Contents - AL-Tax

120 8 Replication of Internet-Based Business Modelprice and cost plus methods presuppose a particular division of labor that is not characteristicof USP and FS. The comparable profits method would require identifyingquasi-comparable companies in the same start-up stage, and would presumablyyield no residual profits (and, therefore, no royalty fee payable to USP). While onemight argue that an independent licensor would not require the payment of royaltiesuntil its licensee moved beyond its start-up phase and began to earn positive accountingprofits, this position is likely to be challenged on audit. Hence, our analysis ofthis case is solely based on the proposed franchise model.8.4 Analysis Under Alternative RegimeAs described above, FS will replicate USP’s operations, with the exception of certainsupport functions that will remain centralized. This duplication requires that USPtransfer its proprietary business format (inclusive of its proprietary IT, its trademarksand its successively refined Internet-based data collection and marketing tools).In principle, one can analyze each of these intercompany transfers of intangibleassets and the performance of services separately. However, business models as suchare only transferred as part of a franchise arrangement or an acquisition, not in isolation.This fact makes it difficult to apply the CUT method to individual transactions.Conversely, by bundling USP’s intercompany transfers of intellectual property andthe performance of certain services, we can apply the inexact CUT method, becausethe relationship between USP and FS in its totality is akin to that of a franchisor andfranchisee:Business format franchising is a method by which one business entity expands the distributionof its products and/or services through independent, third party operators. Franchisingoccurs when the operator of a concept or system (the franchisor) grants an independentbusinessperson (the franchisee) the right to duplicate its entire business format at a particularlocation and for a specified period, under terms and conditions set forth in the contract(franchise agreement). The franchisee has full access to all of the trademarks, logos,marketing techniques, controls and systems that have made the franchisor successful ...Itis important to keep in mind that the franchisor and franchisee are separate legal entities.Ongoing services [rendered by the franchisor] include research and development, marketingstrategies, advertising campaigns, group buying, periodic field visits, training updates [andother forms of support]. 2The bundling of intellectual property and services is permitted under the IRCSection 482 regulations when it will improve the reliability of one’s results:The combined effect of two or more separate transactions (whether before, during or afterthe taxable year under review) may be considered, if such transactions, taken as a whole,are so interrelated that consideration of multiple transactions is the most reliable means ofdetermining the arm’s length consideration for the controlled transactions. 32 See Bond, Robert E., Bond’s Franchise Guide, CA: Source Book Publications, 2006.3 See Treas. Reg. Section 1.482-1(f)(2)(i).