Licensor-licensee profit split and the income approach

A number of recent tax controversies have prominently dealt with the application of the arm's-length principle in intellectual property (IP) transactions involving cross-border related-party licensing arrangements. In this context, the key transfer pricing issue involves the determination of a royalty payment charged by the licensor for the licensed rights and the evaluation of whether the resulting allocation of profits between related licensor and licensee is in accordance with what would be expected between independent parties.

To identify the income generated by IP for tax purposes, the general view, based on the US transfer pricing regulations and the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (transfer pricing guidelines), focuses on the concept of economic ownership. This approach is particularly relevant in situations where both the licensor and the licensee invest in IP.

Consider, for example, a brand licensee with rights in a specific territory that invested considerable resources for successful commercial exploitation of the licensed brand. Under the economic ownership concept, that party may be considered an economic owner of the marketing IP and could claim some of the financial rewards from the exploitation of the licensed rights.

Because the analysis is heavily driven by facts and circumstances and necessarily requires economic and legal considerations, it is not surprising that the determination of the real economic owner can be very difficult and generate controversies. Two leading international cases illustrate the wide spectrum of issues tax practitioners face, and shed some light on opposing views regarding licensed intangibles.

In the first case, GlaxoSmithKline Holdings (Americas) Inc., v. Comr., T.C. No. 5750-04, GlaxoSmithKline Holdings (Americas) Inc., v. Comr., T.C. No. 6959-05, the key question was whether the value of a branded product in the US market was created by (and therefore attributable to) GlaxoSmithKline (Glaxo UK), which developed the "blockbuster" drug, or by GlaxoSmithKline Holdings (Americas) (Glaxo US) which developed and made investments in the US marketing strategy, or by both. The Internal Revenue Service (IRS) argued that Glaxo US was the economic owner of a US marketing intangible through its investment in the marketing strategy (non-routine, above normal marketing expenses) that created the US market for the drug. The IRS further argued for adjustments to trademark royalties paid by Glaxo US totaling $20 billion, resulting in almost $8 billion in tax assessments and penalties. The case was settled for $3.4 billion, a record-high pricing settlement.

In the second case, DHL Corp. v. Commissioner, 285 F.3d 1210 (9th Cir 2002), the non-US DHL affiliates incurred above-normal, non-routine expenses developing the DHL trademark in their respective local markets. The IRS, taking the opposite view than in the Glaxo case, argued that royalty income should be imputed to DHL Corp. (DHL US) for the non-US DHL affiliates' use of the DHL trademark. Opposing this notion, the taxpayer argued that the non-US DHL affiliates had, through their investment in developing the DHL trademark in their local markets, acquired economic ownership of the trademark outside the US for tax purposes, and therefore no royalty was required.

While the two cases provide a good illustration of how different sets of facts and circumstances can result in dramatically different outcomes, numerous attempts have been made to justify the adoption of "rules of thumb" for splitting profit between the licensor and the licensee of valuable intangibles. One of the most widely cited is the 25% rule, which states that in licensing transactions the licensee should pay a royalty to the licensor equal to about 25% of the licensee's pretax profit from exploiting the licensed intangible. Advocates of the 25% rule argue that this split presumably constitutes an arm's-length result. (For an excellent review on the origins and relevance of this rule, please refer to Clark, R.A., H. Sanders, and L. Powell, "Splitting Profit from Intangibles: Is There a Rule of Thumb?" Global Transfer Pricing, October-November 1999).

Such rules of thumb can be consistent with an arm's-length result but this should be seen as a mere coincidence, providing no reliable support to the analysis of profit splits in complex transactions dealing with high value intangibles.

Parties entering into license agreements are ultimately concerned with their own expected monetary gains from such ventures. Because intangibles are an integral part of these arrangements, the economics determining the share of profit that will be allocated to the licensor and the licensee suggests that the way the parties will split the profit generated by these enterprises should depend largely on each party's contribution to the intangible development activities (IDAs). In particular, because the profit split is determined by the functions, risks, and assets brought to the table by each party, a reliable analysis must be sufficiently flexible to analyse arrangements whereby the licensee takes on no or limited IDA risks versus arrangements whereby the licensee is entirely or largely responsible for carrying out further IDAs and the licensor has no significant additional role in the process.

