A royalty is the fee one company pays another for the right to use intangible property — a patent, trademark, brand, know-how or software — without owning it. When the two companies are related, transfer pricing rules require the royalty to reflect an arm's length rate: the price independent parties would have agreed. Setting that rate wrong, or failing to document it, is one of the most litigated areas in transfer pricing.
Key takeaways
- A related-party royalty must be benchmarked to an arm's length rate; under the UAE Corporate Tax Law (Federal Decree-Law No. 47 of 2022) this applies to all related-party royalty payments.
- Royalty entitlement follows DEMPE — the entities that develop, enhance, maintain, protect and exploit the intangible and control the associated risks should earn the return, not the mere legal owner.
- A benefit test must show measurable, quantifiable value from using the intangible; simply holding a licence agreement is not enough.
- Royalty rates are benchmarked mainly with the CUP, profit split (PSM) and transactional net margin (TNMM) methods, drawing on databases such as RoyaltyStat, RoyaltySource and RoyaltyRange.
- Eight comparability factors — including exclusivity, geographic scope, useful life and the royalty base — drive a defensible royalty rate.
- Courts have repeatedly held that a tax authority cannot set a royalty to nil simply because manufacturing is outsourced or the payer is loss-making.
What counts as a royalty, and when TP applies
A royalty arises from licensing — the grant of a right to use intangible property without transferring ownership — and between related parties it must be benchmarked to an arm's length price. That is what separates it from a transfer, which is a sale of ownership, where the asset's valuation rather than a recurring fee drives the price. The UAE Transfer Pricing Guide defines an intangible, consistently with the OECD, as something that is not a physical or financial asset, can be owned or controlled for commercial use, and would be compensated between independent parties on use or transfer — from patents and know-how to trademarks, brands and contractual rights.
For UAE businesses, the Corporate Tax Law mandates arm's length pricing for all related-party royalties. Royalty income earned by a Qualifying Free Zone Person is generally taxed at 9% unless it meets the narrow definition of Qualifying Intellectual Property income and passes the nexus approach under Ministerial Decision No. 265 of 2023. And royalties routed through low-substance entities can attract permanent establishment or place-of-effective-management scrutiny.
Why does DEMPE decide who earns the royalty?
The return from an intangible is not simply owed to whoever holds legal title. Under the DEMPE framework — Development, Enhancement, Maintenance, Protection and Exploitation, set out in Chapter VI of the OECD Guidelines and Para 7.3.3 of the UAE Transfer Pricing Guide — the reward should follow the entities that actually perform those functions and control the related risks. Legal ownership is only the starting point; contribution to DEMPE matters more (OECD BEPS Actions 8-10). In practice, SBC maps each DEMPE function to the entity that actually performs it and controls its risks, because that functional matrix — not the licence agreement — is what determines the split on audit.
A cash-box owner with no substance earns little from an intangible it merely holds on paper. Under DEMPE, the real return follows the entities that develop, enhance, maintain, protect and exploit it and control the related risks.
How an arm's length royalty rate is benchmarked
Benchmarking an arm's length royalty rate starts with a functional and comparability analysis. The CUP method is used where reliable third-party comparables exist, with adjustments for differences in contractual terms, exclusivity or geography. The profit split method (PSM) fits where both parties contribute uniquely and significantly to the value of the intangible, and the transactional net margin method (TNMM) suits entity-level aggregation across multiple scenarios. Specialist databases such as RoyaltyStat, RoyaltySource and RoyaltyRange — drawing on licence agreements from filings such as those with the US SEC — support the search for comparable rates. Method choice is closely tied to the type of arrangement.
| Arrangement | Common TP method | Key comparability factors |
|---|---|---|
| Trademark / brand royalty | CUP or TNMM | Brand recognition, market exclusivity, geography, marketing support |
| Technical know-how | CUP, TNMM or PSM | Patented technology, lifecycle, exclusivity |
| Software / IP licence | CUP (if a third-party licence exists) or TNMM | Enterprise versus back-end technology, exclusivity |
| Franchise fees | CUP or PSM | Sector, degree of support, location |
| Patent / IP royalty for R&D entities | PSM or CUP | Patent lifecycle, industry, DEMPE alignment |
Eight comparability factors shape the arm's length rate across all of these arrangements: the industry, the type of agreement, the royalty base (net sales, units sold or operating profit), exclusivity, geographic scope, the stage of development of the intangible, its useful life, and the expected future benefits.
