Transactions involving intangible assets, such as trademarks, patents, know-how or licences, are at the centre of interest of tax authorities. In tax practice, they constitute one of the areas with increased transfer pricing risk. This results from the difficulty in valuing such assets and from the fact that they are often used in transactions between related parties. The key challenge is to determine remuneration that reflects market conditions while at the same time limiting tax risk.

How to determine the level of a licence fee

The arm’s length nature of a licence fee should be supported by a benchmarking analysis. Such an analysis must take into account the actual roles of the parties to the transaction. Correct identification of the functional profiles of the licensor and the licensee is of key importance. A helpful tool in this respect is the DEMPE analysis, which focuses on the actual management of the intangible asset.

The DEMPE concept aims to analyse the functions performed by the entity managing the licensed intangible in the context of the remuneration obtained for this purpose, in particular in the following areas:

• Development – whether the licensor creates or develops the licensed intangibles, for example through brand building or research and development activities;
• Enhancement – whether the licensor continues to work on improving the intangibles;
• Maintenance – whether the licensor undertakes activities ensuring the usability of the intangibles and the preservation of their profit-generating potential;
• Protection – whether the licensor protects intellectual property rights, for example through filings with authorities, obtaining patents or monitoring competitors’ activities;
• Exploitation – whether the licensed intangibles are used to generate profits, for example by marking products with trademarks, granting sublicences or using the results of research and development work.

If the licensor finances development work, carries out marketing activities, takes care of the brand’s reputation and bears the related risks, it may be regarded as the economic owner of the intangible asset. In such a case, it is entitled to a significant share of the benefits generated by the licensed asset. If, however, its role is limited to formal legal ownership and the performance of administrative activities, the level of remuneration due should be appropriately lower.

Not always a percentage of revenues

In market practice, royalty payments are often determined as a percentage of revenues generated through the use of a trademark or another intangible asset. However, this approach is sometimes challenged by tax authorities, particularly where it is not justified by the licensor’s functional profile.

Tax authorities take the view that an entity which, for example, does not employ personnel, does not conduct marketing activities and does not participate in building brand value, but merely performs administrative and legal activities related to the protection of a trademark, cannot be regarded as its economic owner. In such circumstances, determining remuneration as a percentage of revenues is not justified. Instead, the transactional net margin method is considered more appropriate, as it reflects the limited scope of functions and risks borne by the licensor.

This means that formal legal ownership alone does not determine the right to full economic benefits from an intangible asset.

The importance of selecting the appropriate valuation method

The choice of the method for determining a licence fee should always result from an analysis of the specific facts and circumstances of a given case. The profit split method or the comparable uncontrolled price method may be appropriate where the licensor actively participates in the creation and development of the intangible asset. In the case of simple holding structures, where an entity performs passive functions, tax authorities increasingly expect the application of cost-based methods or routine margins.

Please remember that the benchmarking analysis must be up to date and based on reliable market data. A lack of proper justification for the selected method or the level of remuneration may result in an upward adjustment of income and the imposition of tax penalties.

In summary, determining an arm’s length licence fee requires a detailed analysis of the functions, assets and risks of the parties to the transaction. What matters most is not formal ownership of an intangible asset, but the actual contribution to its development and commercialisation. A DEMPE analysis and a properly selected valuation method can significantly reduce tax risk. Current practice of tax authorities shows that a schematic approach based solely on a percentage of revenues is increasingly being challenged. Therefore, each transaction involving intangible assets should be assessed individually and appropriately documented.