Intercompany trademark royalty fees: practical experience and a Swiss Supreme Court Case
Caterina Colling Russo and Monika Bieri of Tax Partner explain the key issues as tax authorities focus on the potential for MNEs to benefit from profit shifting through the transfer and licensing of intangibles.
Introduction to trademark licensing transactions
Having a strong trademark has always been a vital part of business, but it may be more important now than ever before, since consumers are exposed to new brands every day through social media and differentiation via a well-known brand is key.
In a B2C business, the brand is important as it has an unquestionable impact on end-customer choices. Similarly, in a B2B context, it is empirically proven that customers prefer to enter into business relationships with well-known suppliers associated with a lower business risk and higher quality.
As intangibles, including trademarks, take a central role in the value chain of most industries, tax authorities are increasingly concerned that tax base erosion can be attained by multinational enterprises (MNEs) shifting profit in low-tax jurisdictions through cross-border transactions involving the transfer and licensing of intangibles.
In this article, the authors share their practical experience regarding intercompany trademark royalty fees, taking inspiration from a recent Swiss Supreme Court case in which an intercompany trademark royalty was at the centre of the dispute.
Practical experience in intercompany trademark licence fee cases
MNEs face the following challenges in the payor’s jurisdiction.
Lack of benefit
According to the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022 (Section 6.81), it is reasonable to conclude that a payment for using a trademark is at arm’s length if the trademark provides a financial benefit to members of the group other than the member legally owning the intangible. Tax authorities might not recognise the financial benefit received by the licensee. Practically speaking, the question is how to prove this financial benefit.
Empirical studies conducted in various geographies, and on different sectors, confirm the indisputable correlation between trademark use and financial benefit.
A positive correlation between trademark registration, product innovation and productivity was found in a study conducted on a sample of firms in the UK with registered trademarks in the UK and the EU. The study provided evidence of substantial differences in performance between firms that have registered a trademark and those that have not, with a wider gap across services firms (see Greenhalgh, C., & Rogers, M., Trade Marks and Performance in UK Firms: Evidence of Schumpeterian Competition through Innovation (2007)).
However, despite this confirmation, the challenge for taxpayers remains that of being able to evidence their own benefit. When the trademark is only licensed to MNEs with no proof that a third party would be willing to pay for it, the ability to evidence that the trademark is generating value for the licensee remains of paramount importance; i.e., positively impacting sales and, thus, causal for the development of the licensee’s revenue.
In cases where the licensee was integrated within the group via acquisition, the comparison of the pre- and post-acquisition sales has often produced the necessary evidence that the use of the group trademark positively impacted post-acquisition sales. Especially in B2B businesses, the use of the trademark allowed the licensee to access big industry players, imbued with the trust that the group trademark creates. Furthermore, existing contractual relationships could be secured and renegotiated over time at more attractive conditions, allowing better margins. The financial benefit of the licensee was hence tested.
Alternatively, when the licensee was not part of an acquisition, providing a detailed industry context of the licensee's business would help to relate post-royalty results with those of the peer group, while explaining the comparative effect of the trademark on the licensee’s financial ratios.
Fragmentation of the DEMPE functions
As part of the BEPS Project of the OECD and G20 countries, the OECD revised its guidance on intangibles in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2017, with the introduction of so-called DEMPE analysis. This approach is aimed at aligning the allocation of intangible-related profits with the functions, assets and risks relating to the development, enhancement, maintenance, protection and exploitation (DEMPE) of intangibles.
The Transfer Pricing Guidelines distinguish between three main cases:
A legal owner that performs and controls all the functions, all the assets (including funding) and all the risks related to the DEMPE functions;
A legal owner that outsources part of the DEMPE functions to third parties or associated parties; and
A legal owner not performing any relevant function relating to the DEMPE functions of the intangible.
In the first case, the legal owner is entitled to the full profit deriving from the exploitation of the intangible, whereas for the second case, the legal owner will be left with the residual part of this profit, after compensating at arm’s length the functions performed by other group entities contributing to the value of the trademark. The third case will evoke the correct delineation of the transaction that will likely leave the legal owner with the entitlement to no or minimal residual profit.
