Introduction
Intangible assets such as trademarks, patents, software, technology, and know-how have become the most valuable drivers of profitability in multinational enterprises (MNEs). As a result, royalty transactions involving these intangibles are among the most heavily scrutinized areas in transfer pricing.
Because intangibles are unique, difficult to value, and often transferred within related parties, tax authorities insist on clear evidence that royalty rates comply with the arm’s-length principle. Benchmarking and accurate documentation are essential to avoid adjustments, penalties, and long disputes.
This article outlines the types of intangibles, the key challenges in valuing them, and the practical steps needed to benchmark and defend royalty rates in line with OECD standards.
1. Understanding Intangibles in Transfer Pricing
The OECD defines intangibles as assets that:
Are not physical or financial
Can be owned, controlled, or transferred
Contribute to economic value creation
Are used in business operations
Common categories of intangibles:
Marketing intangibles: trademarks, brands, customer lists
Technology intangibles: patents, software, algorithms, databases
Trade intangibles: manufacturing know-how, formulas, processes
Relational intangibles: licensing relationships, distribution networks
Intangibles are often the source of supernormal returns, making their valuation especially sensitive.
2. What Are Royalty Transactions?
Royalty transactions occur when one entity grants another the right to use:
A trademark
Technology
Software
Franchise model
Know-how
Copyrights
In exchange, the user pays:
A percentage of revenue (royalty rate)
A fixed license fee
A hybrid performance-based structure
Because these payments shift value between related entities, tax authorities closely examine whether:
The intangible is actually used
The royalty rate matches market behavior
The licensor controls and bears the relevant DEMPE functions
The licensee receives measurable benefit
3. DEMPE: The Foundation of Pricing Intangibles
The OECD introduced the DEMPE framework to determine which entity truly owns and controls intangibles:
Development
Enhancement
Maintenance
Protection
Exploitation
The entity performing and controlling DEMPE functions — not merely the legal owner — is entitled to the economic returns.
Why DEMPE matters for royalty pricing
If Entity A owns the patent legally but Entity B performs the key development and protection functions, Entity A cannot charge high royalties without evidence of meaningful contribution.
4. Challenges in Pricing Intangibles
A. Limited Comparable Data
Patents and brands are unique finding perfect external comparables is nearly impossible.
B. Variation in Licensing Models
Different industries use:
Running royalties
Upfront fees
Milestone payments
Cost-sharing arrangements
Buy-in payments
C. Subjective Valuation
The economic life, expected benefits, and market potential of intangibles vary widely.
D. Tax Authority Skepticism
Authorities often challenge:
High royalties paid by profitable subsidiaries
Royalties to companies lacking DEMPE
Structures appearing to shift profits artificially
5. How to Benchmark Royalty Rates (Practical Steps)
Benchmarking royalty rates requires a structured approach. Here are the key steps:
Step 1: Define the Transaction Clearly
Document:
Type of intangible
Rights granted (exclusive vs. non-exclusive)
Duration of license
Market coverage
Economic benefits expected for the licensee
Step 2: Conduct a DEMPE Analysis
Determine:
Who developed the intangible
Who maintains or enhances it
Who controls risk
Who funds the development
Who profits from exploitation
This ensures the right entity charges the royalty.
Step 3: Gather Comparable Licensing Agreements
Use:
Commercial databases (RoyaltyStat, ktMINE, etc.)
Public filings
Industry licensing reports
SEC documents
Filtering criteria include:
Industry
Geography
Type of intangible
Rights granted
Contract length
Relationship (only third-party deals allowed)
Step 4: Apply the CUP Method (Preferred for Royalty Benchmarking)
The Comparable Uncontrolled Price (CUP) method is the primary approach for royalty benchmarking.
Calculate:
Median royalty rate
Interquartile range
Adjustments for differences in rights or markets
Step 5: Justify the Selected Royalty Rate
Choose a rate within the arm’s-length range based on:
Profitability of the licensee
Intangible’s contribution to revenue
Expected benefits vs. costs
Licensing structure in the industry
Step 6: Perform a Benefit Test
Demonstrate that the licensee:
Receives measurable value
Increases efficiency or revenue
Avoids cost of development
Uses the intangible in actual operations
Without a clear benefit, even an arm’s-length royalty may be challenged.
6. Alternative Approaches When Comparables Are Limited
When external CUP data is weak, the OECD allows:
A. Profit Split Method
Allocate combined profits between entities based on DEMPE contribution.
B. Valuation Techniques
Relief-from-royalty method
Discounted cash flow (DCF)
Incremental income method
These methods require:
Financial forecasting
Market analysis
Technical assessment
7. Documentation Needed to Defend Royalty Transactions
A strong file must include:
DEMPE analysis
Industry overview
License agreements
Comparable search strategy
Benchmarking results
Economic explanation of chosen rate
Financial capacity and risk control evidence
Benefit test documentation
Strong documentation reduces audit risk significantly.
Conclusion
Intangibles and royalty transactions lie at the core of value creation in multinational enterprises. Because they are complex, unique, and economically powerful, tax authorities worldwide apply strict scrutiny to ensure compliance with the arm’s-length principle.
A disciplined approach grounded in DEMPE, strong benchmarking, and clear documentation is essential to justify royalty rates and maintain defensible transfer pricing positions.
