Business acquisitions can provide many benefits. Examples include opportunities to increase capabilities, build on existing talent, realize synergies, protect and grow existing markets, expand offerings and mitigate risks. To realize the potential benefits, effectively integrate targets and comply with various requirements triggered by M&A activity, organizations are often required to perform multiple valuation analyses. These are likely to include:
- Purchase price allocation (PPA) for financial reporting purposes under ASC 805
- Allocation of total purchase consideration to the underlying legal entities acquired for pushdown accounting and/or tax purposes
- Valuation of intangible property (IP) for tax planning (e.g., post-acquisition integration and restructuring) and tax reporting purposes
Many of our clients question why they can’t use the PPA results (No. 1 above) to price a cross-border intercompany transfer of IP (No.3 above). This is in part because transfer pricing (TP) analyses depend on specific facts and circumstances related to the exact intercompany transaction. Further, current transfer pricing standards in the U.S. and in many other jurisdictions expect that IP valuations consider a “platform” view that includes additional (and in some cases different) anticipated income that PPAs may attribute to goodwill and going concern value. A TP analysis also requires the explicit consideration of the realistic alternatives principle, which essentially states that related parties would only enter into a particular intercompany transaction if each realistic alternative was economically equivalent. These important transfer pricing considerations are not usually included within the financial reporting analysis, and clients who rely on PPA conclusions face an increased risk of review and adjustment by the relevant tax authorities.
Once clients understand the need to develop each analysis separately for their respective purposes, questions often arise when results are compared. The most common questions we hear involve two related topics:
- Why is the [transfer pricing] IP value so much larger than the [PPA] technology intangible asset value? Aren’t they the same thing?
- How do I appropriately allocate the [PPA] customer relationships intangible asset to legal entities? Customer relationships value is large, yet my sales entities earn a limited fixed margin commensurate with their relatively lower risk.
Many of the differences between a PPA and the related transfer pricing IP valuation are appropriate, correct and can be explained and quantified. Other differences can be explained and understood but will remain unreconciled.
Bridging the Divide – Differences That Can Be Quantified and Reconciled
Income Attribution: Routine vs. Non-Routine Returns
In a PPA, all value (i.e., purchase consideration) above tangible assets is identified and estimated. When we aggregate all identifiable intangibles and goodwill (which in itself includes the value of future intangible assets and assembled workforce), this “excess” amount is derived from all profit above tangible contributory asset charges (CACs) which are essentially economic rents that are deducted to estimate income specifically attributable to intangibles. In fact, the net present value (NPV) of the total CACs will equal the value of net working capital (NWC) + fixed assets. When computing CACs in a PPA, no additional returns are identified above tangible asset returns.
Under many common transfer pricing structures, a company’s IP owner(s) or entrepreneur(s) will contract out various routine functions, such as R&D, manufacturing and distribution to related parties that perform those functions on the IP owner’s behalf, and that bear the relevant risks and employ any necessary assets to perform those functions. In other cases, the IP owner(s) may also perform routine activities. In either case, when valuing IP for transfer pricing purposes, the value of routine bundles of functions, assets and risks (FAR) is often identified distinctly from the IP to be valued (“Subject IP”).
A helpful concept to consider is that intangible assets, as defined under a PPA, may contain both an underlying routine element as well as non-routine elements of income and value. For example, we can think of a pivotal PPA technology intangible asset as being comprised of two “layers” of value. First, there is routine technology value that provides a fixed level of economic return, and second, there may be additional non routine technology value that is the excess commercial value above the routine amount. The company’s arm’s length mark-up on R&D services under its transfer pricing policies can proxy the routine technology value, with the difference then attributed to non-routine income and value.
Similarly, we can also think of a pivotal PPA customer relationships intangible asset as having what would be identified as both routine and non routine elements under a corresponding TP framework. The routine customer relationships value is derived from a fixed margin earned on limited-risk distribution activities, with any excess value related to incremental commercial value. We can use the company’s arm’s length value associated with the routine distribution FAR to quantify the routine customer value, with any remaining income attributed to the non-routine portion of the customer relationships intangible asset. That non-routine portion would typically inure to the IP owner(s)/entrepreneurial legal entity(ies).
When we bifurcate the routine and non-routine components of PPA intangible assets, the routine intangible value plus the NPV of associated CACs is often similar to the corresponding total value of routine functions (e.g., R&D services and distribution services) that is estimated within a transfer pricing analysis. Similarly, the total non-routine portions of PPA intangible assets can be reconciled closely to the total IP values from a transfer pricing analysis.
As an example of the routine versus non-routine elements, if you consider a PPA where the customer relationships asset is pivotal and is valued at 10% of revenues on an annual basis, one could bifurcate that value into two parts: three percent for the routine value as benchmarked by comparable companies; and an implied seven percent non-routine return for the customer relationships intangible.