Intuitively, the basic reason why any rule of thumb fails to encompass the broad range of licensing arrangements is, clearly, because a licensee that provides additional value and assumes significant development and business risks should receive more pretax income than one that contributes relatively little.

The US transfer pricing rules concerning licensing arrangements are included under US Treasury Regulations §1.482, and more specifically under Treas. Reg. §1.482-4. Chapter VI of the OECD guidelines presents special considerations for IP transactions, and additional topics related to IP issues are discussed in Chapter IX. Under Treas. Reg. §1.482-4, the arm's-length amount charged in a controlled transfer of intangible property must be determined under one of the following four methods:

• The comparable uncontrolled transaction (CUT) method, substantially similar to the comparable uncontrolled price (CUP) method in the OECD guidelines;

• The comparable profits method (CPM), substantially similar to the transactional net margin method (TNMM) in the OECD guidelines;

• The comparable profit split method (CPSM) and residual profit split method (RPSM), substantially similar to the profit split method (PSM) in the OECD guidelines; and

• Unspecified methods.

Unspecified methods include, among others, the methods presented in the context of (qualified) cost sharing arrangements (CSAs) such as:

• Income method, described in Treas. Reg. §1.482-7(g)(4);

• Acquisition price method, described in Treas. Reg. §1.482-7(g)(5); and

• Market capitalisation method, described in Treas. Reg. §1.482-7(g)(6).

In general, facts and circumstances will dictate the choice of best method following an analysis of the functions performed, risks assumed, and resources employed by each of the parties in the controlled license transaction.

In a nutshell, the income method evaluates whether the amount charged in a controlled intangibles transaction is at arm's-length by comparing the present values that a related party anticipates from entering the controlled transaction versus entering into its best realistic alternative.

These present values calculations should reflect the relative risks borne by each party under the different alternatives; therefore, the relative reliability of an application of the income method depends on the degree of consistency of the analysis with the applicable contractual terms and allocation of risk among the parties.

In the specific context of licensing arrangements, the analysis must address the relative contribution of the parties in generating profit over and above a routine level.

In situations in which the licensee contributes relatively more value or bears more risk by funding intangible development costs (IDCs), the licensee will require a royalty rate that leaves it with a larger pretax profit earned from the exploitation of the licensed intangible. The income method provides a systematic way of analysing licensing transactions where both the licensor and licensee make significant investments in IDAs. More specifically, the income method allows us to analyse the resulting profit split as a function of the risk associated with IDAs borne by the licensee. In situations where the licensee bears significant IDCs, the licensee takes significant intangible development risk because IDCs are a fixed cost needed to be incurred to exploit the licensed property. In this context, fixed costs mean costs that are committed before the associated revenues are generated, creating additional operating leverage which increases risk. Operating leverage is the percentage of fixed costs in a firm or project's overall operating cost structure. The presence of fixed costs magnifies the volatility of revenue similar to the impact on shareholder's earnings of interest payments to debt holders in the case of financial leverage.

While a detailed presentation of the technical issues related to the reliable application of the income method is beyond the scope of this article, some key concepts can be articulated by reference to a simple, stylised example.

Consider a licensing arrangement that will run for 10 years in which the licensee is (contractually and economically) committed to spend a given budget of IDCs. The licensee's business is expected to generate profit before royalty payments of 15% of sales. Based on a CPM/TNMM analysis, companies earning purely routine returns in this business, and bearing no intangibles risks, earn an expected pretax income level of 5% of sales. Disregarding the additional risk borne by the licensee, the CPM/TNMM unadjusted royalty rate would be 10% of sales (10% = 15% - 5%). The resulting split of total operating profit split would be 67:33 in favour of the licensor.

