Selecting Discount Rates in the Application of the Income Method

Transcription

1 Selecting Discount Rates in the Application of the Income Method The U.S. Treasury Department on December 22, 2011, published in the Federal Register the final U.S. cost sharing regulations (Treas. Reg ). 1 The emphasis placed by the Internal Revenue Service on the use of the income method as the best method to analyze platform contribution transactions (PCTs) has resulted in tremendous pressure on taxpayers and practitioners to come up with practical methodologies to reliably estimate the cost of capital to be used to value the expected operating income stream in the cost sharing alternative and in the licensing alternative, respectively. 2 Although the final regulations recognize that those two costs of capital may be different, little practical guidance is provided. 3 The object of this article is to provide a succinct, nonmathematical discussion of the relationship that has to exist in a meaningful and internally consistent application of the income method (as specified in the final regulations) between the cost sharing alternative and licensing alternative discount rates. This discussion is based on extensive analyses recently published by the author in the following two articles: The 2012 IRS Cost Sharing Regulations Examined: An Argument For Focusing on the Intangible Development Costs Discount Rate, 21 BNA Transfer Pricing Report 11, 10/4/2012 and The Mathematics of Cost Sharing Under The Income Method, 21 BNA Transfer Pricing Report, 13, 11/1/2012. Analysis Why should the cost of capital used to discount the expected income stream in the cost sharing alternative be different (presumably higher) than that used to discount the expected income stream in the licensing alternative? The typical answer to that question generally invokes the development risks involved in the intangible development activities (IDA) as the primary reason to assign an additional risk premium to the cost sharing alternative discount rate. 4 Because the outcome of research and development (R&D) activities is risky, investors require and competitive markets provide a premium to compensate for the financial losses that are bound to occur when the R&D efforts fail to produce a marketable product. Or so the story goes. Despite sounding appealing and intuitively correct, this story is fundamentally flawed and violates well-accepted basic principles in the corporate finance literature. The reason the story is flawed is that the risk of success or failure in most R&D activities is uncorrelated with the level of economic activity. Consider, as an example, a pharmaceutical company that invests large amounts of money over a long period of time to develop a chemical compound into a marketable FDAapproved drug. The development risks the company faces include the very high risk that the drug will not meet the standards of safety and efficacy necessary to receive FDA approval. Failure to receive FDA approval translates into a loss of the entire R&D investment. Since the safety and efficacy of a chemical compound has absolutely nothing to do with the overall state of the economy, or with the movements in value of a well-diversified portfolio of market securities, the systematic risk of this investment is close to zero, and hence the appropriate discount rate for this development activity is arguably close to the risk-free rate (or the cost of debt in the case of default risk) regardless of how risky the development itself is. Once, or if, a marketable drug has been developed, that is when systematic risk (that is, co-movements with the market) will affect the cash flow of exploiting the drug; by that time the development risk has ceased to exist. The view that only the systematic risks (if any) introduced by the intangible development costs (IDC) will justify a difference in discount rates used in the cost sharing alternative and in the licensing alternative seems consistent with the positions taken by the Treasury in the final regulations. Consider, for example, Treas. Reg (g)(4)(i)(F): In circumstance where the market-correlated risks as between the cost sharing and licensing alternatives are not materially different, a reliable analysis may be possible by using the same discount rate with respect to both alternatives. Further consider Treas. Reg (g)(4)(vi)(F)(1): 1 REG , T.D. 9568, 76 Fed. Reg , December 22, For the remainder of this article, we will use the words cost of capital and discount rate interchangeably, depending on the context. 3 See for example Treas. Reg (g)(2)(v) and in particular Treas. Reg (g)(2)(v)(B)(1); Treas. Reg (g)(4)(vi)(F); and Treas. Reg (g)(4)(vi)(F)(1). 4 IDA can consist of a single project or investment under development, or of a portfolio of various projects or investments under development. Arm s Length Standard Page 1 of 6 Copyright 2012, Deloitte Global Services Limited.

