When intangibles are sold, tax laws in most countries require that the developer/owner receive the fair market value of the intangible at the time of transfer. The geographic rights to the property that is sold can be broad or narrow. For example, the developer may sell the North American rights to the property. Alternatively, the developer may sell the worldwide rights for uses other than for the use that it wishes to keep for itself.
For example, in the pharmaceutical industry, the developer may keep the rights for human use while selling the rights for animal use.
Once the sale has taken place, the party that purchased the intangible is the legal owner of the property and is entitled to receive any third-party or related-party royalties that accrue to the property. The owner also has the right to sublicence or dispose of the property.
515. Licence
The typical method of transferring intangible rights between related parties is through the use of an exclusive or a non-exclusive licence agreement. When a licence is used, the developer continues to own the property and can dispose of it as she/he see fit.
The rights given to the licensee may vary. In general, the licence is evidenced by a document specifying the terms of the licence. The key terms of a licence are likely to include the following:
• The geographic rights the licensee is granted;
• The length of time for which the licensee may use the property;
• The uses to which the licensee may put the property;
• The exclusivity of the licence (i.e. exclusive or non-exclusive and the basis of exclusivity);
• The amount and type of technical assistance that the licensee may receive from the licensor (together with fees for assistance above that which is provided as part of the licence);
• The royalty rate, method of computing the royalties and the timing of payments; and
• Whether the licensee has sublicensing rights.
It is important that licence arrangements be committed to writing. It should also be noted that several of the points listed above play a significant role in the determination of the royalty rate. For example, an exclusive licence typically carries a royalty rate significantly higher than a non-exclusive licence. Broader geographic rights may result in a higher royalty rate, although this is not always the case.
516. Determination of arm’s-length royalty rates
Determining the proper compensation due to the developer/owner of intangible property can be difficult. In setting an arm’s-length royalty rate it is important to distinguish, as precisely as possible, what property is to be licensed. Once the property is identified, the rights granted to the licensee and their relative value is determined.
The property may be an ordinary intangible in that it provides some, though not complete, protection from competitors (this type of intangible is sometimes referred to as a typical or a routine intangible). Alternatively, it may constitute a super-intangible, which effectively gives the licensee a monopoly or near-monopoly over the market in question. There is no difference in the approach to setting an arm’s-length royalty, however. The concept of super-intangibles is mentioned here for completeness only.
It arose following the 1986 Tax Reform Act in the US. One of the key issues included was a requirement that the licence income to be enjoyed by a licensor in the US from an overseas affiliate should be “commensurate with the income” associated with the intangible. There was concern that insufficient royalty income was being derived from
US intangibles that proved to be valuable after being licensed overseas. There was considerable concern outside the US that excessive use has to be made of hindsight in this area.
The optimal method for determining an arm’s-length royalty is to refer to licences between unrelated parties under which identical property has been transferred. Such licences can be identified where the developer has licensed a third party to use the technology under terms identical or similar to those granted to the related party, or where the inter-company licensor has received the technology from a third party. If such a licence agreement is identified, adjustments can be made for differences in terms in order to determine an inter-company, arm’s-length royalty rate.
Example
Abbra Cadabbra AG (ACAG), a German company, has developed a method of removing grass stains from clothing, which does not also remove the colour from the cloth. It has obtained a patent on its invention and is manufacturing the product for sale in the German market. It has recently decided to establish a manufacturing affiliate in Ireland, where it will benefit from a favourable low-tax regime for the earnings of the Irish subsidiary.
The Irish subsidiary will manufacture the product for resale throughout Europe.
ACAG wishes to maximise the income that it places in Ireland. Therefore, it is taking all steps necessary to ensure that the Irish subsidiary is a full-fledged manufacturer.
To this end, it has decided to licence the patent and related technical know-how to the Irish subsidiary.
It will grant the Irish subsidiary an exclusive licence to make, use and sell the product in all European markets. A written agreement is drawn up containing all the relevant terms. The remaining issue is to determine an arm’s-length royalty.
Assume that ACAG licensed ZapAway Inc., an independent US company, to make, use and sell the product in North America. The technology provided to ZapAway is identical to the technology licensed to ACAG’s Irish subsidiary. Both licences are granted for the life of the patent and both provide for 20 workdays of technical assistance in implementing the technology. The only significant difference between the two licence agreements is that the third-party licence gives the licensee the rights within North America and the related-party licence grants the licensee the rights to European markets.
The question that must be addressed is whether the North American and European markets are economically similar so that the royalty rate applied to the North American licence would be expected to be the same as the royalty rate for the European licence.
The economics of the two markets must be examined in order to answer this question.
In general, if the differences are small, then the third-party licence should form the basis for the related-party royalty rate. If significant differences exist, adjustments can be made to account for them so long as they can be valued. The underlying question here, of course, is that both licensor and licensee, at arm’s length, give thought to the profit potential of the intangible when arguing a royalty rate. If markets are different from one another, potential investment returns will also differ and hence the acceptable royalty rate.
517. Determining an arm’s-length royalty rate in the absence of perfect comparables
If a perfect comparable does not exist (a common occurrence), then licence agreements between unrelated parties for economically similar technology may be used to determine the appropriate inter-company royalty rate. Typically, this is done by reference to third-party licences within the industry.
Example
Assume that the ZapAway agreement (see section 516) does not exist (i.e. ACAG does not licence the property to any third party). However, another competitor licences a similar product (another grass stain remover) to a third party. This licence agreement is subjected to the same analysis discussed in section 516. If the differences do not affect the royalty rate or can be valued, then this third-party licence arrangement can be used as a basis for the determination of the arm’s-length royalty between ACAG and its Irish subsidiary.
In a situation where no comparables exist, it is possible to impute a royalty rate by reference to the factors that unrelated parties would consider in negotiating royalty rates. For example:
• The expected profits attributable to the technology;
• The cost of developing the technology;
• The degree of protection provided under the terms of the licence as well as the length of time the protection is expected to exist;
• The terms of the transfer, including limitations on geographic area covered; and
• The uniqueness of the property.