In a previous blog post we reviewed a suggestion published in TaxNotes International to downplay the role of the Comparable Uncontrolled Transaction (CUT or CUP) approach. We also noted that in one of the litigation examples brought to illustrate pervasive issues with the CUT approach, the application of the method was not the primary point of controversy:
While the issues in Medtronic are focused on what represents an arm’s length royalty rate, the other two litigations noted by Finley involve the valuation of a bundle of intangible assets. Both the taxpayer’s experts and the IRS experts used applications of CUT to separately determine the appropriate royalty rates for the Amazon trademark and the internet technology in Amazon.com v. Commissioner. The differences in the valuation estimates turned more on assumptions with respect to economic useful life of these two intangible assets as well as the appropriate discount rates.
The general approach to the valuation of transferred intangible assets by both the representatives of the IRS and the taxpayer were applications of the discounted cash flow (DCF) model. The author, Ryan Finley, noted that while DCF is favored by the IRS in valuing a bundle of intangible assets, it is not a specified method in the US Transfer Pricing Regulations.
Even though the DCF model is not formally recognized as a specified method, courts in the U.S. and other nations have accepted the need to convert annual projected cash flows from the use of an intangible asset to a reliable estimate of the fair market value of the intangible asset. Of course, any DCF approach is only reliable as the underlying assumptions of its application.
A recent case in the Danish National Tax Court involved the Danish distribution affiliate of software company that was converted into a commissionaire during a 2010 restructuring that established a Swiss marketing hub. The Danish tax authority (SKAT) successfully argued that there was a transfer of customer relations and contract rights. The National Tax Court ruled in SKAT’s favor in July 2, 2020 ruling, which noted the general business of the multinational:
Market leader in software solutions that enable customers to plan, develop, manage and secure applications and work environments across smaller computer systems, cloud, mobile and mainframe platforms. This includes areas such as infrastructure management, project and portfolio management, security management, operations management, application management and data center automation and visualization.
The restructuring involved several intercompany transactions, which ultimately lowered the profitability of the Danish affiliate. SKAT approached the intercompany issues in terms of a transfer of intangible assets, which it valued using an application of the DCF model.
While the multinational asserted that no intangible assets were transferred, the court ruled otherwise:
The company has stated that no intangible assets have been transferred in connection with the restructuring. The National Tax Court finds that SKAT has proven during the restructuring and the company’s conversion into a commission agent, valuable intangible assets have been transferred.
While the multinational provided transfer pricing documentation on the various intercompany transactions after the restructuring, it provided no estimate for the value of transferred intangible assets. The court ruling noted that the Swiss marketing hub:
...has thus obtained a payment for making its intangible assets available in the form of brand and software products equivalent to what an independent party would have obtained. It is a direct consequence of this that intangible assets generated by H1 DK's activities on the Danish market belong to the Danish company. It is therefore important for SKAT to establish that H1 DK at the time of the change in the business set up is the owner of accumulated intangible assets in the form of know-how regarding the Danish market and the adaptation / implementation of the Group's products to Danish customers and not least the over many years built customer relationships. And at the same time, it is important to establish that the intangible assets are valuable, which is documented by profit margins around the x% for H1 DK in the years prior to the restructuring.
While the court rejected the multinational's blanket assertion that no intangibles were transferred, much like in Amazon v. Commissioner, the Danish court disagreed with SKAT's assumption of a perpetual useful life for the intangibles.
The valuation of any transferred intangible assets depends on three key factors: the economic useful life of the transferred intangible assets, the expected future cash flows generated by the intangible assets, and the appropriate discount rate.
SKAT approached this issue as the difference between the value of the total business and the value of the business after the conversion to the commission structure. The business after restructuring consisted of a commission function as well as a service function. The commission activity was assumed to receive profits equal to 2.5% of sales, which was significantly less than the profit margin for the overall business. SKAT also assumed the sales would grow by 2% per year and extended the valuation into perpetuity. SKAT used a 10% weighted average cost of capital (WACC) to discount the expected future cash flow. The court noted the objections of the multinational that:
... that SKAT's valuation is aggressive and results in an unrealistically high value. It is emphasized that if cash flow is to be used, this should be limited to reflecting the life of the intangible assets, as also stated above. It is stated that 3-5 years is the maximum time frame … According to Bloomberg, the WACC for the group was 10-11% in 2010 and we therefore do not consider a 10% WACC to be a prudent bid. A prudent bid would be a WACC that was higher than 10-11%, whereby it would be reflected that the risk on intangible assets is generally assumed to be higher than the company's overall risk.
The taxpayer noted that the profitability of the Danish enterprise was volatile. If this volatility represented considerable systematic risk, then a proper analysis may have been able to demonstrate a significant premium for bearing systematic risk.
While SKAT used the 2009 operating profits or earnings before interest and taxes (EBIT) as the initial basis for the cash flows being generated by the overall business, the multinational suggested the following alternative:
A normalized level of EBIT for the purpose of calculating the net present value of H1 DK should - contrary to what SKAT assumes - be a period of more than one year to guarantee a sustainable and realistic level of earnings for the calculations. The average of EBIT realized in 2006-2009 is therefore far more representative of a realistic level used for the calculation of future earnings.
Ultimately, the court accepted neither the infinite useful life proposed by SKAT nor the short useful life proposed by the multinational, pegging the assumed economic useful life at 10 years, but accepted SKAT's cash flow forecasts because of a lack of documentation by the taxpayer:
Against this background, these litigants find that a valuation based on an expected useful life of the assets in question of 10 years is a reasonable estimate based on an assumption about the length of the company's customer relationships in addition to the specific length of the individual contracts entered into...
These litigants note that the company has not provided budget material for the expected future earnings and has not documented that the key figures for the most recent income year before the restructuring contain extraordinary items that make them unsuitable as a starting point for the calculations of the future earnings. These members of the court therefore find that the company's earnings level in the income year 2009/2010 can be used as a basis for the valuation.
Reorganizations often transfer profits from an affiliate in a high tax jurisdictions to a principle affiliate in low tax jurisdictions, such as Switzerland. Part of the transferred profits represent cash flows from intangible assets owned by the affiliate in the high tax jurisdiction. Multinationals would be well advised to provide their own estimate of the value of the transferred intangible assets.
This litigation focused on three key economic issues with respect to using a DCF approach for the evaluation of the value of the transferred intangible assets. While SKAT’s assumption that the cost of capital should be only 10% may have been weakly based, the multinational did not provide a convincing alternative estimate. The multinational also critiqued the SKAT approach to estimating future cash flows but did not provide a convincing alternative forecast.
Both took extreme positions with respect to the economic useful of the transferred intangible assets. Tax authorities often argue for an infinite economic useful life, which multinationals typically argue for very short economic useful lives. This court reasonably asserted an intermediate position on the economic useful life of the transferred intangible assets.
ReferencesPublished on Nov 9, 2020 12:27:57 PM
Harold McClure has over 25 years of transfer pricing and valuation experience. Dr. McClure began his transfer pricing career at the IRS and went on to work at several Big 4 accounting firms before becoming the lead economist in Thomson Reuters’ transfer pricing practice. Dr. McClure received his Ph.D. in economics from Vanderbilt University in 1983.
He can be contacted at: firstname.lastname@example.org
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