Super Royalties in Transfer Pricing: Going Beyond "Economics 101"

May 17, 2022 by Harold McClure
About the Author
Harold McClure
is an economist with over 25 years of transfer pricing and valuation experience.
Dr. McClure began his transfer pricing career at the IRS and went on to work at several Big 4 accounting firms before becoming the lead economist in Thomson Reuters’ transfer pricing practice. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983.
Read more

More articles by this author

Find Harold McClure on LinkedIn

Gregory Ballentine recently defended the IRS preference for the Comparable Profits Method (CPM) over the OECD approach with respect to the evaluation of arm’s length royalty rates:

The OECD’s BEPS project asserts the following two propositions about profits:

  • At arm’s length, profits will be earned by the entities that perform the activities that generate profits;
  • At arm’s length, profits are aligned with the creation of value.

Both statements are false. The error in the first statement is that the OECD fails to distinguish between activities that in some sense generate profits and the activity that generates a claim on profits. The latter activity is the ownership of valuable assets (including intangible assets) and the attendant risk of, and rights conveyed through, ownership. The error in the second statement is the failure to recognize that value is created by labor as well as by capital, but profits are only aligned with the value created by capital.

He provides an example of a company that provides medical services to illustrate what I will call his “Economics 101” approach to the issue. I extend this example to a simple numerical illustration as a prelude to certain critiques of this approach.

Ballentine’s main contention is that if a low-tax affiliate owns all of the valuable intangible assets for a highly profitable multinationals, then high intercompany royalty rates are consistent with the arm’s length standard. This logic was argued by the IRS in the Cola Cola v. Commissioner and the Medtronic v. Commissioner litigations. The trial court ruling in the former litigation and the Appeals Court remand in the latter litigation have been hailed as victories for the IRS in their pursuit of an aggressive CPM approach. I reviewed both litigations arguing that this approach overstates the arm’s length royalty rate.

Ballentine’s Basic Model

Ballentine describes the economics behind the IRS view on arm’s length royalties thusly:

The logic behind the commensurate with income provision is based on what would happen in a market for the use of a valuable intangible asset. Consider a licensor that owns an intangible asset. Suppose the licensor and a potential licensee both believe that the licensee’s business will be made more profitable if the licensee could use that intangible asset. The provision simply states that the royalty the licensee will pay will be commensurate with the amount of profit the intangible asset adds to the licensee’s business. According to the OECD, it is because the licensees, not the low-tax jurisdiction licensors, carry out many activities that generate profits, and the correct royalty would allocate the profit to the entity that carries out the profit-generating activities. This is incorrect. To see why, one needs to differentiate between activities that in some sense contribute to generating profits and activities that generate a claim on profits. Step back from the related-party setting and ask who earns the operating profit of any publicly traded corporation. The answer is undeniable: Profits are earned by the stockholders and the debtholders of that corporation. The stock and debt owners do not do anything in the business - they do not make business decisions, they do not make sales, they do not manufacture, and they do not use tangible or intangible assets. They simply own assets through owning stocks and debt.

The idea that profits represent the market return to capital dates back to Phillip H. Wicksteed's An Essay on the Coordination of the Laws of Distribution, which was published in 1894. The basic thesis of Wicksteed's work was that in a perfectly competitive market, if all factors of production were paid the value of their marginal products, then economic profit would be zero. In other words, accounting profits would barely cover the cost of capital. Wicksteed envisioned companies that use only labor and tangible assets to produce goods, ignoring not only monopoly power, but also valuable intangible assets. Proponents of the CPM approach to evaluating intercompany royalty rates attempt to extend this logic to cover the use of intangible assets owned by a related-party licensee. I later assert that these contentions violate basic financial economics.

Ballentine provides us with this interesting scenario:

Consider a group of doctors with their nurses and medical technicians. They constitute one firm. Another firm owns both the building in which the doctors work and all medical equipment used. The doctors, nurses, and medical technicians create considerable value. Furthermore, the doctors earn high incomes. The doctors’ firm, however, does not earn much profit. The value the firm creates comes from the personal services of the doctors, nurses, and medical technicians. Their compensation for providing those services is labor income, not profit. Now consider the firm that owns the building in which the doctors work and all the medical equipment. This firm also creates value. This firm has only a few clerical employees that process rent and lease payments received from the doctors. The income earned by this firm is rent and lease payments less the small salaries of the clerical staff and depreciation. That income is true profit. It is the return to ownership of assets.

