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Planning for Digital Intangibles in Economic Ups and Downs

Investments in intangibles have increased dramatically over the past few years. Global tech leaders based in California invested hundreds of billions of dollars in digital technologies to grow their userbase and commercialize data. Market leaders from other industries–automotive, aviation, retailers, and others–have been jumping on the digital train, investing similar amounts in new technologies like self-driving vehicles, electronic warehousing, and related digital services to improve customer satisfaction and commercially exploit user data. Such enormous financial investments will likely weigh heavily on profits, but are necessary for medium- and long-term survival.

Investments in intangibles are often regarded as riskier than tangible assets investments, which is why they are not always booked as assets but rather expensed.

The reluctance on the part of accounting departments to book intangible assets is largely due to a lack of security, particularly in times of financial crisis. However, OECD provides excellent justification and effective guidance on how to securely book intangibles.

The DEMPE and hard-to-value intangible concepts defined by the OECD 2018 transfer pricing principles requires the definition and arm's length valuation of intangibles each time an intangible contribution of value is transferred from one country to another or when it is used in another country (even when it has not materialized into a traditional intangible asset). This is independent of the intangible's treatment in financial statements, tax balance sheets, double tax treaties, etc.

This guidance opens new approaches to using and valuing intangible transactions.

In most cases, intangible investments are unique, with no comparable market prices. Therefore, traditional benchmarking will be highly unreliable and not acceptable by tax authorities. Today, rules of thumb like Goldscheider or Knoppe are obsolete. Profit splits may be adequate in some cases but are very often misleading.

Expenses Versus Assets: When to Remunerate a Flop

Accounting rules are different but, in general, they suggest that intangibles have to be booked as an asset when the intangible can be defined as something usable (e.g., an active ingredient or a vehicle part), whereas a flop has to be expensed. Pure research has to be expensed, as long nothing usable has been developed.

In the case of digital intangibles, the large majority of early projects for the analysis of the behaviour of platform users, consumers, patients, drivers, bikers, and others, are failing. However, these failed projects often generate valuable platform ideas, insights, and data on how to further develop digital solutions. Therefore, many initiatives that are deemed flops at first may still create great value for follow-up initiatives. As far as another company would pay for the insights and data generated, and would no longer need to make similar research in a defined first step, the results from failed initiatives are in fact economically valuable. As such, they should be valued and remunerated as they would be when transacted between third parties.

In many cases, European multinationals conduct comprehensive research or prototype manufacturing and testing in countries like the US or China. Subsequently, the insights gained (= platforms) may allow the development of tailored solutions in Europe. Effectively, the US and China have created intangible contributions that are transferred to or used in other countries.

Therefore, it is essential to develop adequate criteria for evaluating the extent to which the results from seemingly failed intangible investments should be remunerated, when they will be transferred to other countries. Similar criteria may also be used for accounting rules like IFRS.

How to Value Such Intangibles

1. Cost

Traditionally, the development of early-stage intangibles has been valued at cost. If the results are not protected, third parties could purchase these results based on their own costs saved and on the results from earlier access to market. Therefore, the costs of the initial research is only a first indication of potential value; values related to timing and other markets would also need to be taken into account.

If the results are protected by patents or other protective measures, generally costs are no reasonable indication of the value of research results. However, there are exceptions.

2. Internal Comparable Data

Sometimes, pharmaceutical and automotive companies have joint ventures with other pharmaceutical and automotive groups for research on models, pieces, or active ingredients. As far as the profit potentials are similar, these comparable data can be used for a company's own developed research as well, and the license fees agreed with these competitors can be used for internal transactions.

3. External Comparable Data

To the extent that intangibles are not unique, benchmarks from external comparable data can be used. As far as there is no high or extraordinary profit potential, this may be the case in routine films, books, and standard software. There is a grey area regarding trademarks and brands. However, there is generally no reasonable data from third parties for early developments in, for instance, data analysis of user behaviour or self-driving cars.

4. Profit Split

Here, we have to differentiate between the valuation of the entire intangible and the calculation of the license fee and the valuation of the share of each contributor.

A. Valuation of the Intangible

Following the OECD principles, the valuation of intangibles should usually be based on discounted cash flow approaches. Subtracting normal asset returns on material assets from the company value may give a good indication of the residual, reflecting the combined value of all intangible contributions.

To break down the share of each individual intangible in these future cashflows is more problematic. Often, this is determined by capitalized cost approaches. Expert surveys may support the choice of costs, gestation lags, and amortization. In cases of digital contributions and highly valuable userbases, capitalized costs will usually not work. Case specific data-based industrial economic analysis may provide more reliable results. There is a certain consensus how to calculate the net present value of future cashflows from investments in technologies and in user data by the New Economy; in many cases, such calculations lead to very high values for early investments. These calculations can also be used by car or airplane manufacturers or by retailers for their investments in technologies for analysing user data and user behavior.

B. Calculation of License Fees

The remuneration of non-unique intangibles may be determined by benchmarking standard royalty rates. This may be the case for standard software, books, films, or active ingredients without high profit potential.

License fees for technology and userbases, or for active ingredients or the behavior of drivers etc., should be determined by profit split analysis, which is based on the individual DEMPE contribution to each intangible.. Sometimes the contributions can be measured by capitalized costs of each intangible. This had often been the case in the traditional automotive industry. In general, the investments in the userbase, the analysis of users, or the behaviour of car drivers require more complex valuations, considering the various and very distinct contributions. Good results can be achieved by game theoretical analysis. Practice shows that game theory analytics can be translated into fairly reasonable license fees.

These license fees can be paid in the form of fixed or variable royalties. Variable royalties are very helpful in times of high profits and reduce cash flow problems in times of crisis.

C. Economic Ownership of contributors

The economic ownership of the intangible has to be split between the contributing companies. Research and development may be exercised by contract researchers and developers working for one economic owner. Contract R&D and cost sharing for one legal or economic owner can be reasonable when the entire R&D is led, managed, financed, and controlled by one entity in one jurisdiction. These traditional situations changed in the last few years due to the acquisition of intangible owning companies and start-ups, and because of globalisation and scarcity of talents. As a result, economic ownership is spread over multiple jurisdictions.

Economic ownership in several countries is not only negative. It also leads to many advantages because the ownership or the usage can be transferred across countries. In such case, OECD and DEMPE guidance can be applied, resulting in high profits (helping in crisis) or losses (avoiding discussions on amortization). Companies may transfer the economic ownership or keep it where it is. Insofar as companies have ownership across countries, MNCs can influence their results.

5. Digital intangibles and trademark value

The value of trademarks is closely linked to the value of digital intangibles in many companies. Such trademarks cannot only be licensed but also transferred within the group. When transferring to foreign group entities, the trademarks must be valued at arm's length, often resulting in extraordinary profits. In times of losses, such transfers are disclosing hidden reserves and can have an enormous positive effect on the bottom-line.

In addition, there are possibilities of tax-free transfers of trademarks, (e.g., in Germany, trademarks can be transferred to subsidiaries in the form of limited partnerships). In such cases, the transfer may only lead to deferred taxes, but not to cash taxes.

Planning for Intangibles in the Future

The use of traditional tax planning for intangibles is not dead. Patent boxes and similar structures, contract R&D in high-tax countries for principals in low-tax countries, and cost sharing can still be used, as far as the lead, management, and control is with the principal in the low-tax country. Otherwise, the desired tax effects of certain group structures will not be sustainable.

In addition, as described in this article, intangibles can be transferred from one country to another. The tax effects are not necessarily negative. Some structures may be tax saving and these transfers can lead to significant effects on the bottom-line.