This implies that the group’s trademark intercompany licensing structure needs to be grounded in a comprehensive analysis, whereby the value contribution of each party in the development, value enhancement, maintenance, protection and exploitation of the trademark is examined. A review of how the following functions are allocated is relevant to the analysis:
The planning and implementation of advertising campaigns, and the commissioning of external service providers (for example, advertising companies);
Strategic brand positioning, economic value maintenance and brand management in relation to the trademark;
Control and assumption of the legal, economic and financial risks associated with the trademark;
Registration and renewal of the trademark in international and local trademark registers; and
Protection of the trademark, including the ongoing monitoring of infringements against the trademark, and the commissioning of external service providers (for example, lawyers).
Determining the royalty rates
Parties to a licensing agreement are free to choose the basis of royalty calculation that best matches their commercial needs. The most common is the comparable uncontrolled price/transaction (CUP/CUT) method as an expression of the royalty as a percentage of revenue. When internal comparables are not available – i.e., trademark licensing agreed with a third party – the CUP method relies on database studies for external comparable licence agreements.
The extent of publicly availability royalty rates for trademark licensing depends on the industry of the tested transaction and the obligations to disclose. This makes the quest for comparable royalty rates more difficult in some industries/geographies than others. On some occasions, search criteria can be broadened; whereas in others, some comparability criteria have a critical importance in identifying comparable royalty rates. Notably, aspects such as industry comparability and B2B or B2C use of the trademark more often than not play a key role in the level of the royalty rate. Other comparability factors, such as geography of the licence or its validity period, might have a lower impact.
Finding a comparable set with a stable result – i.e., with a reasonable number of comparable agreements – is often a challenge. Especially for a trademark royalty fee, most of the publicly available agreements contain a portfolio of several intangible properties and not only the trademark, so that comparability adjustments might be required.
The arm’s length principle does not require the application of more than one method for a transaction, and undue reliance on such an approach could create a significant burden for taxpayers. However, for difficult cases, increasing the sustainability of an intercompany licensing charge, with a corroborating analysis such as an implied royalty rate calculation, is recommended.
Once baseline functions of the parties involved have been remunerated through an arm’s length EBIT, the excess profit should be split, based on sound qualitative or quantitative criteria, between the owner of the trademark and other high-value contributors; for example, the patent’s owner.
Rule of thumb methods are used in some jurisdictions. In these jurisdictions, taxpayers are normally advised to double check their transfer pricing policy against such rules, knowing that tax authorities will probably do the same.
The most commonly used rule of thumb is the ‘Knoppe rule’, or the ‘25% Goldscheider rule’. According to this rule, the licensee is expected to pay a licence fee equivalent to 25% of the anticipated profits generated by the licensed intangible asset. In Switzerland, a reference to a level of royalty rate is now available as part of the patent box regime, a residual profit calculation for the allocation of profit to the patent box. For this calculation, it is indicated that a 1% profit on sales should be taken out as a trademark fee.
Supreme Court case on a trademark royalty fee
In its decisions 2C_824/2021 and 2C_825/2021 in October 2022, the Federal Supreme Court dealt with a trademark licence fee paid by a Swiss company (Company A) to its sister company in Liechtenstein (Company B).
Company A’s purpose is the distribution, marketing, sale and financing of luxury real estate in Switzerland or abroad. Company B’s purpose is the brokerage of real estate projects in connection with the construction, sale and exploitation of such real estate projects, as well as the distribution, marketing and advertising of such projects. Company B is the owner of the trademarks ‘E’ and ‘F’, which were deposited in the Liechtenstein Trademark Register on September 29 2015. Furthermore, a registration was made with the World Intellectual Property Organization. The trademark protection has existed since October 20 2015 for Liechtenstein, Austria, Switzerland, Italy, Portugal, Spain and the United Kingdom.
