Transfer Price Valuation

Business Commercial Valuation
E
state, Trust, Gift, ESOP, Financial, 409a, IP/Patent, M&A
Forensic Economics, Bankruptcy
Infrastructure Capital & Industrial Assets

Commercial RE Appraisal & Cost Segregation


            213-251-2400        

 
email: david@myaacg.com
 
David Hahn, CVA, ASA, MAFF, CM&AA, CCIM, MBA

WHAT IS TRANSFER PRICING?



U.S Internal Revenue Code Section 482 gives tax authorities the power to reconstruct an intracorporate transfer price and tax the calculated profits whenever there is reason to suspect low prices set for tax evasion. Due to differences in Tax structures among various countries, a firm can obtain meaningful profits by ordering a subsidiary in a country with high corporate taxes to sell at cost to a subsidiary’ in a country where corporate taxes are lower. The profit is earned where less income tax is paid, to give the company as a whole, an overall gain. Transfer Pricing, in short is the ‘strategic’ pricing between members of the same enterprise that is mostly controlled through corporate policy. The manipulation of transfer prices for the mitigation of income taxes, import duties and other reason has caused many governments to insist on arms-length prices. Arms –length prices are prices considered reasonable, fair, market based or prices charged unrelated customers.

TRANSFER PRICING SERVICES 
We provide the following services:

1. Transfer Pricing Benchmarking
2. Transfer Pricing Documentation
3. Transfer Pricing Intangibles Valuation (Intercompany Transfers of Intangible Property)
4. M&A Valuation pertaining to the Transfer Pricing
5. Fair Value Financial Reporting Valuation (IFRS & FASB) pertaining to the Transfer Pricing
6. Forensic Economics Litigation Support



TRANSFER PRICING METHODS IN THE U.S.


U.S. TRANSFER PRICING METHODS

The United States Internal Revenue Code Section 482 provides specified methodologies for determining the arm’s length terms for the transfer of tangible property, and capital between tax—payers. The taxpayer is required to use the method that provides the most reliable measure of arm’s length pricing. Although there is no automatic best method for each taxpayer, the regulations indicate under which circumstances each of the methods is likely to be most reliable for finding the appropriate transfer price.


Section 482 provides five transfer pricing methods for tangible property and three for intangible property.

Tangible Property - 5 Transfer Pricing Methods:
Tangible property methods include the following:
1.
The comparable uncontrolled price method
2. The resale price method
3. The cost plus method
4. The comparable profits method
5. The profit split method

Under the comparable uncontrolled price method, an examination is made to determine whether the amount charged in a controlled transaction is arm’s length by reference to the amount charged in a comparable uncontrolled transaction. The tax-payer must demonstrate that the products, contractual terms, and economic conditions of the controlled transaction bear in a close similarity to the uncontrolled transaction.

Under the resale price method, a determination of arm’s length price is made by subtracting the appropriate gross profit from the applicable resale price for property involved in the controlled transaction. The appropriate gross profit is determined by multiplying the applicable resale price by the gross profit margin earned in
comparable uncontrolled transactions.

Under the cost plus method, the appropriate gross profit is added to the controlled taxpayer’s costs of production in the transaction. The appropriate gross profit is calculated by multiplying the controlled taxpayer’s cost of producing the property by the gross profit markup, expressed as a percentage
of cost earned in comparable uncontrolled transactions.

Under the comparable profits method, an evaluation is made as to whether a transfer price is arm’s length based on objective measurers of profitability derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances.

The arm’s length price is determined by the amount of profit that the tested party would have earned of its profit level indicator was equal to an uncontrolled comparable transaction.

Under the profit split method, an evaluation is made of the allocation of operating profit or loss in a controlled transaction to determine whether the allocation reflects the relative value of each controlled party’s contribution to the combined operating profit or loss. The operating profit allocated to any particular member of a controlled group is not automatically limited to the total operating profit of the group from the relevant business activity. Thus, in a particular year, one member of the group may earn a profit while another incurs a loss.


Intangible Property - 3 Transfer Pricing Methods:
The three specified methods for the transfer of intangible property include the following:
1. the comparable uncontrolled transaction method
2. the cost plus method
3. the profit split method.

Under the comparable uncontrolled transaction method, an evaluation is made to determine if the amount charged for a controllable transfer of intangible property was arm's length as compared to a comparable uncontrolled transactions must involve either the same intangible property or comparable intangible property. 

