Tax & Accounting Blog

Evaluating Intercompany Royalty Rates: Why Agree with the IRS Preferred Method?

Blog, ONESOURCE, Transfer Pricing September 14, 2015

Imagine a U.S. parent that licenses certain technology to a Canadian affiliate which generates significant profits. While this sounds like good news from a business perspective, the IRS habit of assuming that the royalty should represent all of these residual profits could cause double taxation problems. Interestingly, many economists and the latest from the OECD would suggest that the IRS preferred approach might not be correct. Paragraph 6.130 of BEPS Action 8 states:

This Chapter makes it clear that in matters involving the transfer of intangibles or rights in intangibles it is important not to simply assume that all residual profit, after a limited return to those providing functions, should necessarily be allocated to the owner of intangibles.

Paragraph 6.142 notes:

The transfer pricing methods most likely to prove useful in matters involving transfers of one or more intangibles are the CUP method and the transactional profit split method.

The notion that the owner of certain intangibles receives all residual profits in the form a royalty leaving the licensee with only a routine return is being challenged not only by tax authorities in nations in many European nations, Canada, China, India, and Japan but also by some taxpayers as in litigations between certain medical device multinationals and the IRS. There is a growing economic literature that asserts that the licensee deserves a share of residual profits for two reasons:

  • Licensees bear systematic risk and would deserve a share of residual profits even if the licensor owns all of the intangible assets; and
  • The traditional section 1.482-6 reasoning that would apply if the related party licensee owned some of the valuable intangible assets.

The wisdom from BEPS Action 8 seems to be capturing what many economists have said for years. Consider a medical device multinational such as Medtronic that licensed certain intangible assets to an offshore manufacturer. Assume that consolidated operating profits are 50 percent of sales and the intercompany royalty rate is 10 percent. The IRS preferred method would grant the offshore manufacturer with a routine return equal to 10 percent of sales and insist on a 40 royalty rate. The representatives of Medtronic have countered that the offshore manufacturer bears entrepreneurial risk and owns certain valuable process intangibles.

Yet we see other transfer pricing consultants endorsing the IRS preferred approach. Take for example the EU Commission’s critique of Amazon’s transfer pricing in Europe and the rebuttal from WTP Advisors.[1] While the EU Commission argued that the Transactional Net Margin Method (TNMM) – which is the OECD equivalent of the U.S. Comparable Profits Method (CPM) – is not an acceptable method, WTP Advisors not only noted that TNMM was a method but defended the approach that granted the European licensees with a very modest level of operating profits as if they were only limited risk service providers. Paragraphs 6.130 and 6.142 call into question at least this one aspect of this attack on what the EU Commission is saying.

To be fair, I have heard many complaints from clients that the Big Four tends to endorse these CPM/TNMM approaches as if they were working for the IRS. A recent example where simply adhering to a questionable method with respect to the actual facts was the April 1, 2014 hearings conducted by Senator Levin where Caterpillar may have been falsely accused of base erosion. The facts as I understand them were that consolidated profits represented 15 percent of sales while routine returns were 6 percent of sales. As such, residual profits represented 9 percent of sales. The foreign licensee paid the U.S. parent royalties for the use of product intangibles and retained the remaining 3 percent of sales as compensation for bearing entrepreneurial risks as well as owning franchisee relationships. The staff for the Levin subcommittee appeared to abuse CPM type reports to argue for royalties equal to 9 percent of sales. While this approach may be the IRS’s preferred approach in such situations, the OECD is objecting when the facts and well received economics demonstrate that a licensee should receive a share of residual profits under the arm’s length standard.


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