International Transfer Pricing


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International Transfer Pricing

  1. 1. INTERNATIONAL TRANSFER PRICING: WHAT EVERY BUSINESSPERSON SHOULD KNOW presented by The Financial Valuation Group Valuation Issues in Transfer Pricing Jim Rigby The Financial Valuation Group 213-362-9991
  2. 2. Economic Phenomena That Result in an Intangible Asset <ul><li>It must be subject to specific identification and recognizable description. </li></ul><ul><li>It must be subject to legal existence and protection. </li></ul><ul><li>It must be subject to the right of private ownership, and this private ownership must be legally transferable. </li></ul><ul><li>There must be some tangible evidence or manifestation of the existence of the intangible asset (e.g., a contract or a license or a registration document). </li></ul>
  3. 3. Economic Phenomena That Result in an Intangible Asset <ul><li>It must have been created or have come into existence at an identifiable time or as the result of an identifiable event. </li></ul><ul><li>It must have been created or have come into existence at an identifiable time or as the result of an identifiable event. </li></ul><ul><li>It must be subject to being destroyed or to a termination of existence at an identifiable time or as the result of an identifiable event. </li></ul>
  4. 4. Economic Phenomena That Do Not Result in an Intangible Asset <ul><li>Market share </li></ul><ul><li>High profitability </li></ul><ul><li>Lack of regulation (or a regulated environment) </li></ul><ul><li>Monopoly position </li></ul><ul><li>Market potential </li></ul>
  5. 5. Economic Phenomena That Indicate Value in an Intangible Asset <ul><li>It must generate some measurable amount of economic benefit to its owner; this economic benefit could be in the form of an income increment or of a cost decrement. </li></ul><ul><li>This economic benefit may be measured in any of several ways, including net income or net operating income or net cash flow, etc. </li></ul><ul><li>It must enhance the value of other assets with which it is associated; the other assets may include tangible personal property and tangible real estate. </li></ul>
  6. 6. Common Categories of Intangible Assets <ul><li>Technology-related (e.g., engineering drawings). </li></ul><ul><li>Customer-related (e.g., customer lists). </li></ul><ul><li>Contract-related (e.g., favorable supplier contracts). </li></ul><ul><li>Data processing-related (e.g., computer software). </li></ul><ul><li>Human capital-related (e.g., a trained and assembled work force). </li></ul><ul><li>Marketing-related (e.g., trademarks and trade names). </li></ul><ul><li>Location-related (e.g., leasehold interests). </li></ul><ul><li>Goodwill-related (e.g., going-concern value). </li></ul><ul><li>Creative (e.g., copyrights). </li></ul><ul><li>Innovative (e.g., patents). </li></ul><ul><li>Creative and Innovative Assets are also known as “Intellectual Property” </li></ul>
  7. 7. Transfer Pricing Transactions <ul><li>Types of Transactions : </li></ul><ul><li>Licensing the Intangible Asset (Temporary) </li></ul><ul><li>Royalties (most common) </li></ul><ul><li>Lump sum price </li></ul><ul><li>Predetermined payments </li></ul><ul><li>Combination of the above </li></ul><ul><li>Selling the Intangible Asset </li></ul>
  8. 8. Transfer Pricing Transactions <ul><li>Information Needed: </li></ul><ul><li>Licensing the Intangible Asset </li></ul><ul><ul><li>Appropriate royalty rate (market study) </li></ul></ul><ul><ul><li>Value of the License Agreement (Appraisal) </li></ul></ul><ul><li>Selling the Asset </li></ul><ul><ul><li>Value of the Intangible Asset (Appraisal) </li></ul></ul>
  9. 9. Transfer Pricing and the IRS <ul><li>The Internal Revenue Service places the greatest emphasis on the use of market data . </li></ul><ul><li>Therefore, the company has the responsibility to ensure that appropriate market analysis has been performed by the appraisers/consultants. </li></ul>
  10. 10. Royalties and Intangible Assets <ul><li>The process of licensing or valuing intellectual properties is dependant upon determining the appropriate royalty rate(s) that is used for similar transactions in the market place. </li></ul><ul><li>Only a thorough investigation of similar transactions and a proper understanding of the subject of intellectual property will lead to an appropriate royalty rate conclusion. </li></ul>
  11. 11. Royalties can be computed on: <ul><li>Average selling price differential </li></ul><ul><li>Net revenue </li></ul><ul><li>Gross cash flow (net income with an add-back for depreciation) </li></ul><ul><li>Net cash flow (net income plus depreciation, minus capital expenditures, minus working capital addition) </li></ul><ul><li>Operating income </li></ul><ul><li>Net income </li></ul><ul><li>Gross sales </li></ul>