To be comparable, the two intangibles must be used in connection with similar products or processes within the same general industry or market, and have similar profit potential.

For the cost plus method and profit split method, the same definitions are used as for the transfer of tangible property, described above. When MNEs select a methodology for transfer pricing, they should examine pricing data based on results of all unrelated—party transactions to establish the most objective prices. As a corporation attempts to achieve the most appropriate transfer price, the corporation should consider reliability as a function of degree of comparability between the controlled transactions and the uncontrolled ones, quality of data and assumptions in the analysis, and sensitivity of the results to deficiencies in the date and assumptions.


TRANSFER PRICING METHODS by the OECD

The Organization Economic Cooperation Development (OECD) considers the following methods:
1. Comparable Uncontrollable Price method (CUP)
2. Resale Price method (RPM)
3. Cost Plus method (CP Method or C)
4. Profit Split method
5. Transactional Net Margin method (TNMM)

The OECD refers to the first three methods as ‘Traditional Transaction Method’ and the 4th and 5th method as ‘Transactional Profit Method’.

The difference between the U.S methods and the OECD are
customarily applied to situations that involve the manufacture, assembly, or other production of goods sold to related parties. Under the comparable profits method, an evaluation is made as to whether a transfer price is arm’s length based on objective measurers of profitability derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances. The arm’s length price is determined by the amount of profit that the tested party would have earned of its profit level indicator was equal to an uncontrolled comparable transaction. Under the profit split method, an evaluation is made of the allocation of operating profit or loss in a controlled transaction to determine whether the allocation reflects the relative value of each controlled party’s contribution to the combined operating profit or loss. The operating profit allocated to any particular member of a controlled group is not automatically limited to the total operating profit of the group from the relevant business activity. Thus, in a particular year, one member of the group may earn a profit while another incurs a loss.

 

THE ECONOMIC BENEFITS OF TRANSFER PRICING
The economic benefits that a multinational enterprise will gain from transfer pricing are their motivations for practicing transfer pricing. Transfer pricing assists an MNE in evaluating the financial performance of different parts of the company. If the host country of one of the subsidiaries has lower taxes than the other host countries, it would be natural to try to maximize profits in the lower tax country and minimize

them in the higher tax country. In the end transfer pricing may help reduce the consolidated company’s tax burden. Other differences between host countries could dictate the allocation of profit to or from the subsidiaries located there. Such differences could include currency controls, customs duty, tariffs, labor relations, political climate, and social unrest. It is sensible to allocate as much profit as reasonably possible to subsidiaries in countries with the least currency controls, the best labor relations, political climate, and the least social unrest.


DOCUMENTATION OF TRANSFER PRICING
Adhering to the different requirements of multiple tax regulation among various nations is a complicated process. National tax authorities enforce detailed documentation requirements, transaction transparency, audit/inspection activity, and strict punishments. To meet the requirements of U.S transfer—pricing regulations, a taxpayer must annually prepare, prior to the filing of the U.S tax return, all of the transfer—pricing documentation. Corporations that utilize transfer pricing must satisfactorily document their adherence to the arm’s length approach. There are two main motivations for compliance. The first is to reduce the risk of an audit and potential dispute with tax authorities. The second is to maintain transparency with investors and tax authorities. Transparency with stockholders and potential investors enhances consumer confidence which potentially adds value to the corporation. Over 50 countries, including the United States, are beginning to ask their MNEs to report contemporaneous transfer—pricing documentation. Transfer—pricing documentation must show each significant process used by the corporation regarding transfer pricing and the arm’s length methodology applied. When an MNE fails to disclose information concerning transfer pricing, the company faces significant penalties from the country’s tax authorities. For example, in Australia, when an MNE provides inadequate or incomplete information, the country’s transfer—pricing laws permit the taxing authority to assign the transfer price. A second example of the importance of documentation is Mexican’s transfer—pricing rules, in which penalties include denial of deductions for the transfer payments to foreign related parties.

 
ADVANCE PRICING AGREEMENT (APA)

Currently, the US tax Laws and OECD guide allows Advance Pricing Agreement/Arrangement (APA ). The APA program is designed to resolve actual or potential transfer pricing dispute in principled co-operative manner, as an alternative to the traditional examination process. An APA is a binding contract between the IRS and a tax payer by which the IRS agrees not to seek a transfer pricing adjustment under IRC 482 for a covered transaction if the tax payer files its tax return for a covered year consistent with the agreed transfer pricing method (TPM). In 2009, the IRS and tax payers executed 81 APAs and amended eight APAs.


