Canada: Royalty Rate Determination: Approaches and Pitfalls

Charging a royalty or licensing fee by one related party to another within a multinational setting for the use of valuable know-how, technology processes, trade names, or other intangible property, may be one of transfer pricing's most significant and contentious issues. Transfer pricing analysts routinely grapple with a number of issues related to royalty determination, from determining the appropriate royalty rate, to defending such a rate when and if tax authorities challenge the royalty rate. Determining the appropriate arm's length price for the use of intangible assets within a multinational setting is often difficult to ascertain. Finding "comparable" royalty rates are difficult, as the business and economic environments that the related party finds itself in relative to comparable companies are often vastly different.

There are several approaches commonly taken to determine royalty rates. The most common approach attempts to apply the Comparable Uncontrolled Price ("CUP") methodology. This approach endeavors to find comparables that exhibit a high degree of similarity relative to the transaction being examined. A CUP would exist if a high degree of product similarity, as well as similarities in economic conditions and contractual terms exist.

The residual profit split method (RPSM) is another commonly used approach in determining royalty rates. The RPSM requires that each party in a related party setting be assigned a "routine" return for the functions performed, assets pledged and risks borne. The residual profit (i.e. the profits that are derived when employing the intangible asset less the routine profits assigned to each party) is then divided between the related parties by first identifying the appropriate source of the residual profits and then assessing what each party's contribution was with respect to generating these atypical profits. For instance, if it is believed that a marketing intangible is driving the profits of the firm, then the profit driver could be identified as marketing expenses. If related party A contributes 10% to marketing expenses while party B contributes 90%, then party A and B should both receive 10% and 90%, respectively, of any residual profits. If party A is receiving more than 10% of the residual profit then the difference should be paid to party B in the form of a royalty (given B contributed 90%). This approach may run into resistance as tax authorities may first argue about what the "routine" mark-ups are and secondly, whether the identified profit driver is correct.

Another approach is to determine the differential between the net present value ("NPV") that arises from a project that uses the intangible, and determining how this compares to an alternative investment opportunity that a licensee would have undertaken had it not had access to the intangible asset. Any difference that arises can be attributed to the licensee's use of the intangible and will serve as the basis for determining the royalty payment.

For example, suppose that a licensee uses a technology process that results in the licensee earning a return of $1,000,000 (determined from performing a NPV calculation). Also, assume that had the licensee not used this technology, its next best alternative would have been to invest in developing this technology. Developing this technology would require that an initial cash outlay occur (on such things as research and development) with the technology generating a stream of future income. Suppose that a NPV calculation is performed on this investment alternative, with the licensee receiving a return of between $500,000 and $800,000 (depending on the discount factor used). In such a case, the maximum lump sum royalty payment would be the difference in NPV's resulting from the two alternatives, which equals $200,000 to $500,000 in our particular case.

This approach then requires that we divide the difference in returns that these two investment opportunities generate between the licensee and licensor. This can be achieved by utilizing theorems, such as the Nash Bargaining Solution¹, which suggests that any benefits from interactions between two parties (in an economic situation) can be divided 50/50.

The attractiveness of such an approach is that it utilizes specific facts from the licensee to determine the appropriate royalty rate. As such, the resistance to any outcomes this approach may bring should not be as great (relative to other approaches). While this approach may involve more work in terms of providing technical analysis related to the NPV calculations (that can often be quite advanced), the approach is technically sounder and should be considered where possible.

The last approach we will discuss is often utilized by intellectual property and technology industries. The "rule of thumb" approach entails taking a royalty rate equal to 25% of the operating profits of a company and applying this as the royalty charged to the intangible holders. While this may be an easy way to approach the issue of valuing a royalty, it is not based on any facts specific to our tested party and does not consider the economic environment that the related parties find themselves in. From a technical point of view, this approach is often subject to manipulation given the cost base that should be used to determine "profits" is not universally accepted. Some suggest that the rule of thumb should be applied to profits that include (or exclude) depreciation. This is in part why U.S. tax courts have rejected the use of rule of thumb approaches, such as the 25% rule. In our estimation, however, it can be used as a sanity check to determine if the royalty rate determined from other methods makes intuitive sense.

While many approaches may be utilized in determining royalty rates, the rates chosen must make economic sense. Consideration must be given to the net amount of the royalties paid. If the licensee could have developed the intangible at a lower cost, then the approach taken to determine the royalty rate must be revisited.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.