2 The difference, if any, in market-correlated risks between the licensing and cost sharing alternatives is due solely to the different effects on risks of the PCT Payor making licensing payments under the licensing alternative, on the one hand, and the PCT Payor making cost contributions and PCT Payments under the cost sharing alternative, on the other hand. By emphasizing that it is the difference in market-correlated risk between the two alternatives that drives the difference in discount rates, and that absent any material difference in market-correlated risk between the two alternatives, the discount rate could be equal, the final regulations appear to embrace the traditional corporate finance view that only systematic risk receives a risk premium. So if development risk is not the reason why the cost of capital used to discount the expected operating income in the cost sharing alternative should be higher than that used to discount the expected cash flow in the licensing alternative, what can that reason possibly be? A useful clue is found in the final regulations; indeed Treas. Reg (g)(2)(v)(B)(1) states that: In some circumstances, a party may have less risk as a licensee of intangibles needed in its operations, and so require a lower discount rate, than it would have by entering into a CSA to develop such intangibles, which may involve the party s assumption of additional risk in funding its cost contributions to the IDA. Taken literally, this excerpt from the final regulations suggests that the discount rate used to value the cost sharing alternative could be equal to the discount rate used to value the licensing alternative, plus a risk premium that reflects the risk of funding the IDC. Notice that Treas. Reg (g)(2)(v)(B)(1) makes no mention of a risk premium related to the likelihood of success or failure of the IDA. As will be demonstrated below, the final regulations got it right; it is indeed the operating leverage created by the IDC that magnifies the systematic risk in the expected operating income of the cost sharing participant. The greater the operating leverage created by the IDC, the greater the spread between the cost of capital of the levered firm (cost sharing alternative participant) and of the unlevered firm (licensing alternative participant). This result is identical to the well-known and well accepted result in the corporate finance literature that, ceteris paribus, the systematic risk of a leveraged firm is higher than the systematic risk of an unleveraged firm. 5 The greater the financial leverage created by the interest payments, the greater the spread between the cost of capital of the leveraged firm (the firm with debt and equity) and the cost of capital of the unleveraged firm (the firm with no debt and all equity). The close analogy between financial leverage and operating leverage is good news for transfer pricing practitioners faced with the practical issue of determining reliable and supportable discount rates. Indeed, since the work of Modigliani and Miller (1958) on the one hand and Hamada (1972) on the other hand, a vast theoretical and empirical literature has developed around the construction of discount rates for leveraged firms, in reference to the discount rates applicable to unleveraged firms. Recognizing that operational fixed costs are very similar to interest payments to debt holders, a smaller, but more directly relevant literature subsequently developed around the relationship between a firm operational fixed costs and its asset beta. 6 The starting point of that literature is the segregation of a firm total costs into variable and fixed costs. Since, by definition, fixed costs have a zero beta, the appropriate discount rate for these fixed costs is the risk-free rate of return which is the rate of return assumed on debt in the traditional Hamada (1972) formula. Therefore, it should not be surprising that the result that a leveraged firm will have greater systematic risk than an unleveraged firm carries over to the analysis of operationally levered firms. Various corporate finance textbooks offer some version of a Hamada-type formula relating the beta of a levered firm to that of an unlevered firm. 7 Although instructive and useful, the operating leverage literature goes only so far to analyze the impact of the assumption of IDC funding on the systematic risk of the levered firm. This is because we do not want to assume that IDCs are perfectly fixed costs, and because they are the only costs that should be analyzed to support the existence of magnified systematic risk in the cost sharing alternative. 8 We will show that it is easy to generalize the textbooks formula (derived to analyze purely fixed costs) to a formula that allows IDCs to not be purely fixed costs, and that focuses exclusively on IDCs and not 5 We will use the terms leveraged firm and unleveraged firm to describe firms with and without financial leverage, respectively, and use the terms levered firm and unlevered firm to describe firms with and without operating leverage, respectively. This language will eliminate the need to specify each time which type of leverage (financial or operational) we are considering. 6 See, for example, Lev (1974). 7 See, for example, Pratt & Grabowski (2010) and Brealey, Myers, & Allen (2008). These textbook formulae deal with the effect of perfectly fixed costs, and thus assume a zero beta for those fixed costs. 8 See Treas. Reg (g)(4)(i)(C). Arm s Length Standard Page 2 of 6 Copyright 2012, Deloitte Global Services Limited.

