McDonald's France Intercompany Royalty: CUT v. CPM on Steroids

Before 2008, the French affiliate of McDonald’s paid the U.S. parent intercompany royalties equal to 5% of its company sales. This intercompany royalty rate was consistent with the royalty rates paid by third-party licensees such as Arcos Dorados.

A 2008 restructuring transferred the European rights to the McDonald’s intangibles to McD Europe Franchising Sàrl, a Luxembourg-resident subsidiary with branches in both Switzerland and the U.S. While this migration of intangible assets created substantial controversy in Europe, the real transfer pricing concern would be an IRS issue and not an issue for the French Tax Authority (FTA) if the royalty rate remained at 5%.

Tim Worstall attempted to defend McDonald’s intercompany policies by assuming that the Luxembourg affiliate was the rightful owner of these intangibles and that the intercompany royalty rate had not been increased. Worstall states:

The only remaining question is whether McDonald's are charging their own subsidiary the same royalty rate that they charge a franchisee? That's the part that we don't know. But that is the part that the French tax claim rests upon.

But we do know, as this dispute has revealed the fact that the intercompany royalty rate was raised to 10%, which is twice what McDonald’s charged third-party franchisees. A report prepared by various European trade unions noted the restructuring and offered the following:

McDonald’s appears to uniformly charge its European franchisees a royalty fee of five percent of franchisees’ sales … McDonald’s largest subsidiary by turnover in France is McDonald’s France SA. When McDonald’s restructured its European operations in 2009, McDonald’s France sold significant intellectual property assets to McD Europe Franchising Sàrl in Luxembourg.    A­fter the transaction, McDonald’s France’s profit margin fell precipitously.

TPCases.com noted the 2022 settlement between McDonald’s and the FTA:

On 16 June 2022 McDonald’s France entered into an settlement agreement according to which it will pay €1.245 billion in back taxes and fines to the French tax authorities. The settlement agreement resulted from investigations carried out by the French tax authorities in regards to abnormally high royalties transferred from McDonald’s France to McDonald’s Luxembourg following an intra group restructuring in 2009. McDonald’s France doubled its royalty payments from 5% to 10% of restaurant turnover, and instead of paying these royalties to McDonald’s HQ in the United States, going forward they paid them to a Swiss PE of a group company in Luxembourg, which was not taxable of the amounts.

One might wonder how the representatives of McDonald’s thought they could justify such a high intercompany royalty rate. I noted the conflict between the Comparable Uncontrolled Transaction (CUT) approach and potential abuses of the Comparable Profits Method (CPM or TNMM in OECD nomenclature) in my February 2020 discussion of Coca Cola v. Commissioner in the Journal of International Taxation. Dr. Sanjay Unni attempted to use the financials for Arcos Dorados to justify an uncompelling position, which the tax court rejected. My discussion, however, noted how McDonald’s licensing could represent an interesting comparison between CUT approaches and reasonable applications of profits-based approaches:

A proper use of fast food franchising agreements illustrates our point that licensees deserve more than a routine return to their tangible assets. Such comparisons are absurd because consolidated profits for fast food companies are generally much lower than in controlled transactions, while the tangible assets required to run a fast food restaurant are higher relative to sales than what were observed in controlled transactions. As such, the share of residual profits to consolidated profits in the controlled transaction was much higher than the share of residual profits to consolidated profits for most fast food operations. We should also note that many of these fast food franchisee agreements require third-party operators to contribute to the franchisor's advertising budget. In fact, most of the hamburger multinationals including McDonald's, Burger King, Wendy's, and even Fat Burger mandate that their third-party franchisees contribute 4 percent of sales to the advertising funds. Even within this narrowly defined market of selling hamburgers, royalty rates differ. While Burger King and Wendy's charge royalties equal to 4 percent of sales, McDonald's charges royalties equal to 5 percent and Fat Burger charges royalty rates equal to 6 percent of sales. The reason likely is due to the generally lower consolidated profits for Burger King and Wendy's, while one would expect a Fat Burger franchise to have a higher profit potential than a McDonald's franchise. We have argued that enterprises with higher ratios of residual profits relative to consolidated profits would tend to pay not only higher royalty rates to the owner of the intangible assets, but also have higher ratios of royalties to residual profits. Unni's attempt to split consolidated profits rather than to examine a split of residual profits is based on a fundamental misapplication of financial economics – at least in terms of how we modeled this issue. We shall, however, attempt a simple application of our model to a reasonable understanding of the economics of a McDonald's franchisee.

I posed a simple financial model where the operating costs of the licensee represents 80% of sales, while its tangible assets (land, building, and equipment) represents 120% of sales. The value of the intangible assets within the region represents 80% of sales, so consolidated asset value represents 200% of sales. Since expected profits represent an overall return to consolidated assets = 10%. The following table applies this to the McDonald’s France issue by assuming annual sales = €2 billion.

Table: Illustration of Alternative Intercompany Royalty Rates for McDonald’s France

My discussion also noted:

Consolidated operating profits represent 20 percent of sales, the owner of the intangible assets captures a royalty equal to 5 percent of sales or 25 percent of consolidated profits. We are not, however, endorsing the Goldschreiber rule of thumb even if a stopped clock might be correct two times a day. We should note that a naïve application of CPM would argue for royalty rate equal to 8 percent of sales.

The naïve application of CPM assumes that both the licensee and the licensor deserve a 10% return to the assets it formally owns. This assumption, however, ignores basic financial economics which would grant the licensee a share of residual profits as it bears substantial commercial risk by leveraging valuable assets formally owned by another entity. As such, the licensee deserves a higher expected return on the tangible assets it formally owns, while the licensor deserves the risk-free rate on the intangible assets it owns plus a modest premium for bearing ownership risk. Under the arm’s length rate of 5% as established by a reliable CUT approach, the licensor expected return on assets (ROA) is reasonably 6.25%. The licensees ROA on the tangible assets it formally owns is reasonably 12.5%.

Our table also explores the implications of a 10% royalty rate. The licensee would receive only half of the consolidated profits even though it owns 60% of the consolidated assets and bears substantial more risk than the licensor. Its low ROA of 8.33% is evidence that the intercompany royalty rate is excessive. Some transfer pricing practitioners, however, attempt to rationalize applications of CPM on steroids by claiming the related-party licensee is as a limited-risk entity. Such claims are fundamentally inconsistent with sound financial economics.

My 2020 discussion of the Coca Cola litigation noted licensing arrangements for various hamburger corporations. Their third-party royalty rates vary because of different profit potentials. For example, Fat Burger licensees have higher expected profitability than McDonald’s licensees and yet their third-party royalty rates are far below the 10% intercompany royalty rate charged to McDonald’s France.

The FTA successfully challenged this high intercompany royalty rate. Appropriate applications of profit based approaches that take into account the leverage risk borne by licensees and a well reasoned application of the CUT approach both suggest royalty rates near 5% even if aggressive approaches of CPM might be abused to rationalize higher intercompany royalty rates.

References

Tim Worstall, “France Hits McDonald's With $341 Million Tax Demand: Possibly Unfairly,” Forbes, August 20, 2016.

“Unhappy Meal: €1 Billion in Tax Avoidance on the Menu at McDonald's,” www.EPSU.org, February 24, 2015.

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