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Controversy Aside, IKEA on Solid Economic Footing in Royalty Dispute

Posted by Harold McClure
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European affiliates of multinationals such as IKEA face scrutiny from a variety of agencies including the European Union (EU), which issued EU Council Directive 2011/16 also known as DAC6. The stated purpose of DAC6, which became effective on June 25, 2018, is to provide transparency and fairness in taxation. DAC6 applies to cross-border tax arrangements between EU affiliates and tax havens. One of these cross-border tax arrangements is intercompany royalty payments from EU affiliates to affiliate in tax havens such as Liechtenstein. Such intercompany payments by European affiliates of IKEA are being challenged by the European Commission in a State Aid inquiry, which was initiated on December 18, 2017, according to an EC press release:

The European Commission has opened an in-depth investigation into the Netherlands' tax treatment of Inter IKEA, one of the two groups operating the IKEA business. The Commission has concerns that two Dutch tax rulings may have allowed Inter IKEA to pay less tax and given them an unfair advantage over other companies, in breach of EU State aid rules … In the early 1980s, the IKEA business model changed into a franchising model. Since then, it has been the Inter IKEA group that operates the franchise business of IKEA, using the "IKEA franchise concept". What this means more concretely is that Inter IKEA does not own the IKEA shops. All IKEA shops worldwide pay a franchise fee of 3% of their turnover to Inter IKEA Systems, a subsidiary of Inter IKEA group in the Netherlands. In return, the IKEA shops are entitled to use inter alia the IKEA trademark, and receive know-how to operate and exploit the IKEA franchise concept.

This passage already identifies what DAC6 hopes to discover. The various IKEA operating affiliates pay intercompany royalties equal to 3 percent of their sales to the Liechtenstein owner of the IKEA intangible assets. The identification of an intercompany payment does not address whether the payment is consistent with the arm’s length standard or not. A Green Party report noted this issue in February 2016:

IKEA is paying royalties to itself presumably to reduce overall taxation (disguised by the supposed independence of two corporate groups). From 1991 through 2014, the Inter IKEA Group seems to have used a Dutch conduit company to avoid paying tax on 84% of the €14.3 billion in royalty income it received from IKEA stores around the world. Despite lack of accounts disclosure, our findings indicate the possibility that these royalties have been channeled through the Netherlands and Luxembourg to Liechtenstein (or other tax havens) with very little tax paid along the way … The Inter IKEA Group owns the IKEA “retail system” and, at least since 2012, the IKEA trademark. This Group is the franchisor of IKEA and every IKEA store in the world sends Inter IKEA royalties equal to 3% of sales … The IKEA Group operates 328 IKEA stores in 28 countries under franchise agreements with the Inter IKEA Group. In addition, the Group currently owns IKEA’s factories, forestry operations and logistics network as well as subsidiaries responsible for developing the IKEA product range (under contract with the Inter IKEA Group). However, most of these secondary functions will be transferred to the Inter IKEA Group as of 31 August 2016.

Large multinationals such as IKEA are required under Action Plan 13 of the Base Erosion and Profit Shifting initiatives to provide a Master file that includes Country-by-country (CbC) reporting. The Green Party report provided the key descriptive elements of the Master file as it identified the nature of the business, the functions of each affiliate, as well as the ownership of assets including intangible assets. We review various approaches to evaluating whether this 3 percent royalty rate is consistent with the arm’s length standard or excessive including two not very convincing defenses as well as an economic approach that would rely on the key financial information in the CbC reporting.

Two Unconvincing Defenses

Transfer pricing practitioners often rely on one of two regulatory methods that unfortunately do not provide any real insight as to the arm’s length nature of an intercompany royalty rate. One approach examines royalty rates paid by licensees in the same industry as the related party licensee. While practitioners argue that this approach is an application of the Comparable Uncontrolled Transaction (CUT) approach, it is more properly known as an industry norm approach. Tax authorities often reject an industry norm approach unless the profit potential in the controlled transaction is similar to the profit potential for the alleged CUTs. This insistence on analyzing profit potential essentially requires a profits based approach that begins with the expected profitability of the related-party licensee. Tim Worstall offered a particularly absurd version of this approach in a 2016 opinion piece in Forbes:

And Ikea charges a 3% royalty. The brand obviously does have a value: you can try selling flat pack furniture by calling yourself "Tim's flat pack furniture shop" but you're just not going to get the trade that one called Ikea is going to get. Thus international tax law actually insists that Ikea must be charging itself something for the value of that brand. And 3% is actually fairly low by the standards of these things. Starbucks, an unrelated EU investigation found, charges itself 4% and this is considered just fine.