Now, let us consider a Utah based Real Estate Investment Trust (REIT) that not only owns the building but also has purchased the medical services firm as a Taxable REIT Subsidiary (TRS). Since Utah’s state tax rate is 5%, this firm would love to shift any intangible profits to a Nevada affiliate where they would avoid state taxation, but our original example assumes that this firm barely covers its cost of capital. Any profits attributable to the TRS are subject to both state income taxes and Federal income taxes but any profits attributable to rent payments escape income taxation.

In our example, expected revenues = $100 million per year. Since this firm provides services, there are no material costs so value added equals revenues. The firm pays its doctors $60 million per year, its nurses and technicians $25 million per year, and its other employees $5 million per year. As such, expected profits = $10 million per year.

The firm owns only two forms of tangible assets – the medical equipment and the building, which includes the value of the land. The market value of both forms of tangible fixed assets = $50 million each. As such, the market value of the entire company = $100 million, so the expected return to the market value of operating assets = 10%. Our example avoids the usual complications over defining operating assets versus total assets, as we have assumed this company has no non-operating assets. Our example avoids any issues over the composition of assets as we have assumed that this company holds neither inventories, receivables, nor any other form of working capital.

The key issue in REIT transfer pricing is what represents an arm’s-length lease payment. Some practitioners would assert that the owner of the building deserves a 10% return to the value of the leased property. In our example, the lease payments would = $5 million per year under this assumption, which would leave the TRS with expected profits of $5 million per year. In an earlier paper, I noted why such intercompany lease payments exceed the arm’s length standard.

A Miller-Upton Extension of the Capital Asset Pricing Model

A profits-based approach to intercompany leasing is consistent with the seminal model for the pricing of leases as presented by Merton Miller and Charles Upton. Their model is an application of the capital asset pricing model (CAPM), which posits that the expected return to any asset equals the risk-free rate plus a premium for bearing systematic risk with a specific means for estimating the latter:

R = Rf + β(Rm - Rf),

where Rf = risk-free rate, Rm = expected return on the market portfolio of assets, and β = beta coefficient for this particular asset. The beta coefficient measures the tendency of the asset's return to move with unexpected changes in the return to the market portfolio. Beta coefficients are often estimated for the equity of publicly traded companies. Equity betas reflect both operational risk and leverage risk. Since the task herein is to estimate the expected return to assets rather than the expected return to equity, the beta estimates must be on a debt-free, unlevered, or asset basis. Remove the effect of leverage on these equity betas (βe):

β = βe/(1 + D/E),

where D = debt and E = market value of equity. To the degree that a company engages in leverage risk by financing its assets through debt instead of equity, the equity beta would tend to exceed its asset or unlevered beta (β).

Let’s assume that Rf = 4%, Rm - Rf = 5%, and the overall unlevered beta for the combined firm in our example = 1.2. CAPM implies that its expected return = 10% given these assumptions.

BEPS Action 9 (Assure That Transfer Pricing Outcomes Are in Line with Value Creation- Risks and Capital), paragraph 63, notes:

Risks should be analyzed with specificity, and it is not the case that risks and opportunities associated with the exploitation of an asset, for example, derive from asset ownership alone. Ownership brings specific investment risk that the value of the asset can increase or may be impaired, and there exists risk that the asset could be damaged, destroyed or lost (and such consequences can be insured against). However, the risk associated with the commercial opportunities potentially generated through the asset is not exploited by mere ownership.

While this discussion relates to the leasing of tangible property, the same economic principle holds for the licensing of intangible assets.

The expected return to any leased or licensed asset is given by:

R = Rf + β1Rp,

where β1 represents the systematic risk from bearing obsolescence risk. If β1 = 0.4, then the premium for bearing ownership risk is only 2%. The expected return to leased asset would therefore be only 6% and not the 10% figure, which includes the premium for bearing commercial risk. In our illustration, the REIT’s lease payments should be $3 million per year and not $5 million. The TRS undertakes additional commercial risk by leasing property formally owned by another affiliate. As such the TRS’s expected return must be $7 million per year under the arm’s length standard.

