Intercompany royalties.

• Author: Feinschreiber, Robert

Royalties and other payments for intangibles paid to affiliated companies are subject to special scrutiny by the IRS. All royalties on the transfer of intangibles are subject to reallocation for any controlled transactions covered under the provisions of Sec. 482 and Regs. Sec. 1.482-4. The pervasive nature of royalties can be seen from the following examples.

Example 1: X a closely held, well-known, long-established company uses the surname of the founder, an uncommon name. X protects its name from use by other companies by fling appropriate registration statements with the department of state's corporation unit in each jurisdiction. X allows one of the children of the founder's timely to set up a separate corporation that uses the well known name without payment for its use. The Service could claim that X transferred the name without payment and could determine the royalty that should be charged. A similar situation could arise with a transfer of trademarks, trade names, trade dress, etc.

Example 2: Y, a domestic company, develops a secret process for use in producing its products. Y sets up a foreign company, M, and Y technicians assist M in implementing the production process overseas. The IRS could claim that Y transferred an intangible (the secret process) and could determine the value of the intangible transferred as a royalty. The transaction could be subject to international reorganization rules and to additional customs duties if the products are imported into the U.S.

Example 3: Z, a foreign closely held company, prepared an extensive survey, study and forecast of the U.S. market ("market data"). Z's owner's son moves to the U.S. to implement the market data. With proper structuring, the son may be able to deduct royalty payments made to Z for the use of the market data.

Regs. Sec. 1.482-4(b) delineates six types of intangibles:

1. Technology: e.g., patents, inventions, formulae, processes, designs, patterns and know-how.

2. Literary rights: e.g., copyrights and literary, artistic and musical compositions.

3. Marketing intangibles: e.g., trademarks, trade names and brand names.

4. Business relationships: e.g., franchises, licenses and contracts.

5. Business operations and lists: e.g., methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists and technical data.

6. Other similar intellectual property.

   Regs. Sec. 1.482-4 regulates the amount charged in a controlled transfer of intangible property in transactions with common control through ownership or control, determined on an empirical basis. The royalty is to be at arm's length (i.e., commensurate with the income attributable to the intangible). A transfer of intellectual property is viewed as a royalty rather than as a capital contribution and is subject to periodic IRS audit. While many potential penalties could apply to mispriced intercompany royalties, Regs. Sec. 1.6662-6 imposes additional penalties.

   Determining Royalties

   Regs. Sec. 1.482-4(a) provides four methods of determining the arm's-length amount charged in a controlled transfer of intangible property:

1. The comparable...