Transfer pricing: Types of transactions: intangibles: how are intangibles exploited?
There are various ways a third party might choose to exploit the valuable intangibles it owns. The most obvious is that the intangible owner can trade and exploit the intangible directly itself. This has the advantage that the owner will enjoy the profits from the whole trade. With this potential reward comes more risk. This option is also dependent on the asset owner having the economic power to exploit the intangible itself.
There are, however, other options open to the intangible owner. These might include
Any owner of intangibles would consider very carefully the different ways in which it might exploit those intangibles, since the decision would be likely to critically affect its business. When reviewing how intangibles have been exploited between affiliates, always consider how a third party may have acted.
Valuable intangibles can be sold outright. Generally, this is uncommon for newly created, or core, intangibles. An independent would be unlikely to sell any core intangibles without very good reason (name, trademarks, copyright, know-how, etc.). Intangibles tend only to be sold where there are strong commercial reasons for doing so: perhaps where sales are declining or where regulatory bodies have to be appeased as part of a merger or acquisition, or in some cases to help raise income while new products are brought to market.
Transfer of intangibles between group members is more common. The full facts and circumstances should be reviewed to determine at what price a third party would have sold the intangibles in comparable circumstances (especially where these are still to be used in the trade - that is, where they are sold and licensed back by the purchaser to the seller for continued use in the latter’s business).
The sale may not be for just a lump sum payment. There may be a series of payments, linked to sales achieved by the new owner. There are a number of ways in which a sale might be constructed.
Under the legislation at CTA09/Part 8 (formerly FA02/Sch 29) dealing with the acquisition and sale of intangibles, the sale of intangibles will generally be taxable as a trading receipt. See the manual on Corporate Intangibles Research and Development for detailed guidance.
Grant of licence
The intangible owner can grant a licence to someone else who will exploit the intangibles in return for a fee. This might occur, for example, when a relatively small company discovers a process or develops a product that has significant potential, but the company does not have the size, infrastructure and funding to fully (or even sometimes even partly) exploit its intangibles. It needs a larger partner who can help develop the intangibles, incorporate them into products that people want to buy, and then market those products. In an arm’s length situation, the intangible owner is going to want to share in the spoils of exploiting the intangibles. How much he gets will depend on a number of factors, including the nature and likely economic life of the intangibles, the expected sales and profits, the market covered by the licence, whether the licence is exclusive, size and resources of the licensor and licensee; and the risks borne by each party in developing the products for market and then in marketing those products.
A licence agreement will set out the terms of the agreement between the licensor and licensee. It will generally include
- A definition of the intangibles. This can include patents, trademarks, trade names, know-how, etc.
- The territory for which the licence is granted. This can vary from worldwide, to just particular countries, or even regions.
- Whether the licence is exclusive or not, and in relation to what territories.
- The term of the licence and any renewal clauses.
- Payments due under the licence.
- Who is liable if something goes wrong?
- If activities that exploit the intangibles themselves produce further valuable intangibles, then the licence agreement may state who is to own them.
Licence agreements between third parties may have break or re-negotiation clauses. This allows the terms of the agreement to be reviewed after a set number of years and either party can potentially benefit. The most likely change at a break clause is the royalty rate. Break clauses, if present, tend to be found in longer-term agreements.
While the nature of the valuable intangibles will influence the amount due under the agreement, so will the terms of the agreement. A worldwide exclusive licence for ten years for a valuable patent is likely to attract a higher royalty than a non-exclusive licence for the UK only.
It is fairly common for third party licence agreements to grant the licensee the rights to manufacture and market branded goods, but it is unusual to find a licence agreement between third parties where the licensee pays a royalty on finished branded goods that it buys. A third party is more likely to pay a price for the goods themselves which effectively includes a reward to the owner of the relevant trade mark, design, logo etc.
The price of a licence can take a number of forms:-
1. A straight royalty based on the sales of goods to the third-party customers - sometimes referred to as an ‘in-market royalty’. The definition of sales in the agreement can sometimes cause misunderstanding. A third party agreement may be on net sales, after allowing for items such as VAT, import duties or other excise, and returns for damaged goods. Generally the calculation will also be net of discounts offered by the distributor, but free samples may not be included. In some industries, significant free samples are used to help establish a new product, and this can have a big effect on royalties. If a licensor is expected to forego royalties on free samples then he may look to increase his return elsewhere in the agreement.
2. The agreement may allow for a stepped royalty, for example
- On sales under £100 million the royalty payable will be 10%.
- On sales between £100 million and £250 million the royalty payable will be 12%.
- On sales between £250 million and £500 million the royalty payable will be 14%.