Similar considerations apply to intercompany licensing. In my discussion of the Medtronic litigation, I applied this financial economics model to a consolidated entity that generated an operating margin = 60% of sales with routine profits = 10% of sales, so residual profits = 50% of sales:

The beta coefficient for pure leasing companies tends to be near 0.4, implying a 2% premium for bearing obsolescence risk. If the assumption is βl = 0.4, β' = 5.2 in this case, the licensor's expected return equals 6%, while the licensee's expected return to its tangible assets is 30%. Royalties would represent 60% of residual profits, with the licensee capturing 40% of residual profits. 

While CPM would suggest a royalty rate = 50% of sales (100% of residual profits), sound financial economics suggests that the arm’s length royalty rate = 30% of sales.

The Coca Cola litigation was similar in terms of high overall operating margins with only modest routine returns. If expected overall profits = 45% of sales and routine returns represent only 5% of sales, residual profits represent 40% of sales. The IRS abused the extreme CPM view that the licensor captures all residual profits in the royalty to assert that the modest intercompany royalty rates, which were less than 20% of sales, be increased to 40% of sales. The licensee, however, bore significant commercial risk by using valuable intangible assets owned by the related-party licensor. Proper consideration of the role of risk suggests an arm’s length royalty rate closer to 25%.

Intangible Profits Defined as Profits in Excess of the Cost of Capital

Aswath Damodaran’s “ROC, ROIC and ROE: Measurement and Implications” (June 2007) examines accounting and cash flow measures of excess returns:

The notion that the value of a business is a function of its expected cash flows is deeply engrained in finance. To generate these cashflows, though, firms have to raise and invest capital in assets and this capital is not costless. In fact, it is only to the extent that the cash flows exceed the costs of raising capital from both debt and equity that they create value for a business. In effect, the value of a business can be simply stated as a function of the “excess returns” that it generates from both existing and new investments.

If the expected return to our hypothetical medical service firm is 10%, then there are no excess returns if the cost of capital is 10%. Our assumption that the unlevered β = 1.2, however, is quite arbitrary. If the appropriate unlevered β = 0.9, then the cost of capital would be only 8.5%. This more reasonable assumption would imply that our hypothetical firm has excess returns equal to 1.5% of the value of its tangible assets, which implies residual profits = 1.5% of revenues since the tangible asset to revenue ratio is 1.

Estimating routine returns is quite controversial in the practice of transfer pricing. For firms with modest profit margins, considerable care needs to be taken in terms of estimating routine returns as small differences can lead to significant changes in the estimated residual profit to sales ratio. This situation is quite different from examples like Coca Cola and Medtronic where profit margins are enormous, even as reasonable estimated of routine returns are very modest.

In our example, we suggested that the tax planners for the firm would like to shift profits from the Utah affiliate to Nevada intangible asset holding company. Such planning may run into several difficulties, including factual issues and measurement issues. The factual issues involve determining what the intangible assets are and which entity owns them. If the intangible assets were owned by the Utah affiliate and not the Nevada affiliate, then no intercompany royalty would be consistent with the arm’s length standard.

Even if all intangible assets were owned by the Nevada intangible holding affiliate, the determination of the arm’s length royalty rate not only requires a reliable estimate of residual profits but also consideration of the share of residual profits that should accrue to the licensee for its bearing of commercial risk. While we have suggested that residual profits = 1.5% of sales, a 1% royalty rate would likely be closer to the arm’s length standard since licensees bear additional commercial risk when licensing property owned by another entity.

Monopsony Power as an Intangible Asset

The "Economics 101" model assumes a perfectly competitive labor market, which implies wages are set at their value of marginal product. Economists are increasingly finding evidence that labor markets may exhibit monopsony power. Chris Yen’s recent paper noted:

Most economic models assume that labor markets are perfectly competitive. In that case, worker pay equals the marginal contributions to their employers' revenues, or marginal revenue products of labor …  the notion of a perfectly competitive U.S. labor market has been contested in the past few years. It has been argued that employers' market power has increased in recent decades. In turn, this rise is responsible for the decline in workers' compensation relative to value added (i.e., the labor share).

