While start-ups primarily focus on product development and increasing their market share, understanding TP becomes essential once they expand to become a group of companies with intercompany transactions. Start-ups, with their inherent dynamism and rapid growth, can often present unique TP challenges.
This article covers the basic TP principles most relevant to expanding start-ups, what the arm’s-length principle is, significant TP aspects of intangibles and centralised corporate functions, and the importance of functional analysis, followed by common cases for TP challenges.
Egyptian tax law follows the OECD's arm's-length principle (ALP), which dictates that the pricing of intra-group transactions should reflect what an independent company would charge for the same goods or service.
This principle ensures fairness and prevents companies from artificially shifting profits to jurisdictions with lower tax rates. As such, expanding start-ups need to guarantee that transactions with affiliated companies (e.g., a parent company or a subsidiary) are priced based on their economic value. Determining economic value added by each entity along the value chain can be challenging and is governed by TP methods prescribed by law.
Intangibles are critical for start-ups due to their increasing importance in value creation. Intangibles such as patents, trade names, trademarks, copyrights, and know-how are the key to innovation for many start-ups. Owning and strategically managing intellectual property (IP) rights allows start-ups to demonstrate where value is created and justify profit allocation accordingly.
The development, enhancement, maintenance, protection, and exploitation framework, recommended by the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, is used to assess the value contributed by each party involved in an IP transaction between related entities. By applying this framework, expanding start-ups can establish a strong rationale for the pricing of transactions with related parties early on. This approach helps to demonstrate to tax authorities that pricing policies reflect economic substance and adhere to the ALP.
Brand, technology, and R&D are known to create the most value. However, this should not overlook the significant contributions of centralised corporate functions (e.g., business development, marketing, strategy, treasury, and fundraising) that support these activities.
To ensure a fair application of TP principles within a group, it is crucial to accurately identify the activities that contribute to value addition and provide benefit to different entities within an expanding start-up group. Upon identification, the associated costs are expected to be charged to the benefiting group party, in addition to a profit element to align with the ALP. The notion of ‘benefit’ is very important in this context and these benefits must be documented early on.
Creating a functional profile for each counterparty within an expanding start-up group enables them to determine the specific activities each party undertakes in a transaction (R&D, manufacturing, distribution, sales and marketing, etc.). It also allows them to identify associated risks borne with the transaction and the essential assets used for completing the transaction, such as IP contributions in the form of knowledge and expertise, customer lists, trade names, and trademarks. The functional analysis is therefore key to determining the economic value added by each entity and, accordingly, remuneration/profit allocation, and is the primary source for tax authorities to test a group’s adherence to the ALP.
Start-up groups often operate with a decentralised structure, with activities such as R&D, marketing, and sales spread across different legal entities in various countries. Their focus on innovation can lead to a lack of well-defined boundaries between legal entities. This makes it difficult for tax authorities to understand the value chain and how profits are allocated across jurisdictions, which may lead to unnecessary tax challenges.
Expanding start-ups should also consider the location of key employees who perform significant functions. These are individuals with the direct power to impact profits, such as CEOs, CFOs, and CTOs. In the context of blurred jurisdictional boundaries, this creates challenges in determining where IP is developed, what intra-group services are conducted, and where value is created. For example, founders might set up a company in a country with strong IP protection laws to own the IP, while having all the significant people functions, IP development and enhancement functions, and all the operational costs in another. This structure can raise red flags for tax authorities.
Therefore, the specific group company and country where these key personnel are located is important. Relocating a CEO or CTO can significantly impact the group's TP model.
Start-ups used to prioritise rapid user acquisition and market share growth over profitability. However, coupled with blurred jurisdictional boundaries, this often led to a mismatch between revenues and expenses, mispriced transactions between related entities, and challenges from tax authorities. The new shift to unit economics and profitability is a move in the right direction; however, these legacy habits have left traces. This can be remedied by a recalibration of TP policies ensuring a fair allocation of profits among group entities according to the ALP.
Many start-up groups look forward to an exit route or an IPO, both representing a major milestone for start-ups. However, before taking either leap, it is vital for start-ups to ensure they have strong TP policies and governance practices in place. This gives more credibility to potential buyers in the exit route and makes an IPO route, with all its required documentation, progress in a much smoother manner.
TP is essentially about meeting regulatory requirements. However, having sturdy TP policies early on leads to a large reduction in advisory costs and clearer communication with tax authorities, resulting in a reduction of tax costs.
When structuring intra-group transactions, expanding start-ups should:
These measures help to ensure sound TP practices are being followed, thus minimising potential tax risks, and achieving a heightened readiness for exits or IPOs.
