RoyaltyStat Blog

Hard-to-Value Intangibles?

Posted by Ednaldo Silva on Jun 26, 2017 7:38:26 PM

Unlike the debutant affection of the OECD, we discourage using projected cash flows for hard to value intangibles (HTVI) calculations because this method is speculative and based on numerous impeachable assumptions.

May 23, 2017, the OECD released BEPS Action 8, implementation guidance on hard-to-value-intangibles (HTVI): https://www.oecd.org/tax/transfer-pricing/BEPS-implementation-guidance-on-hard-to-value-intangibles-discussion-draft.pdf

The HTVI draft provides that “a tax administration is entitled to use, in evaluating the ex-ante pricing arrangements, the ex-post evidence about financial outcomes to inform the determination of the arm’s length pricing arrangements that would have been made between independent enterprises at the time of the transaction (see paragraph 6.192).” One of the contemplated methods to determine related party income tax is discounted projected cash flows.

In several blogs, we have discouraged usage of speculative methods based on discounted forecast of anticipated profits. Instead, we proposed using objective, tractable data from past enterprise investments (CAPX) to measure capital stock, including intangibles. In practice, CAPX measures investment in property, plant & equipment (PPENT), excluding intangibles.  Therefore, we must look for intangible producing investments.

According  to current accounting practices, R&D (XRD) and Advertising (XAD) expenses are deducted and are not accumulated on the tested enterprise’s balance sheet. One testable hypothesis we can use is that although XRD and XAD add to the aggregate capital stock, they do with a different time-lag than PPENT. To start, we use two data inputs to construct the capital stock:

     a) CAPX (B) that may have an immediate effect on the PPENT capital stock, and depreciates; and 

     b) XAD plus XRD (C) that add to the capital stock but with a longer time-lag, and amortizes (not necessarily with the same rate as B stock).

In any audit year, we can combine two separate and distinct investments:

     (1)     It = Bt + Ct

Because of lax disclosure rules (e.g., the SEC in the U.S. does not require XAD disclosure), it may be difficult to separate B and C among comparables. As remedy, we can assume that B/C = w, a constant, and measure it among companies making voluntary disclosure:

               It = Bt + Ct                   

                  = w Ct + Ct

     (2)     It = (1 + w) Ct

As stated, intangibles represent the accumulation of XAD and XRD investments, which can be measured in combined form of "trade" and marketing intangibles, or separately. Therefore, we obtain two related formulae to calculate the separate (tangible, B; and intangibles, C) capital stock based on aggregated investments defined by (1) above:

     (3)     Ct = It / (1 + w) and Bt = w It / (1 + w)

For simplicity (we can always make it more complex later), we assume that tangible investments (CAPX) add to the PPENT capital stock in the current year and depreciates at rate β, and intangible investments (XAD + XRD) add to the capital stock with one-year lag, and amortizes at rate γ. Thus, we create a recursive formula:

     (4)     Kt = Bt + β Bt – 1 + β2 Bt – 2 + …

                   + Ct − 1+ γ Ct – 2 + γ2 Ct – 3 + …

After we substitute (3) into (4), we obtain:

     (5)     Kt = {(w It + (1 + β w) It – 1 + (γ + β2 w) It – 2 …)

                   + (γ2 + β3 w) It – 3 + …)}/(1 + w)

Because of the declining depreciation and amortization rates, we don't need to backtrack to time immemorial. Usually, three to five backward iterations will produce reliable results. We can calculate the tangible-to-intangible ratio (w) by dividing the selected enterprise’s annual CAPX by their annual XAD and XRD sum. As you can see, intangibles are not hard to value if we use our objective investment formula (5) and approach this HTVI problem sans mystère


Ednaldo Silva (Ph.D.) is founder and managing director at RoyaltyStat. He helped draft the US transfer pricing regulations and developed the comparable profits method called TNNM by the OECD. He can be contacted at: esilva@royaltystat.com

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Topics: Valuation of Intangibles