3 on any other type of costs, whether variable, fixed, or in between, since those are present in both the licensing and the cost sharing alternatives. The cost sharing alternative participant can be thought of as an unlevered firm, namely, the licensing alternative participant, accepting the operating leverage of IDC, thus becoming a levered firm. The relationship between the cost sharing alternative discount rate and the licensing alternative discount rate therefore boils down to establishing the relationship between the systematic risk of a levered firm and the systematic risk of an unlevered firm. As discussed above, a vast literature exists to guide us in deriving that relationship; we thus proceed to demonstrate that it takes the form of a simple formula referred to as Penelle (2012), closely analogous to the Harris & Pringle (1985) formula for de-leveraging and releveraging equity beta in the case of financial leverage under the assumptions of risky debt and the value of the tax shield of interests discounted at the cost of equity of the firm. 9 The formula is: Penelle (2012) 10,,, In the previous expression, denotes the cost sharing alternative discount rate, denotes the licensing alternative discount rate, denotes the IDC discount rate (cost of debt), denotes the operating income of the cost sharing participant (pre-idc), and denotes the present value operator. This critically important formula states that the cost sharing alternative discount rate is equal to the licensing alternative discount rate plus a non-negative risk premium equal to the product of the systematic risk premium of the business multiplied (magnified) by the operating leverage created by funding the IDC. Since the IDC and the operating income pre-idc are provided in the financial projections, developing meaningful projections is critical, because the implied operating leverage drives the delta between the two relevant discount rates (the cost sharing alternative discount rate and the licensing alternative discount rate). It should be clear from Penelle (2012) that the presence of operating leverage does not create risk the controlled foreign participant would not face as a licensee; the presence of operating leverage merely magnifies risk the controlled foreign participant would face as a licensee and for which it would receive a return from the market. Notice that this formula is derived by imposing present value accounting equalities and present value weighted average cost of capital equalities. This means that any violation of the previous formula means that either accounting equalities or weighted average cost of capital equalities are violated breaking the required internal consistency of the application of the income method. An exactly analogous formula exists linking the rate at which to discount the expected operating income of the licensor in the licensing alternative called the differential income stream in the proposed and temporary regulations of December 2011, to the licensing alternative discount rate. Penelle (2012) 11,,, In the previous expression, denotes the differential income stream discount rate, denotes the licensing alternative discount rate, denotes the IDC discount rate (cost of debt), denotes the gross income of the licensor in the licensing alternative (pre-idc), and denotes the present value operator. Since the gross income of the licensor in the licensing alternative is always lower than the operating income (pre-idc) of the controlled foreign participant in the cost sharing alternative, the operating leverage of the licensor in the licensing alternative will always be greater than the operating 9 Mathematically, those assumptions combine to eliminate the value of the tax shield of debt in their beta de-leveraging and re-leveraging formula, which ends up not having the tax rate as an argument (most other such formulas do). 10 The proof of the formula can be found in Philippe G. Penelle, The Mathematics of Cost Sharing under the Income Method, 21 BNA Transfer Pricing Report, 13, 11/1/ The proof of the formula can be found in Philippe G. Penelle, The Mathematics of Cost Sharing under the Income Method, 21 BNA Transfer Pricing Report, 13, 11/1/2012. Arm s Length Standard Page 3 of 6 Copyright 2012, Deloitte Global Services Limited.

4 leverage of the controlled foreign participant in the cost sharing alternative. It thus follows that the four relevant discount rates always satisfy the following inequality: Under which circumstances are different discount rates required to value the expected operating incomes in the cost sharing alternative and in the licensing alternative? Penelle (2012) illustrates that Treas. Reg (g)(2)(v)(B)(1) should probably have read in almost all circumstances, as any beta strictly less than one for the IDC will result in magnified systematic risk for the levered firm (cost sharing alternative participant) compared to the unlevered firm (licensing alternative participant) this simply means that IDCs are not perfectly variable costs. The IRS s withdrawal of the 2007 Coordinated Issue Paper thus appears to be the right move, because Example 1 incorrectly assumed the cost sharing alternative discount rate and the licensing alternative discount rate to be the same, violating the fact that legitimate IDCs cannot possibly be perfectly variable costs. Penelle (2012) also illustrates why early-stage development firms tend to face higher and less stable over time costs of capital than more mature firms, ceteris paribus. These early-stage development firms will initially face greater operating leverage than more mature ones, because they will have relatively lower levels of expected revenue per dollar of IDC. As time goes by and revenue is expected to increase (per dollar of IDC), the level of operating leverage decreases and so does the cost of capital. Similarly, the formula illustrates why we do not find too many firms that develop intellectual property and rely exclusively on licensing to generate their revenue. Indeed, by exploiting the intellectual property themselves and capturing the routine return associated with the manufacturing and distribution functions, firms can decrease the level of operating leverage they face, and thus decrease their cost of capital. 12 This point was illustrated analytically in the two versions of Penelle (2012), one for and one for, by noting that the gross income of the licensor in the licensing alternative is always lower than the operating income (pre-idc) of the controlled foreign participant in the cost sharing alternative. Since the resulting operating leverage faced by the controlled foreign participant in the cost sharing alternative is therefore always lower than the operating leverage faced by the licensor in the licensing alternative, its cost of capital is therefore always lower. The last comment is a great segue into describing, from an economics standpoint, what a cost sharing arrangement is really all about. There are those who believe that a cost sharing arrangement is about shifting the development risk (risk of project failure) from a U.S. parent company to a controlled foreign corporation, and compensating the controlled foreign corporation for the risk of development failure it agrees to take on. This view is economically flawed. Cost sharing arrangements are about de-levering the financial statements of the U.S. parent company as a licensor (by removing the IDC obligation), and levering the financial statements of the controlled foreign participant (by introducing the IDC obligation). This swap of an obligation to pay a purely variable cost as a licensee (the royalty) to an obligation to pay a fixed cost as a cost sharing participant (the IDC) has a market price, namely, the difference between the cost sharing alternative discount rate and the licensing alternative discount rate. As demonstrated in Penelle (2012), this market price is exactly equal to the magnification of the systematic risk borne by the controlled foreign participant (as a licensee), resulting from the obligation to fund the IDC (as a cost sharing participant). The risk of failure of the development activity associated with the IDC is irrelevant. Our analysis also underscores the fact that developing an intangible asset, within the meaning of Treas. Reg (b), is not an economic requirement to justify a return in excess of a perfectly competitive return (e.g., a CPM return). What is economically required to justify a return in excess of a perfectly competitive return is the existence of fixed costs whether 12 This is the reason why the proposed and temporary regulations of December 2011 addressing the differential income stream discount rate which is really the discount rate at which to discount the operating income of the licensor in the licensing alternative has very little practical use. Indeed, applying that methodology would require observing in the market place the cost of capital of companies that do not exploit any of the intellectual property they develop, and rely entirely on licensing income. The suggested methodology is thus limited to the extent that such companies exist and can be found. Arm s Length Standard Page 4 of 6 Copyright 2012, Deloitte Global Services Limited.

