Royalty Methods for Intellectual Property

Article excerpt

In the week ending July 25, 1996, the market value of Microsoft Corporation reached $70.9 billion. The company's latest available balance sheet, however, indicated that shareholder equity amounted to a mere $5.7 billion, i.e., the stock market valued Microsoft at approximately $65 billion more than was recorded on the balance sheet. Similarly, Netscape Communications Corporation had a market value of $3.7 billion versus a balance sheet value of just $173 million.(1)

The knowledge-based economy makes our current accounting systems a poor guide to the true value of software companies. The principal assets of these companies are not cash, building, equipment, or other tangible assets. Rather, the earnings power of these companies is linked to trademarks, patents, copyrights, know-how, skilled workforce, and other intangible assets.

Intangible assets do not appear on the balance sheet. But they are quite real. Intangible assets contribute to revenue and growth. The stock market recognizes these assets and reflects their value in stock prices. According to a study by Smith and Parr [1993], "A comparison of stock market value with accounting book value for selected companies indicates that the investment community recognizes the value of intellectual properties in a big way."(2)

Fashion design is another example of an industry where intangible assets plays a significant role. Ralph Lauren, Calvin Klein, Tommy Hilfiger, Giorgio Armani, Yves St. Laurent, Pierre Cardin, Bill Blass and Donna Karan are all designers who have made their name their fortune. Licensing provides them a significant and risk-free source of profits. For example, in September 1996, Donna Karan International granted Designer Holdings Ltd. a thirty-year license to produce, sell and distribute DKNY men's and women's jeanswear. In return Donna Karan International received $60 million plus an annual 7 percent royalty on total sales and an additional 2 percent on international sales.(3)

TYPES OF LICENSING

When a company licenses intellectual property, it is necessary to establish a royalty rate. There are two broad types of licensing transactions. The first is a license to a third party. Such a license provides a risk-free method for exploiting a market where the licensee may have marketing and distribution resources that are not available to the licensor. For example, Amgen Inc., a leading U.S. biotechnology company, recently announced that it had licensed to Yamanouchi Pharmaceutical Co. of Japan certain foreign rights to a new Amgen drug against hepatitis C, a liver disease that afflicts many more people in Asia than in North America.(4)

The second type of license is a so-called intercompany transfer. This happens more frequently than is realized. U.S. and OECD tax law prohibits a company from transferring an intangible asset to a foreign subsidiary without being properly compensated. Any time a foreign subsidiary uses intellectual property developed by the parent, it must pay a royalty to the parent. These intercompany payments must meet certain transfer pricing rules. In July 1994, the Internal Revenue Service (IRS) issued the final regulations for transfer pricing under Internal Revenue Code (IRC) [section]482. The final regulations reaffirmed the basic principle that intercompany transfer prices must be established on an arm's-length basis. A transaction between related affiliates satisfies this standard if the results of the transaction are consistent with the results that would have been realized if unrelated parties had engaged in a comparable transaction under comparable circumstances. Thus, the arm's-length principle requires that the company treat its affiliate in the same way as it would treat an independent third party.

To document that these transfers are being conducted in an arm's-length manner, an economic study must be prepared. Usually, a multinational company will hire a "Big 6 Firm" or an economic consulting firm to prepare these economic studies. …