Scoping of the new OECD project on the Transfer Pricing Aspects of Intangibles Valuation issues

Scoping of the new OECD project on the Transfer Pricing Aspects of Intangibles Valuation issues Pim Fris Special Consultant Working Party No.6 of the OECD Committee on Fiscal Affairs - Paris 9 November 2010

Valuation issues - Introduction Questions posed: Should the project consider adoption of methodologies for intangible transfers that go beyond the five OECD approved methodologies? Should the OECD provide further guidance on the determination of the parameters used in valuation methods? Should the OECD provide further guidance on comparability issues for intangibles? What is the relevance for transfer pricing purposes of standards developed for accounting and financial purposes? 1

1. Methods Should the project consider adoption of methodologies for intangible transfers that go beyond the five OECD approved methodologies?

Degree of complexity There are various valuation methods routinely used in TP analyses These approaches are likely to be transfer pricing sensitive Real Options DCF Approach Market Multiples Approach Replacement Costs Low High Reliability 3

Which one should be used in a particular analysis depends on various factors The use of two methods is common (and strongly recommended) in valuation Techniques improve regularly Financial data availability is improving making the use of some methods more reliable Some methods do enable to take into account significant levels of risk (e.g., real options) The structure of the transaction strongly influences the value, e.g. Contingent pricing (e.g., earn out clauses) Mix of immediate payment and royalty type of arrangements 4

Should they be incorporated in the TPG? Valuation is a dynamic field. Consequently, it should be avoided that TPG are interpreted, not as guidelines, but as codified methods that would then risk to crystallize and soon become outdated. Thus, OECD should avoid adoption of detailed guidance on valuation techniques and endorse instead best practices and generally accepted methods in valuation (including guidance issued by valuation authorities), possibly under the other methods heading MNE groups retain the freedom to apply methods not described in these Guidelines to establish prices provided those prices satisfy the arm s length principle in accordance with these Guidelines. TPG 2.9 Also, OECD might consider integrating guidance on a key dimension currently lacking from the TPG in the context of intangible assets and cost contribution arrangements: intangibles need to be understood in the context of the total value of the enterprise, consistent with a value chain framework. It would thus take into account more explicitly roles and responsibilities of parties in that context, i.e., give due attention to the commercial and financial relations between the transacting parties. 5

2. Parameters Should the OECD provide further guidance on the determination of the parameters used in valuation methods?

What are the most important parameters? The selection of the variables is dependent on the techniques used and the facts of the case OECD should refer to generally accepted valuation techniques as the framework to guide on aspects such as premise of value, useful economic life, appropriate discount rates etc as they depend on the industry, the intangibles considered, and so on Possibly can publish separate examples of application of various methods for illustrative purposes only - but not as part of the TPG to avoid overreliance on and misapplication of the examples It would be more beneficial to focus on the impact of TP on valuation: Businesses, valuation and TP, one shared issue: understanding value Value in a business environment is generally relating to cash flows (or a measure of it) Cash flows in an intra-group context tend to be transfer pricing sensitive; and Valuations in an intra-group context tend to be cash flows sensitive How do we reduce the risks of inconsistencies? 7

The inside outside challenge The inside challenge (transfer pricing policy) The alignment of a firm s transfer pricing structures with its internal value creation process o Transfer pricing domestic regulations (compliance focused) o The international Arm s Length standard and OECD guidelines on Transfer Pricing o Management control, performance measurement and profit-linked remunerations The outside challenge (valuation) What happens when arm s length is challenged in the real world? o Minority shareholders entering or leaving o Spin-off of a business or parts of an enterprise o Start-up, (re-)negotiation and termination of collaborative relationships o Other external stakeholders: investment funds, banks, suppliers, creditors, labor unions 8

The IP valuation paradigm A hierarchical view of methodologies The economic approach Theoretical framework Practical guidelines 1. The inside and outside valuation paradigms are strongly connected TP compliance without outside challenge is often not arm s length CUP CPM/TNMM CPS/RPSM UM: DCF etc. Valuation, assuming TP policy (inside challenge) is arm s length, is often illusory Flows (TP) One Shot (valuation) 2. Building a sustainable valuation framework requires to consider the inside valuation challenge in conjunction with the outside valuation challenge and vice versa 3. In many cases, the inside valuation challenge preexists to the outside valuation challenge,.. and tends to ignore it 9

Example of when TP and valuation collide Ford of Canada case Minority shareholder squeeze-out Apparently tax compliant transfer pricing system used as input for the valuation A few lessons from the Case Functional analysis Functional analysis is a fundamental step in transfer pricing analysis that enable taxpayers: To identify the role and responsibilities of related parties To measure the contribution of related parties to the value creation process Fairness Fairness is a key concept guiding long term third party relationships (i.e., in developing an arm s length TP policy), & economic analysis plays a central role in the quantitative transposition of the fairness concept in the intra-group context Valuation Valuation is realistic only if the TP policy is relevant. Valuation, just assuming TP is arm s length, is in many cases an illusion 10

