Some companies may sell assets such as equipment and tools to their related parties (note, we are not talking about inventory or otherwise goods for sale). For highly integrated operations, this may be more than just a one-off type of transaction. How should a company price such transfers? Here are six potential ways:
- Book Value
- Replacement Cost
- Depreciated Replacement Cost
- Liquidation Value
- Transactional Data
- Based on a DCF Model.
The advantage of book value is that it’s the easiest way to value an asset since it’s what recorded on your books already. The main downside is that book value rarely represents the fair market value of your assets so there is a high probability the assets will either be over or understated upon the transfer. Book value tends to the most useful when performing one-off transfers that are not significant in dollar value, or when the assets being transferred are non-operational in nature. Where the dollar value is potentially large or involves tools that incorporate some form of intellectual property, you may wish to consider other options.
Replacement cost values an asset at the price to either purchase it on the open market brand new or to reproduce it internally. In an inflationary environment, especially when the price of materials is rising quickly, replacement cost better reflects these increases that some other methodologies. In reality, replacement cost is not often used for transfer pricing purposes because it does not take into consideration for economic depreciation, rather, its primary use is for calculating economic damages. However, there may be a limited number of circumstances where replacement cost may reasonably represent the4 fair market value of an asset. For example, if the asset is unique, then a prospective buyer may wish to pay replacement cost in lieu of incurring the efforts and risks of reproducing the asset themselves. Again, this valuation methodology may ignore a potentially large intangible value embedded in the asset itself.
Depreciated Replacement Cost
Similar to above, the Depreciated Replacement Cost values an asset at its replacement or reproduction cost but also includes some measure of economic depreciation. In many cases, this economic depreciation could be based on the estimated economic life of the asset. For example, an asset with a replacement cost of $500,000, estimated useful life of 20 years and a current age of 10 years might be valued at $250,000 (ignoring any potential salvage value). For long lasting assets, the replacement cost of that asset will vary greatly over its life due to inflation. Thus, this method prevents assets from being understated when they are transferred since older assets will likely have much lower original capital costs and, depending upon the Company’s depreciation policy, may be fully depreciated. For many operational assets where intangible value is likely minimal, this method can provide both a practical and reasonable transfer pricing policy.
Liquidation value is the price a purchaser of an asset would pay if it were being sold by a business that is no longer a going concern. For example, a business goes into bankruptcy and its assets are sold at an auction by the trustee. There are also two potential types of liquidations to consider: an orderly liquidation and a forced liquidation. Obviously, an orderly liquidation will most likely produce a higher price than a forced liquidation since the motivation to sell is higher in the latter case. From a transfer pricing perspective, liquidation value is rarely a good methodology to use since presumably transfers are occurring between two going concern business within a corporate group. However, there may be rare cases where a particular product line is failing or has failed, or where obsolete assets must be transferred within a corporate group where liquidation value should be considered.
In the perfect world, we could use real life transactional data to support all transfers of assets. However, the reality is it’s very hard to find open-market data that is comparable to support the transfers of assets. The only exception to this might be a transfer of an entire line of business (with all assets included) whereby an M&A database might provide insight into valuation, although even there would be lots of issues around comparability. In most cases, there won’t be comparable transactional data available unless you consider auction transactions. However, these transactions are more analogous to liquidation value that carries with it the same limitations (discussed above).
Based on a DCF Model
Sometimes, the physical and intangible assets are intrinsically linked in which case valuing the assets may require the development of a DCF model to reflect the cash flows derived from their use in operations. This is often the case where technology and hardware are combined in equipment that is used in operations rather than intended for resale. For example, this is common within mining and oil field services operations. If possible, a discrete royalty license rate should be calculated either using a relief-from-royalty approach or via some synthetic royalty rating analysis, where feasible. However, there may be cases where the tangible and intangible may be practically difficult to separate.
Lease/Rent vs Buy
When moving tangible assets between related parties, the taxpayer should consider whether an intercompany sale or lease should be established. In the case of one-time permanent transfers, a sale might be the most prudent method of accounting for the intercompany transaction. However, in cases where assets will only spend a limited amount of time in one geographic location before being moved elsewhere in the corporate group, some type of intercompany lease or rental should be contemplated. The advantage of using a lease arrangement is that if the corporate group tends to move assets throughout its corporate group, a valuation needs not be performed each time equipment crosses a border. The type of lease arrangement will heavily depend on the facts of the case. Some questions that should be asked are:
- Is this more of a long-term financial lease (essentially a lease-to-own) scenario or a more short-to-intermediate term rental?
- To what degree does the equipment have intellectual property embedded within, or is it more commoditized in nature?
- To what degree does the lessor assume the role of asset manager, or is this more controlled by the lessee?
These questions will go a long way towards helping you or your clients determine if a lease arrangement is appropriate, and if so, how such a lease should be constructed.