Read Valuation Insights, Fourth Quarter 2018
The enactment of H.R. 1, formerly known as the Tax Cuts and Jobs Act (“TCJA”), on December 22, 2017 marks the first major overhaul of the U.S. federal income tax system in over 30 years. The new law makes sweeping changes to the tax code with widespread business implications that create challenges and opportunities for corporate leaders as they address a variety of operational decisions.
In particular, the new law has reshaped the way corporations look to optimize their international operations and intangible property holding structures, giving rise to potential planning opportunities and particularly with surrounding acquisitions. As multinational companies integrate acquired IP, they may elect to transfer the economic ownership of certain acquired intangibles within the controlled group for a host of reasons, including supply chain optimization, improved tax efficiency, the simplification of intercompany transactions, and the facilitation of research and development/technology-sharing within the group.
These transactions involve a unique intersection of financial reporting and transfer pricing, and often raise the question: Can valuation analyses performed for financial reporting be used for transfer pricing purposes?
Rules governing the movement of intangible assets between legal entities within a controlled group fall under the various tax codes and regulations that govern the intercompany pricing of such transactions – most notably, Section 482 of the IRC and its corresponding regulations (“Section 482”). Meanwhile, valuation analyses performed for financial reporting purposes are subject to generally accepted accounting principles. As such, values determined within a transfer pricing framework may vary, sometimes significantly, from fair value measurements for financial reporting purposes.
The Internal Revenue Service (“IRS”) addresses this issue in the Section 482 regulations with respect to Platform Contribution Transactions1 (“PCT”), stating, “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.”2 To understand the IRS’s reluctance to accept valuations prepared for financial reporting purposes, it’s important to understand the key differences in the frameworks underlying each type of analysis.
Pursuant to Accounting Standards Codification (“ASC”) Topic 805, the cost of an acquired company should be assigned to the tangible and intangible assets acquired and liabilities assumed on the basis of the fair values at the acquisition date. Generally, the excess of the purchase price over the fair value of the net assets acquired (including identified intangibles) is recorded as goodwill. Under the financial reporting framework, an intangible asset can be valued and recognized separately from goodwill if it arises from contractual or other legal rights or can be separated/divided and sold, transferred, licensed, rented, or exchanged, either individually or with a related contract, asset, or liability. For financial reporting purposes, intangible assets may be amortized according to guidance delineated in the ASC regulations.
In a financial reporting context, entity-specific synergy cash flows are excluded from the fair value measurement of the recognized assets. Therefore, if the purchase price included any payment for entity-specific synergy value, this amount would become part of goodwill through the residual calculation. Goodwill may include such elements as the value of assembled workforce acquired, technology to-be-developed, and future customers.
Under the transfer pricing framework, the economic value of intangible assets may be considered on a consolidated basis, including the value of various types of intangibles. Typically, in a transfer pricing context, intangibles are not separately identified from goodwill. This broader definition of compensable intangible assets under transfer pricing constructs generally produces values that are higher than those which would be indicated by valuations performed for financial reporting.
While business combinations often give rise to the need for valuations for transfer pricing purposes, the regulations indicate that the results of financial reporting valuations typically should not be relied upon in a transfer pricing context. As such, it is important to ensure these analyses are performed independently according to each set of regulations, while aligning the two efforts where necessary. Specifically, it is best practice to rely on similar, if not the same, underlying operating projections for the subject business(es) being valued, such as revenue growth rates and profit margins. Aligning these assumptions across the two analyses helps mitigate risk and produce cohesive, economically sensible results.
1 A PCT is a buy-in payment required for one cost-sharing participant to buy into another participant’s existing intellectual property. The payment equals the arm’s-length value of the contribution.
2 IRC Section 1.482-7(g)(2)vii(A).