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Brands have gradually been moving up thecorporate agenda and today play a major role inthe life of most successful companies. Thefinancial role of brands has increasingly beenrecognised and accounting standards and taxlegislation have been introduced that begin torecognise their growing importance and reflect thevalue that brands and other intangibles add to thebottom line.

In terms of accounting standards, FinancialReporting Standard 10 (“FRS10”) in the UK,effective since 28th December 1998, was one ofthe first standards to allow separate recognition ofacquired intangible assets, provided that their fairvalues could be measured reliably. This was a signof recognition from the accounting bodies of thereal value those intangibles, especially brands, add.

New US accounting standards, effective since 1stJuly 2001, took the accounting treatment ofintangibles a step further. FAS 141 “BusinessCombinations” requires acquired brands and otherintangibles (provided they arise from contractual orother legal rights or are “separable” (para 39, FAS141)) to be disclosed separately from goodwill onthe balance sheet. FAS 142 “Goodwill and OtherIntangible Assets” then sets out the appropriateaccounting treatment of intangibles postacquisition, with the requirement for impairmentreviews to be conducted in certain circumstances.

Finally, a new International Accounting Standard(“IAS”), IFRS 3 “Business Combinations”, wasissued on 31 March 2004, together with revisedstandards IAS 36 “Impairment of Assets” and IAS38 “Intangible Assets”. IFRS 3 is effective for allUK (and numerous other countries where it isbeing adopted) quoted companies for businesscombinations entered into on or after 31 March2004 and requires acquired intangibles to berecognised separately from goodwill provided theirfair values can be measured reliably.

With auditors coming under increasing scrutiny, therequirement for independent intangible assetvaluations following the acquisition of a business,and their subsequent impairment reviews, hassignificantly increased as a result of the new USand international standards.

In addition to accounting standards, the UK taxregime for intellectual property (“IP”), goodwill andintangibles, including brands, which for so longfailed to keep pace with developments elsewhere,was also modernised in Schedule 29 of theFinance Act 2002, “Gains and losses of a companyfrom intangible fixed assets”. The underlyingprinciple of this legislation is the alignment of thetax and accountancy treatment of intangibles andgoodwill. Companies are entitled to tax relief,based on the amortisation of assets in theaccounts, for the cost of most intangible fixedassets and goodwill incurred from 1st April 2002.Similarly, all receipts from this date relating tointangibles and goodwill within the new regime willbe treated as income (good news for companieswith substantial brought forward trading losses,provided the intangibles are held for the purposesof the trade).

More recently, the UK tax regime as it relates tobrands and other intangibles was affected by theEuropean Court of Justice (“ECJ”) ruling thattransfer pricing rules between UK and continentalEuropean companies must also be applied totransactions within UK groups. New legislation toimplement this took effect on 1 April 2004. As aresult, Brand Finance is assisting IP-owningcompanies in the UK with their reviews of internallicensing arrangements.

We now discuss in more detail specificapplications of tax planning connected with brandsand IP management.

Brands and tax planning

The increasing importance of branding

Issue 3

Brand Finance Report

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Internal licensing and centralisation of IP managementThe realisation that brands are contributors to profits,coinciding with a rise in joint ventures and brand useby third parties, has led to companies increasinglycharging royalties for the use of, and considering theappropriate domicile for, their brands. Consequently,tax authorities now show a keen interest in brandsand most international organisations carefullyconsider the tax implications of internal licensingarrangements and cross-border transfers of brands.The recent ECJ ruling on UK to UK transfer pricingmeans that this interest will now also extend to UKonly transfer pricing arrangements.

Nestlé, Vodafone and BAT are examples ofinternational companies that have created centralbrand management organisations which then chargeroyalties to operating subsidiaries around the world.

Internal licensingUntil the mid-1990's, organisations would generallyallow their affiliates to use their brands for little orno charge. Some companies allowed their affiliatesto use the brands completely free, or otherwise theymerely passed on direct costs on a cost-sharingbasis. Organisations may have charged for the useof their technology or for their management timebut tended to allow the brand name to be used atno cost.

