Royalty and Transfer Pricing

Prepared by Ganesh R

Intercompany Royalty

Royalty is a consideration received by the owner of an intangible right or knowhow under license in any technology transfer. Such intangibles may be of two types which are trade intangible and marketing intangibles. Trade intangibles include patents, knowhow, designs and models used for production of goods and services and computer software. Marketing intangibles include trademarks or trade names/brand names, logo etc.

In a royalty based transactions the owner of the intangible property continues to retain the intangible property and permits only the use or right to use the intangible property to the other party.

An Inter-Company royalty is the fees that one entity charges a related party for the use of its Intangible right. The intangible property transfer can be between a parent entity and a subsidiary, or the transfer can be between two related parties.

In order to meet the Indian and global transfer pricing regulatory framework, the royalty payment made between the associated Multinational Enterprises (MNEs) should meet the arm’s length principle.

  • Pricing terms

The transfer of intangible between related parties may be either through sale or through licensing. The more popular and widely used way of transferring intangibles between related parties is through the use of exclusive or non-exclusive licence agreement.

There are many ways to structure such licensing agreements, the simpler among them may be in these forms:

(i) A fixed annual fee

(ii) A fee based on a percentage of licensee’s sales of the licensed products

  • Marketing Intangibles

As per the Organization for Economic Cooperation and Development’s (OECD’s) transfer pricing guidelines on Chapter VI, which were released as part of base erosion and profit shifting (BEPS) Actions 8 to 10, defines Marketing intangible as an intangible that relates to marketing activities, aids in the commercial exploitation of a product or service, or has an important promotional value for the product concerned.

A marketing intangible may include trademarks, trade names, customer lists, customer relationships, and proprietary market and customer data that is used or aids in marketing and selling of goods or services to customers.

Both the OECD and UN transfer pricing guidelines have made it clear that marketing intangible needs to be “unique” or “non-routine”; and non-existent within comparable companies that are selected the purpose of transfer pricing analysis.

Taxation of Royalty as per Model conventions

The OECD and the UN conventions provide for taxation of royalty income in Article 12. The OECD Convention and the US Model provide for taxation of royalty income in the state where person who beneficially owns the IPR is resident. In the UN Convention, the source (on income) state also has taxation rights, and the resident country may reserve its taxation right.

Also, the tax is imposed by the source state at a pre-negotiated percentage of the gross amount. There are also differences in the definition of royalty itself in the two model tax conventions. It is seen that the OECD convention does not have any clause on equipment royalty, which is available in the UN Convention. Rentals for commercial and scientific equipment fall under the category of equipment royalty.

  • OECD Transfer Pricing guidelines

The authoritative statement of the arm’s length principle is found in paragraph 1 of Article 9 of the OECD Model Tax Convention, which provides:

“[Where] conditions are made or imposed between the two [associated] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly.”

  • DEPME functions

In transfer pricing the issue is which entity or entities within the group should ultimately bear the costs, investments and other burdens associated with the development, enhancement, maintenance, protection and exploitation of intangibles. Multiple entities within an MNE (including the legal owner) may be involved in the creation of an intangible’s value. They may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible. Those entities within an MNE should receive a portion of the profits that were gained from the exploitation of the intangible at arm’s length principle.

DEMPE Analysis



The development of intangibles refers to everything that is associated with coming up with ideas for the brand and products, and putting plans and strategies in place for their creation.

Enhancement The term ‘enhancement’, in the context of DEMPE, involves continuing to work on aspects of intangibles to make sure they can perform well at all times and be constantly improved.
Maintenance Maintaining intangibles involves doing everything that is possible to ensure they continue to perform well and generate revenue for a business.
Protection Brand protection is important for ensuring that the value of a brand’s assets remains strong. It involves securing IP legal rights, making sure nobody can copy the ideas and monitoring competitor’s activities.
Exploitation In relation to intangibles, the term ‘exploitation’ refers to the way in which intangibles are used to generate profits.

The framework for analyzing transactions involving intangibles between associated enterprises is found in Para 6.34 requires taking the following steps.

