FAIR VALUE & TRANSFER PRICING: And the twain shall never meet? Transfer Pricing Panel ABA Fall Conf., Denver Oct. 21, 2011
Introduction Fair Value & Transfer Pricing Panel: David Ernick, Treasury Jason Osborn, IRS Assoc. Chief Counsel, Intl. Jerry Mehm, American Appraisal Clark Chandler, KPMG Moderator: Tracy Gomes 2
Transfer Pricing and Valuation Increased focus on valuation issues Valuation techniques Business restructuring Internal rationalization Acquisition and reorganization Valuation of intangibles 3
Transfer Pricing and Valuation Growing convergence in TP methods Financial accounting standards But what of TP and financial accounting? 4
Transfer Pricing and Valuation Treas. Reg. 1.482-7T(g)(2)(vii) Accounting principles (A) In general. Allocations or other valuations done for accounting purposes may provide a useful starting point but will not be conclusive for purposes of the best method analysis in evaluating the arm's length charge in a PCT, particularly where the accounting treatment of an asset is inconsistent with its economic value. 5
Key Terms and Definitions Financial accounting vs. Tax/Transfer pricing Fair value Fair market value Arm s length value US vs. OECD (IFRS) 6
Key Terms and Definitions US GAAP vs. IFRS Assets Intangible assets Goodwill Accounting vs. Tax 7
Key Terms and Definitions Comparison of Fair Value and Fair Market Value Fair Value Fair Market Value (per US GAAP and IFRS) 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. (per IRS Valuation Guide) Price at which property would change hands, When the buyer is not under any compulsion to buy, or seller is under any compulsion to sell, Between a willing buyer and a willing seller, Both parties having reasonable knowledge of relevant facts. 8
Key Terms and Definitions US Regulations "The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts." Treas. Reg. 1.170A-1(c)(2), 20.2031-1(b) and 25.2512-(1): 9
Key Terms and Definitions Arm s length value US - Arm's Length Standard - Treas. Reg. 1.482-1(b)(1) "A controlled transaction meets the arm's length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm's length result)." 10
Key Terms and Definitions Arm s length value OECD Model Treaty Arm s Length Principle Article 9, paragraph 1 "[When] conditions are made or imposed between... two [related] enterprises in their commercial or financial relations which differ from those which would be made between independent enterprises, then any profits which would, but for those conditions, have accrued to one of the enterprises, but, by reason of those conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly." 11
Key Terms and Definitions Intangible Assets US Regulations Intangible Property - Treas. Reg. 1.482-4(b) Definition of intangible. For purposes of section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual (1) Patents,.... (for complete list, see Appendix) 12
Key Terms and Definitions Intangible Assets Platform Contribution - Treas. Reg. 1.482-7T(c)(1) "A platform contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to contribute to developing cost shared intangibles." 13
Key Terms and Definitions Intangible Assets OECD Transfer Pricing Guidelines Intangibles, Chapter 6 6.2 For purposes of this Chapter, the term intangible property includes rights to use industrial assets.... These intangibles are assets that may have considerable value even thought that may have no book value.... There also may be considerable risks associated with them.... (for complete definition, see Appendix) 14
Key Terms and Definitions Intangible Assets Something of Value", Chapter 9 (2010) 9.65 "When applying the arm s length principle to business restructurings, the question is whether there is a transfer of something of value (rights or other assets) or a termination or substantial renegotiation of existing arrangements and that transfer, termination or substantial renegotiation would be compensated between independent parties in comparable circumstances." 15
Key Terms and Definitions Financial accounting (IAS 38) Intangible Asset The definition of an intangible asset requires an intangible asset to be identifiable to distinguish it from goodwill. Goodwill recognized in a business combination is an asset representing the future economic benefits arising from other assets acquired in a business combination that are not individually identified and separately recognized. (11) (see appendix) 16
Key Terms and Definitions Financial accounting (IAS 38) An asset is identifiable if it either: (a) is separable, i.e., is capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so; or (b) arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations. (12) 17
Key Terms and Definitions Financial accounting (IAS 38) An intangible asset shall be recognized if, and only if: (a) it is probable that the expected future economic benefits that are attributable to the asset will flow to the entity; and (b) the cost of the asset can be measured reliably. 18
Key Terms and Definitions Financial accounting (IAS 38) The recognition of an item as an intangible asset requires an entity to demonstrate that the item meets: (a) the definition of an intangible asset (see paragraphs 8 17); and (b) the recognition criteria (see paragraphs 21 23). Is there really a difference in Fair Value, Fair Market Value? What are the principles that underlie US/OECD definitions of intangible assets?... similar items of substantial value apart from services? How do financial accounting principles distinguish between services and intangibles? 19
Key Terms and Definitions Fair Value - Fair Market Value - Arm s Length Value Is there really a difference in Fair Value, Fair Market Value? What are the principles that underlie US/OECD definitions of intangible assets?... similar items of substantial value apart from services? How do financial accounting principles distinguish between services and intangibles? Is there potential convergence? (see comparative 20
Valuation Context Illustration 1 SmallCo has several patents in NFC (near field communication) that allows cellphones to make purchases from vending machines. SmallCo has a group of 10 developers and a marketing/business development staff of three. They have one agreement with a local bottler in their city and are in discussions with regional beverage distributor in US as well as in Canada and Mexico. To date, the company has minimal sales and annual losses of $6-$10 million. SmallCo is acquired by USTelCo a multi-national telecom company that develops telecom equipment, including cellphones and operates telecom networks outside of the US, but not in Canada and Mexico. 21
