Controlled licensing of trademarks used to sell consumer branded products are easily misunderstood when attempting a transfer pricing analysis of the transaction. Consumer brands that require substantial ongoing advertising and marketing (“A&M”) investments at the local market level present the toughest challenge. In these cases, the legally registered owner of the trademark within a Multi-National Enterprise (“MNE”) is often different from the affiliate that makes most of the A&M investments that create brand value. Under this fact pattern, it is difficult not to conflate the notion of a legally registered trademark with the notion of a valuable brand. It is also difficult to realize the critical distinctions that differentiate most controlled trademark licensing arrangements from arm’s length brand licensing transactions.
Discussions concerning the appropriate treatment of a legal owner of a trademark versus the economic developer of a brand received considerable attention in tax and transfer pricing journals during the 1990s and into the 2000s. The Coca-Cola Company’s case11 currently being argued before the U.S. Tax Court has brought this issue back to the forefront of the transfer pricing conversation. In this case the IRS essentially argues that the legal registrant of the Coke trademarks should be treated as the primary owner of the brands in foreign markets despite not making the local ongoing A&M investment that create brand value in each market during the audit period in question.
After defining important terms, this article discusses the economics, facts, and regulations surrounding controlled licensing transactions and suggests that the underlying principle put forth in the Investor Model2 presents the most unbiased and logically satisfying approach to the problem.
In this article we use the term “trademark” to define only the trademark, trade name, trade dress and other legally protected marks that are used to distinguish a brand. Ownership of a trademark within an MNE requires only one function and that is legally registering the trademark and incurring annual administrative and legal expenses to assure legal protection of the mark in each geographic market. These legal and administrative expenses are nominal, and generally immaterial relative to the costs incurred to exploit the brand.
We use the term “brand” to define the economic concept of a trademark that already has economic value within a geographic market due to successful A&M investments. Thus, ownership of a brand within an MNE requires two functions:
- Owning or licensing a trademark; and,
- Making the A&M investments required to create brand value.
THE ECONOMICS OF BRANDS
As a general rule, per se trademarks are intrinsically worthless. The economic literature universally agrees that almost all the economic value associated with consumer brands (signaled to the market through legally registered and protected trademarks) stems from many years of sophisticated A&M efforts aimed at creating consumer demand.
When analyzing the value-added chain of the consumer branded product industry, economists treat A&M as the primary barrier-to-entry. That is, any potential new entrant would need to make massive A&M investments to catch up with the consumer awareness of existing brands. Additionally, the new entrant would need to continue to match annual A&M investments in each different market that the product would be sold to keep pace with the industry. As the primary barrier-to-entry, A&M is the primary function that drives value for a brand. Considering all types of A&M investments (e.g., TV advertising, in-store marketing, promotional activities, etc.), A&M investment requirements for a mature consumer brand can typically range from around 10 percent of sales to more than 50 percent of sales.
The other functions required in the consumer-branded product industry that could potentially pose a barrier-to entry are product development and the establishment of distribution networks. However, developing a functionally similar consumer product is cheap and easy3. R&D, when measured as a percentage of sales, typically peaks at approximately 3 percent of sales for a mature consumer branded product that is not high-tech. Establishing distribution channels for a consumer-branded product is highly dependent on first developing a valuable brand with consumer demand that the retail trade is willing to buy. Therefore, the other two requirements to entering the consumer branded product market—development and distribution—do not independently pose barriers-to-entry on their own. The wide prevalence of low-priced private label competition in the industry illustrates just how easy these potential barriers are to overcome4.
To summarize, economists generally agree on three things concerning brands in the consumer product market:
- The owner of a brand must be willing to continuously make massive investments in A&M for many years;
- These A&M investments must also be sophisticated in that they expertly adapt and change to local market preferences and consumer tastes through time and across different geographic markets; and
- These A&M investments are the primary barrier-to-entry in the industry and are responsible for almost all the economic value associated with a brand.
FACT PATTERN FOR LICENSING WITHIN MNEs
Controlled licensing transactions for the use of a trademark within an MNE often deviate in a very critical way from arm’s length brand licensing transactions. Within an MNE, the controlled trademark licensor can only function as the legal registrant of the trademark and is not necessarily engaged in the A&M needed to create value for a brand. In some cases, the A&M function rests almost entirely with the commonly controlled licensee. Thus, the two functions required to own a brand are split between two controlled affiliates.
In contrast, an arm’s length licensing transaction arises between two unrelated companies when one company (the licensor) legally owns a trademark and has performed the A&M in a geography needed to create a valuable brand worth licensing in that geography. The other company (the licensee) then benefits from the ability to in-license that brand that already has value in its market. Importantly, the two functions initially required to create a valuable brand were performed by the licensor5.
Trademarks void of A&M investment are never licensed at arm’s length, as that trademark would hold no economic value to a third party. MNEs can divvy up functions along a supply chain in ways that do not happen at arm’s length. This is certainly the case with respect to the legal registration of a trademark versus the A&M function that creates brand value for that trademark.
ANALYZING LEGAL AGREEMENTS FOR CONTROLLED LICENSING
The trouble with analyzing legal agreements concerning controlled licensing transactions is that both parties are under the same control.
