2015 is shaping up to become one of the largest years on record for M&A activity.1 For many companies involved in such transactions, an inevitable outcome will be the preparation of purchase price allocation analyses (PPAs) in order to satisfy financial reporting requirements. At the same time, these combined companies typically engage in exercises to understand, rationalize, and value their newly acquired intangible property within the relevant legal jurisdictions in which it resides for tax purposes. Moreover, movement of the newly acquired intangible property often occurs at this time. This may be done to simplify intercompany transactions, improve tax efficiency, or to facilitate the sharing of research and development, technology, or brand assets within the newly combined companies.
All of this activity leads to an important but complicated question raised with increasing frequency by the tax and finance departments of companies and the tax authorities auditing those companies: Can an intangible asset valuation done for financial reporting purposes be used for transfer pricing purposes? In fact, the cost sharing regulations governing transfer pricing in the United States address this matter directly: "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 [Platform Contribution Transaction], particularly where the accounting treatment of an asset is inconsistent with its economic value."2
To understand the Internal Revenue Service's (IRS) reluctance to take valuations prepared for financial reporting purposes at face value, it is helpful to first look at the differing frameworks underlying each type of analysis. Attributes of financial reporting analyses include:
- Pursuant to Accounting Standards Codification (ASC) 805 and International Financial Reporting (IFRS) Standard 3, intangible assets are identified and valued if they are separable or arise from contractual or other legal rights;
- The useful life of each identified intangible asset is the period over which the asset is amortized for financial reporting purposes;
- The difference between the consideration paid and the fair value of the identified tangible and intangible assets is represented by goodwill, a residual concept;
- For financial reporting purposes, if the financial projections used to value the acquired intangible assets include buyer specific synergies and if these synergies were paid for, then these synergies are subsumed within goodwill; and
- Goodwill may also include the value of the acquired assembled workforce, future (to-be developed) technology, and future (to-be acquired) customers.
On the other hand, taxing authorities generally assert an expanded definition of what comprises intangible asset value for transfer pricing purposes, and thus goodwill recognized for financial reporting purposes has a higher value compared to transfer pricing purposes.
There are also several key methodological distinctions that may lead to material differences in value in most cases. For instance, intangible asset valuations prepared for both financial reporting and transfer pricing purposes often utilize an Income Method. Given the common name and the common use of projections and discount rates, the differences, many of which are seemingly subtle, are often missed. Thus, blindly allowing a valuation done for financial reporting purposes to perform "double duty" as a transfer pricing valuation increases the risk of unrecognized tax exposures.
To better understand this dynamic, below are a few examples of key methodological differences between the Income Method used for financial reporting purposes and the Income Method used for transfer pricing purposes.
Difference 1: Pre-Tax vs. Post-Tax Analysis
Valuations performed for financial reporting purposes are prepared using after-tax cash flows. Valuations done for transfer pricing purposes often apply a post-tax discount rate to pre-tax operating income. This treatment is, under the regulations, meant to provide a shortcut that ensures both buyer and seller are willing to enter into the transaction in question after tax costs (i.e., capital gains taxes) and tax benefits (i.e., tax deductible intangible amortization) are taken into account. While the shortcut is appropriate only under certain circumstances, its use by practitioners and the IRS is fairly pervasive. The inclusion of a tax amortization benefit in financial reporting may work to mitigate the different treatment of tax under financial reporting and transfer pricing frameworks, but it likely will not completely eliminate the difference.
Difference 2: The Premise of Value is Different
Fair value is the definition of value used for financial reporting. For transfer pricing, the premise of value is the arm's length standard. The critical difference between the two definitions is that fair value looks to estimate the price that an asset could be sold for, in an exit transaction with a market participant buyer, while the arm's length standard looks to estimate the price that would be paid by a specific buyer to a specific seller at arm's length. Thus, while a valuation prepared for financial reporting purposes always excludes buyer-specific synergies from the fair value of an intangible asset, these synergies may need to be included in the intangible asset value for transfer pricing purposes.
Difference 3: The Treatment of Future Business Opportunity
Other than in-process research and development, the value of the right to create future business opportunity and, therefore, new intangible assets, is generally subsumed within goodwill for financial reporting purposes. If in any specific instance the right to exploit future business opportunities is considered compensable for transfer pricing purposes, this difference, all else being equal, will likely to lead to increased intangible asset values for transfer pricing purposes relative to financial reporting purposes.
Difference 4: Reporting Units vs. Legal Entity Valuations
Intangible asset valuations prepared for financial reporting purposes are generally performed at the enterprise level with intangible asset values then assigned to reporting units. Reporting units may be organized based on either product, geographic, or other criteria, depending on how the business is managed. This is most often different than the legal entity framework required for transfer pricing purposes. For instance, one legal entity may contain portions of different reporting units, and a single reporting unit may include several legal entities. Therefore, intangible asset values determined for financial reporting purposes may span across several taxing jurisdictions and legal entities. This difference may make the use of projections developed for financial reporting purposes inappropriate for transfer pricing purposes, though it is advisable that reconciliation between different sets of financial projections be performed when valuations are performed contemporaneously.
While intangible asset valuations prepared for financial reporting purposes are often done in close proximity to the movement of intangible assets within the controlled group, the transfer pricing regulatory requirements are sufficiently different than those governing financial reporting, thus having the potential to yield materially different values. As such, valuations done for financial reporting purposes should not be blankly relied upon for transfer pricing purposes. Companies should be prepared to bridge the financial projections and other inputs and assumptions used for each purpose in order to make certain that their tax risks are mitigated.
- See for example, The Wall Street Journal, "M&A Activity on Pace for Record Year", August 10, 2015. http://www.wsj.com/articles/m-a-deal-activity-on-pace-for-record-year-1439249011
- IRC Section 1.482-7(g)(2)vii(A).