Intellectual property (“IP”) owners will sometimes license the use of their assets to others in exchange for a fee. For example, Liam Neeson may choose to offer his name to a company that plans to market its new kidnapping escape kit in exchange for a royalty fee of 5% of the revenue the company generates from the sale of the kits. This (highly unlikely) hypothetical example involves the licensing of a celebrity name, but there are other types of IP (e.g., tradenames, trademarks, patents, technology, etc.) that are often authorized to other parties for a fee.
In these instances and others, a company may set up a separate holding company to manage its IP. The holding company then licenses the use of the IP to the operating subsidiaries of the company in exchange for a royalty. The operating subsidiaries receive a tax deduction when paying the royalty and the holding company is normally based in a more favorable tax jurisdiction compared to the operating subsidiaries. In order to comply with U.S. transfer pricing regulations, however, the client must utilize a royalty rate that is determined to be consistent with the “arm’s-length principle,”1 a process that can involve reviewing licensing agreements between third parties involving relatively similar IP.
Our firm has access to various databases that provide information on licensing agreements, data from which can be utilized in the valuation of IP for financial reporting purposes. The Relief-from-Royalty Method, a form of the Income Approach to valuation, calculates the value of an IP asset as the amount that a company saves by owning the IP instead of licensing the use of the IP from a third party. An applicable royalty rate is multiplied by the future sales expected to be generated by the IP asset; these future royalty savings are discounted to the present day to determine the value of the IP. The applicable royalty rate is normally based on an analysis of third-party licensing agreements for similar property.
Schneider Downs has significant experience in determining the appropriate royalty rate for clients to use in transfer pricing and financial reporting applications. Please contact Steve Thimons (412-697-5281; [email protected]) or Thomas D. Pratt (412-697-5615; [email protected]) of our office if you need assistance valuing or determining royalty rates applicable to your IP.
1 Although a discussion of details of the arm’s-length principle is beyond the scope of this article, the principle generally states that the royalty charged from one related party to another for a given transaction must be the same as if the parties were not related.
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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.