Expanding through brand licensing or franchise agreements has become a go-to model for many hotel groups. It often grow by allowing subsidiaries or third-party operators to use their brand trademarks, systems, and know-how. While this model creates opportunities, it also requires careful planning to ensure tax efficiency without falling foul of transfer pricing rules.
Why It Matters?
Tax authorities around the world now pay close attention to how hotel groups set up their licensing agreements. A structure that looks smart on paper but has no real substance can easily be challenged. Getting it wrong could lead to double taxation, heavy penalties, or reputational risks.
To optimize tax outcomes while staying complliant, the following should be considered:
a. Jurisdictional Structuring
- Locate the IP-holding entity in a jurisdiction with robust tax treaties, moderate royalty withholding tax, and strong substance requirements.
- Ensure the IP-holding entity has real economic substance (management, staff, decision-making, R&D or brand management activities) to avoid challenges under anti-avoidance or “substance-over-form” rules.
b. Agreement Design
- Clearly separate brand licensing fees (royalties for trademarks, systems, reservation platforms) from management fees (operational support, training, marketing) to align with OECD guidelines.
- Include territorial rights, exclusivity terms, and IP usage limitations to substantiate the commercial reality of the agreement.
c. Tax Efficiency Measures
- Use arm’s length pricing models (e.g., Comparable Uncontrolled Price, Profit Split for integrated offerings) to set royalty rates that are defensible.
- Factor in withholding tax impacts: sometimes gross-up clauses are included to address local taxes.
- Align agreements with OECD Transfer Pricing Guidelines (2022) and local BEPS-compliant legislation to prevent double taxation.
d. Documentation
- Maintain contemporaneous transfer pricing documentation showing functional analysis (who performs DEMPE functions: Development, Enhancement, Maintenance, Protection, Exploitation of intangibles).
Key Considerations in Determining Arm’s Length Royalty Rates for Franchise Agreements & Defending in Audits
When setting royalty rates under hotel franchise agreements, the following are critical:
a. Determining the Arm’s Length Rate
- Benchmarking Studies: Identify comparable agreements in hotel and hospitality sectors using royalty databases (e.g., Royalty Source, ktMINE, Markable).
- Profitability of Franchises: Royalty must allow franchisees to earn sustainable profits after fees. Too high a royalty rate risks being challenged as non-arm’s length.
- Brand Strength & Market Position: Premium global brands (e.g., luxury chains) can justify higher royalty rates than mid-market or economy brands.
- Scope of Rights Granted: Higher rates justified if franchise includes brand name, reservation system, loyalty program access, training, and marketing support.
- Territorial Exclusivity & Market Conditions: Exclusive rights in a lucrative region may command higher royalties than non-exclusive rights in a less profitable market.
b. Defending During Audits
- Present robust transfer pricing reports showing benchmarking results and explaining method selection.
- Demonstrate the commercial rationale: show why an independent hotel operator would agree to such a rate (brand value, system access, customer loyalty).
- Use profit split analysis if benchmarking comparable are scarce.
- Maintain consistency: rates should not fluctuate arbitrarily year-on-year without commercial justification.
- Document any adjustments for local market conditions (e.g., lower royalties in developing markets to encourage adoption).
Balancing Operational Efficiency with Transfer Pricing Compliance in Global Hotel Operations
Global hotel groups face the challenge of ensuring efficient management across multiple jurisdictions while complying with transfer pricing. Strategies include:
a. Centralized vs. Decentralized Functions
- Centralize high-value functions (brand management, loyalty programs, IT systems, global marketing) in entities with real substance, charging appropriate fees to operating hotels.
- Decentralize routine/local functions (local sales, housekeeping, maintenance), keeping them cost-based and locally charged.
b. Transfer Pricing Alignment
- Apply the arm’s length principle consistently across jurisdictions, ensuring intercompany fees reflect actual services/benefits received.
- Adopt a standardized global transfer pricing policy
c. Risk & Substance Considerations
- Ensure DEMPE functions for intangibles are aligned with the IP-owning entity.
- Staff and decision-making must be located where profits are booked to avoid challenges under BEPS Pillar 1 & 2.
d. Documentation & Compliance
- Prepare Master File & Local File in line with OECD Action 13.
- Monitor changes in local TP laws (Nigeria, Kenya, UAE, EU, U.S. etc.), as regulators often scrutinize franchise/royalty arrangements.
- Use advance pricing agreements (APAs) where available to reduce audit risk.
e. Operational Balance
- Maintain efficiency by leveraging centralized booking and loyalty platforms but clearly price intra-group services.
- Regularly review fees to ensure they reflect market conditions and avoid profit shifting perceptions.
The Takeaway
For hotel groups, success is not just about filling rooms. It’s also about structuring operations in a way that is both tax-efficient and compliant with global transfer pricing rules. When done right, brand licensing not only protects the business but also builds stronger, long-term partnerships with operators.