Transfer pricing: risk assessment: transfer pricing risk indicators: payment of royalties
Royalties are recurring payments under a licence agreement allowing the licensee to make use of an asset belonging to the licensor. Royalty agreements can relate to many different types of asset, both tangible and intangible. For instance, the licensee might pay a royalty in return for the rights to manufacture or market particular goods or to make use of a patent or trademark belonging to the licensor.
There is a more detailed discussion about royalties at INTM440180 but at the risk assessment stage an issue to consider is how much profit the licensee company is paying away under the royalty agreement, especially where the royalties are reducing the net profits to a negligible level. It can be worthwhile looking at the results for a number of years and adding back the royalties to come to a figure of pre-royalty operating profit (‘PROP’). The royalties as a proportion of PROP can then be calculated. If a large amount of the PROP is being paid away as royalties then potentially the company may be under-rewarded, but case teams should note there are no set proportions.
A royalty rate at arm’s length will reflect many factors, including the value of the asset in question, the market sector in which the business operates, the company’s position in respect of its competitors and the overall profit potential of the enterprise. For these reasons, it is not possible to risk assess by using rules of thumb or averages and each case must be looked at on its own facts and circumstances. These examples show the importance of this approach:
- A service industry company may also charge a royalty for the use of its trademark and logo. Consider whether the royalty means a premium price can be charged for the services and, if so, whether the value lies with the name or the people supplying the service. It should not automatically be assumed that all goodwill in a business can be ascribed to the trademark.
- A sudden increase in royalties payable (or decrease in the case of royalties received) may well be the result of the group carrying out regular checks of its licence agreements. However, the change might also be the result of another tax authority reviewing the royalty rate and the group deciding to accept the arguments raised by that other authority. On an examination of the facts, the change might not be justified. If a group has changed a royalty rate to satisfy the concerns of another country’s tax authority, this does not prevent HMRC from making enquiries about the transfer price (see the guidance on Mutual Agreement Procedure at INTM423000 onwards).