The second primary difference relates to the remaining economic useful life applied in each analysis. In a PPA, existing intangible assets are more narrowly defined such that (non-maintenance) investment incurred to grow, expand or replace assets after a specific valuation date generally translates into future asset value (i.e., goodwill). New features within an existing product that contribute to the obsolescence of the existing technology are part of goodwill, as are new customers.
In a transfer pricing analysis, existing IP is defined through intercompany contracts and is generally broader than individual intangible assets as identified in a PPA. IP for transfer pricing purposes generally includes the benefits associated with the right to continue to invest in a platform over time. Said differently, IP can be broadly defined as the economic rights to a basket of IP assuming continued investment to maintain and maximize value into the future. The value derived from future investment to improve and enhance what exists today is evaluated differently for TP and PPA purposes. A TP analysis is likely to include more of such value in IP, whereas in a PPA, investment to improve and enhance is generally associated with future technology and would be ascribed to goodwill. Through a transfer pricing lens, the period over which existing IP elements might be expected to contribute positive economic value might be quite long. Depending on the facts and circumstances, a terminal value associated with some level of “core” IP may also be appropriate. All else equal, the platform concept of IP value will usually result in a larger IP value compared to an existing technology intangible asset value established in a PPA.
Together, routine vs. non-routine income allocation and life determinations associated with related but notably different definitions of the underlying asset explain and quantify many of the differences between PPA values and transfer pricing IP values.
There are certainly additional quantifiable, reconcilable differences between PPA and transfer pricing values, which we will not cover in detail, although one deserves mention related to how transfer pricing routine returns are estimated compared to CACs.
The CAC for tangible assets in a PPA equates to the value of the fixed assets themselves and generally is smaller than a corresponding functional return for manufacturing activities. This difference can be quantified as the difference between the estimated total business enterprise value of a contract manufacturer legal entity and the value of tangible assets. We can alternatively think of this difference as the routine goodwill of the contract manufacturer legal entity. In a more comprehensive example, assembled workforce may explain some portion of this routine “goodwill.”
The Divide Remains – Differences That Can Be Quantified but Not Reconciled
Another category of differences also exists: Those which can be quantified but cannot be reconciled in the same way the items noted above can.
Within a financial reporting PPA, the fair value framework assumes a willing buyer and seller, although that definition usually requires judgement and references the term “hypothetical.” The purpose of the transfer pricing analysis is to establish an “arm’s length” price that reflects the amount under which the intercompany transaction would take place if the parties were operating at arm’s length. For transfer pricing purposes, the actual parties to a specified transaction are generally known, and consideration must be paid to the realistic alternatives for each participant consistent with the arm’s length principle, the prevailing global transfer pricing standard.1 When considering specific buyer and seller perspectives, issues such as tax rates, synergies and associated restructuring costs, discount rates, transaction-specific tax costs and benefits, etc. need to be assessed. Consideration of these factors may result in establishing ranges of arm’s length values, from which clients can ultimately choose a final transfer price that, by definition, satisfies the requirements of the arm’s length principle.
The treatment of transaction-specific tax costs and benefits deserves special mention. Whether values are calculated pre-tax or post-tax, considering both seller and buyer tax rates will result in a range of value indications when those rates are different. Any particular scenario, or a conclusion within an indicated arm’s length range, can be quantified and compared to the values within the PPA analysis.
To address more specifically the two questions posed up front:
The difference in a PPA technology intangible asset and transfer pricing IP value can be primarily explained by differing frameworks for 1) how routine and non-routine income is defined and allocated and 2) how definitional differences in the asset being valued impacts economic life determinations and modeling. Transfer pricing IP value will often include part of what is identified as goodwill and/or customers in a PPA and may also have a longer life.
When allocating customer intangible value to legal entities within an existing corporate structure, we recommend that the total customer relationships intangible asset is first split between identifiable routine and non-routine elements, and then each element allocated in a different manner. In simplistic terms, the routine portion of the PPA customer relationships intangible asset can be allocated based on some reasonable methodology to the limited risk distribution entities, and the non-routine portion can be allocated to the entrepreneur entities. As a result, it is possible that a significant portion of the “customer relationships” asset as defined in a PPA would end up in the broadly defined “IP” bucket through the specific contractual transfer pricing relationships.
The important but difficult issues addressed herein need to be understood by acquisitive clients as they navigate integration into and restructuring of existing legal and contractually defined intercompany economic ownership structures. Coordination between controllership and tax teams when performing the required analyses is key. Inputs should align where they make sense, and assumptions should differ when the respective guidance dictates alternative views and definitions. When valuation results naturally diverge, clients and their advisor(s) should be comfortable explaining and supporting why seemingly divergent conclusions are appropriate. In certain circumstances, advisors should be able to assist clients in the identification and quantification of the specific factors that lead to different conclusions, and in doing so, reconcile PPA, legal entity and transfer pricing values.
1.Examples of such alternatives being to buy, sell or maintain the status quo