- On sales over £500 million the royalty payable will be 16%.
The rationale for this arrangement between third parties is to provide an incentive to the licensee and a reward to the licensor if the product is very successful. For smaller levels of sales, the licensee pays a smaller royalty, helping them to build up their business. The decision on what royalty rates to use, and on which level of sales will depend on the overall result both parties want to achieve at arm’s length.
3. Some licence agreements will provide for a minimum royalty; so whatever the level of sales achieved to customers, the licensor will always receive a guaranteed payment each year. The taxpayer may argue that at arm’s length, a licensor would accept a lower royalty rate, in return for a guaranteed minimum royalty. While this may happen between third parties, it will be influenced by a number of factors and there are likely to be situations where it is unlikely, particularly where the licensor is bargaining from a position of strength (for example because of its size and the nature of the intangible being licensed). Consider any such agreement between connected parties critically, and scrutinise forecasts to see how the minimum payment compares with expected sales.
4. There may be cross-licence agreements. These are somewhat similar to a joint venture or a cost-sharing arrangement. Under such agreements, both parties own valuable intangibles, which they agree to licence to each other. Third parties might do this if they each expected to derive more or less the same benefits from the outset.
5. As well as royalties, a licence agreement may include an up-front payment. This will have an effect on the overall royalty rate. The difference will depend on how long the licence agreement is for and how the overall profit is to be split. An up front payment of £5 million is going to be worth more to a licensor than an anticipated flow of royalties totalling £5 million over say a period of 5 years.
6. Always consider all of the factors surrounding any licence agreement and consider whether third parties would have entered into the arrangements.
Granting a licence agreement enables the owner of the valuable intangibles to spread the risk of exploiting them. If someone else is going to manufacture and market the products on which the intangibles are based, they stand to incur losses if the products under-perform. Conversely if the products sell well, the licensee stands to share in the reward (although his share of the reward will depend on his risk and function).
However, the owner of the valuable intangibles may decide they want a much larger degree of involvement in exploiting those intangibles. An alternative to a licence agreement for some activities is to outsource functions necessary for the exploitation of the intangibles by way of a contract. For example, a third party may decide to outsource the manufacturing of the products and engage a contract manufacturer to make a set number. A third party distributor might be used where sales are likely to be relatively small and it is economically unviable for the intangible owner to set up their own distribution infrastructure, or where because of regulatory reasons there needs to be an independent co-marketer.
A MNE will be able to split functions between legal and geographic entities in ways that independents would be unlikely to adopt. The pricing of transactions between group entities still has to be that which would have been adopted by third parties. Any claims that a business is low risk should be scrutinised critically.
The intangible owner can enter into a joint venture. This generally happens in a meeting of apparent equals. The joint venture may involve limited activities, such as pooling research and development, or manufacturing. It may encompass all the activities related to a particular range of products. Joint venture agreements will split the proceeds based on what each party puts in - it will not necessarily be a 50/50 split. The transfer pricing requirements of TIOPA10/Part 4 will apply in where the JV has two 40% or more shareholders (see Section 160 TIOPA10 and the guidance at INTM412060) in respect of transactions between the joint venture company and any 40% shareholder.
Collaboration agreements are a form of joint venture, and are encountered in particular industries that traditionally spend large amounts on research and development; the pharmaceutical and high-tech industries are particular examples. A collaboration agreement may be the meeting of two unequal parties. The smaller partner will generally have some promising product, process or research that they have not got either the money or infrastructure to develop and market. The larger partner can provide cash, assistance and a route to the market.
Different levels of collaboration agreement may be seen between third parties. In the pharmaceutical industry, for example, universities enter into agreements with biotech companies, who in turn will enter into agreements with large multinationals.
The payment structure tends to follow a set pattern. The smaller partner will have a promising idea or product, but little or no turnover to generate the cash necessary to exploit it. Under a collaboration agreement, the smaller partner will often receive a series of milestone payments - usually an amount of cash when the agreement is signed, followed by a series of payments at different stages of the product development (for example, another tranche of cash when a working prototype is produced, and a further sum when the product is approved for the market).
However the smaller partner would be unlikely to lose sight of the fact that their product may ultimately be sold around the world, producing sales in the hundreds of millions. They will want a share of this. Hence collaboration agreements usually include a royalty to be paid by the larger partner on any eventual sales of the product.
In some cases the owner of the intangibles may decide to pick a partner to co-promote a product. This may be because they have a limited presence in the partner’s country or territory. It may be because they are required to use a co-promoter for regulatory reasons. The co-promotion may take the form of a licence agreement, or may be some form of more limited agreement.