DEMPE in Practice: Aligning Intangible Returns with Functions, Risk, and Control

01Why the Framework Exists

The modern approach to intangibles grew out of a specific concern. Multinational groups were able to assign legal ownership of valuable intangibles to group members in low-tax jurisdictions, members that often carried out little economic activity, and then route a large share of the group’s intangible-related profit to those owners on the strength of title alone. The contractual paperwork allocated functions, assets, and risks in a way that did not match where the real economic activity took place.

In October 2015 the OECD released the final report on Actions 8 to 10 of the BEPS Action Plan, Aligning Transfer Pricing Outcomes with Value Creation. Because the three actions are interdependent, they were issued as a single combined report. Action 8 addressed intangibles, Action 9 addressed risks and capital, and Action 10 addressed other high-risk transactions. The OECD concluded it did not need special measures beyond the arm’s-length principle; it needed to strengthen how that principle is applied, so that profit follows economic substance rather than contractual labels.

The principle that emerged for intangibles is straightforward to state and demanding to apply. At arm’s length, every group member is compensated for the functions it performs, the assets it uses, and the risks it assumes in connection with an intangible. Legal ownership is the starting point of the analysis, not its conclusion. An entity that holds legal title but performs none of the value-driving functions is entitled to a limited return for providing legal ownership, while the residual intangible return is allocated to the entities that perform the important functions and control the associated risks. The five functions that frame this enquiry are Development, Enhancement, Maintenance, Protection, and Exploitation, known by the shorthand DEMPE.

02The Five Functions

The DEMPE functions are set out in Chapter VI of the OECD Guidelines. They provide a structured way to ask which entities create and sustain an intangible’s value, and they are analyzed together with the assets used and the risks assumed.

What counts as an important DEMPE function depends on the facts, and the burden falls on the taxpayer to establish which functions are important and why. An important function need not fit neatly into a single category. The Guidelines give different illustrations depending on the type of intangible.

For a self-developed intangible, or an acquired intangible used as a platform for further development, the important functions typically include the design and control of research and marketing programs, the direction of and priority-setting for creative undertakings, control over strategic decisions on development programs, and the management and control of budgets. For any intangible, significant decisions on defense and protection, and ongoing quality control over functions performed by others that may materially affect value, are important. For a fully developed intangible purchased from a third party and then exploited, the important functions center on the selection of the right intangible, the analysis of its potential benefits to the group, and the decision to take on the risk-bearing opportunity of acquiring it.

03Risk and Control: The Chapter I Foundation

DEMPE does not stand on its own. It rests on the revised Chapter I guidance on risk, because identifying who controls the risks attached to an intangible is central to deciding who is entitled to its returns. The two analyzes are designed to operate as one: the same principles delineate the actual transaction whether the question is framed as risk assumption under Chapter I or intangible functions under Chapter VI.

3.1 The six-step risk framework

Chapter I sets out a six-step approach for analyzing risk in a controlled transaction.

1. Identify the economically significant risks with specificity.
2. Determine how those specific risks are contractually assumed.
3. Determine, through a functional analysis, the conduct of the parties: which entities control the risks, which bear the upside and downside, and which have the financial capacity to assume the risks.
4. Determine whether the contractual assumption of risk is consistent with that conduct, that is, whether the entity assuming a risk controls it and has the financial capacity to assume it.
5. Where the party contractually assuming a risk does not control it or lacks the financial capacity, reallocate the risk to the party that does control it and has the capacity. Where several parties control it and have capacity, allocate to the one exercising the most control.
6. Price the transaction as accurately delineated, compensating risk management functions and reflecting the consequences of risk assumption.

3.2 Risk management versus control over risk

The guidance draws a careful line between risk management and control over risk, and the distinction matters because only control, not mere management, grounds entitlement to risk-related return.

Risk management comprises three elements: the capability and actual performance of decision-making to take on, lay off, or decline a risk-bearing opportunity; the capability and actual performance of decision-making on whether and how to respond to the risk; and the capability and actual performance of risk mitigation. Control over risk requires the first two elements. It does not require performing day-to-day mitigation, which can be outsourced, but where mitigation is outsourced, control requires the capability and actual performance of deciding to engage the provider, setting the objectives, assessing whether they are met, and adapting or terminating the arrangement as needed.