ARM'S LENGTH PRINCIPLES
Determining transfer pricing based on arm’s length principles in not always possible, even with the help of the OECD guidelines. Identifying comparable market transactions to determine an appropriate transfer price can be a challenge for any company.
Nonetheless, authorities continue to explore alternative methods to make both the estimation and disclosure of transfer prices as accurate as possible. When corporate affiliates and subsidiaries are situated in different countries, transfer pricing affects taxes owed and thereby company profits. As a result of this ability to affect profits, it is critical that upper management carefully consider its transfer—pricing strategy. If done carefully, a Multinational can financially benefit from its international transfer—pricing strategies. A Multinational must endeavor in their transfer—pricing strategies to use appropriate transfer prices that comply with the rules and principles established by tax authorities in the various countries in which business operations are conducted.





TRANSFER PRICING VALUATION

Most MNEs (Multi-National Entity) have internal capabilities to evaluate Transfer Pricing for their products and components meeting the IRS Compliance or Other OECD guidelines. However, they typically are lacking of capability to value the capital tangible assets, intangible IP assets, and shares securities. That is where we can help bringing our expertise to solutions. When transferring assets within or outside of a group or when accounting for a business combination, it is important to have an economically robust valuation to support the values. We are able to provide with valuation knowledge and expertise compliant with international accounting standards as well as the arm's length principle.

We offer the following services:

Transfer Pricing Intangibles Valuation:
Valuation of Intellectual Property Intangibles,
Cost Sharing Arrangement: Buy-ins and Buy-outs
Licensing of technology know-how and patents
Licensing of Trademarks and Brands
IP Migration
Valuation of Securities Interests,
Reorganization Valuation

Services Valuations:
Technical, R&D and Manufacturing Services
Sales, Marketing, and Distribution Services
Supply Chain and Logistics Services
Business Support Services
Corporate Management Services

M&A Valuation and Operational Changes:
Valuation support for Merger, Divestiture, Spinoffs
Integration after Acquisitions
Due Diligence Support
Cost Sharing
IP Migration
Supply Chain Efficiencies

Fair Value Financial Reporting:
SFAS 141r (business combinations)
SFAS 142 (goodwill impairment)
SFAS 157 (Fair Value)

Forensic Economics Litigation Support Valuation -
Expert Witness for Disputes between the firm and the governmental authorities or IP infringement matters,
economic loss, lost profits, and business damages evaluation

Valuing intangible assets such as trademarks, copyrights and patents for tax purposes can prove to be a complex task. It is often difficult to estimate the cost of development and resulting profits and to analyse the correlation between the two. Nonetheless, the intangible nature of IP rights makes them easily movable and creates the potential for valuable tax planning and profit maximization. Transferring intellectual property between subsidiaries in different countries, for example, allows a company to reposition cash. But transfer pricing of intangible assets bears some risks as it can lead to valuation disputes between tax authorities in the jurisdictions concerned.

In recent years, intangibles related to marketing and technology have become crucial sources of value and of competitive distinctiveness and now play a greater role in a company’s profitability. Today’s world, with ever reducing differences in availability of routine factors of production, is evidenced by highly increasing level of competition in every field.



INTERCOMPANY TRANSFERS
OF INTANGIBLE PROPERTY


Common Definition of intangible

Marketing intangibles
− trademarks trade names customer lists distribution channels, trademarks, names, lists, channels, unique name, signal or picture, know how, trade secrets

− Usually registered for protection by law

− Value based on:
• Reputation and credibility of intangible, based on quality of goods/services
• Distribution and availability of associated goods/services
• Extent and success of promotional expenditures

Commercial intangibles
Trade intangibles (manufacturing intangibles)
• e.g. technology, know-how, trade secrets, patents, designs, models
• Often created through risky and costly R&D
• Owner recovers expenditure through sales, service contracts, licence agreements, etc.
• Not always registered for protection by law

Definition of intangible, U.S. TP regulations
• For purposes of IRC 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:

− Patents, inventions, formulae, processes, designs, patterns, or know-how

− Copyrights and literary, musical, or artistic compositions

− Trademarks, trade names, or brand names

− Franchises, licenses, or contracts

− Methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data, and

− Other similar items. For purpose of Section 482, an item is considered similar to those listed above if it derives its value not from its physical attributes but from its intellectual content or other intangible properties

 