However, with the growing realisation that brandsirrefutably add value to businesses, an increasingnumber of brand-owners are now charging for theuse of their brands by other group companies. It istherefore imperative that internal licenseagreements contain credibly constructed royaltyrates. Brand valuation techniques are usually usedto substantiate internal royalty rates. Many taxauthorities, including the Inland Revenue and IRS,are prepared to acknowledge independent brandvaluations as a basis for this process.

An internal licence – where the licensee is asubsidiary company or associate company of thelicensor – arises because the user of the trademarkor licence will not necessarily be the owner. An UScompany which is a wholly owned subsidiary of anUK company is a separate legal entity, andtherefore can only use the trademark after receivingexplicit or implicit permission.

It could be argued that formally granting a licencebetween different parts of the same company –where ultimately the same set of shareholders willbenefit from the licence exploitation – isbureaucratic and unnecessary. However, every partof an organisation is now expected to contribute aseffectively as possible to the overall results of thegroup, and many directors and brand managersargue that formalising the relationship betweenthose who own the brand and those who use it actsas an incentive to maximise the use of the licensedbrand rights, and to ensure that the rights and

obligations on both sides are more fully understoodand adhered to.

MNE tax strategies aim to distribute income flowsand assets between countries so as to avoid oneterritory paying tax while accumulating tax losses inanother. Inevitably IP management seeks to locateexpenses to obtain tax relief at the highest localrate possible and income in low tax jurisdictions.

When this occurs internationally, tax authorities areparticularly vigilant. Numerous large organisationshave been struck with retrospective tax charges forimputed royalties not levied on foreign affiliates.Additionally, certain companies have also comeunder attack for charging excess brand royalties totheir US affiliates as a means of expatriating profitsearned in the US. Importantly, independent brandvaluations help to support companies againstclaims made by the tax authorities regarding theselection of an appropriate royalty rate.

Our understanding is that, in the UK, the InlandRevenue will perhaps be more vigilant in theirreviews of international arrangements than UK toUK arrangements, nevertheless, a de minimis levelof analysis and support for UK to UK arrangementswill certainly be required.

One of the key drivers for the growing trend ofinternational licensing is the desire to understandand measure the profit contribution from differentgeographical and business divisions. Severalleading edge companies are now taking the issue ofinternal licensing so seriously that they are creatingcentral trademark holding companies. This meansthat the ad hoc trademark and licensing system thathas grown up over the years is replaced by asystem where one company - the trademarkholding company - holds all the group’s trademarksand licences. The most famous examples of thistransfer of trademarks to one separate legal entityare Nestlé, Shell and Vodafone (with IP located inSwitzerland for the first two and Ireland for thelatter). The IP is then licensed to the subsidiariesand those subsidiaries are charged for the use ofthe trademarks, patents and licences. The primarydriver for this depends on which company you talkto. Some claim improved efficiency and control ofbrand management (e.g. Shell) while others admit itis primarily about the tax benefits.

In terms of the efficiency and control of brandmanagement, benefits accrue because operatingcompanies do not take for granted the use ofvaluable assets. Just as they would pay for the useof central research facilities or for shared productionfacilities, operating companies also pay for brandsthey are using. The charge made for the use of abrand is seen to relate directly to the value of theasset being licensed.

All companies which own trademarks, copyrightsand licences should continually audit the inter-groupuse of those assets. There is increasing evidencethat managing, protecting and developing suchintangible assets requires specialist marketing andfinance skills, and therefore, all such assets shouldbe held and managed centrally.