Valuation Context Transfer Pricing Financial valuation Transaction As actually structured As actually structured Perspective Dual perspective (?) - Specific buyer, seller (TPG 6.14) Single perspective - Hypothetical participant Transactional context Aggregation Standalone asset/ combination Application context Actual use (TPG 6.15) or Realistic alternative (TPG 1.34) Conditional use: Highest/best use Value result Specific, market-based Hypothetical, marketbased Valuation standard Arm s length value Market value 22
Valuation Context What are the assets to be valued? Are separable, identified intangible assets valued as standalone assets? Would valuation change if USCo were not TelCo? If USCo had operations in Mexico? What is the role, impact of synergies in valuation? What is the role of risk? Is there a difference between Transfer 23
Dissecting the Divergence Illustration2 Company X is a startup firm with no currently exploitable products or marketing intangibles and its workforce consists of a team of developers working on NFC applications. Company X has negligible liabilities and tangible property. USP purchases Company X, for $100m as part of an uncontrolled transaction in order to acquire its patents and workforce for purposes of the development activities of the CSA. USP files a consolidated return that includes Company X. For accounting purposes, $50 million of the $100 million acquisition price is allocated to the patents and workforce, and the residual $50 million is allocated to goodwill. 24
Dissecting the Divergence Illustration2 (cont d) The patents and workforce of Company X acquired by USP are reasonably anticipated to contribute to developing cost shared intangibles and therefore the rights in the patents and workforce of Company X are platform contributions. 25
Dissecting the Divergence Illustration2 (cont d) Treas. Reg. 1.482-7T(g)(2)(vii) provides that accounting treatment may be a starting point, but is not determinative for purposes of assessing or applying methods to evaluate the arm's length charge in a PCT. The facts here reveal that Company X has nothing of economic value aside from its patents and assembled workforce. The $50 million of the acquisition price allocated to goodwill for accounting purposes, therefore, is economically attributable to either of, or both, the patents and the workforce. 26
Dissecting the Divergence Panel questions/discussion: Is allocation affected if subsequent to acquisition, but before valuation similar patents sold for $90m? Is it permissible under valuation principles to use information obtained after event (acquisition) date, but before valuation date? What is the role of hindsight in valuation? What is the criteria for proper application of projections? Scenarios, assumptions? 27
More Questions? 28
Appendix 29
Intangible assets - Transfer Pricing vs. Financial accounting Comparison of Definitions Transfer Pricing: 482 Patents, inventions, formulae, processes, designs, patterns, or know-how; Copyrights and literary, musical, or artistic composition Franchises, licenses, or contracts; Trademarks, trade names, or brand names; Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; Financial Statement Reporting: FAS 141R Technology-Based Intangible Assets, which include patented technology, computer software unpatented technology, trade secrets. Artistic-Related Intangible Assets, which include plays, books, magazines, newspapers, other literary works; musical works, pictures, photographs Contract-Based Intangible Assets, which arise from and which include customer contracts, Licensing agreements, supply contracts, leases, franchises Marketing-Related Intangible Assets, which include trademarks, trade dress (unique color, shape, package design), newspaper mastheads, etc. Customer-Related Intangible Assets, which include: customer lists, backlog, customer contracts and related customer relationships, non-contractual customer relationships Other similar items that do not derive their value from physical attributes, but from the intellectual content of the item or from other intangible properties 30
Intangible assets - Components of Goodwill Overpayment (excess of price paid over fair value of entity). Assembled workforce Entity-specific synergies Expectation of future technology or product development, expansion into new markets, and new customers. 31
Intangible Definition US -1.482-4(b) For purposed of section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual- 1) Patents, inventions, formulae, processes, designs, patterns, or know-how; 2) Copyrights and literary, musical, or artistic compositions; 3) Trademarks, trade names, or brand names; 4) Franchises, licenses, or contracts; 5) Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer list, or technical data; and 6) Other similar items. For purposes of section 482, an item is considered similar to those listed in paragraph (b) 1) through 5) of this section if it derives its value not from its physical attributes but from its intellectual content or other intangible properties. 32
Intangible Definition OECD Guidelines, Ch. 6 Intangible property, 6.2 The term intangible property includes rights to use industrial assets such as patents, trademarks, trade names, designs or models. It also includes literary and artistic property rights, and intellectual property such as knowhow and trade secrets. This Chapter concentrates on business rights, that is intangible property associated with commercial activities, including marketing activities. These intangibles are assets that may have considerable value even though they may have no book value in the company s balance sheet. There also may be considerable risks associated with them (e.g. contract or product liability and environmental damages). 33
Valuation context OECD Guidelines Valuation perspective, Chapter 6 6.14 Arm's length pricing for intangible property must take into account for the purposes of comparability the perspective of both the transferor of the property and the transferee. 34
Valuation context OECD Guidelines Use of property, Chapter 6 6.15 This analysis is important to ensure that an associated enterprise is not required to pay an amount for the purchase or use of intangible property that is based on the highest or most productive use when the property is of more limited usefulness to the associated enterprise given its business operations and other relevant circumstances. 35