Many multinational companies own valuable intellectual property, such as software, patents, trademarks, or technology, in one country and allow their foreign subsidiaries to use it. In return, the subsidiary usually pays a royalty to the company that owns the intellectual property. The royalty should be similar to what independent companies would agree to pay.
Suppose ABC Software Inc. is a U.S. parent company that owns valuable software technology.
ABC Software licenses this technology to its UAE subsidiary, which uses the software to develop and sell products in the UAE and other markets.
In return for using the technology, the UAE subsidiary pays a royalty to the U.S. parent.
A royalty is a payment made for the right to use intellectual property, such as software, patents, trademarks, or other technology.
The royalty rate charged between the U.S. parent and its UAE subsidiary is a transfer pricing issue because the companies are related.
Under the arm’s-length principle, the royalty should generally be similar to what an independent company would pay for comparable technology under similar circumstances.
Suppose the UAE subsidiary has:
Sales: $2,000,000
Other business costs: $1,600,000
Comparable arm’s-length royalty rate: 10%
In this case, a 10% royalty on $2,000,000 of sales would be:
$2,000,000 × 10% = $200,000
The UAE subsidiary would therefore pay $200,000 in royalty to the U.S. parent.
Its remaining profit would be:
$2,000,000 − $1,600,000 − $200,000 = $200,000 (A)
Now suppose the UAE subsidiary actually pays only a 2% royalty.
The royalty would be:
$2,000,000 × 2% = $40,000
The UAE subsidiary’s profit would then be:
$2,000,000 − $1,600,000 − $40,000 = $360,000 (B)
The difference is:
$360,000 (B) − $200,000 (A) = $160,000
So, compared with the 10% arm’s-length royalty, the UAE subsidiary retains an additional $160,000 of profit, while the U.S. parent receives $160,000 less royalty income.
In simple terms, $160,000 of profit has shifted from the U.S. parent to the UAE subsidiary.
Let’s understand this Profit Comparison in table format:
| Arm’s-Length Royalty: 10% | Actual Royalty: 2% | |
| Sales by UAE subsidiary | $2,000,000 | $2,000,000 |
| Other business costs | $1,600,000 | $1,600,000 |
| Royalty paid to U.S. parent | $200,000 (10%) | $40,000 (2%) |
| Profit remaining in UAE | $200,000 | $360,000 |
| Additional profit retained in UAE | 0 | $160,000 |
| U.S. royalty income | $200,000 | $40,000 |
Now let’s see how the different royalty rates affect the group’s tax liability.
For this simplified example, assume:
U.S. corporate tax rate = 21%
UAE corporate tax rate = 9%
These rates are used only to illustrate the effect of different royalty amounts.
If the Royalty Is 10%
The U.S. parent receives $200,000 ($200,000 x 10%) of royalty income.
$200,000 × 21% = $42,000
Here, the UAE subsidiary would pay $200,000 in royalty to the U.S. parent; the remaining UAE profit would be:
$2,000,000 (Sales)− $1,600,000 (Costs) − $200,000 (Royalty) = $200,000 UAE Profit.
Thus, the UAE subsidiary has a net profit of $200,000. (A)
$200,000 × 9% = $18,000 (B)
Therefore, the simplified combined tax is:
$42,000 (A)+ $18,000 (B) = $60,000
If the Royalty Is 2%
The U.S. parent receives only $40,000 ($200,000 x 2%) of royalty income.
$40,000 × 21% = $8,400 (A)
The UAE subsidiary now has $360,000 of profit after paying the lower royalty.
$360,000 × 9% = $32,400 (B)
Therefore, the simplified combined tax is:
$8,400 (A) + $32,400 (B) = $40,800
Let’s see the same calculation in a simplified tax comparison table format.
| Line | Calculation | 10% Royalty | 2% Royalty |
| A | Royalty rate | 10% | 2% |
| B | Sales by UAE subsidiary | $2,000,000 | $2,000,000 |
| C = A × B | Royalty paid to U.S. parent | $200,000 | $40,000 |
| D | U.S. tax rate | 21% | 21% |
| E = C × D | U.S. tax on royalty income | $42,000 | $8,400 |
| F | UAE profit after royalty | $200,000 | $360,000 |
| G | UAE tax rate | 9% | 9% |
| H = F × G | UAE tax | $18,000 | $32,400 |
| I = E + H | Combined tax | $60,000 | $40,800 |
The difference in combined tax is:
$60,000 − $40,800 = $19,200
Under these simplified assumptions, the 2% royalty results in $19,200 less combined tax than the 10% royalty.
The U.S. parent’s tax on royalty income falls from $42,000 to $8,400. This results in a U.S. tax difference of $33,600 ($42,000 – $8,400).
This means that by charging a 2% royalty, the U.S. parent is able to shift the royalty from the U.S. to the UAE. This results in a reduction of U.S. taxes through profit shifting.
This example shows why transfer pricing matters when related companies operate in countries with different tax rates. The royalty rate determines how much profit is reported in each country.
Therefore, the group cannot simply choose the royalty rate that produces the lowest overall tax. The royalty should generally be supported by the arm’s-length principle.
If the IRS determines that the royalty charged between the U.S. parent and its foreign subsidiary does not reflect an arm’s-length amount, it may adjust the transaction under IRC Section 482. Such an adjustment can increase U.S. taxable income and may also result in interest and, depending on the circumstances, penalties.