INTM440170 - Transfer pricing: Types of transactions: intangibles: establishing an arm’s length price for valuable intangibles: profit split method

Profit split - variations

There are a number of variations on the profit split model. A common one will feature a business owning intangibles and the residual falling to a manufacturer, which is usually based in a low tax country. Under this structure, a company based in a territory offering tax incentives for manufacturing will have been granted a licence by a group company that owns valuable intangibles. The licensee will sell the products it manufactures to group distributor companies worldwide; the transfer price for these transactions will be set using the resale price method. The owner of the valuable intangibles will be rewarded by annual royalties and this will be calculated by reference to industry benchmark figures.

The royalty may have been derived from a number of independent licence agreements, hopefully covering that particular industry. The agreements will cover a broad spectrum producing probably a large range of royalties, with the rate picked from the middle. In other cases a more generic 25% to licensor, 75% to licensee split might be presented as the going rate (a commonly mis-used ‘rule of thumb’. See the comments on rules of thumb at INTM440140). This approach has the effect of marginalising valuable intangibles and makes no allowance for the fact that the intangibles in question may be much more valuable than those generally found in that industry.

Such arrangements should be carefully reviewed. It is more likely that a method where the anticipated residual profit is allocated to the company owning the intangibles will produce a more accurate arm’s length arrangement. Establish the anticipated system profit. Allocate an appropriate arm’s length reward to routine functions and the residual to the intangible owner if it is clear from the evidence that this reflects what would happen at arm’s length.

Often at arm’s length when an intangible is licensed by one party to another, its anticipated value to the licensee at the time of licensing will be calculated by application of the income valuation approach, frequently by means of the construction of a discounted cash flow model (see INTM440140). An appropriate royalty rate will then be calculated based on this valuation. Royalties are essentially a mechanism to split the total anticipated profit to be derived by the licensee from its activities which make use of the licensed intangible and attribute that proportion of the total profit arising directly from the intangible to the licensor.

Does the cost of the intangibles affect the value of the intangibles?

(see the comments on the Cost approach to asset valuation in INTM440140)

The expense of discovering and developing valuable intangibles has no direct relation to the price of products manufactured and sold using that technology. If the R & D programme cost £100 million, the products will rarely be priced directly to try and recoup those costs over say the next 5 years. There is of course an indirect link; a business will bear in mind the costs of its current R & D programmes for future products, and what it would like to spend on that R & D in the future, but the pricing of goods and services is subject to a very complex interaction of many commercial factors. While a revolutionary new product will no doubt attract a premium price in some markets, there is generally a limit on what people are prepared to pay.

When intangible rights are sold at arm’s length, the price the buyer is prepared to pay is by definition the arm’s length value of those intangibles at that time.

The price agreed between independents would also be subject to complex interaction of market forces. The transfer of intangibles between affiliates is a difficult area but one where it is always necessary to establish the facts and consider carefully evidence that the transfer is arm’s length.

The reward for marketing intangibles

Marketing intangibles are not defined comprehensively, but the OECD Transfer Pricing Guidelines suggest that, depending on the context they may include trademarks, trade names, customer lists and other proprietary customer data.

Some distributors have a large, well trained, well paid sales force - backed up by an efficient infrastructure and managed by an innovative management team.

Case teams may have to consider claims that a well run marketing organisation creates a separate intangible associated with such a marketing organisation, a super marketing intangible - and that this intangible should attract much more than a routine reward that a standard distributor would earn. Always consider very carefully the evidence that has led to this assertion. Expenditure on creating such a marketing organisation may generate goodwill, this will likely be very dependent on retaining the distribution agreement for the particular product in question. In other cases the type of product may be much more important. Without the product and/or distribution agreement it is questionable how valuable the marketing organisation remains. While the marketing organisation should be sufficiently rewarded and incentivised, this can be achieved without resorting to a profit split and without the allocation of profit to a marketing intangible which either does not exist or exists but does not have any significant value.

Bundles of intangibles

A contract to use valuable intangibles may be relatively straightforward, perhaps a licence to use a trade name. In other cases an agreement may exist where a whole bundle of intangibles has been packaged and a royalty charged in return for the licensee being allowed to use the whole suite of rights.

For example an agreement may provide the licensee with:

• The right to use certain trade names and trademarks for the products.
• The right to use key patents and know-how for manufacturing the products.
• Provision of additional technical assistance as required.
• Provision of marketing strategy assistance.
• Training for manufacturing and marketing personnel.
• Provision of IT to help support the manufacturing and marketing processes.
• The right to buy materials under global procurement contracts
• Assistance in arranging sales to very large customers who have a worldwide presence.

It may be difficult to value all services individually. Always scrutinise carefully any agreement where extra payments are made for bundled services which seem of little value. As a general principle, an independent would only pay for these where it can perceive a benefit and pay at a price which would allow it to make a profit on top. Find out precisely what goods and services are being received and how they are being used. The facts might reveal that, for example, a third party would pay for some additional services only where they are actually of value.

On the other hand, a third party might agree to buy a package with the aim of being able to use a particular key element of that package. Case teams should establish what precisely is being paid for and how it is being utilised in the user’s trade.