Periodic adjustments under U.S. TP regulations

• Under U.S. Transfer Pricing rules, the consideration charged for the transfer of an intangible in each year under an arrangement that covers multiple years must be commensurate with the income (“CWI”) attributable to the intangible (§1.482-4(f)(2))

− CWI established to accommodate need for “Super Royalties” in the transfer of extremely valuable intangibles or “Crown Jewels”

• CWI provisions also apply in the case where intangibles are transferred for lump-sum consideration

• Exceptions to the CWI rule include:

− CUT
− Extraordinary events
− 5-year period
− 80-120 Rule

The total profits actually earned or the total cost savings realized by the controlled transferee from the exploitation ofthe intangible in the year under examination, and all past years, are not less than 80% nor more than 120% of the prospective profits or cost savings that were foreseeable when the controlled agreement was entered into.

Additional observations

• The need for properly written intercompany agreements that clearly define intangible property rights has increased

• The need for the transaction to follow the terms and conditions set out in the agreements is paramount

• The allocation of risks and rewards as set out in the agreement should be consistent with the economic substance of the transaction

• A stronger basis is created for arguments in favor of higher (profit split based) compensation for high value services, instead of lower (cost plus based) returns Applicable transfer pricing methods under OECD guidelines

• OECD Guidelines do not have specific transfer pricing methods for valuing intangible property. But the following methods can be applied to evaluate intangible property:

− Comparable Uncontrolled Price Method (“CUP”)
− Discounted Cash Flow Method (“DCF”)
− Historical Costs Method (“HC”)
− Resale Price Method (“RS”)
− Profit Split Method (“PSM”)
− Unspecified Methods

Applicable transfer pricing methods under US regulations

• Reg. § 1.482-4(a) specify the following methods for pricing transfers of intangible property

− Comparable Uncontrolled Transaction Method (“CUT”)
− Comparable Profits Method (“CPM”)
− Profit Split Method (“CPSM” and “RPSM”)
− Unspecified Methods

• Reg. § 1-482-7T specify additional methods for valuing transfers of intangible property in the context of a cost sharing arrangement

 

Comparable Uncontrolled Transaction (CUT) method

• Most reliable – comparable uncontrolled transaction involves transfer of the same intangible under the same, or substantially the same, circumstances

− “Internal” comparables – controlled party licenses same intangible to unrelated third party

• “Comparable” intangibles transferred under “comparable” circumstances less reliable

• Comparable intangible asset

− Similar products or processes within the same general industry or market (Reg. § 1.482-4(c)(2)(iii)(B)(1)(i))

− “Similar profit potential” (Reg. § 1.482-4(c)(2)(iii)(B)(1)(ii))

• Net present value of benefits to be realized

• Need to reliably measure profit potential increases as total potential profits and potential rate of return increase

• Comparable circumstances (Reg. § 1.482-4(c)(2)(B)(2))

− Terms of transfer (exclusive v. nonexclusive)

− Stage of development

− Right to receive updates

− Uniqueness of intangible

− Duration of transfer

− Economic or liability risks assumed by transferee

− Collateral transactions

− Functions performed (ancillary services)


Comparable Profits Method (CPM)

• Reg. § 1.482-5 – In general, determine whether pricing is arm’s length indirectly, by seeing if a controlled taxpayer (the “tested party”) earns profitssimilar to those earned by comparable companies that engage in similarbusiness activities under similar circumstances

• Comparability of functions more important than specific product

• Compare profit level indicators (“PLIs”), such as operating margin, return on assets, etc.

• For intangibles, tested party would generally be the licensee (why?)

• If licensee’s profits are lower than those of comparable companies (after adjustment for royalties paid for the use of the intangible in question),the implication is that the licensee is paying too high a royalty for use ofthe intangible

• This method typically presumes that the licensee should earn only a routine return

Profit Split Method

• Reg. § 1.482-6(c)(2)(i) – “Comparable profit split”

− Information is rarely available apply to apply.

− Allocates income between parties based on observed uncontrolled transaction

− Most likely to be available when uncontrolled party is acquired and previously uncontrolled transaction is now a “controlled” transaction

• Reg. § 1.482-6(c)(3)(i) – “Residual profit split”

− Applicable only when both parties own intangibles

− Splits nonroutine or residual profit between parties based on relative value of nonroutine contributions

 

Additional methods – Temporary cost sharing regulations

• Temp. Treas. Reg. §1.482-7T(g) define five specified methods for valuingPlatform Contributions to a cost sharing arrangement (in addition to an unspecified method)

CUT method

Income method

Acquisition price method

Market capitalization method

Residual profit split method




CRITICAL ISSUES OF
TRANSFER PRICING VALUATIONS

 


TP valuations may not converge to IFRS/ FASB valuations

 TP valuations frequently involve bundling of intangibles not ordinarily transacted between unrelated parties – less a question of valuing a “going concern” which is an issue for IFRS TP valuations frequently involve closely linked transactions that cannot be considered separately in deciding if the overall “package” deal complies with the arm’s length standard.

