Transfer Pricing: Types of transactions: Intangibles: Establising an arm's length price for valuable Intangibles: Uncertainty in valuation
Difficulty in valuation of intangibles
The nature of intangibles means that it is frequently difficult to have any certainty as to their value at any particular time.
A fixed rate royalty does, of course, adjust the amount payable to the transferor (licensor) by the transferee (licensee). However, royalties are usually, for reasons of practical administration, charged as a percentage of the sales derived by the licensee from its activities which include use of the intangible. This acts as a proxy for the profits attributable to use of that intangible, but will frequently produce an inappropriate result where sales differ significantly from those anticipated when the royalty rate was agreed due, in particular, to variations between the fixed and variable costs incurred by the licensee.
Consequently at arm’s length some form of contingent payment mechanism might be used where it is considered that the benefits from use of the intangible are so uncertain that a single one-off payment or a fixed rate royalty is inappropriate.
Various approaches might be taken to address or mitigate the impact of the uncertainty including:
- a variable or stepped royalty rate
- additional payments to be made upon the occurrence of specific events
- clauses within the agreement between the parties that provide for re-negotiation of the terms of the agreement if specific events occur