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Tax planning and brands

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Case study:The advantages ofCentralised InternalLicensing (“CIL”)Brand extension and cross branding isaccomplished more effectively and efficiently ifbrand control is held centrally. This reinforcesunderstanding that the brand is a shared resource.For example, if one territory operates anestablished brand, CIL makes it more likely that thebrand can be successfully transferred elsewhere.The maintenance of brand rights involvesconsiderable effort. It is vital that trademarks areregistered, renewed and that all necessary actionsfor brand protection (prosecuting infringement andpursuing passing-off actions) are pursued withappropriate vigour. In an increasingly multi-nationaltrading environment legal action is often crossborder, reinforcing the need for central control. Byperforming the function centrally, organisationsensure that they make best use of expensivespecialist skills and also that they take a consistentapproach to the issues across all territories. Withoutcentral co-ordination local management may be toofastidious or too lax in registering trademarks, or inpursuing legal action for real or imaginedinfringement of the trademarks. Many argue thatCIL ensures that the value of brands is moreacutely appreciated across a group in areas suchas finance and legal. Over the years, manymarketers have argued that they alone haveunderstood and appreciated the value of thisparticular class of assets. CIL backs up thecentralised marketing concept, where marketingresource is shared and co-ordinated, maximisingthe homogeneous nature of brand image, productdevelopment and advertising. CIL generates aholistic, group-wide approach to brand licensingensuring that the management and development ofthe brand is controlled for the whole of the groupand not just one part of it, which may have anarrow or particular focus.

Despite the centralisation of brand management, itis still possible to ensure that brand managers inindividual territories are incentivised to ensurebrand value is maintained and enhanced in thosecountries. This has a direct impact on maximisingshareholder value. With CIL it is possible tostandardise performance targets and theremuneration structures across groups (althoughflexibility may need to be maintained in response tolocal conditions). CIL is the first step toincorporating brand values within managementaccounts. Using CIL means that there will be apayment from the subsidiary to the licence holdingcompany. By ensuring that payment is made, thedirectors of the subsidiary clearly focus on thevalue in use for their part of the organisation. Somealso argue that directors of subsidiaries react betterto being charged a licence fee for the use of brandsand trademarks, rather than an amount charged to

cover head office costs, which are often perceivedas being unfair and arbitrary. The use of a royaltypayment can reinforce and align with the taximplications of valuing brands and IP. Finally, CILprovides a solid base for new licensing deals withinthe company and with joint venture partners orother third parties.

Choice of location for IP management companies

After the decision to manage IP centrally has beenmade, the location for the management companymust be decided. Both Nestlé and Shell hold theirIP in Switzerland, whilst Vodafone selected Ireland.They then charge arm's length royalty payments forthe use of brands by their subsidiaries. Lower taxrates in the country of brand ownership means sucha policy can have major fiscal benefits in addition tomanagement and organisational advantages.

This practise is entirely legitimate. It is taxavoidance, rather than tax evasion. Switzerland/Ireland, as the countries where the IP managementcompanies are based, manage and control thebrands. Tax authorities are unlikely to allowpayment of royalties for the use of a brand (or anyother asset) if the country that owns the brand, andis charging for the use, is not the place from whichmanagement of the brand is directed. It will, forexample, be difficult for management to justify whyan offshore shell company with no involvement inthe management, control and direction of a brandshould charge for the use of that brand.

It should be noted that UK-based companies mayencounter problems in transferring their IP rights toan offshore holding company, as CFC (“ControlledForeign Company”) rules dictate that the InlandRevenue can charge tax on the profit of a foreignsubsidiary in exactly the same way as an UK-basedcompany. Both the UK and the US havetransparent regimes of this type which minimise thescope for shielding subsidiary earnings from tax inthe head office country.

When IP is transferred to a central managementcompany there are likely to be capital gainsimplications. The tax authorities in both jurisdictionsinvolved are likely to take a keen interest in thecapital value of the asset leaving or entering theirjurisdictions. As with internal licensing rates, brandvaluation techniques are used to establish a valuewhen the domicile of a brand is changed.

Tax authorities are becoming generally moresuspicious over the amount of value attached toany intangible asset. Estimates are, in the opinionof the authorities, susceptible to over or underinflation, to accord with the tax strategy of thecompany. Another benefit of a brand valuationbeing conducted by an independent body is that itadds credence to any brand value and is less likelyto attract suspicion from the authorities.