  12. 12. Guideline License Agreements <ul><li>Factors in selecting the sample of guideline license agreements: </li></ul><ul><li>An assessment of whether the agreements under consideration as guidelines are in fact, independent party, arm’s-length agreements </li></ul><ul><li>An assessment of whether the agreements are directly comparable to the subject intangible asset or whether they are useful only as guideline transactions to give the analyst guidance with respect to the appropriate royalty rate </li></ul><ul><li>The degree of comparability of the subject to the guideline intangible assets </li></ul>
  13. 13. Guideline License Agreements <ul><li>The industry in which the subject intangible asset is used </li></ul><ul><li>The age of the intangible asset </li></ul><ul><li>The degree of consumer or other market recognition </li></ul><ul><li>The geographical coverage of the agreement </li></ul><ul><li>The remaining legal protection </li></ul><ul><li>The remaining term of the license agreement </li></ul><ul><li>The functionality and/or utility of the subject intangible asset - in comparison to the guideline intangibles </li></ul>
  14. 14. Potential Adjustments to the Guideline Royalty Rate <ul><li>Differences between the subject intangible asset and the guideline intangible assets including: </li></ul><ul><ul><li>Location of use of the various intangibles </li></ul></ul><ul><ul><li>Term of the various agreements </li></ul></ul><ul><ul><li>Functionality of the various intangibles </li></ul></ul><ul><ul><li>Economics of the various intangibles </li></ul></ul><ul><li>Conversion to a common-size royalty rate basis, if the guideline license agreements encompass various royalty formulas. </li></ul>
  15. 15. Technology Factor Definition of: Technology Factor is a measure of the extent to which the incremental cash flow derived from the practice of technology is based on the technology asset itself. It is a systematic methodology to allocate the cash flow between the value of the technology and the value of the company’s other tangible and intangible assets. The Technology Factor analysis can also be used to analyze the subject technology as part of selecting the appropriate guideline licensing agreements.
  16. 16. Technology Factor Analysis Team Competitive R&D and its impact on the obsolescence of the technology being evaluated R&D Defines the exact boundaries of the protected intellectual property Attorney Strategic fit of technology with long-term business plan Business Management Leads the team and facilitates the generation of the technology factor Appraiser Contribution Team Members
  17. 17. Technology Factor Analysis Team Performs market research (royalty rates and cost of capital), analyzes results of the team’s work, and then consolidates all of the known data into the appropriate methodologies to arrive at the technology’s value Appraiser Economic impact (profit/loss of market share or price). Calculates the incremental cash flow and NpV of the products relevant to the technology Business Analyst Product attributes, market application and competitive response Marketing/TS&D Scale-up hurdles and competitive manufacturing processes Technology Center Contribution Team Members
  18. 18. Technology Factor Affect of Technology: Percent 0 30 50 100 75 COST (Savings) PRICE (Premium) VOLUME (Increased Market Share) HIGH (Exceptional) MEDIUM (Above Average) LOW (Average) IMPACT
  19. 19. Technology Factor <ul><li>Issue </li></ul><ul><li>Competitive Advantage </li></ul><ul><li>Differentiation </li></ul><ul><li>Alternative Tech </li></ul><ul><ul><li>In kind </li></ul></ul><ul><ul><li>Not in kind </li></ul></ul><ul><li>Legal Strength </li></ul><ul><ul><li>Defensibility </li></ul></ul><ul><ul><li>Scope of claims </li></ul></ul><ul><ul><li>Detection of Infringement </li></ul></ul><ul><li>Useful life of patent </li></ul><ul><li>Anticipated competitive response </li></ul><ul><li>Teaching value of patent </li></ul><ul><li>Right to use the technology </li></ul><ul><li>(Dow/others) </li></ul>Intellectual Asset Valuation Competitive Advantage Issues + 0 - Effect on Value Creation
  20. 20. Technology Factor <ul><li>Issue </li></ul><ul><li>Utility </li></ul><ul><li>Usefulness to Company </li></ul><ul><li>Usefulness to others </li></ul><ul><li>- # of potential licenses </li></ul><ul><li>Capital required for implementation of tech </li></ul><ul><ul><li>Company </li></ul></ul><ul><ul><li>Others </li></ul></ul><ul><li>Time required for </li></ul><ul><li>implementation of tech </li></ul><ul><li>Useful life of technology </li></ul><ul><li>Other (Meets EPA Reg.) </li></ul>Intellectual Asset Valuation Utility Issues + 0 - Effect on Value Creation
  21. 21. Valuation Approach Market The market approach develops a value indication based on the premise of comparable market transactions or market license/royalty agreements of intellectual property or intangible assets. In most instances, intellectual property is usually part of a transaction of an entire entity, and at times, is also acquired or sold as a sole asset. When intellectual property transactions do occur, however, the terms and conditions of a transaction are usually not divulged to the public.
