INTM467160 - Establishing the arm's length price: gathering your own evidence - Establishing an arm’s length price for valuable intangible property
Establishing an arm’s length price for transactions involving intangibles is difficult. There are a number of points you will need to consider
Is the intangible property actually worth anything?
All businesses own intangible property, which can take many forms. Some of it is very valuable, such as a new drug that effectively treats a medical condition that has formerly been untreatable, or a valuable brand name such as Coca Cola. Some intangible property will be worthless. Some intangible property may once have been revolutionary and very valuable, but now has only minimal value, such as the technology used to make Betamax video machines.
The different types of intangibles are considered in more detail in INTM464070. Valuation of intangibles is a genuinely difficult area. Start by considering the following fundamental points:
- What is being paid for?
- Is it likely that these things would be paid for at arm’s length?
- Why would an independent pay this amount?
- How does the amount of the payment affect the level of profits enjoyed by each party?
- Is the level of profits accruing in each party what you would expect to see between independents?
- Is the company paying for something it has helped to create in the first place?
Consider a few examples of different types of intangible property and expenditure that may create an intangible that an independent would or would not be prepared to pay to use:
- A brand which has widespread recognition can generate both volume of sales and premium prices.
- A patent which will provide the exclusive right to exploit a particular process or invention for a set period. This may lead to a new drug with no competitors, or perhaps a widget in a can of beer to produce the effect that it has been pulled from a pump. During the period of patent protection the company can market the product in the knowledge that there may be no direct competitor in key markets. The company can both generate volume of sales and may be able to charge a high price.
- A large multinational with a number of retail stores in a number of countries sets up a subsidiary in the UK (where there was no presence previously), which then establishes retail stores across the country. The group sells a small range of its own products, but in the main sells branded goods. The parent charges the subsidiary a royalty for using the group name. At arm’s length a company is not going to pay for the use of a name that has no or very little recognition in the UK.
- A new bespoke computer system for a group helps streamline and rationalise business activities. While it might deliver tangible benefits to members of the group, the expenditure doesn’t necessarily create an intangible asset that an independent would pay a royalty for. A recharge of the costs of commissioning the system from the (independent) contractor would be more appropriate.
- A company engages a firm of consultants to advise on establishing an overall theme and set of values by which the company and its employees will operate, both internally and with its customers. While this may have some indirect benefits it would be very difficult to try and put a value on any intangibles created. Would a third party pay for such an intangible?
There will be situations where although an intangible asset may be identified, it is very unlikely that anyone would want to pay for it. Alternatively, part of the group may own intangibles that are so key to the business that they would not be licensed or, if they were to be licensed out at arm’s length, the form of the license would be markedly different.
Is the company name worth anything?
You will sometimes see charges for the use of a company name.
First of all you must identify the company name and/or logos and brands owned by that company. A company may own a large range of brands. A brand will usually consist of the product (or service) itself, the brand name together with probably an associated logo or trademark and the 'packaging' for the brand (e.g. a drink may be presented in a particular style of bottle). The brand may have nothing that immediately visibly connects it with the company. A brand introduced to a new market may well have no value there, even if it is well known in other countries.
By contrast, an enterprise may promote its services or products predominantly by using its company name and logo, or may promote its brands predominantly through the use of its name and logo.
MNEs develop their names and reputations though a variety of means. It may be through the exceptional high quality of the products an MNE makes and sells - customers will have a perception that whatever the company produces will be high quality and worth paying more for. The MNE may have developed a monopoly or cornered a significant proportion of the market and so can charge high prices for its products or services. Alternatively the MNE may invest very heavily in marketing itself so customers will associate them with particular products or services.
Always take care to clarify what activity generates the profits: marketing or innate quality of product. This will lead to an informed view of what the arm’s length reward for an activity would be.
Who the customer is will reflect why a brand has value. Consumer brands and company names are generally promoted to attract 'high street' customers. A commercial organisation on the other hand may not be interested - they will be concentrating on the product or service that is being sold to them. An associated enterprise should only be charged for use of the company name if the group can demonstrate that the name adds value, either by allowing a premium price to be charged or being able to secure a definite advantage in obtaining and maintaining market share. You have to consider whether a charge would exist from the perspective of the user of the name, as well as the owner.
This might be demonstrated in a case where there are associated marketing intangibles and clear business benefits linked with the name, and the product clearly bears the company name or logo.
In some cases a charge might not be appropriate as an associated enterprise is merely obtaining the incidental benefit of belonging to a large MNE. In other cases there may be legal issues concerned with ownership of a name and/or logo. If for example a subsidiary of a large MNE has been using the company name and logo for 20 years, and a charge is then introduced, it is possible that if the parties were independent, the subsidiary would be able to challenge any payment. Alternatively the value the name may have been built up by the efforts of the subsidiary.
If a charge is appropriate, check that there is not already a charge for the name through the transfer price of goods or services.
OECD Transfer Pricing Guidelines - comments on valuation of intangibles
The OECD Transfer Pricing Guidelines devote a complete chapter to intangibles (Chapter 6), recognising that transactions involving intangibles are hard to value for tax purposes. As well as looking at different types of intangible property, the Guidelines also offer advice on how to establish an arm's length price on transactions involving intangibles.
The Guidelines state that you must take account of both parties to the transaction. Applying the arm's length principle to the owner of the intangibles means looking at the price an independent would be prepared to accept for carrying out the transaction. From the point of view of the person paying to use the intangibles, an independent party acting at arm's length would consider the value and usefulness of the intangibles to their business when deciding what price they would be prepared to pay. It is not a case of 'one size fits all' - one person may be prepared to pay more than another, if they think they can derive more benefit from using the intangibles.
Paragraphs 6.20 to 6.22 of the OECD Transfer Pricing Guidelines discuss the various factors you should consider when trying to establish a comparable price. They include the likely benefits to be derived from using the intangibles, the nature of the rights (particularly in relation to patents), the likely market and costs that will need to be incurred to manufacture and market the products that use those intangibles.
The application of the various OECD pricing methodologies is discussed at INTM463000 onwards:
- Comparable uncontrolled price - internal comparables, if available, may provide a suitable CUP. Agreements between independent parties can also provide a guide although access to such information may be difficult.
- Resale minus method - can be of use for pricing the sale of goods incorporating a trademark, or trade intangibles such as manufacturing know-how. Where intangible property transferred under licence to a connected party is sub-licensed to an independent party, a resale minus method can potentially be used to try and establish the price of that licence.
- Profit split - in cases involving highly valuable intangibles where no CUP is available a profit split method may be relevant, as other methodologies will be difficult to apply.