Passing the benefit test
Benchmarking a rate is not enough on its own — the payer must also show it actually benefits from the intangible. The benefit test requires clear, quantifiable evidence of the economic value derived from using the intangible; merely having an agreement does not satisfy it. Ideally the taxpayer can also show the intangible was unique, not available from a low-cost alternative, and beyond its own capability to develop internally. Supporting that position means a functional analysis, a DEMPE functional matrix, an IP register, financial analyses linking the intangible to revenue or cost savings, the underlying agreements and board approvals, and the benchmarking study itself.
Lessons from royalty litigation
Royalty is one of the most contested areas in transfer pricing, with a recurring theme in the case law. Tax authorities frequently try to set the arm's length royalty at nil, and courts — Indian courts applying OECD-aligned principles, in the leading examples — have pushed back. In PCIT v. Sony India (ITA No. 551/2023), royalty paid under a valid licence was held deductible even though manufacturing was outsourced to third-party OEMs, and the court confirmed a transfer pricing officer cannot benchmark royalty at nil or question commercial expediency. In CIT v. EKL Appliances (I.T.A. Nos. 1068/Del/2011), continued losses were held not to justify disallowing a legitimate royalty, because profitability is not a precondition for the deduction. And in PCIT v. Samsung India (ITA No. 40/2018), a licensed manufacturer using the parent's essential technology was found entitled to pay an arm's length royalty, so the rate could not be reduced to nil.
The lesson for UAE businesses is twofold: a nil royalty cannot be assumed acceptable, but the taxpayer still carries the burden of proving DEMPE alignment, a genuine benefit and an arm's length rate. Challenges commonly trigger on DEMPE misalignment, rates outside the arm's length range, hard-to-value intangibles causing ex-post adjustments, payments to cash-box entities being re-characterised, and a gap between legal ownership and value creation.
Frequently asked questions
How is an arm's length royalty rate determined?
An arm's length royalty rate is set by benchmarking the licence against comparable third-party arrangements, most often using the CUP, profit split or TNMM method and databases such as RoyaltyStat, RoyaltySource or RoyaltyRange. The analysis weighs eight comparability factors — including exclusivity, geographic scope, the royalty base, useful life and the stage of development of the intangible.
What is the benefit test for royalty payments?
The benefit test requires the payer to show clear, quantifiable economic value from using the intangible — merely holding a licence is not enough. The taxpayer should show the intangible is unique, was not available from a low-cost alternative, and could not have been developed internally, supported by financial evidence linking it to performance.
Does DEMPE affect royalty entitlement?
Yes. Under the DEMPE framework, the return from an intangible follows the entities that develop, enhance, maintain, protect and exploit it and control the related risks — not simply the entity that holds legal title. A related party that only funds or legally owns the intellectual property, without substance, earns a routine return, while the residual reward goes to the DEMPE performers.
How are royalties taxed for UAE free zone companies?
Royalty income earned by a Qualifying Free Zone Person is generally taxed at 9% unless it meets the narrow definition of Qualifying Intellectual Property income and passes the nexus approach under Ministerial Decision No. 265 of 2023. Either way, related-party royalties must be priced at arm's length, and low-substance royalty structures can attract permanent establishment or place-of-effective-management scrutiny.
How SBC Tax Consulting can help
SBC's transfer pricing team sets and defends related-party royalty rates — running DEMPE and functional analysis, benchmarking the rate against reliable databases, and building the benefit-test evidence the FTA and other authorities expect. We also handle the international tax and withholding-tax side of cross-border IP flows and support you through an audit or dispute. To review your royalty arrangements, contact SBC.
This publication is for general information only and does not constitute professional advice. Please consult your SBC advisor before acting on any matter covered here.