CA Rahul Bhatia
As businesses operate, they may create/ own/ direct intangibles assets which may provide them an extra edge over their competitors. The extra edge may be in the form of better product or service or even more customers, etc., and discerns it and as a result the entity may generate more revenue and/ or profits.
These intangibles may be in the form of knowhow, patent, copyright, franchise, trademarks & trade names, licenses, customer lists, engineering designs, new product introductions, dies, moulds, formulae, etc.
Intangibles may be created while performing the operations of an enterprise such as sales and marketing (example customer lists), manufacturing (new product introductions or improvised processes),research and development (formulae, technology IP) or may be acquired specifically from an inventor or by virtue of acquisition of a business.
Almost all the intangibles have a useful life over a period of which they are amortised in the books of the tax payer and such amortisation is treated as an operating expense. These are also tested for impairment in accordance with the local GAAP. Some intangibles may continue to provide benefits even though they are written off in the books of accounts (example: dies and mounds).
However it may so happen that the entity  may not use the asset on its own, but may license the use of asset to another party for a consideration.  The consideration may be determined in a number of ways, the objective being to recover the cost of the asset over a period of time along with an appropriate return (the period of recovery may be short as is the case with technologies related to say video games and similar technologies, or may be long for certain types of Industrial IP) .  The consideration may be a percentage of sales, with or without a lump sum cash payment, periodic cash payments, stock options, etc.  This consideration may be called a license fee or a royalty if recovered separately.  At times the licensor may bargain and build into the royalty the opportunity cost that it might have forgone if technology had been used or extract a share of profit from the licensee’s potential use of the IP over a period of time.
To calculate an effective royalty rate for a comparison with a third party royalty rate, one may have to not only determine what will be the future economic benefit that may arise in the form of cash flows but also convert them into a rate (say as a percentage of sales).
Royalty forms an essential basis of remuneration for a parent co setting up new operations in a new place/ jurisdiction. Typically the parent may provide IP that is used by the local entity to perform their operations and therefore the licensor needs to be compensated.  It is one of the other methods for repatriating profits by an MNE (remember DIRT- Dividend, Interest, Royalty, we will cover their taxability in a separate article).
How to test royalty?
 
CUP Method –
 
Internal CUP – compare the arrangement with a comparable uncontrolled royalty arrangement available with the tax payer. It may be that the licensor provides the same technology under same market economic and contractual circumstances to third party and related party licensees and therefore arm’s length comparison is possible.
External CUP – compare the arrangement with arrangement/s that could be found in public databases. Databases such as Royaltystat, etc. are repositories of global royalty agreements.  These databases would access agreements that have been filed as statutory obligations.  These databases do not have significant amount of royalty arrangements from India.
TNMM – payment of royalty is an operating expense that forms part of the relevant operating P&L and if the operating P&L is tested on an arm’s length basis, then that should take care of the royalty payments as well.  In other words the royalty payment would have been aggregated with the main activity of the entity.

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One response to “Transfer Pricing. – Royalty and testing thereof”

  1. Rahul Bhatia says:

    Profit Split Method- it may so happen that two or more parties may get together for a business operations/ venture and one of the parties may provide IP as its contribution to the arrangement. Clearly these are cases where the use of IP may generate more than normal returns for the venture. Typically the complexity around providing remuneration is resolved by logically identifying the routine functions in the operations, identifying arm’s length returns based on a comparable study. Once the routine returns are provided to the routine returns the residual returns may be shared with one or more functions of which one of them may relate to IP.

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