Can’t See the CUTs? Consider Looking at Your Own License Agreements

Aug 8, 2013

At a recent transfer pricing conference, I was struck by the number of times I heard the phrase, “it’s rare to find a CUT for intangible property.”  The Comparable Uncontrolled Transaction (“CUT”) method compares controlled transfers (intercompany transactions between two or more of a taxpayer’s entities) to a comparable set of uncontrolled (or third party) transactions.  While it may be rare to find CUTs for intangible property when conducting searches of publically available databases, it may be easier for multinational firms that engage in substantial licensing activity of similar intangible property.  Such firms may benefit from looking for CUTs among their own intangible property transactions with third parties before pursuing other methods.  In fact, if reliable data from these transactions exist and are properly analyzed, the CUT method “will generally be the most direct and reliable measure of the arm’s length result.”[1]

A significant hurdle in identifying a CUT is meeting the comparability criteria in the IRS section 482 regulations.  These criteria include comparable:

(1)    intangible property that is used in connection with similar products or processes within the same general industry and demonstrates similar profit potential; and

(2)    circumstances, including terms of transfer, stage of development, rights to receive updates, uniqueness of property, duration of license, economic or product liability risks assumed, existence of collateral transactions, and functions to be performed by the parties. 

A benefit of using a firm’s own transactions with third parties as CUTs is that many of the comparability criteria in the section 482 regulations may be more readily met.  Specifically, if a firm is active as a licensor or licensee, its licenses are likely to be in the same industry and for the same technology (e.g., patented technologies embodied in a pharmaceutical product) as the controlled transaction.  Moreover, when engaging in licensing negotiations, many firms prepare net present value (“NPV”) analyses to estimate the expected profitability of the transaction, which management considers when deciding whether to enter into an agreement.  These analyses typically report the anticipated revenues, costs, and profits associated with the use of the technology.  In addition, the company will use a discount rate, which reflects the time value of money and anticipated risks, to calculate the total NPV.

In addition, the firm is likely to have access to detailed information regarding the comparable circumstances listed above.  For example, information on the terms of transfer, stage of development, rights to receive updates, duration of license, allocation of risks, and collateral transactions are often included in license agreements with third parties.  These license agreements should be readily available.  More importantly, a contemporaneously prepared NPV analysis provides a basis for adjusting for any differences between the circumstances of the controlled and uncontrolled transactions.  Specifically, each of the comparable circumstances listed above affect the revenues, costs, risks, or timing of the cash flow associated with the use of the licensed technology.  For example, if a transaction requires the company to bear the cost of building a special production facility, other things equal, these costs would result in a lower NPV and a lower effective royalty rate for the controlled transaction.  Similarly, if profits are going to be realized in the more distant future, other things equal, the present value of these profits and the effective royalty rate will be lower.

Finally, the U.S. Tax Court has expressed support for the CUT method in situations where data on sufficiently similar transactions exist.  For example, in Veritas v. Commissioner, the U.S. Tax Court found that the CUT method, using the taxpayer’s own transactions with third parties, was the best method.  The Court stated that although these “agreements are certainly not identical to the controlled transaction,” they were “sufficiently comparable” and only required “certain adjustments” to enhance the reliability.

Because of the rich set of information often available on a company’s transactions with third parties, finding CUTs within this set of transactions often allows for reliable adjustments and a defensible transfer price.  This approach also may reduce the risk of tax controversies and adjustments, as it does not require the selection of comparable license agreements or companies based on a potentially more limited set of information available in public databases.  Specifically, as discussed above, the advantages of using a taxpayer’s transactions with third parties include:

  • Multinational taxpayers are unlikely to find a richer source of information on comparable technologies than their own transactions with other parties.
  • The very information that is used to decide whether to enter into a license agreement may prove useful in evaluating and adjusting for comparable circumstances.
  • There is substantial support for the use of reliable CUTs in the section 482 regulations and in judicial decisions.

As a result, companies may want to take a closer look at their own transactions before applying other methods.

If you are interested in learning more about our experience using a company’s own license agreements as CUTs for intangible property, please contact George Korenko at

[1] IRS Final section 482 Regulations (TD 8552) For Intercompany Transfer Pricing, issued July 1, 1994.


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