Establishing an arm's length price when the intangibles are owned by someone else
You are more likely to encounter cases where the intangibles in question are owned by someone else, but are being used by a group company in the UK. The most likely scenarios are the marketing of branded goods and the manufacture of products using intangibles such as patents and secret know-how, and the provision of services.
A company may be charged for using the intangibles in a number of ways. For example:
- Royalties may be payable under a licence agreement. This is more likely for a manufacturing business or a business providing services. You are less likely to see royalties paid by a distribution/marketing business or a business selling goods retail.
- Turnover-based fees, similar to royalties might be paid, perhaps by a business selling services (e.g. a hotel).
- The purchase price for branded goods. Businesses that distribute and/or market branded goods are likely to pay a premium price to the manufacturer. The brand owner may receive his reward in the form of royalties from the manufacturer.
Marketing of branded goods
In general terms, an independent will only pay to use something if he stands to benefit from using it. However, it is often undeniable that an affiliate is using, say, a brand name and at arm’s length if you use something owned by someone else you have to pay for it. What you pay, however, will very much depend on what the brand name is worth. This may of course be nothing if you can’t make profits from using it. Furthermore, if you have created or helped to create the brand value in the first place in your territory (through incurring marketing and advertising costs) this might affect the amount you were willing to pay to use the brand. An independent might be reluctant to create brand value in the first place if someone else owned the brand.
Carefully consider a situation where a company pays a royalty or a premium through the purchase price, for a consumer brand owned by an affiliate when the brand has value largely because of the efforts of the licensee in the first place. For example a foreign parent company registers a new brand name in a tax shelter. The brand is new and therefore has absolutely zero value. The UK subsidiary begins to manufacture and sells under the brand name. There is nothing particularly special about the products - only the brand name and packaging differentiates the product (as opposed to a product that has intrinsic value due to its quality). To promote sales the UK company incurs massive advertising and marketing expenditure. The products are a spectacular sales success. To maintain the sales the marketing expenditure is ongoing.
- Would a royalty be payable and at what point in time?
- Why would an independent pay a royalty to use something which initially has no value?
- Even when the brand begins to become valuable, why would an independent pay to use it when the value has been generated purely by its own endeavour?
- Why would an independent create a brand it didn’t own and take the risk that in the future the brand owner might prevent it from using the brand?
The brand owner would say that ownership entitled it to a reward because legally the brand belongs to it and someone else is using it. The answer is that in the real world the UK company would probably have used a brand of its own and not a brand owned by someone else.
You may encounter cases where despite heavy promotional expenditure, consumers have not taken to the brand and are not prepared to pay a premium price. If the licence agreement allowed the UK to potentially earn a significant proportion of the expected premium profit, and the business model looked reasonable, then you may consider that such arrangements were arm’s length when they were made. However, an independent would attempt to renegotiate as soon as it became apparent that losses were being made. If the brand has truly failed they would pull out. If it is clearly going to take longer to establish the brand then an independent distributor will expect the terms of his agreement to be modified to ensure he can start making some profits.
Example involving sale of branded products
The OECD Transfer Pricing Guidelines consider that a comparable uncontrolled price ('CUP') or a resale price method can be used to price the sale of goods that incorporate intangibles, typically branded goods. It may be difficult to obtain comparable material to provide evidence to produce models using these methods.
For example, a distributor, Bodgit & Scarper (Wicked Runners) Ltd, sells expensive trainers from the 'Pull Factor' branded range, aimed at the teenage market and selling for on average £100 a pair. The product cost much less to produce; this premium pricing can be attributable to brand value. The brand is widely recognised throughout the UK, due to heavy promotion and the connection with the Bodgit & Scarper name and logo, which is well known throughout the world. The brand has been cleverly promoted by the company, helped by the England cricket team's famous 5-0 winning test series in Australia the previous winter. The England team wore 'Pull Factor' trainers both on and off the field for the whole tour. The brand is owned by the parent company and the trainers are bought from a group company based in a tax shelter offering incentives for manufacturing enterprises. The results for Bodgit & Scarper (Wicked Runners) Ltd are shown in the table below.
| 2006 | 2007 | 2008 | 2009 | 2010 | |
| £’000 | £’000 | £’000 | £’000 | £’000 | |
| Sales | 50,000 | 80,000 | 110,000 | 130,000 | 140,000 |
| Cost of sales | 35,000 | 56,000 | 76,000 | 90,000 | 96,500 |
| Gross profit | 15,000 | 24,000 | 34,000 | 40,000 | 43,500 |
| GPR | 30.0% | 30.0% | 30.9% | 30.8% | 31.1% |
| Distribution | 750 | 1,500 | 2,500 | 3,000 | 3,500 |
| Promotion | 4,500 | 6,500 | 7,500 | 8,500 | 9,500 |
| Marketing and selling | 7,000 | 11,500 | 16,000 | 19,000 | 20,000 |
| Administration | 2,250 | 3,500 | 6,000 | 7,000 | 7,500 |
| Operating profit | 500 | 1,000 | 2,000 | 2,500 | 3,000 |
| OPR | 1.0% | 1.25% | 1.8% | 1.9% | 2.1% |
Are Bodgit & Scarper (Wicked Runners) Ltd making an arm’s length return? The company should be able to explain how it has set the transfer price. You are not convinced on this evidence that pricing is arm’s length.
The best way of testing the controlled price- the price and terms by which the company pays for the trainers - is to look for a comparable uncontrolled price (CUP). The best (and likely only) source will be internal comparables; is the Bodgit & Scarper group selling the same trainers to any independents in the same quantities, in similar markets, and under the same terms? While there may be cases where the group is selling to independents, the terms may be very different. For example, the trainers may be sold to a distributor which is not expected to support the brand. Unless adjustments can be made to account for this, it will not be of much use as a comparable.
An external CUP will involve finding an independent distributor, of the same size, selling the same volume of very similar trainers, aimed at the same teenage market. Obtaining this information will be extremely difficult: such an independent may not exist. Failing a CUP, for a distributor the best OECD method is resale price as this looks at the actual transactions that need to be compared. As Bodgit & Scarper (Wicked Runners) Ltd are selling branded goods, and are actively promoting those goods then you need to look for independent companies selling and promoting similar numbers of similar branded trainers to the same teenage market. The best information on likely competitors will be Bodgit & Scarper (Wicked Runners) Ltd - they will probably have marketing data on their chief competitors. The marketing team may well have information about how competitors’ brands are being promoted (for example, they may turn up to the same trade fairs, advertise in the same trade journals, etc). Some, if not all of these, will be subsidiaries of other groups, but you might find an independent. One good comparable is better than a number of other independent companies who are markedly different in ways which would affect price (e.g. distributor of other types of branded goods, distributor in another country, significantly different levels of turnover, etc.).
