Royalties and Transfer Pricing: Why Multinational Companies Must Tread Carefully

Why Royalty Payments Are a Red Flag for Tax Authorities

As intangible assets become central to value creation, multinational enterprises (MNEs) must be especially careful with how they structure and document royalty payments for intellectual property (IP). Intercompany royalties are often seen as a red flag by tax authorities, who increasingly view them as a vehicle for profit shifting. When poorly substantiated, these arrangements can trigger audits, penalties, and major legal disputes.

Transfer Pricing Challenges for Intellectual Property

A common tactic is to park IP—like patents, trademarks, or software—in low-tax jurisdictions and then charge affiliates in higher-tax countries royalties for their use. While this may be legal, it won’t pass tax scrutiny unless the pricing adheres to market terms and provides a clear benefit to the payor. The OECD’s Transfer Pricing Guidelines (2023) make this point explicit: “a legal owner not performing any relevant function relating to the development, enhancement, maintenance, protection or exploitation of the intangible will therefore not be entitled to any portion of such returns…” (6.54).

The Importance of DEMPE Analysis in Royalty Structures

A cautionary tale can be found in a Swiss Supreme Court case. In that case, a related-party trademark royalty was largely denied because the company could not demonstrate how the licensee benefited. The court noted the lack of a DEMPE (Development, Enhancement, Maintenance, Protection, and Exploitation) analysis, which is now a critical piece of any robust transfer pricing defense related to intellectual property benchmarking.

How Australia Is Leading the Charge on Royalty Scrutiny

Australia’s tax authority (ATO) has been particularly aggressive in scrutinizing intangible arrangements, especially those involving embedded royalties or related-party licensing. In the high-profile PepsiCo case, the Full Federal Court ruled in favor of the company, however, the ATO has taken the matter to the High Court. The outcome of this case will have broad implications for how royalty withholding tax is applied to cross-border agreements.

Best Practices for Structuring and Documenting Royalty Payments

To mitigate risks, companies should ensure that their royalty arrangements are closely tied to genuine economic contributions. This requires maintaining proper transfer pricing documentation, aligning legal contracts with robust internal transfer pricing procedures, and documenting how the intangible benefits the payor’s bottom line. Without this foundation, even well-intentioned structures may not hold up under scrutiny.

Royalty Arrangements: A Growing Transfer Pricing Risk

Royalty payments are not merely a technical detail; they represent a significant area of risk. With enforcement intensifying globally, it is essential for MNEs to view the transfer pricing of intangibles not just as a compliance obligation, but as a business risk that requires serious attention.

Please contact our Global Business Services team if you have any questions or concerns about these regulations or any other international tax issue.