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CUT: Pricing a Royalty

When a company licenses a patent to a related company, look for a license of the same patent to an outsider. Its royalty is the starting point for the arm's length royalty.

7 minutes, five short steps

  1. Guess
  2. Play
  3. Explain
  4. Check
  5. Try it

First, a bet

The US Entrepreneur owns a patent on a battery-cooling design. It lets an unrelated company in Korea use the patent for a 5% royalty on sales. A RoyaltyA fee paid for the right to use another company's intangible, such as a patent, brand or software. It is usually a percentage of the user's sales.Open in the Glossary is a fee for using someone else's IntangibleSomething of value that is not a physical or financial asset, such as a patent, brand, software or know-how, that a company can own or control and use in its business. Using another company's intangible is usually paid for with a royalty.Open in the Glossary, usually a percentage of sales. It also lets Japan Maker, its own subsidiary, use the same patent. Japan Maker sells $20m a year and pays a 3% royalty. One difference: Japan Maker's license is exclusive (no one else may use the patent in Japan). The Korean license is not.

What royalty should Japan Maker pay?

Price Japan Maker's royalty

5%Korea5%Arm's lengthJapan Maker pays 3%

Japan Maker pays too little

It pays 3%, which is $0.6m a year. At 5% it would pay $1.0m. So $0.4m of income a year moves from the US to Japan. The IRS can raise the US Entrepreneur's royalty income under section 482.

The working

  1. The Korean company pays, same patent5%
  2. Exclusivity: not adjusted0 pt
  3. Arm's length royalty: 5% of $20m of sales$1.0m

Japan Maker's license

3%

On $20m of sales a year.

One adjustment: exclusivity

Only Japan Maker may use the patent in Japan. The Korean company shares it with others. An exclusive license is worth a bit more. The +1 point is an illustration: in real work it needs evidence.

Adjust for exclusivity

Same patent, comparable terms

The Comparable uncontrolled transaction (CUT)The US method for intangibles that compares the royalty in a related-party license with the terms of a comparable license between unrelated parties (Treas. Reg. § 1.482-4(c)). It is the intangibles version of CUP.Open in the Glossary (CUT) is the US method for licenses of intangibles. It is CUP for intangibles: compare the royalty between related companies with the royalty in a comparable license between unrelated companies.

Arm's length royalty = outside royalty ± Comparability adjustmentA change made to a comparable's price or results to remove the effect of a difference from the tested deal, such as freight, payment terms or working capital. It should only be made when the effect can be measured reliably.Open in the Glossary

The best comparable is the same patent licensed to an outsider, as here. Then you compare the two licenses and adjust for each difference you can measure with evidence. The calculator shows one, exclusivity, and its +1 point is only an illustration. Others to check:

  • Territory. A license for a bigger market, or a country with stronger patent protection, is usually worth more.
  • Term. A longer license, or one that includes updates to the patent, is usually worth more.
  • Profit potential. Each licensee should expect a similar profit from using the patent.

When the CUT is not reliable. Say Japan Maker expects far more profit from the patent than the Korean company does, and nobody can measure how much more. Then the Korean royalty is not a good guide, and you should use another method, such as a profit split. Under § 1.482-4(c), the same intangible licensed under substantially the same circumstances is generally the most reliable measure. A different intangible can only be a comparable if it is used for similar products and has similar profit potential.

Later years. In the US, a royalty must stay in line with the income the patent actually earns (the "commensurate with income" rule). If the patent turns out to earn much more than expected, the IRS can adjust the royalty in later years. A CUT based on the same patent can avoid this, but only if strict conditions are met.

Watch who does the work. Owning the patent is the starting point, but what each side does also matters. Here the US Entrepreneur owns the patent and runs the research, so the Korean royalty fits. If Japan Maker started improving the patent itself, the Korean license would no longer match.

Strengths: a real license of the same patent is strong evidence. Weaknesses: valuable intangibles are unique, so true comparables are rare, and published royalty data often lacks the contract details you need to adjust it.

Source: Treas. Reg. § 1.482-4(c), the CUT method and its comparability factors; § 1.482-4(f)(2), periodic adjustments

Check yourself

Three quick questions. Each answer explains itself, right or wrong.

Question 1 of 3An unrelated company pays a 5% royalty to use a patent. A related company, Japan Maker, uses the same patent with an exclusive license, which evidence shows is worth 1 more point. Japan Maker sells $20m a year and pays a 4% royalty. How much income moves out of the patent owner's country each year, in $ millions?
Question 2 of 3Japan Maker expects far more profit from the patent than the unrelated Korean licensee does, and nobody can measure the gap. Under § 1.482-4(c), what follows?
Question 3 of 3In the lesson's case, Japan Maker starts running its own research that improves the patented design. Why might the Korean royalty need a fresh look?

0 of 3 answered.

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