TP valuations inherently compare two states: the “as is” (or before the transaction) to the after. IFRS valuations do not always take place in this framework.

TP Valuations Methodologies

  • Income approach (Discounted Cash Flow or “DCF”) is the principal method to evaluate TP package transactions comparing Present Value (PV) before versus PV after.
  • Comparing two states means that TP valuations determine PV before and after by discounting pre-tax income with risk-adjusted post-tax discount rate (of acquirer or acquirer’s industry) -- WACC of seller may not be relevant except to set floor return for seller.
  • In the context of the “package deal”, TP valuation seeks to determine the value of the necessary balancing payment, if any, such that the results post transaction comply with the arm’s length standard.
   

Transfer pricing valuations can be based on pre-tax cash flows

  • DCF method (income approach) used in both IFRS and TP valuations -- but there are differences of Pre- versus post-tax discount rate. Corporate finance theory says that pre-tax cash flows should be discounted with a pre-tax rate & post-tax with a post-tax rate.
  • However to determine valuation of combined package of transactions for TP purposes pre-tax cash flows should be discounted at the post-tax rate adjusted for relative risk of each separate cash flows (per standard finance theory) because of the before & after comparison of states.
  • Corporate finance theory would propose a discount rate reflecting the fundamental riskiness and capital structure of the entity; but for TP valuations capital structure (degree of leverage) does not need to enter into the computation.
  • Need to consider terminal value (TV) adjustment for TP valuations, relates to economic useful life of assets evaluated.
  • Perpetuity assumption often used in IFRS may not be appropriate.
  • TP valuations are not for a going concern & therefore need to consider economic useful life in determining the TV.
              

Purchase Price Allocation (PPA) can be a useful starting point

 

  • Purchase Price Allocation (PPA) can be a useful starting point to determining TP valuation. Need to carefully consider the definition of the intangibles as defined for the PPA exercise relative to definition of intangibles transacted for TP valuation purpose.
  • Adjustments may be needed (e.g., terminal value, discount rate, may need to regroup PPA defined intangibles into bundle that aligns to the TP package deal intangibles ,or adjust the scope of the business activity)
  • Presence of goodwill in PPA should not be considered blocking point to use of PPA valuation of intangibles included in TP transaction (e.g., R&D know-how, process know-how, patents, TMs, etc.)


CRITICAL ISSUE for Transfer Pricing Valuation for Cross-border M&A

When the transaction is cross-border Mergers & Acquisitions (M&A), different rules come into play that may require the transfer pricing method, which leads to a higher valuation and a bigger tax bill.

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.

One of the valuation methods -- financial reporting -- results in significantly lower valuations for intangibles than the other -- transfer pricing. The financial reporting approach is standard in most transactions.

The method used for financial reporting differs in fundamental ways from the method used in transfer pricing. Transfer pricing is usually the basis for taxation in cross-border transactions, since tax is often determined when an asset is moved from one jurisdiction to another. Also, transfer pricing typically produces a higher valuation than financial reporting, so there is more tax to be collected when transfer pricing is used.

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.

There are several major differences between the two methods. Among the most significant is that in transfer pricing, goodwill is considered part of the value of an intangible asset, and the valuation is determined from the perspective of an actual buyer. In financial reporting for fair value standard, goodwill is not a part of the asset, and the valuation is determined from the perspective of a market participant. Market factors generally lead to a lower price. In addition, transfer pricing is done on a pre-tax basis and estimates a longer useful life. Financial reporting is done on an after-tax basis and assumes a shorter useful life. For those reasons and others, the transfer pricing method produces a much higher valuation than the financial reporting method.
  
Tax authorities including the IRS and the Organization for Economic Cooperation and Development (OECD) are tightening controls. The IRS has issued guidance 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 OECD is moving similarly to make sure that member countries do not assign a low value to intangible assets in order to transfer them into a more favorable tax jurisdiction.  Companies may face audits or litigation if they apply the financial reporting method.













 

               
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