When two unrelated companies transact for the use of a brand, the licensor already created a valuable brand and, due to that economic value, the licensee wishes to benefit from exploiting that brand. Both parties answer to separate management who represent separate sets of owners or shareholders. Both parties hire separate legal advisors and separate negotiators. As true separate legal entities in a commercial sense, they are incented to make sure every term of that licensing arrangement allows their shareholders to maximize long-term profits.
In addition, a major goal of arm’s length licensing agreements is to make sure that the terms are consistent with the licensor not abandoning its rights to that trademark. Concerns regarding trademark abandonment motivate many terms to an arm’s length brand licensing agreement6.
In contrast, licensing transactions within an MNE are drafted by one legal team on behalf of the overall MNE and at the behest of one management group (who commonly represent the interests of one set of owners or shareholders). A controlled licensing agreement is not the result of tough negotiations where each controlled affiliate is concerned with their own long-term profitability. Instead, the intercompany license agreement is typically an after the fact “to-do” for the MNE’s internal lawyer(s) and is drafted mainly to maintain rights under trademark law for the overall MNE and to satisfy abandonment concerns. Often, an intercompany trademark licensing agreement simply mimics an arm’s length brand licensing agreement despite the critical differences in fact.
As a result, an intercompany licensing agreement will be drafted in a manner that gives all brand rights to the licensor (to satisfy abandonment concerns) even if the only role it plays is as the legal registrant of the trademark.
Considering the purpose (to protect the overall MNE’s joint trademark rights who is the true legal registrant with respect to the outside world) and the lack of negotiating leverage for the controlled licensee, it becomes obvious that intercompany license agreements can be very misleading when performing a transfer pricing analysis.
Remember, MNEs can divvy up functions and risks however they see fit. Once MNE functions and risks are in-place, it is then the transfer pricing analyst’s job to make sure income gets appropriately attributed to those functions and risks in a manner that mimics arm’s length results.
Stacking up all the rights accumulated by a controlled affiliate via an intercompany agreement and then imagining potential economic value that could or might be gained by exploiting those rights by taking action outside the current fact pattern under review misreads what is meant by the arm’s length standard. Rights obtained via terms typed into an intercompany agreement by a commonly controlled lawyer represent rights that were not necessarily obtained via arm’s length negotiations or after arm’s length compensation to receive those rights.
REGULATORY GUIDANCE PRIOR TO INVESTOR MODEL
26 C.F.R. §1.482 (hereinafter the “§1.482 Regulations”) provides guidance on the identification and ownership of intangible property such as trademarks and brands. In this regard, §1.482-4(f)(3)(i)(A) provides:
The legal owner of intangible property pursuant to the intellectual property law of the relevant jurisdiction, or the holder of rights constituting an intangible property pursuant to contractual terms (such as the terms of a license) or other legal provision, will be considered the sole owner of the respective intangible property for purposes of this section unless such ownership is inconsistent with the economic substance of the underlying transactions.
The logical conclusion of this guidance is that intellectual property law and the holder of intellectual property rights under contractual terms of a license agreement are irrelevant in determining the ownership of intangibles within an MNE for purposes of a transfer pricing analysis. Applying logic, if something (legal rights) ONLY matters (to determine ownership) if it is consistent with economic substance, then economic substance is the only thing that matters. While the logic of the sentence is that only economic substance matters, the first half of the sentence implies that legal rights are somehow determinative regarding ownership—which is misleading.
Adding to the confusion, §1.482-4(f)(3)(i)(A) then goes on to provide that:
If no owner of the respective intangible property is identified under the intellectual property law of the relevant jurisdiction, or pursuant to contractual terms (including terms imputed pursuant to § 1.482–1(d)(3)(ii)(B)) or other legal provision, then the controlled taxpayer who has control of the intangible property, based on all the facts and circumstances, will be considered the sole owner of the intangible property for purposes of this section.
This guidance then provides that if no legal agreement exists, then the taxpayer that has “control” of the intangible, based on facts and circumstances, will be considered the sole owner. This part of the guidance adds confusion in two ways. First, looking to the issue of “control” only when no legal agreement exists again implies that legal rights matter, which contradicts the logic of the earlier guidance that the legal rights do not matter. Second, looking to the issue of “control” also contradicts the earlier guidance stating that economic substance is determinative regarding intangible ownership. Does this imply that the regulations view economic substance and “control” as being synonymous concepts? Economic substance is a straightforward concept that is less vulnerable to interpretation; while “control” based on facts and circumstances is a pliable concept that is vulnerable to different interpretations.
The §1.482 Regulations then provide guidance on the contribution to the value of intangible property, such as trademarks or brands, owned by another. This section appears to double down on the confusion introduced during the guidance on intangible ownership. In this regard, §1.482-4(f)(4)(i) provides:
The arm’s length consideration for a contribution by one controlled taxpayer that develops or enhances the value, or may be reasonably anticipated to develop or enhance the value, of intangible property owned by another controlled taxpayer will be determined in accordance with the applicable rules under section 482. If the consideration for such a contribution is embedded within the contractual terms for a controlled transaction that involves such intangible property, then ordinarily no separate allocation will be made with respect to such contribution.