The IP valuation paradigm Successfully manage the inside and outside valuation challenge Valuing flows (transfer pricing) Understand value o Characteristics of intangible assets, functional analysis, analysis of market pricing processes, market structure, strategic profile of the group o Use economically sound methodologies INPUT Meaningful projections One Shot valuation Build the right valuation model If appropriate, use valuation enablers to account for a dynamic/uncertain environment (such as option pricing models etc.) VALUATION OUTPUT Inside-Outside challenge aligned 11

3. Comparability Should the OECD provide further guidance on comparability issues for intangibles?

Transactional and profit versus relational comparability Comparability analysis focusing merely on transactions and/or entity profits delivers potentially useful indications (usually), but misses the essential point that third parties are only comparable in their behaviour in the context of a similar type of relationship. By dealing lightly with the relational dimension, the TPG tend to ignore that the related parties are generally involved in a long-term cooperative relationship aimed at jointly creating value, committed to maintaining that relationship, usually combined with considerable investment in resources. The proper starting point for a TP analysis dealing with intangibles is to focus on the relationship between the transacting parties, identifying the role of intangibles in the value creation, and mapping the roles and responsibilities allocated to the parties involved in joint value creation according to the business model defined for the enterprise. 13

TPG should look at the context of the valution Only then do we have the ability to identify how this behaviour would translate on the open market, i.e., between parties without shareholder relations per se but otherwise engaged in similar commercial and financial relations. Total value chain perspective Roles & responsibilities in joint value creation Options realistically available & Relative bargaining position Terms & conditions for specific intra-group transactions = Arm s length, i.e. how companies would behave, in similar circumstances (but for the shareholding) Commercial & financial relations 14

4. TP & Other Standards What is the relevance for transfer pricing purposes of standards developed for accounting and financial purposes?

Valuation continuum Valuation exercises are at the very heart of any company s decision making process Valuation is one of the main quantitative tools that supports decisions within an MNE Strategy Accounting Transfer Pricing Legal Management Some examples Acquisition Divesture / Spin-off Partnership etc. Purchase Price Allocation Asset Impairment etc. Tangible Intangible Services etc. Legal restructuring Litigation etc. Performance Measurement EPS etc. The valuation continuum 16

An example Fact Pattern An acquisition followed by a business restructuring (IP migration) Intercompany transactions Acquiror A Entity A Acquisition Target B Entity C Entity B Step 1. Acquisition Step 2. Business restructuring 17

An example valuation issues The example of an acquisition followed by a business restructuring including IP migration Valuation exercise in the pre-acquisition context Strategy Post-acquisition valuation - IFRS 3 on business combination Valuation in the context of an Internal restructuring (e.g. IP migration) Valuation in the context of litigation on patents in various countries Accounting TP Legal Valuation continuum Valuation of performance in the post-acquisition world Management 18

Valuation continuum and TP: implications Transfer pricing goes beyond a compliance driven exercise, the transfer pricing mode that has become dominant in the past decade Arm s length has to be based on the strategic and operational realities inside the MNE and connected with the broader MNE valuation environment Accounting Strategy Transfer Pricing Legal Management Build a sound and consistent valuation framework to support both business/strategic decisions and transfer pricing objectives 19

Recap & Conclusions

Valuation issues some answers 1. Should the project consider adoption of methodologies for intangible transfers that go beyond the five OECD approved methodologies? No. Valuation is a dynamic field Need to avoid risk that TPG are interpreted as codified methods OECD should endorse generally accepted methods in valuation, under other methods 2. Should the OECD provide further guidance on the determination of the parameters used in valuation methods? OECD should refer to generally accepted valuation techniques Possibly can publish separate examples but not as part of the TPG More important would be guidance on impact of TP on valuation methods: Building a sustainable valuation framework requires awareness of the connection between internal transfer pricing policies and external valuation requirements and challenges 3. Should the OECD provide further guidance on comparability issues for intangibles? TP goes beyond a compliance driven exercise and should not concentrate on testing based on a toolset for testing individual transactions or of outcomes of individual entities Instead, the TPG should concentrate on insuring that the starting point of the analyses and valuations performed takes into account the perspective of the total value chain and the role of intangibles defined in a broad sense 4. What is the relevance for transfer pricing purposes of standards developed for accounting and financial purposes? Arms length has to be based on the strategic and operational realities inside the MNE and connected with the broader MNE valuation environment Transfer pricing analyses interpret available accounting data with suitable adjustments to align the tests and their conclusions with these objectives 21

Thank you 22