The group has provided data on 16 companies who sell branded goods, which show that between 2006 and 2010, an inter-quartile range of between 1% and 3% net margin. Only reliable data on five companies was available to provide information on gross margins, so a transactional net margin method ('TNMM') method was chosen. A detailed examination (including looking at the web-sites of the comparable companies) reveals that:
- Two of the companies are making continual losses.
- Thirteen of the companies are in other European countries.
- Nine of the companies have a turnover of less than £5 million.
- Only four of the companies just sell footwear.
- Five of the companies sold other non-branded, or minor league branded goods.
- One of the companies sells kitchens.
- Three of the companies sell goods retail.
- Three companies were not independent during the review years.
- You find an additional company which did not show up on the search carried out by the group.
You conclude that there are two companies which are properly comparable (one of which was a new find). Both are UK independents distributing branded footwear, with turnover of between £30 million and £75 million. Both promote well-known brands in the UK and both are known to Bodgit & Scarper (Wicked Runners) Ltd, who agree they are competitors. Financial reviews of both companies reveal sufficient data to be able to compare gross margins.
Although there are only two companies, they are much better comparables. It is far better to use the two exact comparables as opposed to any number of inexact ones.
Adjustments are proposed as follows, using the average gross margin of the two comparable companies for each year being reviewed:
| 2006 | 2007 | 2008 | 2009 | 2010 | |
| £’000 | £’000 | £’000 | £’000 | £’000 | |
| Bodgit Sales | 50,000 | 80,000 | 110,000 | 130,000 | 140,000 |
| Bodgit GPR | 30.0% | 30.0% | 30.9% | 30.8% | 31.1% |
| Average GPR of comparable companies | 34.2% | 33.9% | 34.7% | 34.5% | 35.0% |
| Bodgit gross margin | 15,000 | 24,000 | 34,000 | 40,000 | 43,500 |
| Adjusted gross margin | 17,100 | 27,120 | 38,170 | 44,850 | 49,000 |
| Operating profit | 500 | 1,000 | 2,000 | 2,500 | 3,000 |
| OPR | 1.0% | 1.25% | 1.8% | 1.9% | 2.1% |
| Adjusted op. Profit | 2,600 | 4,120 | 6,170 | 7,350 | 8,500 |
| Adjusted OPR | 5.2% | 5.1% | 5.6% | 5.7% | 6.1% |
Assume instead that there was insufficient data on the two comparable companies to produce a resale price model. In this case, then the net margin results of the two comparable companies might be a better comparable to establish the arm’s length margin.
What if you can’t find comparable companies who sell and promote branded trainers? The OECD Guidelines suggest that, in this situation, one way of establishing the arm’s length price is to look at independent distributors which sell unbranded trainers. If the difference between the two is only the existence of the brand, it might be possible to make adjustments to the comparable so it can be used to establish the arm's length price for the controlled provision. Alternatively, you could consider companies that are functionally similar even though they sell different products.
Consider the information from the table below, which is the summary for Soleless Shoes Ltd, a distributor of shoes (including athletic footwear) throughout the UK, which started trading at around the same time as Bodgit & Scarper (Wicked Runners) Ltd. While some branded shoes are sold, these are less successful consumer brands.
| 2006 | 2007 | 2008 | 2009 | 2010 | |
| £’000 | £’000 | £’000 | £’000 | £’000 | |
| Sales | 70,000 | 75,000 | 80,000 | 85,000 | 90,000 |
| Cost of sales | 52,000 | 55,000 | 61,000 | 63,000 | 67,000 |
| Gross profit | 18,000 | 20,000 | 19,000 | 22,000 | 23,000 |
| GPR | 25.7% | 26.7% | 23.8% | 25.9% | 25.6% |
| Distribution | 2,500 | 2,750 | 2,800 | 3,200 | 3,400 |
| Marketing and selling | 9,000 | 10,000 | 9,500 | 11,000 | 11,500 |
| Administration | 5,000 | 5,250 | 5,200 | 5,600 | 6,100 |
| Operating profit | 1,500 | 2,000 | 1,500 | 2,200 | 2,000 |
| OPR | 2.1% | 2.7% | 1.9% | 2.6% | 2.2% |
So Soleless Shoes Ltd makes on average a gross margin of 25.5% and an average operating margin of 2.3%. By contrast Bodgit & Scarper are making an average gross margin of 30.6% and an average operating margin of 1.6%.
The key issue here is whether you can make adjustments to the results of Soleless Shoes Ltd to produce a good comparable. Here it is unlikely.
The gross margins for Bodgit & Scarper are higher and so the company may argue that the price charged by the manufacturer is clearly arm’s length - in fact they are paying too much. However there may be a reason why the gross margins would be higher; remember they are selling expensive premium trainers. Gross margins may be different for branded and unbranded goods.
Consider the example below which shows mini profit and loss accounts for the manufacturer, distributor and retailer for two pairs of trainers, one branded which sells in the shops for £100, the other unbranded which sells for £60. Both cost the same to manufacture - the manufacturer pays a 15% (calculated on recommended retail price) royalty on the branded trainers. If a distributor sells both trainers and makes the same gross margin rate of 30% on each, then the distributor will be unlikely to make sufficient margin to cover the additional promotional costs he will incur on the branded trainers. The manufacturer will instead be earning the profits that might at arm’s length accrue to the distributor. The example demonstrates that gross margins may well be different in this type of scenario and that it may not appropriate to take the gross margins made by Soleless Shoes Ltd as a comparable for a resale price model.
The dynamics in a real case will be very complex. Branded goods might be higher in quality or incorporate novel or patented features and so cost more to manufacture. There are promotional costs and brand maintenance costs. Retail costs may be higher (e.g. selling goods from a prestigious high street location). The costs of manufacturing, marketing and selling branded goods might be higher at all points along the chain than for unbranded goods. The profit potential is higher for branded goods, but the premium element of the profit will be shared along the chain. Some will be due more of a share than others, though.
In this case Bodgit & Scarper (Wicked Runners) Ltd are earning lower net margins than Soleless Shoes Ltd, yet undertake additional promotional activities. At present you know very little about what goes in the Bodgit & Scarper supply chain below the distributor. The trainers are manufactured by a group company in a tax shelter and it is possible that the manufacturer, whilst likely paying royalties to the parent company, is also making in excess of an arm’s length profit.
You establish that the group manufacturer is making average operating profits of 10% and the parent company receives royalties from the manufacturer which roughly equates to 6% of the sale price charged by Bodgit & Scarper (Wicked Runners) Ltd. For example in 2006, Bodgit & Scarper (Wicked Runners) Ltd makes a profit of £2 million, the manufacturer makes a profit of £7.6 million (£76 million sales of goods to the UK, at 10% operating margin) and the parent company receives a royalty of £6.6 million. This shows that while everyone in the Bodgit & Scarper group is making a profit on the trainers, Bodgit & Scarper (Wicked Runners) Ltd is not doing as well as others.