The income approach, as laid out above, using the concept of operating leverage and differential discount rates, produces a royalty rate of 7.5% of sales, with a resulting operating profit split of 50:50. The 2.5% reduction allows the licensee to earn a risk-adjusted return on its non-routine IDAs. In general, the higher the spending on IDAs by the licensee, the larger the fraction of pretax income allocated to the licensee for taking the risk. Table 1 provides a comparison of the CPM/TNMM unadjusted and the risk-adjusted royalty payments.

Table 1
Expected P&L	2012	2013	2014	2015	2016	2017	2018	2019	2020	2021
Sales	30	40	50	60	70	80	90	100	100	100
COGs (variable cost)	15	20	25	30	35	40	45	50	50	50
SG&A (cariable cost)	3	4	5	6	7	8	9	10	10	10
Contribution margin	12	16	20	24	28	32	36	40	40	40
IDCs (fixed cost)	7.5	10	12.5	15	17.5	20	22.5	25	25	25
Consolidated operating profit	4.5	6	7.5	9	10.5	12	13.5	15	15	15
CPM/TNMM routine profit	1.5	2	2.5	3	3.5	4	4.5	5	5	5
CPM/TNMM unadjusted royalty payment	3	4	5	6	7	8	9	10	10	10
Residual profit after CPM/TNMM unadjusted royalty payment	-	-	-	-	-	-	-	-	-	-
Operating profit after CPM/TNMM unadjusted royalty payment	1.5	2	2.5	3	3.5	4	4.5	5	5	5
Risk-adjusted royalty payment	2.3	3	3.8	4.5	5.3	6	6.8	7.5	7.5	7.5
Residual profit after risk-adjusted royalty payment	0.7	1	1.2	1.5	1.7	2	2.2	2.5	2.5	2.5
Operating profit after risk-adjusted royalty payment	2.2	3	3.7	4.5	5.2	6	6.7	7.5	7.5	7.5

In this example, the income method calculations are based on a discount rate for the consolidated operating profit of 10% per annum, which results in a (pretax) value of 60. Under general conditions, it can be shown that a discount rate of 6.7% for routine profits is consistent with a 5% discount rate for IDCs. The resulting present value (on a pretax basis) of the routine profits is 24, which must also be the present value of operating profit after the risk-adjusted royalty payment. Therefore, the pretax value of the royalty payments must be the difference between the pretax value of operating profit before and after the risk-adjusted royalty payment, that is, 36 = 60 - 24. The final step is the conversion of this value to a risk-adjusted royalty rate on sales, 7.5% = 24 / 481, where the present value of sales of 481 is calculated (on a pretax basis) using the 6.7% discount rate.

When the licensee funds significant IDAs, it is generally more difficult to find comparables CPM/TNMM that adjust for IP risk borne by the licensee. Information based on CUT/CUP analysis is seldom available to the taxpayer and, even in circumstances when data is present, the uniqueness of the licensed intangibles and specificity of the IDAs reduce the reliability of a direct application. Profit split methods, in principle, require valuing relative contributions of the parties at market values; however, most of the applications use relative historical costs and life assumptions, to the detriment of the reliability of the profit split methods. The income method is an alternative way of pricing the intangible transaction and is consistent with generally observed licensee/licensor profit splits.

Marco Fiaccadori
		Manager, Washington National Tax Deloitte Tax Washington, DC Tel: +1 202 758 1407 Email: mfiaccadori@deloitte.com Marco Fiaccadori is a senior manager in Deloitte Tax's Washington National Tax office. He has been part of Deloitte's global transfer pricing and international tax group since 2008. Dr Fiaccadori has extensive experience in company financial and quantitative research analysis and industry data. He has prepared economic analyses of intercompany pricing strategies, and assisted with transfer pricing planning, documentation, and competent authority negotiations for multinational companies in a wide range of industries. Mr Fiaccadori has managed and coordinated transfer pricing projects involving business restructuring and intellectual property portfolios for global clients in the media and technology, pharmaceutical and medical equipment, lodging and hotel, automotive, and branded consumer products industries. He is responsible for the economic analysis and the day-to-day management of advance pricing agreements and cost sharing arrangement for global clients with local operations in the Americas, EMEA, and APAC regions. Mr Fiaccadori earned his PhD at the Department of Economics of the University of Chicago, where he was also a lecturer in economics at the College before joining Deloitte. Education PhD in Economics, University of Chicago MA in Economics, University of Chicago BA in Economics, Bocconi University

