Intercompany Royalties: Does the Realistic Alternatives Principle Endorse CPM?

Ryan Finley of Tax Notes recently criticized the unspecified method used by the Tax Court in Medtronic Inc. v. Commissioner (T.C. Memo. 2022-84). His excellent review and critique rightfully noted that “the unspecified method accepted by the court is difficult to defend under the regulations, economic theory, or anything else.”

However, one reference he made did raise a potential concern:

But the more clear-cut reason that Medtronic II shouldn’t be affirmed in a potential appeal is its failure to properly evaluate the selected method in accordance with the realistic alternatives principle. Although the regs characterize the realistic alternatives principle as the basis for all potential methods, reg. Section 1.482-4(d) places particular emphasis on the concept as the reliability standard for unspecified methods.

Section 1.482-4(d)(1) notes:

The comparable uncontrolled transaction method compares a controlled transaction to similar uncontrolled transactions to provide a direct estimate of the price the parties would have agreed to had they resorted directly to a market alternative to the controlled transaction.

Finley reminds us of this example under Section 1.482-4(d):

In the example, the IRS uses an unspecified method that compares the royalty a U.S. parent (USbond) company charges for licensing its manufacturing technology to a European manufacturing and regional distribution subsidiary (Eurobond) with the profit the parent could have earned under the realistically available alternative of selling directly into the European market. USbond receives a royalty of $100 per ton of industrial adhesive sold by Eurobond, which sold the product to related and unrelated customers at a price of $550 per ton. Because a price of $300 was assumed to be sufficient to cover USbond’s costs plus an appropriate routine return for its functions, risks, and assets, the parent was effectively surrendering $250 to Eurobond in exchange for a royalty of only $100.

Let us consider a modified version of this example to address the realistic alternative principle explaining why sound economics would not endorse the usual application of the Comparable Profits Method (CPM) for the evaluation of the arm’s length royalty rate.

Table 1 presents our version of this industrial adhesive example in terms of prices and costs per metric ton, the same data in terms of pounds, and the overall income statement assuming that the European operations produce and sell 4 billion pounds of industrial adhesive per year.

Table 1: European Affiliate Income Statement Under Intercompany Policy

If this product sells for $550 per metric ton, its price per pound = $0.25 and overall annual sales in Europe = $1 billion. The European licensee affiliate incurs production and distribution costs of $0.10 per pound or $220 per ton, which implies operating costs = $400 million per year. As such, profits = $330 per ton or $0.15 per pound, which translates into a 60% operating margin or $600 million per year.

Table 1 assumes that routine returns = 20% of sales or $200 million per year. Residual profits represent 40% of sales or $400 million per year. Table 1 assumes that the multinational set the intercompany royalty rate at 20% of sales so intercompany royalties = $200 million. Under this intercompany pricing policy, the licensee share of residual profits represents 20% of sales or $200 million per year. The licensee’s total profits would therefore be $400 million per year.

Section 1.482-4(d) does not explain the nature of the unspecified method that led to this result. It should be noted that the taxpayer and the IRS in the Coca Cola litigation had originally agreed to a 10/50/50 approach to determining the intercompany royalty rate where the routine return was assumed to be 10% of sales and residual profits were evenly split between the licensor and the licensee. The IRS later rejected this approach arguing for a somewhat lower routine return and an allocation of all residual profits to the licensor’s royalty rate via application of CPM. Perhaps the authors of this example had something similar in mind.

While the example in Section 1.482-4(d) notes that the IRS could object to such a low royalty rate under the realistic alternative principle, it does not specify how high of a Section 482 adjustment the IRS would be entitled to make. One can speculate that the IRS would argue for an increase in the intercompany royalty rate such that it captures all of residual profits. I would argue such an interpretation violates basic financial economics for reasons I have noted in earlier publications on the evaluation of arm’s length royalties.

Table 2: Three Alternative Intercompany Royalty Rates

Table 2 considers the implications of three alternative royalty rates including the intercompany policy noted in table 1. The IRS view under CPM would raise the intercompany royalty rate from 20% to 40%, which leaves the licensee with none of the residual profits. Under this intercompany royalty rate, the European licensee's overall profits would be only the $200 million per year, compensating this affiliate with only a routine return. We shall argue that a sound financial economic model would set the royalty rate at 30%, at most. Under this economic interpretation of the arm’s length royalty rate, the licensor captures at most 75% of the residual profits, with the licensee entitled to not only its routine return, but also a share of residual profits.

The Basic Arm’s Length Return Method (BALRM) as the Foundation of the IRS Approach

Daniel Frisch in a May 19, 1980 Tax Notes paper outlined how BALRM could be utilized to justify royalty rates that capture all operating profits beyond the routine return for the licensee’s functions. Frisch applied the Capital Asset Pricing Model (CAPM) as means for evaluating the cost of capital for both the tangible and intangible assets for a consolidated entity. My writings on the evaluation of intercompany royalty rates also utilizes CAPM but in a different way from Frisch’s 1989 discussion.