There are several problems with the use of Starbucks as an alleged CUT. Ready to assemble furniture and fast food franchising are not even remotely the same industry. We should also note that Starbucks charges royalty rates equal to 6 percent of sales – not the 4 percent Worstall claimed. This 4 percent figure may be related to a challenge from the UK tax authority, which Saumyanil Deb and I noted in a 2015 piece for the Journal of International Taxation:

The 6% royalty rate is what third party licensees pay Starbucks for the use of its brand and business processes. The Form 10-K filings for Starbucks provide not only consolidated income statements but also financial data by regions. For fiscal year ended September 28, 2014, worldwide sales were $16.448 billion and operating profits were $3.081 billion or 18.7% of sales. The operating margins for the Americas region and the China Asia Pacific region exceeded 20%. For the Europe, Middle East, and Africa (EMEA) region, sales were $1.295 billion with operating profits of only $119 million or 9.2% of sales. The EMEA operating margin for the previous year was only 5.5%. … the U.K. affiliate has had modest profits historically. This does not necessarily mean that the intercompany royalties are excessive, as the business facts indicate that the third-party costs in the EMEA region are substantially higher than third-party costs in other regions. This fact pattern presents the classic conflict between market-based or CUT approaches versus profits-based approaches such as TNMM.

TNMM stands for the Transactional Net Margin Method, which is equivalent to the Comparable Profits Method (CPM). In the next section, we shall note the very limited role that such approaches play in the evaluation of arm’s length royalty rates. For now, let’s note that most of Starbuck’s common owned stores and third party franchisees generate significant consolidated operating profits such that paying a 6 percent royalty rate leaves them with profits that allow for a generous return on their operating assets. As we shall note in the next section, licensees bear commercial risk implying some will do better than expected whereas other licensees may have a low actual return to operating assets. As such, we disagreed with the UK tax authority’s abuse of TNMM. More importantly, Starbucks is a highly profitable fast food franchise. The idea that one could use market evidence on its third party royalty rates as evidence for IKEA’s royalty rate misses the point about profit potential.

On March 6, 2019, the Spanish Court of Appeal ruled in favor of IKEA Distribution Services, a wholesale distribution company that sells products to related party retail companies. The Spanish tax authority argued that its operating margin was too low. This operating margin averaged 2.2 percent over the 2006 to 2008 period. The representatives had presented the operating margins for other wholesale distributors for the 2003 to 2005 period where the median operating margin was 4.1 percent and the interquartile range was from 2.1 percent to7.6 percent. These figures were presented as an application of TNMM, but it is unclear how being just above the lower quartile of a set of wholesale distributors is a meaningful analysis of whether the 3 percent royalty rate was arm’s length is unclear. This TNMM analysis did not address whether the Spanish retail affiliates received adequate compensation for their functions, nor did it address the profitability of the related party suppliers. Any profits based analysis should begin with expected consolidated profits and then follow an economic approach, which we address in the next section.

An Appropriate Profits Based Methodology

Profits based approaches take on several form including a now discredited 25 percent rule of thumb promoted by Robert Goldscheider. While this rule of thumb has never been endorsed either by the IRS or the Organization of Economic Cooperation and Development, it had been used in both patent infringement litigations and by a few transfer pricing practitioners. The Federal Circuit Court for the District of Rhode Island strongly condemned this rule of thumb in Uniloc USA, Inc. v. Microsoft Corp. ( 632 F3d 1292 (CA-F.C., 2011)). I discussed the court’s sound reasoning as well as recent developments in transfer pricing in a another 2015 article for the Journal of International Taxation that opened with:

This article compares the key insights from BEPS Action 8 and how these insights support the Federal Circuit's advice in Uniloc. It then considers five examples in which a U.S. parent licenses certain intangible assets to its Canadian affiliate. While the IRS often argues for a high royalty rate, the Canadian Revenue Agency (CRA) argues for a low royalty rate. The goal is to show how a true analytical approach may resolve such double tax disputes. Three scenarios are considered: where the consolidated operating margin is only 10%, where it is 50%, and an intermediate case involving an actual multinational that may have been falsely accused of base erosion.