On November 7 2015, Company B entered into a licensing agreement with Company A, permitting use of the ‘E’ trademark. The licensee had to pay an amount of CHF 100,000 and an ongoing licence fee of 10% of each project’s net sales.
The cantonal tax authority increased the taxable profit of Company A in the amount of CHF 655,228, asserting the existence of a deemed dividend for the excessive part of the licence payments (i.e., the taxable profit was corrected from CHF 53,882 to CHF 709,110). An objection filed by Company A against this decision was rejected by the tax administration and the cantonal court. An appeal was filed by Company A with the Federal Supreme Court.
What the Federal Supreme Court said
The court reiterated its established case law on the practice on hidden profit distributions, which requires that:
The company does not receive any, or no equivalent, consideration;
The shareholder receives an advantage, directly or indirectly;
The company would not have granted this advantage to a third party under the same conditions; and
The character of this set-up – in particular, the disproportion to the consideration – was apparent for the executive body of the entity.
Furthermore, the court stressed that the burden of proof is with the tax authorities. It is the tax authorities that need to demonstrate that a service rendered by an entity is not matched by any, or an inappropriate, consideration. If disproportion conduct is evidenced, it is thus up to the taxpayer to prove the arm’s length nature of the consideration under review.
The Federal Supreme Court considered the 2010 version of the OECD Transfer Pricing Guidelines to examine whether intra-group services stand up to third-party comparison.
In its decisions, the Federal Supreme Court confirms the view of the lower court that assessed that the level of company A’s net profit margin after royalty deduction (3.8%) was a relevant indicator to prove the obvious disproportion between service and consideration. The complainant had – according to the court – not made any serious attempt to prove the appropriateness of the payment by means of a suitable transfer pricing method, or at least to provide the cantonal authorities with relevant information in this respect. The court did not accept the argument raised by Company A that the margin was high enough to cover the royalty payments to the Liechtenstein trademark owner and that the added value was actually attributable to the registered trademarks.
Despite the fact that the Federal Supreme Court refers to the OECD Transfer Pricing Guidelines, it does not follow the guidelines’ approach to pricing intra-group transactions involving intangibles.
The court only used quantitative arguments (i.e., too low margin) of the complaint to reverse the burden of proof. The court did not consider qualitative arguments, as it did not delineate the transaction at hand and neither analysed the assets used and risks employed, nor the functions performed by the involved parties, which is key in correctly pricing transactions. With incomplete facts at hand, no correct transfer pricing analysis is possible.
Referring to the above practical issues discussed, the following can be summarised:
Benefit test – this was mentioned by the court but the taxpayer could not prove any benefit.
DEMPE functions – no functional DEMPE analysis was performed. The court accepted only the part of the trademark licence fee that referred to expenses incurred for the registration of the trademark, thus recognising a reimbursement of third-party costs rather than a compensation for protection functions.
Royalty fee determination – the taxpayer should have put effort into showing the positive impact on sales of the trademark and the lower court should have identified the peer group of licensees and compared Company A’s net margin of 3.8% after royalties with the net margin achieved by peer group entities with comparable activities to give significance to this ratio, and/or introduced a rule of thumb calculation in support of its case.
Despite any sound qualitative analysis performed, the authors agree with the result of the court’s decision.
Another significant case
Finally, and as something of an aside, the highest Swiss court recently had to deal with a case regarding the inter-cantonal allocation of a B2C trademark by a Swiss enterprise to one of its Swiss permanent establishments (FSC 2C_131/2021, decision of February 15 2023). Even though it was a pure national tax allocation case, the court did refer to the OECD Transfer Pricing Guidelines in its decision and – in contrast to the case discussed in this article – delineated the DEMPE functions performed, the risks borne and assets employed.
This was the first time that the Swiss Federal Supreme Court explicitly referred to DEMPE analysis. Furthermore, the reference was made with respect to a transaction that took place in a pre-BEPS era, contradicting the previous case law practice establishing that reference should be made to the version of the Transfer Pricing Guidelines applicable for the fiscal year in question.