TRANSFER PRICING IN HOTEL FRANCHISING

Business

In this context, transfer pricing governs how intra-group charges like franchise fees, royalty payments, technical service fees, management fees, and marketing contributions are set to ensure they reflect the arm’s-length principle, that is, the pricing that would have been charged between independent and unrelated hotels in a similar transaction.

Transfer pricing in hotel franchising refers to the method of determining the prices, fees, and financial charges applied to transactions between related entities within a hotel group such as the franchisor and its affiliated franchisee hotels for the use of brand assets, management services, intellectual property, reservation systems, and other shared resources.

WHY IT IS EXPEDIENT TO HAVE A STRUCTURED BRAND LICENSING AGREEMENT TO OPTIMIZE TAX OUTCOME

A well-structured transfer pricing framework is essential for related hotel entities to ensure that profits are allocated appropriately to the jurisdictions where real economic activities take place. Proper design of transfer pricing policies prevents distortions in income reporting and supports compliance with international tax requirements.

Key reasons why transfer pricing must be properly structured include:

  • Preventing the franchisor or management company from overcharging or undercharging fees such as royalties, management services, or technical support.
  • Avoiding artificial profit shifting to low-tax or zero-tax jurisdictions.
  • Protecting the taxable income of hotel operators located in higher-tax countries.
  • Reducing the risk of regulatory disputes, tax audits, penalties and financial adjustments.
  • Safeguarding the hotel group’s reputation by demonstrating transparent and compliant tax practices.
  • Ensuring each entity pays tax on the income genuinely earned in its respective jurisdiction, consistent with international transfer pricing standards.

Hotel groups typically license trademarks, brand standards, reservation systems, and loyalty programs to operating entities. To optimize tax outcomes while remaining compliant, the structure should achieve three things: value alignment, risk allocation, and substance.

A. Align functions, assets and risks (FAR) with the licensing structure

  • The IP owner (HoldCo or BrandCo) must demonstrably perform DEMPE functions (Development, Enhancement, Maintenance, Protection, Exploitation).
  • If DEMPE is split across the group (e.g., marketing in one region, IT in another), inter-company service charges must reflect those contributions. 

B. Allocate revenues using an arm’s length royalty structure

  • Typical models:
    (i) Percentage of gross room revenue
    (ii) Percentage of total hotel revenue
    (iii) Profit-based royalty (less common; used where room revenue fluctuates heavily)
  • Groups may use differentiated royalty fees for:
    • Brand usage
    • Management services
    • Central reservation systems
    • Loyalty program contributions
    • Marketing fund contributions

C. Location of the IP entity

To optimize tax outcomes legitimately:

  • Situate the IP owner in a jurisdiction with:
    • Double tax treaties
    • No or low withholding taxes on royalties
    • Substance provisions that can be met (e.g., Ireland, UK, Netherlands, UAE with substance)
  • Avoid stateless income. Ensure CFC rules do not attribute income back to parent jurisdictions.

D. Draft robust intercompany agreements

  • Agreements should specify DEMPE roles, quality control obligations, KPIs, service levels, termination rights, and pricing mechanisms.
  • Annual transfer pricing documentation is essential (Master file, Local file, economic analysis).

Key considerations in determining arm’s length royalty rates and how franchisors defend these during audits

A. Key considerations for arm’s length royalty rates

  1. Comparable Uncontrolled Price (CUP) Method
    • Benchmark royalty rates for similar hospitality brands using external databases (Royalty Source, ktMINE, Bloomberg).
    • Typical range: 2% to 7% of gross room revenue depending on brand strength.
  2. Profit Split or TNMM (when CUP is unavailable)
    • Used when the franchisee and franchisor jointly create value, e.g., loyalty programs.
    • Allocate profits based on contribution to intangibles and operational functions.
  3. Brand Strength & Market Position
    • Luxury vs mid-scale vs economy brand differentiation.
    • Strong brands command higher royalty percentages due to brand equity. 
  1. Geographic Factors
    • Emerging markets may justify lower royalties due to market risk.
    • Saturated markets (US, EU) may support higher rates.
  2. Support services
    • If franchisor provides training, marketing, reservations, etc., those services should be priced separately not double counted within the royalty.
  3. Duration, exclusivity, termination rights
    • Longer, exclusive agreements may support higher royalties.

B. How franchisors defend royalty rates during audits

 

  • Comparable search file - Document the filtering criteria, range, and final selection of royalty comparables. 
  • Functional analysis - Demonstrate unique value drivers: brand loyalty, quality standards, proprietary systems. 
  • Economic rationale - Show how royalty enables franchisees to generate higher revenues or occupancy.
  • Consistency - Royalty rates across countries should be consistent unless a defensible reason exists.
  • Local file disclosure - Clearly identify revenue basis for calculating the royalty (gross room revenue vs total revenue).
  • Evidence of DEMPE - Auditors focus heavily on who “truly controls” the brand. Provide evidence: marketing budgets, R&D, global brand strategy documents, etc.

 Balancing operational efficiency with transfer pricing compliance for global hotel operations

A. Centralization vs. Localization

  • Many hotel groups centralize marketing, loyalty programs, reservation systems, and IT to drive efficiency.
  • However, tax authorities scrutinize centralized structures to ensure local entities are not overcharged. 

B. How to balance both

  1. Shared Service Centers (SSCs) with clear cost allocation keys
    • Room nights, number of hotels, transactions, members in loyalty program.
    • Allocation keys must be reproducible and justified.
  2. Use of Advance Pricing Agreements (APAs)
    • Bilateral or multilateral APAs can lock in royalty rates and management fee structures for 3–5 years.
    • Provides certainty and reduces future disputes.
  3. Local substance
    • Ensure local hotel operators have management personnel, local decision-making capacity, and documentation of day-to-day operational control.
  4. Modular fee structures
    • Separate brand royalty, reservation fees, management fees, and marketing contributions.
    • Easier to benchmark individually.
  5. Annual global transfer pricing monitoring
    • Central TP team should review profitability of all entities to ensure:
      • Franchisees earn routine returns
      • Brand/IP entity earns residual returns
      • No entity persistently shows loss (red flag) 
  1. Tax technology and documentation tools
    • Real-time dashboards tracking TP KPIs (e.g., margin bands).
    • Automated data extraction from PMS (Property Management Systems).

KEY TERMINOLOGIES TO NOTE

1.     DEMPE in Transfer Pricing (TP) refers to the framework used by the OECD to assess which entity in a multinational group should earn profits from intangible assets. It stands for the key functions involved in managing and exploiting intangibles. Authorities uses DEMPE to check who really creates value for intellectual property inside a multinational group.

2.    FRANCHISING is a business arrangement in which one party (the franchisor) grants another party (the franchisee) the right to use its brand name, business model, operating systems, and intellectual property to run a business in exchange for fees or royalties.

3.   OPTIMIZE TAX OUTCOME means arranging a company’s or individual’s financial affairs in a lawful and efficient way so that they pay no more tax than is legally required.

4.   ARM’S LENGTH PRINCIPLE is the foundational rule in transfer pricing that requires transactions between related parties (such as companies within the same multinational group) to be conducted as if they were unrelated, independent parties dealing with each other in an open market.