INSIGHT: Multinationals Face Formidable Challenges in Valuing Intangibles: Part I--Purchase Price Allocation

In this two-part article, the authors explore interdisciplinary approaches to valuing intangibles.

Valuing intangible properties is one of the most interesting, yet challenging exercises in transfer pricing for multinational companies, worldwide. What makes this exercise even more fascinating is when the intangible properties change ownership or cross borders, and taxpayers have to work with specialists from multiple disciplines.

In Part I we briefly review the similarities and differences intangibles valuation for transfer pricing and financial statement purposes, focusing on purchase price allocation. We address the conceptual differences that are fundamentally different between these two disciplines as well as technical differences when taxpayers are applying certain methodologies at the implementation level.

Part II will visit the recent gap-bridging effort between transfer pricing and customs valuation. To conclude, we provide some recommendations.

The Purchase Price Allocation (PPA) Framework

After a merger or acquisition, a valuation analysis of the assets acquired needs to be performed under Accounting Standards Codification (ASC) 805: Business Combinations.

This exercise, driven by the change of control, is referred to as purchase price allocation (PPA). The premise of value used in ASC 805 measurement is fair value, which is defined in ASC 820: Fair Value Measurement.

PPA analysis allocates the purchase price into four blocks: working capital, fixed capital, identifiable intangible properties, and goodwill.

Generally, the total purchase price minus the sum of the value of working capital, fixed capital, and identifiable intangible properties is a residual that is classified as goodwill. Conceptually, goodwill consists of synergy, going concern value, prospects for future growth, and sometimes a separately reported line item of assembled workforce. Goodwill can be thought of as “the whole is greater than the sum of its parts.”

The Issue

When multinational companies integrate the acquired business units into existing operations, the process typically involves the transfer of intangibles across legal entities and maybe across borders.

Taxpayers often like to use the PPA valuation results to determine the transfer prices of the acquired intangibles when the intangibles migrate across different legal entities—understandably, to manage costs, reduce duplicative procedures, and to avoid using inconsistent data and assumptions across analyses. However, by simply adopting the PPA analysis and using the analysis as a transfer pricing study, there could be tension between these two sets of valuations.

Primarily, it is unclear whether the Internal Revenue Service fully supports using PPA results for transfer pricing purposes. The regulations do mention that valuations done for accounting purposes may provide a useful starting point but cannot be relied on as a conclusive support in the best method analysis. However, the IRS does not go any further in helping taxpayers fill in the gap between the start and finish—it does not specify what constitutes a useful starting point, nor does the agency outline the missing analyses required to achieve arm’s length support. Furthermore, the recent U.S. tax reform (Pub. L. No. 115-97) expands the definition of intangibles to include goodwill, going concern value, and workforce in place, which means that any future valuation for transfer pricing purposes will need to consider these items.

The OECD provides a slightly more positive tone and a little more detail for the organization’s view about valuation for accounting purposes, and recognizes the benefits of the valuation techniques. The revised Chapter VI of the Transfer Pricing Guidelines indicates that the comparable uncontrolled profits method and the transactional profit split method are the most useful ones in valuating transfers of intangible properties. If reliable comparable uncontrolled transactions cannot be found, valuation techniques can be useful tools in estimating the price for intercompany transfers of intangibles. Hence, income based methods or valuation techniques based on discounted cash flows or future income streams can be useful.

Differences

Although the IRS and OECD do not preclude the use of valuation based approaches, these transfer pricing methods also do not rank higher than an unspecified method without the taxpayer first exhausting all other specified methods. The tax administrations’ hesitation of formally recognizing a valuation based approach as a specified method can be attributable to the following fundamental differences between transfer pricing valuation for tax purposes and PPA for financial statement purposes, and several technical differences.

One major difference that OECD’s Action 8 report pointed out is that valuation results could be sensitive to a few key assumptions, and it cautioned against using intangibles valuation done for accounting purposes or PPA analyses as transfer pricing support because of the use of conservative assumptions. Specifically, “For sound accounting purposes, some valuation assumptions may sometimes reflect conservative assumptions and estimates of the value of assets reflected in a company’s balance sheet. The inherent conservatism can lead to definitions that are too narrow for transfer pricing purposes and valuation approaches that are not necessarily consistent with the arm’s length principle.”

Fair Value

Another issue is that fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. There are three unique concepts that are worth mentioning: exit price, market based measurement, and orderly transactions in the principal market.

