Determining an arm’s-length price for transactions involving intangible assets is particularly challenging due to their intrinsic characteristics. The uniqueness of intangible assets, the difficulty in identifying reliable comparables, and the complexity of valuing them at the time of transfer often complicate the application of the methods outlined in the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022 (the OECD Guidelines), as well as in Italian transfer pricing regulations.
The choice of the most appropriate transfer pricing method for transactions involving intangibles must be based on a thorough functional analysis. This analysis should provide a clear understanding of the multinational enterprise’s overall business model and the role that the transfer of intangible assets plays in relation to the business’s core functions.
Functional analysis and DEMPE considerations
While identifying the ‘legal ownership’ of intangible assets involved in intercompany transactions can be a useful starting point for determining the parties entitled to receive the related economic returns, a more in-depth functional analysis (including DEMPE analysis – development, enhancement, maintenance, protection, and exploitation) is necessary to identify all parties that should share in the economic benefits (legal ownership versus economic ownership).
Depending on the facts and circumstances of each case, any of the methods recommended by the OECD may be appropriate. However, in practice, the comparable uncontrolled price (CUP) method and the profit split method are particularly relevant for transactions involving intangibles.
Applying the CUP method and royalty benchmarks
The CUP method can be applied where reliable comparable transactions are available. In such cases, special attention must be given to the comparability analysis, ensuring that the controlled transaction and the uncontrolled transaction are sufficiently similar.
In some instances, a multinational group entity may acquire intangible assets from an independent third party and subsequently transfer them to another group entity. In these cases, the price paid to the independent entity, subject to necessary adjustments, can serve as a reliable benchmark for determining the arm’s-length price in the controlled transaction under the CUP method.
When no internal comparable transactions are available, it is appropriate to apply the external CUP method. This involves conducting benchmarking analyses using specialised databases to identify comparable licensing agreements for intangible assets, and, consequently, to establish market-based royalty rates.
The Italian tax administration’s Circular No. 32/1980 offers guidance on market-based royalty rates under certain conditions:
Royalties up to 2% of turnover may be accepted when:
The transaction is based on a written agreement executed before the payment of the royalty; and
The utilisation and relevance of the incurred costs are well documented.
Royalties between 2% and 5% may be deemed appropriate, provided that:
Technical factors justify the declared rate (e.g., research, obsolescence, technical life, originality, results achieved);
Legal factors justify the rate (e.g., exclusive rights, the ability to sublicense, the right to exploit developments of the intangible asset); and
The actual utility obtained by the licensee is demonstrated.
Royalties above 5% of turnover may only be accepted in exceptional cases, justified by the high technological level of the industry or other specific circumstances.
These guidelines have often been used by the Italian tax administration in tax audits. However, given the changes introduced by the OECD and the evolving landscape of transfer pricing regulations, it is recommended to conduct a specific benchmarking analysis to identify royalty rates that are better aligned with the relevant industry.
Comparability and risk allocation under the OECD Guidelines
When applying the CUP method to intangibles, it is crucial to consider the specific characteristics of the asset, which are often unique. The OECD highlights several key features that may affect comparability, including:
Exclusivity of rights;
Scope and duration of legal protection;
Geographic coverage;
Useful life of the intangible;
Stage of development;
Rights to future improvements or enhancements; and
Expectations of future economic benefits.
An effective comparability analysis should also assess the risks associated with the likelihood of generating future economic returns from the transferred intangible. The allocation of such risks between the parties plays a critical role in ensuring arm’s-length conditions, as outlined in Chapter I of the OECD Guidelines. Risks to consider include:
Risks related to the future development of the intangible;
Risks of obsolescence or impairment of the asset’s value;
Risks of intellectual property rights infringement; and
Product liability and commercialisation risks.
Profit split method, valuation techniques, and documentation
In transactions involving unique and highly valuable intangibles, performing a reliable comparability analysis can be particularly challenging, especially when both parties contribute valuable or unique intangibles. In such cases, the profit split method may be the most appropriate approach for allocating profits between the parties.
In situations where reliable comparables cannot be identified, the OECD acknowledges the possibility of using valuation techniques to estimate the arm’s-length price of the transferred intangible. Income-based valuation methods, such as discounted cash flow or discounted future income projections, can be useful for determining appropriate compensation by estimating the future economic benefits derived from the intangible asset.
In transfer pricing for intangible assets, comprehensive documentation is crucial to support the arm’s-length nature of royalty rates, particularly during tax audits. Key elements of this documentation include:
Contracts – detailed agreements that specify the terms of the intangible assets being transferred and the royalty rates;
Transfer pricing analysis – a functional analysis that details the methodology used to determine the transfer price, ensuring compliance with the arm’s-length principle;
Market studies and industry benchmarks – relevant data comparing similar transactions within the industry, helping to justify the agreed royalty rates; and
Performance reports – evidence of the licensee’s financial results, demonstrating the benefits derived from the intangible assets and validating the reasonableness of the royalty payments.