Arindam (Arin) Mitra
		Deloitte Tax Suite 400 555 12th Street, NW Washington, DC 20004 Tel: +1 202 879 5670 Email: amitra@deloitte.com Arin Mitra is a principal and senior economist based in Washington, DC. He co-leads Deloitte's business model optimisation (BMO) practice and leads the Washington office's transfer pricing team. Over the last 18 years he has practiced in Deloitte's offices in Los Angeles, Tokyo, and Sydney. Mr Mitra primarily focuses on complex BMO engagements related to the restructuring of intercompany transactions involving intellectual property, management and functional rationalisations, and supply chain rationalisations. He specialises in dealing with tax authorities on transfer pricing, including audits, competent authority negotiations, and advance pricing agreements (APAs). He has developed and negotiated transfer pricing methods for over 30 APAs, mostly bilateral, involving Australia, Canada, China, Japan, and the US. He has been recognised by Euromoney and the International Tax Review as a leading transfer pricing adviser in the US. Mr Mitra has advised companies across a wide spectrum of industries, including media, telecommunications and technology; pharmaceuticals and medical equipment; and branded consumer products in planning and documenting their transfer prices. He has successfully defended several clients in audits conducted by the tax authorities and has worked with attorneys from several leading law firms. Mr Mitra has published extensively on transfer pricing topics. He is a member of the American Finance Association. Educational qualifications and professional affiliations Brown University, Providence, RI, USA PhD in Economics, May 1994; MA in Economics, May 1991 Concentrations in Financial Economics and Applied Game Theory Jawaharlal Nehru University, New Delhi, India MA in Economics (First Class), December 1987 The Institute of Chartered Accountants of India (ICAI), New Delhi FCA – Fellow Member of ICAI, November 1986 Calcutta University, Calcutta, WB, India Bachelor of Commerce with Honors in Accounting, July 1984

Robert Plunkett Jr
		Principal Deloitte Tax New York, NY Tel: +1 (212) 436 5261 Email: rplunkett@deloitte.com Robert Plunkett is the managing principal of Deloitte Tax's Northeast transfer pricing group. In addition, he leads the firm's financial services transfer pricing practice. Mr Plunkett has served a wide array of the firm's clients, including those involved in banking, investment banking, asset management, insurance, insurance brokerage, private equity, and hedge fund management. In serving these and other clients, Mr Plunkett has worked on contemporaneous documentation, planning, audit defence, and APAs. Some of the banking projects on which Mr Plunkett has worked have involved income and expense allocation among branches for activities ranging from global trading to provision of ancillary/support services. His investment banking experience includes analysis of global trading of derivatives, merger & acquisition activity, loan syndication, and prime brokerage. In global trading transactions, Mr Plunkett has helped to price the assumption of market risk, the assumption of credit risk, the performance of trading functions, and the provision of sales/marketing services. He has assisted insurance companies in pricing the transfer of risk among entities, and insurance brokerages in allocating income and expense from global placements. Mr Plunkett has worked on a number of investment advisory projects, including the pricing of advisory functions, subadvisory functions, custody functions, and brokerage functions for both traditional and alternative investment managers. Mr Plunkett has also spent a considerable amount of time on the pricing of intercompany lending, the pricing of intercompany guarantees, and the pricing of various intangible assets and intangible asset transfers. Mr Plunkett has published numerous articles on transfer pricing and speaks frequently on transfer pricing issues. Education Harvard University: AB in Economics University of California, Los Angeles: PhD in Economics