Financial economists note that the cost of capital represents the risk-free rate plus a premium for bearing non-diversifiable or systematic risk. CAPM captures the enterprise’s premium for bearing systematic risk by the estimated unlevered beta for the enterprise times the market premium for systematic risk. Let’s assume a risk-free rate = 5%, the market premium = 5%, and the overall enterprise’s unlevered beta = 1, which implies overall cost of capital = 10%. The value of the enterprise’s overall assets can be seen as its consolidated profits divided by its cost of capital. Since consolidated profits in our example = $600 million per year and the cost of capital = 10%, the value of all assets including tangible assets owned by the licensee and the intangible assets owned by the licensor = $6 billion. BALRM assumes that the cost of capital for both routine functions and the ownership of intangible assets are both the same as the overall cost of capital, which is 10% in our example. Since routine returns = $200 million per year, the value of tangible assets = $2 billion. Since residual profits = $400 million per year, the value of intangible assets = $4 billion.

Let’s assume that the “realistic alternative” envisioned in the Section 1.482-4(d) example is for the US parent to be the seller of record for industrial adhesives with the contract manufacturing activities and European sales functions being performed by European affiliates who bear only modest commercial risks. The IRS CPM approach would then rightfully determine the expected profits for the European affiliates as 10% of the value of tangible assets, which would imply they would be entitled to only the routine return of $200 million per year. The US entrepreneurial affiliate would be entitled to 10% of the value of its intangible assets or $400 million per year as it incurs significant commercial risk.

This scenario, however, is fundamentally different from a licensing arrangement, as the licensor only bears ownership risk whereas the licensee bears all commercial risk not only from utilizing the tangible assets that it owns, but also from utilizing valuable intangible assets owned by another entity.

The BEPS Action 8 Deliverable also notes the importance of determining which affiliate owns each of the intangible assets by an examination of the contractual arrangements, as well as a proper functional analysis (see paragraph 6.35). The role of risks is noted in the BEPS Discussion Draft on Action 9 (paragraph 63):

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.

Merton Miller and Charles Upton described the expected return to the owner of leased assets using a variation of CAPM where this expected return (R_l) is given by:

R_l = R_f + b_l(R_m - R_f).

The beta coefficient for a lessor or for a licensor (b_l) would tend to be modest relative to the beta for the assets of an entity that actually runs a business. Miller and Upton note lessors bear only the risk of obsolescence of the assets that they leased but not the commercial risk. My discussion in a 2015 piece in Journal of International Taxation of intercompany licensing mirrors the economics of the Miller-Upton leasing model.

Table 3 shows the return on assets (ROA) for both the licensor and the licensee under our three intercompany royalty rates. Under the taxpayer’s policy where the intercompany royalty rate is only 20%, the licensor’s return to its intangible assets is only 5% or the risk-free rate. While the IRS would rightfully argue for a higher royalty rate, the 40% royalty rate implied by CPM would leave both the licensor and the licensee with a 10% return to the assets each owned.

Table 3: Return to Assets Implied by Three Alternative Royalty Rates

If the licensor merely bears ownership risk and not commercial risk, then the arm’s length royalty rate should be higher than what the taxpayer’s policy suggests, but lower than the rate suggested by CPM. If the royalty rate = 30%, then the licensor’s expected return to intangible assets would be 7.5%, which is consistent with  b_l = 0.5. One could reasonably argue that this represents a generous estimate of the systematic risk from mere ownership. If the appropriate value of b_l is less than 0.5, then the arm’s length royalty rate would be lower than 7.5% but higher than 5%.

Licensees bear significant commercial risk when they use valuable intangible assets owned by another entity. As such, any method that affords them with an expected return to its tangible assets that is only as high as the overall enterprise’s cost of capital is inconsistent with sound financial economics. As such, the arm’s length royalty rate is less than what an application of CPM implies. Section 1.482-4(d) suggests the analysis consider the implications of the multinational’s realistic alternatives. If this realistic alternative is a contract manufacturing structure, we must protest that licensing and contract manufacturing involve very different assumptions with respect to which entity bears commercial risk.

References

Ryan Finley, “Medtronic and the Role of Unspecified Transfer Pricing Methods,” Tax Notes International, September 12, 2022.

Medtronic, Inc. and Consolidated Subsidiaries v. Commissioner of Internal Revenue Service, T.C. Memo. 2022-84, August 18, 2022.

US Code 26 CFR 1.482-0.

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

Harold McClure, “Arm's-Length Royalties in Light of BEPS and Uniloc," Journal of International Taxation, November 2015.