Publication date: 22/04/2020
Must a heavily impacted licensee continue to pay royalties under its intercompany license agreements?
The 2019 novel coronavirus (COVID-19) is disrupting all our lives and requires full attention to our health and safety. It is, however, also heavily impacting businesses around the globe with many legal issues and questions arising in this unforeseen new environment but also with respect to the post-COVID-19 period, which may be one of long economic recovery.
This is no different in the area of tax, with various issues coming to the fore, such as the pressure of approaching deadlines for certain filings, practical arrangements to be taken in audits that have been ongoing for years that are about to become statute-barred, the impact on rulings and advance pricing agreements and their (re)negotiations, valuation of deferred tax assets, possible permanent establishment risks arising from remote workforce, etc. Different governments are taking actions in this respect and the OECD is helping to clarify certain issues and to provide guidance.
In the field of transfer pricing, the COVID-19 pandemic also poses a lot of questions and challenges in terms of allocation of risks and losses resulting from this disruption, supply chain analyses and reorganizations, valuation and pricing of assets and transactions, the treatment and impact of government interventions, etc.
Below, we will further elaborate on another eminent transfer pricing topic, i.e., the possible impact of COVID-19 for licensees and their obligations to pay royalties under intercompany license agreements.
The first question to be addressed is, of course, what the licensee’s contractual rights are. Generally speaking, almost all legal systems have specific legal concepts dealing with the problem of changed circumstances and excusing a party from performance of its obligations when a contract has become unexpectedly onerous or impossible to perform. Some systems only accept a narrow range of excuses, others are more generous, e.g., the concepts of imprévision or hardship, force majeure, frustration or Wegfall der Geschäftsgrundlage.
The rules regarding situations of changed circumstances are typically oriented toward the two basic concepts of hardship and force majeure. Broadly speaking, hardship refers to the performance of the disadvantaged party having become much more burdensome, but not impossible, while force majeure refers to the performance of one party’s obligations that have become impossible, even on a temporary basis.
Needless to say that the law applicable to the license agreement will be important in order to determine what the parties’ rights and obligations are. Also, the precise wording of force majeure, hardship or similar clauses will need to be examined, as the rules thereon are typically of a supplementary nature and can be tweaked by the parties in their contracts.
Following this examination of rights, the next question to be addressed in intercompany transactions is obviously what independent parties with comparable transactions would do in comparable circumstances. It should not be taken for granted that each licensee would, per definition, want or have an interest in ‘playing hardball’ as other factors, such as future business, long term relationships, other business transactions with the licensor, etc., may shed a different light on the situation. A licensor may, on the other hand, equally have an interest in agreeing on a royalty waiver or deferral to secure the survival of the licensee and the continued relationship and future royalty stream that is expected from this licensee.
Royalties dependent on the profit of the licensee
A more economic and, by that token, transfer pricing oriented way of looking at the situation is to ask ourselves whether an arm’s length royalty should not be dependent on the profit realized by the licensee and hence be decreased, waived or deferred in case that licensee is, temporarily, loss-making. Such a question is relevant in the COVID-19 period but also beyond it, when licensees, and licensors, may face a long period to economically recover from these exceptional circumstances.
Royalties often depend on the revenue generated by the licensee and will, as the mere result thereof, decrease in the hands of licensees impacted by COVID-19, but the impact on the licensee’s operating result may be much more dramatic than on its turnover.
Whether loss-making companies can, under arm’s length conditions, be held to continue to pay royalties and, in particular, license fees for trade-related intangibles, trademark, trade name, logos, business concept, etc., is a complex matter well known amongst transfer pricing specialists. Similar thereto is the topic of whether royalties should per definition be revenue-based or if they can also be calculated on the basis of the licensee’s profit.
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