Finding an Intersection Between Intangibles Valuation and Transfer PricingBy Angela Sadang | July 9, 2015 | Download PDF
Valuation of intangibles for financial reporting and transfer pricing are prominent and challenging areas in the entire M&A transaction process. The objective of this article is to dissect the differences and find the intersection that can turn the divergence into opportunities for convergence.
Cross-border mergers and acquisitions (M&A) are at their hottest pace since before the financial crisis, and a large proportion of transactions has increasingly involved intangible assets or intellectual property (IP) as the dominant acquired asset. As multinational companies shift ownership of intangible assets between legal entities and across jurisdictions for various strategic purposes, the most critical considerations in cross-border M&A, therefore, are the identification and valuation of intangible assets and transfer pricing. Simultaneously and of equal importance are valuations for financial reporting which involve the allocation of purchase price among the target company’s tangible and intangible assets and the resulting annual goodwill impairment testing.
The initial perception is that the value of any transaction and the largely acquired intangible assets is driven by financial reporting valuation rather than by transfer pricing valuation. However, it is important to ask in such transactions whether the valuation of intangible assets in purchase price allocations can be used for transfer pricing purposes, or whether the same can be tweaked to address transfer pricing requirements for intangible assets.
Differences: Devil is in the Details
In recently published papers, the US Internal Revenue Service (IRS) as well as many tax authorities in many countries drew the distinction between valuations for financial reporting purposes and valuations for transfer pricing purposes, stating that financial reporting valuations, specifically purchase price allocations, should only be used as a “starting point” for transfer pricing purposes and may not be probative. The recent US Tax Court cases involving Veritas, and Xilinx sharply demonstrate the divergence of the two perspectives. The Organisation for Economic Cooperation and Development (OECD) is moving in a direction similar to the IRS in tightening controls, making sure that OECD member countries do not assign a low value to intangible assets for purposes of transferring them out of one jurisdiction into a more favorable tax jurisdiction.
The skepticism and hesitancy of the IRS and OECD stem from intangible asset values determined within the context of financial reporting, being notably different from and often lower than, the values determined for transfer pricing purposes. To better understand the dynamic between valuations for transfer pricing and financial reporting, we highlight some of the key differences underlying each framework.
Most important to note among the differences is that in financial reporting, goodwill is a residual concept as projections used to value intangible assets only include market participant assumptions and exclude buyer specific synergies. In transfer pricing, goodwill is embedded in the intangible value and consists of buyer specific synergies, future customer relationships, future technology and all future opportunities which are part of residual goodwill value in financial reporting and are not considered goodwill in transfer pricing. In transfer pricing, there is a broader view of the definition and what comprises intangible asset value.
The difference in the treatments of goodwill and the definition of an intangible asset from the perspective of a specific buyer (transfer pricing) versus a market participant buyer (financial reporting) leads to higher valuations done for transfer pricing than those performed for financial reporting.
Similarities: Shall the Twain Ever Meet?
Given all the differences, financial reporting valuations share general concepts with transfer pricing valuation such as the concept of comparables in a Market Approach, use of present value and discounting under an Income Approach, and the fact-finding process, i.e., the industry analysis and functional analysis in transfer pricing are conducted and performed in a similar fashion as part of due diligence in financial reporting. In addition, the documentation process is very similar: transfer pricing contemporaneous documentation requirements (Treas. Reg. 1.6662) mirror the standards set by the ASA and AICPA on the requirements of a comprehensive valuation report.
Finding an Intersection
It is clear that valuations done for financial reporting purposes should not be fully relied upon for transfer pricing purposes. Relying on valuation from purchase price allocation results in undervaluation of transferred intangibles for transfer pricing purposes because of different treatment and definitions of intangibles, goodwill, intangible life, buyer specific synergies, pre-tax vs. post-tax analyses, etc., as mentioned above.
However, aligning the two disciplines, especially in the context of M&A, presents opportunities for practitioners to become value-added service providers. The acquisition of a target often will be the best time to make a change from prior practices and perhaps harmonize inconsistent policies of buyer and target. For companies to arrange and have a defensible IP structure, streamlining valuations for purchase price allocation and transfer pricing purposes is key. The absence of any consensus between the respective disciplines, coupled with the fact that different analyses may be performed by different project teams for different purposes, can potentially result in widely divergent intangible asset valuations.
The lack of coordination between financial valuation and transfer pricing leads to redundant work and waste of resources and time, different databases and sources used, different approaches, different discount rates, different comparable sets, and wider divergence if not inconsistent valuations. This presents tax risks due to differences in values between analyses and misalignment of the placement of intangible assets when setting a company’s global transfer pricing policy. In addition, and more importantly, audit risks are higher due to inconsistent values of IP and challenges to post-acquisition transfers.
Aligning efforts and coalescing the two disciplines early in the process saves time and cost rather than having to justify different methodologies later when potentially material tax consequences may arise. For instance, fact finding and due diligence meetings can be conducted as one, and both disciplines leverage from the same information using the same set of projections and one similar set of market comparables. In addition, analytical models from both frameworks can be aligned to have similar inputs and assumptions. The documentation requirements of both can also be synchronized and performed jointly as there are many intersecting portions between the reporting requirements of transfer pricing and financial reporting valuation. This leads to a more enhanced ability to support tax positions and reduce audit risks.
Synchronized project teams and advisers with the skills, knowledge and experience from both disciplines enable both transfer pricing and financial reporting frameworks to be supported more consistently, with fewer discrepancies and potential disputes between all tax, accounting and corporate stakeholders.
About the Author
Angela Sadang is a Director at Marks Paneth LLP. She is a Chartered Financial Analyst and an Accredited Senior Appraiser in Business Valuation and is in the process of obtaining an intangible asset valuation certification from the American Society of Appraisers. She was involved in numerous transfer pricing and valuation projects while at PwC and BDO, and provides valuation for tax and financial reporting purposes in her current position.
About Angela Sadang
Angela Sadang is a Principal in the Advisory Services group at Marks Paneth LLP. Ms. Sadang specializes in business valuations and the valuation of intangible assets and has over 20 years' experience providing corporate financial consulting services and performing valuations. She serves both publicly traded and closely held companies in a wide range of industries that also involves various asset classes. Ms. Sadang is a Chartered Financial Analyst (CFA) as designated by the CFA Institute and is... READ MORE +