OECD definition of royalties
According to Article 12 of the OECD Model Convention with Respect to Taxes on Income and on Capital, the term 'royalties' refers to 'payments' of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience'. As stated in the Glossary of Industrial Organisation Economincs and Industrial Law (term 116), published by the OECD, 'Copyright, trademark and patent holders may license others to use or produce the good, usually in return for a fixed payment and a royalty rate'.
According to the Commentaries on the Articles of the Model Tax Convention (Commentary on Article 12, Paragraph 2 (point 8)), 'the definition applies to payments for the use of, or the entitlement to use, rights of the kind mentioned, whether or not they have been, or are required to be, registered in a public register. The definition covers both payments made under a licence and compensation which a person would be obliged to pay for fraudulently copying or infringing the right'.
There is an ongoing debate about whether the definition of royalties should be an open or a closed definition. The current approach used in the Model Tax Convention suggests that the closed definition is appropriate; however, some people argue that a new sentence should be included in the OECD definition that states that other types of rights or assets similar to those expressly mentioned may also bring about royalties.
Alternative definition of royalties
Following a simpler definition, royalties are payments made by one party, the licensee (the user of intangibles), to another party, the licensor (the owner of intangibles), for the use of intangibles owned by the licensor. Royalties are often expressed as a percentage of the revenues obtained using the owner’s property; however, they can be also expressed in other terms (including a fixed value), depending on the specific characteristics of the licence agreement.
What are intangibles
In order to better understand what royalties are, it is important to define the term 'intangibles'. According to the definition given in paragraph 6.6 of Section A of the final report of Action 8 published by OECD on 5th October of 2015 under the Base Erosion and Profit Shifting (BEPS) initiative: 'Intangible is intended to address something which is not a physical asset or a financial asset, which is capable of being owned or controlled for use in commercial activities, and whose use or transfer would be compensated had it occurred in a transaction between independent parties in comparable circumstances'.
Economic and legal ownership of intangibles
This definition also brings up an extremely important question regarding ownership of intangibles and of what 'being owned or controlled' actually means. There is an ongoing debate about the distinction between economic and legal ownership of intangibles. As paragraph 6.32 of Section B of the final report of Action 8 published by OECD on 5th October 2015 under the BEPS initiative notes: 'Although the legal owner of an intangible may receive the proceeds from exploitation of the intangible, other members of the legal owner’s multinational enterprise (MNE) group may have performed functions, used assets, or assumed risks that are expected to contribute to the value of the intangible'.
In this regard, it is considered that the companies of the group that perform such functions, use such assets, and assume such risks must be compensated for their contributions under the arm’s length principle. Consequently, it is derived that 'the ultimate allocation of the returns derived by the MNE group from the exploitation of intangibles, and the ultimate allocation of costs and other burdens related to intangibles among members of the MNE group, is accomplished by compensating members of the MNE group for functions performed, assets used, and risks assumed in the development, enhancement, maintenance, protection and exploitation of intangibles'.
Royalty rate data
How can one get the royalty rate data? As indicated below, a source for such arm’s length royalty rates could be found in commercial databases. Royalty rates for various types of intangibles, e.g. trademarks, trade names, patents, know-how and others can be found there.
OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Chapter III, Section A.4.3.1, paragraph 3.30) identifies that there are various sources of information that can be used to identify potential external comparables. A common source of information is commercial databases that can be practical and cost-effective way of identifying external comparables and may provide the most reliable source of information. Revision of the Special Considerations for intangibles in Chapter VI of the OECD Transfer Pricing Guidelines and Related Provisions (Chapter IV, Section D.1., paragraph 103) further states that 'Comparability, and the possibility of making comparability adjustments, is especially important in considering potentially comparable intangibles and related royalty rates drawn from commercial data bases'.
RoyaltyRange royalty rate database provides reliable and detailed data on the comparable licence agreements involving intellectual property and royalty rates. Our proprietary royalty rate database contains manually gathered and analysed data on the most recent licensing transactions and royalty rates in various industrial sectors. Our data reports contain more than 50 standartised comparability factors on royalty rates and other terms of the licence and only unredacted agreements (i.e., licences where royalty rate is disclosed) containing royalty rates expressed in percentages are included in the database.