Searching for Comparable Royalty Rates
The Italian revenue agency recently issued guidance related to a Patent Box regime that has driven a recent surge in interest focused on mapping and measuring income generated by intellectual property and intangible assets (“IP & IA” or “the intangible”). Income mapping and measuring begins with identifying the qualifying intangible source available for preferred tax treatment. This income can be related to out-licensing of IP & IA rights to third parties or using an internally developed intangible directly.
…royalty rates have been the focus of many tax and valuation experts as an excellent tool to help map and measure the income attributable to IP & IA rights for preferred tax treatment…
To identify and calculate a royalty income measure for an internally developed intangible, a search strategy for comparable royalty rates needs to be outlined. Again, begin by identifying the intangible asset that is the source of the income, such as a copyright-protected software, a patent, a trademark or design. Next, assemble a description of the intangible asset and gather unique keywords that will help start a search at RoyaltySource or IPSCIO. Finally, understand that it is rare to find an exact comparable license and the need to expand the search to include other possible licenses that can be used as a guide is important.
For example, searching for a copyrighted furniture design license would include keywords such as furniture, fixtures, drapery, chair, carpet, seat, mattress, sofa, couch, and table. Similar licenses that could be considered proxies include other consumer household goods, such as appliances and decorative lighting.
More on the Patent or IP Box
Italy has now joined many other EU countries, such as Ireland, France, Belgium, Hungary, Luxembourg, Netherlands, Spain and the United Kingdom in promoting research and development and the contribution resulting from the developed IP & IA to overall economic development by using a Patent Box regime. This regime encourages qualifying companies to not only profit from the exploitation of their IP & IA rights, but to qualify for tax relief when generating income attributable to the exploitation of IP & IA.
This article is not intended to be a detailed review of the Italian tax regime or those of other countries. We simply want to point out that royalty rates have been the focus of many tax and valuation experts to help map and measure the income attributable to the products and agreements involving IP & IA rights for preferred tax treatment. One source of these royalty rates is publicly available IP licenses. These licenses report the royalty rate data needed to add insight and quality support to the evidence required in developing fair agreements with tax authorities.
Using the Italian Patent Box regime as an example, income mapping begins with identifying the qualifying source of intangible income. This income can be related to out-licensing IP & IA rights to third parties or an internally developed intangible.
… Identifying and calculating the income from the direct use of the internally developed intangible is not straight forward …
Identifying and calculating the income measure from out-licenses to third parties is fairly straight forward since the royalty paid to the licensor or IP holder is the initial measure. Then applicable costs are deducted from these royalty revenues in arriving at the qualifying income.
Identifying and calculating the income from the direct use of the internally developed intangible is not as straight forward. The income measure for these intangibles begins with a measure of the company’s earnings. However, these earnings represent the return attributable to all assets assembled, including current, fixed and IP & IA, to generate revenue and earnings. This means a more rigorous analysis is required to allocate these earnings/income to the qualifying intangibles. The tools available to make the allocation include those used in transfer pricing and valuation.
… A benchmark royalty rate can be used to directly identify the income from internally developed intangibles …
A benchmark royalty rate can be used to directly identify the income from internally developed intangibles contributing to the company earnings. For example, if the company did not internally develop the IP & IA, the company would in-licensed the necessary intangibles resulting in lower earnings from the expense associated with making royalty payment. It is this royalty savings, resulting from the application of the royalty rate to the identified sales measure that forms the basis for measuring the required income. In other words, this method looks at the costs saved by owning the IP & IA right instead of leasing it. This method is referred to in valuation as the “relief from royalty method.”
This method can also be used indirectly to identify and apportion company income/earnings to identify excess earnings attributable to the identified intangibles. In other words, the earnings, after recognizing all expenses and royalty payment, are mapped first to current assets, fixed assets, other IP & IA assets to identify the excess earnings to the target IP & IA.
Finally, once the income attributable to the use of the qualifying assets is identified, a certain percentage of the income is excluded from taxable income.