Recent high profile court cases, including Xilnix and Veritas, have resulted in scrutiny of valuation methodologies used in transfer pricing situations. The IRS and the Organization for Economic Cooperation and Development (OECD) have recently revised their guidelines to address concerns, particularly with respect to intellectual property (IP) valuations in a transfer pricing context. In this article, we provide an overview of transfer pricing and recent guidance concerning the valuation of IP for transfer pricing purposes.
Transfer Pricing Basics
Transfer pricing refers to the prices charged for goods, services, and intellectual property (IP) between and among related parties. These may include royalties, management fees, intercompany interests, and reimbursements. Prices must follow the arm’s length standard, i.e. related parties must act as if they are unrelated parties acting in their own interests. The arm’s length standard is defined in Internal Revenue Code (IRC) Section 482 Allocation of Income and Deductions Among Taxpayers, Organization for Economic Cooperation and Development (OECD) guidelines and various foreign rules/guidelines. Jurisdictions that have not adopted their own transfer pricing rules may follow OECD guidelines when preparing a non-U.S. transfer pricing study.
Under U.S. transfer pricing rules, companies must follow the “best method” principle. Companies must choose the method which provides the most reliable measure of arm’s length. Determining the best method relies upon producing data on the results of transactions between unrelated parties.
Comparability is the key factor in determining the arm’s length range. Whether a controlled transaction produces an arm’s length result is generally evaluated by comparing its results to comparable uncontrolled transactions. Related party or transfer prices should be within an acceptable range, referred to as the “interquartile” range. The range allows for differences between related party and unrelated party transactions. Typically if the results of the related party transactions fall between the 25th and 75th percentile of the results of the uncontrolled analysis, the results are deemed to be within the arm’s length range.
IRC Sec. 6662 requires that companies maintain contemporaneous documentation, meaning the company must file documentation at the same time that it files its tax return. The documentation must include the economic analysis to support the transfer prices, in addition to other requirements. Failure to provide the necessary documentation can result in significant penalties.
Requirements for IP Transactions
IRC Sec. 482 contains specific requirements pertaining to IP transactions. IRC Sec. 482-4 outlines methods in connection with the transfer of IP besides cost-sharing arrangements (CSAs). IRC Sec. 482-7 outlines methods in connection with IP transactions in the context of CSAs. A CSA is a contractual agreement between companies in the same multinational group which allows the companies to share the costs and risks of developing, producing, or obtaining assets. Recently, both sets of regulations were revised amid controversy surrounding the application of methods used in high profile court cases. As a result of U.S. companies abusing cost-sharing regimes, cost-sharing participants are no longer able to contribute cash to a CSA. In addition, the new cost-sharing regulations stipulate that companies are allowed to use the income method to value IP. Previous requirements called for use of a valuation approach but didn’t identify a specific approach. Other common methods for valuing IP include the Comparable Uncontrolled Transaction Method (“CUT”), Comparable Profits Method (“CPM”), and the Profit Split Method.
Allocation of Purchase Price “Starting Point”
The IRS has referenced in recently published papers the distinction between valuations for financial reporting purposes and valuations for transfer pricing purposes, specifically stating that valuations for allocation of purchase price should only be used as a “starting point” for transfer pricing purposes. The following are other key considerations with respect to valuations for transfer pricing purposes:
Differences in definitions of IP and goodwill. The IRS has the perspective that some of goodwill should be included as part of intangibles. If U.S.-based IP is going to be transferred out of the United States, the IRS wants to ensure that the value placed on that IP is as high as possible.
Discount rates. The IRS states that discount rates associated with certain IP transactions should be higher than the overall discount rate from the weighted average cost of capital (WACC).
Technology. The IRS views technology, such as software, as something that never fully amortizes. Thus, the income stream would go out further, impacting the valuation.
OECD Discussion Draft
In 2012, the OECD issued a discussion draft containing a proposed “Revision of the Special Considerations for Intangibles in Chapter VI of the OECD Transfer Guidelines and Related Provisions.” The Draft contains guidelines for identifying intangibles, determining arm’s length prices for transactions involving intangibles, and valuation methods, among other topics.
The OECD specifically states in its draft paper that, “valuations of intangibles contained in purchase price allocations performed for accounting purposes are not relevant for transfer pricing purposes.” The OECD adds that “it is essential to consider the purpose for which a valuation is conducted. Valuations conducted for business planning purposes may be either more or less relevant than valuations conducted purely for tax purposes, depending on the circumstances.”
In light of recent guidance from the IRS and OECD, companies should be mindful of the valuation methodology used in transfer pricing situations. At VRC, our professionals understand the intricacies of transfer pricing engagements and have extensive experience providing valuation support for these types of engagements.