic activity occurs.
Asset Control
Decision making power over the life cycle of an intangible asset determines which entity is entitled to the economic returns. Analysis of DEMPE functions requires identifying who manages the research and development programs and who decides on the strategic direction of the technology. It is not enough for a company to simply pay the bills for a project; it must have the technical capacity to oversee the work and evaluate the results.
The tax authorities examine the personnel records and organizational charts to see if the legal owner of the IP has the staff required to exercise control. If the parent company in a tax haven has no employees with technical expertise, its claim to the IP profits is weakened. The control of risk is inseparable from the performance of these management functions.
An entity that cannot understand the risks involved in developing a new technology cannot be seen as controlling those risks.
Risk Assumption
Financial responsibility for the failure of an intangible asset project is a key indicator of where the profits should be taxed. The framework of DEMPE functions looks at which entity bears the costs of unsuccessful development or the legal expenses of defending a patent. If a Chinese subsidiary is the only party that loses money when a project fails, it is the one assuming the risk.
This assumption of risk must be supported by the financial capacity to absorb the loss. Contractual terms that shift risk to an entity without the assets to cover it are often ignored by tax inspectors. The analysis also looks at how the risks are managed on a day to day basis, including quality control and market monitoring.
An entity that manages the risk is generally entitled to a higher return than one that merely provides the funding.
Profit Entitlement
Calculating the fair distribution of income from intellectual property involves weighing the relative importance of each function performed by the different group members. The application of DEMPE functions ensures that the entity performing the exploitation, such as marketing and sales using a global brand, is rewarded for its efforts. However, the largest share of the profit usually goes to the entities that developed and enhanced the asset.
The Chinese tax bureau often argues that the local market’s unique characteristics contribute to the enhancement of global brands, a concept known as location specific advantages. This can lead to demands for higher profit allocation to the Chinese entity even if the brand was originally developed elsewhere. The final allocation must be documented in a transfer pricing report that justifies the split based on functional analysis.
Failure to align the profit with the DEMPE functions leads to significant tax adjustments and the potential for double taxation. Compliance with these principles is essential for managing the global tax risk of a multinational group.
