Transfer Pricing is the set of rules and methodologies applied to transactions between related entities within multinational enterprises (MNEs) ensuring that these intra-group transactions follow the arm’s length principle. In practice, one of the most challenging aspects of Transfer Pricing is the comparability of license agreements, which often involve intangible assets and can be highly complex.

What is a licensing agreement?

To understand the notion of comparability and the difficulties associated with it, we must examine in more detail what exactly a license agreement is. A license agreement is a legal contract in which the owner of certain rights, such as intellectual property (the licensor), grants permission to another party (the licensee) to use those rights under specific conditions. This agreement typically involves using intangible assets like patents, trademarks, copyrights, trade secrets, or software, in exchange for payment or royalties.

The standard license agreement typically outlines the scope of the license, including any types of intellectual property, rights granted, industry or products covered by the specific intangibles, territorial coverage, royalty rates or other payments, and any other conditions, such as limitations or obligations on the use of the licensed material, such as quality control measures or compliance with specific laws, which makes it almost unique in each case.

License agreements are commonly used to enable businesses to access and commercialize intellectual property while ensuring that the rights and interests of the owner are protected. Licensing agreements are widely used in various industries, allowing businesses to monetize their intellectual property and expand into new markets without directly engaging in production or distribution. MNEs often use licensing arrangements to transfer or allow the use of these intangibles between related entities across borders. From a tax perspective, it is important to ensure that the terms and pricing of these transactions are comparable to those between unrelated entities (third parties) to prevent profit shifting and avoid tax base erosion.

Comparability analysis

The fundamental principle in Transfer Pricing requires related-party transactions to be priced as if they were conducted between unrelated parties under similar circumstances. This ensures that the royalties or fees paid for using intellectual property between related entities align with those paid between independent parties in comparable transactions.

The most complex comparability factor in this case is intellectual property. Intangibles are often challenging to value because of their unique nature, long-term economic impact, and the difficulty in finding external comparable data. You need to make sure that the remuneration for the use of these intangibles reflects their value, market conditions, and the contribution to profits made by both parties involved. Therefore, achieving comparability in license agreements requires assessing the terms and conditions of third-party arrangements and benchmarking them against related-party transactions.

Having in mind the unique aspects of each agreement and intellectual property type within the license agreement, presented below you may find the essential factors to consider for a reliable comparability analysis:

1. Nature of the Intangible:
   The first step is to analyze the nature of the intangible being licensed. Each intangible asset may have different economic characteristics, life spans, and revenue-generating potential, making direct comparisons challenging. For instance, different types of intangibles have varying levels of value and risk – a well-known brand or patent with significant market recognition commands a higher royalty than a less-known brand or patent for the same product or industry. Further, an important aspect to take into consideration is also whether the intangible in question is fully developed, partially developed, or in the early stages of development, as this also impacts the comparability of the transaction.
2. Rights granted:
   License agreements may vary in the scope of the rights granted to the licensee. A simple example would be that a license may be exclusive or non-exclusive, cover either specific or global territories, allow sublicensing, or be restricted to the licensee only with no rights for further transfer. A broad, exclusive right to use an intangible asset in a large market may directly contribute to a higher royalty rate, rather than a limited, non-exclusive license. These variations must be carefully considered in any comparability analysis.
3. Duration and Renewal Terms:
   The length of the agreement and the terms for renewal or termination can also significantly impact the comparability. A long-term license agreement might provide more certainty to both parties and therefore may involve different royalty rates compared to a short-term or renewable transaction. Additionally, termination rights (or lack thereof) can affect the comparability of license terms.
4. Economic and Market Conditions:
   Jurisdictional factors, including varying legal frameworks, regulatory environments, and market conditions, can affect the valuation and structure of license agreements. These factors play an important role in determining appropriate royalty rates in license agreements. For instance, a licensing arrangement in a booming, high-demand market is likely to command a higher royalty than one in a declining market. When conducting a comparability analysis, it’s essential to align the conditions under which third-party agreements were made with those affecting the related-party transaction.
5. Functions, Risks, and Assets (FAR analysis):
   Analyzing the functions performed, assets used, and risks assumed by each party in the license agreement is essential. Licensing deals often involve complex risk allocations and profit-sharing arrangements between the parties. Differences in the assumed risks or shared benefits (such as development costs or future profits) add layers of complexity that need to be accounted for when comparing agreements. For example, a licensee that undertakes significant marketing, distribution, or customization may warrant a different royalty structure than a passive licensee.
6. Profit Potential and Expected Benefits:
   The expected profitability from the use of the intangible should also reflect the royalty structure. An agreement involving a highly valuable intangible expected to generate significant profits will justify a higher royalty than one where the potential benefits are uncertain or limited. Related-party agreements should reflect the same profit potential as would be the case for unrelated entities.
7. Industry:
   In addition to the above, it is also important to consider the industry or products covered by the intellectual property. The comparisons between license agreements are typically more reliable when they occur within the same or similar industry, for example, licensing agreements in the pharmaceutical industry must adhere to strict regulatory approvals that may not be relevant in other industries, such as entertainment or apparel. Therefore, the industry also plays an important role in comparability analysis.

Achieving accurate comparability in license agreements is a nuanced and multifaceted task that demands careful consideration of a range of factors—from the nature of the intangible asset and rights granted, to market conditions and the industry context. Given the unique characteristics of each agreement, MNEs must perform a thorough comparability analysis to ensure that related-party transactions adhere to the arm’s length principle. By doing so, they not only comply with Transfer Pricing regulations but also safeguard against potential risks of tax base erosion and profit shifting. In a globalized economy where intangible assets are increasingly driving value, mastering the complexities of license agreement comparability is essential for maintaining both legal and financial integrity.

If you require any help with finding the right comparables or choosing the appropriate method for your Transfer Pricing analysis, you can review the solutions offered by RoyaltyRange here.

Sources:

https://www.wipo.int/edocs/pubdocs/en/licensing/906/wipo_pub_906.pdf

https://www.researchgate.net/publication/309748350_The_Nature_and_Characteristics_of_the_License_Agreement_and_Its_Compatibility_with_Certain_Contracts_in_Civil_Law

https://www.linkedin.com/pulse/insights-license-comparability-software-firmware-reverse-engineering-qmcke

https://corporatefinanceinstitute.com/resources/accounting/licensing-agreement/