Valuation Issues in the U.S.

This is a high-level summary of issues likely to be relevant to international groups with operations in the U.S. or that are considering transactions in the U.S. The following overview was prepared by VRG member firm VRC.

Valuations in the U.S. are generally required around a transaction and can be grouped by needs for financial reporting, tax or legal purposes. There are also several instances where valuations are required for compliance or regulatory purposes (some on a recurring basis), outside of a current transaction.

Financial Reporting

Fair value is a commonly used term in U.S. GAAP.

When are Valuations for Financial Reporting Required in the U.S.?

Business Combinations/Asset Acquisitions:

• Valuation of Assets and Liabilities. In a business combination or the acquisition of a group of assets the value of the acquired assets and liabilities is required to be re-set to fair value, regardless of transaction structure (i.e., taxable or non-taxable structures). Assets commonly adjusted to fair value include inventory, PP&E, intangible assets. Liabilities commonly adjusted to fair value include deferred revenue, contingent consideration.
• Valuation of Stock Issued as Compensation. As part of a business combination, management is often given stock or options. When the stock or options are part of a complex capital structure (i.e., multiple classes of stock) an analysis must be completed to determine the fair value of the stock or options issued as compensation.

Asset Impairment. Post-acquisition, companies are required to test assets for impairment on an annual or more frequent basis. Recently rules for private companies have been adjusted such that the requirements for public and private companies now diverge.

Valuation of Stock Issued as Compensation. Management is often given stock or options as part of their compensation package. When the stock or options are part of a complex capital structure (i.e., multiple classes of stock) an analysis must be completed to determine the fair value of the stock or options issued as compensation for purposes of determining the appropriate level of expense.

When are Valuations for Tax or Statutory Purposes Needed in the U.S.?

Fair market value is a commonly used term in U.S. tax law.

Valuation of Stock Issued as Compensation (Section 409A). Management is often given stock or options as part of their compensation package. When the stock or options are part of a complex capital structure (i.e. multiple classes of stock) an analysis must be completed to determine the fair market value of the stock or options issued as compensation for employee tax purposes.

Business Combinations Structured as an Asset Acquisition. In a business combination or the acquisition of a group of assets the tax basis of the acquired assets can be re-set to their fair market value in a taxable transaction. Taxable transactions include an asset deal or stock deals structured under IRC Section 338(h)10. Assets commonly adjusted to fair market value include inventory, PP&E and intangible assets. Most intangible assets have a 15-year tax life.

Business Combinations, Valuation of Legal Entities. When acquiring a business with operations in multiple countries it is necessary to value the entities by country in order to determine their tax basis as well as the appropriate level of deferred taxes. There are multiple purposes (see discussion below regarding allocation of interest expense and transfer pricing, among other items).

Allocation of Interest Expense (IRC Section 861). Multinational companies must allocate interest expense to U.S. and foreign source income in accordance with Treasury Regulation §1.861-9T(g), which calls for the allocation of the interest expense based on the source of income generated by the specific asset. While the allocation is generally based on the tax basis of the assets, an election can be made under §1.861-9T(g) to base the allocation on fair market value of the underlying assets. The fair market value election can result in a more favorable interest expense allocation if, for example, there are U.S. assets with low tax bases but high fair market values.

Transfer Pricing, Valuation of Intangibles, Value of Debt. 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.

IRC Section 482 contains specific requirements pertaining to IP transactions. IRC §482-4 outlines methods in connection with the transfer of IP besides cost-sharing arrangements (CSAs). IRC §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, the Comparable Profits Method, and the Profit Split Method.

Fiduciary Duty Options

Fiduciary Duty Options (FDOs) include fairness, solvency, and stated capital (also referred to as capital surplus or capital adequacy) opinions. These are generally not mandated by law or contract but desired to help the boards of directors fulfill fiduciary duties of loyalty and care by acting on an informed basis and also provides liability protection under the Business Judgment Rule.

Other interested parties besides the board of directors include independent committees of the board (buyer and seller), general partners, trustees, banks/senior lenders, other creditors, and governmental agencies. FDO valuations are typically completed on fair value or fair market value standard, although the standard of value is likely defined differently than it is for financial reporting or tax purposes.

• Transactions Using Fairness Opinions. A wide variety from an arms-length, related party and other types of transactions (for example: technical fairness opinions for Trust Indenture Compliance); companies that are in the “zone of insolvency” also should consider obtaining a fairness opinion for material transactions such as the sale of substantial assets, forbearance agreements, new debt financings, affiliate transactions, and winding down operations.
• Transactions Using Solvency Opinions. A solvency opinion is a document stating the borrower is, and will remain, solvent, under the burden of additional debt and is usually provided to protect the security position of senior lenders and to protect the selling shareholders, the board of directors, and transaction advisors from having the transaction unwound in a future bankruptcy. Solvency tests involve demonstrating that assets exceed liabilities (balance sheet test), ability to pay debts (cash flow test), and adequacy of capital (capital adequacy test).
• Transactions Using Capital Surplus Opinions. Boards of directors obtain a capital surplus opinion in combination with a transaction involving a dividend distribution. In addition to being prohibited from touching capital cushion, boards of directors may only declare a dividend after complying with the Legal Capital Rule. In Delaware, boards of directors may declare and pay out a dividend to stockholders out of surplus or when there is net profit for this fiscal year or the preceding year (DGCL §170(a)). Surplus is equal to Total Assets minus Total Liabilities minus Capital. If there is a positive surplus amount, Directors can pay out aggregate dividends up to that amount. In New York, Directors have an additional hurdle to jump before declaring a dividend payment. The company must pass the Insolvency Test before considering a dividend payment. This means that the company cannot be insolvent or rendered insolvent as a result of the payment (NYBCL §510).

To learn more about how VRG and VRC can work with your company, we welcome you to visit us online or contact PJ Patel at PPatel@ValuationResearch.com or Dan Peterson at DRPeterson@ValuationResearch.com.

For more information about VRG’s full scope of international valuation and value-related services, contact Bill Hughes.