His empirical research focused on certain manufacturing sectors and did not address the provision of medical services. If our hypothetical Utah firm did possess monopsony power, it could reduce the payments to its employees. While it would be counterintuitive to suggest doctors were paid less than their value of marginal products, a monopsonist could limit the pay to nurses and technicians if there were few options to pursue other higher-paying positions.

If monopsony power exists in a certain jurisdiction, the intangible profits derived from the exercise of that power would likely be deemed to be attributable to the particular jurisdiction. I offer this possibility only to suggest that the OECD position is not as untenable as has been suggested, as this type of intangible asset is not transferable to a tax haven in another jurisdiction.

Takeaways

Ballentine has long argued that much of the reason why profits have been shifted to tax havens emanates from the transfer of intangible assets at valuations that are unrealistically low. Once that transfer has occurred and the initial valuation was not challenged by the tax authorities of the affiliates which had produced the intangible asset, the application of the arm’s length standard with respect to the evaluation of the intercompany royalty rate should properly focus on the economics of the new structure.

Ballentine’s case of high intercompany royalty rates relies on a very simple economic model but is consistent with the IRS approach in certain high profile litigations. Sound financial economics, however, suggests licensees deserve a portion of residual profits for two reasons:

  1. Compensation for profits attributable to the value of intangible assets owned by the licensee; and/or
  2. Compensation for the role incurred by the leveraged risk when using valuable intangible assets owned by another entity.

The U.S. Sec. 482 regulations acknowledge the first factor, but the IRS generally ignores the role of licensee risk. My extension of Ballentine’s example allows for consideration of issues that go beyond his "Economics 101" approach. These considerations may include non-traditional intangible assets that cannot be migrated to a tax haven affiliate, as well as the sound financial economics proposition that licensees deserve more than a routine return when utilizing valuable intangible assets owned by another entity.

Taxpayers have also used CPM to argue for a high intercompany royalty rate when the licensor affiliate has a lower effective tax rate than the licensee affiliate. A classic example is the use of Delaware Intangible Holding Companies, which receive royalty rates that capture all residual profits for the use of a trademark even though the licensee often owns valuable manufacturing intangibles. Utah State Tax Commission v. See’s Candies, Inc. involved a state transfer pricing issue where See’s Candies produced and sold chocolates using intangible assets that were owned by another affiliate. While the consolidated profit margin = 22%, a Deloitte analysis argued for a 16.5% royalty rate on the premise that the routine return for producing and selling the chocolates was 5.5%. I critiqued this analysis in a paper entitled “CPM versus CUT: Intercompany Royalties for Really Good Cookies,” which noted that market rates in this sector tended to be 10% or less.

 

References

Gregory Ballentine, “BEPS, Economic Activity, and Value Creation,” Tax Notes International, March 28, 2022.

Harold McClure, “Coca Cola's Intercompany Royalty Rate: An Intermediate View,” Journal of International Taxation, February 2020.

Harold McClure, “Medtronic's Intercompany Royalty Rate: Bad CUT or Misleading CPM?” Journal of International Taxation, February 2019.

Harold McClure, “REIT Transfer Pricing: Is the Rent Too Damn High?” Journal of Corporate Taxation, September 2015.

Merton H. Miller and Charles W. Upton, “Leasing, Buying, and the Cost of Capital Services,” Journal of Finance, June 1976.

Aswath Damodaran, "Return on Capital (ROC), Return on Invested Capital (ROIC) and Return on Equity (ROE): Measurement and Implications," June 2007.

“Measuring Labor Market Power in the U.S. Manufacturing Sector,” Federal Reserve Bank of Richmond Economic Brief No. 22-01, January 2022.

CPM versus CUT: Intercompany Royalties for Really Good Cookies,” Tax Notes International, November 8, 2021.

 

Headquarters
EdgarStat LLC
6931 Arlington Road, Suite 580
Bethesda, Maryland, 20814-5284
USA
Customer Support
+1 (202) 558-2356
support@edgarstat.com