Valuation of intangibles for financial and tax purposes … or EPS vs. the IRS - earnings per share

Tax Executive, The,  May-June, 2003  by Brian Andreoli,  Ed Dembitz

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In applying the U.S. transfer pricing regulations to the support the arm's-length royalty, valuation experts must assess whether there are any comparable licenses to unrelated parties or else they must use one of the comparable profits methods (CPM). One of the commonly used methods to determine the appropriate arm's-length license is the discounted cash flow method, which is also the preferred method for valuing intangible assets for financial accounting purposes. If the company wishes to defend a high royalty rate against attack by the tax authorities, it must find a high value in the underlying (non-goodwill) intangible.

The Challenge

Clearly there is no easy solution. One can only speculate whether senior management will be more interested in presenting higher earnings in the public financials or in avoiding a large tax assessment three years or so in the future. The more important issue is that the financial and tax valuations, if they are not identical, be reconcilable. Even if both employ a discounted cash flow technique, there will be differences.

The purpose of the tax allocation is to simply determine the fair market value (FMV) of the intangible asset. This is only an intermediate step in the financial valuation. In the case of purchase accounting, the valuation group must allocate a finite amount, the purchase price, to the assets. Stated differently, the amount allocable to all intangibles is the purchase price, less the amounts allocable to cash, cash equivalents, inventory, and other tangible assets. Any remaining balance of the amount paid must be allocated to all intangible assets on the basis of their underlying fair market values. The purchase price allocable to any individual asset may be at or below its FMV, depending on whether the purchase price was above or below the fair market value of the target. Any value remaining after allocating the purchase price to the FMV of the assets goes to goodwill. Thus, the value of any asset may be less but not more than its FMV.

Typical Fact Pattern

Assume the following fact pattern. Foreign parent with a U.S. subsidiary purchases a major U.S. operating company. The final purchase agreement has the foreign parent purchasing target's intangibles, such as trademarks and patents, leaving the U.S. subsidiary to operate a distributor/contract manufacturer. The U.S. subsidiary will have to license the trademarks and patents from its foreign parent to operate the target's business.

A value is assigned to target's plants and inventory, which increases the U.S. tax deductions and decreases the U.S. tax payable. Foreign parent places a high value on intangible goodwill and a low-value on the non-goodwill intangibles bought by foreign parent. This allows the acquiring company to keep the bulk of the value in goodwill, thereby maximizing post-acquisition earnings. Future royalties based on the transferred patents, however, will be measured against the low value assigned by the financial accountants.