How do patent royalties work?

In this article, we’ll take a look at:

– What patent royalties are and how they work

– How patent royalties fit into transfer pricing

– Some common questions about patent royalties

What are patent royalties?

In most countries, any intangible assets, whether owned by a company or individual, can be legally protected from use without consent via a patent. In the US, for example, intellectual property can be protected through the US Patent and Trademark Office, while in the UK the Intellectual Property Office (IPO) handles all patent requests. A patent gives an inventor exclusive right to their invention, which could be a process, design, or physical invention like a machine.

If a third party wants to use patented property for whatever reason, they must pay patent royalties to the owner of the IP. These are usually a percentage of the revenue generated by the patent, though licensors may agree to a fixed fee. Once both parties agree on patent royalty rates, they sign a patent royalty agreement. The agreement also clarifies how, when, and where the licensee can use the patent.

Setting patent royalty rates

Several factors can affect patent licensing royalty rates, including:
– Whether the licensee has paid any compensation upfront
– The stage that the patent is at
– The market potential of the patented invention
– The industry concerned
– The size of the market
– The level of competition in that market
– The exclusivity of the patent license
– How unique the invention is

When deciding on fair royalty rates, all the above factors must be considered,
regardless of whether it is for setting royalty rates for a license agreement, valuing a patent, or transfer pricing analysis.

Licensing professionals typically use one of three methods to work out rates for a patent:
1. The income approach: Bases the rate on an estimate of how much income
the patent will generate.
2. The market approach: Bases the rate on comparable rates within the same
market.
3. The cost approach: Bases the rate on working out the cost of producing a
similar patented asset.

Once you have your calculations, it’s recommended that you compare and contrast the results with comparable market rates, like those found in the RoyaltyRange royalty rates database.

Kris Rudzika, Managing Partner at RoyaltyRange, says: “When determining royalty rates, the importance of accurate data can’t be understated. The RoyaltyRange databases are some of the most comprehensive available, and are relied on by transfer pricing professionals and tax authorities worldwide.”

Patent royalties in transfer pricing

For anyone carrying out a transfer pricing analysis for a transaction involving
intellectual property patents, third-party royalty rates data can inform your
calculations. Royalty rates set for comparable uncontrolled transactions are useful for helping you to work out if the transfer pricing is at arm’s length.

The arm’s length principle is described in Article 9 of the OECD Model Tax
Convention: 
“[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

There are five primary methods for determining arm’s length transfer prices. These are:
1. The comparable uncontrolled price method (CUP method)
2. The resale price method
3. The cost-plus method
4. The transactional net margin method (TNMM)
5. The transactional profit split method

Whichever method you decide on, all the third-party royalty rates you need can be found in the RoyaltyRange royalty rates database.

Documentation requirements for transfer pricing compliance related to patent
royalties vary from country to country. However, many countries follow guidelines provided by the Organization for Economic Co-operation and Development (OECD) in their Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations. Common requirements include:

1. A transfer pricing documentation report: Includes a detailed analysis of the controlled transactions, comparability analysis, and the selection and
application of the appropriate transfer pricing method.
2. Functional analysis: Identifies and analyses the functions, assets, and risks of the parties involved in the patent transaction.
3. Economic analysis: Benchmarks the controlled transaction against
comparable transactions between unrelated parties.
4. Royalty rate determination: Explains the basis for setting the royalty rate and demonstrates that it aligns with market rates.
5. Advanced Pricing Agreement (APA): A binding agreement that
determines the transfer pricing method and sets the arm’s length range for
future transactions.
6. Country-by-Country Reporting (CbCR): Detailed information on global allocation of income, taxes paid, and other indicators of economic activity.
7. Local file and master file: In some countries, the transfer pricing
documentation is divided into a local file and a master file.
8. Legal agreements: Copies of the relevant legal agreements related to the
patent royalties.
9. Comparable company data: Details and analysis of comparable companies
used for benchmarking.

Patent royalty FAQs

Patent royalties can be a complex subject. Here we’ve answered some of the most frequently asked questions, so you can refer back whenever you need to: