INTM467170 - Establishing the arm's length price: gathering your own evidence - Industry standards and intangible property

The OECD Transfer Pricing Guidelines, at paragraph 1.16, discuss the idea that trading transactions at arm’s length involve both parties considering and comparing options open to them. In looking at those options, they will take account of how the different choices affect the value of the transaction.

This is clearly difficult to do when looking at an intra-group transaction. The aim is to mirror the conditions you would find between two independent parties. This may involve making considered adjustments to the terms and prices of the transaction actually entered into between connected persons.

The OECD Transfer Pricing Guidelines conclude that in no event can unadjusted industry average returns themselves establish arm’s length conditions.

Scrutinise carefully any claims that transfer pricing is in accordance with industry averages and is therefore arm’s length.

For example, profit split models may include statements that between a quarter and a third of the profits should accrue to the licensor with the balance being earned by the licensee.

This idea has several origins. In the 1980s, the US courts considered a transfer pricing case. The case involved a multinational group, Bausch & Lomb, and a licence agreement between the US parent and its Irish subsidiary. The US courts decided that the parent should receive 25% of the profits.

There are various books and articles that have been written by licence industry experts, where a universal split of rewards under a licence agreement is cited at between 25% and 33% to the licensor. It is probably the case that many licence agreements are structured so that the rewards end up being split in these proportions, but it is certainly not true that there is an arbitrary rule that dictates the extent of a profit split. There are numerous articles written by other licence industry experts, where the view is taken that there is no universal standard. There are non-tax cases that have been considered by the UK courts in respect of exploitation of valuable intangibles and which have awarded royalties in excess of 40% of sales to customers (which would point to a profit split that awarded the licensor over 25% to 33% of the profits).

The picture which emerges from this is that there is no standard or average that can be applied. Every case must be decided on its own merits.

Arrangements between third parties would be likely to be agreed after a consideration of many facts including:

• The type of valuable intangible and the type of good that might be sold, which is based on that technology.
• The size of the respective parties.
• The likely sales and profit expectations.
• The territory for the licence.
• Whether the licence is exclusive or non-exclusive.
• The length of the licence agreement.
• How each party expects to benefit.

This dynamic may be missing from the relationship between connected parties. It is always necessary to consider how these commercial factors would have influenced the bargain struck between third parties.