A large pool of profit clearly exists. You have to review how this would accrue between independents.
The 'premium' element of the profit on branded goods might be earned at arm’s length by the person who has economic ownership of the marketing intangibles associated with the brand. These intangibles might include such things as the brand name, logos, trademarks, marketing strategy, customer lists, etc. It is possible for one person to own some of the marketing intangibles and another person to own the remaining intangibles.
The parent company own the significant marketing intangible in this case - the brand name, but Bodgit & Scarper (Wicked Runners) Ltd have clearly been building up and maintaining the brand. They have incurred significant promotional expenditure and may have built up an efficient, well-motivated marketing organisation.
Expenditure on building up and maintaining a brand does not generally give any rights to legal ownership of marketing intangibles such as the brand name or logos. However, intellectual property law is complicated, and different laws apply to different types of intangible. It is possible for someone to lay claim to certain intangible property if the legal owner has done nothing to maintain those intangible rights.
Bodgit & Scarper (Wicked Runners) Ltd may not own the brand name. But it may own other marketing intangibles and it is also spending large sums each year promoting the brand. A third party would expect a reward for this endeavour. Creating a brand may be relatively inexpensive. Building up brand awareness and maintaining the brand is much more expensive and involves recurrent expenditure year on year. Some brands have a long shelf life, e.g. Coca-Cola. Other brands have a more limited life span. Some brands may endure, but particular products marketed using the brand name may only last a year or two. While it might not own key marketing intangibles, an independent would certainly expect to share in the potential rewards if it is obliged to spend large sums of money each year promoting a brand it has no legal ownership interest in. It will be conscious that the distribution agreement may not last, or that consumer appetite for the brand may wane.
What should the UK company expect in the way of reward? Between independents, brand support may take a number of forms such as
- A number of products will be provided free, to help break into the market.
- Products may be discounted.
- Particular promotional expenditure might be reimbursed, or contributed to.
- Marketing material may be provided.
- Royalties (if payable under a licence agreement) may be reduced.
There may be a mix of incentives. Some are designed to provide reimbursement or contribution. Some are designed to allow additional profits to reflect the risks incurred in promoting the products. Replicating these commercial terms is not an easy task. Depending on the complexity of the case and the type of industry you may look to reflect the additional reward by discounting the purchases, or imputing a recharge for some of the promotional expenditure. You may want to try to replicate a number of different commercial terms.
Examine critically any claims that the distributor is a service provider, that it should recharge all of the promotional expenditure and earn a basic reward for the other activities it undertakes. If the company were merely an agent outsourcing all the promotional activity then this might be appropriate. Generally however, independent distributors who have to promote their products are more than just agents, and their licensing agreements will reflect this, although such agreements may oblige the licensor to contribute towards brand promotion and maintenance.
An independent may be prepared to incur significant promotional expenditure if there is a good chance that it will generate increased sales and profits. While it may be inappropriate to use Soleless Shoes as a basis for a comparable, we can use it as an example of the return an independent is making, without the risk of significant additional promotional expenditure. If Bodgit & Scarper (Wicked Runners) Ltd were independent, they would expect a return for promoting the brand. The company might expect a share of the higher profits margins that branded goods can generate.
There are at least two ways that this might be reflected between independents. The price charged by the manufacturer for the trainers can be reduced, increasing the company’s gross margin. Alternatively, Bodgit & Scarper (Wicked Runners) Ltd might expect contributions from its parent towards the promotional expenditure, particularly if there was significant expenditure on establishing the brand initially. In practice a combination of the two might apply. The difficulty lies in establishing what levels the discounts or contributions should be, to ensure the UK company earns an arm's length reward. It is very unlikely that any information on comparable provisions exists. The only possibility of CUPs for these types of transaction lies with internal comparable transactions.
Another possible solution might be to look at the profits being earned by other entities within the group. The brand is clearly producing significant profits for the group as a whole. This would suggest the brand is very successful. The parts of the group responsible for this success are likely to be Bodgit & Scarper (Wicked Runners) Ltd, through its marketing and promotion endeavours, and its parent through ownership of the brand. The manufacturer may be making good quality products, but the nature of the product does not suggest the use of valuable manufacturing intangibles.
Establishing what reward an independent manufacturer of branded trainers would expect to earn, could help demonstrate that within the Bodgit & Scarper group, the manufacturer is making excessive profits. After some more work on searching for independent comparable manufacturing companies, you conclude that on average, they earn a net margin of 5%. This suggests that in this case, the Bodgit & Scarper manufacturer should reduce the prices it charges Bodgit & Scarper (Wicked Runners) Ltd by one half (as it currently makes an average operating margin of 10%). This would produce the following results:
| 2006 | 2007 | 2008 | 2009 | 2010 | |
| £’000 | £’000 | £’000 | £’000 | £’000 | |
| Sales | 50,000 | 80,000 | 110,000 | 130,000 | 140,000 |
| Cost of sales | 35,000 | 56,000 | 76,000 | 90,000 | 96,500 |
| Reduction in price | (1,750) | (2,800) | (3,800) | (4,500) | (4,825) |
| Gross profit | 16,750 | 26,800 | 37,800 | 44,500 | 48,325 |
| Operating profit | 2,250 | 3,800 | 5,800 | 7,000 | 7,825 |
| OPR | 4.5% | 4.8% | 5.3% | 5.4% | 5.6% |
In this case the facts reveal that the manufacturer would at arm’s length support Bodgit & Scarper (Wicked Runners) Ltd (by discounting the products); the manufacturer appears to be making excessive non-arm’s length profit. At arm’s length, the manufacturer might provide a discount, even if he were not making excessive profits. However, in such a scenario you would need to consider carefully the full facts of the case.
The other method of increasing the profits of Bodgit & Scarper (Wicked Runners) Ltd to the arm’s length amount would be to consider contributions to marketing and promotional expenditure from the brand owner. This might be in addition to, or as well as, discounts from the manufacturer. At this point, you will probably have exhausted the chances of finding comparable transactions, unless there are internal CUPs for this type of expenditure. You will have to agree with the group what form of evidence might help determine the level of contributions an independent party would expect to receive. This will need to be informed by the benefits both parties would expect to receive at arm’s length, bearing in mind their respective risks and functions.