Proponents of TNMM or CPM approaches assert that the licensee deserves a routine return to the tangible operating assets used in the production and distribution of the product. This approach starts with the expected systems profits as a percent of sales and then deducts a routine return for operations expressed as a percent of profits. This difference is known as residual profits with the arm’s length royalty rate being set as residual profits as a percent of sales. A considerable literature has noted, however, that the licensee deserves a share of residual profits for two distinct reasons:

  • The licensee may own a portion of the valuable intangible assets; and
  • The licensee bears extensive commercial risk by using intangible assets owned by another entity.

While the IRS’s version of the Residual Profit Split Method allows consideration of the first argument, it ignores the commercial risk consideration. My paper focused on this latter issue by in part noting paragraph 63 of BEPS Discussion Draft on Action 9:

Risks should be analyzed with specificity, and it is not the case that risks and opportunities associated with the exploitation of an asset, for example, derive from asset ownership alone. Ownership brings specific investment risk that the value of the asset can increase or may be impaired, and there exists risk that the asset could be damaged, destroyed or lost (and such consequences can be insured against). However, the risk associated with the commercial opportunities potentially generated through the asset is not exploited by mere ownership.

The implementation of any profits based model must begin with the projected system profits of IKEA relative to sales as well as its tangible assets. While this information is readily available for publicly traded multinationals, the fact that IKEA is privately held means that there may be limited if not confusing information in the public domain.

IKEA’s Income Statement and Balance Sheet as Key Information

The Green report provided limited financial information for IKEA through 2014. Their information suggested worldwide sales were nearly €30 million during 2014 with over three-fourth of those sales in Europe. Their reporting of consolidated profits suggested that operating profits were nearly 13 percent of sales for 2014. This report claims:

Total sales for all IKEA stores obtained from the annual accounts of Inter IKEA Holding SA, the Luxembourg domiciled parent of the Inter IKEA Group. Franchise fees equal 3% of sales, as disclosed by the Inter IKEA Group in its annual accounts.

The Green report presents certain 2014 financial information for eight European affiliates, which is reproduced in table 1. Sales and intercompany royalties are reported for Austria, Belgium, Denmark, France, Germany, Spain, and the UK. Profits after the payment of royalties are reported for six of these affiliates. We also reported the consolidated operating margin defined as (profits + royalties)/sales. Note that this margin ranged from 4.67 percent to 8.67 percent, which is lower than the reported consolidated margin on a worldwide basis. These lower margins may be due to a couple of possible reasons. One goes to our realization that licensees bear risk. The other may relate to the possibility that these margins reflect the possibility that these affiliates are reasonable for distribution functions with manufacturing profits being captured by related party supplying affiliates.

Table 1: Certain 2014 Financial Information Noted in the Green Report

Millions

Sales

Profits

Royalties

Margin

Belgium

 €733.5

 €41.6

 €22.0

8.67%

Denmark

 €461.8

 €16.1

 €13.9

6.50%

France

 €2380.2

 €39.3

 €71.4

4.65%

Germany

 €4015.9

 ND

 €120.5

 

Spain

 €1070.8

 ND

 €32.1

 

Sweden

 €1536.4

 €53.1

 €46.0

6.45%

UK

 €1,43.1

 €36.7

 €55.3

4.99%

Austria

 €547.1

 €21.2

 €16.4

6.87%

Table 1 can be seen as a subset of the information contained in a CbC report. This information, however, is incomplete as it only captures the profitability of a limited number of distribution affiliates. The Green report information not only omits the profitability of producing affiliates but it also contains no balance sheet information.

IKEA provides Annual Reports that show worldwide sales and operating profits as well as balance sheet information. Sales were €28.5 billion in 2013 and rose reaching €36.3 billion by 2017. Over the 2013 to 2017 period the operating margin varied from 14.14 percent to 8.35 percent, reflecting the fact that a licensee paying a fixed royalty rate bears commercial risk. Over this five-year period, the operating margin was 11.9 percent. As such, the 3 percent royalty rate was just over 25 percent of operating profits. Of course, an appeal to Goldscheider’s rule of thumb is not a convincing argument.

