Chapter INTM440170
| Published date | 09 April 2016 |
| Record Number | INTM440170 |
| Court | HM Revenue & Customs |
| Issuer | HM Revenue & Customs |
There are a number of variations on the profit split model. A common one will feature a business owning intangibles and the residual falling to a manufacturer, which is usually based in a low tax country. Under this structure, 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 (a commonly mis-used ‘rule of thumb’. See the comments on rules of thumb at INTM440140). 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.
Such arrangements should be carefully reviewed. It is more likely that a method where the anticipated residual profit is allocated to the company owning the intangibles will produce a more accurate arm’s length arrangement. Establish the anticipated 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.
Often at arm’s length when an intangible is licensed by one party to another, its anticipated value to the licensee at the time of licensing will be calculated by application of the income valuation approach, frequently by means of the construction of a discounted cash flow model (see INTM440140). An appropriate royalty rate will then be calculated based on this valuation. Royalties are essentially a mechanism to split the total anticipated profit to be derived by the licensee from its activities which make use of the licensed intangible and attribute that proportion of the total profit arising directly from the intangible to the...
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