The following table of results shows a possible (illustrative) outcome whereby, as well as the discount on purchases, it is agreed that the brand owner, the parent company, will meet one third of the promotional expenditure.
| 2006 | 2007 | 2008 | 2009 | 2010 | |
| £’000 | £’000 | £’000 | £’000 | £’000 | |
| Sales | 50,000 | 80,000 | 110,000 | 130,000 | 140,000 |
| Cost of sales | 35,000 | 56,000 | 76,000 | 90,000 | 96,500 |
| Reduction in price | (1,750) | (2,800) | (3,800) | (4,500) | (4,825) |
| Gross profit | 16,750 | 26,800 | 37,800 | 44,500 | 48,325 |
| Contribution of 1/3 of promotional costs | 1,500 | 2,167 | 2,500 | 2,833 | 3,167 |
| Operating profit | 3,750 | 5,967 | 8,300 | 9,833 | 10,992 |
| OPR | 7.5% | 7.5% | 7.5% | 7.6% | 7.9% |
In this case Bodgit & Scarper (Wicked Runners) Ltd returned results showing profits in all years. Other cases you encounter involving the marketing and promotion of branded goods will have different features. There may be a royalty payable by the distributor, rather than the manufacturer. The company may be making significant losses, which outstrip the expenditure on brand promotion and maintenance. The company may be manufacturing and marketing/promoting the products. Whatever the situation you should consider what the distributor would have profited at arm’s length
Product line income statements
One of the difficulties when reviewing a controlled transaction, particularly when considering a profit split method, is isolating the transactions and establishing what functions add value along the product chain. You may be enquiring into a large company that manufactures and distributes a large number of products. You may, after consideration of the facts, decide to review the pricing of only the main products. It may be that different companies within the group carry out different activities.
A useful tool to help overcome these problems is a product line income statement. A product line income statement is a profit and loss account for a particular product showing how and by whom the profit is made (manufacturers, distributors, intangibles owner). It enables you to isolate the results of a particular product, and to compare the profits made by each link in the chain. A product line income statement can also be prepared on projected costs and profits.
A product line income statement may be called by other terms: if you explain to a taxpayer what is needed they may be able to help provide this information in a different way. This information will show where profits have accrued to function in the whole trade. You can then consider whether this is in accordance with the arm’s length principle.
Consider the example below, involving the group, Jolly Good Sounds Plc. The group is recognised worldwide as producing excellent audio equipment, and the brand name 'Jolly Good' has global recognition. One of their divisions is involved in the development, manufacture and marketing of recordable DVD players. The figures are illustrative only.
- The technology to make the players and the brand name is owned by the intangible owner, Jolly Good Sounds Plc.
- Sub-assembly manufacture is carried out in Singapore, by Jolly Good Incentives Pte Ltd, which has been granted a licence to manufacture and market the players. They also carry out process R & D, to try to increase quality and reduce manufacturing costs. Singapore pays a royalty to Jolly Good Sounds Plc, calculated at 5% of the sale price of the distributors (the in-market price).
- Finished goods manufacture is carried out in regional markets - for example, Jolly Good Packages GmbH carries out finished goods manufacture for the European region. All the regional finished goods manufacturers buy the sub-assembled products from Jolly Good Incentives Pte Ltd.
- Distribution is carried out in the local markets - for example Jolly Good Deals Inc distributes and markets the DVD players in the USA and Mexico. They develop and implement their own marketing strategies. All the DVD players are bought from the regional finished goods manufacturers, such as Jolly Good Packages GmbH.
- The results of the regional finished goods manufacturers have been aggregated, as have the results of the local distributors.
| Product line | External | Allocation | |
| income statement | sales and costs | of profits | |
| £'000 | £'000 | £'000 | |
| Jolly Good Deals | |||
| Distributors | |||
Sales |
1,000,000 | 1,000,000 | |
Cost of sales |
450,000 | ||
Gross profit |
550,000 | ||
Distribution |
50,000 | (50,000) | |
Marketing |
300,000 | (300,000) | |
Administration |
100,000 | (100,000) | |
Net profit |
100,000 | 100,000 | |
| Jolly Good Packages | |||
| Finished goods manufacturers | |||
Sales |
450,000 | ||
Costs of goods |
350,000 | ||
Raw materials |
25,000 | (25,000) | |
Factory costs |
50,000 | (50,000) | |
Gross profit |
25,000 | ||
Administration |
10,000 | (10,000) | |
Net profit |
15,000 | 15,000 | |
| Jolly Good Incentives Pte Ltd | |||
| Sub-assembly manufacturer | |||
Sales |
350,000 | ||
Raw materials |
60,000 | (60,000) | |
Factory costs |
80,000 | (80,000) | |
Gross profit |
210,000 | ||
Royalties |
50,000 | ||
R & D |
5,000 | (5,000) | |
Administration |
10,000 | (10,000) | |
Net profit |
145,000 | 145,000 | |
| Jolly Good Sounds Plc | |||
| Intangible owner | |||
Royalties |
50,000 | 50,000 | |
| System profit | 310,000 | 310,000 |
The product line income statement actually shows a mini profit and loss statement for each of the four distinct stages in the product chain, for the DVD players only. Jolly Good Sounds Plc does not have any costs as all the extensive, expensive R & D work was carried out in previous years. In practice there may be relatively small ongoing costs relating to protecting its intellectual property such as registering patents and renewing trademarks.
Jolly Good Sounds Plc will be incurring lots of other expenditure (e.g. R & D on new products). However this product line income statement is concerned only with expenditure associated with the DVD players.
The highlighted figures are the inter-group cross-border transactions that should be priced in accordance with the arm’s length principle. The figures in blue are the sales to the third party customers and all the external costs. Together they produce the system profit for the whole product supply chain. The figures in red show the individual profits made by the various companies that contribute to the supply chain. The total of these profits equals the overall system profit.
Profit split method
In cases where you need to establish the arm’s length price of transactions involving highly valuable and sometimes unique intangibles, the profit split method can be used in the absence of any comparable uncontrolled price. This may involve considering the transfer price for the grant of a licence agreement. There are two key steps involved:
- Calculating the reward the intangible holders should receive.
- Allocating that reward between the different types of intangibles that are used in manufacturing and marketing the products.
The foundation for the first step will often be a product line income statement. This should be based as far as possible on projected figures for sales and costs that were available at the time. You should refrain from using hindsight as you are looking to replicate what the negotiation process would be between two independent parties. This can potentially involve trying to estimate how a product is going to perform over a number of years.
In cases involving valuable and perhaps unique intangibles, independent parties are likely to be very wary of committing themselves to long term agreements, without some way of redressing any imbalances. A break clause (i.e. a review after a set period of time, with the option for the royalty to be increased or decreased, depending on performance so far), or stepped royalty agreement may be a realistic alternative to a ten or fifteen year agreement.