We attempt an application of our economic model based on the information provided by these Annual Reports. IKEA’s tangible fixed assets were approximately 65 percent of sales. Working capital, which represents inventories plus receivables minus payables, were approximately 5 percent of sales. As such, operating assets were approximately 70 percent of sales.

Table 2 provides a profits based model of IKEA’s intercompany royalty rate making the following assumptions:

  • Worldwide sales = €40 billion per year;
  • Operating costs = 88 percent of sales so operating profits before royalties (OPB4Royalty) = 12 percent of sales;
  • Value of tangible assets owned by the licensees = 70 percent of sales = €28 billion; and
  • Value of intangible assets owned by the licensor = $20 billion.

Note under these assumptions that the consolidated return to operating assets including licensee tangible assets and licensor intangible assets (ROA) = 10 percent.

Table 2: A Profits Based Model for IKEA’s Intercompany Royalty Rate

   

TNMM

 

Policy

 

Millions

Consolidated

Licensee

Licensor

Licensee

Licensor

Sales

 €40.0

 €40.0

 

 €40.0

 

Costs

 €35.2

 €35.2

 

 €35.2

 

OPB4Royalty

 € 4.8

 € 4.8

 

 € 4.8

 

Royalty

 € 0    

 € 2.0

 € 2.0

 € 1.2

 € 1.2

Income

 € 4.8

 € 2.8

 € 2.0

 € 3.6

 € 1.2

Assets

 €48.0

 €28.0

 €20.0

 €28.0

 €20.0

ROA

10.0%

10.00%

10.0%

12.86%

6.0%

Table 2 considers two royalty rates. A TNMM approach would grant both the licensor and the licensee with a 10 percent return to their respective assets. Under this approach, the royalty rate should be 5 percent resulting in intercompany royalties being €2 billion per year. As we noted earlier, TNMM ignores the role of commercial risk borne by the licensee. IKEA’s intercompany policy, however, is not that aggressive as its royalty rate is only 3 percent with intercompany royalties being €1.2 billion per year. The licensees under this policy received both a routine return to its tangible assets as well as 40 percent of residual profits, which represents reasonable compensation of its commercial risk taking.

Our model is based on the overall financial information presented in IKEA’s Annual Reports. As such, our defense of their intercompany royalty rate can only be seen as a broad justification for the 3 percent royalty rate but not an explanation for the more granular intercompany policies between IKEA’s manufacturers and various distribution affiliates. The Green report provided only a slice of information that would be provided in a full CbC reporting. We have argued that these slices of information can provide a distorted picture especially since such slices of information are presented without an overall model for the evaluation of whether the intercompany royalty rate is arm’s length. A properly prepared Master File along with the corresponding CbC reporting could provide the broader picture for why IKEA’s 3 percent royalty rate is arm’s length. If our interpretation of the facts and financials is correct, we have used the information on IKEA’s business to suggest a defense of at least its 3 percent intercompany royalty. Our broader message is that multinationals should welcome the Master File and CbC requirements as an opportunity to tell their story as to why their intercompany pricing policies should be respected as being arm’s length.

Citations

State aid: Commission opens in-depth investigation into the Netherlands' tax treatment of Inter IKEA,” European Commission Press Corner, Dec. 18, 2017.

“IKEA: Flatpack Tax Avoidance,” The Greens/EFA, Feb. 12, 2016.

“The Green Party Doesn't Grasp EU Tax Laws Concerning IKEA”, Forbes, Feb. 15, 2016

 “The Google Tax: Transfer Pricing or Formulary Apportionment?”, Journal of International Taxation, June 2015.

 “Arm's-Length Royalties in Light of BEPS and Uniloc”, Journal of International Taxation, Nov. 2015. 

Published on May 20, 2020 10:03:18 AM

Harold McClure has over 25 years of transfer pricing and valuation experience. Dr. McClure began his transfer pricing career at the IRS and went on to work at several Big 4 accounting firms before becoming the lead economist in Thomson Reuters’ transfer pricing practice. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983.
He can be contacted at: hmcclure@edgarstat.com


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Topics: Royalty Rates, OECD BEPS Action, Tax Litigation, Net Profit Indicator, CUP Method