1893. Setting the right royalty rate
November 2010 - Issue 135
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, as to 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 world-wide 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 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, 25 November 2008) conducted in 2007/8, 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 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 (IP). As a step towards releasing our Income Tax Act from reliance on our Exchange Control Regulations, and ensuring increased revenues from the use of foreign registered IP, section 23I has been inserted into our Income Tax Act and the "connected persons" definitions in our transfer pricing provision (section 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 section 23I limiting potential tax deductions. This is furthermore compounded by the wording of the Exchange Control Rulings where in section 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 section 31 of the Income Tax Act No. 58 of 1962 that 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. These are:
· 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. From an application perspective, an estimate is made of the licensee's expected profits for the product/service that embodies the IP in question over a certain time period. Those profits are then divided by the expected net sales over that same period to arrive at a profit rate. The resultant profit rate is multiplied by 25% to arrive at a running royalty rate.
· The Market Approach values assets based on comparable transactions between unrelated parties. Factors to consider include the nature of the assets transferred, the industry and products involved, agreement terms, and other factors, which may affect the agreed-upon compensation.
From a transfer pricing and hence a SARS perspective, the choice of one of the three commercial approaches in valuing IP and as a result setting an appropriate arm's length royalty rate will determine the transfer pricing method to be used, as espoused by the OECD Transfer Pricing Guidelines and SARS' Practice Note 7, towards setting appropriate arm's length royalty rates.
The Cost Approach would necessarily require either the application of the Cost Plus Method or alternatively, the Transactional Net Margin Method (TNMM). Successful application of these methods, however, assumes that the costs incurred in creating the IP is known i.e. the IP in question is in an "embryonic" stage or may be easily replicated.
The Income Approach is best suited to the Profit Split Method. The Profit Split Method would normally be used to test the results of the IP developer and the IP user. This approach has gained momentum in recent years and is largely supported by most tax authorities. Again in principle, the TNMM would be used to benchmark the user of the IP in its respective jurisdiction with the 25% rule as the starting point.
The Market Approach and its counterpart from a transfer pricing perspective, the Comparable Uncontrolled Price Method (CUP Method), has generally been regarded as constituting the most direct approach towards setting arm's length royalty rates. From a transfer pricing perspective, the Market Approach is akin to the Comparable Uncontrolled Price Method (CUP).
The CUP method is used to compare the actual prices charged between unrelated parties with the prices charged between related parties for the same goods/services. However, this is complicated by the fact that the CUP Method has strict comparability requirements for its successful application. To this end, assessment of comparability can be affected, inter alia, by:
· the characteristics of goods and services,
· the relative importance of functions performed,
· the terms and conditions of relevant agreements,
· the relative risk assumed by the taxpayer, connected enterprises and any independent party where such party is considered as a possible comparable,
· economic and market conditions, and
· business strategies.
As IP is generally unique in nature and closely guarded by the owner or developer, it is difficult to identify independent comparable transactions in the open market. From a practical perspective, the Income Approach is generally regarded as the best method in terms of setting appropriate arm's length royalty rates. Although the Profit Split Method was seen by SARS as a method of last resort, the OECD is making it more and more acceptable. Nevertheless, from a transfer pricing perspective this would have been problematic in the past as the CUP Method would have been the most preferred method of choice, but recent developments at SARS is to move more towards transactions or groups of transactions, which provides impetus for the Income Approach. The Cost Approach was identified as a suitable method in setting arm's length royalty rates. However, its application is only conclusive under very specific circumstances and will only be usable if internal comparables exist as external comparables would be extremely difficult to identify.
Edward Nathan Sonnenbergs
Practice Note 7
South African Reserve Bank Exchange Control Regulations