The first sentence in this guidance is straightforward and consistent with economic substance. The second sentence is not clear. The problem is the unclear meaning of the “contractual terms” that should consider the contributions in developing an intangible by another. Did the regulations really mean “economic terms” and again all we need to do is follow economic substance? Or did they mean “legal terms” whereby a licensee could be contractually obligated to be the primary contributor, yet based on words drafted in an intercompany agreement the licensor could “legally” retain all ownership privileges?
These two sections of the regulations provide eight examples intended to illustrate the principles in §1.482-4(f)(3)(i)(A) and §1.482-4(f)(4)(i). The common theme throughout these examples is that economic substance is the determinative factor and that a transfer pricing analysis should reward all contributions (primarily A&M activities) being performed by either the licensor or the licensee at market rates. However, in a few examples the legal terms drafted in intercompany agreements are also mentioned and appear to determinative7. Thus, the examples do not fully clear up any of the confusion
THE INVESTOR MODEL
A theoretical underpinning of the Final Cost Sharing Regulations issued in 2011 is the principle of an “Investor Model,” where arm’s length results are defined by circumstances in which each controlled participant’s net investment earns a rate of return appropriate to the riskiness of the controlled participant’s activity and consistent with market returns on similar investments. The Investor Model dictates that controlled affiliates should generally earn market rates of returns on investments. If the licensor that is party to a controlled licensing arrangement is solely the legal registrant of the trademark and never invested in developing brand value within a geographic market, any payment to it as the legal registrant must be limited to a market return on its investment in legal and administrative activities. Most importantly, allowing the legal registrant of the trademark to earn market returns on the A&M investments made by the licensee would conflict with the Investor Model principle.
In conjunction with finalizing §1.482-7 (“the Final Cost Sharing Regulations”), parallel rules were also finalized in §1.482-4(g) (“the Intangibles Regulations”) and §1.482-9(m)(3) (“the Services Regulations”). Under these provisions, the principles and methods for valuing platform and operating contributions under a cost sharing arrangement, or the Investor Model, may also apply for valuing similar contributions relating to controlled transfers of intangibles or provisions of services.
The principle behind the Investor Model is very clear. When the principle behind the Investor Model is combined with the guidance concerning intangible ownership and contribution8, it becomes clear that only economic substance can matter when addressing the ownership of trademark versus the development of a valuable brand. While the earlier guidance was somewhat ambiguous and open to interpretation, applying the Investor Model simply requires two very quantitative and practical steps:
- Identify the at-risk A&M investments associated with creating the brand value in question, and
- Provide market rates of return to those investments
IDENTIFYING AT-RISK INVESTMENTS
Transfer pricing asks a hypothetical question that is solely related to the payment of annual income taxes. The arm’s length standard is applied after the fact and requires looking back on overall income (or losses) earned and the jurisdictional division of functions performed that generated that income. MNEs can divvy up the functions and assets for each year however they see fit to maximize overall MNE income (subject to the desires of the owners and shareholders). MNEs are then required to allocate and report the taxable income in each jurisdiction in a manner that is at parity with where income (or losses) would be reported by unrelated entities acting at arm’s length.
To be logically consistent with the hypothetical question being asked, determining at-risk investments for purposes of a transfer pricing analysis also requires another hypothetical question solely related to annual income taxes. Thus, the identification of at-risk investments is straightforward. The entity that is at-risk is simply the entity that would report a tax loss should the investment not bear fruit.
One very practical way to determine where tax losses would occur is to assume an exogenous shock and model a sudden reduction in revenues (enough of a reduction to trigger system losses for the MNE) and then see which jurisdiction is most hurt and would end up reporting tax losses because the investment did not work out. From a tax reporting standpoint, that is where the investments are at risk.
Intercompany license agreements themselves are of limited use for a transfer pricing analysis aimed at deciphering the economically valuable functions performed and the risk borne by commonly controlled licensors and licensees. Rights can easily and inappropriately be granted during the drafting of an intercompany licensing agreement, which can lead to the misallocation of assets and risks.
Fortunately, introduction of the Investor Model in 2011 provides a simple and straightforward analytical framework to address controlled licensing arrangements that unambiguously looks to the economic substance of the transaction. Under the Investor Model, once all at-risk A&M investments, and the party that is truly at-risk (from a tax reporting perspective) for those investments, are identified, it is relatively straightforward to test if those investments receive market returns.
Truly comparable uncontrolled transactions (“CUTs”) obtained from the brand licensing market rarely exist that perfectly mimic the fact pattern of most controlled licensing arrangements9. Thus, it is rare that CUTs can be used to provide market returns to commonly controlled licensors and licensees under the Investor Model. In many cases, a simple Comparable Profits Method (“CPM”) analysis on the simpler entity that only makes relatively small and benchmarkable A&M contributions, or a Residual Profits Method (“RPM”) analysis that provides both the licensee and the licensor a market return on all substantial A&M investments will elegantly satisfy the requirements of the Investor Model.9