Sometimes the disciplines of valuation and transfer pricing intersect. This can most commonly occur when valuing intellectual property that is being sold by one entity to one or more of its related parties. This can often occur after a major reorganization or acquisition where it may make strategic sense to move the ownership of IP in certain jurisdictions. This article outlines some of the common applications of valuations that may arise during the course of any transfer pricing analysis. While the OECD Guidelines do not delve into commonly accepted valuation methodologies, best practices should be employed based on the various valuation organizations within North America such as the:
- CBV Institute (formerly the Canadian Institute of Chartered Business Valuators);
- American Society of Appraisers;
- American Institute of Certified Public Accountants; and
- National Association of Certified Valuation Analysts.
Transfer of IP
Transfer of IP is common in related party situations, especially where a related party within a multinational group owns valuable intangibles such as know-how, patents, copyrights, or processes. Transfers may happen in one of three ways in a transfer pricing context:
- Related parties pay a license for the use of the intellectual property;
- They pay the related party for a transfer of the intellectual property; or
- A hybrid of i) and ii).
In the case of the former, it is common for related parties to pay royalties for the use and exploitation of a valuable technology. Issues may arise when the related parties paying the royalty are generating low profits or losses for extended periods of time, since it brings into question the true value of the IP to the licensee. (That is, what value can an IP have if the licensor cannot make money with it?) Of course, a functional analysis might indicate there are other operational reasons contributing to the low profits that should be considered.
When transferring intellectual property, a related party (transferee) is usually acquiring certain rights from another member of its corporate group (transferor). The transferee may receive only partial rights to the intellectual property (for example, the rights could limit the IP use to a specific geographic region or limit access to certain features). In some cases, the transferee may acquire full world-wide rights to use and exploit the intellectual property. Another key factor is whether the rights are exclusive or non-exclusive. One may have rights to exploit a technology, but if others can also exploit such technologies in the same territory, the value of the IP will most likely be lower than in n exclusive scenario.
The nature of the transfer will play also a role in how the IP must be valued. For example, it is common in cost sharing arrangements for related parties to purchase geographic rights to an IP in exchange for a lump-sum amount, on-going royalties, and possible continued support of R&D activities. A transfer of an IP may occur with some combination of a lump-sum amount, declining royalty rate, and full control and responsibility over the R&D function related to that IP. Valuators and transfer pricing practitioners often have to value either an arm’s length royalty rate, a fair market value lump sum, or some combination of the two.
One common valuation method when valuing a lump-sum amount is the relief-from-royalty (“RFR”) approach. The RFR method values IP based on the savings made by an owner through not having to license a comparable technology. Ideally, for IP such as patents and copyrights, third-party royalty rates can be found to support this exercise. This exercise must be performed as a discounted cash flow calculation using an appropriate discount rate. The advantage of the RFR approach is that when there are good comparables, the valuation is otherwise sound. However, finding comparable royalty arrangements for newer technologies may practically be difficult, requiring alternative methods to be considered. Also, a recent Norwegian transfer pricing case illustrated some of the limitations of this approach when full rights are being purchased by a related party (see Dynamic Rock Support AS).
Other methods may be used if appropriate, including the market approach (if there have been recent sales of similar IP, a situation which would be rare), the cost approach (when the future benefits of IP is highly uncertain), and other more complex approaches such as:
- The Multi-period Excess Earnings Method (often called the “MPEEM”), an approach that calculates a return on various assets such as working capital and tangible assets to help in assessing the excess returns from intangible assets.
- The With-or-Without Approach is a type of discounted cash flow (“DCF”) analysis which compares DCF values when exploiting a certain intellectual property and without. The different, in theory, is the value of the IP. In practice, a number of critical assumptions need to be made that may render this exercise challenging.
- The Greenfield approach assumes a hypothetical situation where a start-up develops and uses only that intellectual property. Based on certain assumptions, a DCF analysis can be prepared. Again, while theoretically sound, this approach may be difficult to implement.
A transfer of IP, by its nature, involves some degree of financial forecasting which inherently involves risk of the future not turning out quite as expected. IP transfers can be risky in that the perceived value of intellectual property at the transfer date may materially differ from its real value several years later. This can create a transfer pricing issue whereby if the IP is more successful than first projected, the tax authority in the transferor jurisdiction may argue the transfer was undervalued. Conversely, if the IP is less successful than projected, the tax authority in the transferee jurisdiction may argue the transfer value was overstated. The best way to reduce risk is to spend an appropriate amount of time documenting the facts and circumstances of the transfer along with a solid valuation report that follows best industry practices. This should include a discounted cash flow forecast that outlines all the assumptions made at the time of the valuation. This can provide support if there is ever a tax audit since the ley driver of the exercise is what was known to the parties at the time of sale. While such arguments should suffice from a Canadian perspective, US exposure may still exist due to the IRS Code’s commensurate-with-income standard.
In the second part of this series, we will explore the transfer of tangible assets between related parties and the related valuation issues associated with it.
Like all transfer pricing arrangements, licenses and IP transfers should make sense from a big picture perspective. For example, while a business may tolerate paying royalties to third parties while losing money in the short-term, it will not do so indefinitely. The technology being licensed must provide above normal returns to the user eventually, otherwise there is no advantage to it. Similarly, in intercompany situations, it is prudent to see how profits are distributed amongst members of a corporate group once royalties have been taken into consideration.