  22. 22. Valuation Approach Market Thus, the market approach, which is dependent on market data, is often difficult to apply due to lack of information. Further, even when information is actually available on transactions, establishing comparability is often very difficult due to the fact that the assets are unique, which accounts for the protection as intellectual property in the first place.
  23. 23. Valuation Approach Income The income approach develops an indicated value based on the future stream of earnings or cash flow associated with either ownership or exploitation of the intellectual property. “When accurate economic information is available, the income approach is the most reliable approach to valuing an intangible. When valuing an intangible asset, however, it is important to isolate income associated with that particular asset and not include income attributable to other, related intangible or tangible assets.” (Financial Valuation: Businesses and Business Interests, 1996 Update James H. Skin, p. 13B.3[3])
  24. 24. Valuation Approach Cost The cost approach develops an indicated value based on the principle of substitution. The market value indication arrived at under this approach is based upon the cost to either reproduce or replace the asset. Adjustments are made to the reproduction or replacement cost of the asset for physical depreciation or functional obsolescence where appropriate. The cost approach, while an effective approach, for such assets as real estate and machinery and equipment, may be the least desirable for intellectual property and intangible assets.
  25. 25. Valuation Approach Cost The cost approach does not directly consider the amount of economic benefits that can be achieved nor the time period over which they might continue. It is an inherent assumption with this approach that economic benefits indeed exist and are of sufficient amount and duration to justify the development expenditures. (Valuation of Intellectual Property and Intangible Assets, Gordon V. Smith and Russell L. Parr, p. 223)
  26. 26. Preferred Valuation Methods Market Income Cost Assembled work force Cost Market Income Copyrights Cost Market Income Trademarks and brands Cost Market Income Patents and technology Weak Secondary Primary Asset
  27. 27. Preferred Valuation Methods Cost Market Income Core deposits Market Income Cost Distribution networks Cost Market Income Computer software Income Market Cost Management information software Weak Secondary Primary Asset
  28. 28. Preferred Valuation Methods Market Income Cost Engineering drawing Market Income Cost Corporate practices and procedures Cost Market Income Franchise rights Weak Secondary Primary Asset
  29. 29. Valuation Approaches - Methods <ul><li>Market Approach Methods </li></ul><ul><ul><li>Market Transaction Method </li></ul></ul><ul><ul><li>Market License/Royalty Method </li></ul></ul>
  30. 30. Valuation Approaches - Methods <ul><li>Income Approach Methods </li></ul><ul><ul><li>Yield Capitalization Method </li></ul></ul><ul><ul><li>Direct Capitalization Method </li></ul></ul><ul><ul><li>Relief from Royalty Method </li></ul></ul><ul><ul><li>Profit Split Method </li></ul></ul><ul><ul><li>Capitalized Excess Earnings Method </li></ul></ul><ul><ul><li>Residual from Business Enterprise Method </li></ul></ul><ul><ul><li>Residual from Purchase Price Method </li></ul></ul><ul><ul><li>Postulated Loss of Income Method </li></ul></ul>
  31. 31. Valuation Approaches - Methods <ul><li>Cost Approach Methods </li></ul><ul><ul><li>Replacement Cost New </li></ul></ul><ul><ul><li>Reproduction Cost </li></ul></ul><ul><ul><li>Replacement Cost </li></ul></ul><ul><ul><li>Depreciated Replacement Cost Formula </li></ul></ul>