While you should try to avoid using hindsight to set the price, you should compare the actual results against the projections to see if there are major differences. If there are, this may highlight inadequacies in the forecast figures that potentially can be adjusted for. For example you may find that sales forecasts have been downgraded, expenditure has been overstated, the forecast sale price is significantly lower, etc. You should obtain as much information as you can about the original estimates, including:
- The source of the estimated figures.
- Details of assumptions made.
- Details of adjustments made.
- Details of how the projections have evolved (there may be a series of projections).
- Whether any other projections (not just limited to the products you are considering) were prepared at around the same time for other purposes - perhaps for a presentation to business analysts.
- Copies of all reports dealing with the viability or go ahead for any project involving the intangibles.
- Copies of any reports comparing locations and costings for the project.
- Copies of any reports to the board of directors or finance director.
You should call for evidence to support the credibility of contemporaneous projections.
Having agreed the forecast figures, the product line income statement can be constructed along the lines of the example in the previous section. Please note the figures and margins in this example are purely illustrative - they are set at particular rates to help demonstrate how the method works. The mini profit and loss accounts for each specific activity are shown again below:
| Jolly Good Deals | Jolly Good Packages | Jolly Good Incentives Pte Ltd | Jolly Good Sounds Plc | |
| Activity | Distributor | Finished goods manufacture | Sub-assembly manufacture | Intangibles owner |
| £’000 | £’000 | £’000 | £’000 | |
| Sales/Royalties | 1,000,000 | 450,000 | 350,000 | 50,000 |
| Cost of sales/goods | 450,000 | 350,000 | ||
| Raw material | 25,000 | 60,000 | ||
| Factory costs | 50,000 | 80,000 | ||
| Gross profit | 550,000 | 25,000 | 210,000 | |
| Distribution | 50,000 | |||
| Marketing | 300,000 | |||
| R & D | 5,000 | |||
| Royalties | 50,000 | |||
| Administration | 100,000 | 10,000 | 10,000 | |
| Net profit | 100,000 | 15,000 | 145,000 | 50,000 |
- This is a fairly high-level product income statement. It identifies the overall system profit and shows how it has been split between the various activities. It could be more detailed, providing further breakdowns of expenses and include information on balance sheet items such as capital expenditure, stock, debtors and creditors.
- The figures are probably only for one test year. It will be best to get multiple year data if possible. If a net present value model (see INTM467200) based on discounted cash flow models is being put together, you need to include figures for all years covered by the licence agreement.
- The information only shows one inter-group transaction involving the UK - the grant of the licence by Jolly Good Sounds Plc to Jolly Good Incentives Pte Ltd. There will be transactions between the UK distributor and the European regional finished goods manufacturer, Jolly Good Packages GmbH. However the key transaction here is the grant of the licence agreement. The licence agreement is for 10 years, by which time the technology will probably be redundant, the market is likely to be saturated and the prices (and profit margins) low. If this was a bargain between independents we might expect to see a break clause after the first few years.
- On examining the licence agreement you establish that
-
- It is an exclusive licence covering the whole world, entitling Jolly Good Incentives Pte Ltd to manufacture and market the DVD players. It can sub-licence to other group companies.
- The licence is for 10 years, with no break clause.
- Any liability for design fault lies with the parent company Jolly Good Sounds Plc.
- Any new intangibles developed by Jolly Good Incentives Pte Ltd remain the property of that company.
- On the information so far presented, there is no evidence that the transfer prices between Jolly Good Incentives Pte Ltd and the finished goods manufacturers or the distributors are not arm’s length. However in all cases, you should construct the profit-split model by applying the arm’s length principle to each cross-border transaction - otherwise the profit-split method is meaningless. It doesn’t matter where in the model the company you are interested in appears. In a deal between independents, the licensor would be concerned if the model effectively included sub-licences which showed some parties being unduly rewarded. Here, even though the transfer price between Singapore and the distributors may not be subject to enquiry, we would look to the model to ensure that Singapore pays a royalty to the parent on the basis that the margins being enjoyed by the distributors was set at an arm’s length rate. If this leaves Singapore with a shortfall, they can adjust the prices of their transactions with the distributors to compensate for this.
- Once you are satisfied that the figures in the product line income statement are as accurate as possible, you can start looking at the returns for the individual companies. The aim is to reward each company in the chain for the basic functions carried out; you do not at this stage reward any of the companies for intangibles it may own. This means you need to have a functional analysis covering each company, together with details of the intangibles owned by each that are relevant to the transactions in question. If you are looking at say two products out of a possible thirty a company owns, you will only be interested in the intangible rights that relate either solely to the two products under review, or relate to the company's operations as a whole.
In this case the following intangibles or possible source of intangibles have been identified
- The patents and manufacturing know-how relating to the manufacture of the DVD players belongs to Jolly Good Sounds Plc.
- The brand name, 'Jolly Good', is owned by Jolly Good Sounds Plc.
- Jolly Good Incentives Pte Ltd carries out R & D, which might potentially result in valuable intangibles.
- The distribution companies all develop their own marketing strategies, which might result in marketing intangibles. (You should always consider carefully whether marketing activity has actually created a valuable intangible. See INTM464070).
The other problem here is the potential number of companies as there may be a number of distribution and finished goods manufacturing companies. To carry out a complete exercise, you may need to look at the forecast figures for each individual company. For example, the product line income statement for the distributors may be made up as follows:
| US | Canada | Aus | Japan | UK | Germany | France | Total | |
| £'000 | £'000 | £'000 | £'000 | £'000 | £'000 | £'000 | £'000 | |
| Sales | 600,000 | 30,000 | 20,000 | 200,000 | 40,000 | 60,000 | 50,000 | 1,000,000 |
| Cost of sales | 240,000 | 16,200 | 10,000 | 96,000 | 24,000 | 34,800 | 29,000 | 450,000 |
| Gross profit | 360,000 | 13,800 | 10,000 | 104,000 | 16,000 | 25,200 | 21,000 | 550,000 |
| GPR | 60% | 46% | 50% | 52% | 40% | 42% | 42% | 55% |
| Distribution | 25,000 | 1,500 | 1,200 | 14,000 | 2,000 | 3,300 | 3,000 | 50,000 |
| Marketing | 200,000 | 8,000 | 6,000 | 56,000 | 8,000 | 12,000 | 10,000 | 300,000 |
| Administration | 60,000 | 3,000 | 2,000 | 20,000 | 4,000 | 6,000 | 5,000 | 100,000 |
| Net profit | 75,000 | 1,300 | 800 | 14,000 | 2,000 | 3,900 | 3,000 | 100,000 |
| NPR | 13% | 4% | 4% | 7% | 5% | 7% | 6% | 10% |
In this case the various countries show differing results, both at the gross margin and net margin level. You would need to consider the arm’s length margins for distributors of branded goods, by reference to searches for comparable independent companies in those countries. This is likely to be very difficult, unless Jolly Good Sounds Plc itself has commissioned such searches. This example is designed to demonstrate various points, but the revenue authorities of the distributor countries will themselves want to be satisfied that their distributor companies are returning profits in line with the arm's length principle. Many authorities, like the UK, will have regulations requiring that returns are made on the basis that inter-group cross-border transfer prices are set in accordance with the arm's length principle.
