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Royalty Rates as a Transfer Pricing Pricing
Introduction
Transfer of intangible goods between related parties usually proceeds in three different ways: contribution to capital, sale or licence. Probably the most common, yet the most challenging to transfer pricing issue is licensing. In globalised, corporation-based world licensing of intangible goods (such as know-how, technology, patents, trademarks, etc) is a frequently occurring problem. OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Chapter VI) touch upon a question of transfer of intangible goods between related parties recognizing, at the same time, serious difficulties with determining arm's length pricing of such properties. The aim of the present article is to indicate the most common and convenient ways of valuing in licence agreements.
Licensing Royalty Rates Characteristics
A commonly used way of transferring intangibles between related parties is through the use of exclusive or non-exclusive licence agreement. When licence rights are granted to the licensee (licence is being sold), tax laws in most countries require that the owner receives a fair market price of the intangible. Such price is usually established as one-off fee, annual fee or royalty rate. There are, probably, as many ways to structure such payments as there are licensing agreements. Some of the more common forms are:
A one-off lump sum payment to the licensor.A fixed annual fee with no royalty.An ongoing royalty based only on a percentage of licensee's sales of the licensed products with no advanced or guaranteed minimum royalty payments.An ongoing royalty in a fixed amount based on each licensed product sold with no advanced or guaranteed minimum royalty payments.An ongoing royalty based only on a percentage of licensee's sales of the licensed products with either or both an advance against royalties and an annual minimum royalty.An ongoing royalty based on the number of ‘hits' that occur on a Website featuring the licensed property.A combination of the above.
Despite the multiplicity of different possibilities the royalty based on a percentage of licensee's sales is, by far, the most popular charge. The level of such royalty payment, to satisfy the arm's length principal, should broadly mirror the actual conditions and scope of the licence. The most important factors determining royalty payments level are:
Type of industry (innovative or traditional).Competition (competitive environment or monopoly).Geographical scope of the licence.The length of time when the licensee may use the property.Scope of uses to which the licensee may put the property.The exclusivity of the licence.Amount and type of technical assistance received from the licensor.Sub-licensing rights.
Taking into consideration the above mentioned factors we can easily indicate the relationship between the level of royalty payments. For example, an exclusive licence usually carries a royalty rate significantly higher than a non-exclusive one and a licence that grants the licensee monopoly or near-monopoly should result in a higher royalty rate.
Defining an Arm's length Royalty Rate
The most appropriate method for evaluation of arm's length royalty rate of intangibles is the Market Approach. In defining the arm's length royalty rate it is crucial to identify, as precisely as possible, what property is to be licensed. Then the rights granted to the licensee and their relative value should be determined. When the property owner is involved in existing licensing programmes with unrelated parties, or the licensee uses similar licence granted by third party, the evaluation of a proper royalty rate is evident.
Significant difficulties occur when such comparable does not exist. As the optimal way to define an arm's length royalty rate is to refer to licences granted or received between unrelated parties, the Market Approach is also required. Thus related companies should consult an appropriate industry survey to review the state of the industry and commonly established royalty rates. Moreover special consideration should be given to the particular products being licensed to insure that the royalty rate will be properly adjusted to the product.
Additional problems with defining an arm's length royalty rates can occur when the property is licensed between related parties. While this may not be an exact science, the Market Approach could govern the royalty rate as well. There are, however, a number of factors that must be taken into consideration. Besides the factors mentioned above that determine the level of royalty rates, related parties should consider such elements as: investment risk, net profits, market size, growth potential, etc.
Comparable data, embracing royalty rates established between unrelated parties in various industries are accessible in internet statistics data bases such as: RoyaltyStat.com. Furthermore suitable data are issued annually in special publications like: "Licensing Royalty Rates" G.J.Battersby, Ch.W.Grimes (Wolters Kluwer publication).
Summary
Considering the fact that royalty licensing as a result of the transfer of intangibles between related parties is a common occurrence, OECD urges companies and tax authorities to give careful attention to the valuation of intangibles. Companies may have difficulty in demonstrating evidence that they took as much effort as possible to settle royalty rates at an arm's length level. But on the other hand tax authorities should not use hindsight. However both related companies and tax authorities share the same dilemma, however, tax authorities have to consider whether or not agreements between related parties are arm's length.
Contact the HLB Transfer Pricing Team for more information and assistance.
