Intangibles in group structures: declining royalty arrangements

It’s not uncommon in group structures for there to be a change in the treatment of IP / intangibles at a particular point in time. This may reflect the integration of an acquired business. Or just a desire to manage operations more efficiently.

One scenario involves the use of declining royalties for existing or ‘legacy’ intangibles. This is the subject of Example 1 in the ATO’s draft Practical Compliance Guideline PCG 2023/D2 on the TP treatment of intangibles, issued in May 2023.

In Example 1, AusCo is part of a group that manufactures and sells goods. AusCo owns existing intangibles including patents, know-how, trade marks and copyright. It manages and controls certain DEMPE activities and assumes associated risks. It also licences the existing intangibles to other group entities, and receives royalties.

The group decides to centralise the ownership of existing and new intangibles in a new entity (NewCo) located outside Australia. New arrangements are entered into whereby:

• The licence granted by AusCo in respect of the existing intangibles is terminated
• AusCo grants a new licence to NewCo to exploit the existing intangibles, in return for royalties which decline over the useful life of those intangibles
• NewCo appoints AusCo to provide R&D services, and pays a cost-plus fee. NewCo owns all intangibles produced by those R&D activities
• NewCo licences the existing Intangibles and new intangibles to other group entities, and receives royalties.

In this Example 1:

• The DEMPE functions carried on by AusCo do not materially change
• NewCo manages and performs limited DEMPE activities and assumes limited risks regarding the Existing / New Intangibles.

The PCG characterises this arrangement as a migration of intangibles. The risk score is 35, corresponding to ‘high risk’.

In this post I will comment on just one aspect of Example 1, namely the declining royalties.

Declining royalties are commercially equivalent to a sale of the intangibles on an earn-out, with no up-front payment. If this were an M&A negotiation between unconnected parties, the seller’s (AusCo’s) concerns would include the following:

• It is still exposed to market risks relating to the existing intangibles
• Whether NewCo will successfully exploit market demand
• Whether NewCo’s strategic focus will change, and de-prioritise the existing intangibles
• Whether NewCo will have the financial standing to pay the royalties when due.

All these concerns would be factored into the negotiation, including the amount of the declining royalty (and whether to enter into the arrangement at all).

For me, this is an important example of how the legal perspective on proposed intercompany transactions can complement the TP view, and can help create an overall structure with genuine substance.

Finally, if this area is of particular interest or relevance for you, take a look at my recent posts on how the new guidelines raise the bar for TP compliance and on the bifurcation of local vs offshore intangibles.