Intangible Asset Valuation & Intercompany Sales In The Context Of COVID-19
Posted by Nancy Voth and David Talakoub on May 22, 2020
COVID-19 continues to impact the global economy. Businesses are working hard to adjust to the changing needs of their customers, suppliers, and employees while navigating new regulatory, financial, and operational challenges. While every industry, function, and geography will experience challenges unique to their sectors, the virus has also brought about problems that are shared by all businesses. Examples include workforce productivity issues, disruptions in demand, supply chain continuity fears, security risks, and more. Businesses are doing their best to continue normal business operations to the extent possible, while at the same time planning for an uncertain future.
Specifically, some multinational businesses, who in a pre-COVID environment intended to reorganize their structures by transferring intangible property (IP) between entities, may be wondering if these internal IP transfers should be executed given the highly uncertain economy and market volatility. This article seeks to address two questions:
- Is the current COVID environment too uncertain to permit intercompany IP transactions because the intangible asset valuations derived in this context are too speculative?
- How can management mitigate audit risk with respect to the values of IP transferred internally during these uncertain times?
Intangible Asset Valuation: Assuring Transfer Pricing Defensibility During COVID-19
Depending on the facts and circumstances of the transaction, intercompany IP transfers may require a valuation of intangible assets for book purposes, tax purposes, and/or for financial reporting purposes. Generally, a valuation analyst will base projections of future performance on the circumstances existing at the date at which the value of the subject interest is estimated (i.e. the valuation date). The future is difficult enough to forecast under normal conditions. What should one do with projections in the context of COVID-19? (Tweet this!) For intercompany IP transactions with a valuation date where the onset of COVID-19 was known and knowable (though its effects were far from predictable), the analyst has many tools with which to carefully develop an IP value that is defendable and not speculative. In particular, cost sharing agreements (CSAs) are an example of a valuation that cannot be postponed, even in the current COVID environment.
These strange times do not necessarily require new valuations methods and approaches, but rather merit a greater focus on best practices for key variables. While a careful analyst will consider all approaches, this article focuses on instances when the income approach provides the most appropriate framework. Under the income method, a business or an asset is valued as the present value of its future cash flows. Under this approach, in general, future cash flows driven by the asset are projected and adjusted for changes in growth, cost structure, etc. The present value of the asset is calculated using a discount rate which reflects the relative risk of the asset being valued and the time value of money. While the income method does not rely on past transactions or similar transactions, the estimated value it produces is very sensitive to the inputs in the model. As such, these inputs must be carefully determined and vetted, especially in the present environment.
Performance expectations and risks should be reflected in cash flows in the valuation model to the extent possible. In current circumstances, it may make sense to develop multiple scenarios and assign a probability to each. For instance, a best-case scenario may show a business’s recovery and return to normal operations during the summer of 2020. A worst-case scenario may suggest that supply chain disruptions will prevent a return to normal operations until mid-2022. Based on management’s expectations, these scenarios can then be weighted (e.g., 50% likelihood for early recovery and 50% chance of 2022 recovery) to determine a reasonable estimate of value.
For risk and uncertainty that cannot be modeled in the cash flow projections, the discount rate contains multiple levers that can be used to capture risk. We explore an overview of critical assumptions to be considered in valuation models in the article Financial Impact Of COVID-19: Valuation Modifications. Since there is overlap between risks that can be considered in financial projects and those that can be taken into account in the discount rate, care should be taken to avoid double discounting.
Mitigating Transfer Pricing Audit Risk
The first step to mitigating the risk associated with a transfer pricing audit is to test the model for sensitivity to changes in assumptions. Indeed, the OECD Guidelines in paragraph 6.160 suggest that sensitivity testing be presented as part of a company’s transfer pricing documentation, “…reflecting the consequential change in estimated intangible value produced by the model when alternative assumptions and parameters are adopted.”
Another step to mitigate audit risk is to document carefully what assumptions were made in the valuation and why. Often, by the time an intercompany IP transaction is audited, the company’s team members most knowledgeable about the transaction may have left the company or may not recall the rationale for each small decision made in a model. “Must-have” information to document includes the logic and details of the projections used, a description of how risks were accounted for, management’s perspective on reasonably foreseeable events and risks, and the probability of occurrence.
Management should also consider how best to structure the transaction itself to manage risk. For instance, companies could consider different payment timing, forms of payment, or the use of option values in contracts in order to potentially “true up” values if they should change. The OECD Guidelines in paragraph 6.183 state that independent enterprises may, in cases of high uncertainty, “…adopt shorter-term agreements, include price adjustment clauses in the terms of the agreement, or adopt a payment structure involving contingent payments to protect against subsequent developments that might not be sufficiently predictable.” In all cases, management should work with legal counsel to ensure intercompany terms and conditions are valid and enforceable.
Finally, management should be careful to coordinate all stakeholders, including tax, treasury, finance, accounting, and others, to ensure a smooth transaction. On a go-forward basis, the tax department will need to coordinate with finance and accounting to manage requirements for financial reporting obligations and testing for impairment of intangible assets.
In summary, intangible asset valuations should carefully consider how to incorporate current economic uncertainty into valuation model inputs. Furthermore, detailed notes and files should clearly and carefully document the basis for model assumptions. Considering the valuation tools available, it may not be necessary—or prudent—to postpone intercompany IP sales because of the COVID-19 pandemic. Clear and careful documentation of the model will mitigate transfer pricing audit risk, as will consideration of the type of intercompany agreement and payment terms that are most appropriate given the facts and circumstances of the transaction.
Any opinions expressed in this article are those of the authors, and not necessarily those of Valentiam Group.
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