Application of the DEMPE Methodology in Latin America and Central America: Cases, Challenges, and Obstacles. The Potential Effect on Royalty Calculation

The DEMPE analysis (Development, Enhancement, Maintenance, Protection, and Exploitation) is a transfer pricing approach used to evaluate intangible assets, seeking to identify which entity within a multinational group performs the substantive functions related to an intangible asset.

Unlike traditional approaches based on legal ownership, the DEMPE methodology focuses its analysis on determining economic substance, i.e., identifying the functions, assets, and risks actually assumed, in order to identify the entity that generates value creation and ensure that the associated benefit is aligned with the arm's length principle.

This approach was promoted by the OECD (Organization for Economic Cooperation and Development) Transfer Pricing Guidelines as part of Actions 8–10 of the BEPS project, seeking to align the right to remuneration with the actual creation of value.

DEMPE Methodology vs. Traditional Functional Analysis

The DEMPE methodology does not replace traditional functional analysis; on the contrary, it seeks to strengthen it by delving deeper into the reality of the operation when it comes to intangibles. In other words, traditional functional analysis answers "what each entity does," while the DEMPE approach answers "who generates or creates value from the intangible and who deserves the corresponding benefit based on the activities carried out around the intangible."

Situation in Latin America

As for Latin America, the vast majority of countries have incorporated transfer pricing rules that follow, in whole or in part, the OECD recommendations. Although very few jurisdictions expressly mention the DEMPE methodology in their local regulations, they emphasize that an in-depth functional analysis is required in order to identify the actual functions performed by each of the parties, the assets involved, and the risks effectively assumed. Therefore, it could be said that the functional analysis required in these countries is close to the rigor of the DEMPE analysis. For example:

• Mexico, Colombia, Chile, Peru, Argentina, and Ecuador have robust transfer pricing frameworks based on arm's length principles, where the tax authorities can question the allocation of returns on intangible assets when it is not justified by an in-depth functional analysis.
• In Central America, countries such as Costa Rica, Guatemala, Panama, and Honduras have strengthened their regulations or are in the process of doing so, although they have less practical experience in intensive audits of intangibles.
• In the case of Brazil, until recently, it maintained a traditional transfer pricing system focused on fixed margin methods; However, the recent tax reform introduced significant structural changes in the way transfer pricing analyses are approached, converging with the OECD's recommendations and the principle of free competition. Therefore, although a DEMPE analysis is not explicitly required, a robust functional analysis is requested to clarify which entities assume the functions, assets, and risks.

How does DEMPE analysis influence the determination of the value of a royalty?

The DEMPE methodology has a direct impact on how the value of consideration is determined in the case of royalties and other payments for the use/transfer of intangibles (trademarks, patents, software, know-how, among others). Among the main characteristics we can mention:

• Legal ownership of the intangible asset is not enough: A multinational group may have a contract that assigns intellectual property rights to a local entity, but if that entity does not perform development, enhancement, maintenance, protection, and exploitation (DEMPE) functions or activities, it cannot be granted the right to receive the economic benefits generated by the intangible asset.
• The allocation of benefits is based on the participation that each entity of the Group may have in the DEMPE functions (development, improvement, maintenance, protection, and exploitation), which may decrease or increase the market value of royalties, or even justify the use of an alternative method to a fixed royalty value. 

Potential critical points in audit processes

• Companies that "own" the intangible asset and do not have personnel or real capacity but do receive the main benefit of the intangible asset.
• Royalties paid to entities that do not develop or control DEMPE functions (development, improvement, maintenance, protection, and exploitation).
• Local R&D or marketing centers that do not receive commensurate remuneration.
• Lack of documentation consistent with the economic reality of the operation.

Challenges of applying this type of methodology in the LATAM region

Undoubtedly, the DEMPE methodology helps to clarify the picture of which company creates intangible value based on the functions performed, assets involved, and risks assumed. Among the main benefits of applying this methodology, we can mention:

• Better alignment with value creation. It allows intangible assets to reflect the real economic contribution of each company, promoting greater equity.
• Deterrence of artificial schemes. Discourages the structuring of holding companies that only maintain legal ownership of intangibles without making a real or substantive economic contribution.
• Greater international consistency. It aligns the local practices of the different countries in the Latin American region with OECD/BEPS standards, facilitating defenses against audits and bilateral agreements.

Notwithstanding the above, there are challenges that taxpayers will face in applying or using the DEMPE methodology, such as:

• High technical complexity. The implementation of this type of methodology requires detailed analysis of functions, assets, and risks that may require specialized resources (financial and human).
• Shortage of local comparables. The lack of comparable regional data limits the applicability of market value-based methods, especially for complex intangibles.
• Documentation and tax defenses. Multinational companies and taxpayers must prepare rigorous documentation demonstrating actual functions and supporting methodologies, otherwise the authorities may make substantial adjustments to the tax base.
• Regulatory standardization. Although many are aligned with the OECD's transfer pricing recommendations, the absence of clear and detailed definitions of the DEMPE methodology and how it should be applied in the different regulations of the countries in the Latin American region can lead to divergent interpretations in audits.
• Uneven administrative capacity. Some tax administrations in Central America lack (or are in the process of forming) solid technical teams to perform robust DEMPE analyses, which can lead to inconsistencies in audits.

Final Technical Reflections

DEMPE analysis represents a significant evolution in the valuation of intangibles and the determination of royalties in the field of transfer pricing, focusing on the economic reality of each entity within a multinational group. Its adoption in Latin American countries, although partial and still maturing, is promoting more sophisticated audits that seek to prevent tax base erosion and ensure that returns are allocated where value is actually created.

This approach requires both tax administrations and taxpayers to be more technically and documentarily rigorous, which has clear benefits but also presents challenges in terms of application and consistency. Strengthening local capacities, improving information exchange, and harmonizing regulations will be key factors in consolidating the effective application of DEMPE in the region.