  1. Identify the specification of intangibles used or transferred in the transaction, specific and economically significant risks associated with the DEPME functions.
  2. Identify the full contractual arrangements the contractual rights and obligations, including contractual assumption of risks in the relations between the associated enterprises;
  3. Identify actual functions performed by parties by functional analysis and identify which parties control any outsourced functions, and control specific, economically significant risks;
  4. Confirm the consistency between the terms of the contractual arrangements and the conduct of the parties, and determine whether the party assuming economically significant risks controls the risk and has financial capacity to assume the risk relating to DEPME functions.
  5. Delineate the actual controlled transactions related to the DEPME of intangibles based on the legal ownership of the intangibles, relevant contractual relations and the conduct of the parties, taking into account the framework for analysing and allocating risk.
  6. Determine arm’s length prices for these transactions consistent with each party’s contributions of functions performed, assets used, and risks assumed.
  7. Key issues in Transfer Pricing
    • Excessive payments

In order to evade taxes and to claim excessive expenditure, an entity in a high tax jurisdiction from a MNE group may make excessive payment of royalty to its related party entity which is in a low or tax jurisdiction. It may also be doubtful whether the underlying intangible property is particularly valuable and if such arrangement would be made between two independent parties.

This issue is associated with the genuineness of the transaction. The expenditure by the licensee may be disallowed while determining its income. The expenditure may also be allowable to the extent of ‘Arm’s length price’. The transfer pricing officers would apply the transfer pricing methods to find the arm’s length price.

  • Concept of Benefit test

Benefit test indicates the amount of benefit derived by the assessee from the use of intangible property owned by the associated enterprise.

Benefit test is applied by the Revenue to disallow partly or in its entirety the royalty expenditure on the ground that no tangible benefit is obtained by the assessee from the use of intangible property owned by the AE.

Delhi bench of the tribunal in case of Reebok India Co. [2013] (Delhi – Trib.) has held that taxpayer is free to conduct business in the manner it deems fit and the commercial and business expediency of incurring any expenditure is to be seen from the businessman’s point of view. TPO argued that the percentage of net profit to sales was lower this year in comparison of the previous year and thus held that the assessee did not derive any benefit from the payment of royalty. The tribunal held that profitability can be lower due to various business reasons and lower profitability in the current year as compared to previous year does not conclude that no benefits were derived.

Delhi HC in case of EKL Appliances Ltd. [2012] (Delhi) has held that it is not necessary for the assessee to show that any legitimate expenditure incurred by him was incurred out of necessity. It is also not necessary for the assessee to show that any expenditure incurred by him for the purpose of business carried on by him has actually resulted in profit or income either in the same year or in any of the subsequent years. The only condition is that the expenditure should have been incurred “wholly and exclusively” for the purpose of business and nothing more.

  • Economic ownership

Whether the entity which is the user of the royalty should be compensated for its functions performed, assets used and risks undertaken for developing the intangible. The licensor is the legal owner and the economic ownership is based on facts of the case. The licensee may become an economic owner if it bears the cost in developing the intangible. The Issue is that the licensee should be adequately compensated for its efforts by the legal owner.

The transfer pricing authority, while determining the arm’s length price of the license payment made by the licensee, would adjust any compensation that should have been received by the licensee for its marketing efforts.

  • Bright Line Concept

The Bright line concept recognizes that every licensee need to incur some expenses like advertisement, sale promotion, etc. in relation to the intangible for which royalty is paid to the licensor. However, if the investment of the licensee crosses the ‘bright line’ of routine expenses, the licensee becomes an economic owner. The economic owner in that case becomes entitled to economic return from the legal owner (licensor).

Indian tax authorities have been identifying excessive advertising, marketing and promotion (AMP) expenses incurred by the Indian taxpayer by applying the brightline test and applying a markup on such expenses to allege that the taxpayer was provide a service to the foreign brand owner, for which a compensation is due.

The ruling of the special Bench of the Delhi Tribunal in respect of marketing intangibles in the case of LG Electronics India Private Limited held that TP adjustment in relation to AMP expenses incurred by the Indian taxpayer for creating and improving the marketing intangible for and on behalf of the foreign parent company is permissible.

  1. Application of Methods

Intangibles often have unique characteristics and generates returns and creates future benefits that may vary widely. While conducting the comparable analysis, it is important to know the unique feature of such intangible.

This is important where the CUP method is considered to be the most appropriate transfer pricing method, but also has importance in applying other methods that rely on comparables. In the case of a transfer of an intangible or rights in an intangible that provides the enterprise with a unique competitive advantage in the market, purportedly comparable intangibles or transactions should be carefully scrutinised. It is critical to assess whether comparables in fact exhibit similar profit potential.