The fair value measurement is an exit price, which is a price to sell an asset rather than a price to buy that asset from a market participant’s perspective. The exit price and entry price may be identical in many situations; however, they are conceptually different. Therefore, although the valuation process is termed “purchase” price allocation, the underlying valuation is a price to sell. This implies that what the buyer does with the purchased asset is not relevant in measuring fair value—even if the buyer decides to immediately discard the intangibles after acquisition, the fair value may still be positive. For example, when the buyer acquires the target entity with a portfolio of intangibles consisting of customer relationships, technology, and trade name, the buyer may strategically decide to discard the acquired brand and use its own brand post-acquisition. In this case, PPA may still assign positive fair value for each intangibles element in the analysis.

Another potential difference is that fair value is a market based measurement instead of an entity specific measurement, and is measured using assumptions that typical market participants would use in pricing the assets and assuming the risks. Market participants could be actual or theoretical buyers of the businesses or assets, and ASC 805 does not require specific market participants be identified or named, only that their characteristics be described.

Furthermore, the orderly transaction concept entails that the fair value is measured assuming the transaction takes place in the principal market, the market with the highest transaction volume and level of activity, where the “highest and best use” principle follows. In the absence of a principal market, the transaction is assumed to take place in the most advantageous market, which is the market that would maximize the amount that would be received to sell an asset.

From a transfer pricing perspective, although both sides (or multiple sides) of a transaction negotiate and set the most advantageous price from their own perspectives, their guiding principle is the arm’s length principle—the highest and best use principle is not explicitly applied.

Additionally, the exit price concept is also distinctive to the fair value measurement. For transfer pricing purposes, it is important to consider both the buyer and the seller side of the transaction, the profit potentials of the intangibles, and the buyer’s operational plan for the acquired assets.

The market participant concept, where a seller and market participants interact, is also unique for financial statement purposes. The fair value adopts hypothetical transactions, participants, and market conditions, whereas transfer pricing analyzes specific transactions, entities, and market conditions. When transfer pricing practitioners are uncertain as to how to determine an arm’s length price, they typically ask: “what would third parties do?”, whereas practitioners preparing PPA studies will inquire: “what would the market do?”

Timeframes

PPA analyses are generally performed based on information available at the time of the transaction and reviewed by practitioners during the financial statement audit process, normally a few months after the analyses are prepared. In other words, the completeness of information available is more limited because of the restricted timeframe, and the reviewers would review the study shortly after the studies are prepared where the information and assumptions are less likely to change.

For transfer pricing purposes, the tax authorities may not look at the study until a transfer pricing audit is initiated, which could be several years after the transaction is concluded. IRS auditors may not have the same training as the transfer pricing specialists, and they may take a deeper dive to inquire about the assumptions, financial projections, or other data.

The IRS auditors are also equipped with the advantage of hindsight where an expanded timeframe allows more operational changes to come into play. Although the tax authority recognizes the valuations are determined based on information available at the time of the transfer, it can apply actual financial results to challenge the reasonableness of the analyses. Acquirers may also have surprises or discover different fact patterns that deviate from the original assumptions, which could require anything from a short explanatory memo to an updated study. To sum up, the level of scrutiny and the timeframe is expanded for transfer pricing purposes.

Rights Valuable for PPA Purposes

Certain rights may not require a payment under transfer pricing purposes but they are valuable for PPA purposes. Although the underlying reasons vary by facts and circumstances, it is relatively common to have a larger customer relationship value in PPA analyses, compared with transfer pricing studies.

For example, assume subsidiary A has established a client base in a certain country as a non-exclusive distributor, and the intercompany agreement does not specify any payment if that relationship is terminated by the parent entity, which manufactures the products and owns the associated intangibles.

If the group sells subsidiary A to a third party, that party may include customer relationship in the purchase price.

Alternatively, if a new distributor is established (distribution subsidiary B in a nearby country) and customers could buy the same products from this new distributor, the original distributor would not get any compensation from this change. The parent may buy back the inventory from subsidiary A, but the loss of distribution rights or client base is not compensated under transfer pricing considerations. In other words, transfer pricing focuses more on rights that are specifically described in the intercompany agreements.

What this implies is that taxpayers who observe large customer relationship values in PPA analyses need to pay attention to the robustness of the methodology in PPA and examine the consistency of the transfer pricing policy around this particular intangible property.

Technical Differences

Besides the structural differences that make PPA and transfer pricing valuation different, there are also several technical differences:

First, when valuing intangibles, a common approach in PPA is the relief from royalty method. Essentially, this method calculates the royalty payments saved or income enhanced by owning the intangibles as opposed to licensing the rights to use them. Through the acquisition of intangibles, the owner avoids making a series of hypothetical royalty payments.

