Transfer pricing and valuation intersect in many ways, from valuing intangible assets for transfer pricing planning to determining what a legal entity is worth during corporate restructuring. A lack of coordination between your approaches to transfer pricing and valuation can have significant tax repercussions, including audits, penalties, and even litigation.
In this article, we’ll analyze the intersection of transfer pricing and valuation and the challenges that arise as a result; we’ll also share some key tips to minimize risk and ensure compliance.
Standards Of Value & Types Of Valuations
Transfer pricing, the setting of fair prices for intercompany transactions, and valuation, the practice of estimating something’s worth, have a close relationship. To understand that relationship it’s important to be familiar with the basics of each. We’ve written about transfer pricing before on our blog; here we’ll share some background information on valuation.
Valuation: The Basics
When analyzing the current value or worth of an asset or company, there are three different standards of value used:
- Fair market value (FMV) is the price of property in a sale between a willing buyer and seller, with neither under any obligation and both aware of all relevant facts.
- Fair value is the price of business assets or liabilities, often in the event of a shareholder dispute, with certain adjustments made in the interest of being fair to both parties.
- Arm’s length value is an intercompany transaction price consistent with unrelated companies engaging in similar transactions under the same circumstances.
There are also three different types of valuations:
- Accounting Valuations—Also called purchase price allocations (PPA), are used to determine the value of a company that’s being acquired, based on its post-tax cash flows. PPAs look to determine the total value of assets based on FMV, without regard for which specific legal entities within the larger company own the property. For example, they value intellectual property (IP) based on what actual technology or trademark exists on the transaction date, without necessarily considering future IP value.
- Legal Entity Valuations—These are used to determine the value of a specific legal entity within a multinational enterprise based on FMV. This type of valuation is often required following internal restructurings or external transactions that result in transfer of entity ownership within a company. This is accomplished by reviewing an entity’s economic activities—functions performed, risks assumed, and assets in operation—and forecasting the historical and projected earnings of that entity, based on relative contribution.
- Transfer Pricing Valuations—These valuations are used to determine the value of intangible property, typically occurring when the rights to intangible assets are being sold or shifted to related entities within a larger corporation. Transfer pricing valuations take into consideration which specific legal entity owns an intangible asset. Rather than focusing on FMV, transfer pricing valuations use the arm’s length price as a standard, which considers not only the current value of intellectual property, but also how current IP contributes to the value of future IP.
Transfer Pricing & Valuation: Relationship Challenges
Multinational companies face a myriad of transfer pricing and valuation challenges—particularly when the two aren’t carefully coordinated to minimize potential risks. Those challenges include:
- Lack of coordination between purchase price allocations and transfer pricing valuations can be very problematic—particularly if intangible asset values determined in a PPA are used for transfer pricing purposes. Generally speaking, a PPA valuation of intangibles will be understated relative to other valuations, as it is done on a post-tax basis and generally does not take future IP value into consideration. Tax authorities have specified that PPAs may provide a useful starting point, but are not necessarily truly reflective of arm’s length pricing.
- Unreliable profit forecasting that doesn’t take future transfer pricing policies into consideration can have serious tax consequences. Companies often fail to realize how much changing transfer pricing policies impact forecasts for the business, which can result in unreliable financial projections and inaccurate valuations.
- Increasing review by tax authorities is causing many companies to take a second look at the way they navigate the intersection of transfer pricing and valuation. With restructuring on the rise, tax authorities are finding that companies aren’t managing them correctly from a tax perspective—and they’re even deploying transfer pricing experts to scrupulously examine valuations for inconsistencies.
4 Tips For Coordinating Transfer Pricing & Valuation
1. Consider the differences in enterprise value and FMV.
The differences between an entity’s business value and fair market value of equity can be material and should be given careful consideration early on in the planning stages of corporate restructuring. Proactively review intercompany financing positions, indirect investments in other subsidiaries, and the legal organizational structure during times of restructuring to minimize your company’s financial risk.
2. Be aware of existing valuations.
The ability to proactively reconcile key inputs and assumptions across valuations is critically important—and not doing so can jeopardize tax positions. Existing valuations, assuming that the forecast data and other factors are relevant, can also help you simplify the data gathering process if used in multiple contexts.
3. Carefully review all profit forecasts.
Review all forecasts and understand their purpose. Is it for business planning, deal modeling, an investor pitch, or something else entirely? Be prepared to explain to tax authorities why different forecasts are used for different purposes. The accuracy of valuations is highly dependent on whether forecasts used for valuations are consistent with future approaches to transfer pricing.
4. Be ready to explain differences between valuations.
As previously mentioned, tax authorities are paying close attention to these areas of business. That’s why you must be prepared to explain (and defend) differences in assumptions, selection of comparables, and anything else that comes into question, as the result may lead to valuation changes that will impact the amount of taxes you pay.
By taking proactive steps to better manage the intersection of transfer pricing and valuation, you can ensure they work in concert, minimizing financial risk for your organization. (Tweet this!)
Button Up Your Transfer Pricing & Valuation Strategies
If you’re struggling to manage the way your organization approaches transfer pricing and valuation, Valentiam can help. Our expert advisors specialize in developing innovative, personalized solutions that help your company both reach its goals and stay compliant. Let’s talk about the unique transfer pricing and valuation challenges at your organization and how we can help solve them.