Depending on the size of the case, it may be possible to take a broader view, particularly where a lot of countries are involved. For example you may look at the top five distributors individually, and then treat the remaining countries as a 'rest of the world' group, applying margins that are reasonable.
- Once you have established what functions each company carries out, you need to allocate each a reward, based on the arm's length principle, using the OECD methods discussed in this chapter.
The distributors market the goods in their own territories. They are selling branded goods, but do not own the brand name. While each develops their own marketing strategy, this does not mean that these create intangibles that should necessarily share in the residual profit. The comparison needs to be made with independent companies, distributing similar branded goods, where someone else owns the brands. Adjustments might need to be made to reflect high levels of initial marketing expenditure.
Assume that the transfer prices to the distributors are adjusted as follows, after reviewing the results of comparable companies. Adjusted figures are shown in red and adjustments have been made using a resale price method. The rates chosen are purely illustrative of what the evidence reveals is an arm’s length margin in this particular example, although in an actual case you may well find that different regions or countries will end up with different gross and net margins.
| US | Canada | Aus | Japan | UK | Germany | France | Total | |
| £'000 | £'000 | £'000 | £'000 | £'000 | £'000 | £'000 | £'000 | |
| Sales | 600,000 | 30,000 | 20,000 | 200,000 | 40,000 | 60,000 | 50,000 | 1,000,000 |
| Cost of sales | 240,000 | 16,200 | 10,000 | 96,000 | 24,000 | 34,800 | 29,000 | 450,000 |
| Gross profit | 360,000 | 13,800 | 10,000 | 104,000 | 16,000 | 25,200 | 21,000 | 550,000 |
| GPR | 60% | 46% | 50% | 52% | 40% | 42% | 42% | 55% |
| Comparable GPR | 55% | 50% | 50% | 50% | 40% | 40% | 40% | |
| Adjusted Xfer price | 270,000 | 15,000 | 10,000 | 100,000 | 24,000 | 36,000 | 30,000 | 485,000 |
| Adjusted gr. Profit | 330,000 | 15,000 | 10,000 | 100,000 | 16,000 | 24,000 | 20,000 | 515,000 |
| Distribution | 25,000 | 1,500 | 1,200 | 14,000 | 2,000 | 3,300 | 3,000 | 50,000 |
| Marketing | 200,000 | 8,000 | 6,000 | 56,000 | 8,000 | 12,000 | 10,000 | 300,000 |
| Administration | 60,000 | 3,000 | 2,000 | 20,000 | 4,000 | 6,000 | 5,000 | 100,000 |
| Adjusted net profit | 45,000 | 2,500 | 800 | 10,000 | 2,000 | 2,700 | 2,000 | 65,000 |
| NPR | 13% | 4% | 4% | 7% | 5% | 7% | 6% | 10% |
| Adjusted NPR | 8% | 8% | 4% | 5% | 5% | 5% | 4% | 7% |
- You confirm that the companies carrying out the finished goods manufacture own no intangibles. You also establish that the Jolly Good Packages companies act under a tightly drawn contract, whereby they are guaranteed to sell the products they finish, subject to acceptable quality control. Jolly Good Incentives Pte Ltd will buy any surplus that the distributors have not contracted to buy. As such the risks are limited. The same problem with the distributors will arise with the regional manufacturers, i.e. there are a number of them and, as they are based in different territories, the comparables in each country may show different ranges of results. Having made the point once in this example, the regional manufacturers will be treated as one generic company.
For final assembly of sub-assembled goods, a cost plus method is probably most appropriate. In this case the group have provided you with evidence for a number of manufacturers around the world. The comparable range of results show that external costs of manufacture are marked up by between 20% and 25%. The group has taken the top end of the range, 25%, when setting the transfer prices for this group of companies. The evidence shows that in this case this is an arm’s length margin.
Jolly Good Incentives Pte Ltd holds the licence from Jolly Good Sounds Plc and under that licence manufactures the sub-assemblies. You establish that the R & D it carries out is geared towards improving the quality of the products, and reducing manufacturing costs. This expenditure could potentially create valuable intangibles. Any reduction in the manufacturing costs would not affect the royalties payable under the licence. Jolly Good Incentives Pte Ltd will in theory receive its reward for any successful R & D on this front by being able to reduce its manufacturing costs, but still charging the same sale price to the regional finished goods manufacturers.
For example, the manufacturing costs are reduced by £10 million per year. The system profit increases to £320 million because the external costs have been reduced by £10 million. Jolly Super Sounds Plc will still receive the same royalty as this is calculated as a proportion of the in-market sales (sales to the third party customers).
If the R & D increases the quality of the DVD players, this would be a valuable intangible. While it might not allow the end price to be increased, it may well allow profit margins to be maintained, together with market share, once competitors enter the market.
There is of course the chance that the R & D undertaken in Singapore will not be successful. An independent manufacturer might view this work in a number of ways:
- It might refuse to do it altogether
- It might agree to do the R & D on a contract basis, where it is guaranteed to receive a set fee (perhaps with some linked incentive for reward)
- It might be prepared to take a risk, but would expect to reap a reward by way of the reduced manufacturing costs, and perhaps some other incentive, in case the R & D is fruitless.
The potential for Jolly Good Incentives Pte Ltd to produce any valuable intangibles has to be considered very carefully, along with risks of the R & D producing nothing. You could review whether there are any staff in Singapore working on specific projects. Are those projects designed to measurably increase either volume of sales or the profit margin, or to maintain market share and current margins? If there is significant work of this nature then it might be appropriate to allocate a small proportion of the residual profit to Jolly Good Incentives Pte Ltd. Depending on the nature of the work, it may be more proper to treat the R & D as contract R & D, with the arm's length price being set by a traditional method.
The basic function of the company is that of manufacturer. It also bears the risk of having to buy the excess production not required by the distributors. You establish that the distributors submit their expected purchases three months before the start of each financial year. They must buy the DVD players contracted for, and can submit increases on a quarterly basis. They cannot decrease the amount they contract to buy however. Jolly Good Incentives Pte Ltd bases its manufacturing output for any one year on the agreed contracts plus an additional 5% to cover returns etc.