  • Unique Features of Intangibles
  • Exclusivity
  • Extent and duration of legal protection
  • Geographic scope
  • Useful Life
  • Stage of development
  • Rights to enhancements, revisions, and updates
  • Expectation of future benefit


  • Benchmarking for closely linked transaction

The term ‘transaction’ is defined in rule 10A (d) to include a number of closely linked transactions. As per ICAI Guidance note , two or more transactions can be said to be closely linked when these transactions emerge from a common source being an order or a contract or an agreement or an arrangement and the nature, characteristics and terms of these transactions are substantially flowing from the said common source.

For example, a master purchase order is issued stating the various terms and conditions and subsequently, individuals orders are released for specific quantities. The various purchase transactions are closely linked transactions

Mumbai Bench of the Tribunal in case of Cadbury India Ltd. v. Addl. CIT [2014] 147 ITD 487/[2013] has upheld the bundling of closely linked transactions as royalty payment was inextricably linked with the production and sales. In the absence of production and sale of products, there would be no question arising regarding payment of any royalty. That being so, royalty cannot be considered, and examined in isolation on a standalone basis. Royalty is to be calculated as a specified percentage on net sales. Thus ITAT upheld the use of overall TNMM for examining the royalty transaction.

Delhi Bench of the tribunal in case of Gruner India (P.) Ltd. [2016] 70 240 (Delhi – Trib.) has held that international transaction of payment of royalty for use of technical know-how and brand name of AE cannot be clubbed with international transactions of import of raw materials and export of finished goods since said transactions had no link with each other.

Thus if royalty payment is a closely linked transaction then it can be bundled and benchmarked accordingly.

  • Most appropriate Method

In selecting the most appropriate transfer pricing method in a case involving a transfer of intangibles or rights in intangibles, attention should be given to

  • the nature of the relevant intangibles,
  • the difficulty of identifying comparable uncontrolled transactions and intangibles in many, if not most, cases, and
  • the difficulty of applying certain of the transfer pricing methods

The selection of the most appropriate transfer pricing method should be based on a functional analysis that provides a clear understanding of the MNE’s global business processes and how the transferred intangibles interact with other functions, assets and risks that comprise the global business. The functional analysis should identify all factors that contribute to value creation, which may include risks borne, specific market characteristics, location, business strategies, and MNE group synergies among others.

Comparable uncontrolled price (CUP) method may be the most appropriate method to determine arm’s length royalty rate if owner of intangible asset has granted similar licensing rights to independent parties.

But when internal comparables are not available, the royalty rate can be calculated by comparing the transaction under consideration with similar licenses involve in other transactions and making appropriate adjustments for differences in conditions and terms of contracts. However, when traditional transaction methods cannot be applied the taxpayer can rely on profit methods. The TNMM is most common method applied in such situation.

In case of Denso India Ltd. (supra) the Hon’ble Jurisdictional High Court has approved the decision of the TPO in applying TNMM for benchmarking the arm’s length price of royalty paid.

In case of CLSA India Ltd. (supra) and Frigo Glass India Pvt. Ltd. (supra) the Tribunal has rejected applicability of CUP method for determining the arm’s length price of royalty payment and has held that TNMM is the most appropriate method to determine the arm’s length price of royalty payment.

  • Other method

Where information regarding reliable comparable uncontrolled transactions cannot be identified, the arm’s length principle requires use of another method to determine the price that uncontrolled parties would have agreed under comparable circumstances. In making such determinations, it is important to consider:

  • The functions, assets and risks of the respective parties to the transaction.
  • The business reasons for engaging in the transaction.
  • The perspectives of and options realistically available to each of the parties to the transaction.
  • The competitive advantages conferred by the intangibles.
  • The expected future economic benefits from the transaction.
  • Other comparability factors such as features of local markets, location savings, assembled workforce, and MNE group synergies.


  1. Royalty rates Table
Company Nature of Royalty % Base Industry
Adidas Pvt Ltd Brand 5% Net Sales Footwear
Nissin Brake India Pvt ltd Product Development 3% Value added Automobile
Mondelez India Foods Pvt ltd Trademark license 1% Net sales Food processing
Vodafone India limited Trademark license 0.30% Net sales Telecommunication
Motorola Incorporation Trademark license 7% Net sales Telecommunication
A.W. Faber Castell (India) P.Ltd Trademark license 3% Net sales Stationery
Honda Siel Power Products Ltd Trademark license 4% Ex-factory price Power Products

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