  32. 32. Factors in Selecting the Appropriate Discount and Capitalization Rates <ul><li>The relationship between risk and expected return for the subject intangible asset. </li></ul><ul><li>The cost of debt capital for the company using the subject intangible asset. </li></ul><ul><li>The cost of equity capital for the company using the subject intangible asset. </li></ul><ul><li>The weighted average cost of capital for the company using the subject intangible asset. </li></ul>
  33. 33. Factors in Selecting the Appropriate Discount and Capitalization Rates <ul><li>A market-derived capitalization rate, based on consummated intangible asset sale transactions. </li></ul><ul><li>A built-up rate, based on a risk-free rate plus a risk premium appropriate to the subject intangible asset. </li></ul><ul><li>A before tax or after-tax discount rate. </li></ul><ul><li>An estimation of the appropriate long-term growth rate in the projected economic income. </li></ul>
  34. 34. Common Errors in Forecasting Income/Royalties <ul><li>Overstating the size of the potential market </li></ul><ul><li>Incorrectly estimating the product’s market share </li></ul><ul><li>Royalty rate inconsistent with profit margins </li></ul><ul><li>Using inaccurate remaining life (economic or legal) </li></ul>
  35. 35. Relief from Royalties Method Single Period Economic Variables Projection Next year revenues associated with the use of the subject intangible asset $600,000 Projected long-term growth rate in royalties 3% Market-derived royalty rate 5% Company’s cost of capital 13% Expected remaining useful life of the subject Trademark Perpetuity
  36. 36. Relief from Royalties Method Relief from Royalty Method A Trademark Valuation Economic Variables Projection Revenues related to intangible asset $600,000 Times: Market-derived royalty rate 5% Equals: Projected royalty income 30,000 Divided by: Capitalization rate (i.e., 13% rate - 3% rate) 10% Equals: Indicated value of the trademark $300,000
  37. 37. Checklist of Items Needed for Analysis <ul><li>Consolidated and product line financial statements </li></ul><ul><ul><ul><li>Income statement </li></ul></ul></ul><ul><ul><ul><li>Balance sheets </li></ul></ul></ul><ul><ul><ul><li>Cash flow statements </li></ul></ul></ul><ul><ul><ul><li>Accounting notes </li></ul></ul></ul><ul><ul><ul><li>Securities & Exchange Commission Form 10K </li></ul></ul></ul>
  38. 38. Checklist of Items Needed for Analysis <ul><li>Unit sales of the products associated with the subject intellectual property or intangible asset. </li></ul><ul><li>Customer lists </li></ul><ul><li>Product price lists </li></ul><ul><li>Standard cost accounting information including variances </li></ul><ul><li>Extraordinary business events and non-operating assets </li></ul>
  39. 39. Checklist of Items Needed for Analysis <ul><li>Business plans and forecasts, along with internal planning memorandums </li></ul><ul><li>Feasibility studies </li></ul><ul><li>Investment return analysis </li></ul><ul><li>Research and development budgets </li></ul><ul><li>Product brochures </li></ul>
  40. 40. Checklist of Items Needed for Analysis <ul><li>License agreements </li></ul><ul><ul><li>Internal </li></ul></ul><ul><ul><li>Related parties </li></ul></ul><ul><ul><li>Unrelated parties </li></ul></ul><ul><li>Identification of competitors and their market shares </li></ul><ul><li>General economic conditions </li></ul><ul><li>Industry conditions </li></ul>
  41. 41. Checklist of Items Needed for Analysis <ul><li>Brokerage investment analysis reports </li></ul><ul><li>Economic remaining life data </li></ul><ul><li>Prospectuses </li></ul><ul><li>Trade association data </li></ul><ul><li>Company public relations information </li></ul><ul><li>Complementary intangible assets </li></ul>