The new regime for intellectual property, goodwilland intangibles

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Tax planning in relation to brands has historicallyfocussed on areas such as internal licensing andthe relocation of IP to offshore tax havens. Thenew tax regime in the UK has sparked renewedinterest in tax planning for brands as a result ofplanning ideas generated by the new legislation,and simultaneously raised the awareness of theimportance of independent brand valuation tosupport such planning.

Generally speaking, the planning ideas developedin relation to the new regime fall into one of twoareas. The first is to attempt to bring an existing(pre 1st April 2002) intangible asset, often a brand,within the scope of the new regime. The second isto create a completely new intangible asset, towhich the new regime rules would apply, from anexisting one.

The Inland Revenue moved quickly to close certainloopholes in the legislation relating to a particularlypopular tax avoidance scheme falling into the firstcategory above (known as a “de-relating” scheme).The principle of the scheme was for companies totransfer assets within a group for capital gains taxpurposes but between parties that were not relatedfor the purposes of the intangibles regime.Essentially, a transfer of an intangible assetbetween unrelated parties would bring that assetwithin the scope of the new regime, enabling thenew owner to receive tax relief at 4% p.a. straightline for a period of 25 years.

Several companies have submitted corporation taxcomputations having implemented such “de-relating” transactions, resulting in swift preventativeaction by the Inland Revenue. It remains too earlyto tell whether the transactions implemented priorto the amendments will be successful but the factthat the Inland Revenue moved so quickly to closethe loophole may be seen as an indication that itwas a robust scheme.

The majority of schemes being implemented todayfall into the second category. One such schemeinvolves the licensing of IP, such as a trademark, byone company to another in return for a lump sum.The key issue is whether the lump sum receipt fallsunder s171 TCGA 1992. Assuming that the receiptdoes fall under s171, then the transfer is at no gain/no loss, and the new asset, the license, receivestax relief in line with its amortisation in theaccounts.

This is also contested by the Inland Revenue. Fors171 to apply there must be a disposal of an assetto another company. The Revenue argue thatalthough one company has acquired an asset, it isnot the case that the other has disposed of it, thelicense having been created from an existing assetby the transaction and not disposed of. This isanalogous to the granting of a lease for land out ofa freehold, which does fall under s171, but theRevenue argue that this is by concession only.Despite considerable resistance from the InlandRevenue, it seems likely that some companies willcontinue to implement tax avoidance planningrelating to the new legislation.

Brand Finance is aware of several companiescurrently in the process of implementing suchschemes. As part of the feasibility planningprocess, it is undertaking brand valuations toenable tax departments to assess the cost versuspotential tax benefit of implementing suchschemes. Clearly the maximum tax benefit will bederived from the highest valuation for the brand orother IP that can be reasonably justified to the taxauthorities. Provided the auditors can be satisfied,it is likely that a directors’ valuation would besufficient. However, there can be a tendency for aninternally prepared valuation to be ratherconservative. Usually, those involved in theplanning are more concerned with whether thescheme will work at all than the value attributed tothe brand, and rightly so.

An independent brand valuation does haveadvantages, however. Firstly, it is likely that avaluation report prepared by an independent partyhas a greater chance of being accepted by the taxauthorities, possibly also with less scrutiny. This iseven more likely where the valuers, like BrandFinance, have had brand valuations put before thetax authorities in the past and accepted. Secondly,it is likely that an experienced valuer would be ableto support a less conservative valuation whichwould result in higher tax relief, provided thescheme itself is accepted.

The future of tax planningfor brandsBrands and the values that they represent havesignificantly increased over the last decade.Following this, companies increasingly need to lookat brand values when planning for tax purposes.They need to gauge how to most effectively gainvalue from their intangible assets while minimisingtax payments. The domicile of the brand needs tobe carefully considered, as does the royalty ratecharged for its use. Both the domicile and royaltyrate are likely to be reviewed by the tax authorities,who are increasingly paying attention to brandsand other intangible assets, using their extensivedatabases - a fact that needs to be remembered atthe initial point of planning. Due attention must bepaid by organisations or they may be forced to paya heavy penalty by the tax inspectors.

