The allocation of licensing fees for trademark rights is increasingly coming under scrutiny by tax authorities during tax audits. In particular, inbound trademark allocations – i.e. payments made by companies based in Germany to affiliated foreign entities for the use of trademark rights – are subject to heightened examination. According to statements from tax authority representatives, this focus is driven by the fact that German affiliated companies of, for example, US corporations regularly record such payments, while many German companies forgo the allocation of a licensing fee for trademark rights to their subsidiaries. Therefore, companies should proactively review their documentation and transfer pricing structures to minimise potential risks during tax audits.
Below, we have summarised the key tax audit aspects, as well as recommendations for documentation and risk minimisation:
Need for the licensing payment
During tax audits, the tax authorities require a clear and substantiated explanation as to why a trademark is being used and what specific benefits this brings to the company. The focus is often on the necessity of quantifying the financial advantages that may accrue to the German group entities and providing appropriate evidence of these benefits. Detailed documentation is frequently requested to support the economic justification for the payments. This is required not only at the time of the initial payment of the royalty fee but also on an ongoing basis, particularly if the licensing agreement includes an annual clause for the automatic renewal of the licensing relationship.
Reasonableness of the fee amount
Determining the reasonableness of a licensing fee in accordance with the arm's length principle presents companies with a range of challenges that require a detailed and well-founded analysis. A key issue is that often very few (at least partially) comparable transactions between independent parties exist, particularly for specialised trademarks or licensing rights. The lack of relevant comparison data significantly complicates how to determine an appropriate licensing fee.
Different valuation methods, such as the market price method, income method, or cost method, can lead to varying results. The choice of method depends on the specific conditions of the licensing agreement, which introduces uncertainties regarding the licensing fee amount. Market conditions, regional differences and industry-specific peculiarities influence the licensing fee and complicate the comparability of transactions, as licensing fees for the same trademark can vary depending on the region or product category.
In practice, the comparable uncontrolled price (“CUP”) method is often used to determine the licensing fee. This method compares the licensing fee with the price that independent companies would pay for similar trademarks or intangible assets. However, the application of the CUP method requires careful consideration of factors such as trademark usage, geographical scope, duration of the license and the specific terms of the agreement to ensure that the transactions being compared are in fact (at least partially) comparable. Many of these parameters are not only challenging to measure but also cannot always be directly reflected in a price comparison. Variations in brand recognition, licensing exclusivity and market positioning can result in significant price discrepancies. Additionally, geographic differences and agreements on future exclusive rights are difficult to incorporate into a straightforward price comparison. These factors complicate the application of the CUP method, as relevant differences are often insufficiently accounted for, potentially leading to distorted results.
A hypothetical arm’s length comparison also introduces uncertainties. This method assesses the appropriateness of transactions between affiliated entities by comparing them with comparable transactions between independent third parties. However, the assumption that an independent entity would pay a specific licensing fee is often based on model calculations or theoretical assumptions that cannot be verified through actual transactions. This conceptual approach carries the risk of subjective judgment and methodological inconsistencies, which can result in varying outcomes.
In summary, these factors indicate that neither the CUP method nor a hypothetical arm’s length comparison consistently provide a precise or reliable basis for determining an appropriate licensing fee. Consequently, the selection of the valuation method and the interpretation of comparative values should always be critically evaluated and assessed for their suitability in each specific case.
Regardless of the chosen method, it is important for companies to document the analysis thoroughly to clearly demonstrate the reasonableness of the licensing fee during an audit, thereby minimising audit risks. Factors such as exclusivity, legal protection, geographical scope, development stage, and future benefits should be considered to determine the licensing fee at arm's length.
Contractual basis
A written licensing agreement is a crucial reference point during tax audits for determining the reasonableness of licensing fees and ensuring compliance with tax regulations. It should include all relevant details, such as licensing rights, fees, payment terms and valuation methods. However, it is essential that the actual practice aligns with the agreement, as tax authorities apply a "substance over form" approach. This means that it is not only the written agreement that matters, but also its practical implementation. Any discrepancies may increase audit risks, making a consistent and transparent application of the licensing allocation critical.
Scope of use
The scope of use of a trademark is a key factor in assessing the reasonableness of licensing fees, as it forms the basis for determining the actual value of a trademark in practice. To set the licensing fee at arm's length, it is essential to clearly define how and where the trademark is used in the business operations. This includes analysing whether the trademark is used globally or only in specific geographical regions or markets, and whether it is utilised across various product categories or only in certain areas. This distinction is critical, as the value of a trademark used in limited markets or regions does not equate to that of a globally deployed trademark.
Conclusion
Determining the reasonableness of licensing fees and justifying their necessity are central issues in German tax audits. Companies must ensure that their licensing agreements comply with tax requirements and that the licensing fees align with actual market conditions. A thorough analysis of relevant factors, such as the scope of use and geographical coverage, is essential to substantiate the reasonableness of the payments.
Companies should therefore ensure comprehensive documentation of their licensing agreements and of the valuation methods applied. It is advisable to conduct market analyses and identify (at least partially) comparable transactions on a regular basis.
Our KPMG Transfer Pricing Experts would be pleased to assist you with any questions you may have.
Publishing date:
27.03.2025