In transfer pricing, the comparable uncontrolled transactions (CUT) method is frequently applied when valuing intangibles that are licensed by one party from the other (e.g., patent, technology, or brands). Legal agreements that license the rights to use comparable intangible properties between independent entities or between a taxpayer and an unrelated party are identified to establish an arm’s length range of royalty rates. The results then form the basis to calculate the arm’s length value of selling the intangible property.

In practice, transfer pricing generally applies more specified criteria when selecting comparable agreements. Factors such as exclusivity, rights conferred, rights to obtain updates, services provided in connection with intangibles licensed, territory, etc., all need to be taken into consideration, whereas PPA adopts a high level, market-based multiples cash flow approach. However, a potential issue for the CUT method is that it implicitly assumes the value of owning a certain intangible property is similar to the value of licensing it, this assumption essentially does not distinguish between an owner and a licensor.

Second, there are different ongoing maintenance or subsequent measurement between PPA and transfer pricing analyses. For financial statement valuation purposes, after the purchased assets have been initially valued, goodwill is not amortized while the identified intangibles with finite lives will be amortized over a certain period. Both the goodwill and the intangibles are subject to an impairment analysis to evaluate whether there has been any loss in value.

For transfer pricing valuation, after the first planning study, an annual true up is required and a certain amount of documentation is recommended. Some taxpayers may request, even several years after the acquisition, to keep using the PPA as their primary ongoing transfer pricing support—the longer time elapses, the more divergence in value will result by using this approach.

Third, transfer pricing typically uses operating profit as a measurement of profits in a certain period, whereas PPA uses present value of the discounted cash flows over multiple periods. None of them is without criticism: some blame transfer pricing for its static view of approaching valuation as a point estimate without reflecting the business cycle or the true economic potential of the intangibles, while others argue the long-term nature of the PPA discounted cash flow analysis approach may demand unrealistically long and unreliable projections.

Transfer Pricing and PPA Valuation in a Volatile Economic Environment

One situation worth considering is that, in a volatile market or an industry characterized by recession, will the difference in intangibles valuation between PPA and transfer pricing diverge or converge? What are the valuation challenges taxpayers face in this type of environment?

For PPA, because fair value measurement draws on markets to provide the vast majority of the information and assumptions, in an environment that is accompanied by market fluctuations, many of the natural support or indicators that would be provided by the markets are missing. For the income approach, the lack of positive earnings in the near future may require longer time periods to be modelled, which may also require higher discount rates to reflect the increased uncertainty and risk incorporated by longer term projections. For the market approach, applying observed multiples to represent the trailing or forward 12-month earnings that are negative posits an extra challenge, in addition to the fact that the environment is volatile.

In a recessionary environment, the two sets of value could be very similar in the year immediately following the transaction, but the divergence could take place quickly and drastically. The income projections, from a tax perspective, would be trued-up under the commensurate with income (CWI) standard and certain assumptions would be modified with the passage of time. Such modifications could be more likely in a volatile industry or macroeconomic environment.

For both analyses, one obvious challenge is finding comparable companies or transactions. The identified comparable royalty agreements under either the relief from royalty or CUT methods are more likely to reflect only the market condition on the date of the transaction and is more likely to become obsolete quickly in a volatile economic setting.

One may draw on the similarity between the routine profits calculated under the CPM and the contributory asset charges that are used to compute excess profits and view the CPM as a better choice in a recessionary environment. Because the application of the CPM is performed on a multiple year basis, to some extent, it allows the year-over-year fluctuations to be smoothed out. For transfer pricing, the CPM is gaining popularity in part due to the ease of access to comparable databases and because it is subject to a lower comparability threshold. However, we note that the CPM works well for routine transactions but becomes problematic when there is not enough entity-level profits to satisfy the profits attributable to routine functions, or there are entity-level losses. The application of the CPM requires entities with low-end profits (or losses) to be discarded, and the survival bias in the comparable company database has always been a structural issue. All these factors add to the doubt as to whether the final selected comparable companies are actually comparable to the taxpayers’ functions and risks.

Author Information

Joyce Beebe is a research fellow at the Center for Public Finance at Rice University’s Baker Institute for Public Policy. Bill Spiller is a lecturer in the Department of Accounting at the University of Texas at Austin’s McCombs School of Business and an independent economic consultant. The comments, views, and opinions in this article are those of the authors, and do not necessarily represent the views of Baker Institute for Public Policy or University of Texas at Austin.