Royalty fee should not always be calculated as a percentage of sales revenue
- INSIGHT, Transfer pricing
- 4 minuty
In order to correctly determine the remuneration for providing an intangible asset, you need not only an analysis of the legal aspects of the asset. An analysis from the transfer pricing is also required. It is extremely helpful to make the so-called DEMPE analysis provided for in the OECD guidelines.
A royalty fee for providing intangible assets should be established taking into account the functions performed, the assets involved and the risks incurred that are related to the development, enhancement, maintenance, protection and exploitation of the intangible asset. Such an analysis will make it possible to establish the arm’s length remuneration due to the licensor. The royalty fee depending on the revenues of a licensee is not always appropriate.
In the judgment of the District Administrative Court in Poznań[1] (and others) you will find an example of how the tax authorities challenged the method of calculating the remuneration reflecting the licensor’s functional profile.
Consistent approach by the court
The court had no doubts that the royalty fee to the licensor, whose role is only to protect trademarks and perform simple administrative activities, should be calculated based on the transactional net margin method – not as a percentage of sales revenue.
Before determining the method for calculating the royalty fee and its amount, it is worth answering these questions:
- does the royalty fee established reflect the contribution made by the licensor to the transaction?
- is the method for determining the royalty fee common on the market or is it specific to our case – if so, why?
- was the royalty fee amount determined arm’s length, i.e. under the terms that would have been agreed between third parties?
- does the licensee actually obtain benefits from the license held that are adequate to the fees incurred?
In the analyzed case, the licensor did not employ any staff and almost all the costs incurred concerned the amortization of trademarks. The functions performed were of an administrative and legal nature and related exclusively to the legal protection of the trademarks. In addition, the parties to the transaction carried out no advertising and marketing activities aimed at boosting the recognition of the trademark or the group. Profits earned by the licensees were transferred in the form of royalty fees to the licensor – the legal owner of the trademark.
As a consequence, the court agreed with the authorities that the licensor is only the legal owner of the trademarks, while the licensee is the economic owner. The so-called substance (i.e. employees, costs related to e.g. promotion of the trademark) was missing which indicates a limited function of the licensor. This role of the legal owners of trademarks entitles only to reimbursement of the costs of registration and legal protection of trademarks.
According to the court, it was reasonable in this case to determine the royalty fee calculated on the basis of the transactional net margin method. In order to determine the arm’s length remuneration for the trade mark administration functions performed, the tax authority compared the licensor’s financial results with the results achieved by comparable third parties.
A similar position was featured in an earlier judgment by the District Administrative Court in Rzeszów[2]. Here the court also found that it was reasonable to determine the royalty fee calculated on the basis of the transactional net margin method due to the licensor’s limited functional profile. A licensor with limited involvement in the performed functions – who hires no staff and incurs no costs related to, among others, the promotion and development of a trademark – can only be regarded as the legal owner, not the economic owner.
Summary
Improperly defined functional profile or remuneration calculated inadequately to the profile triggers a significant risk in the event of a potential tax audit. With the entire method of calculating the remuneration and, consequently, the amount of the fee challenged, you may face a potential additional assessment of income by the tax authorities.
Tax authorities are increasingly scrutinizing intra-group transactions concerning the use of intangible assets and their inspections in this area are becoming more specialized and detailed.
In addition, the analyzed judgment confirms that intangible assets, such as licenses, are still in the spotlight of the authorities and their inspections in this area are increasingly detailed.
We recommend that transactions related to the transfer of intangible assets be analyzed in terms of their legal and economic ownership. The aim is to have them properly settled from the perspective of transfer pricing regulations. It is worth taking into account the functional profile, including the involvement of the parties to the transaction in the functions performed. It is extremely important to make the so-called DEMPE analysis, provided for in the OECD guidelines, examining the participation of an entity / entities in the performance of such functions as: development, enhancement, maintenance, protection and exploitation of intangible assets. This analysis makes it possible to determine the economic ownership of an asset.
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[1] Judgment of the District Administrative Court in Poznań of 7 June 2022, file no.: I SA/Po 100/22, link: https://orzeczenia.nsa.gov.pl/doc/CBEE23CAF0
[2] Judgment of the District Administrative Court in Rzeszów of 8 March 2022, file no. I SA/Rz 4/22, link: https://orzeczenia.nsa.gov.pl/doc/315D6FE858.
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Martyna Filipiak
Project Manager, Transfer Pricing Practice
Tel.: (+48) 608 401 370