The reward for the manufacture in this case could be calculated using a cost plus method. After searching for suitable comparables you conclude that the direct costs of manufacture should be marked up by 20%. You also agree that Jolly Good Incentives Pte Ltd should receive a reward for the risk of having to buy back any over-capacity. This could be calculated in number of ways, but you agree with the group that this will be covered by a margin of 5% on turnover. This is a purely illustrative figure, but a margin linked to turnover is probably appropriate to cover this aspect of the business.
So the reward for Jolly Good Incentives Pte Ltd for its basic functions are as follows:
| £M | ||
| Manufacturing costs (60 + 80) x 20% | = | 28 |
| Turnover 350 x 5% | = | 17.5 |
| Adjusted net profit for basic functions | = | 45.5 |
You agree that the company will be entitled to share in a small proportion of the residual profit in respect of the R & D it undertakes.
- Jolly Good Sounds Plc carries out no routine functions. Its reward will come wholly from its share of the residual profit.
- Having established the reward for each of the companies carrying out routine functions, the residual profit can be established. Remember the overall system profit hasn’t changed, all the external costs remain the same.
| Jolly Good Deals | Jolly Good Packages | Jolly Good Incentives Pte Ltd | Jolly Good Sounds Plc | ||
| Activity | System profit | Distributor | Finished goods manufacture | Sub-assembly manufacture | Intangibles owner |
| £’000 | £’000 | £’000 | £’000 | ||
| Original net profit | 310,000 | 100,000 | 15,000 | 145,000 | 50,000 |
| Adjusted net profit for basic functions | 125,500 | 65,000 | 15,000 | 45,500 | Nil |
| Residual profit | 184,500 |
The residual profit is £184.5 million. The companies that hold intangibles are Jolly Good Sounds Plc, and potentially Jolly Good Incentives Pte Ltd in respect of any potential improvements to the quality of the DVD players and the risk of fruitless R & D.
A practical solution for Singapore might be to allocate a small basic incentive element, along with an increased share in the event that the R & D produces tangible outcomes. This would reflect arrangements that you might find between independents.
In this case the evidence shows that 5% of the residual profit should be allocated to Singapore, and 95% to the UK company, with the option for a review if the R & D produces some tangible outcomes.
Jolly Good Sounds Plc receives £175.275 million from the profit split model. A royalty of 17.5% from Singapore based on the in-market price, instead of the existing royalty of 5%, results in £175 million.
In this example the evidence presented is for one year only. In a real case, you may look at data from a number of years and take an average royalty over that period.
Profit split - variations
There are a number of variations on the profit split model. A common one will feature a company owning intangibles and the residual falling to the manufacturer, which is usually based in a tax shelter. Under this method, a company based in a territory offering tax incentives for manufacturing will have been granted a licence by a group company that owns valuable intangibles. The licensee will sell the products it manufactures to group distributor companies worldwide; the transfer price for these transactions will be set using the resale price method. The owner of the valuable intangibles will be rewarded by annual royalties and this will be calculated by reference to industry benchmark figures.
The royalty may have been derived from a number of independent licence agreements, hopefully covering that particular industry. The agreements will cover a broad spectrum producing probably a large range of royalties, with the rate picked from the middle. In other cases a more generic 25% to licensor, 75% to licensee split might be presented as the going rate. This approach has the effect of marginalising valuable intangibles and makes no allowance for the fact that the intangibles in question may be much more valuable than those generally found in that industry.
You would need to carefully review such arrangements. It is more likely that a method where the residual profit is allocated to the company owning the intangibles will produce a more accurate arm's length arrangement. Establish the system profit. Allocate an appropriate arm's length reward to routine functions and the residual to the intangible owner if it is clear from the evidence that this reflects what would happen at arm’s length.
Does the cost of the intangibles affect the value of the intangibles?
The expense of discovering and developing valuable intangibles has no direct relation to the price of products manufactured and sold using that technology. If the R & D programme cost £100 million, the products will not be priced directly to try and recoup those costs over say the next 5 years. There is of course an indirect link; a company will bear in mind the costs of its current R & D programmes for future products, and what it would like to spend on that R & D in the future, but the pricing of goods and services is subject to a very complex interaction of many commercial factors. While a revolutionary new product will no doubt attract a premium price in some markets, there is generally a limit on what people are prepared to pay.
When intangible rights are sold at arm’s length, the price the buyer is prepared to pay is by definition the market value of those intangibles at that time.
The price agreed between independents would also be subject to complex interaction of market forces. The transfer of intangible property between affiliates is a difficult area but one where it is always necessary to establish the facts and consider carefully evidence that the transfer is arm’s length.
The reward for marketing intangibles
Marketing intangibles are not defined comprehensively, but the OECD Transfer Pricing Guidelines suggest they cover trademarks, trade names, marketing strategies, customer lists - essentially assets that will help market the products.
Some distributors have a large, well trained, well paid sales force - backed up by an efficient infrastructure and managed by an innovative management team. There will be excellent relationships with customers.
You may have to consider claims that a well run marketing organisation creates a separate intangible associated with such a marketing organisation, a super marketing intangible - and that this intangible should attract much more than a routine reward that a standard distributor would earn. Always consider very carefully the evidence that has led to this assertion. Expenditure on creating such a marketing organisation may generate goodwill, this will likely be very dependent on retaining the distribution agreement for the particular product in question. In other cases the type of product may be much more important. Without the product and/or distribution agreement it is questionable how valuable the marketing organisation remains. While the marketing organisation should be sufficiently rewarded and incentivised, this can be achieved without resorting to a profit split and without the allocation of profit to a marketing intangible which either does not exist or exists but does not have any value.
Bundles of intangible property
A contract to use valuable intangible property may be relatively straightforward, perhaps a licence to use a trade name. In other cases an agreement may exist where a whole bundle of intangible property has been packaged and a royalty charged in return for the licensee being allowed to use the whole suite of rights.
For example an agreement may provide the licensee with:
- The right to use certain trade names and trademarks for the products.
- The right to use key patents and know-how for manufacturing the products.
- Provision of additional technical assistance as required.
- Provision of marketing strategy assistance.
- Training for manufacturing and marketing personnel.
- Provision of IT to help support the manufacturing and marketing processes.
- The right to buy materials under global procurement contracts
- Assistance in arranging sales to very large customers who have a worldwide presence.
It may be difficult to value all services individually. Always scrutinise carefully any agreement where extra payments are made for bundled services which seem of little value. As a general principle, an independent company would only pay for these where it can perceive a benefit and pay at a price which would allow it to make a profit on top. Establish precisely what goods and services are being received and how they are being used. The facts might reveal that, for example, a third party would pay for some additional services only where they are actually of value.
On the other hand, a third party might agree to buy a package with the aim of being able to use a particular key element of that package. Establish what precisely is being paid for and how it is being utilised in the user’s trade.