The new regime for IP, goodwill and intangiblesadds a new dimension to tax planningopportunities for certain companies. Although theInland Revenue has moved swiftly to block certainschemes, opportunities remain. Recent changes toUK to UK transfer pricing regulations also addanother layer of compliance for IP owners.

In all the cases of tax planning for brands that wehave discussed, the case for independent brandvaluation is a strong one and specialist companieslike Brand Finance, with a strong track record oftax related intangible asset valuation work, will bemonitoring further developments in this area withinterest.

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Appendix 1

Royalty rate determinationfor internal licensingStep 1: Establish royalty rate range

The royalty rate range is set by reference to areview of comparable licensing agreements andindustry norms.

The ultimate test is always, what would an unrelatedthird party pay to use the trademark under review?

A review of existing licensing agreements for othertrademarks in comparable sectors will reveal theroyalty rates set between third parties in arm’s-length transactions. Brand Finance has extensivepractical experience of appropriate royalty ratesused in comparable circumstances. Where possible,it would be helpful to speak to licensingprofessionals in the sector under review to obtain aqualitative assessment of the typical royalty ratesfor that sector.

Step 2: Establish the appropriate royalty ratewithin that range for the trademark in question

Having established the royalty rate range, it isnecessary to pin-point where in the range isappropriate for the trademark under review. This iscalculated by reference to a “Brand Strength Index”.

The Brand Strength Index score (out of 100)demonstrates how strong or weak the trademark is.Brand Finances scores the trademark relative to itskey competitors with reference to a number ofdifferent business and brand attributes. Eachcompetitor is scored out of 10 on each attribute.The attributes are then weighted and an overallscore out of 100 is calculated for each competitor.The resultant score for the trademark is thenapplied to the royalty range to pinpoint the royaltyrate figure. A score of 100 would result in a top ofrange royalty rate and the reverse for a score ofzero.

Step 3: Compare royalty rate with operatingmargins within the business

The profitability of the licensee’s business will alsoaffect the level of royalty rate that it is able to pay.This must be taken into account when concludingon the royalty rate to be used.

A “Rule of Thumb” exists within the licensingindustry which states that, on average, a licenseewould expect to pay approximately 25% of itsexpected profits for access to the IntellectualProperty (which could include brands) attached tothe license itself .

The “25% rule” has been widely used for manyyears, is supported by empirical studies and hasbeen adopted in legal infringement cases. Thetheory behind the “25% rule” is that the licensorand licensee should share in the profits resulting

from the licensed property with the preponderanceof profits going to the licensee, for its role in“commercialising” the property. Excluding specialcases, the profit receivable by the licensor isgenerally accepted as reasonable if it is in the rangefrom one-quarter to one-third of profits from theexploitation of the licence.

It is important to note that the “25% rule” is only astarting point for royalty negotiations and theroyalties are often adjusted to be higher or lower,depending upon, among other factors, thenegotiating strength of each party and thecommercial realities of that specific situation. Suchadjustments to the split to reflect special factorshave been recognised by the courts.

The rule is based on historical use and provenrelationships between royalty rates and operatingmargins and is accepted by many experts as a validapproach to value royalties. However as Goldwater,Jarosz and Mulhern conclude in their article,“Ultimately, royalty rates are often higher or lowerthan 25% of fully-loaded product profits, dependingupon a host of quantitative and qualitative factorsthat can and should affect a negotiation (orlitigation)”.

When setting internal royalty rates, the “25% rule” istherefore a useful indicator of what an appropriateroyalty rate might be and, therefore, whether therate established from the comparable licensingagreements search and Brand Strength Index scoreappears reasonable.

Brand Finance plc8 Oak LaneTwickenhamTW1 3PA UK

T +44 (0)20 8607 0300F +44 (0)20 8607 0301

www.brandfinance.com

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Brand Finance plc8 Oak Lane Twickenham TW1 3PA UK

T +44 (0)20 8607 0300F +44 (0)20 8607 0301

www.brandfinance.com

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