RoyaltyStat Blog

Valuation of Intangibles - Future Benefits May Not Be Realized

Posted by Ednaldo Silva on Feb 29, 2016 4:52:49 PM

The present value (“PV”) of intangibles based on projected (unrealized) royalties is speculative. As such, the PV of intangibles determined for tax purpose is mostly advocated by naïve analysts, policy-makers, and tax administrators. It's well-known that the PV of any income-earning asset, including intangibles, can be computed by using a weighted sum formula: 

                        Kt = SUM[αt + 1 φ St + 1

where α is a discount factor and (regarding intangibles) φ is a comparable royalty rate obtained from RoyaltyStat. For tangible assets, φ can be a comparable profit margin.

However, it's seldom discussed that the stream of future, forecasted, or unrealized net sales (revenue, turnover) per period expected from the licensed intangibles, S(t + 1), is tricky to obtain. Moreover, as the lifespan of the income-earning asset is expected beyond two or three years, say T = five, seven, ten or more years, the forecasting error band widens like a megaphone (showing unequal variance), making S(t + 1) very unreliable. Among others, see Henri Theil, Applied Economic Forecasting (North-Holland, 1966), pp. 7, 19-22, 26-29.

The U.S. Tax Court case Veritas Software Corp. vs. Commissioner, 133 T.C. No. 14 (2009), shows that using PV to determine tax liability associated with the intercompany transfer of intangibles is perilous. In this regard, we note legislative skepticism using “future benefits” over the “separate-and-distinct” standard to value intangibles.  E.g., the preamble to the U.S. Treas. Reg. § 1.263(a)-4(b) states: “A ‘significant future benefit’ standard, however, does not provide the certainty and clarity necessary for compliance with, and sound administration of, the law.”  Notice of Proposed Rulemaking, 67 Fed. Reg. 77,702 (2002).

As a remedy to such needless uncertainty, consider using the perpetual inventory method (“PIM”) because it's more reliable than PV to determine the value of intangibles, especially regarding not yet commercialized intangibles that are devoid of customer list and goodwill. Policy-makers at the OECD recommend using PIM, without making reference to PV as a viable alternative. Also academic research about determining the value of "capital stock," such as the value of intangibles, prevail using PIM instead of PV. See “Measuring Intellectual Property Assets” in OECD, Handbook on Deriving Capital Measures of Intellectual Property Products, OECD, 2009. See also the compendium edited by Dan Usher, The Measurement of Capital (University of Chicago Press, 1980). The OECD Handbook can be retrieved at: http://dx.doi.org/10.1787/9789264079205-3-en

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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