A party must have both capability and actual functional performance to control a risk. Formalising decisions made elsewhere, through board approvals or signatures, and setting the general policy environment, do not by themselves amount to control.

3.3 Financial capacity

A party assuming an economically significant risk must also have the financial capacity to assume it, defined as access to funding to take on the risk, to pay for risk mitigation, and to bear the consequences if the risk materialises. The guidance treats financial capacity more as a necessary condition to confirm than as a concept it defines in detail, which is one reason it generates interpretive disputes in practice.

The practical consequence of this framework, and the heart of the BEPS concern, is that capital without functionality earns no premium. An entity that contributes funding but neither performs functions nor controls risk is not entitled to the returns that flow from controlling the risk. The next section sets out what such a funder does earn.

04Funding Versus Decision-Making

Economic activity in intangible development needs both funding and people who deploy that funding to create value. The framework separates the two and rewards them differently, distinguishing financial risk, which attaches to the provision of funding, from operational risk, which attaches to the development activity the funding pays for.

The return to a funder depends on what it controls.

A risk-adjusted return can be benchmarked against, for example, the cost of capital or the return on a realistic alternative investment with comparable economic characteristics, taking into account the financing options realistically available to the recipient. The funder’s expected (ex ante) return and the actual (ex post) outcome may diverge, and that divergence is itself a feature of bearing risk rather than a defect in the analysis.

The guidance is somewhat asymmetric. It is clear that funding without decision-makers earns little or no share of the residual, but it is less explicit about whether an entity that performs important DEMPE functions and controls the DEMPE risks, yet provides no funding, can claim the returns. The guidance frames the necessary condition as “access to funding” rather than the actual provision of capital, and the reasonable reading is that an entity with the relevant decision-making functions should have such access. On that reading, decision-making functions, not the cheque, drive entitlement to the residual.

05The Six-Step Chapter VI Framework

Chapter VI applies a parallel six-step framework specifically to transactions involving intangibles, consistent with the general approach to identifying commercial and financial relations.

1. Identify the intangibles with specificity, together with the specific, economically significant risks associated with their DEMPE.
2. Identify the contractual arrangements relating to the intangibles, with particular attention to legal ownership.
3. Identify the parties performing functions, using assets, and managing risks related to DEMPE, through a functional analysis.
4. Confirm consistency between the contractual terms and the actual conduct, and determine whether the party assuming DEMPE-related risks controls them and has the financial capacity to assume them.
5. Delineate the actual controlled transactions in light of the above.
6. Price those transactions consistently with each party’s contributions of functions, assets, and risks, unless the delineated transaction is not recognized under the non-recognition provisions of Chapter I.

The pivotal step is the fourth. Where an entity that does not perform important functions is contractually assigned ownership, the comparison of conduct against contract drives the delineation and pricing in steps five and six to move the economic benefit away from that contractually identified owner toward the entities that in fact perform the functions and control the risks.

A reasonable interpretation is that Chapters I and VI prescribe the same principle: only an entity that performs the key decision-making functions, whether framed as risk assumption or intangible development, can earn the income tied to those functions. Risk management and DEMPE are not separate worlds. Developing an intangible through development activity is itself a way of controlling development risk, so the important DEMPE functions generally encompass the significant risk-control functions for the intangible, and the associated excess returns follow the entity that performs them.

06Contract Research After DEMPE

A frequent question is whether the framework rules out contract research and development between related parties. It does not. Contract R&D can still be outsourced within a group. What the framework changes is the conditions under which the traditional feature of contract R&D, that the service provider has no claim on the intangible’s risks or residual returns, continues to hold.

For a contract R&D arrangement to be respected, so that the provider earns an arm’s-length service return but not the residual, one of two conditions must be met. Either the provider performs no important DEMPE functions, including no control of DEMPE risks; or, if it does perform some, then other entities perform the important DEMPE functions and control the DEMPE risks, and the intercompany contracts assign the rights to the intangibles and the associated risks to one or more of those other entities.

Where the strategy and direction of the research are set in one entity and the hands-on research is performed in another under contract, the framework allocates the DEMPE functions, the risk control, and therefore the intangible-related returns to the entity setting strategy and direction. The provider’s remuneration for the risk mitigation it performs through the development work is built into its arm’s-length service fee, and neither the intangible risk nor the residual income is allocated to it.

