Trademark in Transfer Pricing – how to determine an arm’s length royalty rate?

What happens when a trademark is owned by a shareholder and the company uses it in its business?

This model is not unusual. From a transfer pricing perspective, however, it raises questions about the terms on which the company uses the trademark and the remuneration payable to its owner.

Is a benchmarking analysis enough to establish an arm’s length royalty rate?

Not necessarily.

Two trademark licences may appear similar at first glance while justifying different levels of remuneration. Differences may arise not only from the nature of the brand itself, but also from the scope of rights granted to the licensee, the way in which the trademark is used, and the functions performed and risks assumed by the parties.

Therefore, the mere presence of similar transactions in a benchmarking analysis does not, in itself, determine the appropriate royalty rate. It is necessary to assess whether the comparable transactions are genuinely comparable to the licence being analysed and whether any differences could affect the level of remuneration.

Comparability of transactions – why is a benchmark alone not enough?

Not every trademark licence agreement will provide an appropriate reference point for the transaction under review. The fact that the licensed asset is the same type of intangible does not, in itself, establish comparability.

Relevant factors may include the market in which the trademark is used, the market position of the brand, the term of the licence, the method used to calculate the remuneration and whether the licence is exclusive. Differences in these elements may affect the level of the royalty.

For example, two agreements may concern trademarks operating in the same industry but differ in the scope of rights granted to the licensee, territory, term or manner in which the brand is used. Such differences may have a direct impact on the level of remuneration.

Who actually invests in developing the brand?

When comes to a trademark, particular importance should also be given to the extent to which the parties contribute to building and enhancing its value.

A company using the trademark may not only pay for the right to use it, but may also incur costs associated with increasing brand recognition and developing the brand. Where such activities are significant to the functioning and value of the brand, they should be taken into account when assessing the licence terms and the level of the royalty.

This does not automatically mean that the royalty should be reduced. What matters is whether the company’s involvement and the expenditure it incurs on promoting and developing the brand are reflected in the licence terms and the remuneration paid for the use of the trademark.

In practice, this means that particular importance should be given to analysing the actual conduct of the parties, rather than relying solely on the formal provisions of the licence agreement.

Does the licensee’s profitability affect the royalty rate?

Determining an arm’s length royalty rate does not mean that its impact on the profitability of the company using the trademark can be disregarded entirely.

If the trademark royalty represents a significant operating cost and affects the company’s profitability, its level may require further analysis.

However, a loss or low profitability of the licensee does not automatically mean that the royalty is not at arm’s length. It may nevertheless be a signal to verify whether the licence terms reflect the economic circumstances of the parties and whether an independent party would have accepted comparable terms.

It should also not be assumed that there is a single “appropriate” level of profitability that automatically determines the royalty rate.

The key question remains whether the terms of the transaction are consistent with the arm’s length principle.

Main findings

In the case of a trademark, a transfer pricing analysis should not be limited to a single question: “What is the arm’s length royalty rate?”

The starting point should be a broader question: What licence terms would independent parties in a comparable situation have agreed to?

This question provides the basis for assessing the appropriate level of remuneration.

The arm’s length royalty rate should be determined in the context of the actual terms of the transaction, the scope of rights granted to the licensee and the functions performed, assets used and risks assumed by the parties.

Therefore, a properly conducted analysis of a trademark licence fee should combine an economic analysis of the transaction with an assessment of the comparability of the data used to determine the level of remuneration.

Key takeaways

• A benchmark does not, in itself, determine the arm’s length royalty rate.
• The comparability of transactions should take into account the actual terms of the licence.
• Expenditure on brand development and promotion may be relevant when assessing the remuneration.
• The licensee’s profitability may be a factor considered in the analysis, but does not automatically determine the royalty rate.
• The key consideration is whether the overall terms of the transaction comply with the arm’s length principle.