5 or not those fixed costs fund the creation of an intangible asset is irrelevant. Fixed costs magnify the systematic risk of the routine business. Therefore, any market participant funding those fixed costs will receive a return in excess of a perfectly competitive return (an economic rent), since a perfectly competitive return provides an appropriate return on variable costs but not enough return to cover the fixed costs. 13 Conclusions Although the law draws a clear distinction between cost sharing arrangements and licensing arrangements, the underlying economics of both types of arrangements are exactly the same; thus, the governing valuation principles that apply to both should be the same. The theory outlined herein applies not only in the context of the income method pursuant to Treas. Reg , but also in the context of the income method as an unspecified method pursuant to Treas. Reg Developing and exploiting intellectual property requires funding fixed costs that in a cost sharing arrangement are distributed between the two parties in different proportions than in a licensing arrangement. 14 However, in both cases, some of those fixed costs will presumably be borne by the foreign party, whether as a licensee or as a transferee. The only economically relevant question is what proportion of those fixed costs will create operating leverage, and thus magnify existing systematic risk, in the financial statements of the foreign party. Once that question has been answered, the valuation technique discussed in this article can be implemented by plugging the appropriate numbers in Penelle (2012). It is the delta between the resulting cost of capital applying to the operating income of the foreign party pre-fixed costs versus post-fixed costs that will dictate the proportion of intangible income the foreign party is entitled to as a reward for agreeing to take on the funding of those fixed costs and facing the resulting magnified systematic risk. The takeaway from this article for taxpayers and transfer pricing professionals should be that a thorough analysis of the nature of the costs associated with developing and exploiting intangibles is required to perform a meaningful valuation of a cost sharing or licensing transaction. Focusing on an analysis of the riskiness of the intangible development activity itself is unproductive, because that analysis will have no bearing on the valuation. What will have a definite bearing on the valuation, however, is the level of operating leverage the cost sharing or licensing transaction introduces in the financial statements of the transferee or licensee, respectively. The need for that analysis can no longer be overlooked by practitioners. Philippe G. Penelle (Los Angeles) Principal Deloitte Tax LLP ppenelle@deloitte.com 13 Perfectly competitive returns are achieved by profit-maximizing firms facing a perfectly elastic demand when they produce a level of output such that marginal cost is equal to the price they face (no market power). This results in a loss in the presence of fixed costs. Perfect competition is thus inconsistent with a market with perfectly elastic demands and the presence of fixed costs. Profit-maximizing firms facing fixed costs will produce at a level of output where marginal cost is equal to marginal revenue, which requires some inelasticity in the demand they face (some level of market power). The resulting price markup over marginal cost is what provides the return to the fixed costs. In other words, the presence of fixed costs creates barriers to entry and the resulting market structure cannot be perfectly competitive. 14 Typically, in a licensing arrangement, the U.S. parent company will bear all the fixed costs associated with the development of the intangibles, and the controlled foreign licensee will bear all the incremental fixed costs associated with the exploitation of the intangibles. In contrast, in a cost sharing arrangement, the controlled foreign participant will typically bear all the fixed costs associated with both the development and the exploitation of the intangibles. Under U.S. law, nothing prevents a licensing transaction to provide that the licensee will bear some of the costs associated with the development or maintenance of the intangibles, thereby increasing the proportion of fixed costs the licensee agrees to fund, and thereby justifying leaving a greater portion of the intangible return to the licensee. Arm s Length Standard Page 5 of 6 Copyright 2012, Deloitte Global Services Limited.

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