07Measuring DEMPE in Practice

The framework states a principle. Applying it requires evidence of where the functions, assets, and risks sit. Two tools do most of the work: value chain analysis to locate the pockets of value, and governance mapping to show who really makes and controls the decisions.

7.1 Value chain analysis

A value chain analysis breaks the business into its sequence of activities and rates where value is created, so that DEMPE contributions can be located rather than asserted. A common output is a heat map: each activity across the chain is rated high, medium, or low value, and tagged where it carries a significant risk or deploys a key asset. The exercise turns an abstract claim (“the principal controls development”) into a mapped, defensible picture of which entity performs each high-value activity.

Consider, as an illustration, a group operating a connected-home security business: hardware devices, a cloud monitoring platform, and a subscription service. A simplified heat map of its value chain might rate the activities as follows.

The high-value stages, strategy and the software and algorithm engineering, are where the entities performing them have the strongest claim to the residual intangible return, provided the governance evidence confirms they also control the associated risks.

7.2 Governance mapping

A heat map shows where value is created. A responsibility map shows who controls the decisions behind it. A common technique assigns, for each function, the entity that is Responsible, Accountable, Consulted, and Informed, sometimes with a Support category as well. Mapping the DEMPE functions this way tests whether the entity claimed to control a function in fact makes the decisions or merely executes or rubber-stamps them.

The table below illustrates the approach for a small set of development and protection functions, using a fictional group with a principal company and two affiliates.

In this pattern the principal sets strategy, approves budgets, and remains accountable across the functions, while the affiliates perform execution and routine protection work. If the conduct evidence (board materials, delegations of authority, stage-gate approvals, internal controls, and the contracts) supports that picture, the principal’s entitlement to the residual is well founded. If the evidence instead shows the affiliates making the substantive decisions, the contractual allocation will not hold.

Governance evidence that supports a DEMPE position includes board composition and charters, delegations of authority, stage-gate processes, internal control frameworks, process maps, and the intercompany contracts, alongside the functional analysis itself, which is typically built from personnel interviews, organizational charts, identification of the key intangibles, and review of human-resources data on roles and locations.

7.3 Where multiple entities perform DEMPE

A value chain analysis often shows that more than one entity performs important DEMPE functions. Where that is the case, more than one entity is entitled to share in the intangible’s returns, and a one-sided method that rewards a single entity will not produce an arm’s-length result. In these situations the transactional profit split method is frequently the most appropriate method, because it can allocate the residual among the contributing entities by reference to the relative value of their respective contributions. The presence of multiple substantive DEMPE contributors is one of the clearest indicators that a profit split should be considered.

08Sources of Controversy

Because the Guidelines were drafted as consensus language to which no participating country objected, some of the wording is open to differing interpretations, and several recurring disputes follow from that.

Authorities differ on what qualifies as an important DEMPE function and on how much involvement, and how senior, the decision-makers must be to constitute control over a risk. Where multiple entities perform DEMPE functions, the entitlement of each is contested: one view, associated with the United States, is that the contractual arrangement should determine which of the controlling entities is entitled to the returns, while some language in the Guidelines, including references to a profit-sharing element in the remuneration, can be read by other authorities to mean that important DEMPE functions earn a return regardless of the contractual terms. There is also an asymmetry problem: any risk can resolve positively or negatively, and an authority may readily attribute the upside of a controlled risk to an entity that controls but does not contractually assume it, while resisting the symmetrical attribution of a loss.

On the US position specifically, officials have stated publicly that the section 482 regulations are consistent with the revised Guidelines. The US regulations respect contractual risk allocations where they are consistent with economic substance, looking to whether conduct matches the allocation, whether the taxpayer has the financial capacity to bear losses, and the extent of managerial or operational control over the activities that drive income. The regulations do not, however, define managerial or operational control with the specificity of the OECD’s control-over-risk and DEMPE concepts, and in the cost sharing context the US rules permit intangible-related returns to participants without insisting on operational control over DEMPE functions in the way the OECD framework emphasizes. The ambiguous shared language can therefore mask real differences in how the United States and other authorities apply it.

Comp-Press · Transfer Pricing Practitioner’s Guidance. General best-practice reference, not legal or tax advice.