While the arm’s length principle is the fundamental concept governing the valuation of intellectual property (IP) for Transfer Pricing purposes, a number of additional aspects need to be considered in order to limit the potential risk of challenges by tax authorities and double taxation.
As oil and gas companies dominated the list of the world’s most valuable companies only a decade ago, technological innovations in recent years led to IP-heavy companies with predominantly digital business models leading the valuation tables. In light of this, questions around the valuation of IP become more frequent and more important.
Intellectual Property (IP)
IP is defined as intangible assets that are non-physical in nature, the value of which can be derived from their potential to generate revenue and, due to their nature, can be legally protected. The most common types of IP are patents, trademarks, copyrights and trade secrets. Each of them qualifies for legal protection, which means that these assets can only be exploited through parties who own the respective IP rights or have these rights assigned to them (e.g. through franchising or licensing agreements).
Rationales for evaluating IP
The valuation of IP is necessary when transferring IP or rights thereto, for determining the terms and conditions of licensing arrangements, for evaluating IP heavy businesses or for litigating infringement cases.
OECD guidance on IP valuation
Even though the valuation of IP is an important and frequent topic in practice, the 2017 OECD Transfer Pricing Guidelines offer rather limited guidance on IP valuation and remain somewhat vague on the topic. The general guidance provided in the Guideline is summarized below:
- Be cautious with the use of valuations performed for accounting: Valuations performed for accounting purposes, e.g. PPAs, should be considered with caution due to their “inherent conservatism” that may impair their arm’s length nature;
- Don’t use cost-based methods: Cost-based valuation methods should be used in limited cases only (for example, for non-unique internally developed software), as “there rarely is any correlation between the cost of developing intangibles and their value or transfer price once developed”. It is therefore suggested to use discounted cash flow methods;
- Consider both, the value to the buyer and to the seller: It is assumed that unrelated parties would only engage in a transaction which yields a positive return, and they would use valuation techniques to determine their minimum price (seller) and maximum price (buyer) and use these values as starting point for their negotiations. The arm’s length transfer price should therefore lie somewhere in-between these two values;
- Don’t forget taxes: In applying the selected valuation method, it’s important to consider taxes when i) determining the correct cash flows after taxes, ii) considering the tax amortization benefit (for the buyer), if any, and iii) considering the tax impact on a potential sale (on the seller), if any.
- Be sure to document: As income-based valuation approaches exhibit great sensitivity to input parameters, it is important to document the determination of each input parameter.
Challenges in practice
In practice, challenges in evaluating IP mainly arise from two sources.
Firstly, in many cases the planning of IP-related income and cost streams is rather difficult. Depending on the development stage and nature of the IP, significant uncertainty with regards to the remaining useful life of the IP, to-be-expected income streams as well as the risk posed by competing companies or technologies may make business planning particularly tough. This group of intangibles is referred to as “hard-to-value intangibles” (HTVI) by the OECD, which acknowledges the issues with regards to the creation of accurate financial projections in these cases that may lead to different ex-ante and ex-post valuation outcomes. In order to mitigate the risks arising from such uncertainties, the OECD suggests that the taxpayer either:
- Document the relevant projections, including the consideration of reasonably foreseeable events in its ex-ante pricing arrangements, and demonstrate that any significant deviation from such ex-ante projections in actual (ex-post) outcomes results from not foreseeable events;
- Enter into a bilateral or multilateral APA between the country of the transferor and transferee to cover the transaction;
- Demonstrate that the ex-post results would not change the ex-ante pricing/compensation by more than 20%; or
- Demonstrate that revenues generated with by the IP within the first five years under ownership of the transferee do not deviate more than 20% from ex-ante projections.
In addition, price adjustment clauses may be introduced as a way to ensure that the compensation determined ex ante is in alignment with the ex-post materialization of results.
Secondly, in many countries, local laws and regulations, or even worse, common practice of tax authorities may include specific requirements with regards to the valuation of IP, which may not only challenge the arm’s length nature of a valuation but may also lead to situations of valuation mismatches between two countries, and, thus lead to double taxation. Such requirements or practices may be tied to the following valuation aspects:
- The determination of the remaining useful life and/or consideration of a terminal value;
- Assumptions related to the hypothetical negotiation outcome between unrelated third parties, i.e. the determination of the transaction value between the minimum selling price and the maximum purchase price;
- Considerations regarding the cost of capital; or
- Considerations regarding tax aspects, i.e. consideration and determination of the tax amortization benefit (incl. amortization period) and the tax impact on the seller.
How to face the challenge
The fair valuation of IP requires a broad skillset, ranging from the technology and market know-how needed for business planning, the technical performance of the valuation as well as the tax law and common practices in the countries involved. The early involvement of tax and valuation experts ensures the avoidance of any blind spots and limits the risk of tax assessments and potential double taxation down the road. In addition, significant transactions can be secured in a bilateral or multilateral APA, which provides additional certainty on the tax treatment of a transfer of IP.