Transfer Pricing: Setting the Right Royalty Rate – A Practical Approach
July 7, 2010 in World Intellectual Property Report
This is an article by Marko Schinis from Edward Nathan Sonnenbergs, South Africa. It is taken from the latest edition of World Intellectual Property Report, a BNA International publication. Access World Intellectual Property Report on a free trial now.
Globalisation and technological advances are changing the shape of the world economy. With the increase in international transactions in a globalised world, a potential for tension and conflict among countries arises when it comes to the question of which country has the taxing rights in respect of certain cross-border transactions. As the transfer pricing of goods and services across borders is fundamental to the taxing rights of different countries, it is currently receiving increased attention, especially in light of the fact that most tax authorities worldwide struggle to maintain their desired levels of revenue.
In South Africa, this is no different and can clearly be seen in the increased audit activity, the hiring of staff and the proposed changes to the transfer pricing legislation. A substantial increase in transfer pricing audit activity, compared to the approximately fifty audits that were, according to the previous Commissioner, Pravin Gordhan (“South Africa: Gordhan Warns on Transfer Pricing Abuse”, Business Day, November 25, 2008) conducted in 2007–08, is therefore highly likely. This is in light of the fact that only fifty transfer pricing audits had been conducted in the last two years, which clearly shows that SARS’ transfer pricing resources are still extremely limited, both in quantity and quality. However, this lack of resources has clearly been recognised by SARS as one of the major obstacles in their quest to collect the budgeted tax revenues and, according to its Strategic Plan for the years 2009–2012 (South African Revenue Service Strategic Plan 2009–2012, Update for 2009–2010, page 28) a target has been set to employ an additional 15 staff members as dedicated resources to focus on tax avoidance, reportable arrangements and transfer pricing in the large business segment. Further to this, SARS in the latest proposed tax amendments has indicated its intention to change the scope of the South African transfer pricing rules to bring them in line with international norms.
One of the main areas of concern in this context has been the transfer of intellectual property. As a step towards releasing the Income Tax Act from reliance on the Exchange Control Regulations, and ensuring increased revenues from the use of foreign registered intellectual property, a new s 23I has been inserted into the Income Tax Act and the “connected persons” definitions in the transfer pricing provision (s 31) was recently amended. These amendments reflect the growing importance of IP (patents, trademarks, designs and copyright) in the value of business operations and the management of its tax liabilities. Historically, expatriation of IP to a foreign registered entity (typically in a tax haven) required Exchange Control approval, and this continues to be the case. In effect, this results in tighter exchange control requirements with s 23I limiting potential tax deductions. This is furthermore compounded by the wording of the Exchange Control Act where in s B2(6) it is stated that, “South African owned Intellectual Property may not be transferred by way of a sale, assignment or cession and/or the waiver of rights in favour of non-residents in whatever form, directly or indirectly, without prior Exchange Control approval.”
Within this ambit, there has been an increased focus by both the South African Reserve Bank (“SARB”) and the South African Revenue Service (“SARS”) on their respective approaches towards IP in the South African market. SARB has actively inhibited any cross-border movement of IP that is owned or was developed in the South African market. That is, SARB prohibits the sale of South African IP owned or developed by a South African entity to non-resident related entities, preferring the South African entity to rather license the IP to non-resident related entities. This leads to the topical question of what an appropriate royalty rate would be for IP owned or developed in South Africa. This is particularly relevant from a SARS perspective, which requires, under s 31 of the Income Tax Act 58 of 1962 that all transactions with non-resident related parties should adhere to the arm’s length principle. Section 31 forms the foundation for transfer pricing in South Africa. Based on paragraph 1 of Article 9 of the OECD Model Tax Convention, the arm’s length principle is largely shaped by the concepts of “willing buyer” and “willing seller”, where the price in a transaction is influenced by market forces and not manipulated based on internal company proxies.
As the importance of IP protection has evolved and grown, so has the sophistication of tools used to value it. Commercially, there are three primary methods used by licensing professionals to determine an arm’s length royalty rate — the Cost Approach, Income Approach and Market Approach.
The Cost Approach values IP assets based on the costs to be incurred to create and develop or to replace the assets under consideration. This valuation method is based on the premise that no party involved in an arm’s length transaction would be willing to pay more to use the property than the cost to replace the property.
For property dedicated to a business enterprise, including IP, future benefits are preferably measured in terms of income expected to be generated by the IP. The Income Approach, which is also known as the “look ahead” approach, values assets based on the present value of the future income streams expected from the asset under consideration.
Whilst a number of Income Approach based technical IP valuation tools are available, the 25 percent rule in valuing IP (“the 25% rule”) has emerged as a simpler and widely used method of determining appropriate royalty rates for IP.
The theory underlying the 25% rule is that the licensor and licensee should share in the profitability of products embodying the IP. Enjoying this article? You can read the rest of it by activating your free trial access to World Intellectual Property Report today.
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